There isn’t one clear strategy for companies to take when managing financial risks but, in these uncertain times, treasurers can take steps to manage potential pitfalls. Associate policy and technical director at the Association of Corporate Treasurers Stephen Baseby discusses the impact of Brexit and such events on financial stability.
The Association of Corporate Treasurers (ACT) was established in the late 1970s when interest rates and inflation rates were rising steeply, and sterling was volatile. Since then, the ACT has expanded to 4,700 members, established training courses, run a full calendar of events, and actively engaged with regulators and key decision-makers to ensure that financing the real economy is represented. A key role of ACT is to inform its members how financial regulation will affect their activities in the financial markets.
The past 30 years have seen the development of the derivative markets, which enable the real economy to better manage exposure to volatility across foreign exchange, plus interest rates and commodities – referred to as hedging the risks. The use of these markets has been challenged by two major events: the gradual imposition of tight and novel regulation on the financial services industry since the global economic crisis in 2008; and now, the potential impact of Brexit and deglobalisation on regulation and commercial ambitions.
Simply put, says Stephen Baseby, associate policy and technical director at the ACT, “The advantage of derivatives has been to enable businesses to modify their risks detached from the detail of procurement and sales, and from the means of raising capital.”
The treasurer’s job is to know what can be achieved in the derivative markets, develop market access through bank relationships and access to exchanges, and maintain the physical processes and internal authorities to be able to trade. The treasury is then able to take the commercial objective of the business, develop hedging policies and strategies, and execute transactions to manage the risks identified.
“That sounds an elegantly simple statement to make,” admits Baseby. “More difficult is for the board to define the commercial strategy. There is a danger that an overly cautious approach to risk management leads to a competitive disadvantage if markets move in favour of less-cautious competitors that choose to ride the volatility. The post-Brexit and post- Trump movements in foreign exchange rates provide a good example of the difficulties that the markets present to us in the real world.”
“What risks do your shareholders want?” posits Baseby. “The simple answer is probably none; they want consistent growth in profits and dividends, and no surprises unless they are pleasant ones – such as an aggressively priced bid.”
In reality, he says, businesses will seek to achieve consistency of returns on capital by dampening down the risk of volatility of financial variables. Many seek to neutralise foreign exchange effects on balance sheet values by borrowing in the currencies of their assets. Many will have rolling programmes to hedge interest rate and foreign exchange rate exposure using derivative contracts. Those with clearly identifiable exposure to commodity prices will hedge the commodity price risk.
“The corporate problem is that any one business may have exposure to a range of variables, and each needs to be identified and managed separately,” Baseby explains. “This may not be as simple as one wants, because the exposure to any particular variable can be buried away in commercial agreements across the business. Removing exposure to a readily transparent variable may only create risk where that exposure already has an offsetting but less transparent variable.”
Treasurers have long learned to engage with the business to ensure that they understand how and where the variables lie. As an example, procurement contracts can contain factors that the supplier can use to vary the delivery price. It is helpful to know if price varies arithmetically or by reference to competitor activity. Larger businesses may have several similar suppliers under framework procurement contracts and call down batches of materials when required based on price.
The supplier does not necessarily take advantage of all factors if the net effect would be to price itself out of supplying. The treasurer needs to have worked with the procurement department to know how such contracts are managed.
Baseby’s next question is: what risk strategy is required in the real economy?
“For simplicity, let’s focus on foreign exchange rates and the stepchange effect of Brexit,” he says. “Brexit, for some UK domiciled businesses, is a relatively minor event. Those significantly involved in US industries, of which the main example is the extractive industries, saw their pound-sterling-denominated share price strengthen.
“But what if you are a sterling business by sales and a dollar business by purchases? What if you are that business and your main competitor purchases in sterling?
“What if you have hedged your dollar purchases for several years at a cost that you believed matched those of your sterling-purchasing competitor? What if Trump’s policies do not lead to a weakening dollar? You would have foregone cheaper purchases,” Baseby explains. “And then, you have to consider the competitor that purchases in dollars and did not hedge.”
