By Geri Westphal
Emerging markets for some time have become a critical part of multinationals’ business mix and growth strategy. But they have also created a new level of complexity for treasury functions in charge of supporting, financing, hedging and ultimately safeguarding companys’ interests in these areas. Société Générale has experience in assisting clients to manage operations in emerging markets. iTreasurer asked senior officers of the bank to provide their insights into challenges raised by doing business in these geographies.
Emerging markets’ share of the global economy nearly doubled to 40% over the past 25 years. Their rising economic significance is also reflected in trade, financial flows, and remittances. In addition, emerging markets’ share of global M&A has significantly increased and is now larger than that of Western Europe. Fueled by both organic and external growth, these markets have become a major source of corporate revenues.
“Emerging markets represent a very diverse and fragmented universe, even within each major region, so there is really no such thing as LatAm, EMEA or Asia when it comes to understanding the underlying economic situations and specific risks. Getting to country-level is critical,” said Damien De Chillaz, head of market risk advisory for the Americas at Société Générale.
“One interesting fact to keep in mind,” he added, “is the magnitude of the Chinese economy in the emerging market world. When comparing GDP, China is really the elephant in the room, with a GDP equal to the sum of the next nine emerging economies. This certainly explains the market impact of the Chinese FX intervention over the summer of 2015 and the global nervousness around the possible hard-landing of its economy.”
In the same vein, when asked to rank EM countries by the level of challenge or complexity, members of several NeuGroup peer groups ranked China as the most challenging, with Brazil ranking number two. When asked to describe the specific challenges, establishing hedge strategies in a persistent USD strength environment for high premium EM currencies and overall management of hedge costs were the most common.
The Risks involved
When approaching emerging markets, treasury teams have to become familiar with a number of specific risks, which may affect their subsidiaries in varying degrees:
- Political risk is definitely a consideration at the investment stage as it defines the quality of the business environment. Argentina and Russia are two countries which come to mind on this front.
- Regulatory risk is another important risk where the country’s trade and investment framework features a thick forest of rules which has become hard to navigate. China and India are certainly high on the list.
- Tax risk can be a significant source of business com-plexity and uncertainty requiring dedicated local experts.
- Market risk generally covers risks associated with FX and interest rates. Hedging and funding philosophies are very diverse across companies and sectors, but generally revolve around a central dilemma: hedging long EM FX exposures is considered expensive for high-yielding currencies; so how do you balance this against the potential value deterioration of market volatility and possible tail risk?
Measuring relative hedge costs across EM currencies
Most multinational companies operating in emerging markets have a net long exposures to the EM currency, which can be considered costly to hedge, especially for some high-yielding currencies (where the rate differential between local currency and USD can be very large). Brazil, Russia, and to some extent India, fall into this category. At the same time, volatility of these currencies has increased substantially and these currencies are now prone to material tail-risk.
The decision to hedge a given EM exposure, or fund the subsidiary in local EM currency through local or synthetic debt (using cross-currency swaps), has become a dilemma for treasurers. To help navigate this complexity, Société Générale recommends the following methodol-ogy, which can be customized based on each specific currency exposure and business model:
- Cost of hedging. This simple metric considers the annualized cost of hedging a long EM currency position vs. USD, as derived from a 1-year FX forward. This essentially reflects the 1-year rate differential between a given EM currency and USD, including the effect of the basis. See Chart 1 above.
- Cost-of-hedging ratio. This metric looks at the cost of hedging relative to the implied volatility of the currency. It is expressed in basis points of cost of hedging, per unit of volatility.
- Real cost of hedging. This metric measures the cost of hedging net of growth and inflation expectations in the country, bringing the cost of hedging back to a “real” cost of hedging. This is a macroeconomic view of the cost of hedging that considers the benefit of growth and inflation at “sea-level”. See Chart below.
These three metrics can be part of a dashboard of metrics across EM and FX exposures in general, and help guide the decision to hedge, coupled with other market timing factors as well as business and strategic factors.
A specific example: Brazil
In Société Générale’s experience an excellent example of an important country for multinational companies, but one which exhibits some of the risks mentioned, is Brazil. Developing and protecting business growth in its volatile environment has become an increasingly complex task for treasurers and CFOs.
The Brazilian economy entered its worst recession in several decades following the end of the commodity boom a couple of years ago. More recently, private consumption has come under severe pressure (given rising joblessness and high inflation), public spending programmes have led to increased public debt and the new government’s aim for fiscal consolidation faces serious hurdles (such as domestic and external demand weakness and political and legislative challenges).
