All exporters will have to tackle the issue of foreign exchange. With the Australian dollar fluctuating regularly, it literally pays to know how to manage the risks when exporting.
Cameron Bayley reports on hedges, hybrids and other solutions.
By its very nature, exporting doesn’t occur unless money changes hands (although many exporters may claim they never see it!), so deciding how to approach the issue of foreign exchange is something all exporters need to face.
However, for something so integral to the export process, it can be left at the bottom of the ‘to do’ list for many SMEs, behind considerations such as distribution, logistics and marketing. "When most companies look at the challenges and risks around their business they tend to focus on things that are unique to their industry," explains Paul Appleby, Travelex managing director for commercial foreign exchange for Asia Pacific and Japan. "They tend to overlook, or not place enough significance on, one of their greatest risk exposures, which is currency fluctuation."
A bad idea, says Carsten Pedersen, Westpac’s senior manager, financial markets. He says the humble Aussie dollar can go through some turmoil because it’s one of the most heavily traded currencies in the world. "While we can put a figure on it for some time in the future, it can move an awful lot between now and then," he says. How foreign exchange works is reasonably simple. If you receive payment for your product or service in an overseas denomination, you then sell that amount to the bank and buy Australian dollars in return, according to the exchange rate at the time. "Every foreign exchange transaction is sale of one currency and purchase of another, they can’t happen in isolation," Pedersen explains.
And it’s all focused on the US dollar, the currency in which most trading outside Europe is conducted. "[It’s] the largest currency in the world," Pedersen says. "By far the most transactions are against the US dollar." Even if, for example, you’re working out the exchange rate between Australian dollars and Japanese yen, the exchange starts by working out how each currency stands against the US dollar, and then applying the relevant formula.
For an exporter, handling international currency can generally be done in two ways. First, a business can establish a foreign currency account with their bank or financial institution, with customers and suppliers paying the foreign currency into that account. The exporter can then exchange this for Australian dollars and transfer it to the business. Alternatively, most financial institutions have the facility to accept funds in foreign currency on behalf of their clients. They then contact the client and ask what they would prefer to be done with it.
Of course, the amount you get from the bank when you exchange depends on the currency exchange rate at the time, and that’s the risk, Pedersen explains. "If I know that my customer in the US is going to send me US$100,000 on January 31, the risk I have is that today the Aussie dollar is trading at 78.06 cents [but] if that were to become 80 cents between now and January 31, I’ll get less Australian dollars in my pocket when I do the exchange." For many exporters, he adds, payments are frequent, and for any business’ cash flow, consistency and predictability of those payment values is important. "You don’t want a payment coming in that you’ve got to convert on a day when the currency’s very high. Because it’ll cost you money."
Hedging Risk
However, there are tools in place which businesses can use to help control risk, a practice that is often called hedging. The most common tool is using a Forward Exchange Contract (often called an FEC or forward). "An FEC is simply a means of fixing the rate that you would convert US dollars to Australian dollars on a future date," Pedersen explains. "I can price up a rate today that I’m guaranteed to be able to do that transaction on January 31. Once I’ve done that I’m hedged," he says, using his earlier example.
Another tool is called an option, which gives a business owner the right to buy or sell one currency in exchange for another within a certain timeframe, for a premium rate. The difference is, the owner of the option is not obliged to do so. "Options can be used in a similar vein to insurance, in that the client can protect against a worst case but still take advantage of favourable movements in currency," Pedersen says, noting several different forms of options.
"If you start playing around with how the option itself is structured and the payoff that it gives, then that’s what is called a hybrid."
One way to completely remove any currency exchange risk is to sell in Australian dollars only. Catherine O’Keefe, general manager for The Purist Company, which exports its range of skin and beauty products to markets including the UK, US, Brunei, and Singapore, says the company made a decision to trade solely in Australian dollars right from the start. "We were too small and didn’t have the expertise to deal with all the foreign currency. " The company weighed up what the export side of the business would bring in, and whether it was worth investing in some assistance. "We made the conscious decision around what our infrastructure could handle," says O’Keefe. "So that’s why in our discussions we stuck to saying that we would quote in Australian dollars and get paid in Australian dollars."
