Avoiding the Edge of the FX Risk Cliff
By Stephane Knauf, MD, Global Head of FX & PM Structuring, Global Markets and Rahul Badhwar, MD, Global Head - Corporate Treasury Solutions, Global Markets Corporate Services, HSBC Bank plc
While the principles and concepts of FX risk management remain constant, the environment in which treasurers operate has changed dramatically over the past decade. During the past year alone, we have seen the rise of populism driving major shifts in political direction, emphasised through the results of the Brexit referendum and US presidential election. More than ever before, the FX markets are being shaped by immediate political events rather than longer-term economic trends, which in turn influences treasurers’ risk management approach. The year ahead looks set for just as bumpy a ride, as the priorities under Trump’s presidency take shape, Brexit negotiations commence and key European elections in Germany, France, Italy and Netherlands take place. As we travel deeper into what is arguably a new era for risk management, how should treasurers equip themselves for the challenges ahead?
The new economics
To borrow a phrase from David Bloom, HSBC’s chief FX strategist, “Politics is the new economics”. This summarises exactly the state of the markets we saw in 2016, and are set to encounter in 2017. Most of the currency shocks that we saw in 2016, both in G10 and emerging currencies, such as the Mexican peso, renminbi and sterling, can be traced to a political event or major news story. Consequently, rather than simply analysing forecast economic data and taking a view on currency direction, treasurers need to be prepared for repricing following major announcements followed by the currency trading at new levels for an indefinite period.
While much of the 2017 focus is on events in Europe and the United States, the impact is not only felt on G10 currencies, but on emerging market currencies too. Furthermore, political and economic uncertainties in Asia, Africa and Latin America, such as Thailand, Malaysia and Korea, and low, volatile commodity prices, could have significant effects on currency values.
Fig 1. Boxplot/candle chart - 5 Year history
Source: HSBC calculations, EMRI countries shown according to November 2016 values, underlying data per 05 Dec 2016 (EMRI data sources: Bloomberg; World Bank; Transparency International; HSBC)
Adapting corporate hedging
In this environment, treasurers need firstly to assess carefully where their exposures are, and how material these are. This is not always easy in practice, particularly in organisations with a decentralised treasury approach, but building a central view of group-wide currency risks is essential during a prolonged period of market volatility and shocks. Having done so, treasurers can then stress test their balance sheet to gauge the potential impact of currency risks on their financial ratios. We work with clients to establish what solution works best for them, given their end goal, the different risk/reward characteristics for the wide range of alternatives and how this ties in with the company’s risk tolerance. For example, a key factor that influences hedging behaviour is whether the company is in a position to pass on the hedging cost to customers.
We have observed that within our client base many treasurers took a tactical approach to hedging in the past, and focused on the short to medium term, hedging specific short-term exposures and applying hedge accounting principles. However, when currency values crash, which can happen quickly, there may not be sufficient time to adjust the level of hedging, creating a cliff effect and therefore an earnings impact that could be material. To overcome this, we are now seeing treasurers looking to implement a more flexible approach with a longer hedging duration. By hedging over a longer period, for example, the business has more time to adjust to a new currency valuation. At HSBC, we model client solutions that have long optionality. For example, the Mexican peso (and currencies such as Malaysian ringgit and Turkish lira) was recently trading at historical lows, so for an exporter to Mexico or a Mexican company with large USD liabilities, the prospect of locking into a rate with a forward or currency swap is unattractive, and could result in a negative mark-to-market value. Furthermore, for most EM currencies, a longer duration has a higher cost of carry. This is a particular challenge for corporations operating in low-margin industries, where hedging costs can erode already narrow margins.