Effective FX management

Mark Deans, Dealing Manager

Recent currency fluctuations and the current economic situation mean that any company exposed to foreign exchange (FX) should have a strategy to avoid unexpected losses or benefit from advantageous market movements.

Sterling's sharp fall at the end of last year turned a drama into a crisis. Its twelve-month decline from €1.50 to €1.25 was uncomfortable, but understandable. Its slump from there to near-parity with the Euro was disturbing. When it hit €1.02 on New Year's Eve, few analysts thought it had touched bottom. They were waiting for the other shoe to drop. Surely the market would go for the £1=€1 jugular when it was within such easy reach?

But investors decided they had had their fun. Sterling had taken its kicking and there was no point in meting out further punishment. Even George Soros, the chap who made his reputation and his fortune selling the Pound in the early nineties, admitted there was no more mileage in short Sterling positions. The Pound would not fall any further. It would "fluctuate", he said. He was right.

Exchange rates

Sterling's woes late last year were a product of a belief that the recession in Britain would be deeper and longer than in any other country. Investors were persuaded that the Eurozone would remain largely unaffected. The financial and economic crisis was somehow an Anglo-Saxon malaise that would not trouble Brussels, Berlin or Paris. The European Central Bank clung stubbornly to its mantra of "price stability" and "vigilance" on inflation. This presumed immunity helped the Euro to rebound by more than 15% against the US Dollar at the end of the year and reach record highs against the Pound.

That perception has since changed. Astonishingly to some, it transpires that Euroland is not, after all, on a different economic planet. The problems affecting Britain, the United States and everywhere from Albania to Zambia are affecting the Eurozone too. When consumers and companies are not buying, they are not fussy about whose products they don't buy. French and German banks are no keener to lend money than their competitors in Britain or the States. Residential property prices in Dublin and Madrid are no more resilient than they are in New York or London.

The market

Look at the hard economic data: Real Gross Domestic Product declined by 1.5% in Britain during the fourth quarter of last year – exactly the amount by which the Eurozone's GDP shrank. The contraction in Germany was even greater at -2.1%. Industrial production in the Eurozone fell by 12% in 2008; in the UK it fell by 9.4%. Unemployment at 8% in Euroland is appreciably higher than Britain's 6.3%. Retail sales rose by 4% in Britain in the year to December; in Euroland sales were down by 2.6%.

As an importing nation, Britain faces a major battle against rising prices derived from the reduced buying power of Sterling. The effective cost of imported goods from the Far East has risen by nearly 30% since last summer, as Sterling has fallen against the Dollar, and by 20% for goods from within the Eurozone. Export-led companies may welcome the softening of the Pound, but excessive exchange rate fluctuation is not considered desirable for business in general.

In this period of unprecedented market volatility, businesses are at risk of being exposed to the weakened pound. Every company trading internationally is at risk from currency fluctuations, irrespective of its size, or how complex those trading activities may be. Unexpected exchange rate movements can eliminate otherwise healthy profits.

The numbers so far suggest that the Pound and the Euro share a playing field which is, if anything, tilted in Sterling's favour. But the problem with almost all economic data is that it relates to what happened in the past. It does not show what is happening now and cannot foretell the future. Will Britain's recession really be deeper and longer than that of the Eurozone?

Not surprisingly, investors are divided on the matter. Some say the British government's open-handedness with taxpayers' money will mean a huge burden of debt that will weigh on the Pound. Others reckon the lack of any coordinated rescue plan across the Channel will handicap the Eurozone economy, therefore the Euro. On the one hand, investors are worried about the Bank of England's plans for Quantitative Easing, which will effectively amount to printing money. On the other, they worry that the European Central Bank is behind the curve with its reluctance to relax monetary policy. A popular rumour is that heavy government borrowing will lead to the loss of Britain's triple-A credit rating. Meanwhile, three members of the Eurozone – Greece, Spain and Portugal – have already suffered a credit downgrade. Ireland and Italy are hot candidates to join them.

Exchange rates

In the last couple of months Sterling/Euro has moved a lot and gone nowhere. As Mr Soros predicted, it is fluctuating. A comparison of the economic data suggests that the Pound should move higher. History, however, illustrates how accident-prone Sterling can be. If ever there was a time to hedge Euro exposure, this is it.

The G20 Summit sent ripples of confidence through stock markets around the world. FTSE shares soared above the 4000-mark on the day and sterling strengthened against the Dollar more than 1.2% to $1.47 – while the Euro fell 0.6%, dipping below 91p. International Monetary Fund resources were trebled to $750 billion and the markets responded with optimism. However, the outlook remains bleak for business owners, despite the Summit.

Sterling’s health in the year ahead is dependent on a number of factors. There are signs that it could recover. Much of the bad news surrounding the currency has been priced in already – unlike the Euro, where investors are switching out of Euro-based assets, on concerns that the downturn in the Eurozone will be particularly prolonged.

Trading conditions are tough, especially for those operating in industries that are heavily reliant on imports. In fact, Moneycorp is experiencing its highest ever levels of first-time queries from businesses facing financial problems due to the weakness of Sterling.

An exchange rate that moves a lot and goes nowhere is a mixed blessing for those with currency exposure. On the one hand it offers regular opportunities to buy the dips or sell the peaks, minimising costs or maximising revenues. On the other, it provides just as many chances to be panicked into wrongly-timed trades, selling the dips and buying the peaks. The best strategy is a 50% hedge of any currency exposure combined with a readiness to cherry-pick the peaks or troughs as they occur. After all, there is bound to be more movement.

Despite the uncertainty, there are a number of steps any company can take to reduce and manage the FX risk that results from volatility in the currency markets:

  1. Define and understand your risk: How does a movement in the exchange rate affect your business? Before you decide how best to hedge your exposure, it is essential to understand what type of exposure you actually face. Most import and export businesses encounter ‘transactional’ risk, ie. the risk that invoice costs will increase, or future cash flows will be reduced due to adverse exchange rate movements. Identifying risk as early as possible is important.
  2. Plan ahead: What is your contingency plan if exchange rates move below a project’s budget level? Ideally companies should take a balanced approach, using a combination of spot and forward contracts. How and when to use products like these should be dictated by your company’s FX policy.
  3. Manage your risk: Once identified, it should be managed proactively. Whether your business needs to make ongoing payments or has to negotiate one large overseas contract, exposure to currency movement is inevitable. Don’t let FX management be an afterthought, as adverse rate fluctuations can disrupt months of planning.
  4. Gather information from a variety of sources: Make sure you find out exactly what options are available to you. Compile data from a number of sources to give yourself a well-rounded view of the markets.
  5. Do speak to a currency specialist: When it comes to foreign exchange, the first port of call for many organisations tends to be the bank. Although banks have a sound understanding of the currency markets, an FX specialist can provide a more personal service and will offer expert guidance specifically tailored to your business.

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