From moving capital and managing foreign exchange to building partnerships with local banks, how should treasurers navigate emerging market risk and regulation?
Emerging markets have long been a critical part of the business mix and growth strategy of multinationals. For many, initial sales growth has been followed by acquisitions or has driven decisions to relocate production to emerging markets to match costs with sales growth. This trend is set to continue, despite the slowdown in global trade and mutterings of some multinationals retreating as domestic growth and interest rate hikes draw investment back to the US.
According to the Boston Consulting Group, some 300m additional households will enter the consuming class in emerging markets this decade. Populations in developing countries are also growing four times faster than those in developed countries so that by 2020, 6.4bn people out of 7.5bn people worldwide will be living in emerging economies.
Managing fast-growing trade in emerging markets is a top priority in corporate treasury at British ingredients maker Tate & Lyle. New consumers in China, Mexico, South Africa and Brazil are driving growth for the company’s high margin, speciality ingredients that includes brands like Dolcia Prima, a low-calorie sugar, and Claria, a “clean label” starch range, free from artificial ingredients.
“We are currently spending a great deal of time making our emerging markets treasury proposition as good as our developed markets treasury proposition,” says Oliver Whiddett, Head of Group Treasury at Tate & Lyle. “The business will look to make targeted acquisitions in speciality food businesses in emerging markets. This will drive treasury complexity and how we assess our local needs.”
Managing trade and investment in emerging markets ushers in a new level of complexity for treasury, which is responsible for financing, hedging and safely steering the company’s financial interests in these more challenging jurisdictions. Each country has unique risks, regulations and restrictions, be it around moving capital, managing foreign exchange or governing relationships with local banking partners. Different cultures and time zones add to the challenge. So where should fast-growing companies focus to ensure a strong emerging market treasury?
Get the FX right
Even if a corporation has a small exposure to emerging market currencies, exchange rate volatility can cause chaos, pushing up costs or evaporating margins. “FX plays a crucial role; get it wrong and it can have a big impact on corporate earnings,” says Gerald Dannhaeuser, Head of Corporate Sales in Asia for Commerzbank.
Corporates tend to have fixed hedging programmes in developed market currencies. But when it comes to managing FX risk in emerging markets, where hedging is expensive because of transaction costs and interest rate differentials, a bespoke and dynamic approach can work best.
“In emerging markets, a corporate’s hedging committee often decides to meet quarterly rather than have a definitive approach,” says London-based Adrian Williams, Head of Corporate Solutions at Commerzbank who counsels a nimble approach. “If markets are illiquid, treasury may think the market is too thin to get an effective hedge. In more dollarised economies, corporate exposure may be moving more in line with the dollar and treasury could better react to changes in the market by putting up costs. Nor may a team always know in advance what specific derivatives to draw on, like forwards or options.”
At Tate & Lyle, which hedges transactional FX exposure, reports in sterling and has its largest exposure in dollars, the most challenging aspect of currency risk is understanding where the company’s FX exposures lies in its supply chain. “In a business with integrated supply chains, unpicking FX exposure is complex. It can also overlap with tax rules around transfer pricing like, for example, which entity is expected to bear the commercial risks,” says Whiddett. “When a business is rapidly expanding, it could be that FX risk management is pushed down the list of priorities compared to building customer relationships or sales. But treasury has to keep up to speed to actively support the business, enabling its ambitions whilst ensuring that risks are managed to within acceptable limits.”
“When a business is rapidly expanding, it could be that FX risk management is pushed down the list of priorities compared to building customer relationships or sales. But treasury has to keep up to speed to actively support the business, enabling its ambitions whilst ensuring that risks are managed to within acceptable limits.”
Oliver Whiddett, Head of Group Treasury, Tate & Lyle
Companies with growing trade in China will have to navigate a complex and volatile currency environment. According to SWIFT, the renminbi was the fourth most used currency for global payments behind the dollar, euro and sterling in 2015. That was the same year that treasury teams woke up to renminbi volatility following the currency’s sudden devaluation by the Chinese central bank.
“Hedging renminbi risk requires a degree of sophistication,” says Dannhaeuser, explaining that corporations can hedge renminbi onshore, offshore or in the NDF market. Deciding whether to manage a renminbi hedging policy on a centralised basis from head office, or to delegate decisions to subsidiaries, is an important consideration.
