Global Risk: With risk now dispersed around the globe, companies need to stay one step ahead

June 1, 2014

By: Mark Frey & Scott Smith

Dealing with liquidity drainage from the financial system, the global market place has seen risks become more regionalized, which has brought new complexity to the game for participants in the commodity and FX markets. Nearing the end of Q1 2014, some of the bleeding by emerging markets had abated, but it is clear that we are well situated in a global economic environment that differs substantially from the landscape witnessed in 2013.  The excess liquidity made increasingly abundant by a host of central banks in their efforts to navigate their respective economies through the global recession is being slowly scaled back as developed markets, like the United States and United Kingdom, begin to see economic activity advance in a constructive manner. Emerging market economies that, up until recently, have enjoyed strong capital inflows as traders and investors parked their money in these regions in chase of higher-yields, are now seeing those same flows reverse. As a result, developing nations have been subject to funding cost increases and in turn have had their current account balances collapse.

 

For the precious metal market, it would be an understatement to say that it’s been a rough couple of years and with the Federal Reserve’s commitment to ending their balance sheet expansion by the end of 2014, as inflation remains well anchored around the globe, new challenges are likely ahead for the commodity sector as a whole in the near-term.  The gradual unwind of Quantitative Easing will most likely keep a lid on precious metal prices, but the FOMC’s guidance towards an interest rate rise as early as mid-2015 isn’t all bad news for Canadian-based mining companies. The combination of a slightly more hawkish Federal Reserve and increased concerns in regards to domestic growth from the Bank of Canada have led to a sharp decline in the value of the Loonie, allowing domestic businesses that sell commodities denominated in USD to enjoy a welcome bump in their purchasing power when repatriating those funds.  What’s more, the trend of a weakening Loonie is set to continue in the few months ahead, with the gradual normalization of interest rates on the long-end of the curve in the US attracting investment flows south of the 49th parallel.

 

Although there may be further short-term pain in the cards for the Canadian dollar, stronger economic growth from Canada’s main trading partner should start to pay dividends towards the latter portion of 2014 and into 2015, with the spill-over effects of firmer demand in the US helping to remove some of the extra slack from the Canadian economy. A rebound in Canada’s export sector as the recovery in the US gains traction will help the Loonie claw back some of its losses in the early part of next year, pushing it up to $0.90 against its American counterpart.

 

With the stage set for a bumpy ride in the U.S.-Canadian dollar exchange rate over the course of this year, we’re seeing proactive FX risk management become a greater focus for mining firms. Non-traditional option-based methods of hedging are now more commonly used as part of the overall diversification strategy.  The increased flexibility inherent with an option-based hedging strategy when used in conjunction with more traditional vanilla forward contracts and spot market execution, helps smooth volatility and dispels the rigid cash management requirements that distinguish vanilla offerings.

 

Canada’s mining companies operating in emerging markets face impending hurdles that are not typically as easy to navigate. While the Federal Reserve eases off on its stimulus program, the turmoil in developing economies has become widespread and countries running large current account deficits have been particularly hard hit.  As capital flows out of these troubled areas, their depreciating currencies have acted as a benefit to companies that pay operating expenses in domestic cash; however, if a corporation is faced with using USD as its operating currency due to liquidity constraints in certain areas, they will be confronted by a rising U.S.-Canadian dollar exchange rate, which will have increased operating costs by 10% over the last year. That being said, the widespread contagion effects that have painted all emerging markets with the same brush are likely to subside in the coming months, as quality and strong fiscal balance sheets garner investor premiums.

 

Furthermore, exchange rate considerations are only a portion of the overall risk spectrum when dealing in emerging markets due to the variety of qualitative aspects developing as a result of less established market structures. South Africa, for example, a country highly reliant on US bond yields, lost 24% of its currency’s value by the end of 2013. However, besides the uncertainty for the Rand, the ongoing, highly publicized strikes across various sectors in the region, predominantly within mining, have had substantial repercussions felt by the entire industry. Looking towards South America to Argentina, in January the government was forced to liberalize their exchange regime and ease capital controls in the face of dwindling foreign exchange reserves as a result of propping up their beleaguered peso. This caused a sharp devaluation in the ARS where the domestic currency lost over 20% of its value. One of the most prominent downstream effects will be the surge in inflation as the value of imported goods increases, giving way potentially to major unrest in the labour market as workers lobby for the pay increases required to keep up with costs.  Therefore, even if a mining company can benefit from a falling Argentinian peso in terms of its operating expenses, the broader economic issues of a country experiencing capital flight and decreased investor confidence presents a greater threat than the foreign exchange implications on their own.

 

So what does this mean for international producers in their navigation of foreign markets in the years ahead?  The evolution towards a more decentralized global economic landscape, and the increasing volatility inherent with this progression, has demanded that more companies engage in robust risk management programs.  While the outlook for precious metals is not especially bright, a change from the previously witnessed “risk-on/risk-off” atmosphere we’ve seen in the past can provide opportunities for  renewed competitiveness for those that pursue a more proactively managed FX hedging strategy..  Treasurers and financial executives for mining multinationals should consider that a vanilla approach will likely be outperformed by a more dynamic approach.

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