FX hedging to the fore
Corporates’ use of hedging – most notably of FX – has risen markedly since the financial crisis began. While regulatory change looks set to significantly increase hedging costs, the adoption of new market practices could ensure than that it remains affordable.
By Arek Szperna, Head of Financial Markets CEE at ING
Corporate clients active in CEE – whether they are local or international firms – must manage three principal risks: foreign exchange (FX) risk, commodity risk and interest rate risk. Of the three, FX risk is by far the most important. With the exception of Slovakia (which is a member of the Eurozone) and the countries with a currency peg, most countries in the region have free-floating exchange rates that create the potential for companies to have huge FX exposure.
The scale of that exposure has been vividly displayed in recent years. During 2008 and 2009, the Polish zloty weakened by up to 50% in just six months. More recently, in 2011 the Hungarian forint lost up to 20% of its value in five months, while in 2012/2013 the Russian rouble lost about 15% against the US dollar. Such huge swings are not beneficial for anyone. However weak, a local currency can create opportunities for some companies: for those that manufacture in the region and distribute elsewhere, such a decline in costs can be a boon. On the other side, for international companies distributing products or services in the region, devaluation on such a scale can rapidly price them out of the market.
Before 2008, many corporates were reluctant to hedge long-term FX risk because the economic backdrop was relatively stable and there were few negative consequences of failing to hedge. Since the onset of the financial crisis, awareness of FX risk has necessarily grown – CFOs and treasurers rapidly increased their knowledge as volatility spiked – and demand for longer-term hedging solutions has therefore risen.
Local presence is crucial
The market for hedging corporate FX risk is dominated by local and regional banks, according to central bank statistics from across CEE. For international banks without an onshore presence it is more difficult to develop the relationships needed to win business: generally FX and risk management business is awarded to banks willing to make their balance sheet available to clients.
In addition, given the complexity and diversity of local markets in CEE it is difficult for banks without a local presence to develop the appropriate expertise or knowledge necessary to adequately address the dynamics of FX in the region and hedge risks accordingly. ING is well positioned in each local market and offers expertise, execution and research locally. It is also heavily committed to supporting its clients and deepening its corporate relationships. While a local presence remains essential, many companies are increasingly centralising their corporate treasury at a regional or global level. To reflect this ING also operates global emerging markets FX desks in Amsterdam, Brussels and London to provide coverage at head office level: clients can access local know-how and still execute globally – which can prove to be more cost effective.
A new second risk factor
While FX has undoubtedly become the most important risk factor facing CFOs and treasurers in the past three years, the significance of commodity risk has also increased over the same period. Indeed, commodity price risk has become sufficiently elevated to overtake interest rate risk as the second most important risk facing companies.
Large local companies in the natural resources sector, such as local refineries or gas distributors, are used to buying a product based on a price formula that differs from the formula used to set a selling price. Similarly, some companies may have a long lag between production and sales. Given commodity price volatility, such companies can face significant discrepancies in these prices. As a result they have increasingly hedged the gap between their buying and selling price or tried to guarantee forward prices. At the same time, many logistics clients have reacted to the increase in diesel fuel prices by using commodity derivatives to hedge their exposure (see box on commodity derivatives for more details).
Interest-rate hedging has historically been relatively unimportant to companies in CEE as most countries in the region have benefited from a downward movement of interest rates. Even as the cost of funding has fluctuated, it has been offset by this downward trend. Naturally CFOs and treasurers are aware of interest rate risk, but it is not a primary concern. After all, a 50% movement in FX has a much greater effect on a company than a 100 basis point increase in interest rates.
The impact of regulatory change
The torrent of regulatory change – most notably Basel III – will have a significant impact on banks and major knock-on effects for corporates in all regions seeking to hedge FX risk, commodity risk or interest rate risk. Basel III is already impacting the pricing of derivatives to end clients such as corporates as banks are considering the credit risk of the corporate client, expressed as a Credit Valuation Adjustment (CVA), and the market liquidity risk in order to allocate capital for potential negative valuation of the contract more accurately.
Historically, credit risk has not been fully reflected in derivatives pricing, which was instead determined primarily by a bank’s ability to provide a particular hedge. Under Basel III the rating of individual clients and the sector they operate in will have a major bearing on the price they pay to hedge their risks. For highly-rated companies the expectation is that hedging costs will remain similar to those previously incurred. For lower-rated companies, which include many domestic companies in CEE, costs could increase considerably.
There is, however, a way for such companies to mitigate the potential increase in hedging costs associated with CVA. Long-term hedging contracts are covered by the International Swaps and Derivatives Association documentation that includes a Credit Support Annex. This annex states that if a contract is negatively valued by the market, then the client owes money to the bank (in compensation for the increase in credit risk). So should a certain pre-agreed value be reached, collateral must be posted. The Credit Support Annex can work on a bilateral basis.
To date the Credit Support Annex has been rarely used – most obviously because clients have not been aware of it and have never had to consider using it. Among those companies that were aware of it, there has been a concern that the requirement to post collateral could trigger a liquidity problem. Also, in some countries – including in CEE – it has been unclear whether the existing legal framework supports the use of the Credit Support Annex and whether it is enforceable for corporates. Given the importance of ensuring access to hedging for CEE corporates, it seems certain that these challenges will be overcome and the use of the Credit Support Annex will increase as non-collateralised hedging prices increase.