Risk Management

The storm before the calm

Published: Sep 2013

As companies become more global in their operations and outlook, they are exposed to increased levels of foreign exchange (FX) risk. This may be in the form of an obligation to pay a supplier, or a foreign currency payment the company will receive from a customer. These payments are subject to fluctuations in currencies, which have become more volatile and uncertain since the global financial crisis and its consequences.

“There have been powerful forces at work in the global financial system,” says Robert Minikin, Senior FX Strategist at Standard Chartered Bank in Hong Kong. “Investors in specific markets have been heavily deleveraging; outflows from some types of bond funds are the largest on record in terms of weekly data.” Volatility is occurring across all asset classes, including FX, and corporate treasurers need to be alert to market developments and aware of liquidity conditions as well, he adds.

Recent developments

The internationalisation of China’s currency, the renminbi (RMB), is an important change of the past few years. In July, a survey by Standard Chartered Bank and treasury research company EuroFinance found that 73% of treasurers think the RMB will be the third most important currency (behind the US dollar and euro) within ten years. Of the 307 respondents, optimism was highest among corporates who already use at least one offshore RMB product: 79% think the RMB will be global number three or better. That compares with 70% for those who don’t currently use the currency.

However, the rise of the RMB is not as straightforward as it could be. In June, money market liquidity tightened significantly in China, with inter-bank rates pushing notably higher. This move was much larger than the usual seasonal spike seen in the middle of the year and, in the view of HSBC Asian FX strategists, could start to have more negative consequences for the RMB.

“We have been turning more cautious towards the RMB, and as liquidity has tightened onshore our caution towards the currency has increased. We expect USD/RMB spot to move higher and think USD/RMB FX forward curves will stay supported,” says a research note issued in June.

The sharp move upwards by China’s money market rates has been caused by a combination of seasonal factors, tighter regulations, structurally high leverage and a policy focus, which has shifted away from providing seasonal liquidity to make market participants focus on and try to deal with the root causes of this tightness. China’s money market liquidity tends to tighten towards the end of June when the China Banking Regulatory Commission (CBRC) checks banks’ loan-to-deposit ratios (LDRs). Additionally, says HSBC, corporate tax payments in July and seasonally slower FX inflows contribute to tighter onshore liquidity, as seen in a typical widening in the spread between money market funding costs (seven-day repo) and the one-year benchmark deposit rate in June.

Another contributor to the tighter RMB liquidity picture is a decline in FX inflows. In May, monthly FX purchases by banks and the People’s Bank of China (PBoC) slowed significantly, from an average of RMB 377 billion in the first four months of 2013 to just RMB 67 billion. “This suggests the regulatory changes to curb speculative and hot money inflows booked as real export/trade financing activities are taking effect,” says HSBC’s research note.

Ivan Wong, Head of Corporate Sales, Greater China at HSBC, says the US dollar rally has been putting significant pressure on Asian currencies in the past few months, with the exception of the RMB. “Corporate customers with operations in China are generally still bullish on the RMB in the long term. There has been some concern of late about a liquidity crunch and economic slowdown, but most companies believe the RMB will pull back a bit but will still be at a good level to enter into hedges,” he says.

“The internationalisation of the RMB is a long-term policy and as it gets more traction there will be greater demand for RMB not only for trade settlement but also for investment and as a reserve currency. Our customers recognise that the Chinese government has realised there was an imbalance in the growth in China in the past and that the new government intends to rebalance and channel economic energy into more productive sectors. People are generally very positive about these moves for the long run.”

Dealing with volatility

In addition to the rise of the RMB, there are other, more immediate forces at work in the currency markets. The US dollar, which has been on a downward trend for some years now, seems to be recovering, sending some other currencies into sharp declines.

The US Federal Reserve’s policy of quantitative easing (QE) has had a marked effect on some currencies. Before a Congressional panel in July this year, Fed chairman Ben Bernanke said the institution’s proposed timetable for tapering its $85 billion a month bond-buying programme was not “on a pre-set course”.

