Managing the Foreign Currency Risks of Global Expansion
As corporations expand geographically, they will inevitably acquire exposures to both developed and emerging market currencies. Both can be volatile and this volatility may adversely impact key performance metrics. Central to the success of a company’s global expansion then will be cost-effective strategies to manage these inherent currency risks.
Perhaps surprisingly, emerging market currencies can be less volatile on a day-to-day basis than major currencies (albeit with a few distinct exceptions; e.g. the South African rand). But when they do move, the result can be much more extreme. In Figure 1, the Argentine peso was the weakest currency in the world last year, depreciating 51% against the U.S. dollar (a U.S. dollar appreciation of 102%), closely followed by the Angolan kwanza. In contrast, the Australian dollar was the weakest G10 currency, falling less than 10%.
In the case of the peso, the reasons for the dramatic depreciation were largely local. But for most currencies – that is, currencies not suffering a dramatic depreciation – the key factors were often global not local. And in assessing the outlook for 2019, it is the same set of global factors that need to be considered. In particular:
RELATIVE GDP GROWTH:
Early last year, the discussion was about a synchronized global upswing. That upswing never happened. Instead, the United States outperformed most other major economies, while the euro-zone slumped. The question for 2019 is whether this outperformance can be sustained.
This is perhaps the most contentious issue. The series of tariff increases imposed by the Trump Administration last year fed through directly into a stronger dollar but no reduction in the scale of U.S. trade deficits. Recent headlines suggest progress in trade talks with China but is this enough to ensure a continuation of the current ‘truce’? And this is before we even know the results of the national security investigation into U.S. auto imports.
RELATIVE MONETARY POLICY:
The last few weeks have witnessed a major shift in Fed policy. Previously, the Fed appeared to be on ‘auto-pilot’, with programed increases in interest rates and a steady decline in the size of its balance sheet (‘quantitative tightening’). Now, the intent is for policy to be truly ‘data dependent’ and the latest FOMC minutes imply that a decision will soon be taken to halt quantitative tightening. Ordinarily, such a policy shift would translate into a weaker dollar. But the flip side is that weak growth and inflation elsewhere has halted policy tightening elsewhere, maintaining a significant interest rate differential in favor of the dollar.
The impact of political risk is always difficult to assess, but markets continue to be roiled by elections, changes in government and the associated policy shifts. Brazil and Mexico both experienced major shifts as a result of elections last year and elections are forthcoming in several emerging markets this year, including most notably Argentina (October) and India (May).
These are just some of the global issues to be considered in thinking about the outlook for emerging market currencies, maybe even before the specifics of the individual currency.
Managing Exposure to FX Volatility
For any multi-national business, a critical first step in implementing an FX risk management program is identifying foreign currency operating cash flows and evaluating how FX market fluctuations can affect the value of these cash flows in a company’s home currency. Figure 2 illustrates a commonly used risk quantification methodology where statistics are used to project current FX market volatility into the future over a given time horizon. This calculation provides an estimate of the potential, maximum FX gain or loss that could be incurred on a foreign currency cash flow. As would be expected, the longer the time horizon, the greater the potential impact of FX rate volatility on the cash flow. Said differently, the further into the future that foreign currency payments or receipts are projected to occur, the greater the amount of uncertainty there is over the eventual exchange rate to buy or sell the foreign currency.
However, while it is true to say that there is an equal chance of a favorable versus unfavorable move in FX rates, many companies choose to implement hedging strategies to reduce exposure to FX risks because as uncertainty over future outcomes increases, this may create significant difficulty for senior management as they seek to reduce the volatility in future business performance. A strategy of simply absorbing FX risks as they occur may expose the business to material risks which may not have been quantified and which could lead to a significant erosion in margins and profitability. The other important factor to consider when evaluating a hedging strategy is the cost of hedging as illustrated by the lightest and darkest blue shaded areas in Figure 2. For most currency pairs, the cost of hedging is lower than the potential FX risk which incentivizes companies to attempt to identify hedging strategies where the reduction in risk from the hedge significantly exceeds the cost of implementing that hedge.
The take away is: Are you expecting to receive a certain amount of foreign currency from a foreign sale or do you need to ensure that a foreign currency payment does not exceed a certain amount in your home currency? Was there a FX rate assumption for this FX revenue or expense item? If so, there may be a benefit to look at ways to manage and reduce the risk. FX risk is inherent when conducting business globally. Unless FX risk is estimated not to be material in the context of aggregate exposures, there may be significant benefits to the company of identifying cost-efficient strategies for managing this risk.**
Through Citi, companies have access to a comprehensive set of tools to manage exposure to emerging market currencies (Figure 3).
The most straight forward approach is for a company to transact a spot FX transaction. This entails an exchange of one currency for another for delivery T+2 business days. Alternatively there are a number of automated solutions offered by Citi to manage the spot conversion of incoming and outgoing cash flows. These solutions are particularly cost-effective for smaller, frequently recurring transactions.
Spot transactions bear inherent market risks. A company that converts foreign currency cash flow into its home currency when the associated invoice is due may find that at the time of conversion, that cash flow has been adversely affected by a change in FX rates. These fluctuations can be consequential for margins. One way to mitigate this potential risk is by securing an FX forward rate. A company can enter into a contract with Citi months or even years in advance of an anticipated cash flow to fix an exchange rate for the conversion at the future date. On the trade date, Citi and the company will exchange the predetermined currencies at the predetermined rate, regardless of where spot FX has moved. This allows for more accurate budgeting and reduced potential for market induced surprises. If a company is looking to hedge against adverse moves in FX rates while maintaining the ability to benefit from any favorable FX movements, it can purchase an FX option. For a premium, clients retain the right but not the obligation to exchange currencies at a pre-determined FX rate in the future. If exchange rates move favorably, the option can expire without consequence beyond the initial premium paid. Should the FX rate move unfavorably, the option provides protection at the pre-determined FX rate.
Please contact your CitiFX Salesperson for more details.**
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Managing Director & Economist Foreign Exchange Department Citigroup
Senior Analyst Risk Management Solutions Citigroup