Our dollar’s dream run could turn into a nightmare for exporters – Cameron Cooper looks at risk management options for riding the highs and lows of currency fluctuation.
Our national pride rises and falls with the fortunes of the Australian dollar. Think back to 2000, when the little Aussie battler got the staggers, hovering around a pitiful 50c against the US greenback. Unwanted and unloved. So, when the dollar hit an 18-year high of US87.35c at one point during trading in mid-July, we could afford to puff out our chests.
Yet, the Australian dollar’s dream run is a potential nightmare for many exporters, who are seeing the competitiveness of their goods plummet. And the rise of the Aussie underlines the importance of exporters managing their exposure to currency fluctuations. Tom Averill, a senior consultant at international foreign exchange advisory service HiFX, says small and medium enterprises often have sketchy knowledge of forex strategies.
"Some think they have an understanding, but they don’t," he says.
Averill believes the strength of the Australian dollar has spooked exporters, although the US and Japanese currencies have weakened against every other competitor. "So from a competitive position they’re still okay really, and the Australian brand is still pretty strong."
In the past two editions of Dynamic Export, we have explored the ins and outs of foreign exchange trading, including using hedges—an investment tool to offset market risk—as an insurance policy. Why, though, do currencies fluctuate so much and how can exporters better respond to such volatility?
Many factors determine demand for a currency, including a country’s inflation, interest rates, economic outlook, monetary policies, and the activities of speculators. Currencies don’t move uniformly against each other—the Australian dollar can be rising against the greenback, for example, while declining against the euro or pound.
John Kyriakopoulos, head of currency strategy at nabCapital, says potential yields are the key to the fortunes of our dollar. Interest rates are crucial. During the aforementioned trading period when the dollar pushed through the US87c mark, there was rampant ‘carry trade’ activity—with traders selling low-yielding Japanese yen to buy high interest-rate currencies such as the Aussie.
"And it’s obviously particularly attractive at the moment, especially in Japan, where interest rates are still close to zero," Kyriakopoulos says.
While speculators affect the exchange rate, they may not always have long-lasting effects. "To say the exchange rate is going up just because of speculators buying in anticipation of a rise could be true for short periods, but the real reason the currency’s going up is more fundamental—it’s linked to commodity prices, the strong domestic economy, and the high interest rates on offer."
Far from being over-hyped, Kyriakopoulos believes our dollar may rise further and even hit the $1 barrier. This is not just a weak US dollar story. Recent nabCapital research shows the Aussie has climbed more than 7 percent this year against a trade-weighted basket of 22 currencies. He points to commodity prices and Australia’s terms of trade—the ratio of export to import prices. The Reserve Bank argues that Australia’s real exchange rate tracks with the terms of trade, and they have hit their highest level since the Korean War in the 1950s on the back of huge demand for commodities from booming China.
Kyriakopoulos notes, too, that the greenback is "on the nose" as the US economy slows.
All currencies have a set of factors that cause price fluctuations, and given that the Australian dollar has long been regarded as a ‘currency commodity’ it is not surprising that the strength of underlying commodity prices has correlated with a rising dollar.
At HiFX, Averill agrees that the carry trade is having a huge impact on the Australian and New Zealand dollars. He says 97 percent of all currency market transactions are attributable to speculators, who typically snap up high-yield currencies and sell poorly performing counterparts to take advantage of interest rate differentials. Even ‘ma and pa speculators’ in Japan are adopting this strategy, Averill notes, and the Australian dollar is one of their key targets.
Up & Down
The strong Australian dollar has serious implications—good and bad—for our exporters.
Some may be forced to increase the price of their goods and services in foreign currency terms, which could affect their competitiveness against other international suppliers. However, it also gives extra purchasing power in foreign markets for businesses that import some goods for their domestic operations. And, as tourists and business travellers are well aware, a higher dollar is good news for those staying in the US, for example, when they convert their hard-won Aussie dollars into greenbacks.
Matt Gilmour, managing director of OzForex, a leading foreign exchange service provider that focuses on web-based transactions, says the rising dollar presents a horses-for-courses scenario. Commodity exporters have seen prices for their products go "though the roof" because of the resources boom, so the dollar has not affected them greatly. However, Gilmour says exporters of services that have not experienced a big natural price rise are getting hurt.
There are strategies to ride out currency fluctuations, and clearly hedging is important. As detailed in earlier editions of Dynamic Export, a forward exchange contract allows exporters to lock in an exchange rate without having to pay for the purchased currency until a future date. This reduces uncertainty around foreign exchange transfers.
Gilmour notes, though, that most companies still ultimately feel the effect of exchange rates even with such a hedge "because most don’t forward-hedge their entire exposure over a very long period". Cover generally lasts a matter of months, after which they rely on spot markets that provide an immediate exchange of foreign currency at market rates.
"So, if there’s a sustained appreciation in the Aussie dollar, exporters are really going to feel it eventually."
