When the euro-to-U.S. Dollar exchange rate surged past the record $1.20 level in early December, and kept on climbing, CFOs of some U.S.-based multinational corporations (MNCs) were likely pining for the good old days, when their purchase contracts were denominated in dollars. But according to research by experts from Wharton and Bank of America, dollar-denominated contracts may in fact provide a false sense of security-one that could cause plenty of problems for companies that still use them.
Most American companies don't break out detail on currency invoicing, but anecdotal evidence suggests that many of them continue to use a dollar-denominated price list, according to Wharton finance professor Richard Marston. But he says that's not a wise approach, especially with the spread of the euro. "At one time the dollar offered considerably more liquidity, but an increasing number of countries in Europe now denominate transactions in euros," reports Marston. "American firms that don't match this will be at a competitive disadvantage."
Arnold Miyamoto, Managing Director and Global Head of the Risk Management Advisory Group with Bank of America, confirms that U.S.-based multinationals tend to show a preference for dollar-denominated sales and procurement contracts. In some industries, including oil and gas, computer components, and shipbuilding, dollar denomination is still the norm.
For example, earlier this year the lack of a dollar-denominated contract apparently nearly scuttled a half-billion-dollar shipbuilding deal between Miami, Florida-based Royal Caribbean Cruises and Kvaerner Masa-Yards, a Finnish builder with facilities in Helsinki and Turku.
A June 16 press release issued by Kvaerner Masa-Yards touted a "conditional agreement" signed with Royal Caribbean for the construction of a new luxury liner. But a cautionary line in the release noted that, "One key factor affecting whether this agreement leads to a firm contract is how much the current euro-dollar exchange rate improves," spurring speculation that the shipowner was angling for a US dollar-denominated agreement. On September 19 the shipbuilder announced that the contract had been formalized, but did not disclose the currency-denomination terms of the agreement.
"Companies often justify the practice of denominating business contracts in their domestic currency by claiming that it reduces risk to their shareholders," explains Miyamoto. "But international business does not escape currency risk simply because it's conducted in the home currency. In most cases, foreign currency risk is manageable, but it should never be ignored or considered irrelevant."
In fact, he suggests, during strong USD environments, the competitiveness of dollar-denominated sales contracts is severely impacted or may even be unworkable. As an example, he cites the Asian currency crisis that occurred from mid-1997 through 1998, when Asian currencies plunged relative to the U.S. dollar.
"During the crisis, the Indonesian Rupiah ("IDR") lost 75 percent of its value," he notes. "Similarly, Asian-based companies with purchase agreements that were denominated in U.S. dollars saw their costs increase anywhere from 20 to 75 percent. This had several important implications: the currency change alone would have competitively advantaged local firms or foreign competitors that were prepared to conduct business in local currency since these firms would have been in a position to significantly undercut dollar denominated prices; or perhaps, the costs of doing business could have been be so high that the dollar denominated contract was entirely terminated. "
One such situation arose between a US based firm and the Indonesian government. The contract was for the purchase of electronic equipment, and it was priced in US dollars. Following the IDR's demise (the currency rose from the IDR 2,800/$ to over IDR 15,000/$), the cost for the Indonesian government was so expensive that the entire contract was canceled.
As an alternative, US MNCs could price contracts in local currency, says Miyamoto.
"While a local currency contract shifts the risk to the domestic company, it also gives the multinational the ability to manage it," he reports. "If a business transaction is potentially impacted by currency changes anyway, I think it's better for the US company to have the exposure and control directly, as long as it can be effectively hedged. There may be however, some accounting issues to contend with."
When Miyamoto-who recently completed a white paper titled "In Defence of Hedging"-refers to accounting issues, he's zeroing in on the Financial Accounting Standards Board (FASB) Statement 133, "Accounting for Derivative Instruments and Hedging Activities," which imposed new accounting and reporting standards for derivative instruments and for hedging activities.
Issued in June 1998 and implemented on June 15, 2000, FAS 133 had a chilling effect on the use of hedging to protect against currency swings. According to a survey conducted by the Association for Financial Professionals (AFP) nearly two years after the implementation date, even "after the process of initial implementation of FAS 133 accounting had been completed- a process that imposed special, one-time time start-up costs - nearly half of the respondents still report that complying with FAS 133 rules is excessively burdensome."
Despite that, the number of companies who reported a reduction in the use of derivatives for currency exposure, 13 percent, was almost equal to the number (12 percent) who reported an increase in usage. According to the AFP, the segment that increased its use likely did so because "FAS 133 allows for hedge accounting when forward contracts are applied to uncommitted, anticipated foreign currency transactions, while pre-FAS 133, these applications were not granted hedge accounting treatment."
