Foreign Exchange: Dealing With Volatile Currencies

Pity Japan’s exporters and other companies that bill in U.S. dollars but pay salaries and other expenses in the local currency. The yen has just hit a 14-year high of 85 to the dollar. That’s an appreciation of around 10% over the past year, meaning that dollar earnings in yen terms have now been slashed by a tenth in value.   

It’s a story that’s becoming more and more common across Asia. The U.S. dollar is also weakening against the Singapore dollar, the Malaysian ringgit, the Thai baht, the Indonesian rupiah – any currency you can think of save the Hong Kong dollar, which is formally pegged to the greenback. Even the Chinese renminbi is appreciating, albeit not as fast as other currencies because the government allows it to fluctuate only within a narrow band.     
In light of the falling US dollar, using alternative currencies in settling trade has become increasingly appealing. The People’s Bank of China has signed bilateral currency swap agreements with six other central banks in Hong Kong, South Korea, Indonesia, Malaysia, Argentina and Belarus. The move can potentially inject RMB650 billion in renminbi liquidity into the financial systems of those markets. In July, China started an experiment allowing companies in certain Chinese cities to bill companies in ASEAN, Hong Kong and Macau in renminbi.   
But these are baby steps. Even if the RMB becomes an international currency of trade like the U.S. dollar and the euro, it will not solve the problem facing many companies: the volatility of foreign exchange rates, something that looks like it’s going to be a fact of business life in the post-crisis world.
It’s the dollar that’s falling today as the U.S. struggles with its frightening deficits, but it can very well be the euro’s turn tomorrow and the renminbi’s the day after, if prognostications about asset bubbles building up there come to pass. What is the CFO to do?
Making a checklist
The goal is to minimize foreign currency risk today and in future, which means putting a long-term currency management system in place. FX hedging, while expensive, is certainly one of the options, along with non-deliverable forward (NDF) contracts, for restricted currencies like the renminbi, and natural hedging, where the currencies of revenue are matched as closely as possible with the currencies of expenses.  
To figure out which option or combination of options works best for your business, every company needs to evaluate what risks need to be protected, and the company’s actual level of exposure.
Transaction exposure is amongst those considerations. Multinationals also need to keep in mind their assets and liabilities, which include accounts receivable and accounts payable that are denominated in foreign currencies. With purchase orders, the order’s value may change if the exchange rate changes before the company receives payment.
Another consideration is translation risk, where a company with a foreign subsidiary would have to translate that subsidiary’s balance sheet and income statement into the company’s home currency come financial reporting time, an exercise that can make P&Ls and balance sheets very volatile affairs, particularly with quarterly reporting. Lastly, planning against competitors may mean that your competitor’s decision to hedge or not may enable them to offer their product more cheaply.

Hedges and NDFs

While banks encourage businesses to utilise hedging, the premiums associated with it are an expense that some companies may be unwilling to pay. Remember, though, that hedging can be part of a package of bank services that may include commercial, transactional and investment banking. As such, the company may be able to negotiate competitive pricing not available to others.
Hedging is useful at the project level, ensuring a good accounting outcome because it can minimize forecast errors if payments or receipts are certain but the timing is undetermined. Ease of cash flow and immediate versus long-term returns will be a serious consideration when it comes to using this financial instrument.
But businesses that choose this option should ensure that the future currency rate agreed upon is achievable, not too far from the actual spot or the forward rate, in order to reduce unwanted speculation in the relevant currency pair. The aim is to manage foreign exchange fluctuations, not to make money off them (though that can be a nice by-product), so speculative elements in the hedging exercise should be kept to a minimum.
Companies that deal in the renminbi are hamstrung in this area because forward FX trading is not allowed in the yuan. A non-deliverable forward contract is one answer. Contracts in an NDF market are settled in cash, with the profit or loss being the difference between an exchange rate agreed on the fixing date and the prevailing spot rate on the settlement date. Since the NDF is a cash-settled instrument, the contract’s notional or face amount is never exchanged, only the difference.
The benefits to an NDF are that they are off the balance sheets because they are “non-cash” products. And because the principal sums do not move, they carry lower counter-party risk. The restriction is that both counterparties are committed and obliged to honour the deal because it is a committed short-term instrument, but either party can cancel an existing contract by entering into another offsetting deal at the prevailing market rate.
Natural hedge
For those wishing to bypass the premiums associated with hedging, a natural hedge can also help a business reduce risk in various ways. Some companies have chosen to centralise their treasury operations or consolidate data in a datawarehouse from multiple sources, so that the treasurer can gain a clear picture of company-wide transaction flows. This way, it can be determined where the transactions can offset each other, and the treasurer then has enough information to create natural hedges. Residual risk remains if revenues and costs do not exactly offset each other, but the much of the exposure is still greatly reduced.
An example of this would be a US exporter who, in wanting to avoid the risk of the RMB appreciating against the US dollar, chooses to open a factory in China. By adopting the RMB as the primary settlement currency and holding assets in RMB, the company would able to maintain a purely RMB-based balance sheet that doesn’t have to be translated into US dollars, as would be the case if it maintained its production line in the US while trading within China.
What’s more, the business could then break into the local markets and sell directly in the country of production, thus paving the way for future expansion and avoiding the need to exchange currencies altogether.
This would be a good countermeasure against China-based businesses who wish to conduct only in RMB, which would serve to shift the risk of exchange rate volatility to their overseas counterparts. Settling transactions in RMB would also increase the pricing power for Chinese corporations. At this stage, the use of this currency for trade settlement depends mostly on which counterparty has more leverage in the buy-seller relationship.
Another benefit to the adoption of the RMB as a trade settlement currency is that the People’s Bank of China and China’s tax bureau will offer tax rebates as an incentive for companies to invoice in RMB. In August, the National Tax Bureau announced that the administrative rules for tax rebates in RMB have been finalised and are due to be implemented. Currently, Chinese exporters are enjoying tax rebates from local tax bureaus for the amount of export goods settled in US dollars.
Another example of natural hedging would be the opening of a subsidiary company in the country of interest and borrowing in the local currency to finance operations. Even though the interest rate may be higher than in the home country, the parent company will have reduced FX exposure if it matches the debt payments to expected revenues in the local currency.
An additional alternative worth investigating would be to privately maintain a long-term contract with foreign suppliers. By agreeing to keep the exchange rate constant despite the market fluctuations, both supplier and buyer will benefit from the stability of a pegged rate and thus  enable better payment and receipt forecasting. 
Finally, with a falling US dollar and appreciating RMB, there may be wisdom to be learned from major manufacturers that are shifting their production lines back to the US. Among them are NCR, General Electric and Farouk Systems, maker of a popular line of hair-care products, which made the move to Texas from South Korea and China this July.
In addition to gaining greater control over distribution, inventory and quality, the company’s founder Farouk Shami also cited increased costs of transportation a factor in the move. Despite the fact that the lowest wages offered by the company, at US$10 per hour, will be US$2.75 higher than the federal minimum wage, Farouk will still manage to lower costs with productions in the U.S., and save US$500,000 per month fighting the Chinese-made counterfeits of his products. And his business no longer has to pay import duties or contend with foreign currency on the factories’ balance sheets.  
Pulling up stakes like this, of course, is a radical move to take, involving a complete rethink of the business model and many other factors in addition to mitigating foreign exchange exposure. But in the post-crisis world, every business should be willing to consider all possibilities as it navigates globalised environments whose rules are still evolving.
About the Author
Angie Mak is online editor at CFO Innovation.

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