Managing the Financial Risk to Your Overseas Supply Chain
By: Chris Morris, Cambridge Mercantile Group
October 26, 2013
U.S. manufacturers have long been lured to emerging markets for the many advantages these developing regions offer, including an abundance of raw goods, lower labor and production costs, and for asset investment, higher yielding returns. These countries have also presented enormous market potential with swelling GDPs that have expanded a middle class hungry for western goods. Yet while those manufacturers that have chosen to extend their operations offshore to these areas have been reaping the benefits, there are also real hazards that, if not managed carefully, can potentially outweigh the rewards.
Recently the seductive appeal for these economies has been tarnished by a major downturn in their markets. A volatile mix of economic and political pressures, in addition to energy concerns, has taken a toll which is apparent in the performance of many emerging currencies. While some analysts might see these concerns more as a blip on the radar rather than a lasting deterrence for business, one thing is clear: inflation is on the rise and these regions and their currency values will continue to experience pockets of significant volatility as we finish the year and forecast for 2014. For manufacturers with operations stretched across these developing areas, a thoughtfully advised and dynamic risk management strategy is critical to navigating the potential economic havoc.
Fuel to the Fire: US Fed Tapering
The volatility for emerging markets in the next several months is largely contingent on the actions of the US Federal Reserve. Within the period between now and January 2014, the Fed Reserve is expected to taper its quantitative easing (QE) program. Since the Fed began engaging in QE back in 2008, the bank has been purchasing Treasury Notes and Mortgage Backed Securities from its members, keeping interest rates and the U.S. dollar low, thus providing stimulus to a hurting economy.
With these low rates, investors have struggled to pull in profitable returns and in effect, many have sought higher yields within emerging markets. Once the low rate party comes to its end, which some experts even anticipate by year-end, these investors will adjust their portfolios accordingly, resulting in the intense capital outflow pattern that has extracted approximately $1 trillion from emerging market stocks worldwide this year.
Many emerging economies depend greatly on inflows from the U.S. that are used to leverage their substantial running account deficits and even defend the practice as the retraction in these economies intensifies. Countries with the largest debts have real political, social and economic anxieties that have already led to policy measures designed to mitigate the severity of long-term impact. The IMF has warned that without taking proper measures now, such as adjusting monetary policy and engaging in structural reforms, countries will feel a more concentrated impact in the years to come.
Currencies to Watch
These three currencies of countries that have some of the largest trade agreements with the U.S. are expected to be some of the most volatile.
Fell 16% at lowest in 2013
Last year Turkey’s economic momentum fell sharply, dropping to 2.2% from the previous year’s staggering 8.8% growth figure. The contraction of the nation’s GDP was due in part to the central bank’s tightened monetary policy, instituted in reaction to the European debt crisis. This in turn led to a slowdown in domestic demand, which weighed heavily on overall growth results.
This year, Turkish leaders are strongly optimistic towards a recovery, despite having cut their growth rate from 4% to 3%. However, the country’s success depends on how well it will sustain a decrease in foreign investment and its ability to cut inflation.
In addition, neither the country’s political unrest this summer, nor its proximity to the Syrian crisis, has helped prospects. The Lira’s performance has reflected this uncertainty, hitting record lows against the U.S. dollar in recent months.
Fell 25% at lowest in 2013
India has enjoyed an average 8% GDP growth rate over the last 10 years, but this year that has receded significantly, its government recently announcing a cut to its growth projections for 2014 from 6.4% to 5.3%.The core problems lie in the country’s inability to keep up with its own domestic demands for energy and infrastructure, which poses enormous challenges to foreign business.
The country’s manufacturing has also taken a hit this year, shrinking for the first time in four years. This, in addition to a widening trade deficit threatened further by the U.S. withdrawal of stimulus, has put an enormous strain on its currency.
Fell 19% at lowest in 2013
There was a great deal of buzz around Brazil’s boom over the last several years, its economy famously overtaking the UK’s in 2011 for the world’s 6th largest spot. But just one year later, things fell apart, and the country’s growth dipped to 0.9%. Recovery since then has been slow while the central bank has been in an uphill battle against accelerating inflation rates.
The fallout has taken the form of social upheaval, seen in the June protests that led to thousands in violent clashes with police. In addition, the country is under tremendous pressure to install massive infrastructure projects as it prepares to host the FIFA World Cup and the Olympics, all of which will depend on U.S. investment. Once the Fed’s deadline hits, Brazil hopes to be ready with its $60 billion intervention, but the Real has showed no signs of improvement.
Protecting your Bottom Line
We’ve only covered a snapshot for what is predicted to be some of the worst hit currencies in the coming months, countries that trade heavily with the U.S., Brazil, India and Turkey. But this is only the tip of the iceberg. The ripples of volatility will touch a long list of developing countries, particularly those with the largest current account deficits and infrastructure needs.
If your business operations extend to and widely across these regions, there is little doubt you’ve contemplated hedging your financial risk. While no one has a crystal ball to predict the market’s movements, it’s much better to prepare your business rather than to try and pull off a recovery after the fact.
The best defense for your balance sheet is a solid yet dynamic currency hedging strategy which starts with a thoughtfully prepared currency hedging policy. A common instrument to mitigate emerging market risk is a non-deliverable forward (NDF). As a pure hedging vehicle, NDFs require no exchange of principal amounts at expiry; rather, they simply invoke a cash-based settlement of profit or loss calculated by taking the difference between the agreed upon exchange rate and the spot rate at expiry. This tool is well known to financial risk managers seeking to avoid translation turbulence, pin-down forecasts, reduce or eliminate variance and defend budget targets.
As a measure of best practice, it is recommended to include foreign exchange hedge advisors in the financial planning process. They can help formulate an assessment of risk, specify budget rates and develop a strategy. In periods of significant volatility and murky horizons, success in any hedge is tantamount on your company’s ability to remain flexible in the face of changing market conditions.