What If Hong Kong’s Currency Peg to the US Dollar Gets Broken?

When Group CFO Frank Chi Chung Chan presented the 2015 full year results of Hong Kong-listed consumer and industrial company Techtronic Industries last month, the slides had a column marked “Excl. F/X” – which stands for "excluding foreign-exchange effects."

Global sales of power equipment and floor care products last year came to US$5 billion, up 6% from 2014. Excluding FX, however, sales actually increased 10.5%. Revenue from Europe, Middle East and Africa was the most badly hit, falling by 11.1% to US$861 million. However, stripping out FX effects, EMEA sales rose 5.1%.

“Exposure to RMB volatility should be challenging for CFOs this year, as a result of the transition from a highly managed forex regime to more of a floating one”

“Currency volatility is a threat to business for the foreseeable future,” says the 62-year-old Chan, who joined Techtronic in 1992 and is also an executive director. “For 2016, there will be [continued] volatility in currencies, rates, commodities – some things that cannot be controlled. So we should focus on securing costs and knowing where we stand.”

“The challenge I see ahead is the depreciation of the CNY in near to medium term,” adds Catherine Yu, Vice-President and Regional Controller, Asia Pacific, at Herbalife, a US-based health and beauty company with a significant presence in Asia. “Currency fluctuations would create volatility in both the top and bottom line, and some of the major challenges would be the thinning of profit margins, as raw materials are mostly imported and transacted in USD.”

“Hedging [with derivatives] is required,” says Yu, along with enhanced natural hedging and even negotiating with vendors on a fixed exchange rate. Herbalife reported worldwide sales of US$4.5 billion in fiscal year 2015, down 10% from 2014. Excluding FX, however, sales expanded by 5%. Asia Pacific sales decreased 17% to US$938.6 million.

Fasten Your Seat Belts

Virtually no CFO in Asia can expect a respite from volatile currencies. The forex outlook has become increasingly difficult to map. CFOs across Asia have to deal with an ongoing slowdown in China and a volatile RMB, erratic conditions in financial markets, interest rate hikes by the US Federal Reserve, a still-strong US dollar, strengthening yen and weaker emerging market currencies, and a wide sense of economic and business insecurity.

Even Hong Kong, where Techtronic is based, is not exempt. The Hong Kong dollar is pegged to the US currency, so one would think that companies there would be relatively protected from the FX storm. But Hong Kong is closely linked to China – the city is estimated to have US$750 billion in loan and bond exposure to the mainland – and many businesses in Hong Kong have their factories and other facilities there.

And the renminbi has been volatile. On August 11, 2015, China forced a 3% devaluation of its currency overnight. Another similar move followed in February, when China once again moved the yuan lower. The People’s Bank of China now takes market movements into account in setting the daily onshore fixing rate. Renminbi depreciation has been rapid early this year, but the currency has firmed of late on a mild rebound in the equities markets, moderation in capital outflow, and a rise in China’s foreign-exchange reserves.

Still, the central bank’s ability to keep FX movements stable now has limits. “Exposure to RMB volatility should be challenging for CFOs this year, as a result of the transition from a highly managed forex regime to more of a floating one, for example the fixing reform on August 11,” says William Chou, national leader of Deloitte’s China CFO Program. “The higher flexibility has also resulted in higher volatility of RMB.”

Complicating the picture for Hong Kong is, ironically, the peg itself. Earlier this year, speculation came to a froth that the HKD’s 32-year-old peg to the USD could break under the strain of a speculative attack. In the first month of the year, the HKD lost 1% against the greenback, hitting its lowest points since 2007. The HKD is only allowed to move within a narrow trading band of HKD7.75 – 7.85 against the USD.

CFOs could be far more effective by concentrating on the currency aspects of debt, cost of goods sold, and other business expenses. The impact of FX on sales numbers may be dramatic, but there is really little that finance can do about it

The Hong Kong Monetary Authority (HKMA) spent a few billion dollars defending the peg, which was not in real danger. While speculation of a de-pegging has subsided, the possibility of such a Black Swan event is always there. The consensus view is that the HKMA will remain resolute in its defense of the peg, counting on its US$360 billion in foreign reserves, an all-time high, for significant firepower.

