1. The U.S. Dollar appreciates… another currency depreciates
USD/GBP: +28% USD/EUR: +27%USD/MXN: +45% USD/BRL: +37%USD/RMB: +14% USD/JPY: +6%…and the list goes on.
Is there a currency that the U.S. Dollar (USD) has not appreciated against in the last three years? We identified the start of the rise in the USD in a 2013 report titled Foreign exchange curveballs: Capitalizing on paradigm currency shifts and subsequently discussed the implications, primarily for U.S. firms, of a strong USD in a report titled Who’s worrying about FX? Corporate finance strategies for a strong U.S. Dollar environment.
An often articulated view is that U.S. firms struggle while non-U.S. firms benefit when the USD appreciates. This view was, therefore, the focus of our prior reports on the topic. In recent years, however, both U.S. and non-U.S. firms seem to have faced foreign exchange (FX)-related headwinds (Figure 1). As a result, in this report, we focus on the “other side of the coin”: i.e., the strong USD issues for firms in countries with depreciating currencies. This report also contains takeaways for firms that are looking to capitalize on their strong home currencies through investments in countries with weak currencies.
All else being equal, a moderate decline in currency generally benefits firms in that country. When the decline is severe or prolonged, however, it may be a sign of weaker economic fundamentals. Such a situation may also lead to inflationary pressure and/or government intervention. As a result, movements in key FX markets influence corporate profits and economic values of firms around the world through a number of channels. These FX impacts show up in corporate policies across the spectrum, including import and export costs, cost of capital and relative investment appeal. Thus, when a currency depreciation is sudden and severe, a number of challenges arise for firms operating in such a weak currency environment, as well as for firms from strong currency countries considering investments in these countries. We rely on case studies from three different countries to help us articulate the lessons learned.
2. The role of mismatched balance sheets
FX has always been a thorny issue for firms around the world, but the rising reliance by many firms on global supply chains and foreign end-markets has increased the impact of severe FX movements. Whereas firms have evolved globally from a strategic perspective, they have not always adapted their financial policies to the new reality.3 There are two main patterns of currency mismatch (Figure 2):
• Insufficient foreign liabilities: U.S. firms nowadays earn over half their revenues from foreign markets but have 90% of their liabilities denominated in their home currency, the USD. German and Japanese firms follow a similar pattern. Over the last few years, U.S. firms have aggressively moved to reduce that mismatch by accessing the EUR market
• Excessive foreign liabilities: We observe an opposite pattern with many firms across emerging economies in Asia and Latin America. They may earn less than 50% of their revenues overseas, but more than 50% of their liabilities are denominated in a currency other than their home currency, often a strong currency, such as the USD. Note that firms in China are typically not exposed to a similar currency mismatch
Firms can materially reduce their risk exposure when they minimize the currency mismatch. Matching can be achieved through both operational and financial strategies. Firms should try to match the currency of expenses and sales, through locating production centers in the same country and/or currency as sales. This alternative, however, is often not feasible due to a host of factors, such as political risk, prohibitive cost and lack of infrastructure/talent/scale. Firms can, therefore, also minimize the currency mismatch by increasing financial liabilities or undertaking derivative hedging (on a macro or country basis) in currencies in which they have revenues. Oftentimes, the local capital markets in some emerging economies are not sufficiently developed to allow large local firms to effectively raise sufficient financing in thelocal currency.
The currency mismatch experienced by U.S. firms has affected earnings and leverage metrics, but has generally not led to material financial pressure because most large U.S. firms are conservatively capitalized. In contrast, the currency mismatch experienced by firms in many developed markets has at times led to meaningful financial pressure. For instance, many firms in Asia suffered significant headwinds during the Asian financial crisis of 1997, and these headwinds were accentuated because of the prevalent currency mismatch.
3. Learning from specific situations
Major currency shocks not only impact the actions of companies, but also the actions of governments and central banks. These FX market actions can take the form of foreign exchange market oversight and increased regulations. As firms consider global capital allocation and the optimal financial policies, they should, therefore, also take into consideration the uncertainty associated with such supervisory oversight.
By the end of 2016, Chinese Renminbi (CNY) reached an eight-year low against the USD. In response to the weakening CNY, the Chinese government began selling currency reserves at a rapid pace (Figure 3). One of the factors that may have contributed to the CNY devaluation was the rapid outflow of CNY from outbound M&A by Chinese corporations. Indeed, cross-border M&A activity by Chinese firms more than doubled in 2016 alone. As a result, the regulators implemented temporary measures by increasing scrutiny and reviewing certain types of outbound investments.
This scrutiny may have led Chinese firms to reassess their financial policies and capital structures. One response could be for Chinese firms to soften the impact by raising debt in international markets. This approach may potentially increase their cost of debt and place additional focus on overall leverage, but would effectively diversify their geographic source of capital. In the long-run, this provides Chinese firms with additional protection against unexpected political risk. It may also potentially reduce the equity risk when operating in volatile markets.
