Is it time to reassess your hedging practices?

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Do you have Euro exposures?  Are you worried about the Euro exchange rates?  Are you concerned that volatility will also affect other currencies, perhaps through flight to quality? 

 

As a result, are you scrambling around looking for additional hedges?  If you are, then you should consider if what you are doing is more speculation than hedging.  You should also consider a thorough review of your hedging policies and practices.  A well-conceived hedging policy should be designed precisely for volatile situations such as this and to allow time for longer term adjustments to be implemented. 

 

That is not to say it shouldn’t be constantly reviewed and updated.  It should be.  However, it should not be prone to significant, sudden and little considered changes in times of volatility.

Do I think the Euro will still be around in 5 years?

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The short answer is yes.  And this is due to self-interest, particularly for Germany.  The Euro has certainly been a weaker currency for Germany than a stand-alone Deutschemark would have been.  At the same time it has been a stronger currency for many other Eurozone countries than stand-alone currencies would have been.  This might have been expected to force the latter countries to become more productive and remove some compulsion for Germany to become so.  In fact, Germany has improved productivity substantially over the life of the Euro and produced very strong export performance helped by a weaker Euro.  At the same time, other countries, notably Italy have not restructured, or notably improved productivity, and fallen behind.  However, their borrowing costs, until recently, have been low.  Germany has in effect been benefiting from a weak currency policy (like China has) relative to its economic strength, under cover of the common currency. 

 

If weak Eurozone countries left the Euro, their currencies would likely plunge dramatically making it even more difficult to repay debts that would still be denominated in Euros.  This would apply not only to sovereign debt, but also to corporate debt.  Large bankruptcies and default s would follow resulting in massive losses for German banks that are hugely exposed to these countries.  As import costs for these weak countries would soar, German companies would also lose significant export markets.  Also German goods internationally would be more expensive with a stronger Deutschemark

 

Conversely, if Germany left the Euro, a new Deutschemark, would soar compared to the new weaker Euro and other currencies hitting German exports globally.  German banks would incur large losses as their Euro exposures lost value against the Mark.

 

In short, there is certainly going to be large cost for Germany arising out of all this one way or the other.  They have benefitted from the Euro for over 10 years and now will have been shown to have squandered part of the surplus generated by providing liquidity to unreformed weak economies.  Ensuring survival of the Euro is probably the least bad course, which is why I think the Euro will still be around in something like its present form in 5 years.

Dazed and Confused - Managing Foreign Exchange Risk & the Greek Debt Crisis

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The stakes continue to remain high in Athens as Greece’s economic rescuers attempt to craft another bailout facility.  Demonstrators, while angry, continue to be dazed and confused, and so are investors.  However, if talks breakdown it can have catastrophic consequences for Greece, the euro and the financial system.  The Greek banks and government would run out of money, cause a sharp euro downdraft and severe financial contagion.  The addition of another liquidity facility only postpones the day of reckoning.  Even if the new facility appeases the bears, the fundamental problem remains is that the country remains uncompetitive in global markets.  It will take years of painful structural reforms to restore competitiveness.  Investors with Greek or euro exposure may have to take a painful haircut much as investors in Argentina did in 2001.      

Despite the confusion in the streets, there remains a number of questions about the size of the package, of euro 119 billion (about US $120 billion) and the future viability of the Greek economy in its current state.   There seems to be a mistaken belief by Greek politicians, that the would be rescuers, would make available another euro 120 billion (or more) in 2012 to provide relief through 2014.  This would allow the new EU stability mechanism an opportunity to provide needed relief.  However, it seems to ignore the view of investors, the need for assistance to other countries and the recapitalization/restructuring of European banks. 

In addition, there are a number of challenges in German courts that the facility is “bridge-financing” and does not violate the “non-bailout” clause in the German and European Constitution.  However, analysts do not expect the court to rule the bailouts as unconstitutional, but the uncertainty surrounding the situation adds to potential risks.

In addition while Greek CDS spreads are near record levels, there seems to be further confusion as to what constitutes a default.  Rating agencies consider any type of debt restructuring, reprofiling, or even a voluntary rollover of maturing debt as a potential default.  However, a rollover according to the International Swap Dealers Assn. (ISDA) may not trigger a credit event.  European officials are trying to get around rating agencies’ reservations about a rollover so as to not to trigger a default or credit event.

The depth of the recession is taking a severe toll on the Greek economy as the economy could shrink by 4% in 2011, after falling over 4.5% in 2010.  The politicians continue to defend the welfare state and admit the medium-term budget targets are not achievable.  There is a growing concern that if the fractious politicians cannot make unpopular decisions – how can they avoid bankruptcy?  Dazed and confused - do you know your potential risk exposure?  