Bernanke said the Fed anticipates it will be appropriate to begin to moderate the pace of the $85 billion asset-purchase plan “later this year” and end it “around mid-year” in 2014, if the economy evolves as forecast. If economic conditions were to improve faster than expected, the pace of asset purchases could be reduced “somewhat more quickly”. However if market conditions such as employment or inflation were less favourable, easing would continue.

“We are in an unusual market context,” says Standard Chartered’s Minikin. “There is a question as to how well-equipped treasurers are to deal with this environment.” An important issue is to try to understand what type of volatility can be expected from the financial markets going forward. “We have seen a big jump in realised volatility and implied volatility (in the options market). There are extreme moves in particular currency crosses and powerful day-to-day swings.”

Minikin says it is difficult to be certain how long such volatility will last. The sudden surges in some currencies were due to the prospect of Fed tapering only shortly after the news surfaced of an aggressive QE programme in Japan.

Rahul Badhwar, Head of Corporate Sales, Asia ex-Greater China at HSBC, agrees that it is a very challenging period for corporate treasurers. “There have been too many forces at play on the FX market. The correlation with various market events is very high and it is tough for corporates if they have exposure to particular currencies,” he says. “An event that is unrelated to a certain currency may drive it up or down.”

Even corporate treasurers who do not have sophisticated trading networks and FX strategies should understand that “the world is now highly connected”. For example, a domestic business in Thailand that does not export goods and borrows only in Thai baht may think that what happens in US Treasuries has no impact on it. However, says Badhwar, US Treasuries have an impact on yields in Asian commercial paper. “Companies that think they have no FX risk have to realise that the market is highly interlinked. US investors, for example, will buy Thai debt. Across the world organisations are investing in each other which has created global flows and is increasing correlations that didn’t exist ten years ago.”

James Wood-Collins, CEO of Record Currency Management, an independent currency manager, says any hedging decision must be made with “a clear view of the objectives of the programme”. Corporates face two types of FX exposures: cash flow versus cost, where a manufacturer, for example, produces goods in one country and sells them in another country that has a different currency; and balance sheet exposure, where the funding structure of the corporate is in a different currency from the denomination of a liability.

“The issues and challenges for treasurers are focused on ensuring that the objectives are understood, rather than how a particular hedging programme should be implemented. Corporates have to decide how much of their revenues they should hedge. Sometimes treasurers can focus too much on the losses that are attributed to a currency hedging programme and fail to see that there is a gain – they are offsetting an underlying exposure.” While treasurers are happy when a hedge pays out, they are often uncomfortable with the cost of hedging. “There are times in the market when FX options look historically cheap or expensive, based on how volatility is priced. Treasurers always have to take a view versus the rest of the market.”

Corporates have not been confident about the economic outlook for the past three years, says Sean Yokota, Head of Asia Strategy at SEB in Singapore. The stop-and-start nature of recovery has dampened expectations of growth and heightened uncertainty. “The prospect of a possible change in the US Fed’s QE programme, for example, has led corporate treasurers to become even more conservative.”

New strategies needed

Those corporates involved in emerging markets (EMs) have even higher levels of currency risk. “If a corporate has money in EMs, compensation for the currency risk would usually come from higher growth and profitability, or from higher yields. But with US rates rising, EMs don’t look as attractive as they once did,” he says. Volatility in EMs is also heightened by redemption pressures from investment funds that are pulling money out of these markets because their performance is declining.

This point is highlighted by HSBC’s Badhwar. With US Treasury yields around 100 basis points (bps) higher than a few months ago, investors are rethinking their EM strategies, he says. “Investors are finding that many of these markets are not very liquid and they cannot get out of them very easily. The capital outflows cause a problem in Asia because in many countries the amount of investment in the stock or bonds markets by overseas investors can be as high as 30%. When that money leaves the country it puts pressure on the currency.”

Companies operating in EMs have substantial currency exposures, says Petter Sandgren, Head of Markets Asia at SEB. “The increased volatility means most corporates understand that they need to hedge their currency exposures in different ways. They have to be strict about financial policies and follow them closely, even if it implies higher hedging costs.”

