A Risky Business: Going global with your supply chain? Protect against the risk of currency erosion

August 15th, 2013

By: Julia Kuzeljevich

The world may seem smaller when it comes to communication, but when your supply chain crosses borders, the complexities do not go away.

As companies continue to extend their supply chains across emerging markets, taking advantage of potentially looser monetary policies, they are also facing risks of which they may not be fully aware.

The International Monetary Fund suggested recently that the same policies that encourage investment could actually be creating “ticking time bombs” for these economies.

“A lot of businesses dealing internationally are not making a payment in the national currency. What a lot of end manufacturers do when importing, for example, a raw material, is to look at a non-deliverable hedge. They might buy a million dollars’ worth of Chinese yuan for each month. As it appreciates and buying power erodes they might gain on their contract, and use excess cash to purchase the missing widgets that are being eroded. This offsets the erosion of the buying power,” said Mark Frey, Chief Market Strategist and risk specialist with Cambridge Mercantile Group, in a discussion with Transportation Media.

Currency risk management can help companies navigate this market volatility, he said.

“When someone is dealing with an emerging market, and getting billed in US dollars, they really only think of the currency risk as US-centric. They don’t necessarily see that there is a risk of doing business in (countries like) China if you are billed in US dollars as well,” said Frey.

They key risk they face is over time.

“Whether they’re importing product, or a portion of manufactured goods, effectively, over time, as the domestic currencies continue to appreciate (especially the Chinese yuan) against the US and Canadian dollar, the buying power relating to units of production is going to decrease, and is going to buy fewer and fewer factors of production, eroding purchasing power.”

Some companies may at first be reluctant to consider a hedging strategy to offset risk.

Going back several years, noted Frey, there may have been certain tax advantages in not employing such a strategy, “but over time as purchasing power has eroded there has been a greater level of adoption especially from firms who have seen the cycle already.”

Depending on how well developed the local market is, and the local entity’s access to that market, some companies may go to a local currency model.

“We counsel that whoever is in the best position to manage this risk should take it on. It may not be the case for a component manufacturer to have access to that capital market to manage risk. And it makes sense to be aware of when are the opportune times are to be trading, i.e. during Asian trading hours,” said Frey.

“There’s a lot of volatility in the market at this point, and 5-10 % currency fluctuations can really eat into your margins. It’s a similar market when it comes to commodity products. If you see a 5-6 % move it can more than swarm your operating profit, and often this kind of swing is not that rare, and is not going to go away any time soon. As the central banks around the world begin to slow programs such as quantitative easing down, we think these currency fluctuations will increase and create heightened volatility,” he said.

Frey equates the scenario to removing a patient from life support.

“As you increase trade linkages/dollar flows, there is more question of accessibility to these markets. Ten years ago it was rare to find a company in China doing anything at all to hedge their US dollar price risk. As trade linkages continue to grow in Canada there will be a little more direct trading with the Canadian dollar.”

Brazil is a prime example of this.

“It’s more of an emerged currency where we’re seeing some entities wanting to hedge between the Canadian dollar and Brazilian real directly, with potentially more volatility but better access to the market and more simplification,” he said.

Taking a risk management approach

“One of the key things to do is to sit down and have a realistic discussion quantifying where are the risks, what are our denominations, is the US dollar between us, and who is in the best position to manage these risks?” said Frey

Also key to remember is that currencies may not always appreciate.

“When you’re looking at China it’s almost a one way trajectory in terms of currency appreciation. But it’s not necessarily a one-way trend elsewhere. So managing the down risk is another strategy, moving away from having a US dollar relationship but having some hedging in the local currency,” he said.

There are several approaches to take in terms of foreign exchange hedging strategies.

Among several others, forward contracts allow you to lock in today’s rate, for settlement at a future point in time. The spot rate is adjusted for the difference between the interest rates for the two currencies in question and the passage of time.

A closed forward limits the date at which the contract can be drawn down or exercised, ensuring the most favorable price possible.

Another type of forward contract, the open window forward, offer a range of dates, up to three months, whereby the contract can be drawn down or exercised. This increase in flexibility may in some cases result in a slightly less favorable rate based on the interest rate differential between the two currencies in question.

Non-deliverable forward contracts, or NDFs, can be executed in many currencies for which there isn’t a fully functioning local market, such as Brazil, Russia, India and China, amongst others.

Alternatively, these contracts can also be employed with major currencies where there is an underlying commercial foreign currency risk, but no impending foreign currency payment.