International Treasurer The Corporate Treasurer's Guide to Global Financial Management

May 1, 1995

Sp illover effects

SE Asia: Hedging Against a Yen Bloc

Central banks in Southeast Asia are said to be boosting the level of yen in their currency reserves. MNCs should start contingency plans for Asia to truly become a yen bloc.

Longer-term yen ri sk

1 A Yen for More? With yen exchange rate repeatedly breaking historic highs against the US dollar, more com­panies should start to look beyond simple near­term profits (or losses). Instead, they should look to the longer-te rm tactical and strategic implications of their long-yen positions.

Southeast Asia has been a popu lar pl ace for US MNCs to do bus iness, beca use w ith the do llar as the 1·egional trade currency, and cl ose ly cor­re lated to the local curren c ies, th ey d id not have to manage much currency risk. The situa- 1

tion could be changing.

A majo rity of dol lal'-based MNCs have been enjoyi ng some revenue benefits from the stark apprec iation of the yen in recent months. Whil e the recent situation has been positive, there a1·e some areas of concern for th e long-run. As mar­kets awa it G-7 action and the eventual bottom

Adding yen to reserves

While the components of reserves back ing bas­ket currencies like the M alays ian ringg it and Thai baht are a closely guarded secret, the1·e are signs that th ese South east Asian centl"a l banks are buying up yen to change the mix of their currency reserves away from the doll ar.

Asia n regional treasurers note that increasing central bank yen reserves wou ld explain why yen liquidity has been sapped, desp ite ample se lling of yen by the Bank of Japa n. It also wou ld explain recent strength in dol lar-linked As ian currencies aga inst the do ll ar. Thi s has been seen not onl y in the baht and ringgit, but in the Singapore do ll ar and Indones ian rupiah.

Asian central banks w ill have to perfo rm an interes ting balancing act, as they try to manage the possible transition of th e region to a yen­bloc. On the one hand, they w ant their loca l currencies to be reasonabl y in-line w ith the US do ll ar, and weak aga inst the yen, in order to sustain growth in th eir ex port sec to rs and encourage Japanese capital investments.

This might explain a rumor in late February and March of this year rega 1·d ing the potential for a deva luat ion of the baht aga inst the doll ar,

' of the do ll ar fall , now is a good time to assess the tacti ca l and strategic currency management

' responses to th e yen-do ll ar rate of exchange. Here are some highlights based on conversa­tions ove1· the last week.

Changing hedging approach 1 At first glance, the histo ri c highs for the yen

seem to have had littl e immediate impact on hedging strategies . Most compani es adju sted their tacti cs in the first half of 1994-some of them after wrong-s iding the market by protect­ing budget rates of 120-1 30 yen to the doll a1· aga in st expected greenback appreciation.

Few have changed their hedging appmach dramatica ll y. Yet, on the back of hi stori c yen highs, treasu1·e1·s are looking at ways to lock-in today's currency va lue on long yen positions. Several compan ies say th at they also wi ll be looking to do this as far out as they ca n, per­haps further than their normal hedging pattern. Some are still bound by th e soon-to-be-over­hauled hedge accounting ru les: "W e are look-

' ing to hedge out as far as we ca n and still get hedge accounting," notes one treasu1·er.

to concea l its increasing yen component. The ringgit, w hile strong recently, has also been ta lked down, due in part to po liti ca l uncertain- ' ty surrounding elections. Thi s may be the on ly

A plus for options. According to Jonath an Berg, man ag ing di1·ector w ith KB CLmency Adv iso rs in New Jersey, many co mpani es l ea rn ed th e ir lesso ns about the va lu e of opti ons-based strateg ies last yea r. Using for­wa rds to lock-in budgeted exchange rates,

continued on back page continued on page 2

SE Asia : Hedging Against a Yen Bloc Asian central banks look to manage the trans it ion to a yen­bloc.

page 7

A Yen for More? Apparent structu 1·a l changes in the yen­doll ar exchange rate have MNCs reeva luat­ing their longer-term FX exposure.

page 2

Transferring Yen Profits An aggressive posture by US and japa nese tax authoriti es ca ll s for carefu I transfer pricing, includ ing the management of FX ga ins (o r losses).

page3

A Basle Accord for Market Risk Proposed BIS stan­dards for banks to use internal mode ls to ensure minimum cap­ita l gives corporates new benchmarking guidelines .

page 4

VaR & Corporate In-house Banks Central to the Bas le proposa l, corporales may cons ide1· using va lue at risk as a too l to fo rmally capitalize treasury activ iti es .

page 5

Benefits from "Road Shows" In vestment in compre­hensive p1·ese ntat ions, demonstrat ing finan­cial strength, is money and time we ll spent.