Pedersen and Appleby both warn that one downside of dealing in Australian dollars is that it may make it harder for a business to compete on a global scale. "You certainly limit yourself from the market perspective," says Appleby, who warns that customers and business partners in foreign markets may refuse to deal in Australian currency. In this instance, Pedersen adds, it’s the overseas customers who need to deal with any currency exchange risk. "Which may or may not influence how they perceive dealing with you. That’s a cost they would need to factor in at their end in terms of the overall purchase price."
O’Keefe agrees to some extent, but says it can depend on the product or service involved. When The Purist Company launched into export two years ago, it wasn’t an issue, as their products had found a niche. "Lucky for us, we’ve actually got a product that is highly desirable, so at that stage it was fine, people wanted our products and they were prepared to deal in Australian dollars." She admits, though, things are changing as exports grow. "We’ve found, since we’ve gone to larger exhibitions, that our European customers like to see euros, US dollars, pounds sterling, and then Australian dollars." And Purist has just started quoting in US dollars in markets such as the Philippines (who will only deal in that currency). Michael Tsang, Purist’s financial controller, says not having fixed foreign currency prices does have its limitations, especially as quotes are only valid for a limited period of time due to fluctuations in the Australian dollar.
Going Global
For a company like Jord International, a Sydney-based company specialising in the manufacture and installation of heat separation vessels on power stations, there’s never really been a choice as to whether or not to accept foreign currency. "Australia’s not investing that much in these things yet," explains Mike Healey, chief financial officer. Dealing almost exclusively in foreign markets, such as the Middle East, Africa, Egypt, South America and Asia, the company trades mostly in US dollars, with the euro creeping in too. On top of this, the company also uses Korean won, Chinese renminbi and Malaysi
an ringgits through its fabrication operations in those countries. And Healey pulls no punches as to the ‘ease’ of dealing in foreign currency. "It’s certainly daunting," he says. "That’s the only word I could use."
With the company dealing in varying lead times, and contract changes and extensions, a simplistic approach to hedging just wasn’t going to cut it. "Our contracts can change. We can be committed for contract where we’re spending X amount of money and receiving X amount of money. But over a period that changes because of variations on the contract, so the exposure changes as the variations get added to the contracts, and as the contracts extend the exposure changes," he explains.
Getting a foreign exchange dealer from the bank to come and do a training course in the workplace, was a start in having a more hands-on approach. Healey admits initially it was confusing, but working through transactions with assistance has made a big difference in making sure the company doesn’t lose out on currency fluctuations. "The trouble with learning any other way is that you’re learning theory whereas by dealing with your own forex dealer you’re able to say ‘Here’s the transaction which we’re used to dealing with. Is this the right way to do it?’"
Appleby says finding a provider who understands your business is also important. Factors such as your product or service, customer base, business cycle, trading terms, period of sale can all affect the approach that might be needed. "The hedging strategies that you’re looking for, the payment strategies you’re looking for, will vary simply because of the nature of the business." Pedersen says a good approach to foreign exchange involves three steps. Firstly, he recommends doing some research to give yourself an understanding of current exchange rates, particularly so you don’t have any unrealistic expectations if you are using an FEC. "Secondly, really identify the risk that you have and what that risk means," he advises. At this point, consider what tools could be useful, such as FECs, options and hybrids. Lastly, review the process, and see how your approach did or didn’t work. And don’t be afraid to question established methods, says Healey, who only joined Jord International late last year. "Look at your hedging policy and see whether it actually makes sense. Because a hedging policy in place can look good until you actually dig into it."
"Trading and managing risk around foreign currency isn’t a weird science," Appleby says. "There are some great tools in place that can obviously help small businesses manage that risk and that risk exposure." It’s the difference between turning one unpredictable part of your cash flow into something highly predictable, he adds. And Healey agrees: "The whole idea is that it’s supposed to make things as known as possible."
Both Pedersen and Appleby agree that getting rid of the mystery and confusion around foreign exchange, as well as staking out some security, can make a huge difference to your business’s day-to-day running. And its future, too. "If you are importing or exporting, your business is terribly exposed to the kind of currency fluctuation that we’ve seen, and the volatility we’ve seen over the past year or so," says Appleby. "So you really must be doing something about it, because it really is a business continuity issue."
