At the 3rd CFO Innovation Indonesia Forum in Jakarta last week, one of the hottest topics of discussion was financial risk management – specifically, how to deal with foreign exchange volatility. Like a number of other Asian currencies such as the Malaysian ringgit and the Indian rupee, the Indonesian rupiah has been very choppy against the US dollar in the past 12 months.
At one point in September last year, the rupiah weakened to more than 14,500 against the USD, from the 13,000-level in April, then retraced its fall back to 13,000 in October. “The currency strengthened 12.6% from September 30 through end of February 2016,” said Winang Budoyo, the Chief Economist of CIMB Niaga Bank who spoke at the Jakarta forum.
Other currencies in Asia also experienced the same up-down, up-down-again wild swings, testing the CFO’s mettle in forecasting, planning and budgeting. The see-saw ride is unlikely to become less dizzying this year as the United States continues to raise interest rates, even as the European Union and Japan experiment with negative rates.
“Levels of uncertainties in 2016 are anticipated to be similar to what was seen in 2015,” according to the 2016 Global Foreign Exchange Survey carried out by Deloitte, which polled 133 corporations around the world (15% in Asia Pacific). “The ability of corporations to manage currency risk effectively will therefore continue to be tested.”
The most logical course of action is to eliminate or at least limit the company’s exposure to foreign exchange risk. But that is easier said than done
Matching cost with revenue
Finance functions are going to be particularly tested in countries where the authorities require companies to hedge their foreign currency liabilities. In Indonesia, the central bank requires non-bank borrowers to hedge at least 25% of the difference between their foreign currency assets and foreign currency liabilities falling due in the following consecutive three-month periods.
They are also required to maintain a minimum 70% liquidity ratio of foreign currency assets to foreign currency liabilities that will mature in the next three months.
So how are CFOs in Asia dealing with foreign exchange volatility?
The most logical course of action, of course, is to eliminate or at least limit the company’s exposure to foreign exchange risk. But that is easier said than done.
It is possible for companies whose costs and revenues are both in the same currency. They should just stay away from borrowing in foreign currencies, even though interest rates on US dollar debt is still super-low – and the cost of borrowing in yen and euro are likely to go lower as their central banks push rates to negative territory.
But often, companies cannot avoid FX exposure. Oil, coal and other commodities are priced in US dollars. Aircraft, machinery and other equipment are priced in foreign currencies, as are spare parts and semi-processed materials. And suppliers typically bill in US dollars, which is still the overwhelming currency of choice for cross-border trade.
But the Chinese renminbi is internationalizing and is much less volatile against other Asian currencies, despite Beijing’s policy missteps that invited hedge fund attacks.
Jatin Brahmecha is CFO of Godrej Consumer Products, the second-largest provider of home care and personal care products in Indonesia. The company is now paying Chinese suppliers in renminbi. “That has reduced Godrej’s risk on the USD,” he said in a presentation on Effective Working Capital Management at the Jakarta conference.
Brahmecha and other CFOs are also looking to source locally, if they can find reliable domestic suppliers with good-quality products in the needed quantities and delivered on time. And long term, the ultimate solution is to produce goods in local assembly lines.
This is the strategy of the CFO of an automotive company that recently entered the Indonesian market. The firm currently imports passenger and commercial vehicles, forcing price changes when exchange movements reach a certain magnitude. Passing FX exposure on to customers risks negative effects on sales and customer loyalty.
“Surprisingly, only around half of respondents use natural risk management techniques such as cash-flow netting and exposure matching”
Quality control, product sophistication, infrastructure and specialist skills are issues in Indonesia, however, as they are in other developing economies. It will take some time before companies can totally or substantially localize their production lines in most places in emerging Asia. And some companies – distributors of mining vehicles, for example – will always have FX exposure because importation is their business model.
Natural risk management
What about hedging? In the Deloitte survey, 89% of respondents said their company hedges FX exposure through derivative instruments, mainly FX forwards and non-deliverable forwards. “Surprisingly,” notes the report, “only around half of respondents use natural risk management techniques such as cash-flow netting and exposure matching.”