“Hedging onshore requires an onshore presence, a greater level of documentation and administration,” Dannhaeuser says. Corporations have no administrative risk hedging offshore, but will need to balance this against basis risk. “Offshore and onshore renminbi are highly correlated so they move in parallel; it is not a perfect hedge,” he says, adding: “If corporates decentralise they can take advantage of onshore and offshore markets. In China we see most corporations with this two fold approach, hedging both from their headquarters, and using their local treasury centres to hedge onshore on the ground.”
But not all emerging markets have this flexibility. “The Brazilian real isn’t tradable so it could be cheaper for the subsidiary to do the hedging,” says Williams. “Here corporates can opt for a non-deliverable hedge offshore, or deliverable and settled in Brazil, pricing between the two differentials.”
Hub and spoke
How to structure treasury in emerging markets is the next question. In one model, multinationals are choosing to move their emerging market treasury to financial hubs in the region. Singapore serves Asia; the UAE serves Africa and the Middle East – and basing treasury in Miami serves markets in Latin America. It’s a model that establishes “policy level” governance and regulatory coverage, and solves issues around time zones and the working week.
“A hub and spoke model is fairly common during a company’s growth phase in emerging markets,” says Navinder Duggal, Managing Director, Global Transaction Services, at DBS Bank. “Typically, the hub will be located in an international financial centre that has a well-defined regulatory regime, provides easy access to sophisticated banking services, and has good access to liquidity and FX capabilities as well as the skilled manpower to support a regional treasury operation. At the same time, having people on the ground in the main sales or manufacturing locations allows improved implementation of treasury functions.”
He also observes that as companies become more proficient in emerging markets, so the local presence becomes less necessary. “For more mature industries, it is possible to operate entirely through a centralised regional treasury once the processes and responsibilities have been clearly established.”
In other cases, companies may operate a devolved approach, delegating control to local entities in more challenging countries owing to in-country regulations, complexity of markets or limitations in the financial environment. On a small scale, this could mean a team sitting “in country” to support banking and funding activities, says David Stebbings, Head of Treasury Advisory at PwC.
He notes, however, that integrating treasury activities such as payments and daily cash management in emerging markets into a centralised shared services environment can be a challenge. “It is more difficult, and probably less cost effective, to take cash activities in, say, Angola and put them into a shared services. In emerging markets it would be more likely that these tasks were done in country.”
It’s a challenge that leads him to favour a tiered approach. The first tier would be focused on developed markets where risk and cash management activities can be more centralised, hedging more mechanical and processes more easily automated. Subsequent tiers then comprise less developed and emerging markets where treasury activities require more diversity and flexibility. In lower tiers, it may not be possible to hedge risks or move cash very easily. The actual standards will often depend upon regulation, costs and the banking infrastructure in relevant countries.
Stebbings adds that many emerging market countries should move up through the tiers over time. “For instance, in India treasurers are less restricted in how they can manage FX and cash risk than in the recent past, although there are still a number of significant constraints,” he says.
By ensuring broad expertise, product offerings and geographies in core banking relationships, treasuries can often tap the subsidiaries of their core banks in far flung jurisdictions. Yet this is not always possible, and local bank relationships also bring local market and industry expertise. Local banks also fulfil particular requirements, like cash payments to a local workforce, or providing a source of local funding if strategy has focused on limiting foreign capital going into an emerging market.
Although Tate & Lyle counts ten relationships in its core banking group, including Japanese, US and European banks, the company has still built strong local bank relationships in Brazil and South Africa. “We have a good diversity in our core banking group. But there are some areas where these banks don’t operate and we need to branch out and build contacts with local banks,” says Whiddett, who brought valuable bank contacts in emerging markets to Tate & Lyle when he joined six months ago from mining giant Anglo American.
It’s an experience that leads him to advise treasury teams to develop banking relationships that are strong enough to weather the bad times, not just the good. “If the ratings drop and the cash flows fall away, there are never so many banks knocking on the door,” he observes. Good documentation is also important: “You think you’ll never need that banking clause, but then it turns out that you do.”
Working with banks in emerging markets adds a new level of counterparty risk. The mere thought of a local banking partner being unable to repay deposits made by its corporate clients, or renew a revolving credit facility, is enough to rattle boardrooms. “Global banks are stronger and less likely to go under,” says Stebbings who advises treasury teams to approach only “top end local banks”, carefully assess the extent to which local partners compliment their business, and be alert to early warning signs of bank distress.
