| Managing euro weakness |
Back |
| No-one predicted the euro would fall by as much as it has this year. Finance asked John Rice, a treasury specialist, from AIB Corporate Treasury how corporate treasury managers do, and should, adjust to euro weakness. |
Q. Have businesses in Ireland begun to diversify currency risk - what are they doing?
John Rice: To a large extent the answer to that is no. A number of customers are now seeking guidance from a strategic perspective as to the longer term valuation of the euro particularly against sterling and the US dollar. The rationale driving their concerns along with the general business expense of the current high cost of imports is the requirement to possibly seek suppliers in alternative markets. However as many of them find, switching of suppliers is not easy from a number of perspectives not least quality control, credit and logistics. Companies should consider having suppliers in a number of currency zones or they should seek to include a currency clause in their contract.
Q. Has the large decline in the euro against sterling and the dollar influenced the affordability of financial currency hedging techniques? Will it change pricing assumptions even if the euro recovers to dollar parity?
John Rice: For some products, yes. The main hedging tool used in the active management of foreign exchange rate risk is a forward contract. In this instance the recent decline in the euro has had little or no effect on the price of hedging. The cost or benefit of hedging forward is derived from the interest rate differential between the two currencies involved. In the case of an importer this differential is currently a benefit as euro interest rates are lower than most other major international currencies. Obviously the spot rate element of the forward is now more expensive as the euro has weakened but the cost of forward cover per se has not changed because of the decline of the euro. However in the case of many derivative structures the cost has risen due to the increase of volatility in the foreign exchange markets. The cost of hedging this volatility is a significant driver of the cost of an option structure. If the euro recovers the cost or benefit of forward cover will not be directly linked to such a movement but more to do with interest rate policies. In the case of derivative structures it will depend on market volatility at the time.
Even if the euro recovers, has the attitude of treasury managers in Ireland towards the volatility of the euro been altered for the long term? Are corporate treasurers feeling badly burnt, and how long a period of recovery would it take for them to recover?
John Rice: A complex question. Not for the first time have we seen significant currency movements that very few in the market place anticipated. This is and will be an ongoing feature of the currency markets. The main reason is the size and complexity of the market. Volumes are enormous and are measured in the trillions of dollars daily. Many customers are feeling badly burned given the prolonged period of decline in the euro as much as the percentage decline. However there are two sides to every coin and in as much as importers are suffering, exporters are enjoying the gains. The period of recovery will depend on companies ability to pass on price increases or else as discussed in question Q1 seek alternative markets for supply. Obviously a rise in the euro would be the answer to all their current ills. The period for ‘recovery’ will therefore be company and market specific.
Has the euro's fall changed the view of your bank and your treasury customers of what are going to be the main treasury techniques over a 2-3 year horizon?
John Rice: This is a recurring theme every time we see significant currency movements. AIB’s view is that companies need to constantly review the robustness of their treasury policy and to stress test it for the volatility levels that we have seen in recent times. The use of company specific derivative structures is the only way forward and it becomes increasingly obvious that whilst forward contracts offer protection they are extremely inflexible in current market conditions. Company specific solutions allow the benefits of forward contracts with an element of insurance to ‘buy time’ when markets behave unexpectedly.
Evidence would suggest that many companies are reluctant to enter in derivative solutions due to the complexity and cost involved. Both can be overcome. The cost should be looked at now in light of the alternative, which is exposure to an unfriendly spot market.
Is anyone in Ireland banking on Britain joining the euro within five years?† Should anyone?
John Rice: Five years is a long time to be able to say with any certainty. Our view is that it is a possibility rather that a probability in that time horizon. We would ascribe a 40% possibility that sterling will be a member of the single currency by 2005. I think all business should have parallel business plans - the first assuming sterling remains outside the euro; the second assuming that sterling will join. It tends to focus the mind! |
|
| Article appeared in the May 2000 issue.
|
|
|
