It is important for companies involved in foreign trade to consider the options available to them to protect their bottom line, writes Michael Ade.
Despite the continuous recovery in global commodity prices from the lows recorded in December 2015, it is still too soon to tell whether the positive trajectory will continue. This is due to on-going efforts by China to re-balance its economy and the protectionist policy of the US on steel and aluminum imports, which may just be a precursor to enhanced trade wars which would have dire consequences for all.
The imposition of an import tariff on all steel products by the US, a leading global steel importer, could lead to a fall in international steel prices due to a combination of lower demand and a corresponding oversupply from China. A potential trade war between China and the US has the potential of constricting an up-tick in world growth, overlapping to temporary exchange rate shocks, as capital flows respond to changes in expected returns.
Domestically, production in the metals and engineering (M&E) sub-components continued to be variable and local steel consumption is still low, compelling many businesses to increasingly consider exploring various export markets within and without the African continent. However, exporting into foreign markets and, indeed, international trade is significantly different to domestic trade, given the number of factors such as payment, performance and transportation risks to which companies are exposed. All these risks emanate from trade across borders which are subject to highly volatile exchange rates. Foreign exchange risk, therefore, adds considerable threat to exporters, importers and competitors with imported goods in the local market.
Although financial institutions do play a crucial role in assisting traders in mitigating risks through the provision of trade and supply chain finance solutions, including Letters of Credit, foreign exchange rate risk is still one of the biggest risk factors faced by businesses. Typically, overseas buyers of finished products would pay in their local currency, which the South African exporter then exchanges for the rand, before depositing it in his business bank account. However, while a sale transaction is in progress, the value of a foreign currency may change relative to the value of the rand.
For the exporting company in South Africa, this means that some of its export profits can be reduced in the course of exchanging currency during the trade transaction, with the company incurring losses or exports costs, which can significantly impact on margins over time, and reduce operating margins.
Hypothetically, a South African exporter thought that the pay-off from a trade transaction would be R1,000,000 from a shipment the company is exporting to Germany. However, by the time the shipments of goods make their way overseas and the buyer takes delivery, the rand may have weakened against the Euro and the exporter ends up only getting R910,000, with exchange rate costs accounting for R90,000. The time lag between when the goods are exported and when the buyer takes final possession of the goods is, therefore, very critical.
If, on the contrary, instead of the rand weakening, it appreciates suddenly against the Euro, this means that by the time the South African exporter’s goods arrive at their final destination in Europe, the costs to the buyer must have increased. It may cost the buyer more in the local currency or the Euro, to equal the rand value upon which the transaction was initially agreed upon. The sudden increase in the final selling price to the buyer, due to the appreciation of the rand, may even lead to the buyer in Europe no longer wanting to take delivery of the merchandise and effectively cancelling the deal. Businesses, therefore, need always to monitor currency variability.
A South African company can hedge and maximise benefits from currency volatility by simply opening an account in the country of import, enabling it to deposit the gains from exchanging currencies in an offshore account or in a local bank of the importing country. This will enable the SA business to have a cash buffer to cater for and offset future depreciation of the rand. However, local companies must ensure that they comply with the Reserve Bank’s foreign exchange requirements and its annual limits for companies to remit funds out of the country. The downside with this hedging method is that it’s hard to predict accurately when currency fluctuations will occur, its direction and duration.
Domestic businesses can also take up currency forward contracts agreements which specifically enable them to exchange certain amounts of rands for any foreign currency on a future date. Forward contracts allow a business to lock in an import purchase of input or export sale of output at the current exchange rate, guaranteeing the proceeds of the transaction at a price agreed upon. The benefit of this type of agreement is the protection to the business against the risk of a weakening or depreciating rand. However, the challenge is that if the rand should strengthen afterwards, businesses cannot profit from forward contracts since they are already locked into a mutually-agreed exchange rate with the bank.
Another financial instrument available to local businesses is futures contracts, which are a commitment by the business to purchase currency in the future, at a rate agreed upon rate based on current exchange rates. Although similar to forward contracts, futures contracts have an advantage over the former since there is a secondary market for them. Companies can opt to sell their contracts to a third party before the agreed term of the contracts are up or if they have a change of mind in pursuing the business opportunity or if their businesses need more cash liquidity. The slight snag with futures contracts is that they usually allow a range of forward exchange prices rather than a fixed point. Also, the contracts are only offered in fixed amounts, which may make it hard to hedge the exact amount a company may want through futures.
Currency options as a financial instrument provide the exporter or importer with an opportunity – but not an obligation – to buy or sell a fixed amount of currency at a set price, on or before a chosen date. Currency options come with a “strike price”, which is the price at which the currency can be bought or sold. They also have an expiry date, after which the opportunity to purchase the currency option at a price agreed upon elapses.
However, the caveat is that each of these currencies or hedging strategies, including common spot deals, comes with fees and commissions charged by the banks or any relevant party administering the hedging vehicle. Irrespective of the route chosen, exporters and importers should assess the relevance of hedging against currency risks, before taking up any of the hedging options available. When in doubt, companies are advised to consult with their local banks for flexible and suitable cost-effective options.