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Yen Risk

continued from page 1

th ey were not able to part1 c1pate in any upside w hen the doll ar continued to fa ll through 1994 and not recover as anticipated.

"Ba lancing your assets and liabiliti es is th e fir st step ," re co mm end s Mr. Berg, "and don't focus on pi cking the dollar bottom." A lot of companies did not do as well as they could have last year, he notes, "because they kept try­ing to pick th e bottom of the do ll ar. M ea nw hil e, compani es that bought options and left their yen positions on have done rather well. "

While opt ions are quite ex pensive now, Mr. Berg adm its, " in quiet mar­kets, and fo r the longer term, options are th e r ight way to go." In other wo rd s, look for opportunities to buy slightly out-of-the-money options with str ikes set for the doll ar to ri se, pur­chasing progressively more out-of-the­money options to cover ant ic ipated transactions further out in the future.

Not all companies would necessarily wa it for low vo lati lity period s, and hence cheaper option premiums. " It has been a very long tim e since we have seen single-digit vol atility in 12-month options," says one internationa l treasury manager, "and given the size of our business in japan, and 2-3 yen moves intraday, the potential financial impact of an adve1·se yen-dollar move sign ifi ca ntly outwe ighs the costs of paying up fo r vo latility."

While most companies would wel­come the sight of volatilities coming down a couple of percentage points at the long end of the options curve, they should consider carefully the costs of waiting compared to the addi­tional premium they will need to pay up front.

Pricing negotiations on the business side

Many treasurers note that the most vis i­ble impact of the high-yen situation has been in negotiations on the operations side. Th e most pressing nego ti at ions clearly have been focused on replac ing yen-based sup pi iers with those operat­ing from weaker currencies.

2

Japan 's middle-market companies in th e in te rm ediate stages of the va lue chain have been hit the hardest by the yen's appreciat ion . Companies operat­in g in and out of Japa n are be in g forced to source elsewhere, and many japan ese firm s w ill need to finally come to terms with the cultural impli ­cations of movi ng operations offshore.

Cheaper imports are vita l to many japanese firms' weathering this excep­tion all y strong yen period. Hence, the second se t of negot iations must take pl ace w ith japanese customers, who, knowing full well that translated ea rn ­ings are boosting the bottom line back home, are asking for pri c ing conces­sions from foreigners pric ing in yen.

The same is true for grou p affi I iates in japan, who are trying to 1·enegotiate intercompany pricing arrangements. Transfer pric ing and tax pl anning com ­plicate these nego ti ation s (see p. 3). These and pmtectionist issues lead to a situ at ion where some products and commod ity inputs are priced higher in Japan, independent of the FX rate.

Som e j apanese affili ates and cus­tomers may use the currency apprec ia­tion as an excuse to try to negotiate for the off-shore pri ce.

Currency of billing is a cruc ial fea­ture of all these commercial negoti a­tions. Asi a's treasurers at US MNCs shou ld put the word out to affiliates about the currency 1·isk implica tions of changing invoic ing currenc ies, both positive and negat ive. " People in the fi eld often misunderstand the connec­t ion between the payment currency, th e pri c ing currency, and exchange exposure," notes one Singapore-based regional treasurer.

For examp le, he had one affiliate manager come to him ask ing that pric­ing be shifted from being denominated in dollars to yen, which wou ld allow the affiliate to raise pr ices to Japanese customers. The affili ate manager did not real ize th at whi le rece iv ing pay­ment in yen is no problem, changing the pricing currency to yen shifted yen exposure to him .

With ta lk of Asia-Pacific becom ing a yen bloc, there will be pressure to con-

sider swi tching pr icing from dollars to yen. "A lot of companies w ill have a knee-jerk reaction to switch pric ing to th e hard er currency [i. e., th e yen], notes I<B 's Mr. Berg "and just about the time that they do, the market may finally rea lize that the dollar's decl ine is overdone and it w ill soar toward the end of the yea r." These companies w ill be on th e wrong side of th e market (perh aps aga in).

