In an economic environment characterised by divergent monetary policies and regulatory change, treasurers more than ever need to think holistically across currencies. Nowhere is this demand more insistent than when reviewing investment policy.

Amit Agarwal

EMEA Head of Liquidity Management Services, Treasury and Trade Solutions, Citi

James Lee

EMEA Sales Head, Technology, Media & Telecoms, Treasury and Trade Solutions, Citi

When in December 2015 the US Federal Reserve raised short-term interest rates by 25 basis points – the first rise in nearly a decade – it not only ended near-zero borrowing costs but also signalled that the world’s largest economy had at last turned a corner. The impact of that action was felt far and wide as equity markets quickly rose across Europe and Asia and USD strengthened against a basket of major and minor currencies.

The US central bank’s tightening of monetary policy also heralded a small change for the better for some investors as the two-year Treasury yield pushed past 1% for the first time since 2010. With only gradual increases indicated by US policymakers from now on, caution is the watchword: the Fed said in a statement that it would “carefully monitor actual and expected progress” towards its 2% inflation goal.

Meanwhile, on the other side of the Atlantic, the European Central Bank (ECB) maintained its accommodative course with Mario Draghi taking time in late January to staunchly defend the central bank’s aggressive monetary easing policy. Eurozone borrowing costs have dropped by 80 basis points since the launch in 2014 of the ECB’s quantitative easing (QE) package. The programme has now been extended until March 2017.

Taking the wider view

With two of the largest central banks on an opposing interest rate trajectory, divergence of monetary policy, with far-reaching consequences on both sides, it seems, is the new normal. This is the first time in a long time where we are seeing divergence in major central bank policy rates across the world, notes Amit Agarwal, EMEA Head of Liquidity Management Services, Treasury and Trade Solutions (TTS), Citi. Divergence, he comments, is a symptom of different levels of economic growth: the US is on an upward stroke whereas Europe is exhibiting growing pains and the China-led Asian emerging markets are slowing.

Of course, it is not just USD and euro that are affected, observes James Lee, EMEA Sales Head, Technology, Media & Telecoms, TTS, Citi. In Europe, the ECB’s stance has been mirrored by other currencies with Swiss franc (CHF), Danish krone (DKK) and Swedish krone (SEK) even going negative. Following the Fed’s rate rise, other central banks in LatAm and in parts of Africa also opted for interest rate rises. Clearly, treasurers must broaden the outlook of their currency and associated interest rate exposures.

With the expectation that the Fed will continue to tighten policy and the ECB to remain accommodative, divergence will only increase on the wider scale. But there are other elements to consider too. With Basel III and CRD IV, for example, the different jurisdictional interpretations of key regulations are creating additional challenges for bank and non-bank organisations alike. There is potential for conflict too between the as-yet undecided path of the EU regarding MMF reforms versus the already resolved US approach which will be implemented in October 2016. For investors the world over, this state of affairs demands attention.

The right approach?

“Treasurers have always reviewed their investment policies on a regular basis. But this has caused them to take a look at those policies from the ground up,” says Lee. Security of principle and liquidity remain primary concerns but whilst investment return is of secondary importance, in the current environment certain considerations must be attended to in order to ensure optimisation. Indeed, there is an arbitrage opportunity here, notes Lee. With USD offering a better return, companies using low, zero or negative rated currencies are seemingly at a disadvantage. But borrowing in a low rate environment and investing at a higher rate is a simple opportunity.

To ensure this is the right approach, treasurers need to consider their pool of currencies and if they are associated with USD they may consider leaving them in-country to get better rates of return, Lee explains. “Many corporates look to maximise liquidity and bring cash into the centre for maximum control and to enable them to invest it in the most economical way possible. But maybe they need to leave some currencies in the local market to minimise the cost of negative interest rates.”

