What keeps finance managers up at night when their company ventures into new, exciting, but uncertain emerging markets? Is it the promise of growth, or is it the specter of instability? Consider the rollercoaster of currency fluctuations – how does a sudden dip or spike in an exchange rate impact the bottom line you worked so hard to build? Isn’t mapping this volatile territory one of the biggest hurdles businesses have to clear today?
If that’s the case, then you’re already facing the original problems in FX risk management in emerging markets. How can businesses insulate themselves from such monetary storms and gain enduring prosperity? This article explores these very same questions, reviewing techniques and solutions needed to tame the currency beast in volatile economic landscapes.
Understanding FX Risk Management in Emerging Markets
Think about FX risk management in emerging markets like this: whenever your business is dealing with money in a currency other than your base case – maybe you’re selling goods abroad and getting paid in euros, or buying inputs abroad in yen – you’re exposed to the risk that the exchange rate between their currency and yours can shift while the transaction isn’t complete. If the exchange rate moves the wrong way, the amount you receive (or pay) for your home currency may prove to be less (or greater) than expected. That volatility, that possibility of financial loss (sometimes gain, but the risk factor is the loss part!), is FX risk. It’s a fundamental aspect of doing business across borders.
Now, why is it that this risk is even more challenging to control when we look at emerging markets? Well, these economies are typically on a faster growth trajectory, which is wonderful, but they may also be more susceptible to extreme fluctuations. Consider economies that may be extremely reliant on the export of a single or two commodities, or where political conditions can change rapidly, or where the financial systems are not as entrenched or regulated as in, say, Germany or Japan. These conditions, among others, are able to cause their currencies to wildly – and often surprisingly – fluctuate against the stable currencies of advanced economies. It’s as much a matter of contrasting sailing on a peaceful lake with riding out a tempestuous sea; the chances of ugly waters are that much greater.
And these monetary acrobatics? They have tangible, real effects upon companies doing business in or with these countries. Say you set your product in the local currency of a developing market based on the most up-to-date exchange rate, only to see that currency decline dramatically against your local currency when payment is made. Suddenly, the sale you thought would be profitable is barely breaking even, or worse. And conversely, overnight, the price of raw material imports can shoot ten times higher. This volatility makes budgeting a nightmare, erodes profit margins, impacts competitiveness, and even makes long-term investment decisions seem like a massive gamble. Being able to overcome these challenges is precisely why good FX risk management in emerging markets strategies are not merely best practice, but an absolute necessity to survive and prosper.
Types of Foreign Exchange Risk in Developing Economies
Different situations offer different types of currency risk. However, there are really three types of foreign exchange risk businesses face, particularly problematic when dealing with less stable currencies prevalent in emerging economies.
Transaction Risk
This is the most basic type – it’s the possibility that the exchange rate will fluctuate between the time you agree on a price for a single transaction (like buying or selling something overseas) and when you actually go to exchange the money. In unstable emerging markets, a huge swing can translate into an enormous difference in the real import cost or real value of export receivables, which in turn impacts the profitability of the aforementioned single transaction prior to the exchange of cash.
Translation Risk
Translation risk isn’t cash flow yet, but reporting. If you have subsidiaries in emerging markets, you need to translate their local-currency financial statements back into your native currency for consolidated reporting. If the exchange rate jumps around wildly during the reporting period, the translated value of assets, liabilities, revenues, and expenses will jump around wildly on the parent company’s books, even if the subsidiary’s local performance was stable.
Economic Risk
This is the most difficult, long-term risk. It’s not whether persistent changes in exchange rates affect your firm’s competitiveness and cash flows in the future over the long term, as opposed to the level of individual transactions or reporting periods. For example, a persistently depreciating local currency in a developing economy will make your foreign inputs permanently more expensive or reduce the price of locally produced products relative to yours. Successfully managing this long-term exposure is a critical aspect of effective FX risk management in emerging markets.
Key Challenges in Managing Currency Risk in Emerging Markets
Effectively managing currency risk in emerging nations presents some unique challenges. Let us consider some of the major hurdles that businesses often face.
High Volatility and Unpredictability
Currencies of emerging markets can swing wildly and rapidly, driven by everything from local political shifts to global commodity price fluctuations. It makes the prediction of future exchange rates virtually impossible, much like trying to fire at a blindfolded moving target. Businesses are constantly battling this inherent volatility when they seek to plan financial exposures.
