One of the most discussed FX subjects in corporate treasury at the moment is how to understand and also mitigate specific translation risk. This might come as a surprise, as in the past firms tended to manage most categories of translation risk only passively, and whatever hedging did occur was only through necessity. This is because corporate treasuries were keen to prevent losses on the shareholder’s equity (capital) account, wanted to protect its credit rating or the exit value of a specific sale of an asset, for example.
This passive approach towards translation risk for fixed asset items, eg buildings and equipment, by and large, continues to be unchanged. It makes sense thanks to factors such as hedging costs due to interest rate differentials and changes in exposure value due to FX being predominately recorded in the cumulative translation account (CTA) within shareholder’s equity, in addition to the general view that, over the long run, exchange rates are mean reverting. Hence, hedging can potentially impose a negative impact on cash flows.
Although applying the theory of mean reversion as a basis for translation risk policy certainly has merit, recent emerging market (EM) volatility should flag caution to its validity, especially for those corporations who adopt a similar approach and have significant translation exposures in the emerging markets.
But then, what has been the catalyst for change? What type of translation risk is of concern? A change in the market environment, led by a strong USD cycle and higher FX volatility, has triggered a significant number of discussions among corporate treasurers relating to intercompany loans – especially in the emerging markets (EM). Specifically, these discussions have centered upon how intercompany exposures have impacted, or can potentially impact, earnings at both the subsidiary level and in consolidation at the parent level.
Furthermore, the breach of local capitalisation rules, potential regulatory requirements stipulating the need to re-capitalise the local subsidiary due to FX losses, as well as tax consequences have also raised questions. Cause and effect vary from firm to firm, but frequently subsidiaries have experienced difficulties in raising local EM working capital. This may be due to local regulations, lack of EM liquidity or other associated costs.
Under these conditions, many subsidiaries have turned to the parent for financing, often in hard currency, as this is perceived to be the most cost-effective solution. This method of financing is by no means uncommon and has been practiced for years by global corporate treasuries. So then what is the concern?
In practice, there really should be no concerns as translation risk is hedged either by the local subsidiary or parent, or where the funding is designated as long term in nature (and as a consequence changes in value due to FX would stay in CTA). But problems have surfaced when neither of the above applies and where the hard currency loan from the parent remains either partially or entirely unhedged. Under this scenario, all changes in the value of the liability/loan due to spot FX would impact the income statement of the subsidiary and, ultimately, the parent. Unfortunately, a number of corporations are experiencing the latter case and as a result have seen large and unexpected losses in their earnings.
Consequently, many treasurers have recognised the need to re-examine their current FX policies. For many, this exercise is not limited to translation exposures but rather encompasses a broader scope of FX risk management. The goal being to assess if current risk management practices are actually aligned with company objectives. A good place to start may be with the EM.