Historically, many U.S.-based multinationals have used dollar denominated contracts as a hedge against currency swings-but Miyamoto points out that the practice merely moves the burden to another party.
"A dollar denominated contract shifts the currency risk to the local entity," he says. "The implicit assumption is that the customer is hedging the exposure, which may not be the case. "
The additional reporting and documentation requirements of FAS 133 could be one reason that some companies opt out of hedging. But for others, like the French automaker Peugeot-Citroen SA, the return on investment simply isn't there.
According to a recent Wall Street Journal report, Peugeot CFO Yann Delabriere notes the automaker has long had a policy of not hedging its foreign revenue, and plans to stick with that approach even though the euro's appreciation is expected to wipe out EUR600 million of Peugeot's profit this year.
Delabriere's argument is that currency hedging is "a kind of gamble" anyway-so he says Peugeot will avoid the costs incurred in hedging without substantially increasing its risk. He notes that although the company is incurring currency losses this year, it posted currency translation gains in 2002. He wouldn't specify the size of the 2002 gains.
Meanwhile, Delabriere notes that neither he nor his boss "are smart enough to guess future movements in currencies." If he were, he adds, "I'd quit my job and set up a boutique business specializing in currencies. I'd earn much more than I presently do at Peugeot."
Instead, in his view, the best a corporation can do is to "have a fixed policy, and make sure investors and analysts have all the information they need to know the impact of currency movements" on the firm's earnings.
For companies that are initially entering into the realm of pricing business agreements in a currency other than the US dollar, it can be a confusing and often misguided process, says Miyamoto.
"Far too often, we have seen that the pricing process tends to work backwards," he comments. "Often, a price is set and then, only after the contract is signed, the firm determines whether or not the assumed rate can be hedged. Instead, we would recommend beginning the process by first identifying the appropriate hedge vehicle and its costs. Once management understands the cost, the proper exchange rate will be implicit in the calculations."
"Between 1992 and 1993, the British Pound underwent unprecedented depreciation as it disengaged from the ERM (European Rate Mechanism, a precursor to the euro)," he relates. One US based defense contractor priced a multi-year engagement using a $1.80 exchange rate. By the time corporate treasury was aware of the bid, the Pound Sterling had devalued to the mid-$1.40 range. Had the company been awarded this contract, the potential loss would have been in the hundreds of millions of dollars. Business development blindly attached an exchange rate to a proposal that if awarded, could have driven the company into the ground."
Meanwhile, Marston suggests that there are two ways to manage currency risk: a financial strategy that typically involves hedging strategies; and operational hedging, under which a company prices its contracts in a local currency and also maintains local manufacturing and assembly operations. The two are not mutually exclusive and may be used in tandem to help manage risk.
"The operational hedging approach offers currency protection by matching local revenue with local cost," he says. "Companies that have utilized this strategy include Procter & Gamble Company, and Novartis AG. In fact Novartis is one of the few publicly held firms to disclose its local-currency sales and expenses in an annual report."
The idea of matching local revenues and costs appeals to Miyamoto, too.
"When a local currency contract is applied to both sales and procurement agreements, they can produce offsets," he says. "So although the 'raw' volume of currencies may be higher with a local currency contract approach, the true net exposure may be much less."
In October 2000, Wharton's Marston co-authored a research paper titled A Simple Model Of Foreign Exchange Exposure, which noted that foreign exchange exposure was "quite low for a majority of firms" in a statistical sample "because these firms have been able to match their foreign currency revenues and costs leaving them with little net exposure." Marston further noted that since exposures are related to net foreign currency revenues and profit margins, "firms that develop operational hedges can shield themselves from the large scale effects of exchange rate changes."
Commenting on his paper some three years later he says, "The fundamentals still hold true. There are still viable alternatives to dollar-denominated contracts."
Miyamoto adds there's a certain irony created when a company tries to insulate itself from FX risk by setting up a dollar-denominated contract, only to experience a catastrophic loss like a contract cancellation due to currency movement.
"There's a valuable lesson here," he observes. "FX rate risk will be borne by one party or the other, or it may be shared. But it is not going to be eliminated."
Web Links:
A Simple Model of Foreign Exchange Exposure (pdf)
In Defence of Hedging
Wall Street Journal: Peugeot Shuns Hedging Despite Currency Losses November 10, 2003
CFO.com - Natural Performers
Companies are increasingly relying on natural hedges to juggle currency risks - June 1, 2003
