A morning session on the second day at the Association for Financial Professionals’ (AFP) annual conference 2014 in Washington, DC explored some of the issues that corporates need to be aware of, featuring contributions from Kelly Blanar, financial risk manager with Air Products and Chemicals, and Matt Matthews, managing director at JP Morgan.
Matthews began the session by taking a look at the alternative options for funding a foreign currency subsidiary. If the funding is being provided by the parent organisation, it may take the form of a repayable loan, a non-repayable loan, or equity. A repayable loan creates profit and loss (P&L) risk when remeasured to the US dollar (USD) at the end of the quarter.
Matthews also highlighted that this type of loan also carries a USD cash risk. A non-repayable is treated like equity, but cash is at risk for interest payments made on non-repayable loans, and on the principal if the loan is switched to repayable in the future. With equity, Matthews noted that remeasured gain or loss is reported as other comprehensive income (OCI), while cash is at risk when dividends are paid to the parent.
With the variety of risks these funding options present, it is important to have a clear hedging strategy. There are two main options that treasurers can use here: cross-currency swaps or rolling forwards.
Matthews said that cross-currency swaps effectively operate on autopilot, meaning that there is less administration with this type of hedging tool. There are also no interim cash settlements related to spot foreign exchange (FX) changes on the principal with a cross-currency swap, while the treasurer may also be able to lock in an advantageous basis and interest rate differential.
Using cross-currency swaps in China, the CNH interest expense can reduce CNY earnings at risk.
Cross-currency swaps can experience P&L volatility due to changes in interest rate differentials, currency basis, and FX impact on futures coupons unless they are designated as a cash flow hedge. Matthews also noted that there are incremental transaction charges due to the longer tenor of a cross-currency swap. In addition, there can be cash settlement considerations if the principal is rolled at maturity.
Rolling forwards generally have lower transaction charges than cross-currency swaps, due to the shorter tenor. Matthews also said that this type of hedging tool has no P&L volatility as it locks in a longer-term interest rate differential or currency basis. However, he pointed out that if a cross-currency swap is a cash flow hedge, this negates the advantage of rolling forwards.
When using rolling forwards, treasurers should consider that cash settlement of the net notional and the interest rate differential/basis are not locked in. Matthews also advised that there are transaction costs on each roll, while there is greater hedge administration due to the periodic roll of the hedges.
Looking specifically at China, Air Products and Chemicals’ Blanar looked at the differences between equity and debt. With equity, she noted that the use of FX requires approval from both the Chinese Ministry of Commerce (MOFCOM) and the State Administration of Foreign Exchange (SAFE). Blanar also said treasurers need to remember that each province has different rules and regulations, and just because you have approval for what you are doing in Shanghai that does not mean you can automatically do the same thing in Beijing, for example. If the equity in denominated in RMB, treasurers only need approval from MOFCOM.
Financing Chinese subsidiaries with debt requires SAFE approval, regardless of whether the funds are FX or in RMB. Blanar noted that as her company has a single A rating, it is cheaper for her to do a US dollar bond and then use a cross-currency swap than to do a dim sum bond.
Air Products and Chemicals was the first company to set up a CNH multibank revolver. Blanar explained that the facility was set up in 2012 as a three-year committed facility with a two-year extension offer. However, the companydecided to close the facility after just two years. Blanar said that there were two main reasons for this. The company had excess cash outside the US, which they could utilise as a cheaper source of funds. In addition, regulatory changes that had taken place since the revolver had been established meant that the CNH cross-currency swap market had developed. This meant that it was more efficient for Blanar and her team to fund in US dollars and then execute a cross-currency swap.
Regulations have been issued by the Reserve Bank of India (RBI) regarding how subsidiaries of foreign companies in the country can receive funding. J. P. Morgan’s Matthews explained that companies need to be eligible for external commercial borrowings (ECB) via either an automatic or approval route. While the automatic route is simpler and faster, both options have restrictions. The RBI regularly publishes updates to ECB criteria, so corporates need to be aware of the latest guidelines.
Blanar commented that Air Products and Chemicals has one large project in India. The company qualified for the ECB under the automatic route. This involves 20% of the funding coming from equity, with the remaining 80% being from debt. Blanar said that the debt financing is over US$20m, and that the tenor needs to be at least five years. The lender usually must be the immediate parent of the borrowing entity with at least 25% ownership.
Treasurers managing subsidiaries in China and/or India clearly have a wide variety of regulatory issues to keep on top of. This session at the AFP Annual Conference provided valuable advice on how to avoid some of the common pitfalls.
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