The problem for many corporates, he adds, is that unless they are very big they don’t have the resources to have competence in FX hedging and treasury management in individual subsidiaries. “There is a growing trend for corporates to manage currency exposures in the head office or regional treasury centres (RTCs), and to do the hedging on behalf of the subsidiaries. Another option is to use the local currency internally, for example the parent company will invoice in its subsidiary’s local currency, which moves the currency exposure from the subsidiary to the head office.”

Much of this trend has been driven by the reforms in China, which have created an offshore yuan, the CNH, to enable companies to accept onshore yuan payments from Chinese importers and then change that into US dollars at a more attractive offshore rate. In markets with high interest rates, corporates need to strongly control risks and take into account the real cost of doing business in these markets. SEB’s Yokota says: “Many corporates are looking to produce goods in the places where they are selling those goods. The easiest way to hedge currency exposure is to move production to the country in which you are selling those goods.”

Most corporates use FX forwards or FX options to hedge currency risk. An FX forward is an agreement to purchase or sell a set amount of foreign currency at a specified price for settlement at a predetermined future date, or within a predetermined window of time. These instruments help the user to manage the risk inherent in currency markets by predetermining the rate and date on which they will purchase or sell a given amount of FX. Treasurers use them to: protect the costs of products and services purchased overseas; protect the profit margins on products sold overseas; and lock in exchange rates as much as a year in advance.

An FX option is a derivative financial instrument that gives the owner the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. Treasurers primarily use FX options to hedge uncertain future cash flows in a foreign currency. The general rule is to hedge certain foreign currency cash flows with forwards, and uncertain foreign cash flows with options.

In 2010 treasury systems supplier SunGard conducted a global study to benchmark FX exposure management practices and FX risk management results. It believed one of the fundamental challenges companies faced as they sought to optimise FX exposure management resulted from a lack of standard processes, uniform policies or other benchmarks to define successful programmes.

The study of 275 finance executives across a diverse set of industries, found that 59% of companies had experienced unexpected, material FX gains or losses over the 12 months to May 2010. It found that difficulty in quantifying exposure data, gaining timely access to data, and achieving data confidence were exacerbating the challenge of forecasting and managing FX risk, driving companies to adopt automated FX management and risk solutions.

Many of the companies surveyed used manual accounting processes to calculate and monitor their FX exposure, thereby increasing their risk for error. “As a result, these companies lack confidence in the data they use to make risk mitigation decisions, increasing their susceptibility to unexpected FX losses or gains,” said the SunGard report. Wide swings in currency and market conditions, which continue today, were compounding these issues. SunGard claimed corporate treasuries should gain more reliable data and increase process automation. FX management solutions would help treasurers achieve this goal by aggregating and modelling data from various sources to identify exposures across the balance sheet, helping them make better hedging decisions and decrease their FX risk.

Then and now

Wood-Collins says the FX environment is very different from that of the pre-crisis years. “Rather than having steady, long-term moves in a currency we now see relatively little movement followed by sudden dislocations. This is a different environment, but the principal challenges remain the same for corporates – to decide the objectives and expectations of a hedging programme, backed by a large degree of realism.”

Standard Chartered’s Minikin says forward planning is required and that corporate treasurers need to anticipate hedging requirements and understand market exposures. “In this environment there can be very abrupt and unexpected FX swings. This forces treasurers to be very alert to specific market exposures and cash flows. They have to anticipate their hedging requirements and understand that their ability to trade at a specific level may be short-lived.”

Going forward, he says, there should be “more order” in the currency markets. “We have to be aware of the underlying economic volatility behind the volatility we see in the capital markets is not that great. Our forecasts for the US are broadly benign; we think there will be 1.8% growth this year and 2.7% in 2014. The US economy is ticking along and inflation is not a big problem. The volatility in the financial markets is not justified by the economy or economic policy. Over time, I think we will gradually edge into a more orderly market environment.”

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