An important step when managing foreign exchange risk, according to HiFX, is to establish a good framework of trading rules that helps build discipline into a company’s operations. "If you’ve got this framework that compels you to act, it can remove the emotion from the decision-making process and it means you are always acting to protect the underlying viability of the business," Averill says.
He adds that companies must make a choice: either they view foreign exchange fluctuations as an unwanted byproduct of business and take a hedge to limit risk, or they see currency movements as a chance to bet against the market and add to the bottom line. "But you’ve got to have that objective clear in your mind from the outset," he says. "The problem with SMEs, like anybody, is that they want to take absolutely no risk but not leave out the opportunity for gains."
Waverley Australia, a Tasmanian exporter of luxury blankets to markets such as China and the UK, is keenly attuned to forex markets. International business manager, Mark Bramich, says one key strategy to offset currency fluctuations is to build flexibility into contracts or distribution agreements. "This gives you the right to make adjustments for a plus or minus on currency variations," he says.
Bramich has product price sheets quoting Australian dollar, greenback, and renminbi (RMB) costs. The rates at which they are converted are noted. "Then we say—especially in volatile markets where you can get absolutel
y caned on currency changes, and the US dollar is a classic one—that I reserve the right to change those US dollars and RMB. It’s swings and roundabouts, so the customer can actually benefit sometimes, too."
He says such a strategy depends on good relationships with customers and should be negotiated up front.
Large companies often use so-called natural hedges to protect their business. A resources company, for example, may draw comfort from the fact that the dollar broadly matches movements in export commodity prices, while others may negotiate contracts in Australian dollars to negate currency risks.
Bramich says Waverley has a natural hedge in that it can spend US dollars to source some raw materials or consumables from overseas. "It does minimise the need to actively manage currency movements by taking out forward exchange cover."
He also uses forward contracts as insurance, while the UK contracts are usually paid in Australian dollars. It is worth asking customers if they can pay in the Aussie currency.
"It makes it so simple," Bramich says. "You should always explore the opportunity. I’ve had a couple of hints about the Aussie currency being unfavourable, but it hasn’t got to the stage where they’ve stopped placing orders."
While most exporters would love to trade exclusively in Australian dollars, the fact is that most have little choice. The ‘best’ currency depends where your business bet rests: that is, the one with which you have the biggest revenue and cost basis. Some large Australian resources companies that earn revenue in greenbacks now report in US terms to reduce risk.
In most cases, SMEs are swapping greenbacks: up to 90 percent of Australian import and export trade is in US dollars and that is the default currency for exporters in many parts of the world, especially Asia. Australian exporters can be competitive while trading in US dollars as long as they have a sound risk management strategy. In any case, OzForex’s Gilmour says insisting on Australian dollar payments is not a sound long-term option for serious exporters.
"It makes those customers look less professional and some customers will think it’s a little too hard to do business with them," he says.
There are myriad financial institutions that help exporters with foreign currency transactions. Outside the Big Four of the Commonwealth Bank, National, ANZ and Westpac, major international players such as UBS, Citibank, Deutsche Bank, HSBC, and Travelex are possible alternatives. Then there are the independents.
At HiFX, Averill argues that independent advisers tend to offer a more personalised service than the bigger banks. One of his forex consultants services a maximum of about 30 clients, whereas a dealer in a bank may have 250 clients. "So you’re paying for that extra level of service," he says.
Averill says it’s important to seek out an adviser you trust. "A big concern that I have for a lot of SME clients is they are being sold very complex derivative products that they just don’t understand. So, certainly another big point is: don’t buy anything you don’t understand."
OzForex’s Gilmour advises SMEs, in particular, to assess price. He says exporters can get "the low-hanging fruit" and negotiate a reduced transaction cost for currency exchanges. This immediately allows an exporter to save a percentage on all transactions and boost revenue.
Gilmour also urges exporters to choose a service provider that matches their needs. For example, OzForex is highly regarded for web-based transactions, while some exporters may be happy to pay a premium for a service that is more predictive of currency movements. Others will prefer the security of the Big Four, with whom they may have a loan.
At nabCapital, Kyriakopoulos says SMEs should not ignore the advantages of dealing with a big bank such as the National. "We’re a very large player in the Australian dollar—that’s the biggest benefit," he says. "We know the market very well and are a good provider of liquidity. We’re an expert in the Aussie dollar. That’s our big competitive advantage."
Banks aside, one of the most attractive funding options is government assistance. The Export Market Development Grants scheme is the Federal Government’s main financial program for exporters. The Export Finance and Insurance Corporation also has a raft of solutions, including direct loans, export finance guarantees, and documentary credit guarantees and finance.
Regardless of institutions, Kyriakopoulos believes a strong Australian dollar is here to stay. "We’re advising clients to get used to the exchange rate trading at a very high level for some time—certainly remaining above 80 cents."
That, he says, will be a "sea change" for a lot of companies. "There’s obviously a bit of reluctance to want to hedge the exchange rate at these levels, when it’s above 80 cents, simply because a lot of businesses, looking at the last two decades, believe it will probably fall very sharply at some point," he says. "That might be a dangerous strategy."