Managing currency risk - Hong Kong Institute of Certified...
2
In August 2015, the renminbi stumbled. Over three days the offshore rate for the Chinese currency (CNH) weakened by approximately 5 percent against the U.S. dollar to reach 6.52 on 12 August. Many pundits were puzzled: what did this mean for the RMB? RMB wars – the PBoC awakens The volatility in currency markets contin- ues unabated. In the blue corner, hedge funds are openly targeting Asian currency markets, including the RMB, trying to drive them lower. In the red corner, the People’s Bank of China is locking all the exits to stop a mass outflow of its currency, including the suspension of outbound pooling of RMB, while buying RMB offshore to prop up the CNH exchange rate. What does the future hold? That’s anyone’s guess. Can China man- age its exchange rate lower in a gradual fashion? If so, hedging might prove to be an unnecessary expense. Will the PBoC allow the markets to take a greater role in determining the value of China’s currency, reducing its intervention and raising the possibility of even greater volatility? By closing several doors to outflows of onshore RMB (CNY) this might seem unlikely in the near term. But what if speculators gain the upper hand and find other ways to extract CNY, leading to the potential for an untidy freefall, at which point hedging might – with hindsight – appear cheap? Time will tell. But in times of uncer- tainty, forward-thinking companies often seek to re-assess their exposure to, and tolerance of, foreign exchange risk. How much can they afford to lose? And if they want to reduce their risk, what hedging options are available? Basic tools Perhaps the simplest way to manage currency risk is to avoid it altogether. But in today’s world, few Asian companies can afford to refuse to do business across borders and currencies. Even where set- tlement is in the company’s functional currency, pricing in a competitive market is often influenced by alternatives from suppliers elsewhere. So insulating oneself from every possible currency fluctuation may prove unfeasible. However, other simple strategies might be available. For example, a company may be able to source some of its purchases in the same currencies as forecast sales. Such natural hedges will mitigate cur- rency risk, at least to the extent that such forecasts are reliable. Cash instruments – both bank deposits and loans – can also be used to reduce foreign exchange exposure. For example, companies with large assets in China may wish to take advantage of reduced interest rates to draw down RMB debt. Mainland assets may be mortgaged as security for RMB loans, or funds raised through a private placement in the China market. Not only does this represent a balance sheet hedge of RMB assets, but income gener- ated from onshore assets may be used to pay down the RMB debt. Derivatives – good or evil? For sure, derivatives have the potential to create havoc with a company’s wellbe- ing. Warren Buffett viewed derivatives as time bombs, famously describing them as “financial weapons of mass destruc- tion.” But equally, they can be a very useful weapon to have in the arsenal when fighting currency risk. For example, companies in China may sell predominantly in RMB, but import raw materials in USD. When the RMB strength- ened, the reduced RMB value of imports increased margins. In times of RMB weak- ness, margins are squeezed. At some point the business may become unprofitable. Foreign exchange forward contracts may be a good way to “fix” the cost of imports in Managing currency risk Ian Farrar explores the implications of the ongoing uncertainty in the foreign exchange market for corporates 44 March 2016 Source Risk management
Transcript of Managing currency risk - Hong Kong Institute of Certified...
In August 2015, the renminbi stumbled. Over three days the offshore rate for the Chinese currency (CNH) weakened by approximately 5 percent against the U.S. dollar to reach 6.52 on 12 August. Many pundits were puzzled: what did this mean for the RMB?
RMB wars – the PBoC awakensThe volatility in currency markets contin-ues unabated. In the blue corner, hedge funds are openly targeting Asian currency markets, including the RMB, trying to drive them lower. In the red corner, the People’s Bank of China is locking all the exits to stop a mass outflow of its currency, including the suspension of outbound pooling of RMB, while buying RMB offshore to prop up the CNH exchange rate.
What does the future hold?That’s anyone’s guess. Can China man-age its exchange rate lower in a gradual fashion? If so, hedging might prove to be an unnecessary expense.
Will the PBoC allow the markets to take a greater role in determining the value of China’s currency, reducing its intervention and raising the possibility of even greater volatility? By closing several doors to outflows of onshore RMB (CNY) this might seem unlikely in the near term. But what if
speculators gain the upper hand and find other ways to extract CNY, leading to the potential for an untidy freefall, at which point hedging might – with hindsight – appear cheap?
Time will tell. But in times of uncer-tainty, forward-thinking companies often seek to re-assess their exposure to, and tolerance of, foreign exchange risk. How much can they afford to lose? And if they want to reduce their risk, what hedging options are available?
