‘How can treasurers effectively hedge against currency risk?’ The perennial question is particularly pressing at the moment, given the results of FiREapps’ latest quarterly research report on the impact of currency fluctuations on corporate earnings. In Q312 corporate leaders, analysts and investors alike were surprised that earnings reports reflected significant currency-related losses. This was because they had been focused on the euro and, seeing the dollar weaken relative to it, they expected currency-related gains (dollar down, revenues up). In fact across a subset of Fortune 2000 companies reporting negative currency impact, the aggregate top-line losses totaled US$22.7bn.
Those significant losses resulted from fluctuation in currencies besides the euro; the Brazilian real (BRL), Indian rupee (INR), Japanese yen (JPY) and Canadian dollar (CAD) in particular. So my advice for treasurers is that their first step should be to proactively assess currency risk exposure across all of the currencies they do business in.
The world used to think that when the US dollar (USD) rose or fell, it did so against all other currencies. Today, many believe that what happens to the value of the USD relative to the euro (EUR) happens across all other currencies as well. As US$22.7bn in currency-related losses evidence, that is simply wrong. In fact, comparing Q312 to Q2, while the USD fell 1.56% relative to EUR, it rose almost five times that much against INR and twice that much against CAD.
We’ve all been educated to consider our investments as a portfolio. When making wise investment decisions, we don’t think only about Facebook for example, but our entire portfolio of stocks. Corporate leaders, treasurers and analysts increasingly, and correctly, think about currencies in the same way. It is important to take the same kind of portfolio approach when managing currency risk, a fact that is increasingly evident.
In Q312 corporations were surprised by significant currency-related losses because they didn’t take the portfolio approach when thinking about currencies; they were only focused on the one that was making headlines – the euro.
Escalating Currency Wars
A currency war is happening right now and it is escalating. It has involved many of the world’s most traded currencies. Corporations that don’t manage the resulting volatility will get caught in the crossfire.
The currency-related actions taken by central banks are having the effect of precipitating currency wars. When one country engages in competitive devaluation, other countries are incentivised to do the same. But why would a country want its currency to weaken? It might seek a cheaper currency to counter the effects of its status as a currency safe haven – the cheaper a currency, the less attractive it is to foreign investors. However, at the root of most currency manipulation is the desire to generate export-led economic growth. The cheaper a country’s currency, the less expensive are its exports in global markets. Think of it as a race to the currency bottom and it devolves into a currency war.
For example where Brazil’s policy had been to allow the market to determine the value of the BRL its finance minister, Guido Mantega, has recently been open about his close control of the exchange rate. The country is now operating a ‘dirty float’, much like China does, which allows the BRL to float within a tight band of about BRL$2 to BRL$2.10 to the dollar. Mantega claimed the shift was a necessary reaction to other countries’ currency manipulation, commenting: “If the whole world is going to manipulate their exchange rates, we will too.”
Switzerland has openly manipulated its currency since 2011, pegging its franc (CHF) to the euro in an effort to dissuade use of CHF as a safe haven currency in Europe, which has the effect of increasing the value of the franc and making Switzerland’s exports less competitive. As the ‘Financial Times’ reported: “The head of the Swiss National Bank has vowed to continue its policy of halting rises for the franc against the euro and has warned that a stronger currency would be a ‘substantial threat’ to Switzerland’s export-dependent economy.”
In 2010, Japan unilaterally intervened in foreign exchange (FX) markets to place a ‘defence line’ around the yen at ¥82 per dollar, after it had surged from ¥82.88 per dollar to beyond ¥85. Following the March 2011 earthquake, Japan intervened in the FX markets again, this time in concert with the G7. Then in August and October, Japan took unilateral action to push down the value of the yen, even though, according to the US Treasury’s December 2011 exchange rate policy report “exchange market conditions appeared to be operating in an orderly manner and volatility in the yen-dollar exchange rate was lower than the euro-dollar market.”
The US government has also knowingly taken actions that affect the value of the dollar on occasion. The Federal Reserve’s quantitative easing (QE) programmes – where the Fed prints money to buy trillions of dollars’ worth of mortgage-backed securities and treasury bills in order to stimulate the economy – are widely considered to have the effect of manipulating the value of the USD. The Fed launched its third round of QE in September 2012 and is reportedly considering a fourth round in 2013.
