Interspersed between these two extended periods of turmoil were many other shorter outbreaks of volatility in the money markets. These too required skilful efforts by management, to mitigate or at least reduce the risk of losing value as a result the turbulence.
One of the consequences is that both inflation and the risk premium for this market are high, making lending rates relatively unattractive for business, especially for long-term financing across the Commonwealth of Independent States (CIS), which unites Azerbaijan, Armenia, Belarus, Georgia, Kazakhstan, Kyrgyzstan, Moldova, Russia, Tajikistan, Turkmenistan, Uzbekistan and Ukraine.
For example, interest rates for one-year loans in Russia are still typically as much as 10-12% per annum and in Ukraine 18-20%, often trending even higher during periods of market volatility. The author can recall two examples in Ukraine when short-term rates reached as high as 50%; in 2004 and again in 2009. Although the peaks were only for a short period of time they were nevertheless painful, for example on overdraft transactions.
High interest rates make local currency financing very challenging and the volume in local currency financing is relatively limited due to the low capitalisation of local banks, especially in Ukraine. In Russia, there is a handful of major state-owned banks with large resource pools, which allow them to take leading positions in the local financing market. However, interest rates are higher for local currency business loans, so companies have regularly resorted to foreign currency financing from international financial groups, which have easier access to the international markets.
Consequently, many companies operating in the CIS markets have organised financing either from the international financial markets through loans or bonds or local subsidiaries of foreign banks in foreign currencies, mainly US dollars (USD) and euros (EUR). As a result, the biggest challenge for treasury departments in terms of market risk lies in protecting their assets – mainly cash and accounts receivables (AR) from possible national currency devaluation. Making sales and receiving cash in a foreign currency might suggest itself as an easy protection tool; however legislation in all countries across the region strictly bans any foreign currency transactions between companies inside the country except those for export deals.
So what are the options for treasuries to protect against local currency devaluation risk in CIS countries? Let’s consider the most used and effective ones.
Managing Foreign Exchange Risks
The classic hedging of foreign exchange (FX) risks through forward (option) foreign currency purchase is relatively limited, due to the prevailing regulatory and market conditions. In some jurisdictions such as Ukraine foreign currency forward purchasing was banned for almost five years from 2008 to 2013 and still remains subject to severe restrictions. In Russia it’s more widely used, but is applicable only for very short-term periods of up to six months, meaning that it is not possible to hedge for periods on one or two years let alone for longer-term periods.
Additionally, due to the large difference in interest rates between USD/EUR and the local currency the rouble (RUB) the price for forward transactions is fairly high. In times of volatility the forward rates are very unattractive and it’s easily to significantly overpay for the forward transaction. As money markets in the CIS region are not mature sometimes foreign currency exchange rate movements are motivated by political considerations more than economic, leading to the market forward pricing being overestimated and thus making these transactions less loss-protecting than they could and should be.
In addition, the legislative regulation of forward (option) forex purchases holds little attraction. This is due to the complexities – or impossibility – of recognising FX option purchase commissions as tax deductible expenses, which pushes up the total cost of hedging.
The most typical scenario for non-monetary hedging (i.e. hedging without such financial instruments as forwards and options) is pegging the company’s sales contracts to the market foreign currency exchange rate. In such cases the seller continuously recalculates the pricing of his goods or services, based on changes in the exchange rate. Under some national legislations within the CS region such explicit pegging is legally prohibited so companies make them implicit in the sales contracts, or simply reserve the contractual right of a unilateral selling price revision in the case of a significant (more than 5-10%) change in the exchange rate.
Whatever option is chosen it’s not an easy solution, because transferring risk to the customer may take place only if he or she is heavily dependent on the supplier – and only rarely is that the case. Consequently many customers do not agree to such contract conditions, or to taking any kind of foreign currency exchange rate risk.
Even having customers’ long-term servicing contracts pegged to foreign currency exchange rates is not enough for protecting hedging. Companies are more likely to accept such conditions when money market volatility is low – meaning exchange rate fluctuations of no more than 3-5% – and such market situations have existed for periods of several years between the significant turbulence of 1998 and 2008-09.
Another risk is that in the event of severe market turbulence, customers refuse to continue buying at prices sharply increased to reflect the exchange rate rise. They demand pricing that continues to reflect the previous, pre-turbulence exchange rate and will threaten to break existing contracts where such pegging to the old rate is unavailable.
Even where sales contracts contain clauses to impose contract cancellation penalties, the customer may still prefer to bear the financial penalty rather than continue with a purchase when prices have suddenly increased by 10% or more. For such contracts, particularly, if they are critical for sellers’ business activities it’s recommended to make contract cancellation penalties relatively substantial so the buyer has to think twice before deciding to withdraw their cooperation.
Ideally, some compensation mechanisms such as small discounts or additional services should be offered to the customer to partly compensate, thus showing that the currency risk is shared between both buyer and seller.
To summarise the above, for hedging FX risk the author would recommend applying a mix of monetary tools such as forwards and options where appropriate with a contractual hedge, which is a much stronger and more long-term oriented tool for protecting the company’s assets from devaluation.
Interest Risk Issues
Along with the constant pressure of managing FX risks another market risk requires treasury’s close attention, which is the risk of changing interest rates.
There is much less scope for hedging this risk to protect against volatility than the FX risk. As a classic approach it’s possible to hedge interest rate volatility through interest rate swaps, but it’s only feasible for those loans in foreign currency with a maturity period of up to one year and it requires the cooperation of an international financial institution (FI).
Financing in the local currency is expensive and while it is widely used, poses quite a significant threat in the case of an unexpected event sending interest rates soaring.
For managing local currency interest rate risks everything depends on the company’s cash flow cycles. It’s possible to organise short-term (i.e. up to one year) financing for the following scenarios:
- To make a short-term financing; for example with a one-month rollover and subsequent interest rate revision with the bank.
- To fix the interest rate for a period of one year; negotiating with the bank to agree the most favourable interest rate for the longer period.
The first approach is more demanding of treasury resources, but allows greater flexibility in terms of rate negotiations with the bank. While the second option offers greater protection in terms of risk management, in practice it’s offered less frequently than the floating interest rate.
Finally, the third major risk for treasury management is liquidity management. The first rule when working in the CIS market is to avoid dealings with its smaller and weaker banks. These may suddenly face payment difficulties, or their activities could be limited or stopped by the Central Bank authorities due to some violation of the regulations.
It’s preferable to cooperate with either internationally-known FIs or state-owned banks, which are usually well supported by local governments. In addition to the financial stability and reputation they both provide the access to a variety of financial instruments for hedging, liquidity support (overdrafts), cash pooling for branches in the regions and many others.
As part of liquidity management in the CIS region, one of the most difficult functions is accounts receivable (AR) management. Traditionally, the market has not been well protected by the legal system in terms of the protection of creditor’s rights. This has led to relatively high levels of bad debts in company’s books and year-long litigations with unreliable payers.
The companies with effective AR management apply very strict procedures for customer credibility checking, try to diversify the portfolio of ARs by setting credit limits and quite often apply prepayments (up to 50%) for new deals. For new players in the market 100% prepayment for any purchase is a standard rule.
While there are many challenges and uncertainties in the CIS market as in any emerging market (EM) it’s possible to develop effective hedging strategies, to effectively protect company’s assets from turbulence and manage debt collection.
The precondition for success is a long-term strategy for risk protection and constant diversification. History shows that a tremendous change in market conditions has occurred over the past 10 years, as regulation has become more market-friendly, the market has grown increasingly mature and businesses have gained valuable experience.
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