When Your Home Currency Loses Value

by Moody's Investors Service, 15 December 2011

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topics:
Risk Management

tags:
currency depreciation foreign exchange foreign-currency denominated debt

Depreciating domestic currencies can create credit risk for corporate issuers through 1) foreign-currency denominated debt and 2) net imports.

Debt denominated in foreign exchange

Upon depreciation of a domestic currency such as the Indian rupee (INR), in which most Indian issuers denominate and report their financial results, the issuers’ balance of foreign-currency debt increases in terms of reported currency and consequently results in higher leverage.

Unless the firm must refinance the debt in the near term, the diminished value of the local currency will result in only a translation loss on reported results and in most cases does not affect EBITDA. Interest payments will, however, increase and thus lower the firm’s interest coverage.

Net imports

A weakened domestic currency also raises the cost of imports. Companies with strong pricing power can pass on the increase in cost to buyers—either at home or abroad. Nevertheless, in many cases, the issuer can pass through none, or only part of, the increased expense on imports. Without complete pass-through, such losses weaken the company’s EBITDA, cash flow, and credit metrics.

The adverse impact on credit metrics intensifies for low-margin, highly leveraged firms, which typically have little room to absorb sustained currency shocks. Use of hedges on cash flows can, however, minimize the risks but are expensive.

Measuring a company’s vulnerability

To measure a company’s vulnerability to a depreciation of its reporting currency, we focus on two key risks: 1) decline in EBITDA and 2) increase in debt and interest expense.

Risk of decline in EBITDA. This risk arises mainly for net importers unable to pass through their full increase in costs caused by a depreciating local currency. The higher the proportion of net imports to EBITDA, the higher the risk.

To assess the magnitude of the risk we look at the ratio of net imports to EBITDA. For example, with no ability to pass through higher input costs, a company with net imports to EBITDA of 3x will experience a decline of 30% in its EBITDA for every 10% depreciation in its domestic currency.

Risk of increase in debt and interest. This risk arises from a firm’s use of foreign-currency-denominated debt in its capital structure, which has become increasingly common for emerging Asian companies because of lower costs of capital in international capital markets compared to rates in domestic markets.

We measure this risk by comparing the level of foreign-currency debt to total debt, but find that the risk is smaller in magnitude than potential hits to EBITDA for net importers. For instance, a company with all of its debt denominated in foreign currency will experience an increase in debt and interest cost of only 10% on a 10% depreciation in its domestic currency.

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