In this context, making the appropriate strategic decisions in this environment, in line with companies’ global hedging policies, requires in-depth understanding of the various particularities affecting their businesses in Brazil such as:
- Liquidity. FX spot and non-deliverable forwards (NDF) markets currently present limited liquidity due to the previously described scenario combined with market adaptation to the new global regulatory environment. This change implies higher FX slippage costs in trade execution for bigger tickets. Managing trade size and timing has become even more important in executing hedges smoothly and in reducing costs.
- Pricing. The BRL offshore market replicates the onshore market with spread adjustments mainly for two reasons: (1) the Brazilian Central Bank intervenes in the FX market primarily through onshore NDF, and (2) BRL is deliverable in Brazil (onshore) but it is not deliverable in international markets (offshore). Movements in the onshore and offshore markets can cause price distortions in offer/demand that can impact cross-border link levels.
- Strategy. The high BRL interest rate environment (its official interest rate, the SELIC benchmark rate, is currently at 14.25%) generates high carry cost for the hedging in USD long positions. The structuring of derivatives roll strategies and/or customization of payoffs can minimize the cost impacts. Static strategies can be used to protect annual budgets, dividend remittances or short-term USD denominated loans. Rolling strategies can be used to reduce hedging costs in long-term loans.
- Regulatory. FX transactions are registered with the Brazilian Central Bank following very specific guidelines that depend on the nature of the transactions. Derivatives are traded and registered in different clearings. Listed products and futures are traded in Bolsa de Mercadoria de Futuros (BMF & BOVESPA) while OTC derivatives (NDFs, Swaps, Options) are cleared in Central de Custodia e de Liquidação Financeira de Titulos (CETIP) and can have different registration cost.
- Taxation. In the past few years, there have been several changes in the rate of Brazil’s financial transaction tax (IOF) applicable in FX and fixed income. In addition, derivatives instruments are treated differently in terms of taxation. Options are treated differently from Swaps and NDFs. Cross-border payments are subject to withholding taxes that depend on tax treaties or payment type (interests, capital gains, etc.).
As far as investments are concerned, and considering the discrepancy between the low or negative interest rates in developed markets versus the high Brazilian interest rates, there are several liquid financial investment opportunities with lower risk profiles (sovereign bonds, repos, notes) that international companies can consider while strategic acquisition decisions are under analysis. The tenor of the investments can vary from short term (one day) to long term (up to five years).
“All of these aspects have to be considered in the hedging and investment strategy definition in order to increase efficiency, profitability and reduce costs,” said Carlos Mazzoli, who is responsible for corporate client coverage in Brazil at Société Générale. “Our interest rate and FX derivatives team can support international companies to understand these specific issues and advise the proper market hedging and investment instruments.”
How to finance a Brazilian subsidiary
Provided that there is an adequate and acceptable credit structure in place either by the setup of a well-capitalized subsidiary that’s creditworthy on a stand-alone basis, or that the parent company provides support or guarantees to, there are several funding alternatives in the Brazilian banking market. Local banks are no longer competitive in USD, only the international ones are. “Most of the international banks operating in Brazil have a team that is focused on multinationals,” Mr. Mazzoli said. “And they are prepared to provide financing in local currency and also in US dollars, which is the dominant business currency for exporters since the foreign trade financing presents in general lower costs than the regular working capital facilities.”
The most common form of financing for multinationals is via bilateral loans. Historically, the syndicated loan market has been used for very large financings and the most frequent borrowers have been the large Brazilian corporates and large Brazilian banks. Intercompany loans require attention in the Brazilian market due to the legal and regulatory framework, especially if the intercompany loans could be considered as an advance of future capitalization.
In order to limit the leverage of Brazilian companies, the thin-capitalization rules restrict the deductibility of interest paid by Brazilian companies to their foreign parent companies: beyond a gross debt (owed to foreign related companies) over equity ratio of two, debt interest will not be tax-deductible.
Traditionally, multinational subsidiaries have not been frequent issuers of debt securities in the local market due to the level of disclosure required. This is similar to the disclosure requirement of developed markets; also an investment-grade credit rating is required for most cases in which debt securities are distributed in the market. The international debt capital market has not been frequently used either and for same reasons, but also because of the high ticket size required to make an international security issuance economical.
Navigating the complexity of emerging markets requires a fairly new and comprehensive set of expertise for corporate treasury teams in charge of hedging, funding and cash management. This is about understanding the legal, regulatory and political framework, as well as having a good grip on the dynamic of the FX and interest-rate markets with their specific liquidity, convertibility and execution constraints.
“At Société Générale, the interest rate and FX derivatives team has developed a recognized expertise in advising multinationals on their emerging market operations, designing tailored hedging and funding recommendations, and ultimately executing these solutions in a smooth way, mindful of local market constraints and best market timing,” said Mr. De Chillaz.
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