Implications of Increased Risk in the Foreign Exchange Markets

By Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Currency markets are showing increased signs of investor caution as various measures of risk aversion are rising.  This more cautious investor stance is based on concerns about the sustainability of US and global growth, inflation surprises in emerging markets (China), and general unease about debt levels and new asset bubbles.  Already, global Purchasing Managers Indices suggest that global growth concerns have extended across most countries.

The rise of risk aversion and investor uncertainty could persist for an extended period.  The traditional response of investors was to move into more liquid currencies based on the view that central banks would ease policy to keep the recovery intact.  However, it is possible in this new environment that central banks may become more cautious about providing support.  This can be found in recent policy statements of central banks:  the Fed has shown no signs of implementing QE3, the ECB still plan to raise rate at a slower pace, Canada and Australia continue to show a slight tightening bias and inflation remains a focus in China.   

The soft patch is driven by policymakers emphasizing post crisis adjustments and attempt to reduce the debt overhang.  As a result, G-20 central banks will be less reluctant to support a growth slowdown and investors focus on government debt.  The central bank of China and some emerging markets will continue to tighten monetary policy due to inflation fears reducing global liquidity.   In an environment of upside inflation risk and central bank caution, this could leave some of the commodity and liquidity-driven currencies more vulnerable.

 

The Failure of Risk Management: A Preliminary Look at the Cost of a Greek Bailout

Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

European politicians, when creating the euro, failed to consider the risks of their actions.  Policymakers looked at developments in Greece as a temporary liquidity squeeze rather than a solvency crisis.  Paolo Manasse wrote on this issue in a voxeu communiqué called “Greece, The Unbearable Heaviness of Debt”.   He noted analysts have been arguing that Greece will default on part of its debt – leaving its creditors to take a “haircut”.  Manesse argues the prospect is becoming more likely.

 

S&P further downgraded the junk rating of Greek debt reflecting the larger than projected budget deficit and the unsustainable growth rate of government debt.  They estimate a 50% haircut may be required to restore solvency.  There are expectations of a euro 50-60 billion loan from the EU/IMF, which at best may provide temporary relief.  Currently, the only other alternative to debt restructuring, is to leave the euro which seems extremely unlikely.  The rising interest rate on Greek debt combined with new debt issuance/borrowing indicates that the stock of debt is growing much faster than GDP, which is not sustainable.

 

Currently, there are three potential tools to make Greece’s debt sustainable: lowering the interest rate on outstanding debt, turning the primary deficit into a surplus, or writing down the existing debt stock.  A reduction in the market rate may provide a cushion for Greece.  Any move to a primary budget surplus would most likely cause social unrest.  The most likely scenario would be restructuring plus new money at a concessionary rate.  Eurozone bank exposure to sovereign Greek debt is estimated around $100 billion according to the BIS.  Any write-down of Greek debt along with the need to recapitalize the banks will be an expensive lesson on risk management.

The Euro will affect us all

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

  

Recent talk had been of Germany, France and other relatively strong Eurozone countries withdrawing from the Euro.  This talk has now turned to the possibility of weak countries like Greece, Portugal and others withdrawing from the Euro.  If that happened, their new domestic currencies would surely immediately depreciate massively.  However, they would still have unsustainable debt levels denominated in Euros.  At the same time, the Euro would quite possibly strengthen thus exacerbating the problem.  This would necessitate an immediate requirement to restructure and debt holders would need to take significant write-downs on the debt.  Actually, the underlying economies do not support existing levels of debt and current actions are really only delaying the inevitable.  Sooner or later, recognition of loss of underlying value must happen. 

 

Many of these debt holders are banks in Germany, France, etc.  German taxpayers, and hence the German government, are very strongly opposed to bailing out the weak Euro countries.  However, eventually they may effectively have to do so to some extent if their banks need bailing out.  Weak countries exiting the Euro would precipitate immediate action.  However, markets are pushing for early action in any event with bond yields for weak countries going through the roof.

 

All this has the potential to cause great volatility in foreign exchange rates and that volatility will likely go way beyond the Euro.  That will affect any business transacting in foreign currencies.  It will affect other businesses with significant indirect foreign sourced inputs, e.g. through their suppliers sourcing foreign components, and all consumers. 