Because most companies use derivatives, says Deloitte, “opportunities seem to exist to increase usage of natural hedging to reduce derivatives-related costs.” These missed opportunities include matching costs and revenue in the same currency in the same entity, which is not practiced by 42% of respondents, and netting of exposures across entities (not done by 54%).
One reason why CFOs are not employing this form of natural hedging may be lack of visibility into FX exposures and concern about the reliability of forecasts. Indeed, 56% of respondents in the Deloitte survey flagged this as a serious problem faced by treasurers in managing FX risk. Other issues cited include emerging market/restricted currency market volatility (49%), and manual exposure identification and capture processes (48%).
“Without accurate measurement, risks cannot be managed effectively and, arguably, value erosion from negative currency rate movements cannot be prevented,” the Deloitte report points out. “Organizations with successful FX hedging strategies are those that have invested in the right exposure identification processes and technologies.”
The importance of fixing and optimizing processes was also emphasized by panelists in the CFO Innovation Indonesia Forum. “You need visibility for a number of reasons, including risk management,” said Damien Dugauquier, Commercial Director, Corporates ASEAN, at bank messaging services provider SWIFT.
His organization allows corporations to directly connect with their banking partners, allowing visibility into and control over cash balances and hedging positions, and potentially enabling more accurate forecasting because CFOs and treasurers are able to access real-time information.
What then can CFOs and corporate treasurers do? Here are some courses of action to consider:
Be clear about your hedging objectives. The Deloitte study finds that hedging strategy objectives are mainly focused on protecting cash and minimizing volatility in income statements. “Most hedging objectives focus on protecting discrete periods,” the report adds.
Only 11% say the hedging aims to manage year-on-year financial performance. Deloitte says that “hedging objectives should arguably focus not just on covering the nearest accounting period, but also on providing resilience to FX risk in the longer term and thus protecting business growth.”
Adopt a hedging strategy that is appropriate to your industry. More than half (59%) of respondents in the Deloitte survey use a rolling hedging strategy – hedging on a frequency basis, for example every month or quarter, with a flat hedging target ratio for the full period hedged, or increasing the amount of exposure over time to achieve an average rate (layering).
But a third (33%) use ad hoc/situational hedging, meaning the CFO and treasurer adjust the approach – rolling with flat target ratio, rolling with layering, or static (typically coinciding with the annual budget FX rate setting process) – depending on the situation.
“Financial hedges should be seen as temporary shelter for the firm from unpleasant change in the competitive environment”
The survey finds that the ad hoc approach is mainly employed by energy and resources companies. Technology, media and telecom enterprises tend to use rolling hedges with flat target ratio, while healthcare organizations use both rolling with flat target and rolling with layering.
Improve and automate processes to capture and analyze FX exposures. This is a key recommendation of the Deloitte report, in light of the finding that nearly six out of ten respondents say they lack visibility into the many sources of FX exposure across the organization, and that they rely on less-than-accurate manual processes to forecast and collate these exposures.
Without overall visibility and confidence in forecasts, CFOs and treasurers can hedge only gross exposures at the unit level, not the net exposures across the entire organization. This makes it difficult for commercial teams to maximize opportunities to match currencies of revenue and costs, and possibly makes the FX hedging costs much higher than they should be.
Finally, don’t be lulled into a false sense of security. The financial engineering may smooth out the FX effects on the bottom line and the balance sheet, but it is not a substitute for effective and sustainable financial management. “Financial hedges should be seen as temporary shelter for the firm from unpleasant change in the competitive environment,” says Gordon Bodnar, professor of international finance at The Johns Hopkins University in the US.
They grant the CFO breathing space to develop long-term and sustainable solutions, such as automating processes, optimizing working capital management to free up resources, and reducing exposure to foreign currency risk by matching the currency of cost with revenue and localization of operations.
Financial hedges “will soften the blow of a real exchange rate change but they do not alter the new competitive environment facing the firm,” says Bodnar.
As always, CEOs, CFOs and other business leaders, along with the board, must continue to manage the company in the most effective, productive and efficient way, changing and refining processes, operations, strategies and even the business model when the times call for it.
About the Author
Cesar Bacani is Editor-in-Chief of CFO Innovation. He chaired the 3rd CFO Innovation Indonesia Forum in Jakarta on March 10.
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