Article
Push for the Best—But Prepare for the Worst
Strategies for reducing currency risk when doing business in volatile markets.
It’s an anxious time for many global companies. Dramatic and unexpected events last year, such as the Brexit vote and political shakeups in several other countries, including the U.S., Brazil and Italy, have roiled global markets and spurred speculation of a slowdown in the pace of globalization.
“All of this uncertainty is prompting companies to take a wait-and-see approach in terms of their investment policies,” says Cate Luzio, Global Co-Head of International Subsidiary Banking at HSBC. “Globalization is far from over, and companies aren’t looking to retrench. But they are looking to manage risk in their current markets.”
Multinationals have long balanced the risks posed by a host of different financial, economic and political environments. Recently, currencies have taken on a stronger role as a barometer of political and economic uncertainty. Since just last summer, the Brexit vote sent the British pound plunging; the unpredicted election of President Donald Trump and concerns about the future of the North American Free Trade Agreement (NAFTA) have driven down the Mexican peso; China’s slowdown has hurt the yuan (also known as the renminbi); and an election in Italy has stoked concerns about the euro.
Currencies can have a simple and powerful effect on a global company’s costs and profit margins. Put simply: If China’s currency plunges 10 percent versus the dollar, a U.S. company selling widgets in China will lose 10 percent on each sale. Hedging against currency risk—like hedging other risks such as rising interest rates or commodity costs—can make it easier to mitigate business risks during periods of volatility.
Currency hedging protects international businesses against risks arising from fluctuating exchange rates.
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“Recent events like the Brexit and U.S. election have served as a wake-up call for companies about the need to build out their hedging programs,” says Ivan Asensio, FX Thought Leadership at HSBC.
As surprising as these events were, they’ve helped further spur the strengthening of the U.S. dollar, a trend that started in 2013. A strong dollar has been helpful for companies that rely mostly on imports—such as retailers—but poses challenges for U.S. exporters that are being paid in currencies that are losing value. As a general rule, companies with 25 percent or more of their revenues denominated in a foreign currency should pay special attention to hedging strategies, Asensio says.
Many companies understand the need to hedge against the short-term risk of a currency move in the weeks that transpire between a sale and a payment. In these cases, a relatively simple agreement known as a forward contract can eliminate the risk of a currency moving in an unfavorable direction, with no premium payment required, Asensio notes. For companies with relatively simple overseas commitments—such as a company that grows flowers in the U.S. and sells them to a handful of countries—this financial hedging may be all they ever need.
But many global firms buy and sell in many countries that use many different currencies. This greater complexity presents more risks but also more opportunities for so-called natural hedging. For example, if a company has customers in many different countries, the movements of their currencies may offset each other over time. In a similar dynamic, if a product contains components from multiple countries with different currencies, that could mitigate the impact of any one currency’s movement on that product’s cost. These scenarios are increasingly common as global companies and their supply chains grow in complexity.
For example, firms can reduce currency risk in the supply chain by redeploying foreign-currency revenues into new investments using the same currency. A company that sells products in a country could buy more raw materials and employ more people in the same country. Doing local business in the local currency, rather than U.S. dollars, also helps to reduce currency risk.
Or consider a company with foreign assets such as factories or offices. Like revenues, these assets gain or lose value with relative currency movements. These gains and losses are buried deep in financial statements and therefore are not often hedged. But if there’s a sharp or lasting depreciation—or when the company sells a foreign asset that no longer fits its business strategy—companies have been forced to write down their assets and take a noticeable hit on their earnings, Asensio says.
Firms can mitigate this risk by funding their foreign assets with foreign liabilities. Before the dollar’s turnaround, many firms funded their foreign operations with (relatively weak) dollar debt that they repaid with (strengthening) foreign currency debt. Now the trend has started to reverse, with U.S. companies raising money for foreign expansion by issuing bonds denominated in foreign currencies. Other options include taking out bank loans denominated in foreign currencies and swapping U.S. dollar debt for foreign currency debt.
Taking on foreign debt is a good strategy in regions where interest rates are low, like Europe and parts of Asia and Latin America. But it isn’t viable in regions where rates are high or capital markets are weak. In those areas, asset risk may be better hedged with financial derivatives, such as forward contracts or options, which can be designated under accounting rules to protect net investments in a foreign operation.
Today’s most sophisticated global companies are employing strategic and dynamic hedging approaches that are unique to their industry, risk exposure level, risk appetite and risk management horizon.
Business is all about taking—and managing—risk. And in business, risk and opportunity often present themselves as two sides of a coin. Consider this:
Over the long term, currency values—along with other variables like inflation and interest rates—can influence strategic investment decisions about where a company should sell its products or source its raw materials. In the shorter term, hedging can improve reliability and help smooth out periods of volatility.
“Most global companies want to steer their investment decisions toward long-term opportunities,” Luzio says. “Hedging helps to ensure that you don’t have to base those decisions on unpredictable, short-term issues.”
Watch HSBC’s “Propelling Growth—Managing Risk” webinar to learn more.
©HSBC Bank USA, N.A. 2017. ALL RIGHTS RESERVED. Member FDIC.
This article is intended solely for informational purposes. HSBC Bank USA, N.A. assumes no obligation to update or otherwise revise this article. The information, analysis and opinions contained herein constitute our present judgment, which is subject to change at any time without notice. Nothing contained herein should be construed as tax, investment, accounting or legal advice. In all cases, you should conduct your own investigation and analysis of each potential transaction, and you should consider the advice of your legal, accounting, tax and other business advisers and such other factors that you consider appropriate. This is not a recommendation, offer, endorsement or solicitation to purchase or sell product or service.