How to manage FX risk in emerging markets: success factors for corporate clients
The importance of emerging markets in the world economy has grown steadily but managing EM currency risk can be a nightmare for the unwary corporate treasurer. By 2014, emerging market economies already accounted for 36% of world GDP and 27% of world trade, yet in the period between 2010 and 2015 there were eight large depreciations of emerging market currencies, according to the International Monetary Fund. Managing the company’s financial interests in these challenging markets has become a top priority for treasurers. Which factors should treasurers look at?
1. Create a dynamic hedging strategy
“Many corporate treasurers with large exposure to emerging markets do not have firm policies as they usually adopt for G10 currencies”, says Adrian Williams, Commerzbank’s Head of Corporate and Investor Solutions.
“The approach taken is often on an ad-hoc basis, however a more structured approach can be beneficial. Where an emerging market’s currency is relatively quiet and non-volatile, it tends to be off people’s radar, so they don’t hedge, and typically when it makes news headlines it is too late, because the hedging costs have become too high and you have missed the boat. It pays off to have a bespoke and dynamic approach in place.”
2. Manage the complexity of each local jurisdiction
Local differences of each country when it comes to risks and regulations add to the complexity of managing investment in emerging markets. Most emerging market currencies have restrictions on conversion, and compared to G10 currencies, are often thinly traded. Some can be hedged with forward contracts that involve physical delivery of the base currency, such as the Mexican peso or the Russian rouble. Others, such as the Brazilian real, the South Korean won, Indonesian rupiah or Malaysian ringgit, are restricted meaning they are usually hedged and settled, offshore, in the paired G10 currency, such as the euro or dollar.
In the case of the real, for instance, which cannot be taken out of Brazil, there are two markets. Non-deliverable forwards (NDF) and options are traded offshore, in New York and London, while there is an onshore market for currency swaps, forwards and options for which a Brazilian presence is needed. A corporate with a central treasury and one in Brazil can arbitrage between central hedged NDFs or locally hedged forwards, and choose the cheapest.
3. Turn to options to mitigate risk
The main hedging cost consideration for corporates is the interest rate differential. For emerging market currencies with high interest rates, this can render forward contracts uneconomic. “If you are hedging with a forward contract or borrowing locally, what you want to determine is whether the interest differential you are paying is wider than how much the currency itself devalues on average,” Williams explains. “Some of the analysis we’ve done backs up the common view that on average the interest differential is higher than the amount the currency devalues by, so therefore there is an implicit long-run cost in hedging EM currencies. Therefore, blindly hedging all emerging market exposures all the time is not necessarily a sensible thing to do.”
Many corporates have traditionally shied away from options because of their premium, but Williams says they can actually work out cheaper than hedging with forwards. “Let’s say you are hedging an emerging market currency where there is a 10% interest rate differential (Brazil at the moment). If you hedge with a forward, you are effectively locking in a 10% devaluation of the currency. With an option, you are paying a premium to protect yourself against a devaluation, and because the interest differential is so high in the first place, the pay-off from the option becomes more attractive. You avoid locking in the depreciation.”
In a pioneering study, Professor James found that “a call option on average loses its premium, while a put option on average is in the money”. The effect grows with the interest rate differential, so it is larger for emerging markets, and it grows with tenor, as the interest rate differential naturally increases as the curves get further and further apart.
“I was so fascinated by this that I did a study on about 30 emerging market currencies. In 27 of those cases, if you are looking at any tenor longer than quarterly hedging, and if you use options to hedge against depreciation, then the options were about half the cost of the forward.”
Case study: The Chinese renminbi at the top of the corporate hedging agenda
Emerging markets tend to go in cycles that are more exaggerated than in advanced economies. The current period is risk-on for emerging markets and their currencies are a lot more stable. “At such times of low volatility, it can be beneficial to put in place longer-dated hedges because it’s cheaper,” Williams says. In the last couple of years, the Chinese renminbi has climbed to the top of corporate treasurers’ hedging agendas, a testament not only to China’s growing importance to exporters and importers in Europe, the Americas and Asia, but to the volatility of its currency.