The Chinese government remains supportive of firms embarking on strategic acquisitions but is less likely to support the “growth for the sake of growth” strategy. Firms should focus on fundamental drivers such as: broadening geographic/market coverage; cost synergies; and access to new technology, products and distribution channels. Focusing the firm’s energy on strategic assets may likely secure a more efficient approval and enhance shareholder value in the long run. As a result, outbound strategic M&A from China into the United States and Europe is likely to keep pace with the overall outbound M&A volume.
Non-Chinese firms should also factor in actual and potential government intervention as they consider investments in China, or as they consider selling a stake or assets to Chinese firms.
The secular strengthening of the USD undoubtedly pressures the revenues of U.S. firms and makes their exports to Mexico less competitive. On the flip side, a significant weakening of the home currency is not necessarily a boon to Mexican companies. Imports become more expensive, leading to rising inflationary pressure and stunted growth, as we see developing in Mexico today.
Over the last three years, the Mexican Peso (MXN) has steadily depreciated relative to the USD, reaching several new all-time lows throughout the past year (Figure 4). The decline was initially driven by global macro factors, which also led to a decline in inflation in Mexico. As the MXN continued its downward trajectory, inflationary pressures began to reemerge.
The uncertainty of the situation has raised the cost of capital of firms in Mexico and also deterred investment in Mexico. The situation is rapidly evolving and firms must constantly reassess the impact of this uncertainty and available strategies to counter it. In the near term, firms can lessen the blow by hedging their MXN exposures, then effectively communicating this strategy with investors. In the long run, firms should develop plans to be able to access alternate global supply chains as a mechanism to deal with both economic and political risk in a specific country or region.
Firms should be prepared for the fact that government reactions to severe currency movements may have adverse, unintended consequences. For instance, in 2009, the Brazilian Real (BRL) appreciated 47% against the USD in less than a year. Although the appreciation was supported by a growing economy, the Brazilian government implemented a series of taxes that effectively charged all capital inflows a 2% tariff. As the BRL continued to appreciate over the following two years, the tariff was gradually raised to 6% and additional taxes were enacted (Figure 5).
The increased funding charges led to Brazilian firms having sub-optimal capital structures, diminished their ability to fund themselves and ultimately impaired long-term growth. They may also have driven foreign firms to revisit, and, in many cases, reduce their footprint in Brazil. Political and regulatory risks are difficult to quantify and forecast, but it is nevertheless imperative for firms to implement strategies to minimize their impact. Firms must factor political costs into their long-term value proposition when continuing and/or entering into a market with history of regulatory interventions.
4. Strategic and corporate finance roadmap
Significant currency shocks impact most aspects of corporate finance, including capital structure, distribution policy, M&A strategy, liquidity, earnings and risk management. Global firms have a rich menu of financial and strategic options to navigate the choppy waters of foreign exchange markets (Figure 6). Boards and executives should weigh all options at their disposal and implement the right combination of alternatives to optimize results. Financial roadmap
• Maintain balance sheet strength and liquidity: While firms can rely on many different hedging and financing tools to offset various currency shocks, nothing provides better protection than a conservative balance sheet and robust liquidity. An excessively strong balance sheet, however, may not be optimal for shareholders
• Issue debt locally: Raising debt in local currency can remedy the currency mismatch between the currencies of liabilities and revenues that many firms experience. This approach can also be a strategic tool for companies looking to take advantage of the historic low interest rates available in many developed market currencies, such as the EUR and the JPY. At times, this may take the form of issuing debt non-locally but in the home currency
• Swap debt to local currency: As an alternative to a local issuance, a firm may raise capital offshore, then couple it with a cross-currency swap. Although the hedge will add a cost and may not always be “in-the-money,” it may provide a more efficient means of raising funds
• Intercompany loans in local currency: Global players with multiple subsidiaries can benefit from their global corporate structure by implementing a strategy whereby the parent provides an intercompany loan in the local currency to foreign subsidiaries
• Issue in a currency correlated to the local currency: Firms can issue debt in currencies that are traditionally sufficiently correlated to the local currency, (i.e., currencies that generally move in the same direction) to mitigate FX-exposure risk. For example, currencies of countries whose economies are commodity-driven at times move in lockstep
• Produce locally or in a correlated currency: Firms can lessen their FX exposure by moving production to the same region as their sales, or to a region with a correlated currency. This can be achieved through either acquisitions or capex. The strategy of “build it where you sell it” has the added benefit of shrinking supply chains, thereby potentially reducing costs and boosting earnings
• Produce in a low-cost region: This may not directly reduce FX impact, but it can help boost margins, providing a buffer against FX headwinds
• Adjust pricing: Firms can lessen the impact of FX movements by revising the pricing of their products. This can be achieved through building adjustments into sales contracts, or by denominating the contract in home currency to minimize the FX impact to revenues
• Revisit input agreements: Renegotiating purchase, supply and labor agreements can help mitigate FX mismatch. Such agreements can either directly be linked to exchange rates, or to economic variables that are correlated to exchange rates
Originally published by J.P.Morgan
We thank Mark De Rocco, Chris Hansen and Matt Matthews for their invaluable comments and suggestions. We also thank Jennifer Chan, Sarah Farmer, Deepika Nagarmath and the Creative Services group for their help with the editorial process.
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