Sovereign downgrades are a common hazard that can increase borrowing costs, shrink liquidity and put pressure on local banking systems. Global clients of Brazilian banks had a volatile ride when Brazil was downgraded to junk status in 2015, taking the credit rating of many local banks with it. Today, treasury at Tate & Lyle, which sets a strict risk appetite for the company in each country, is preparing for the impact on South African banks of a similar downgrade to the country’s credit rating.
Local banks’ ability to integrate technology is another consideration. Local banks may not have electronic banking platforms, relying instead on manual, administratively-heavy processes. This is in contrast to regional treasuries being “quite lean and having adopted technology to automate many of the functions,” observes DBS’s Duggall. He adds: “Corporations will need banking partners that can integrate seamlessly with their treasury operations, and can provide timely electronic information to enable faster, and more effective decision making.”
It’s a point that Emre Karter, Head of Treasury and Trade solutions at Citi, expands upon. The treasury trend towards automation, standardisation and centralisation doesn’t stop at the door to emerging markets. Given the challenges of maintaining visibility and control while partnering with different banks in multiple, risky markets, it is more important than ever.
Bank-agnostic services like SWIFT, that enable corporates to exchange information with multiple banks using common channels and standard formats, have become the norm. Treasury in emerging markets needs to ensure it is working with banks that are adapting to this environment and can go beyond single-bank proprietary solutions to address global, multi-banking needs.
“Corporations don’t want to manage bank relationships country by country,” Karter says. “There is a shift towards streamlining bank relationships, whereby companies can plug-and-play bank connectivity between their home banks and network banks. Many businesses want better integration and now enterprise resource planning (ERP) and treasury management systems (TMS) are allowing this between banks, as well as host-to-host solutions for timely information and decision making in near real-time.”
Rules and regulation
Navigating regulation in emerging markets is another priority. In an attempt to curb capital outflows or shore up foreign exchange reserves, governments in emerging markets go to regulatory lengths to stop companies taking money out of the country. For corporations with exposure to China, treasury needs to be prepared for policy makers to tighten capital controls with a suite of regulations when the pace of renminbi outflows accelerates.
Currency controls recently caused havoc in Nigeria’s auto sector, where the likes of Ford, Toyota and Volkswagen have developed assembly plants with local partners. Currency policies and associated import controls, set up to conserve hard currency and boost local manufacturing by forcing Nigerians to buy local, starved the sector of inputs and led to a collapse in supplies of product lines from glass to rubber. Industry body OICA estimates that total new vehicle sales in Nigeria dropped by more than half in 2015 compared to 2014.
“Exchange controls demand day-to-day management and bring complexity against a political backdrop,” says Karter. The problem manifests particularly in cash management, where cash trapped due to sudden, or unexpected currency or capital movement restrictions impacts access to working capital across emerging markets and through supply chains.
PwC’s Stebbings says this leaves some treasury teams deciding to keep “as little cash as possible in the local market – just enough to meet local needs, taking every opportunity to reduce surpluses.” Some corporates request that receivables be paid in another currency altogether, “collecting revenues offshore” with payments made in US dollars to circumvent the currency restrictions. In bilateral trade relationships, where a company both sells into and buys from an emerging market, trapped cash, currently owed as a receivable, could be used to settle accounts payable in that country.
A clear view of what cash the business needs, often difficult because the business is expanding, is crucial. “Trapped cash is the kind of instability that triggers liquidity problems and it demands quick thinking to manage distribution and supply chains,” says Stebbings. “We are seeing key emerging trends from our clients as they get to grips with the process. They are using technology, tightening governance and managing their working capital to improve visibility and control.”
Other regulation may be more mundane, but just as frustrating. Cross-border payments typically require additional documentation and, if mismanaged, can lead to significant delays in receipt of funds. The use of cheques, common in some markets, also poses challenges around the timely realisation of funds. “The regulatory environment in emerging markets does change fairly often and corporate treasuries need to constantly review and adapt their plans. At times, the changes can be quite sudden and the interpretation of the new requirements may need further clarification with the authorities,” says Duggal.
Tate & Lyle’s Whiddett pauses before considering the most important criteria for a strong treasury proposition in emerging markets. “Take, for example, a new customer in an emerging market,” he says. “If treasury is involved halfway through the process, putting in place the infrastructure needed becomes rushed, and there is a sub optimal outcome. Ideally, we are one step ahead of the markets the company is focused on. We’ve already looked to our banking group or started conversations with new banks, and we are already across local regulations, capital restrictions and our hedging options.” Anticipation, it seems, is the magic ingredient.