When treasurers consider hedging, they often think of the possibility of a foreign exchange (FX) rate moving against them with regard to some specific cash flows or profit translation. This isn’t the only way of viewing risk however – and hence hedging – as volatility can be as much a threat to effective business planning as adverse rates.
The ability to hedge the company’s FX risk is always available, but the cost of doing it can vary dramatically between times of calm in the market and periods of market stress. There are three key themes running across the financial markets right now, which this article will review:
- The prospect of rising interest rates.
- US dollar-denominated debt overhang in emerging markets.
- Chinese economic policy
A commitment to low interest rates and the aggressive expansion of central bank balance sheets over the past six to seven years; first by the US Federal Reserve, the Bank of England (BoE) and the Bank of Japan (BoJ) – and more recently by the European Central Bank (ECB) – have suppressed volatility across stock and bond markets around the world. However, it can’t be suppressed for ever. Volatility, much like a coiled spring, tends to rebound strongly when the force compressing it is removed. There’s now a feeling among those working in the markets that we are approaching the time when global interest rates will begin to rise again.
Currency markets are where a good chunk of volatility from other parts of the financial system are bubbling to the surface. The path of least resistance for any country suffering from a shortfall in domestic demand is now to allow its currency to depreciate and hope that foreigners pick up the slack, which traditionally was the role of interest rates.
Economic adjustment between countries is primarily taking place via their exchange rates, often with huge consequences because of the size, and particularly the speed, of the movements. The fall in the value of the Russian rouble over the course of a few days in December 2014 is the most dramatic example of the potential dislocations possible with a freely floating exchange rate. Investors all rushed for the exit at the same time, leading to at 50%+ decline in the exchange rate over the space of a couple of days.
Calculating China’s policy
Low interest rates can also create problems for FX volatility in the future. Many emerging market (EM) companies used low dollar borrowing costs to load up on US dollar (USD)-denominated debt. If you earn revenue in one currency and pay interest in dollars your cash flows match so long as the exchange rate is stable, or your home currency appreciates. However, you’re in big trouble if the dollar starts to rise. The US Federal Reserve is expected to raise interest rates this week, a move which is expected to be dollar-positive. You can therefore expect default rates on USD-denominated debt and corresponding FX volatility in EM domestic currencies to rise significantly.
Chinese FX policy is also worth watching closely, because China’s authorities are trying to manage the transition of the economy from an investment-driven to a consumption-led model of growth. This will be a difficult process. It involves opening the Chinese economy up to capital flows from around the world, both inwards and outwards. The country has built up huge FX reserves from pegging its currency to the USD and will use its war chest to try and smooth the adjustment process as much as possible. Yet if the pace of USD selling becomes too much, the Chinese have already shown they are willing to depreciate their currency to stem the pace of outflows from the yuan (CNY). It is likely that further depreciation of the currency will be used as part of the Chinese transition.
All of these issues will have a significant impact across both the major currency pairs and on many of the less-traded minor currencies as well. For treasury departments exposed to a rising dollar or falling EM currencies, this current period of relative calm offer them an ideal opportunity to hedge. Hedging after another Chinese devaluation will be very expensive. If you’re lucky enough to benefit from dollar appreciation, well done! The winds of change are blowing in your favour.
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