Assistant treasurers are working to suss out the effects of FX volatility, shifting currencies, and interest rate moves while looking ahead for optimal components, functions and infrastructure for in-house banks to seize opportunities.
While the list of priorities across the member companies is quite long, there was a concentrated focus on systems projects and managing FX. The USD is expected to continue to rise in value, and the issue of diversity among financial service providers will likely become more prominent. Assistant treasurers discussed modifying or developing policies to adapt to these changes, as well as spending time sharing lessons in leveraging IHBs to exploit less restrictive currency controls, and incorporating diversity among financial services providers.
1) FX Fundamentals in Times of Volatility: FX strategies are mostly about reducing FX volatility as evidenced by their primary usage of layered hedging.
2) The Now and Next for the IHB: IHBs and less restrictive currency controls in China. Currency flows in China are more easily done in recent years and companies are beginning to experiment with “pay-on-behalf of” (POBO) and “receive-on-behalf of” (ROBO) transactions.
3) Achieving Diversity with Financial Institutions: Responding to growing pressure to incorporate diversity into the mix of financial service providers. The best approach to managing diversity challenges is to have a well-thought-out policy on philosophy, requirements and expectations. This makes it easier to say “no” when necessary.
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Currency Markets: Responding to the Rising USD
Citi’s managing director and FX economist, Stephen Leach, identified major shifts of certain currencies against the dollar, reasons for the rise in the USD, and what to expect in major regions going forward.
The strong dollar is a result of four key factors: (1) a strong US economy and tighter monetary policy vs. the opposite in Europe and Japan; (2) political and military instability associated with Russia and Ukraine; (3) idiosyncratic factors related to Greece, Brazil and China, but the most significant tenet being (4) the dramatic drop in commodity prices. Further, many countries are deliberately trying to weaken their currency to benefit their own economies.
According to Mr. Leach, the Fed is under pressure to return interest rates to “normal” (would that be the “old normal” or a new “new normal”?) even without any inflation pressure. Further, the Fed is committed to avoiding market surprises and therefore wants to give markets plenty of notice on potential rate increases.
Lower oil prices have had a negative impact on weaker economies, which are allowing, if not directing, their currencies to depreciate as an offset. Other contributors are iron ore, corn and soybeans as weakening commodities.
Finally, there is meltdown in emerging markets: China’s growth decline; Brazil’s budget deficit, drought, downgraded debt and the Petrobras corruption scandal; and the realistic possibility that Greece will leave the EU.
FX Fundamentals in Times of Volatility
FX markets have been a bit unsettled (and unsettling) of late, and it is prudent for members to compare notes on how they manage FX risk, and not just among the peer group alone. Citi used their award-winning Treasury Diagnostics benchmarking tool to survey the group and generate a report on the group’s approach to FX management and addressed topics such as FX operations, instruments used, emerging market risk and intercompany lending exposure.
Key Takeaways
1) Risk assessment methods — portfolio VaR is gaining ground. Citi asked the group about their methodologies for assessing risk. While exposure assessment based on notional amounts (78%) and sensitivity analysis (61%) are the methods most commonly employed, 26 percent use VaR on a portfolio basis as one of their methods.
2) VaR requires understanding. Using VaR is not without challenges, and the methodology presents additional complexity when you introduce multiple asset classes, i.e., interest rates and commodities, and their associated correlations. (Fuel was cited as an example of a commodity challenge for companies that are not able to pass on higher costs to customers due to competitive or other circumstances. However, those member companies that are massive consumers of fuel are able to compensate for the exposure with a fuel surcharge, which eliminates or reduces the need for fuel hedging).
3) It is important that companies base hedge decisions on a VaR model. Using a VaR model ensures that there is senior management buy-in and that they understand the strengths and limitations of this methodology and that correlations can break down in times of stress and can naturally alter over time. Ade Odunsi, Director of FX Client Solutions with Citi noted that “a fair number of companies factor correlations into their models but don’t necessarily hedge them, mostly because correlations can change.”
