Beware the Central Bankers and their Currency Wars of Attrition

When the global economic crisis hit in 2008, governments and
central banks stepped in to prevent a full scale meltdown of financial markets.
Since then central banks have gone into overdrive and we have witnessed an
unprecedented array of monetary easing in what is often described as ‘a race to
the bottom’. The aim was to get credit flowing again for businesses and
consumers while lower interest rates were aimed at influencing exchange rates
and stimulating countries’ export sectors. 

While this was fine in
theory, in practise any easing by one central bank usually prompts action by
another. So we have seen large swings in most markets on the back of monetary
stimulus, as each country tries to pursue domestic policy objectives at the
expense of other nations by devaluing exchange rates. We now inhabit markets
almost completely controlled by central banks with the Bank of Japan (BoJ) and
the US Federal Reserve Bank (Fed) leading the way in unconventional measures.  

The BoJ upped the ante earlier this year by specifically using
monetary policy as a vehicle to curb deflation. At the same time, however, the
effect of doubling the money supply gave the added bonus of devaluing the
Japanese yen (JPY) and helping to boost exports. This has raised tensions with
competing economies, as Japan is using its central bank to get a leg up to
growth by devaluing the yen. Now the UK wants a piece of the action too and it
is widely expected that new Bank of England (BoE) governor, Mark Carney will
aim to devalue sterling (GBP) by as much as 15%. Mr Carney, who officially took
up his new post on 1 July, will be given a wider mandate to boost the
flat-lining UK economy by focusing on greater flexibility in monetary policy to
try to plug the productivity gap. 

Little Gain for Sterling
Pain

The key question for corporate treasurers and chief
financial officers (CFOs) is firstly, will this devaluation actually take place
as predicted, and if so, what will the implications be of such a shift in
sterling value? Treasurers should certainly prepare for this outcome as the
BoE’s new chief is expected to be assertive. Following Japan’s aggressive
policy action, the JPY weakened by 10% against the pound in less than two
months, so we should certainly take the threat seriously. If we rewind to the
start of 2013 we saw the pound fall 8% against the US dollar (USD) and this
fall can to a large extent be attributed to dovish comments by the BoE under
Carney’s predecessor, Sir Mervyn King. 

The jury is still out as to
whether the effect of devaluing the pound will actually help to contribute to
an improvement in the underlying growth conditions. Sterling has already
devalued significantly since 2008 and the onset of the financial crisis, yet
the UK economy remains flat.  

Regardless of the impact, businesses
will need to anticipate the changing dynamics and react accordingly- depending
on their level of exposure to a weaker pound. Those who rely mainly on imports
should be especially alert and look to hedge a potential fall in the value of
the pound, while businesses that mainly export will benefit from such a move.
If exporters are pricing at current exchange rates, they may actually be able
to benefit from already agreed orders. In addition, they may become more
competitive on new orders, as sterling falls in value. Those who solely trade
domestically could potentially look at diversifying into overseas markets to
capitalise and expand on the weakening pound.

The action of central
banks is shaking up volatility and this will add pressure to a business to
dynamically adapt their hedging activities.  

Treasurers will need
to know how to respond and how to advise their management and the departments
that face this volatility. 

Whilst it is important to be on the
front in such market dynamics, it is also important not to panic and get
completely swept away by short-to-medium-term sentiment. A hedge cannot last
forever but will buy some time and treasurers can utilise forward contracts or
currency options if necessary.

Formulating a policy in this area
should consider what is important to the business and over what time period.

If maximising margins or staying ahead of the competition is essential
then currency options could prove useful to benefit from the upside potential. 
However, if protecting underlying cash flows is the main priority, then forward
contracts are more appropriate.

The currency impact on financial
statements should also be considered if overseas earnings are required to be
translated back into GBP.  This is especially important when related to the
credit measures, such as leverage and cover ratios.

A Bumpy
Ride

While treasurers must be on the front foot with the
direction in which the BoE is headed, it is equally important to be mindful of
the duration of the easing cycle. Recently, the US Fed’s chief Ben Bernanke
indicated that it would look to
taper its asset purchase programme in September

The effect of this was dramatic, with previous USD
weakness snapping into USD strength very quickly. In addition, we saw a fall in
equities and a rise in yields which treasurers will also need to be aware of.
Timing will be crucial; nimble enough to hedge against expected easing but also
the foresight to look ahead for any hawkish signals and react accordingly.

It is going to be an extremely volatile period over the next year with
central banks stepping up their activities globally. Treasurers need to be
forward looking to the direction of the central banks at is they who are the
current drivers for the financial markets.

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