These are only some of the obvious examples of currency manipulation that every country engages in, as reports like the recent ‘Combating Widespread Currency Manipulation’ published by the Washington-based Peterson Institute of International Economies makes clear. In fact, widespread currency manipulation is one reason why the USD no longer moves against all currencies with the same momentum in the same direction at the same time as it once did. Corporate leaders, analysts, treasurers and investors still are getting used to this phenomena where no end is in sight for the foreseeable future.
Who is Affected by a Currency War?
Currency manipulation is growing exponentially. For multinational corporations (MNCs), the problems that result are threefold:
- It’s not just yuan volatility, euro volatility, real volatility or yen volatility that threatens to materially impact on the corporation’s top line. It’s all of them, as the effects of volatility extend across all currencies. Corporations once assumed that currency fluctuations negatively affecting revenues in Europe, for example, would be offset by fluctuations positively affecting expenses in, say, Vietnam. However, that no longer holds true.
- Currencies impact corporations on almost every line of the financial statement.
- Globalisation pushes multinationals to look to emerging markets for growth opportunities; leading them into riskier markets and riskier currencies. As most corporations aren’t going to produce in these riskier markets, only sell there, they won’t get the benefit of currency risk on revenue being offset by expenses in a given market.
Linkages between what happens in one economy and in another are complex. But add in the fact that central banks engage in reactionary currency manipulation of the kind described above, and management of currency risk for many chief financial officers (CFOs) and treasurers begins to seem impossible. Indeed, it’s easy to see how following the linkages between a rush to safe haven in one country, and an earthquake or economic recession in another, why FX is incredibly complex and impacts on MNCs.
Technology: Managing Your Exposure to Volatility
Despite this complex business world, currency risk management is feasible. Think about how we have solved problems associated with huge amounts of data and complex linkages in the past. We have leveraged technology to make decision making in that environment faster, easier, and more accurate. First it was the calculator, then the room-sized IBM 701 electronic data processing machine, now small smartphones that process data exponentially faster than the IBM 701.
So it should come as no surprise that many companies are turning to technology to address currency risk. Brian Kowles, assistant treasurer at Accenture, recently spoke of his company’s treasury management transformation. “Identifying, summarising and categorising all of our exposures across the enterprise – just getting our arms around that – was the first thing,” he said. “Then we had to be able to identify that data and really divorce ourselves from the accounting cycle. In a matter of days you can have several digit moves of currencies against each other. We wanted to be able to say, ‘An entry is made on the 7th of the month and creates an exposure. So let’s start managing it on the 7th.’”
Accenture implemented a technology solution to solve currency-related profit and loss (P&L) surprises. But, said Kowles: “What we were then identifying was we weren’t using SAP the way we were supposed to; we needed to leverage SAP real time. So we re-tooled how our treasury works, and at the end of the day we have a much better appreciation across many management nodes where journal entries can have a major currency impact.”
There are five steps to gaining the kind of better visibility and timeliness, and greater confidence that Kowles spoke of and corporate treasurers strive for:
- Focus on understanding your exposure and being confident that your exposure data is accurate.
- Define your risk/reward parameters.
- Decide what risk is acceptable, and what is not.
- Decide the areas in which you want to manage your risk.
- Leverage automation and analytics to institutionalise the process of risk management.
The fact that we’re in the midst of an escalating currency war that is generating top-line revenue impact across a company’s currency pairs is one that most CFOs, treasurers, and corporate risk managers aren’t yet thinking about as it hasn’t made the headlines. That’s a big mistake, because only companies that take proactive action to assess their exposure and manage their currency risk will be able to avoid the fallout.
How can treasurers effectively hedge against currency risk? By proactively assessing their exposure across all of the currencies they do business in. A currency war is going on right now, which involves many of the world’s most traded currencies. Corporations that don’t manage against the resulting risk will get caught in the crossfire. China will escalate the war even further, and the issue was constantly debated during the US presidential elections.
Currency risk management is very feasible and already exercised by many. Smart CFOs and treasurers leverage technology to gain increased visibility, better timeliness, and more confidence in their risk management strategies. It is time to join them.
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