Limited or Expensive Hedging Instruments
Unlike major international currencies, the financial markets for some emerging market currencies might not offer a full range of hedging products like forwards or options. Even when available, the products can be much more expensive or less flexible than the equivalents for major pairs, so managing FX risk in emerging markets is expensive.
Regulatory Restrictions
Governments in emerging markets from time to time impose capital controls or restrict the flow of money into and out of the country. These regulations can limit a business’s ability to access foreign currency freely, to transfer funds, or even to use certain types of hedging arrangements, adding complexity to reducing risk.
Lack of Transparency
Getting reliable, real-time market data or learning the nuances of local bank and foreign exchange regulations can be challenging in some emerging markets. Lower transparency compared to developed markets can make it difficult for a business to legitimately quantify its exposure and take timely hedging positions.
Strategies for FX Risk Management in Emerging Markets
Successfully navigating currency swings in developing nations requires proactive strategies. Here are some common approaches businesses employ.
Natural Hedging
The easiest way to reduce FX risk is to match your expenses and revenues in a shared local currency. This could involve discovering local inputs, producing locally, or getting local currency loans for funding local assets. It naturally hedges the currency exposure without involving complex financial instruments.
Hedging Emerging Market Currencies Using Financial Instruments
Sometimes you need more explicit tools.
- Forward Contracts: These enable you to fix an exchange rate now for a future transaction, with the comfort of certainty. But they might not always be accessible for less traded emerging market currencies, and the reliability of the counterparty needs to be assessed.
- FX Options: Options are more flexible; they give you the right, but not the obligation, to sell or buy a currency at a specific rate. This is useful if future exposure is uncertain, but this flexibility usually costs more to enter into than forwards.
- FX Swaps: Swaps involve exchanging principal and, sometimes, interest payments in a different currency for an agreed period of time, frequently used to cover short-term liquidity or refinance foreign liabilities.
Operational Strategies
Apart from financial instruments, structural reforms can also be useful. Centralising FX exposure management, perhaps through the establishment of a special treasury unit, allows tighter control. Timing of payments (lagging or leading), where allowed, or contractual negotiation on terms of sale to allocate or shift currency risk, are also part of FX risk management in emerging markets.
Diversification
Don’t have all your eggs in one basket! By investing and trading in a number of emerging markets with diverse economic drivers and currency behaviors, businesses can naturally smoothen the impact of adverse movement in any one currency. This portfolio strategy diminishes total exposure.
Implementing an Emerging Market FX Risk Management Framework
Having the risks and the strategies is one thing, but how do you implement it? Having a good framework in place is necessary to manage FX risk management in emerging markets:
- First of all, you need to have a precise grasp where your currency risk is. That means diligently documenting and quantifying all your FX exposures for each and every entity and transaction in your business trading in or dealing with emerging markets. You need to have a clear picture – which currencies are you exposed to, how much and when?
- Once you have your exposures, you need an explicit game plan. Developing an explicit FX risk policy that is underpinned specifically by the unique needs of emerging markets is essential. This policy must state acceptable levels of risk, define roles and responsibilities, and outline guidelines for hedging activities, bearing in mind the fact that the tools and regulations can be quite different from developed markets.
- Once you have your policy, you can then select the optimal hedging instruments and tools best for your exposures, the precise emerging market currency, costs, and options available. It is not a one-size-fits-all; you have to pick the right tool for the job with the constraints we noted above.
- Who you have as partners matters enormously. Finding solid banking and financial partners familiar with the vagaries and subtleties of the specific emerging markets you are working in is not negotiable. They are able to provide useful local information, access available instruments, and help you understand regulatory landscapes.
- Finally, this isn’t a set-it-and-forget-it case. Emerging markets are dynamic spaces. You have to regularly revisit your exposures as business operations change and keep an eye on how effective your hedges are. Regular review of your strategy and making changes is the key to staying protected.
In Conclusion
Managing the currency situation in emerging economies is clearly vital, but it is clearly complex. Effective FX risk management in emerging markets is more than a mathematical exercise in finance; it is a vital aspect of long-term global business. We’ve established that it is not enough to rely on one solution; an adequate strategy is all about taking advantage of natural hedges, using available financial tools wisely, and making strategic changes in operations local to conditions.
Implementing all of this – finding exposures, setting policy, choosing tools, and ongoing monitoring – takes experience and the right guidance. So, if you’re looking to set up or enhance your structure and find the financial solutions best suited to your special situation as a supplier, a buyer, or otherwise, please don’t be afraid to reach out to us. Contact the FAUREE experts for an advisory and take one step closer to understanding your emerging market FX risk.