Treasurers can seek to stabilise the costs that are affected by financial market volatility but hedging itself opens risks.
“The reality is that we try to fix costs within current business plans to make the outcome closer to the forecast, but the timescale of the exercise will vary for each business,” says Baseby.
He gives the example that the forecasting horizon for a consumer goods retailer, which must be able to react to changes in consumer taste and demand, will be shorter than that for telecommunications utility, which has contracted customers with tariffs fixed for one or more years.
What real economy businesses do is keep one eye on the customers’ price point and the other on its competitors’, and seek to stay at or below the former, and below the latter. The hedging strategy must recognise the commercial risks and what is possible in the financial markets.
What can the market do for you?
The effect on corporates of the changes in financial services regulation following the financial crises, which have been driven from the G20 throughout its member states, can be summed up in three points:
- Banks’ appetites for any form of credit transaction have reduced in financial volume and tenor, and may fall further.
- Credit margins overall and the cost of hedging is increasing.
- The administration of derivative contracts has become more time-consuming and expensive.
Brexit referendum for UK business
“Polls of our UK-based members revealed that the majority reacted to the uncertainty of the referendum outcome by maintaining or extending their established foreign exchange hedging strategies,” reveals Baseby. “This means that most would have fixed the exchange-rate element of their forecast trading costs for about 6–12 months forward to provide some certainty to their product pricing.
“That tenor will be mostly due to their commercial instinct not to fix too far ahead, partly because these rates are only one of many variables but also because recent and impending bank regulation makes hedging more expensive the longer the tenor and, ultimately, the credit cost will outweigh the benefit.”
The problem for UK businesses in the run up to the referendum was that the outcome was unknown and the impact on financial markets could not be predicted. There was a general view that an exit would weaken sterling but also a sense that the UK would remain in the EU, and that sterling could appreciate as uncertainty was removed.
“One issue when trying to plan for the Brexit referendum was that it was a random event,” says Baseby. “There is no precedent – other than, perhaps, the mid-1970s vote for the UK to join the EU – but our world has changed in many ways since then.
“As a real-economy example, we were asked by an SME what it could have done to preserve its purchase cost for goods acquired in dollars and sold in sterling. The rate the SME wanted was about $1.50 to £1.00, which was the rate it could have achieved on a simple or spot-forward purchase prior to the Brexit vote. It did not hedge and found its purchase would now be around $1.20 to £1.00.
“The real-economy context of the question was, of course, the strategy of competitors. It could not know if they had purchased at $1.50 but would find out when it tried to sell at a purchase cost of $1.20.”
A cautionary tale
Some organisations have good reason to fix interest rates; typically, those in some regulated environments, where they have a strong ability to pass through cost and the customers want price certainty.
The above chart shows UK lending rates on loans at floating rate and for five years plus fixed rate for private non-financial corporations (PNFCs) over 11 years. The pattern is familiar on both sides of the Atlantic over many decades: fixed rate costs more than floating rate over time. This is no more than the effect of a normal yield curve where the passage of time creates uncertainty over the borrower’s ability to pay and inflation.
Unsurprisingly, data from the Bank for International Settlements showed that PNFC appetites for using derivatives to swap to fixed rate shrank after 2008 as floating rates fell. Many would have had fixes in place at 6–8% in addition to those who carried fixed-rate- term loans into the world of ultra-low floating rates.
To the future?
What these examples show is that there is no certain answer for how to manage financial risks in the real economy. A reasonable strategy, according to Baseby, is to use sources of funding, procurement contracts and derivatives to seek to match currency flows through the business.
“The more exposed to inflation your market is, the more reasonable it becomes to ride the changes in exchange rates and interest rates,” he says, “as you can expect to adjust prices to follow real cost changes.
“Our main risks in the real economy come not from the financial markets but from competitors, the changing tastes of customers and, too often, regulators, who remain focused on the financial services industry.”