4) Hedging programs and their primary goals. The most common hedging objectives among members are to reduce the impact of FX to both transactional cash flows and translated earnings (48 percent), while 33 percent prioritize reducing the risk to cash flows and 19 percent prioritize reducing risk to earnings. Consequently, 79 percent hedge forecasted FX-denominated exposures (cash-flow hedging), and 68 percent hedge net monetary FX denominated assets and liabilities (balance sheet hedging).
5) Uncertainty and upside: Options are on the rise. While forwards dominate as the go-to instrument for hedging FX exposure, “options continue to be seen as a tool for hedging uncertain exposures,” according to the Citi presentation. Uncertain exposures arise from uncertain exposure forecasts, either in timing, size or both; or it can be bid-to-award risk, for example. High cost-of-carry currencies may cost a lot in forward points to hedge, but options entail a cash outlay for premium. “The cost for options is a toll for protecting budget rates and guarding against forecast errors and sharp moves in the FX market.” said Erik Johnson, Director of FX Client Solutions. Rather than hedging with forwards across the board, it may be worth considering a policy change that allows options (or costless collars) for currencies where forward-point gains cannot be locked in. (See sidebar on currency markets.)
Outlook
FX volatility has risen and is predicted to remain elevated, coupled with a cycle of dollar-strengthening that could last for years, especially if the central bank divergence continues (hawkish Fed and QE elsewhere). Many companies have already reported negative impacts to earnings as a result of the rising dollar, but the Street seems not to be surprised, provided there is transparency and a prudent hedging plan in place. Similar to the financial crises, where companies had to refine their views on investment policy and counterparty risk, this cycle of the USD brings an opportunity for companies to do a similar exercise with FX objectives, policy and strategy. If companies have not done so already, it is not too late to start.
Responding to Negative Deposit Rates
It’s hard to fathom, but banking in Europe has evolved to where we now have to pay banks to hold our cash, and there is concern that we are close to that in the US. For Europe, a couple of solutions surfaced. One is to try to use the cash as much as possible for things like debt repayment or capex. The other solution is to swap the cash into USD where interest rates are not negative.
For cash in the US, who would have thought that the earnings credit rate (ECR) would be your best bet, but that is the reality. In order to get the type of cash they want, banks are paying a relatively high ECR for operating cash. That is the best return on liquid cash, and if you have more credits than you can use, since it only applies up to the amount of bank fees you incur, some have successfully pushed their banks to apply the ECR to non-traditional fees such as fees for letters of credit.
One of the bigger issues, aside from the egregious economics, is the accounting and administrative headaches of dealing with negative interest rates. Most companies have never dealt with them and are having to figure out how to account for them. One member company’s assistant treasurer has had to seek approval for exceptions to her investment policy that prohibits losses to principal, which in effect is what is happening. Another suggested that banks simply charge extra fees in order to avoid the headaches from negative interest rates.
But the worst of the worst is to “earn a negative interest rate on a depreciating currency” such as the euro, noted one of the group members.
The Now and Next for the IHB
While in-house banks are not new, many members are using them to centralize liquidity, intercompany funding and risk management. But several dynamics are affecting current set-ups and offering new opportunities. With China liberalization, how should companies take advantage of what seems like a huge opportunity? How do FX volatility and interest rate moves affect structures? What are the implications of tax clampdowns? This session featured a guest presenter from Europe and sought to identify what’s now and next in the optimal components, functions and infrastructure of an in-house bank.
KEY TAKEAWAYS
1) The IHB is common among members but is focused on intercompany activities. Sixty-one percent of survey respondents have an IHB, with the most common uses being pooling overnight cash from subs, intercompany term deposits and loans, and intercompany netting. Few companies utilize the IHB for making “payments on behalf of” (POBO) other entities and fewer still use their IHB for collecting “receipts on behalf of” (ROBO) other entities.
2) The IHB is a great supporter of change. Those who have done the hard work of setting up an IHB find that it is much easier to incorporate significant changes from events such as regulatory changes and acquisitions.
