Strategies for Managing a Weaker Euro, part 1
Already US-based companies are reporting that the move in FX is adversely affecting earnings, as EUR revenue translates into lower USD results. Conversely, depending on their hedging approach, EUR-functional companies are benefitting as the USD rises. Chief financial officers (CFOs) are asking treasurers what impact the EUR depreciation has on the organisation’s bottom line. The first half of a two-part article identifies reasons for this market move, provides a market outlook and discussion on the implications, as well as the considerations for corporates from a transactional exposure perspective.
Market Rationale and Outlook
The USD has appreciated against most major currencies over recent months, for various reasons. First, economic growth in the US has strengthened relative to other countries. Second, the relative stance of US monetary policy in comparison to the policies of other countries has changed: the Federal Reserve has discontinued its quantitative easing (QE) programme while the European Central Bank (ECB) delivered a rate cut in September, as outlined below in Figure 1.
Finally, the deflationary pressures in other developed countries seem to be continuously high. Given that interest rates are close to zero, there is limited or no possibility for policymakers to use interest rates as a tool to stimulate growth. Therefore, many countries use the weakening of their currencies as a policy tool to make exports more competitive.
Figure 1- Euro versus US Dollar during 2014:
Looking at current forecasts for the next few years, as per Figure 2, it can be seen that the market anticipates the EUR/USD ranging between 1.10 (low forecast) to 1.35 (high forecast) with the mean of all forecasts between 1.20-1.25. Depending on a company’s FX risk management approach and hedge position, this outlook might trigger the need for further review.
Figure 2 – Expectations for Future USD vs. EUR Movements:
Implications for Corporates
Volatility in FX rates can affect a corporate’s financial results, balance sheet and cash flows. FX exposure is defined as any adverse effect for a company arising from movements in currency rates. In the context of FX risk management, the common objective of a treasury department is to eliminate or reduce the variability of financial performance that results from volatility in the foreign exchange markets.
There are different practices by which to classify FX risks within a corporate treasury environment. Typically, it is differentiated between transaction, translation and economic FX exposure:
Transaction exposure is defined as the risk of value changes of a transaction executed in foreign currency measured in the functional currency as a result of FX fluctuations.
Transaction exposures can be split into recognised transaction exposures and unrecognised transaction exposures.
Both unrecognised and anticipated transaction exposures are classified as cash flow hedges and depending on whether cash flow hedge accounting is applied or not, the respective FX gain/loss is recognised in the income statement or other comprehensive income.
Translation exposures arise when a company has subsidiaries with a functional currency other than the reporting currency of the company. Translation exposures are often split in profit translation exposures and (net) asset translation exposures.
Profit translation exposures arise when the annual net result of the subsidiary is consolidated from the reporting currency of the subsidiary into the reporting currency of the group. As long as the earnings or retained earnings respectively are kept in the non-functional currency entity, it is a translation risk exposure from a group perspective. As soon as a payment transaction, such as a dividend disbursement or loan repayment is executed to the attention of the group, it turns into a transaction exposure.
Asset translation exposures arise when the balance sheet of a subsidiary with a different functional currency is consolidated into the reporting currency of the group. This is also known as re-measurement risk. The group has an exposure on the net asset value (hence equity) of the subsidiary.
Translation gains or losses reflect a change in the way that values are measured by the accounting process and do not per se reflect actual economic losses with a direct cash flow impact.
Finally, economic risk relates to the future impact on cash flows and earnings of a company as a result of long term changes in FX rates, which impact on its competitiveness and other strategic factors such as margins and market share. Long-term changes in FX rates can have material impact on, for example, the production costs or sales of a company compared to its peers using another base currency. FX economic exposures are a very wide ranging type of risk and broadly link into a company’s competitive and strategic position (long-term structural changes of FX flows and rates) within an industry, its relationship with customers, suppliers or competing companies.
While economic exposure is hard to hedge given hedge accounting rules, transactional exposure can be hedged under hedge accounting rules and many companies manage that risk for both recognised and unrecognised exposure. By hedging future cash flows they can begin to hedge economic exposure as well, albeit indirectly.