Basic toolsPerhaps the simplest way to manage currency risk is to avoid it altogether. But in today’s world, few Asian companies can afford to refuse to do business across borders and currencies. Even where set-tlement is in the company’s functional currency, pricing in a competitive market is often influenced by alternatives from suppliers elsewhere. So insulating oneself from every possible currency fluctuation may prove unfeasible.
However, other simple strategies might be available. For example, a company may be able to source some of its purchases in the same currencies as forecast sales. Such natural hedges will mitigate cur-rency risk, at least to the extent that such forecasts are reliable.
Cash instruments – both bank deposits and loans – can also be used to reduce foreign exchange exposure. For example, companies with large assets in China may wish to take advantage of reduced interest rates to draw down RMB debt. Mainland assets may be mortgaged as security for RMB loans, or funds raised through a private placement in the China market. Not only does this represent a balance sheet hedge of RMB assets, but income gener-ated from onshore assets may be used to pay down the RMB debt.
Derivatives – good or evil?For sure, derivatives have the potential to create havoc with a company’s wellbe-ing. Warren Buffett viewed derivatives as time bombs, famously describing them as “financial weapons of mass destruc-tion.” But equally, they can be a very useful weapon to have in the arsenal when fighting currency risk.
For example, companies in China may sell predominantly in RMB, but import raw materials in USD. When the RMB strength-ened, the reduced RMB value of imports increased margins. In times of RMB weak-ness, margins are squeezed. At some point the business may become unprofitable. Foreign exchange forward contracts may be a good way to “fix” the cost of imports in
Managing currency riskIan Farrar explores the implications of the ongoing
uncertainty in the foreign exchange market for corporates
44 March 2016
SourceRisk management
Ian Farrar is the
Corporate Treasury
Leader for PwC China
and Hong Kong
local currency, based on forecasts of esti-mated future purchases. Such contracts can often be rolled-over in the event that the timing of shipments changes.
Equally, Mainland-based companies with significant USD debt may wish to use cross currency interest rate swaps to hedge the repayment of principal and interest or, as a minimum, an foreign exchange forward to hedge any near-dated principal payments.
Option-based contracts, such as capped forwards, collars and the like, are also becoming more popular for hedging purposes, though care needs to be taken to ensure that companies aren’t introducing greater risk than they eliminate through their hedging programme. Companies ought to have a well-defined risk manage-ment strategy, with policies and procedures in place to ensure that only derivatives aligned with this strategy may be used.
CNH or CNY?Not all RMB are created equal. Some-times the CNH trades at a premium to CNY, though of late CNH has tended to be the weaker offspring. The spread between CNH and CNY rises and falls like the tide though, unlike the tides, move-ments doesn’t follow a predictable table. What can be said with some certainty,
however, is that until capital controls are eliminated the RMB brothers are unlikely to be equal.
This has clear implications for the operational efficiency, and accounting effectiveness, of any hedging strategy. From an efficiency perspective, companies need to consider alternative ways to meet their demand for currency either on- or off-shore while obtaining the best rates available. This could be through the use of derivatives that settle directly in the required RMB denomination, either CNH or CNY. Alternatively, transacting onshore and finding a way to transfer the currency offshore (or vice versa) may be achievable. Lastly, net-settled derivatives, such as non-deliverable forwards, might provide the required currency protection where gross delivery of foreign currency under the derivative is not needed.
CNH:CNY spreads can also cause issues for the accountants. For exam-ple, if a Mainland company has issued USD bonds offshore, and the debt will be serviced using onshore income, its income statement exposure is often deemed to arise from retranslation of USD to CNY. In such circumstances, using the com-pany’s offshore treasury centre to buy a CNH:USD swap will create a mismatch. Changes in the spread between CNH and
CNY will create ineffectiveness in the hedge relationship. From an accounting perspective the currency exposure on the debt is not aligned with the hedging instru-ment. This is not an unsolvable problem, but the interaction between operational efficiency and accounting effectiveness needs to be considered carefully before the company’s strategy is defined.
Final thoughtsI cannot tell the future. Unless you’re a for-tune teller, it’s likely that you can’t either.
The important thing to remember, there-fore, is that your hedging strategy shouldn’t be about winning or losing versus the status quo. Rather, it should be aimed at meeting your hedging objective.
Minimizing earnings volatility might be the goal in itself, or it could be to protect your margin within certain limits. Either way, the hedging tool you use should be aligned with your overall objective. If so, your hedging strategy should be viewed as a success.
aplus
March 2016 45