Whil e most compani es acknowledge that the yen wi ll increas ingly become a facto r in Asian regional trade, few have noticed a major sw itch to yen­based pricin g. On th e other hand, many are awa re that Southeast As ian basket currenc ies like th e Thai baht may tend to trend more toward the yen and apprec iate aga in st the do ll a r, espec iall y if the period of yen strength looks to become prolonged (see relat­ed story on p. 1 ).

The strategic currency implications

Because so many multinational s com­pete w ith j ap anese co mp ani es, respo nses to a potenti a l structura l change in the yen -d o ll ar exc hange rate, as well as countermoves by yen­based compet itors, become a compa­ny-w ide strategic initi ative. With th e yen, then, the currency implications of doing busi ness internationall y take on an espec ially high-level significance.

Severa l US-company treasuries, in industries with strong japanese compe­tition, report unusu al " multi-h our" meetings with CEOs and senior man­agement. Whil e these meetings create extra work fo r treasury in researching an ap propriate company respo nse, they clearly benefit the company . As one international treasurer notes, " to the extent that you can get people- as high up as you can- to think about the impact currencies have on the way you operate th e busin ess, you are adding value to the organization."

It ca n' t hurt for treasurers to take the opportun ity, w ithin the context of such meetings, to highlight their functions' valu e to th e underlying business in other areas and in other currencies. -

Internationa l Treasurer/ May 1, 1995

The Back Page

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reason w hy it has still been trending w ith the US doll ar. Even Singapore has expressed con­cern about the ri se of its dollar relative to the greenback.

O n the other hand, those countries that have been fi nancing exports through th e japanese Export- Import Bank or rece ived development loa ns in yen face higher debt-serv ice cos ts. j apa n has refused to renego ti ate th ese yen­denominated loans.

Purchases of yen, therefore, may be merely a means to hedge their loans aga inst the prospect of the japanese currency climbing still higher. In an April 19 press statement, Bank of Tokyo President Tasuki Takagaki w arn ed monetary authoriti es in As ia that the yen would indeed con tinue to ri se and that they should draw up measures to guard aga inst exchange rate fluc­tuations.

Some j apanese companies are not exactly unh appy w ith th e pros pect th at So ut heast As ian countri es might be los ing some of their currency advantage in order to pay back yen­denominated loans (see p. 2).

Finall y, there are speculators, who need to be kept off-balance rega rdin g th e direct io n of local currencies.

Choppy waters ahead

Th e jury is sti ll out on w hether As ia is now poised to go all the w ay to becoming the yen­bloc region many anti cipate. What w ill happen if the do llar starts to app1·eciate aga inst the yen as the year pmgresses, is an equall y uncertain question. Might reserve baskets weight them­selves back doll arward? No one rea ll y knows.

International Treasurer The Corporate Treasurer's Guide to Global Financial Management

I !

What is certa in is that there is more potential I exposu re, more ri sk, fo r companies do ing busi­ness in As ia. Volatili ty and correlation matr ices for FX as well as interest rates should continue to refl ect wave rin g dec isio ns b y mo neta ry authoriti es, w hether to adjust to a stru ctu1·al stro ng-ye n, weak-do ll ar system, o r merely hedge against such a development as they wa it for a lasting doll ar rebound.

Speculators w ill also be contri buting, as they look to bet one way or the other, both on the yen, and on yen/Asian cross rates. Asian central banks, looking to concea l their hand, w ill be fur­ther contribu ting to market uncerta inty.

Given the strategic importance of business in this part of the world , MNC treasurers would do best to focus o n th e long-te rm co mpet it ive impacts of th e do ll ar' s relative va lue in As ia, i nc lu d ing and exc lu d in g j apa n . Thu s, th ey should carefully examine the currency implica­tions of long-term sourc ing and sit ing decisions, for themselves and As ian compet itors.

In the short-term, choppy w aters suggest not leaving pos it ions needl essly exposed to passing market currents. Al so, worth attention is:

• th e potentia I fo 1· i nterm itt en t interest rate sp ikes (up or down) and even FX controls.

• changing trends in the currency of b illing used in intercompany and thi rd-pa rty trade­watch out fo r local moves to yen invo icing.

• making assumptions regardi ng an equilibri­um po int fo r As ian currenc ies (important fo r fu ture budget ra tes)- i .e., some unknown rate which prov ides enough competi tiveness to loca l export sectors, without the potential for a who le­sa le liquida ti on of loca l assets, and suff ic ient debt service coverage in yen term s. •

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