By Joseph Neu
Despite bailouts and fears of a European Lehman weighing on the euro—and even speculation of euro exits or outright collapse—there has been no rush to hedge.
While there are certainly corporates out there that are sitting on optimal euro-dollar hedges—or even scrambling now to cover positions—our general sense is that many treasuries have been fairly sanguine about responses to the euro’s recent demise. Perhaps the best explanation is that they have been so focused on issues in the US, that they were unprepared to imagine the extent of the euro’s fall until it was too late.
“You can’t believe the number of companies that got caught on the way down,” noted one corporate FX banker recently. “Most of the time,“ he explained, “it was the CFO, treasurer or someone telling the risk managers not to do anything with the EUR lower.” Thus, they waited for a hedging opportunity while the euro went lower, and lower and lower. “Before they knew it, they were out of luck.”
Learning the right lessons
Waiting to hedge and paying the price is a lesson in how best-practice risk management requires companies to identify their risks, anticipate potential exposures, and hedge them before it’s too late, or it becomes too costly to do so.
Another way to look at it is that companies fail to place rigorous controls around risk or simply try to achieve budget rates. As a result, they tend to hedge less when the market is moving against them and more when the market is moving their way. “This,” as a corporate FX advisor explains, “is the exact opposite of what you would expect a professional trader to do: they cut their losses and let their gains run.”
But what for most companies may be a lack of risk controls, for others may be a prudent decision not to hedge—based on what they know to be their net exposure. For example, there is evidence to suggest that the recent changes in dollar-euro may not have that big an earnings impact .
Euro exposure not a concern?
Writing in Morgan Stanley’s Global Economic Forum, Richard Berner, their chief US economist noted that with one-third of US corporate earnings, on average, coming from overseas, the dollar’s influence on corporate profits has never been more important. However, the impact of a stronger dollar versus the euro is less significant.
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European affiliates less important. True, a weak euro will cut profits earned in Europe when translated back into dollars. But, as Mr. Berner noted, earnings from European affiliates of US companies are less important than in the past. He cites his strategy colleague Jason Todd’s research, which shows that European affiliates comprised 14 percent of US MNC’s offshore earnings in 1995, but at the end of 2008, the share was just 8 percent.
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Price de-coupling from rate of exchange. Morgan Stanley research also suggests that MNCs are experiencing much more limited exchange rate pass-through than in the past, which means that the end-market pricing changes in Europe are much less than the euro decline. Why hedge, if you can hold the line on pricing?
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Growth more important than rates of exchange. A third factor Mr. Berner identified was the impact of currency translation relative to economic growth. Morgan Stanley expects relatively strong global growth this year of 4.7 percent, and improved US domestic conditions. This growth will more than offset the impact of a dollar rise, thus reducing incentives to hedge. While the eurozone is unlikely to grow more than 1 percent, its declining relative earnings significance also makes this of diminished concern as US MNCs assess their overall dollar positions.
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Margins strong enough to absorb the FX hit. In addition to the favorable FX pass-through pricing conditions, rising operating leverage continues to boost margins. As companies expand in response to recovery, they are able to spread fixed costs across a wider revenue base. According to Mr. Berner, margins have risen by 100bp over the last year, reflecting significant capacity reductions (a record 1.3 percent over the past year) that have allowed companies able to ramp up to exploit operating leverage.
This line of thinking suggests that at least some companies that held off on hedging dollar-euro did the right thing in the context of their economic exposure and their overall dollar position.
What separates a well-reasoned risk management strategy from a mere justification is having familiarity with your exposures in the context of the big picture. Just be sure to keep renewing that familiarity.
alternative hedging
For instance, while Mr. Berner makes the case for a benign view of euro-dollar impacts now, US MNCs will face bigger earnings challenges next year. If, as Morgan Stanley is predicting, overall growth slows in 2011, and operating leverage begins to fade, then layering on some hedges to protect euro-denominated earnings could become more compelling, as every dollar of translated earnings, even from European affiliates, will count more. It may not pay to wait to buy protection.
Like many slower growth forecasts, Morgan Stanley is basing its outlook on assumptions that policy-makers will begin their exit from accommodative monetary policies and that European fiscal austerity will kick in. Uncertainty regarding outcomes will feed volatility anew, and higher rates will push up financial hedging costs. The latter will be burdened further by crowding out effects from government debt issuance and rollover needs.
Oh, and pending regulatory changes to derivatives markets and bank capital and liquidity buffers will make financial hedges dearer still. Perhaps, then, the best solution for the long run is to find ways to avoid the need for financial hedges wherever you can. Using the professional trading analogy, MNCs should look for ways to establish gains and let them run, i.e., through price leadership, higher margins and shifting capital to growth markets. And cut hedge losses.
SEPA AND A EURO COLLAPSE
Not many large MNCs seem overly excited about the Single Euro Payments Area, or the supporting clearing mechanisms of the EBA. Most have created such efficient cross-border payment mechanisms that these initiatives will only offer limited improvements—and then only after Europe has achieved fuller integration and consolidation of its clearing and payment systems.
Similarly, banks and other payment service providers have invested a lot in new systems in preparation for SEPA, not just because of the EU Directive on Payments Services, but to streamline services and make them more profitable.
As the UK-based Financial Services Club’s Chris Skinner has noted, these efforts will not go away just because one or more eurozone countries reintroduces its currency.
So, while the impact of a euro collapse on payments would be meaningful, it might not be an utter disaster operationally.
Still, a few what-if scenarios are worth running to determine all potential operational as well as FX impacts.