Antoine Jacquemin, Global Head of Market Risk Advisory Group, SG CIB
The last 18 months have been characterised by a significant strengthening of the USD versus most currencies, which is strongly impacting corporate treasuries across the globe. The stronger USD started to take its toll on US multinationals for Q3 2014 earnings and triggered a number of downward revisions within the S&P 500.
It hurts most US multinationals in two ways. On one side, a stronger USD raises prices for foreign customers, which can negatively affect demand and volumes. On the other hand, it impacts the bottom line as the USD value of overseas earnings declines when translated back in USD.
Given the structure of the balance sheet of most multinationals, there is actually a leverage on the FX exposure. A 1% move on the USD can have a 2% impact on the earnings of the S&P 500 companies.
Typically, US multinationals are experiencing a “triple USD leverage”, moving FX up the management’s priority list. There is an operational leverage on foreign subsidiaries, a financial leverage related to an excess of USD debt relative to USD EBITDA, and finally USD leverage on the cash.
On the operational side, the FX risk can be split into transaction and translation exposures.
The transaction risk is often hedged by treasury groups to protect margins. When unhedged, this risk can turn a profitable business into a loss-making one if the impact of the currency becomes higher than the margin. The transaction risk can be hedged in an “accounting friendly” framework with cash-flow hedging relationship.
When making decisions on transaction risk hedging, companies should identify the cash flow at risk, assess the recurrence, the cost of hedging versus the risk and maximise netting. They should also consider the FX risk impact on their main competitors, which can have a different cash-flow mix or a different functional currency.
The second effect is known as the translation risk and is related to the translation of all P&L, cash flow, and balance-sheet local items into USD. This risk directly impacts the turnover, earnings and EPS. It should be considered at a group level, on a consolidated basis, looking at potential offsetting and correlations impacts.
There are no direct hedge accounting solutions available for translation risk on earnings, which explains why it is generally unhedged, but specific solutions can be considered and become relevant when the currency market shows a high level of volatility. The financial communication generally refers to the performance on a “like for like basis”, excluding FX impact, but in the end the net earnings distributed to shareholders bear the FX impacts.
When EPS is the focus of the management, specific attention should be given to both transaction and translation risk in order to facilitate reaching the guidance and the financial targets.
There is also a tight line between hedging strategy and pricing mix. In fact the hedging policy gives time to multinationals to review their pricing strategies abroad. The last 12 months show various examples of companies adjusting their pricing mix to reflect currency fluctuation. Pricing power and ability to move price higher without sacrificing volume has to be considered when making strategic hedging decisions.
For the financial leverage, the USD accounts on average for over 40% of the revenues of US multinationals, but for more than 80% of their external debt as USD has been the funding currency of choice for years. It translates into an excess of USD financial leverage of about x1.4 the USD EBITDA. A direct impact is that a stronger USD would negatively reflect on the financial leverage metrics.
Therefore, currency volatility weights on ratios are considered by rating agencies when assessing the credit worthiness of a given company. As a result, topics like debt currency mix rebalancing and EUR funding are part of the strategy of most multinational companies, especially today as the euro has become one of the cheapest currencies for funding.
|Five-year cost of funding by currency vs. USD|
Generally speaking, a stronger USD is credit negative for US multinationals across sectors – for instance, the impact tends to be negative in food and beverage, pharmaceuticals, chemicals, consumer products, technology, etc – and as a result the euro weakness is mostly positive to neutral for European peers (the weakness of some of the emerging market (EM) currencies offset part of the benefit of the stronger USD).
Finally, there is also an impact on the cash as offshore cash is generated in currency, and may sometime be trapped abroad for some time, adding up to the already short USD position, increasing the USD leverage on net debt basis
An efficient way to manage the current USD strengthening is to look at rebalancing debt currency mix. By converting USD debt into currency through cross-currency swaps, companies would lower their USD cost base and increase their costs in currencies (through the net interest expenses), while credit ratios would be more stabilized.
The increase in costs in currencies would also provide a natural hedge to some of the translation impact hitting the EPS. From a credit ratios point of view, it would also lower the sensitivity of the key ratios to FX. It can be achieved in an accounting-friendly framework, as long as the company has assets on balance sheet in the same currency, through the net investment hedging designation.
Such rebalancing should be considered looking at the cost of hedging versus volatility and risk related to each currency. Typically, rebalancing USD debt into EUR would be at a benefit as interest rates in EUR are currently lower than in USD. This impact is likely to be exacerbated over 2016 given the different monetary policy cycles between US and Europe.
For multinational companies, the benefit achieved by swapping USD funding into euro can helps to mitigate the cost of hedging higher-yielding currencies. The cost of hedging emerging countries is often much higher than the benefit achieved with the euro, but the notional at stake are generally lower.
Within the EM space, a case-by-case and currency-by-currency analysis is required as most companies will stay away from hedging the non-liquid or too expensive currencies (the likes of the Argentinian peso). On the other side, some EM currencies remain quite cheap to hedge and synthetic debt rebalancing in those currencies can prove to be very efficient (the likes of the Korean won, Hungarian forint, Polish zloty and of course the Chinese yuan).
Rebalancing debt towards CNY and KRW is very likely to be safer than keeping a high burden of USD debt for companies very active in Asia, and this can now be achieved for significant size and long-dated maturities.
If anything, the recent increase in currency volatility is putting risk management back at the centre of the things management is focusing on, given its material impact on both strategy and performance.
No doubt most large companies will continue to focus on risk management and currency rebalancing in 2016.
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