Managing FX Risk in Emerging Markets

In recent years, it has become increasingly clear just how important emerging markets are to the global economy. Not only do they comprise some of the most populous countries in the world, including Brazil, Russia, India and China (BRICs) and Indonesia, but emerging markets now make up the lion’s share of global economic growth.

As a consequence, the world has turned its attention away from more developed markets to increasingly focus on emerging markets. Indeed, while they are seen as ripe opportunities for companies to forge their futures and optimise untapped liquidity, the world is also looking to these emerging markets to lead the way towards economic recovery.

Developed markets have unquestionably suffered since the financial crisis and struggled to find an impetus to create growth. On the other hand, emerging economies have continued to grow, albeit at different rates, as the knock-on effects of the eurozone crisis and lower US demand has impacted their own output. Despite these factors, emerging markets have far outperformed the growth of developed markets, with maintenance of double digit growth in recent years not uncommon.

According to our projections, global growth will reach 3.5% in 2012, while the emerging markets are expected to outstrip this rate and demonstrate growth of 6%. Demonstrating the paradigm shift in the global economy, emerging markets now represent nearly 50% of global gross domestic product (GDP), expanding from 37% in 2000.

So for companies based in the UK, as both importers and exporters, it would be unthinkable to ignore such vast markets as China, India and many other smaller emerging countries that offer compelling business opportunities as their economies continue on the long road to development. Given the impressive record of growth over the past decade and, perhaps more importantly, the stability that most emerging market economies have shown in the face of adversity, emerging markets will continue to represent an increasing share of global business for corporations in the future.

As the geographical parameters of the commercial world continue to expand, the variety and complexity of these emerging markets must be understood and accommodated. The array of emerging market currencies used on a daily basis also means that there is a wealth of economic data coming out of the developing world that it is necessary to track. Emerging market currencies can behave in conflicting ways. For example, some such as the Russian rouble or Brazilian real reflect the focus of their country’s economy and are positively correlated with commodity prices, while others such as the Turkish lira or Indian rupee are often negatively correlated. Understanding these foreign exchange (FX) exposures is a key responsibility for corporate treasurers.

Emerging markets can be subject to subtle political shifts, or to security events which have wider implications for a plethora of risk management issues, such as sovereign, interest rate and currency risk, which need to be carefully managed and hedged. This means that financial activity in emerging markets should be accompanied by acute awareness of the different issues at play, and corporations active in these countries should look to obtain as much expert information or advice as they can find in the region in order to adopt best of breed regional practices.

While emerging markets clearly offer positive business opportunities, they also present their own, very individual challenges requiring specialised knowledge and expertise. Some emerging market currencies are pegged, others trade in strictly defined trading bands and there are still those freely floating; some are deliverable, while others have stringent regulations related to convertibility. The differences between local currencies in emerging markets requires an understanding of what options can be traded, if rates are fixed then how they work and when payment is required, as well as an acknowledgement of liquidity implications – for example, liquidity can be better or worse on certain days of the week, to name just a few challenges.

What is common across all markets is the need to manage these factors internationally. It is important for corporations to tap into knowledge of the regional nuances and gain the expertise required to understand how different countries and currencies behave. Banks can help treasurers do this. Every emerging market currency will have a certain set of characteristics so a company based in the UK, which is sourcing goods from China to sell in India, for example, will have to contend with a host of different currency characteristics in the course of its daily business.

Managing FX

Managing currency risk is crucial. Emerging markets can seem pretty calm and stable, but at times of crisis, whether due to local or regional issues, such as we saw with the Arab Spring, some national currencies lose their stability and with it, their liquidity, due to a host of economic, political or strategic reasons. It is widely acknowledged that hedging risk in the G10 currencies is vitally important, but hedging this risk in emerging market currencies can be even more critical, particularly as these are usually less known to clients or they have less experience dealing in them. Currencies can become volatile and illiquid so it is important to put hedging strategies in place well in advance and to ensure terms are secured at attractive prices, before trying to predict changes in market behaviour.

Given that companies active in emerging markets should consider hedging underlying currency risks, it is worth noting that the variety of FX products, and the liquidity available, has improved dramatically over the past decade. As the importance of emerging economies and currencies continues to grow, it is expected that the products available in FX to cater for the appetite towards emerging markets will continue to expand. In addition, both onshore and offshore hedging options need to be considered.

There are now at least 25 currencies that trade on a daily basis in reasonably large amounts, and most of these can be executed around the clock, during normal market conditions. In terms of forward tenors, virtually all of these emerging market currencies trade out to one year in good liquidity, with many of them trading to three to five years. All of these currencies are also traded in the options market, again with good liquidity out to one year. Most of them are traded as first-generation exotics, and several are traded in more complex products such as baskets.

Interest Rates

The diversity of emerging markets also demands an understanding of the huge variations in interest rates. In order to minimise the impact on funding costs, the interest rate differentials have to be carefully managed, offsetting the cost of borrowing against those currencies which are more expensive. However, in many emerging markets, notably where internationalisation has not occurred, the US dollar is the ubiquitous currency which has to be converted, leaving it exposed to depreciation from the local currency. As more emerging markets become liberalised, this offers new cash management opportunities as companies look to optimise currency movements.

As clients look to optimise their role in an increasingly globalised business environment, fuelled by this interest in emerging markets, the demand for a broader array of products that are scalable to match their broadening geographical footprint is also increasing. There is increased demand for a broad range of more sophisticated, regional financial solutions, economic analysis and strategic ideas, set in the context of a global solution. The catalyst for new solutions lies around the need for local knowledge to bring about better cash management structures and liquidity capabilities across these emerging markets.

Given the complexity involved in conducting business with emerging markets, all businesses should work closely with their local banking partners to gain an understanding of the regional nuances of trading in these territories. Bigger banks should also continually enhance their relationships with local banks in various emerging markets, thereby gaining access to local liquidity and critical data for the region, which can be deployed to help corporate clients. Despite liquidity often being fragmented across regions, it is this local liquidity which corporations are increasingly tapping into on a global basis to fund their growth aspirations into new regions.

It is precisely the varied nature and complexity of emerging markets that means they not only offer vast business opportunities but create unusual challenges related to specific regional differences. There is always something new to learn, always a way to gain advantage, and therein lies the true fascination with optimising the opportunities presented by these emerging markets.

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