FX Review:

FX Review

Pandemics and Uncertainty: The Challenges for FX Managers


FX risk managers face a multitude of challenges ranging from uncertainty surrounding the spread of COVID-19 to the resurgence of Vox populi-related unrest in many regions. Forecasting the impact of these risk factors on operating performance is likely to be difficult for multinational corporations, even as the broader economic effects become better understood. This may give rise to significant forecast error in company projections, which will likely impact the effectiveness of FX hedging programs.

A Risk of Pandemic Proportions

The world has changed completely in just two months. At the turn of the year, the market focus was on the Phase One trade agreement between China and the United States and the escalation of tensions between Iran and the U.S. If asked what factor would emerge as critical in coming months, most observers would have said the lengthy run-up to the U.S. presidential election in November. But while the U.S. news media still devote substantial time to the election, the market’s focus is now almost exclusively on the novel coronavirus, the implications for the global economy and the response of policymakers.

A Crisis of Unknown Dimensions

That the coronavirus would become a major crisis only became apparent in mid- January. The initial focus was on China, the source of the infection and at the time, home to more than 80% of the confirmed cases. The quarantine imposed on Wuhan and a number of surrounding cities in Hubei province triggered a sharp decline in economic output. This in turn fed through into problems for global supply chains, logistical issues within China, declining industrial commodity prices (China is the dominant purchaser in the global economy), and a hit to tourism and travel globally (China is an increasing source of tourists). In this environment, the U.S. dollar appreciated and a broad range of emerging market currencies depreciated, including those dependent on industrial commodity exports (for example in South America), those dependent on global supply chains (East Asia) and those where tourism inflows are significant (Thailand).

The situation changed again toward the end of February, with a shift away from China to the broader global economy. The genesis of the shift was the sudden explosion of reported infections in South Korea and Italy, but it changed the storyline to one of concern about the growth in infections globally. A crisis of confidence has followed. Equity markets have fallen sharply. GDP growth forecasts are being revised lower across the board. Most governments in East Asia have promised fiscal support measures, while central banks have eased monetary conditions. The U.S. Federal Reserve implemented an emergency 50 bps cut in its target Fed Fund rates, the first such action since the Global Financial Crisis, leading to compensating moves by a number of other monetary authorities. But instead of being U.S. dollar-positive, this has been U.S. dollar-negative. If previously, the United States was perceived as a safe haven with interest rates and bond yields higher than those in other G-10 economies, this is no longer the case with yields falling to record lows. In a risk-off environment, currencies that had previously been well-supported (for example, the Mexican peso) suffered sharp declines.

At the time of writing, there is obvious uncertainty about how the crisis will develop and the associated timing. The consensus view is that it will get worse before it gets better. But if there is any good news, it is that the Chinese economy appears to be starting the lengthy process of a return to something approaching normal.

The Longer Term

The foreign exchange market has always been myopic, focusing on short-term developments to the exclusion of longer-term factors. But it would be a mistake to believe that the key issues at the beginning of the year cannot resurface. The outcome of the U.S. presidential election will be critical for the United States and the global economy. Both sides of the political spectrum are concerned about the Sino-American trading relationship, for example.

Two other issues that captured the market’s attention in 2019 were Vox Populi risk (of volatile and shifting public opinion) and Brexit risk. While receding from view recently due to the coronavirus crisis, both are likely to resurface. Indeed, both issues may be exacerbated by the coronavirus crisis.

Vox Populi risk became an issue starting in late-2018 with the onset of the ‘yellow vest’ demonstrations in France. But it was taken to a new level with the unrest first in Hong Kong and then in Chile and much of South America. At their roots, these were protests against the economic status quo, with demands for increasingly populist policies. Insofar as the coronavirus accentuates inequality in wealth and income, the risk is not only that the protests re-emerge but that they intensify.

The United Kingdom is now in the early stages of negotiating its future trading relationship with the European Union. The initial talks have been far from harmonious. The coronavirus, by feeding through into a slowdown in the respective economies, raises the stakes further. Will the EU and the U.K. recognize the benefit from maintaining strong relations or will the populist pressures they face trigger a breakdown of talks and the re-emergence of a ‘hard Brexit’?

FX Implications

‘Fear of the unknown’ is perhaps the best way to characterize the current crisis. The current macroeconomic environment differs from previous crises because risk factors have manifested themselves as both a supply- and demand-driven shock to the global economy.

From a multinational corporation’s perspective, forecasting the impact of the supply and demand disruption to business is likely to be challenging for corporate treasuries, even as the extent of the economic damage becomes better understood. Of particular concern to FX risk managers will be the difficulty of assessing the extent of disruption to supply chains, especially on the trade in intermediate goods. To generate accurate forecasts, companies will need to assess how the outbreak will affect the company’s suppliers and their suppliers and so on. Moreover, this may give rise to significant forecast error in company projections, which will ultimately affect the effectiveness of FX hedging programs.

For example, with respect to the coronavirus outbreak, a review of the numerous press releases from major multinationals suggests that the operating performance of business units either selling into the affected regions or whose supply chains are being disrupted, will be subject to significant uncertainty. Companies across a broad range of industries have released statements warning about the adverse effects on performance from having to close retail outlets and offices, suppliers closing factories and of having to suspend travel across entire regions. The damage to economic activity will be a function of how quickly infections abate but in the meantime, risk managers must grapple with the adjustments required to their risk management programs to manage the adverse effects of forecast error.

Forecasting Uncertainty and Hedging Programs


For an FX risk manager, a potential worst case scenario is an unrealized exposure that has been either fully or partially hedged. In this situation, a company may have a cash obligation to its banking partner without an offsetting underlying currency position. With many multinationals’ hedging based on forecasts over a year in advance of projected cash flows, this is a likely scenario for a significant number of companies today. While this uncertainty makes it tempting to abandon hedging altogether, such an approach may increase a company’s value-at-risk arising from FX. This is a function of both high market volatility and exposure uncertainty. The key, instead, is to think creatively and strategically about both hedge ratios and hedging instruments, with the goal of balancing risk reduction and program flexibility.


Stephen Leach

Stephen Leach
Risk Management Solutions
+1 212 723-9332
stephen.leach@citi.com

Ade Odunsi

Ade Odunsi
Risk Management Solutions
+1 212 723-7560
ade.odunsi@citi.com

Benjamin Gilbert

Benjamin Gilbert
Risk Management Solutions
+44 (0) 20 7986 1454
benjamin.gilbert@citi.com

Zach Kweh

Zach Kweh
Risk Management Solutions
+65 6657-2859
zach.kweh@citi.com