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In August 2015, the Renminbi stumbled. Over 3 days the offshore rate for the Chinese currency (CNH) weakened by approximately 5% against the US dollar to reach 6.52 on 12 August 2015. Many pundits were puzzled: what did this mean for the Renminbi? At that time, we issued “Managing currency risk”, providing initial guidance for companies wishing to take a more active role in managing currency exposures.
In this sequel, we explore the implications for corporates of the ongoing uncertainty in the FX market.
Managing currency risk – part 2Renminbi wars – the PBOC awakens
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Introduction
The volatility in currency markets continues unabated. In the blue corner, hedge funds are openly targeting Asian currency markets, including the Renminbi (RMB), trying to drive them lower. In the red corner, the People’s Bank of China (PBOC) is blocking several exits to stop a mass outflow of its currency, including the suspension of outbound RMB pooling, while buying RMB offshore to prop up the CNH exchange rate.
The future of China’s currency regime
Can China manage its exchange rate lower in a gradual fashion? If so, hedging might prove to be an unnecessary expense.
Will the PBOC allow the markets to take a greater role in determining the value of China’s currency by reducing its intervention, thereby raising the possibility of even greater volatility? By closing several doors to outflows of onshore Renminbi (CNY), this might seem unlikely in the near term. But what if speculators find other ways to extract CNY, leading to the potential for an untidy freefall, at which point hedging might – with hindsight – appear cheap?
Time will tell. But in times of uncertainty, forward-thinking companies often seek to re-assess their exposure to, and tolerance of, FX risk. How much can they afford to lose? And if they want to reduce their risk, what hedging options are available?
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Tools to manage currency risk
Perhaps the simplest way to manage currency risk is to avoid it altogether. But in today’s world, few Asian companies can afford to refuse to do business across borders and currencies. Even where settlement is in the company’s functional currency, pricing in a competitive market is often influenced by alternatives from suppliers elsewhere. Insulating oneself from every possible currency fluctuation may prove unfeasible. So what can be done?
Natural hedges – One of the simple strategies to reduce financial risk. For example, a company may be able to source some of its purchases in the same currencies as forecast sales. Such natural hedges will mitigate currency risk, at least to the extent that such forecasts are reliable.
Cash instruments – Bank deposits and loans can also be used to reduce FX exposure. For example, companies with large assets in China may wish to take advantage of reduced interest rates to draw down RMB debt. Mainland assets may be mortgaged as security for RMB loans, or funds raised through a private placement in the China market. Not only does this represent a balance sheet hedge of RMB assets, but also allows income generated from onshore assets to be used to service the RMB debt.
CNH versus CNY – Not all RMB are created equal. Sometimes the offshore creation (CNH) trades at a premium to CNY, though of late CNH has tended to be weaker. The spread between CNH and CNY rises and falls like the tide though, unlike the tides, movements does not follow a predictable table.
This has clear implications for the operational efficiency, and accounting effectiveness, of any hedging strategy. From an efficiency perspective, companies need to consider alternative ways to meet their demand for currency either on- or off-shore while obtaining the best rates available. This could be through the use of derivatives that settle directly in the required RMB denomination, either CNH or CNY. Alternatively, transacting onshore and finding a way to transfer the currency offshore (or vice versa) may be achievable. Lastly, net-settled derivatives, such as non-deliverable forwards, might provide the required currency protection where gross delivery of foreign currency under the derivative is not needed.
CNH:CNY spreads can also cause issues for the accountants. For example, if a mainland company has issued USD bonds offshore, and the debt will be serviced using onshore income, its income statement exposure is often deemed to arise from retranslation of USD to CNY. In such circumstances, using the company’s offshore treasury centre to buy a CNH:USD swap will create a mismatch. Changes in the spread between CNH and CNY will create ineffectiveness in the hedge relationship; from an accounting perspective the currency exposure on the debt is not aligned with the hedging instrument. This is not an unsolvable problem, but the interaction between operational efficiency and accounting effectiveness needs to be considered carefully before the company’s strategy is defined.
Derivatives – Have the potential to create havoc with a company’s wellbeing. Warren Buffett viewed derivatives as time bombs, famously describing them as “financial weapons of mass destruction’’. But equally, they can be a very useful weapon to have in the arsenal when fighting currency risk.
For example, companies in China may sell predominantly in RMB, but import raw materials in USD. When the RMB strengthened, the reduced RMB value of imports increased margins. In times of RMB weakness, margins are squeezed. At some point the business may become unprofitable. FX forward contracts may be a good way to ‘fix’ the cost of imports in local currency, based on forecasts of estimated future purchases. Such contracts can often be rolled-over in the event that the timing of shipments change.
Mainland-based companies with significant USD debt may wish to use cross currency interest rate swaps to hedge the repayment of principal and interest or, as a minimum, an FX forward to hedge any near-dated principal payments.
Option-based contracts, such as capped forwards, collars and the like, are also becoming more popular for hedging purposes, though care needs to be taken to ensure companies are not introducing greater risk than they eliminate through their hedging programme. Companies ought to have a well-defined risk management strategy, with policies and procedures in place to ensure that only derivatives aligned with this strategy are used.
Final thoughts
None of us can predict the future. The important thing to remember, therefore, is that your hedging strategy should not be about winning or losing versus the status quo. Rather, it should be aimed at meeting your hedging objective.
Minimising earnings volatility might be the goal in itself, or it could be to protect your margin within certain limits. Either way, the hedging tool you use should be aligned with your overall objective. If so, your hedging strategy should be viewed as a success.
To find out more about how PwC can help you develop a suitable risk management strategy for your currency or other financial risks, please contact:
Ian FarrarCorporate Treasury LeaderPwC China and Hong Kong
+852 2289 [email protected]
Ada SiuSenior Manager, Corporate Treasury SolutionsPwC Hong Kong
+852 2289 [email protected]
© 2016 PricewaterhouseCoopers Limited. All rights reserved. PwC refers to the Hong Kong member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. HK-20150827-2-C4
