Managing Excess Cash in a Low Interest Rate World

Managing Excess Cash in a Low Interest Rate World

The low levels of interest rates in many countries have created a challenging environment for companies seeking to enhance the yield on their excess cash. Citi has worked with many multinationals as they navigate various approaches to mitigating the negative effects of low interest rates.

A common grievance among global corporations is the sting that has come with low or negative interest rates in much of the developed world. Low interest rates have left companies hunting for higher yields on the excess cash generated at their overseas operations. A first step in addressing the difficulties posed by low rates should be to assess the landscape. While interest rates in the United States may be close to historical lows, they are high by the standards of most developed countries; in Japan, Switzerland or the eurozone, negative deposit rates are a harsh reality.

While low or negative rates certainly present challenges, treasurers do have options.

Figure 1

Investment Based Strategies

There are two investment-based strategies commonly used to mitigate the effects of low or even negative rates.

The first involves either extending duration or accepting greater credit risk in order to access higher yields. However, this approach may be inconsistent with a company’s investment policies, which usually stipulate maximum maturity and minimum credit ratings.

The second strategy is to swap cash into higher-yielding currencies and then swap back to the lower yielding currency after a fixed period. For example, a strategy adopted by some companies with excess EUR balances is to tactically convert cash into USD at the prevailing spot exchange rate, deposit the USD in a higher yielding account, while simultaneously locking in a FX forward rate to convert back to EUR at a future date. While this strategy offers certainty, it may result in a worse economic outcome than if the company had simply kept the cash in the low interest rate account. This is because a FX forward rate is a reflection of both the difference in interest rates between two countries as well as the premium, over and above local interest rates, that it costs to enter this swap. This market dynamic is called cross-currency basis, and it can be observed in the FX forward curves of many currencies relative to the dollar.

Beyond investment based strategies, we often see companies use intercompany dividends and loans as part of their risk management plan to more effectively manage the effects of low interest rates.

Declaring an Intercompany Dividend

An intercompany dividend from the low interest rate country back to the US can be one method to shield excess cash from low interest rates.

Nevertheless, the process of paying an intercompany dividend entails risks that should be managed with care. For example, if at the end of 2018 a company declared an intercompany dividend from a European-based subsidiary, that dividend would have lost over 2% of its value in USD terms by the time of settlement three months later. Therefore, it is critical that any approach involving the cross-border transfer of cash should also include an appropriate strategy to mitigate the risks resulting from volatile exchange rates.

Entering Into an Intercompany Loan

An alternative to declaring an intercompany dividend that some companies employ is to make an intercompany loan where the subsidiary loans excess cash to its US parent for a fixed period. This may be preferred where the subsidiary anticipates that it will require the cash back in the future, for example, for working capital purposes. The subsidiary loans the cash to its parent; the parent then enters into a spot FX transaction, converting EUR into USD, and places the funds in a higher yielding USD account. To offset the FX risk from the foreign currency loan created by the parent company, it can hedge the repayment of the EUR liability by entering into a FX forward contract to buy EUR and sell USD at the desired future date.

The disadvantage of this approach is the cost of the FX hedge. However, the company may be able to alleviate some of the interest cost incurred from hedging the intercompany loan by entering into associated hedging transactions linked to the assets of its subsidiary.

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Utilizing appropriate strategies can help companies achieve the following objectives:

i. Maintain flexibility to use excess cash accumulating in different parts of the corporate structure

ii. Increase the amount and predictability of the interest earned on excess cash

iii. Avoid negative effects on P&L from any derivative hedges that are used to manage FX risk

Which option is best for you? It depends. No-one can predict the future, but given continuing macro-economic uncertainty in many countries, low interest rates could persist for some time; few could have foreseen a decade ago that rates would have remained so low for so long. There is no single right solution to address the challenge of low interest rates. The geography of each company’s operating structure, as well as its tolerance for risk, should determine the approach treasury takes. Treasury should seek support and guidance to enable it to earn a return on excess funds.