The sell-off emerging in EM equities and bonds sparked by the US Fed’s announcement in May of its intention to wind down its money-printing stimulus programme has seen currencies from Brazil to India and Indonesia depreciate sharply.
The ultra-low interest rates produced by quantitative easing saw an estimated $2.26 trillion of capital inflows into EMs in 2011 and 2012 alone, pushing currencies ever higher – but reversed in recent months as spooked investors reallocate funds back to developed markets.
Nevertheless, the week-to-September 26 saw the first positive net inflow into dedicated EM bond funds for 17 weeks, as investors cheered the Fed’s decision to stick with the $85 billion monthly asset-purchase plan.
Globalization means many more western companies are active in EMs, with the developing world representing half of global output and 20% of the $5.3 trillion in daily foreign exchange turnover.
EM currencies, which accounted for just 15% of global turnover in 2001, now occupy two of the top-10 most-traded spots – the Mexican peso and RMB.
However, this summer’s volatility has left corporates, which unlike portfolio investors cannot liquidate their assets overnight, exposed to rising exchange-rout risks and accompanying earnings volatility.
Amid the turmoil, corporate treasurers of international groups are relying on tried-and-tested risk-management strategies designed not to eliminate the cashflow fits and starts caused by currency volatility, but to smooth them out.
“The mentality of the treasurer is not to be trying to game whether a particular currency is going up or down, as you’d expect – it’s far more trying to remove volatility,” says Martin O’Donovan, deputy policy and technical director of the Association of Corporate Treasurers (ACT). “They may be opportunistic as to when they cover particular exposures, whether it’s purchases or sales or future investments.
“How they deal with hedging is far more done on a policy approach, for example, that they wish to be 50% covered looking at cashflows out for a year, perhaps 100% covered for cashflows likely in the next couple of months.
“So if exchange rates suddenly move significantly, to some extent they can sit back and do nothing because their hedging programme is designed to smooth out those changes.”
He adds: “International groups tend not to hedge the changing value of subsidiaries or an investment in an emerging market. But they will have covered anticipated volumes of dividends out from those operations well ahead, so that any decline in value has no effect on expected cashflow.”
O’Donovan says many corporates do this through buying and selling currencies forward, including NDFs in some EMs with the gain or loss on the non-deliverable compensating for whatever cashflow is expected in or out.
However, he warns that because EMs currencies lack the huge liquidity of sterling or the dollar, non-deliverable deals more than 12 months forward are rare, although both types of deal can be renewed on a rolling basis.
“You can’t buck a permanent devaluation – the year after next’s dividend flows are going to be much less valuable,” he says. “But hedging strategies buy companies time to find ways within their business to adjust the pattern of exposures. That could mean re-investing those local currency dividends in the local operations, materials or further acquisitions.”
This type of natural hedging is popular among international groups because they operate on long time scales and once they have made a substantial investment in an EM they cannot simply withdraw because the exchange rate becomes unfavourable.
Groups also raise funding for EM acquisitions, expansion or other projects through local currency loans from domestic or international banks. This is another natural hedge that avoids nasty balance-sheet shocks because it means companies’ local assets have corresponding liabilities in the same currency, and are subject to the same rises and falls in value resulting from FX fluctuations.
This provides the added advantage that the interest paid on local currency funding matches against the income generated from the operation creating an ongoing hedge.
One global firm that employs this hedge is SABMiller, the world’s second-largest brewer, operating in 75 markets on every continent and deriving 75% of its $34.4 billion revenue in the year to March from its EM operations.
The company moved into Europe and China in the 1990s and during the past decade has expanded operations to India, Vietnam and Australia, and seven central and south American markets.
“In terms of our overall debt profile, we try to ensure that we actually match some of our local debt liability to revenue so that we have a hedge in that respect,” says SABMiller’s Nigel Fairbrass.
“We don’t manage currency risk on a day-to-day basis. We manufacture and sell locally so effectively we have a degree of translation currency exposure but actually we don’t have to manage much of a transaction currency exposure.”
Fairbrass says the company doesn’t hedge profits, relying instead on the broad basket of currencies in which it operates to even out foreign-exchange swings.
“One of our strategic priorities is to ensure that we actually have as broad a diversification of currency exposure as we possibly can. If you look at our M&A track record over the last 15 to 20 years, the business has very deliberately gone about ensuring that we’ve got a fairly wide exposure to different currencies, which means that they do tend smooth your exposure.”
Apart from the US dollar, SABMiller’s largest exposures are predominantly to EM currencies, ranging from the Colombian peso, South African rand and Australian dollar to the Polish zloty and Czech koruna.
The ACT’s O’Donovan concludes: “The treasury takes a longer-term view of exposures but have hedging programmes to mitigate short-term volatility. For longer exposures they will have modelled those and be comfortable they can weather them, or created some type of natural hedge.
“Companies will have benefited when EM currencies were on the rise, so this is not a zero sum game.”