Google Translate

Tuesday, April 2, 2013

Economic Exposure: Multidimensional Ripples

Any business unit faces foreign exchange risk in three ways—transaction risk, translation risk and economic risk. Contrary to the common notion, economic exposure has a significant impact not just on companies with foreign exchange exposures but on all companies in general. With the ripple effect of economic changes in one part of the world being widely felt in another part, economic risk has become a focus of discussion in today’s globalized world. It is highly essential that risk managers take-up adequate steps to identify and insulate against economic risks if the companies’ operations are not to be adversely affected. What role does economic exposure actually play in forex risk? 

Charles Tschampion, Managing Director of the $ 50 bn General Motors pension fund, once remarked that the real challenge for any company is not to take more risk than needed to generate the return that is offered. It is an iconic statement—pregnant with a high degree of philosophical and mathematical sophistication. But the question is how to know beforehand, how much risk one is taking.  Secondly, if one has to manage risk, one should also know what items and amounts of a firm are exposed to risk. This problem gets compounded if one’s business is exposed to foreign exchange rate risk that too, when markets are witnessing frequent bouts of excessive volatility. Indeed it is not uncommon among the business men to exasperate about their helplessness in the fight to control the associated risks that arise when exporting or importing goods and services, etc.
In a financial context, ‘risk’ refers to the probability of loss. In basic arithmetic terms, a company makes loss whenever its income is less than the expenditure incurred for generating that income. So long, as one records income and expenses in rupee terms, working out profit or loss is no big a task. But if a business is having receipts and payments in two different currencies, profit or loss calculation gets complicated. One way of overcoming this problem is to convert foreign currency receipts into rupees so that revenues can be compared with the rupee cost of production and profit/loss can be arrived at. The other alternative is to convert the rupee cost into foreign currency, compare it with the receipts in foreign currency, and workout the profit.  In either of the cases the exchange rate of rupee against the foreign currency at which such conversions are done, becomes a key variable in determining the profit or loss.

Theoretically one can therefore, say that changes in exchange rate can convert a business unit’s profit to loss and vice versa. Interestingly, these losses are not the outcome of operational inefficiencies or management’s bad practices. These have purely emanated out of change in exchange rates. It is the sensitivity of the real value of a firm’s assets/ liabilities/operating income, expressed in its functional currency, to unanticipated changes in exchange rates that causes the loss. Future cash flow projections, profitability, competitiveness and the ability to service debt can all be impacted by foreign exchange volatility when paying or receiving foreign currency. This probability of a business incurring loss on account of changes in foreign exchange rates is, what is known as foreign exchange rate risk.

Forex exposure vs. risk
This discussion also makes it evident that there are two conditions precedent for a business to suffer from foreign exchange risk. One, it needs to have foreign currency exposure in its books and two, the exchange rate should move adversely. Here by foreign currency exposure we mean, possession of assets/liabilities/cash flows that are denominated in foreign currency. To understand a company’s exchange rate exposure it is necessary to consider how it generates its cash flows. The export/import volumes, the nature of markets from which it sources inputs and the extent and structure of its foreign operations affect exposure to exchange rate changes. Any company having any sort of currency exposure in its books faces the risk of loss due to adverse exchange rate movements. Currency exposure or position could be long position— holding assets, receivables denominated in foreign currency or short position—holding liabilities or payables in foreign currency.

However, it is not necessary that all currency exposures will always result in loss and hence to be avoided. There could be occasions where such foreign exchange exposures result in a gain too. Presume, a shrimp farmer exported shrimps to Japan on May  1, and drew the bill in US dollars due for payment on June 15, 2002. Presume that in the intervening period, the Rupee depreciated and by the due date of the bill it fell to US $1= Rs. 50.12 from Rs. 49.80 because of which, the unit realized more units of domestic currency, resulting in increased profit. This leads us to appreciate that when every thing else remains same, a depreciation of a domestic currency lowers the relative price of a country’s exports and raises the relative price of its imports. In the process an exposure is potential enough to generate a profit or loss.

Exchange risk is thus not a one-way street. Every exposure need not necessarily end-up as a risk. It would therefore be not prudent to avoid all currency exposures. Instead one should give more weightage to other relevant commercial factors that have a bearing on cost efficiencies.

Financial reforms vs. forex risk
In the wake of liberalization of exchange control and trade control regimes, the number of business units having currency exposure and the magnitude of exposures has gone up. Even the perceptions of  the role of foreign trade in growth have changed dramatically in the last five decades. Trade liberalization, no doubt, could contribute to economic growth by facilitating technology transmission, international integration of production and the associated possibility for reaping scale economies, reduction in price distortions and increase in efficiency. In imperfectly competitive markets, increased competition through trade could bring about welfare gains by reducing the deadweight losses stemming from monopolies and oligopolies. Nevertheless it has a flip-side too—it can inflict losses even on companies that were once considered as efficient merely because, under a changing market scenario, the overseas manufactures gain a price-advantage over the domestic manufacturers. Many companies have also raised foreign currency loans from abroad through borrowings/equity placements. More than any thing else, it is the tariff reductions that would generate stiff competition from global players in the domestic market, which is potential enough to adversely impact the local firm’s sales/cash flows. All this implies that many Indian companies today face risk of loss from adverse movement in exchange rates than in the past.

