Foreign currency is something many exporters deal with on a regular basis, and with the Australian dollar often fluctuating it literally pays to manage your foreign exchange risk. Cameron Bayley checks out solutions.
The Australian dollar doesn’t like to sit still. Owen McMahon, the ANZ bank’s head of foreign exchange for the SME market spells it out pretty simply: between 2003 and 2007 the Australian dollar went from being worth just under US48 cents to over 80 at the time of writing this article. Among those feeling the effects of this fluctuation are Australian exporters, he says. "It’s having a significant impact on their margins and in their business."
And while many exporters might think they are too small to worry about the effect of varying foreign currency rates, McMahon doesn’t agree. "It’s a question of relativity more than growth size." The decision to implement a foreign currency risk management strategy, a practice commonly known as hedging, is more dependent on the business itself and the impact currency fluctuations may have on its productivity and viability rather than its size. For example, a small business working with both high volumes and low margins, such as a meat exporter, will have its profits affected by currency fluctuations more than a large service provider locked into a fixed contract with a client, he says. Jim Vrondas, manager of corporate business at foreign exchange specialists OzForex, agrees: "We’ve got customers who do $100-$200,000 a year who are still taking measures to protect their earnings."
Exporters who don’t have a management strategy will generally exchange any funds received from overseas sales for Australian dollars at the current rate. If the Australian dollar is doing well, they may get more than originally expected. However, it’s when the currency moves downwards that concern sets in, especially if they haven’t covered themselves. "If the currency moves unfavourably, without hedging they’re exposed to the full market and will be completely disadvantaged," says McMahon.
The place to start is to consider having a foreign currency account with your bank. These are offered by all banks, and allow you to have foreign currency paid into them, which you can convert whenever you like. For exporters who also import, a foreign currency account is a must, says Vrondas, because that provides a natural hedge. "It limits their exposure to currency fluctuations," he says. "Because they’re receiving US dollars into that account and having to pay US dollars out of that account as well."
For exporters who don’t have an import stream into their business, Vrondas suggests investigating the fees and charges involved with holding a foreign currency account to make sure it’s not too much of an expense for the business. And for all exporters it may be worth looking into some more proactive hedging options, primarily forward exchange contracts (or forwards) and options.
Forward Exchange Rate
Jamie Creer, managing director of the Australian Flower Company, which exports live flowers to markets such as Hong Kong, Singapore, and the US, admits he "lives and breathes" foreign exchange. A background in importing and exporting in stainless steel and agriculture meant he knew what impact Australia’s fluid dollar rate could have. "I saw at times where that company hadn’t covered, and they lost catastrophic amounts of money."
He joined the company in 1988 to launch the former wholesaler into export markets, and says he stays abreast of what the Australian currency is doing, through speaking to other exporters, those in finance, and reading trade journals and bank updates. And he covers himself using forwards for any foreign deal he conducts. "There are a lot of lessons out there in people not covering, and I’ve taken the view that it’s better to have cover, and sleep well at night, rather than just leaving yourself exposed," he says. "And yes, you can make additional margins on your product if you don’t cover, but at the same time you can erode them and it’s just not worth the risk."
Forwards are relatively simple. The exporter takes out a contract with their financial provider that guarantees that in a set period of time the exporter will exchange a certain amount of foreign currency for Australian dollars at a specified rate. This rate will be based on the current rate, plus or minus a forward margin, which is dictated by interest rates. "What the forward does is allow you to lock in the exchange rate today for future receipt," explains Vrondas. And with exporters expecting payments anywhere up to 60 or 90 days from doing a deal, it removes the worry about where the Australian dollar could be in that time, he adds. "Regardless of what happens between now and in two months’ time, you know exactly the exchange rate it’s going to actually go through at."
