Effective FX risk management policy in emerging markets is tricky, with the treasurer tasked with applying clear principles to addressing exposure, manage the cost of hedging, explain the risks to the business, and insure against the catastrophic downside if possible
Emerging market currencies present a set of unique challenges to the corporate, including:
High interest rates and volatility can make derivative and borrowing expensive and illiquid
Exchange controls and tax regimes can make repatriating cash challenging
Rapid devaluations can erode the value of locally held cash and the overall business
Local debt and derivative markets can be underdeveloped
There may be a lack of global banking partners leading to a heavy reliance on local banks
The attractions of doing business in many emerging markets (EM) are often very high with lots of market share up for grabs, high rates of growth and low labour costs. However, the treasurer needs to take extra precautions when designing a risk management policy. Invariably this needs tailoring for each market, but some general themes recur. The fundamental corporate objective remains to extract cash from the emerging market. Even where the EM operation is primarily providing a low-cost manufacturing or service base within a global operation, an initial level of capital investment may be required, and transfer pricing rules will mean that local cash surpluses need to be managed and repatriated.
How to frame emerging market exposure?
The starting point for managing risk exposure from emerging markets is determining the objective. It is only from this that the various options around managing or accepting the risk can be analysed. If we think about some fundamentals, then the treasurer’s primary objective is to protect value. This is a close proxy to protecting cash, but there are subtle differences. There are various means of doing this, but they fall into three main categories:
Fix the value of emerging market currency cash flow(s) at today’s FX rates
Allow the EM exposure to float (do nothing)
Cap the downside (and sometimes upside in a zero-cost structure)
With this in mind I put forward two methods of analysing the risk from emerging market currency exposure presented below. Both could be used in conjunction with each other and are not mutually exclusive. There is a traditional approach based upon fixing the cash flows through the use of a forward FX swap. The same effect can be achieved by borrowing directly in currency from the local operation or offshore as long as cash can be repatriated to repay this debt. Where there are particular issues around the repatriation of cash or the risk of appropriation of assets borrowing locally may address these particular risks, but usually it is more expensive and onerous in terms of conditions and covenants to do so. Each market is different however with varying tax, exchange control and political risk factors. This is why emerging market risks often take up a completely disproportionate amount of a treasurer’s time.
Fix the cash flow versus the high cost of borrowing
Many corporate treasurers with any significant exposure to emerging market currencies will site the high cost of borrowing in these currencies as a genuine pain point. Traditionally the approach has been to sell forward the emerging market cash flow in order to fix it at today’s rate and avoid any material devaluation. The issue is that there is a high level of devaluation baked into the interest charge within the FX swap. There is often a strong compulsion to avoid accepting this cost especially when currency devaluation doesn’t appear directly in the profit and loss account as a line-item. Of course, the profit and loss account is impacted by currency devaluation as translated profits from the emerging market are worth less in reporting currency terms.
Figures one and two compare the payoff between fixing the EM exchange rate for a year and allowing it to float. This has been done for Brazilian Real and Indian Rupee against the USD for the last ten years.
The first insight is that fixing the emerging market currency by selling it forward produces a better result on average than allowing the rate to float. The high cost of interest associated with the emerging market debt or forward contract has been worth it over the last ten years. The table below summarises this.
Generally, the Real and Rupee have weakened at an accelerated rate compared to the implied devaluation within their interest differential against the USD. This has meant that fixing this rate and accepting the interest cost has been an economically beneficial stance to have taken. This should come as a relief to the many Treasurers who sell these cash flows forwards and bear the high interest cost of doing so.
In addition to a straightforward comparison of fixing the exchange rate versus allowing it to float another hedging strategy has been tested. It is referred to as the “hybrid” strategy in the table above. The principle applied is that if the currency is weaker than the long-term trend line it is more likely to strengthen over the next year and conversely if the current rate is stronger than the long-term trend then the currency is likely to weaken. This would support fixing the rate at potentially stronger points in the cycle and adopting a floating stance when the EM currency is weaker than trend. As table one shows, this would have led to further outperformance of circa 1.5 percent in BRL versus a fixing the rate mechanically all the time. The hybrid strategy doesn’t pay off when applied to Indian Rupee, though INR is a significantly less volatile currency than BRL.
How does our risk management approach change if we think about value not cash flow?
There are two contrasting long-term dynamics within an emerging market exposure which remain after all the noise is taken out. The currency weakens over time against “developed world” currency, but at the same time local currency cash flows grow at an accelerated rate partly due to inflation but also because of increases in productivity that better education, infrastructure, and technology bring. We could take the view that a corporate investment into an emerging market is backing the hypothesis that the growth in cash flows from this business unit will outstrip the erosion of value that devaluation brings. In essence this is simply another dimension to the “value case” for investing in an emerging market at the outset.
If we are to think about emerging market risk in terms of value, then we need to analyse the point at which the exchange rate weakens to such an extent in the future that the Net Present Value of the operation becomes zero. If this sounds a little technical then all I am trying to describe is a process that uncovers the level of currency devaluation at which the value in the emerging market business as it stands today is eroded to zero. How much weaker that FX level is determines the “pain point” at which the value of the EM operation is entirely eroded due to currency risk. In risk management terms, this is the level at which an EM currency put option strike could be set to hedge against the loss of the EM operation’s overall value.
Figure three below shows an example of this value-based analysis in determining the pain point. The pain point is determined as an exchange rate of 10.9 versus the current forward rate of 7.96. If the emerging market value were protected at this level through a put option the strike of this option is 37 percent out of the money, making the premium extremely cheap. In addition, the firm could also write an option (a call on the EM currency) at a level significantly out of the money in the other direction to create a zero-cost collar. Although the written call gives away the upside value enhancement due to FX it does avoid the often-painful decision to pay an option premium. That said it should also be noted that writing a call option in theory exposes the corporate to an unlimited potential FX exposure. This is matched by an increase in value of the EM business, but of course that value is not readily convertible to a matching cash inflow. Option writers beware.
Doing business in Emerging Markets exposes the firm to a great many risks that are not present in more developed markets. Many of these factors are based around commercial and strategic considerations. In this article we have considered the age-old question of whether selling forward, or fixing, the EM currency and accepting the usually high interest cost, pays off compared to allowing the exposure to float. The evidence suggests that it does.
We have looked at a refinement of this very straight forward risk management strategy by adding the condition of only fixing when the rate is stronger than its long-term trend and seen a mixed result from this. Lastly, we have also looked at a very different perspective on managing EM currency risk, that of protecting the economic value of the EM business over the longer term. This approach involves calculating the exchange rate “pain point” at which the value of the EM operation is fully eroded. This leads to protection through an out of the money put option at this pain point level. In conclusion both of these risk management approaches can operate alongside each other to provide a cash flow and value hedge over different time horizons.
In this very short article, we cannot do this hugely complex area of treasury management much justice at all. I hope that the points raised are however thought provoking and as always, I welcome further discussion on the these.