By Ron Chakravarti
Citi discusses risk-management trends shaping treasury amid dollar strength and weakness in emerging markets.
Many global corporates continue to show fairly stable sales growth, strong and improving balance sheets, and ample liquidity. Furthermore, the historically low cost of funding, coupled with a substantial fall in commodity prices, have contributed to enhancing net profitability. These are welcome advances compared to the challenges faced during the last global financial crisis.
Yet, against these benign conditions, we continue to see quarterly corporate earnings negatively impacted from foreign operations. While specifics differ from company to company, recent public statements point to foreign exchange (FX) risk as one key source. Our own studies, including data from the Citi Corporate Treasury Diagnostics global benchmarking survey and our bespoke corporate studies, bear this out. There is heightened impact on translated earnings due to continued USD strength and volatility in the emerging market (EM) currencies. And, at least some of these impacts appear to be due to shortcomings in companies’ risk management architectures that can be readily addressed.
Four key themes emerging
From recently conducted Citi Treasury Diagnostics research and our client advisory engagements, we identify four key themes. Figure 1 summarizes some observations that shape these themes.
Theme I: Treasury centralization—still ongoing. For many companies, outside of their major developed operating markets, the focus for centralization was often on cost extraction through centralization of operational activities, for example, deploying Shared Service Centers for payables, receivables, and procurement processes. The advent of sophisticated ERP and Treasury Workstations has changed the landscape. Many treasury departments have materially enhanced liquidity and risk management by deploying “Functionally Centralized—Globally Distributed” treasury models that support the operating businesses across theglobe. Meanwhile, procurement, payables and other functions have progressed towards universal standardization of core financial processes.
This dual centralization—of treasury processes and business working capital processes—enormously enhances the ability to get visibility into risks and funding inefficiencies inherent in commercial activities across the supply chain. This has been a necessary, if not sufficient, step in better measuring and managing risks.
This remains an ongoing process. Many companies can benefit from completing the rationalization and rollout of infrastructure for centralization of treasury. This includes technology enabling full visibility into risk; deployment of people into regional treasury centers closer to the company’soperating markets; and, centralization of processes including liquidity and FX risk management into advanced structures such as in-house banks. Of course, this will continue to evolve as corporates’ exposures grow in more markets and currencies, and as local capital controls and the geopolitical landscape change.
Theme II: Treasury engagement with business — creating value. Citi Treasury Diagnostics survey data shows continuing increase in engagement by treasury in commercial decisions. At many companies, this reflects a formalization of treasury engagement “upstream,” as business decisions are made, to ensure that balance sheet and earnings stability implications are considered. Ensuring there is recognition of the margin impacts of currency moves on nonfunctional currency sales, or working capital funding costs of extended customer credit terms in high interest-rate currencies, has propelled treasury teams to become proactive partners to the business. Again, this is an ongoing trend. With a global view across the end-to-end supply chain, treasury is in a unique position to help identify and mitigate risks—consideration of embedded currency risks and funding costs in contract terms and invoicing decisions, leveraging natural currency offsets across the supply chain, and so on.
Theme III: Risk optimization—it’s about the basket. As noted earlier, many companies have reported significant financial impacts on earnings from currency moves. From survey data and client engagements, one of the underlying reasons is that many companies have been operating under FX policies not well-aligned with their own risk management objectives or with rapidly changing market conditions.
A critical first step is to understand a company’s FX risk from a portfolio perspective—the overall potential impact from the basket of exposures, rather than from each individual currency. From this perspective, the company has a basket of exposures with different currencies that do not move as one, creating natural risk reduction from diversification. Modelling this properly produces a risk profile that incorporates the portfolio effect, which allows companies to make real cost savings in risk reduction. The CitiFX Portfolio Risk Optimization tool supports this analysis and facilitates a company identifying and quantifying the real sources of currency risk—the size of an exposure is not the sole measure of the risk it creates, with volatility and correlation to other currencies as important factors.
In practice, a key input in determining optimal hedging strategies is identifying the greatest contribution to risk (%) in relation to the notional exposure.
Theme IV: Intercompany flows—don’t leave opportunity on the table. From an FX risk measurement perspective, aggregating and netting intercompany flows in original currency to determine currency requirements is a tried and tested process. However, many companies have yet to extend these proven structures beyond their major developed operating markets.
Today, regulatory liberalization allows extension of netting to encompass intercompany commercial flows across many more currencies and markets than was possible a few years ago. Other opportunities include incorporating into the netting process non-commercial flows emanating from treasury transactions and intercompany recharges and allocations, further extending a company’s ability to aggregate and net FX risks.
Where next: from inception to execution
A myriad of functions and responsibilities have fallen within the treasurer’s remit compared to that of just a few years ago. From dealing with the implications of complex regulatory changes, to implications of the OECD Base Erosion and Profit Shifting project on intercompany funding structures, to corporate M&A transactions, the treasurer is being asked to perform more with static or falling headcount. Against this backdrop, the political and economic environment remains both complex and potentially volatile.
In light of this, it is perhaps not surprising that one of the core themes of many treasurers has been reviewing treasury strategy, policy and practices. While most wouldconduct reviews regularly anyway to ensure that practices remain aligned with the operating business, company risk management objectives, and funding needs, what is striking is the scope and granularity of these assessments.
From our work with clients on many of these assessments, it is clear that, across companies, there are many commonelements in key contributors to risk. The path towards effective FX risk management, from inception to execution, often goes along the lines of the illustration.
Our intention is not to single out specific structural risk-management shortcomings, as many of the challenges are company- or industry-specific. Nor is it to prescribe a “one size fits all” solution. However, the perspectives offered in this article are based on our observation that some of the key mitigating constructs to address these issues can be applied by many more companies than are doing so today.
Ron Chakravarti is head of Citi’s Treasury Advisory Services Group, Treasury and Trade Solutions.
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