Further to this, he explains, if exporters are concerned about making a healthy profit they can use the locked-in rate in their forward and factor in an extra amount to give them more of a margin. He gives an example of an exporter whose product will cost $50,000 to produce. The exporter may want to receive a 10 percent markup, to receive $55,000, so the final quoted price will be based on the current exchange rate with an additional margin on top ensuring that the exporter will get the desired amount. Creer says this sort of approach does help, and always costs his products slightly higher than just what the current exchange rate dictates. "That’s like self-hedging internally, within the company."
Obviously, Vrondas says, exporters need to also factor in their competitors, as the higher the price you charge for your product or service, the more chance you are giving other companies to undercut you on price. "That might be the difference between getting a sale or not. It’s a fine line."
Creer has a simple approach to forwards, which he says keeps the stress levels way down and which he advises other exporters to consider. "If you’ve done US$50,000 sales by Friday, then you’d be ringing your bank or whoever you do your foreign exchange through to buy $50,000 worth of currency at the rate that you did your deals at that week. Say your customer payments history is on average 53 days, you book it out 60 days, so you know your money’s in the bank. And you do it again the next week, and again the next week. So you might have 20 or 30 different covers over 20 or 30 weeks, but each week is covered and you’re locked in." This approach means Creer is currently reaping the benefits from some forwards bought last year. "I’m getting money in now at 71 cents, and everyone else is getting money in at 81 cents. That profit is locked away, and I’m feeling very chuffed about it."
Options provide a happy medium between playing the market for the best exchange rate and covering yourself against an unfavourable rise in the value of the Australian dollar. "It gives the customer the right, but not the obligation, to convert currency at a set rate at some point in future," says Vrondas. Options are far more flexible than forwards, with many different types available.
The basic form works as a contract between an exporter and their financial services provider. Like a forward, it locks in a specific exchange rate for a future date, but also allows the exporter to convert at the current rate if it’s in their favour, explains McMahon. So if the Australian dollar is trading at US81 cents but falls to 73 cents, the exporter can take advantage of this. If the rate rose to 85 cents, the exporter would still be guaranteed to be able to exchange at the original set rate.
Options are generally used for longer-term contracts, anything longer than three months, and require an upfront premium to be paid. The premium is calculated via a complex formula, but generally works out as a percentage of the face value of the option (for example, some may be in excess of 5 percent). Because options require an upfront payment, smaller exporters are less likely to use them, says Vrondas. However, in the last three to five years he’s seen an increase in the number of options being offered to SMEs by non-banks. McMahon says banks are also becoming more flexible in their offerings in this area.
The third form of protection is a variant on an option. There are several different forms an option can take, and these are sometimes referred to as hybrids as they combine elements of a forward and an option. Some are structured to reduce the amount of premium, others offer more possibilities for when an exporter may or may not choose to accept the current rate. However, Vrondas warns these can be quite complex and time-consuming, and are often used by larger businesses rather than SMEs.
Whether you choose to go through your bank or another institution is a matter of choice, as they all offer different services, or may be more suited for different size businesses. What it came down to for Creer was having a good relationship with a foreign exchange specialist, to the point that when his adviser moved from one non-bank to another, he followed. "Talk regularly with your forex expert, become a client of theirs and encourage them to ring or email you when the currency moves day or night," he says. "It’s a client–customer relationship. So foster that."
Whoever you decide to work with, ultimately you want to turn foreign exchange risk management into a long-term strategy for your business, says McMahon. Have a look at what you want to cover over the next 12 to 18 months, for example. Creer advises any exporter to make it an integral part of their business processes. "Look at where you’ve made your profits and how much it’s putting onto your bottom line," he says. "Manage it on a monthly basis and make it part of your monthly recording procedures." Keeping it well-documented and part of your overall profit and loss each month, will help you keep track of how well you’re managing the risk. "Make yourself accountable and quantify it."
And Vrondas says if exporters are still wondering how important it is for them, they can learn from the larger end of the market, with big businesses often employing full-time staff to stay on top of foreign exchange. While small business won’t need to go to that extent, there are measures within their reach to help stay on top of their own foreign exchange risk. "They think they’ve got no control over what’s happening and they just have to take what rate comes in on the day, when that’s not necessarily the case."