No wonder FX is top of mind among companies across the world. Responding to PricewaterhouseCoopers 19th Annual Global CEO Survey, released in January, as many as 73% of respondents pointed to exchange rate volatility as third among top concerns. But almost two decades after the Asian Financial Crisis and closing on to a decade after the Global Financial Crisis, it seems companies are still learning how to deal with forex issues effectively.

Lessons Learned

Some lessons have been learned. Fewer companies in Asia these days have loans denominated in foreign currencies, compared with the large number of enterprises that embarked on a US-dollar borrowing spree before the 1997 crisis. Those with significant exposures have been swift to move when the FX rate turned against them. Last year, Chinese companies including China Gas and Wugang Trading prepaid their USD-denominated syndicated bank loans after the renminbi’s August depreciation.

And few, if any, CFOs and treasurers are foolhardy enough to think they can make money off currency fluctuations. “When it comes to currency volatility, this is something that’s very difficult to project, and we CFOs, we’re not a financial institution, so we’re not speculating on currencies,” says Techtronic’s Chan. The danger was highlighted in 2008, when Hong Kong conglomerate Citic Pacific bet that the Australian dollar would continue to rise against the US dollar. It didn’t, and Citic Pacific ended up on the hook for more than US$2 billion.

The focus today, and rightly so, is “securing and protecting our cost of doing business,” as Chan puts it. The impact of FX on sales numbers may be dramatic, but there is really little that finance can do about it, short of pulling out of volatile-currency markets – an option only in the most egregious cases, since geographical diversification and expansion are key growth strategies.

CFOs could be far more effective by concentrating on the currency aspects of debt, cost of goods sold, and other business expenses.

The effectiveness of this approach is best measured in terms of profit margins. Despite the impact of currency volatility on sales, for example, gross profit margin at Techtronic increased slightly to 35.7% in 2015, compared with 35.2% in 2014. The company attributes the achievement to product innovation, such as in the cordless and commercial cleaning product lines – and “global cost improvement initiatives in purchasing, supply chain, value engineering and manufacturing.”

What Finance Can Do

But securing the cost of doing business from currency fluctuations is easier said than done. The 2016 Global Foreign Exchange Survey by Big Four accounting firm Deloitte found that 56% of corporate treasurers reported a lack of visibility into forex exposures and reliable forecasts. They identified this as their biggest challenge to effectively manage forex risk.

“In some cases, exposures may be hidden as values or prices of certain contracts or assets that are denominated in a home currency may in fact be driven by movements in a foreign currency,” says Albert Lo, a partner at PwC’s financial consulting services. That lack of visibility makes it difficult to execute a hedging strategy designed not only to deal with the current situation, but also any potential unexpected events, such as a sudden de-pegging of the Hong Kong dollar.

One of the most common strategies to minimize and hedge risks is restructuring financing arrangements by replacing foreign currency denominated loans with loans denominated in the home or reporting currency. This can be done by activating early-redemption clauses and gradual rollovers

What can finance do? Some suggested action steps:

Maintain a cash cushion denominated in your reporting currency. “We believe that having raw cash in USD is optimal for the time being,” says Chan. “Our major revenue is in USD; it’s a natural hedge for us.” Techtronic, which relies on North America for 75% of total sales, had a cash balance of US$775 million at end-2015, 12% higher than in 2014.

The company does not use derivatives. “There are a lot of products in the market for any CFO to enhance the performance of the company, but having said that, these derivatives or products also affect your performance – in the direction that is not expected,” says Chan.

“If that’s the case, then part of our performance will be at the mercy of where the interest rate or the currency moves. There is no way we can project our profits with considerable certainty. We want to understand and deliver something that we feel comfortable with, that’s why we don’t use derivatives when it comes to hedging,” he explains.