 

Any business not assessing their FX exposures and formulating risk management strategies to deal with such exposures is taking a big gamble.  It may be that, for any individual business, the risk is within tolerable limits.  However, wouldn’t you feel more comfortable if you came to such conclusion from a proper assessment rather than just having a gut feel that this must be the case.  Guts can be very sensitive to a little bad food input.

“I cann’t do it Captain (of industry). We got no power."

by Michael Arbow, MBA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

With these words Chief Engineer Montgomery Scott (Scotty) of television’s starship Enterprise would warn Captain Kirk of the ship’s limits and capabilities.  These very same words are being said again but this time in China where the providers of electric power are warning China’s industries to expect massive rolling black outs and power restrictions this summer.  With subsidies in coal (where industrial users pay 1/10^th the price of oil) and oil, Chinese industry burns through the stuff with near hopeless abandon.  The subsidies may end, eventually, but in the interim expect the demands for energy making stuff – like coal, oil, uranium and equipment like windmills, solar cells, generators to increase.  Assuming you don’t work in the oil industry or at General Electric; sadly what is China’s problem is our problem.  Commodities will continue to rise as will the currencies of those who produce the goods and this will be over a number of years.  In the short term look for another spike in energy prices this summer.

 

While this may sound like a broken record, I fear and sense that many industries and governments are not fully preparing for the shocks and have not put in place risk reduction measures.  Some of these will be long term (energy efficient buildings and infrastructure like public transit) and some will be short term (hedging strategies).  The past is past and we are entering a new dynamic environment – has your risk perspectives and handling changed to better suit this new world?

 

For Jeff Rubin’s thoughts on this subject, click on the link:

 

http://tinyurl.com/4348gtm

 

Martian Foreign Exchange Risk

By Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Even though I lived in the USA for several years, I still do not understand U.S. politics and politicians.  I don’t think most Americans do either.  They just seem to be born either Democrat or Republican and harbour a life-long hatred of the other that borders on vindictiveness at times.  Like many non-Americans, I just observe with amazement and never cease to be astonished about what goes on.  However for better or worse, what goes on in America profoundly affects not only Americans, but also the rest of the world.

Now that we know that the U.S. president wasn’t born on Mars (subject to forensic examination of documentation), will U.S. politicians turn their attention to making a serious attack on the deficit?  And what about the debt mountain?

 

Inflation fears are causing pressure for interest rate rises in a number of countries.  It does not appear that the Fed is yet ready to raise rates but things can change rapidly.

 

The U.S. dollar has been weak while commodity prices have been rising.  However some commentators are now opining that such process have overshot and are predicting falling commodity prices. 

 

What will happen to the Euro if the PIG bale outs become PIGS bale outs?  Or even PIGSI bale outs?  (Portugal, Ireland, Greece, Spain and Italy.)

 

And so on and so on …..

 

The bottom line is that we are facing a very uncertain situation of possible currency volatility.  Does your company have a thorough understanding of its foreign currency exposures in terms of identification, quantification and sensitivity to exchange rate fluctuations?  Do you have well-developed strategies and policies for dealing with these?  Are your hedges really effective and are you sure that they do not create additional exposures you are unaware of?

 

And if you answered yes to these questions, are you absolutely certain?  Are you sure that a yes 12 months ago is still a yes today?

You aint seen nothin’ yet ….

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

So the U.S. government didn’t shut down thanks to an agreement to cut an extra $38 billion of spending (compared with deficit of around $1.4 trillion).  We’ve been here before and life has always gone on.  However, perhaps a more frightening situation is coming up.  The U.S. is about to hit its legal debt ceiling of $14.3 trillion which is getting on towards 100% of GDP.  These numbers just beggar belief.  The U.S. is now the only major economy with such debt and deficit problems that has not introduced some sort of realistic austerity program so the situation keeps getting worse.  Other stats can be quoted that compound the grief – or determination to act – that perhaps should be felt. 

Of course, we’re constantly told that the U.S. is different.  The economy has unequalled potential, it always grows, foreign investors hold so much U.S. debt that if they didn’t keep buying it, their investment would lose value, etc., etc. 

Nobody expects a U.S. debt default but more and more people mention the possibility before coming up with the aforementioned reasons why it will not happen.  But, surely the party cannot go on forever.  Something has to give and with the American form of dysfunctional government, it may take some external event or shock to cause the very painful action required. 

This of course would affect, not only the U.S. dollar but many, if not all other currencies in terms of volatility.  I will leave open the question of: what should companies be doing?  As a partial answer, companies should be thinking very seriously about various scenarios.  They should know and understand their currency and interest rate exposures in a far more detailed, scientific and meaningful way than the traditional “have a handle in my head” of the CFO’s and treasures of many businesses. 