Consideration ought to be given to dividend policy too, says Lee. Where a negative interest rate currency is held, it may be beneficial to dividend up to another company in the group, translating that cash into another currency to mitigate the cost of managing negative interest rates in that jurisdiction. The efficacy of this would depend on local rules around withholding tax. However, these may pale into insignificance as the corporate taxation agenda prepares to take a major new direction as the OECD’s reforming Base Erosion and Profit Shifting (BEPS) project comes to fruition.

Where companies artificially shift profits to low or no-tax locations where there is little or no economic activity, the level of corporation tax being paid is minimised. BEPS, supported by many governments around the world, aims to modernise international tax rules by revising the OECD’s existing Model Tax Convention and Transfer Pricing Guidelines. It is anticipated that these revisions will be completed and released by 2017. Before that, warns Agarwal, there will not only need to be a wholesale review of how treasury centres are managed and where they are located, but also how companies approach investments where their cash ends up in different locations and currencies.

With a full strategic review of investment policy advisable in order to extract the most value, Agarwal urges treasurers also to consider any such revision from a risk management perspective, paying particular attention to translation risk. On the one hand, putting a lot of liquidity into some of the emerging market currencies – Turkish lira (TRY) or Russian ruble (RUB), for example – may yield satisfying results as interest rates in those markets are at a very high level. But some emerging markets have seen devaluations of between 40% and 60% in recent months.

“Companies have to be mindful of their investment policy but also be conscious of their supply chains in terms of where cash is being generated and in which currencies they have appropriate currency translation risk hedges in place,” comments Agarwal. There may be natural hedges available if producing and selling in the same market, but in a global interconnected economy, the supply chains of the companies often tend to have buying and selling patterns in certain currencies. It is here, he notes, that substantial exposures are created which in the current environment “need to be seen in a holistic manner”.

Taking action

In terms of translating this understanding into investment activity, a firm grip on exposures is the essential starting point, says Agarwal. Major corporates and MNCs operating in almost every part of the world will have exposures to most currencies albeit by varying degrees. These companies may have good visibility of their cash across 80% of their market, these tending to reflect the most stable part of their portfolio. But in a volatile and divergent environment, he argues that robust forecasting strategies must come to the fore “so that even before they start building an investment portfolio, they know where their cash is, in which currencies, and where their exposures are”.

There has been a notable shift in the last few years that has seen increasing numbers of corporates opting for a more sophisticated in-house bank model, notes Lee. A key part of this structure is the visibility and control of cash that it brings. Control can come through automation of sweeps from local accounts into centralised locations, minimising or zero-balancing cash locally. Visibility comes from investment in various core systems (such as an ERP or TMS) but also in the deployment of bank proprietary solutions which not only deliver visibility but also assist with forecasting, allowing treasurers to manage their investments “in a much more structured and sophisticated way” and providing a more accurate line of sight for short-, medium- and long-term liquidity needs.

The combination of a stressed global economy, divergent monetary policies and the leveraging of technology has seen a partial shift by some corporate investors away from traditional investments tentatively towards those that might yield a greater return whilst upholding their policies of security of principle. Tri-party repos in particular have seen an uptick in interest (in both senses of the word) and banks such as Citi have responded to market conditions with the introduction of new products such as the 31-day, 60-day and 90-day term deposit options, which allow its clients to invest more strategically and potentially mitigate negative interest rates.

Stay alert

In the long run, keeping a close eye on the Fed and ECB is essential as their actions have far-reaching consequences. But Lee urges treasurers to pay heed to broader political themes. With the spectre of ‘Brexit’ (the UK’s possible departure from the EU) for example looming over the markets, the likely fallout of such an event will spread, potentially with significant bearing on the investment space.

In preparing the ground for control and visibility over cash and investments, Agarwal advises treasurers to use resources that are close to the action – including the banks – as the move towards reshaping investment portfolios gathers pace. Maximising returns whilst maintaining liquidity and security is a tough ask in today’s divergent economic environment. However, Agarwal believes that banks’ own balance sheet needs, their interpretation of regulatory reform and the pace of monetary policy change should be sufficient motivation for all parties to discuss strategic investment options and portfolio mix in terms of the right products, currencies, tenor and even geography.