Consider natural hedging. Surprisingly, according to the Deloitte survey, 42% of respondents do not match costs and revenues in the same entity, while 54% do not net exposures across entities. But a large majority, 89%, hedge FX exposures through derivatives such as FX forwards and non-deliverable forwards. According to the Deloitte report, “opportunities seem to exist to increase usage of natural hedging to reduce derivatives-related costs.”

One of the most common strategies to minimize and hedge risks is restructuring financing arrangements by replacing foreign currency denominated loans with loans denominated in the home or reporting currency. This can be done by activating early-redemption clauses and gradual rollovers.

Companies are also becoming more sophisticated in the way they manage currency at the local level to meet local currency needs and engaging in proactive discussions with local suppliers and customers to limit and share foreign currency risks.

Execute on a well-considered hedging program. The Deloitte report’s observation on natural hedging takes into account the reality that hedging via derivatives represents the action most companies take in managing FX risks, despite CFOs like Chan that shy away from this approach.

But derivatives can be expensive, particularly in volatile times when nearly everyone wants to hedge. This is where natural hedging comes in – CFOs should use derivatives only for exposures that cannot be naturally hedged or netted out.

In writing the derivative contract, it is important to address both the floor and the ceiling, even though this approach may be more expensive. Citic Pacific’s mistake was neglecting to set a limit on the depreciation of the Australian dollar, which at one point fell 25% against the greenback. 

Work towards total visibility into FX exposure. As PwC’s Lo says, values of some contracts and assets may be linked to forex movements, even though they may be nominally denominated in the home or reporting currency. Finance should make sure it knows how FX can potentially affect the value of major contracts, assets and liabilities (including derivatives positions), as part of the effort to mitigate risks to the balance sheet.

Devising a thought-out FX risk management strategy is not only an end in itself. Knowing that systems are in place to effectively respond even to a Black Swan event, CFOs are able to more confidently focus on their many other concerns

The Deloitte survey finds that 44% of respondents do not use a Treasury Management System (TMS) for managing their FX exposures. Of those that do, the TMS is used mainly to cover deal capture and operations, not tasks such as exposure capture and analytics. These are typically done outside the TMS environment.

“We believe there is scope for treasurers to extend the usage of their TMS from its current form to support all tasks,” says the report. “With respect to exposure identification and capture, interfaces with other financial systems may be required to resolve the current key challenges of inaccurate forecasts and the visibility of exposures.”

See if a more global strategy works better for you. Some companies that once delegated the management of forex exposures to local in-country operations have decided to take a more global approach. There is a visible trend towards establishing corporate treasury centers (CTCs) tasked with the specific duty of managing forex risk.

“In order to limit exposure and manage foreign exchange risk efficiently, many corporates are moving towards managing foreign currency risks centrally to aggregate overall foreign currency positions, reduce exposure through netting or natural hedges, and manage any residual exposures through hedging or other activities,” explains Lo.

CTCs may also bring potential tax benefits to companies as many countries are offering tax incentives for qualifying CTCs. In Asia, they include Hong Kong, Malaysia, Singapore and Thailand.

Thought-Out Strategy

The main uncertainties in today’s currently unsettled currency environment stem from the extraordinary monetary policies and fiscal policies in the US, China and Japan, complicated at the moment by the UK’s potential departure from the European Union in a referendum scheduled in June. As such, like it or not, CFOs and treasurers will have to deal with FX volatility for the foreseeable future.

“To handle the currency fluctuation, I think CFOs should understand the economy well and forecast FX trends, and devise a proper treasury strategy that includes currency hedging arrangements,” says Deloitte’s Chou. Adds PwC’s Lo: “What is important is that CFOs and treasurers have both strategic and tactical policies and processes in place to actively monitor and manage their foreign currency exposure, and avoid rash knee-jerk reactions to market condition changes.”

Devising a thought-out FX risk management strategy is not only an end in itself. Knowing that systems are in place to effectively respond even to a Black Swan event, CFOs are able to more confidently focus on their many other concerns, such as the future development of their companies, meeting management demands for analyses and insights, and complying with ever increasing regulatory and accounting requirements.

About the Author

Haky Moon is a Contributing Writer at CFO Innovation.

Photo credit: Shutterstock

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