Recent developments in the global trade environment have been coming hard and fast. First, there’s the possible end, or significant renegotiation, of the North American Free Trade Agreement (NAFTA). Then, U.S. steel and aluminum tariffs have raised fears of a potential U.S. trade war. On top of this, political risk has risen in the United States and around the world in places as disparate as Italy and South Africa.
At times like these, when volatility is rising, middle-market companies that trade with overseas partners should pay close attention to foreign exchange risk, something most executives ignore in tranquil times.
Many executives have found it easy to pay little heed to foreign exchange (FX) in recent years as the U.S. dollar has remained relatively strong and stable. However, last year’s Brexit vote in Britain to leave the European Union was a reminder that even developed nations’ currencies can swing wildly, affecting corporate profits.
As a result of Brexit, the British pound was the most volatile developed-market currency over 12 months, swinging 9% against the U.S. dollar in 2017. Indeed, the currency was so volatile, that Bloomberg noted that, “The British pound has more in common with the Colombian peso and the Polish zloty than you may think.”
Anyone thinking such woes only happen elsewhere was reminded in March that unexpected things that can impact trade happen here, too, as evidenced by the recent tax imports on steel and aluminum.
It’s time for middle-market companies to become more active in dealing with foreign exchange risks.
Many executives believe in the dollar fallacy—the notion that they are not exposed to currency risk because they operate in dollars. Others think they can fix any problems by playing in the foreign exchange markets. But just as individual investors are cautioned against trying to time the stock market, chief financial officers and other financial executives should never risk the financial welfare of their firm on timing the FX markets.
Most U.S. companies doing business overseas have exposure to either the euro, the Canadian dollar, the Mexican peso, China’s yuan, Britain’s sterling, Brazil’s real, or the Japanese yen. Here are four steps that middle-market CFOs can take to mitigate their FX risk.
Evaluate FX risk throughout the entire supply chain: Many U.S. firms erroneously think they don’t have foreign exchange risk because they only buy and sell in contracts denominated in U.S. dollars. That convenience, however, does not eliminate FX risk in the firm’s supply chain. For example, a company may buy steel from a Mexican supplier under a U.S. dollar-denominated contract, but the price will actually be calculated by the supplier using the underlying value of the Mexican peso. Only by understanding the full extent and details of such risk can plans be put in place to hedge against currency fluctuations.
Evaluate cash flow risk: Firms should likewise analyze cash flows to understand FX risk. For example, a manufacturer making a major capital equipment purchase from Germany under a contract that requires payments in euros over several years might buy futures contracts to hedge that risk.
Similarly, companies should regularly assess the currency risk of doing business with their largest customers. For example, a U.S. multinational company with an excess of Mexican pesos may demand to pay a dollar contract in pesos instead, using their size as leverage to transfer the FX risk to the smaller firm.
Establish governance procedures: Making sales is always exciting. However, that thrill can be tempered when sales teams sign contracts that have FX terms that are not in line with the firm’s risk strategy. Governance procedures should be established so that the sales team cannot sign contracts with FX terms without signoff from the firm’s CFO or controller. For public companies, McKinsey recommends disclosing FX risk to shareholders in financial statements, focusing on its impact on cash flows rather than earnings.
Sell in local currency: Traditionally, U.S. firms have preferred to only trade in U.S. dollars. However, it’s easier for foreign companies to do business with overseas firms when they can write contracts in their local currency. In addition, the best deal from a foreign supplier is typically the local currency price—firms tend to tack on an extra charge to convert their price to U.S. dollars and that fee typically exceeds the cost of hedging currency risk.
The good news is, your currency hedging as a middle-market company doesn’t need to be anywhere near as complex as it would be for a multinational corporation. But you can’t ignore it either.
Lou Longo is international consulting practice leader at Plante Moran in Chicago. Francia Harris is a Managing Partner at Bannockburn Global Forex in Chicago.