3) Definite progress in China, but still a long way to go. The liberalization of rules around moving currency across borders is making China cash more accessible. The meeting’s guest presenter for this session noted that his China entity uses the IHB for all available activities except for making tax payments on behalf of other entities and utilizing virtual bank accounts. These two functions are utilized only by Europe and North America. The Chinese entities are therefore able to do POBO and ROBO payments
A group member commented that, “Cash can be moved more freely in and out of China, but cash belonging to China entities must remain owned by those entities. Cross-border pooling is possible. The documentation is onerous, but only necessary for the set-up process.” On the other hand, the tax documentation required for POBO and ROBO is continuously onerous, having to remain compliant with the many local tax authorities.
4) Apprehension remains. On the surface, the changes in China seem very positive and consistent with the country’s overarching goal to be a global financial player on par with the US and Western Europe. But given China’s history of oppression and their other tactics of unfair business practices, many are suspicious of their motives, believing the relaxation provides an incentive to draw more business to the country only to later somehow pull the rug out in favor of local competitors.
Negotiating Rating Agency Fees
Can you or can’t you negotiate rating agency fees? The answers were many but everyone agreed that rating agency fees are way too expensive and that it is like dealing with a monopoly. Not being able to issue debt without an independent rating puts rating agencies in a powerful position, but companies that do a lot of debt capital markets activity reported having been able to successfully negotiate for lower fees. One member company’s experience is that Moody’s won’t budge but that S&P offers a “frequent issuer” rate. Members complained that the agencies charge you for more than just issuing the rating. They also charge you for referencing it on your investor relations website and in your credit facility.
Having separate regulated entities in all states, one member company has 55 rated companies and pays a lot in RA fees. The company is considering rotating the agencies year over year, believing that none of them would pull the rating if it didn’t use it for a year.
With large debt deals, you can sometimes have your banks absorb the RA fees in addition to legal fees. But one group member cautions not to squeeze the banks too much because it will impact the relationship.
Achieving Diversity with Financial Institutions
Companies doing business with the federal government are obligated to make efforts to do business with “diversity firms,” those owned primarily by minorities, women and veterans. Some companies have a commitment to this goal simply because they believe it is the right thing to do. To complicate matters, these firms may call on CFOs, diversity officers, or procurement executives, in addition to treasury, to make their case. Treasury may be actively looking for “qualified” diversity players to support the company’s diversity goals. But in the area of financial services, the pickings can be slim when trying to find service providers that meet counterparty requirements and have a quality offering. However, members agreed on one key point, that any awards of business are not to be handouts, but must be earned and warranted.
Key Takeaways
1) Avoiding backlash. Certain individuals and organizations make it a practice to follow market activity and review which companies have done large transactions and not included diversity companies. The tactic involves calling the CEO or CFO of the firm and giving them grief for not being socially responsible.
2) A little help from your lead arrangers is nice. Unless you have a specific goal or company you want to include in a debt syndication, the most efficient approach to accomplish your goal is to simply ask your lead banks to ensure they include diversity firms in the deal. Many banks do this automatically anyway. Citi was recognized by the group as being very strong in this area.
3) It shouldn’t be a handout. Some members admitted to treating awards to diversity players more as charity, but most agreed they need to be worthy of the business and earn it. Members noted that most of the employees with diversity firms are from large institutions and have strong experience, so you are not necessarily compromising the quality of the representatives.
Outlook
Engaging diversity companies is another trend that is not likely to go away anytime soon. A number of members are grappling with the best approach, but there were some good suggestions in this discussion, as well as recommendations to certain firms. Establishing a policy to guide usage (and non-usage) of diversity firms and working with your lead banks on appropriate inclusion are good places to start for properly setting this foundation.
CONCLUSION & NEXT STEPS
The spring meeting of the AT30 included a bit of nostalgia by returning to the location of its 2012 genesis, but also broke new ground by including a non-member guest as a session leader for two key sessions. Two issues continue their advancement into the foreground for assistant treasurers: the USD’s rising value and issues of diversity among financial service providers. Practitioners were advised to exploit all options under current policies and to prepare for the need to call for and shape new policies to increase adaptability. Additionally, continued low interest rates are expected to fuel more M&A activity.
The AT30 will meet again September 29–30 in San Francisco, hosted by Bechtel and sponsored by Bank of America Merrill Lynch.