Corporates mull EM FX hedges
A rising dollar, a falling euro, a vulnerable Chinese currency and critical elections are just some of the reasons why experts predict heightened emerging-market (EM) currency volatility in 2015.
Uncertainty has taken its toll this year. In April, the world’s biggest distiller Diageo referred to currency volatility impacting consumer demand in the Latin America and Caribbean region, where sales were down more than 10%.
Issuing debt in foreign currencies is at best a very dubious hedge since the timing and average rate
are a mismatch for
Of course, volatility is not always a negative development – consumer goods company Unilever’s first-quarter results were boosted by favourable currency movements and food-products corporation Danone also came out ahead.
However, these are the exceptions rather than the rule, according to the Q4 2014 FiREapps currency impact report, which found that North American and European corporates reported a combined negative currency impact of almost $40 billion last year.
Nilly Essaides, director of practitioner content development at the Association for Financial Professionals (AFP), reckons the rouble and the real are the most likely offenders over the coming months, but says volatility across all EMs is expected as the dollar rises and the euro moves in the other direction.
Sander van Tol, partner at treasury consultancy Zanders, says: “Volatility for emerging-market currencies is normally driven in the short term by political and economic events. For example, an unexpected outcome at June’s Turkish general election could affect the FX market.”
Fathom Consulting has assessed the vulnerability of emerging economies to a rising dollar by looking at the extent to which their currencies are overvalued, the amount of their external debt denominated in dollars, their external debt burden and the degree to which their currencies co-move with the dollar.
“Since January, the currencies we identified as most vulnerable have lost between 15% and 60% of their value, while those described as least vulnerable have largely held their own,” says the firm’s economist Oliver White.
“The currencies most likely to suffer on the back of a stronger dollar are the Ukrainian hryvnia, the Venezuelan bolivar and the Brazilian real.”
With regard to China, the central bank is in a bind and the last thing it needs is tighter monetary policy via its currency or the Fed, he adds.
“It must either let go of the dollar rope or unleash internal deflation,” says White. “We expect it to do the smart thing and let go of the peg, paving the way for the RMB to fall by as much as 25%.
“The combination of a weak Chinese economy and a much weaker RMB will place many EMs, in particular in Asia, under severe stress. Under this scenario, we identify Vietnam, Taiwan and Malaysia as most at risk.”
As for the specific FX hedging tools available, White refers to the increased value of – and therefore demand for – long contracts. By the same token, however, going short a currency option might not be so appealing.
Zanders’ Van Tol warns there are limitations in the use of options because of illiquidity, pricing and hedge accounting impediments.
“Options are not available for all currencies due to regulation or limited liquidity,” he says. “The pricing issue lies in the fact that implied volatility is one of the main drivers of option pricing, hence the high implied volatility of emerging-market currencies leads to higher option premiums.
“This also relates to the third issue, namely hedge accounting. Under hedge accounting, the time value of options is not effective and this part of the fair value should be booked directly via the profit-and-loss statement.”
Alternative strategies available to treasurers include borrowing in local currency and managing working capital as effectively as possible.
AFP’s Essaides says that with options having become more expensive, companies are using supply chain changes to create natural hedges, shifting sourcing to reduce their exposure to particular currencies and creating offsets that match their sales.
“They are also issuing debt in foreign currencies, although that is at best a very dubious hedge since the timing and average rate are a mismatch for the exposure,” she adds.
“Companies are also using cash to invest in the countries they operate in to gain yield. The trend is to hedge earnings overall, not just cash flows or balance sheet, in order to prevent the hit to income resulting from currency volatility.”
Essaides concludes: “The idea is to create an overall programme that instead of managing individual currencies creates a hedge for the company’s earnings overall.”