             Position                     Rupee Depreciates             Rupee appreciates
    Long in Forex position                   Profit                                   Loss     
    Short in Forex position                  Loss                                     Profit

Forex Risk vs. Business valuations
Exchange rate changes do influence the market value of an organization. As a company’s market value is related to the expected future cash flows, analysts estimate the impact of exchange rate movements on current and expected future cash flows of firms.  Investors therefore change the company’s current market value by an estimate of the change in the present value of its future cash flows resulting from the change in the exchange rate. Estimates of the impact of exchange rate movements on an organization’s value may be more difficult to predict if the company participates in activities with off-setting exposures. 

Research indicates that there is a lag structure involved in the response of a firm value to an exchange rate change. It otherwise suggests that an economically significant proportion of the impact of exchange rate changes on the firm value is not immediately incorporated into value.  This affect is however likely to become larger and more extensive as economies become more and more open and companies become more globally oriented.

Different types of forex risk
Generally, a business unit suffers foreign exchange risk in three ways indicating that some categories are to be actively managed by the firm while some others need not be paid so much attention by the corporate treasury.

Transaction risk arises from individual trade transactions that are initiated today but extinguished at a later date because of which any adverse movement in exchange rate in the intervening period alters the net realized amount in terms of domestic currency of the exporter.  It arises when currency has to be converted from domestic to foreign or vice versa in order to make or receive payment for goods or to repay a loan or make an interest payment or currency has to be converted to make a dividend payment. 

 It is purely a cash flow exposure. To better appreciate the impact of transaction exposure on business profit, consider Indian exporters who would have invoiced their shipments in Euro during 1999 looking at its initial quote of 1Euro = Rs. 50. All those who had invoiced their exporters in Euro would have suffered a loss of 12 percent in their cash flows as Euro depreciated by around 12 percent by the year-end.

Translation risk arises out of conversion of assets/liabilities owned in foreign currency and translated into domestic currency for reporting in the balance sheet of the parent company. It is therefore known as accounting exposure. It arises as a result of the process of consolidation of foreign currency items into group financial statements denominated in the currency of the parent company. It has however no direct effect on the firm’s cash flows. 

Translation exposure is dependent on: the degree of involvement by foreign subsidiary in the firm’s business, the location of foreign subsidiaries and the accounting methods used. Different translation methods may have different impacts upon a firm’s reported earnings per share.  But theoretically, the accounting methods of reporting used to record the overseas subsidiaries should not; on their own have any impact upon its valuation. Therefore, corporates may safely ignore pure translation exposures by allowing them to remain uncovered.

Economic risk is nothing but the sensitivity of future cash flows and profits of a firm to unanticipated exchange rate changes. It arises because the present value of a stream of expected future operating cashflows denominated in the home currency or in a foreign currency may vary due to changed exchange rates. 

Amongst the three, it’s the economic risk, which is all pervasive. It affects the future value of every business. It is commonly, though wrongly perceived that companies, which have no exposure to foreign currency, are protected from exchange rate risk. But, this is not always true. If competitors with-in or out-side the country derive a profit opportunity on account of movement of exchange rate, it is bound to have an influence on the Indian company’s cashflows irrespective of the fact of not having a forex exposure.

True, exchange rates can move both ways and thus it can lead to profit as often as to losses. It is also true that the extent of profit or loss owing to exchange rate movement should average out over a period of time. But the danger with forex risk is it could result in large-enough loss to wipe-out the business in one stroke, resulting which the company may not have a second opportunity to wait for the probability of making an equally large profit. 

The economic risk is increasingly becoming significant in the globalized economy, where the ripple effects of economic changes in one corner of the globe are being felt everywhere else. Yet, its management is failing to draw the attention of corporate mandarins to the extent desired. One plausible explanation to this shortsightedness could be that unlike transaction or translation risk, it is not distinctly visible.

Economic exposure
Local currency appreciation
In view of the appreciation of domestic currency, a firm’s local sales are likely to decrease as customers could buy foreign substitute products cheaply, of course depending on the trade regulations allowing their supply, with their strengthened currencies. During 1998 and ’99 the  Indian TV market witnessed a similar situation when noted domestic TV brands like BPL, Onida etc. recorded steep fall in sales vis-à-vis imported Asian brands like Akai, Samsung, LG etc., for the simple reason that the prices of their brands  became cheaper owing to depreciation of their local currencies by 30-50 percent against the US $ while the Indian rupee remained stable. In fact as a sequel to their currencies’ steep depreciation, goods from East Asian countries simply swamped the Indian electronic/white-goods market. With the result, cash flows of many well-known Indian companies were affected though they did  not have any currency exposure in their books. 

