Ex(changing) Times – Pathfinder Business

Posted on May 29, 2008 · Posted in Pathfinder Business

 

(Ex)Changing times

 

by Paul Gosling

 

Currency volatility is one of the most significant factors influencing the future profit of any business committed to overseas markets. Yet predicting currency fluctuations can seem impossible.

 

Take Kenya, a country regarded as one of the most stable and reliable in Africa. Suddenly in December the country’s presidential election was subject to allegations of fraud, the country became engulfed in chaos and murder and the shilling fell by 16% in a month against the pound.

 

The sub-prime mortgage crisis in the United States had a similar currency impact – the dollar fell against the pound by 10% last year, before partially rebounding. The dollar rate not only affects trade with America, but also that with the range of other currencies pegged to it – including the Chinese Yuan, the Hong Kong dollar and the currencies of the Gulf states. There is now further uncertainty over future exchange rates, with predictions that each of these currencies will be decoupled from the dollar within a few years.

 

China and the Gulf states have already demonstrated their loss of confidence in the dollar. Last year they sold dollars and bought euros, helping to drive up the value of the euro and creating further ripples. Several European countries that have not formally adopted the euro, but use it widely – including Estonia, Hungary, Latvia and Lithuania – then found their own currencies under pressure, with the risk of forced devaluations.

 

Some emerging market currencies fell alongside the dollar, while others rose. South Africa’s rand fell – mostly because of concerns over the leadership of the governing African National Congress. But India’s rupee gained 13% against the dollar last year – enough to threaten many outsourcing contracts with United States’ companies.

 

Financial market uncertainty combined with the much greater globalisation of trade have clearly exposed many more companies – particularly SMEs – to serious currency risk. The key question, though, is what those businesses can do to manage and mitigate the risks.

 

Alysoun Stewart [correct spelling], a partner and head of the strategic services group at accountants and advisers Grant Thornton, says: “Obviously for larger corporates it is worthwhile to hedge and take out more sophisticated solutions.” But this “is not worth considering unless you have millions at stake,” she explains.

 

Yet companies can be exposed at much lower levels of deals than this, which still have the capacity not just to put the profitability of a contract at risk, but even the future of the business. Stewart says there are various ways to take low cost, common sense, approaches to mitigate risk. “You can build into the contract pricing some allowance for currency fluctuations,” she suggests. Another possibility is to enter into other commitments that balance the currency risk. This might, for example, involve using foreign currency earnings to buy local goods or services.

 

Then there is the choice of whether to buy some of the currency forward,” says Stewart. “It all depends on the scale of the activity involved: is it worth doing if this is a small amount of trading?” Above all, says Stewart, keep informed of what is happening in the partner country and what is likely to affect the value of both currencies involved in the foreign exchange.

 

Sophisticated advice – such as hedges, currency forwards and currency options (see box) – will usually be beyond the budget of all but the largest corporates. PricewaterhouseCoopers says it will normally provide advice only to businesses with a turnover in excess of £500m – though it will consider entering into arrangements with smaller companies with significant growth potential.

 

Detailed advice on risk mitigation requires intensive engagement, says Barclays Bank. Before it provides advice on mitigating currency risk it will typically require two, three or even four meetings between the client and the bank’s specialist foreign exchange and derivatives sales team. This will enable the bank to properly understand the risk exposure of the client and provide advice that takes into account the type of currency risk exposure and its duration. The advice might then be to conduct an immediate foreign exchange transaction, book a forward transaction for a specified date at a specified exchange rate, or what the bank calls “a more value added solution” – such as a complex options arrangement.

 

But such extensive support does not come cheap and while Barclays will not disclose the likely cost to clients, it does concede it is unlikely to be a cost-effective approach unless the client is involved in a transaction valued at over £250,000. Advised deals are mostly even larger, in the range of £1m to £2m. Barclays admits that clients would get cheaper advice from transactional brokers, but argues that the worldwide presence of a bank like Barclays means that clients can get relevant local advice from both ends of the trade. “Our service is really for someone who continues to do things in the longer term,” says Prasanna Thombre, Barclays’ director of interest rates and risk solutions.

 

One of the brokers that claims to undercut banks’ charges is HiFX, set-up 10 years ago to challenge the banks’ dominance in the foreign exchange market. “The banks had a monopoly on companies’ foreign exchange,” says HiFX’s chief economist, Bob Munro. “It was the only place that companies could go and banks took advantage of this, with spreads that were fairly wide.”

 

As well as undertaking foreign exchange transactions fee-free and with competitive exchange rates, HiFX offers a currency risk mitigation service. HiFX will normally provide ungoing advice, in return for a monthly charge. “We will go into a company looking at its foreign exchange exposure, looking at its cash flows, looking at the volatility in its markets,” says Munro. “Then we will set-up policies of mitigation, advising how to hedge and provide forecasts in the market and put together a risk management strategy for them,” Munro explains. “So if their exposure is to a weakening dollar, we will set-up a contract so that the client is selling in advance of the currency movement.”

 

The cost of such advice from HiFX varies according to the size of currency risk exposure, the nature of that risk, the complexity of any solution and the type of hedging that is to be entered into. While the company declines to indicate the likely size of charges, it says clients will normally be entering into deals of at least £3m a time. “We have clients at that amount, up to, literally, billions a year,” says Munro.

 

But companies need to be aware that risk mitigation cannot be guaranteed to remove risk – even complex hedges can end in tears. That is a lesson that pub chain Mitchells & Butlers learnt the hard way. Its currency hedge failed to protect it when an overseas property deal collapsed. The cost of unwinding the hedge was £391m – two years’ profits. Ouch.

 

Boxes

 

Hedging your currency bets

 

Hedging

 

Hedging risks is, or should be, a natural part of business management. An example might be to insure against a specific risk. Currency hedging can be part of a risk management strategy. A simple type of currency hedge for an exporter paid in the local currency would be to also buy goods or services in that currency, so that exchange rate fluctuations are balanced out.

 

Currency forwards

 

A forward contract agrees the price and quantity for supply on a particular future date. This can protect against adverse currency movements, but means that gains from positive currency movements are lost.

 

Currency options

 

A currency option involves the contract party paying a premium to give it the ‘option’ to buy or sell a currency at a particular price on a particular date. Multinationals involved in regular and substantial international trades will typically have a variety of currency options in place, maturing over various forward periods. Other types of options protect companies from currency movement beyond a certain point – for example, above a 5% fall from current levels. Options can be obtained against specific risks – such as the ‘depegging’ of the Chinese yuan or other currencies.

 

Case study

 

Bishopston Trading Company is a fair trade co-operative, established in 1985 with the specific objective of creating well-paid employment in the Southern Indian village of K.V. Kuppam. A 10% rise in the value of the rupee against the pound created a challenging environment for Bishopston.

 

It eats into our profits,” says Carolyn Whitwell, Bishopston’s founder and director. But the full impact of the currency variation has not been felt by Bishopston because it pays its trading partner in advance, giving it the working capital to buy high quality raw materials. “We have a lot of money in forward payments,” says Whitwell.

 

Whitwell praises its relationship with a local export agency in India, which provides a highly competitive rate of exchange and excellent practical assistance to the producer partner – none of whose tailors had any advanced schooling.

 

Ironically, Whitwell is less concerned about the rupee to pound exchange rate than that between sterling and the Chinese yuan. The continued low valuation of the yuan is the main factor driving down the prices of clothes in the high street, forcing Bishopston to operate on reduced margins.