I will expand on this in coming blogs but it would be interesting to have some discussion of how big an issue others see this as being.

Foreign Exchange Wrecking Ball

by Stephen McPhie, CA

Partner, RSD Solutions Inc

www.RSDsolutions.com

info@RSDsoulutions.com

 

 

If currency exchange rates have been volatile over the last few years, we are possibly looking at volatility squared over the next few years.  Portugal is joining Greece and Ireland in being bailed out.  These economies are relatively very small in the Eurozone.  However, many are wondering if Spain and then Italy will be in the cross hairs next and these are not small in the scheme of things.  Certainly Spain looks much better in many ways than Portugal but an employment rate in excess of 20% is a massive burden. 

 

Having been an observer and sometimes a victim of several economic cycles, I know that events, markets and politics can gain an unstoppable negative momentum.  Prices and rates tend to overshoot their proper level and correct, usually with little disruption on a macro scale.  However if a giant wrecking ball overshoots, it can knock down several buildings and that is a whole lot more difficult to correct.

 

Add to this the increasing number of voices expressing doubt over the whole future of the Euro itself, especially in the 2 large triple A rated Eurozone economies of Germany and France.  Especially so in Germany where more and more people are disquieted over the prospect of paying a high price to prop up much less developed Eurozone countries in order to save the Euro.

 

The Euro itself was a political creation.  It was weakened in its earlier days by Germany and France ignoring the fiscal rules.  Politicians are trying hard to ensure survival of the Euro.  For now, that is.  However, politicians do not always operate in a long term economically optimal way.  After all, politicians’ careers depend on voters in their own country at the next election and not on wider Eurozone’s economics.  Political winds can change direction very quickly.

 

All this suggests increasing exchange rate volatility.  While it does not appear likely that the Euro will die in the near term, there is a giant wrecking ball swinging around that has the ability to knock down a few houses.

 

Do you really have a handle on your company’s FX exposures?  Do you know the natural hedges and economics of your derivative hedges?  Have you done a full and proper evaluation of all this?  I have seen many companies that are comfortable with their positions until that giant wrecking ball comes crashing through the wall.

The Loonie: A new safe haven currency

by Michael Arbow MBA

Partner, RSD Solutions Inc.

www.rsdsolutions.com

info@rsdsolutions.com

 

The past few weeks have been filled with world altering events and uncertainty and the end story for those in Japan, much of the Middle East and the Euro-zone has yet to be written. With uncertainty, the appreciation in the price of gold has happened and is expected but what is not expected is an unwavering Canadian dollar (CAD). In terms of world currencies, when the going gets tough, generally, the tough go the US dollar (USD). However since February 1^st the CAD has traded above par to the USD and that is with long Canadian government interest rates at 80 basis points below comparable US debt and 7 bps below German debt (each holding AAA debt ratings). 

To me this suggests that the CAD is becoming a safe haven currency.  This move is substantiated by double digit immigration and high levels of international capital inflows both of which demonstrate that Canada is globally the preferred place to live and invest.  This new disconnect – that is the Canadian (resource based?) currency as a safe haven, is something to be proud of for Canadians but it will and can cause problems for our exporters. 

Bank of Canada Governor Mark Carney stated last week that the world is in a multi-decade commodity boom.  The effect of this according to economist Patricia Croft and David Rosenberg is that over the next 3-5 years a $1.20 USD/CAD exchange rate could prevail. To me, the trend has become fact.  For Canadian exporters and those investing in the United States, what steps is your organization taking to ease the potential pain?   

Car insurance. House insurance. Company survival insurance(?).

by Michael Arbow, MBA

Partner, RSD Solutions Inc.

www.rsdsolutions.com

info@rsdsolutions.com

 

Recently RSD Solutions was in a discussion with individuals who encourage Canadian companies to export.  At the meeting we discussed the idea of hedging the US dollar relative to the Canadian dollar.  It was pointed out by our host that local firms and possibly many smaller Canadian firms do not hedge either currency or commodities because it is considered risky.  Of course there are other reasons – the idea is seen as intimidating to some senior managers because of its sophistication but we will save that for another blog.

I pointed out to our host that hedging is a form of insurance much like automobile or house insurance but in a company’s case it is helping ensure the firm's very survival.  When I pointed out that effectively what a CEO or CFO is saying by not hedging, is that buying insurance on their corporate survival is “risky”: an epiphany moment was reached in the room. 

So my question is, is hedging considered risky at your firm and what do you think would be a recommended strategy for turning this perception around?