Renminbi weakness in August 2015 and January 2016 unnerved global investors and was linked to severe stock market turbulence on the Shanghai and Shenzhen exchanges. Prior to 2015, it was widely assumed that the renminbi would continue to appreciate; indeed, even allowing for recent falls, since 2005 its real effective exchange rate has risen 26%.
Renminbi weakness encouraged capital flight from China, prompting Chinese authorities to clampdown in November 2016 on the export of capital. This has been coupled with aggressive buying of offshore renminbi by the People’s Bank of China, the central bank.
“Realised volatility over the last few months has been very low, with the market very range-bound, because Chinese regulators and the PBoC were quite successful in stabilizing the renminbi and preventing further capital flight,” says Gerald Dannhäuser, Head of Corporate Sales Asia at Commerzbank. “Still, our customers are concerned that there might be a recurrence of sudden depreciation, and they are looking for hedging possibilities against a weakening renminbi.”
There are three markets for hedging renminbi, and Commerzbank is a market-maker in each one. The onshore renminbi, known as CNY, is regulated by the central bank. “The biggest characteristic is that you need trade documents, so whenever you want to hedge, you have to prove that it is for a commercial reason,” Dannhäuser explains.
“If you have a presence in China, as many multinationals do, then your perfect hedge is onshore, provided it is trade-related and you have the documents. If you are a renminbi seller, which is the normal case for exporters to China, this is usually the cheapest market, because the forward points or the interest rate differential are the lowest.”
He cautions that since 2015 there is a minimum reserve charged on these CNY deals. “The Chinese regulators are very concerned about capital flight, so if you want to hedge and sell the renminbi, they expect you to put 20% of the notional amount into a zero-interest account at the PBOC. That makes the advantage coming from the forward points a little less attractive.”
Offshore renminbi, called CNH, is traded in Hong Kong, Singapore, London and New York. The CNH market is more liquid, and is also traded on electronic platforms, but hedging costs tend to be higher than for CNY. In addition to contracts that involve a physical exchange of renminbi, there is also an offshore market in non-deliverable forwards based on the RMB.
For all three markets, the key consideration is the gap in interest rates between the renminbi and G10 currencies, such as the euro and the dollar. “In terms of bid-offer, the hedging market is very efficient, so the transaction cost is already cheap, but from a client perspective, the main cost factor for options or forwards is the interest rate differential,” Dannhäuser points out. “If it is rising, and volatility starts to go up again, then hedging becomes more challenging and requires more thinking through. That is why we see more and more clients starting to buy options, either onshore in CNY - a fairly new market – or offshore.”
At present, the renminbi market looks remarkably stable. After plunging to an eight-year trough in 2016, the NDF rate now indicates only a modest depreciation against the dollar over the next 12 months. MSCI’s China equity index has shown healthy growth so far this year, and after haemorrhaging an estimated $1 trillion in attempts to defend the currency, China’s foreign-exchange reserves rose for three straight months between February and April.
The calm may be deceptive and Dannhäuser counsels against complacency. “The forward points are widening, so the interest rate differential between euro and renminbi or dollar and renminbi is also widening. For instance, the Shibor – the Shanghai interbank rate – is climbing quite substantially.”
With premiums still low because of low volatility, he advises now is a good time to consider strategic option hedging, if a programme is not already in place. Commerzbank has developed the Timing and Instrument model, which provides advice on the hedging instrument corporates should use, and the duration. “We advise every client to have a hedging strategy or programme so that you don't fall into the trap of saying ‘we don’t hedge because it’s expensive,’ and then all of a sudden, markets move and you lose money from exports.”
The benefits of options can be dramatic yet so can be the potential pitfalls. Expert knowledge and advice is a prerequisite.