Theoretically speaking, the demand for local firm’s product in international markets would not change unless it is invoiced in the local currency.  As against this, imports will become cheaper and thus any cash out-flows would be reduced. Similarly, interest/principal out-payments would require less of local currency.
Local currency depreciation
In the event of a firm’s local currency depreciation, the converse of what has been observed under currency appreciation holds good.  Local sales will increase, as foreign goods will become costlier in terms of domestic currency and thereby reduce foreign competition. The firm’s exports denominated in local currency will become cheaper to overseas importers and thus they would grow. Similarly, exports denominated in foreign currency result in increased cashflows as local currency depreciates. In case of cash out flows the reverse happens: interest/principal payments, payment under imports denominated in foreign currency will cost more in terms of local currency.   In a nutshell, depreciation of local currency increases both cash inflows and out flows of a firm. In view of this, a firm whose cash inflows are out of exports while outflows towards cost of production, and payment of interest etc., are in domestic currency is likely to be benefited from depreciation of domestic currency. 

To better appreciate this phenomenon, let us look at what happened in Korea. During the late 1997, Korean growth abruptly ground to a halt when the country found it-self cut-off by foreign creditors and was on the verge of national bankruptcy. As a result of the Asian currency crisis, the won depreciated sharply in the Forex market. In the summer of 1998, the won was trading at around 1,400 to the dollar as against 900 per dollar in the previous summer. This brought in an immediate and dramatic rise in its net exports to the US. Resultantly, its current account surplus reached to a level of 16 percent of its GDP.  The won’s sharp depreciation against the dollar in1997, coupled with a precipitous fall in domestic income in Korea led to an immediate surge in its trade surplus with the USA. Infact access to American export markets was a critical ingredient of economic recovery for all the Asian countries that experienced the crisis in 1997 followed by the recession in 1998.

Domestic firms
Firms, which are operating purely in domestic markets, are also exposed to economic risk. For example, Essar steel,  a company locally engaged in steel manufacturing,  purchases all its inputs from the domestic market and sells the output locally. Since all its transactions are carried out locally, technically, it should not have any exposure to transaction risk. However, this need not always be true since, presence of a foreign competitor selling steel in the local market can subject the local firm to economic exposure. Imagine for a while that the foreign competitor’s currency has depreciated against the local currency—Indian rupee, then the steel purchasers are likely to shift their purchases towards the foreign competitor. Added to this, if there is any reduction in import tariffs, the price would fall further. This automatically reduces the sales of the local producer and in turn cashflows. In fact this is what has happened in the Indian steel market during the early phase of the financial reforms.

How to measure?
Generally, the degree of economic exposure to exchange rate fluctuations will be more for a firm engaged in international trade than to a company, which is purely a domestic player. Even among the firms engaged heavily in exports, the affect varies from unit to unit depending on the characteristics of their exports such as the currencies in which they invoice their shipments and how their competitors react to the exchange rate movements.  The impact of exchange rate movement on a firm operating purely in the domestic market depends on the level of competition that it faces from foreign players. In either of the cases, economic exposure can impact the effected companies either favorably or unfavorably.  

In view of this, businesses have to measure their exposure and determine if it warrants insulation. The situation becomes complex if a firm has cash flows in a numbers of currencies for the impact varies from currency to currency. One way of assessing the impact of economic exposure on local sales is to collect historical data on how local sales have been affected by exchange rate changes in the past and make use of it to simulate future sales under different exchange rate scenarios.  Alternatively, a firm can assess its economic exposure to exchange rate movements by applying regression analysis on historical cashflows and exchange rate data.

Having said that, let us see how one can predict the exchange rate movements and estimte its likely impact on a firm’s cashflows. But the sad truth is that no theory of exchange as yet is in a position to explain why exchange rates have behaved so in the past, leaving aside the question of forecasting the future rates with any degree of accuracy.  Gone are the days when international trade was thought to be the dominant factor in determining exchange rates. In today’s world free-floats, monetary variables, capital flows, rational expectations and portfolio balances are all found to have an impact on exchange rates. As Jeffery Frankel observed in his review of research on exchange rates, the proportion of exchange rate changes that are predictable in any manner— by the forward discount, interest rate differential, survey data, or models based on macroeconomic fundamentals appears to be almost zero.

To risk or not to risk—that seems to be the question that is haunting every firm. And its intensity is getting sharpened with the globalized economy. There is no escape from it except to face it and handle it on a continuous footing. Firms have to balance the sensitivity of revenues and expenses to exchange rate fluctuations and how deftly it is handled is what ultimately defines ones’ success.

(Written sometime back and so examples may appear outdated but concepts remain valid even now)


Post a Comment

Related Posts Plugin for WordPress, Blogger...

Recent Posts

Recent Posts Widget