Corporate Finance : Focus: Foreign Exchange

Corporate Financing Focus

Active Currency Management Can Turn Risk Exposure Into Source of Potential Returns

Multinational industrial companies trading goods in global markets or building new plants overseas routinely take on exposure to foreign currency fluctuations as part of doing business, and they often consider hedging all or part of their exposure.

When a corporation hedges its overseas revenue, it is effectively buying insurance against unfavorable currency moves, which is a defensive posture, says Scott Arnott, vice president, global fixed income and currencies, at Goldman Sachs Asset Management in London.

More often than not, the currency exposure is seen as a necessary evil, and the price, or rate of exchange, is simply accepted as is, Arnott says.

Instead of ignoring currency risk or deciding how much of it to hedge, companies operating in global markets should realize that techniques for actively managing currency positions could be a good source of potential returns, according to Arnott.

Currency markets are both highly liquid, with average global daily turnover of $1.9 trillion, and inefficient, he says. There are few other markets where such a large number of participants are so accepting of price and unconcerned with profit.

When central banks intervene to influence exchange rates, for example, they are not looking to make a profit, but rather to attain an economic or political objective.

Tourists who are spending money abroad and investors buying foreign stocks and bonds are all involved in the currency markets, but with different objectives in mind. This creates inefficiencies in the market that active currency managers can exploit, Arnott says.

Trends in the currency markets are not only recognizable, but once they become established, they are usually long lasting, he says.

This makes it possible for a chief financial officer to select an active currency manager who can create positive returns or limit losses from currency exposures.

When employing a currency manager, the company should not limit its potential opportunities for gains by restricting the managers ability to trade, such as in a limited number of currencies, Arnott says. The company should ask the manager for his best ideas.

Following a period of low interest rates and lackluster equity-market returns, investors are looking for alternatives, such as currency markets, the Goldman Sachs executive says.


Scott Arnott, vice president, Goldman Sachs Asset Management

Active currency management can be implemented with the same disciplined and rigorous processes used by portfolio managers in more traditional asset classes, including portfolio diversification and fundamental or quantitative approaches, he says.

Glenn Stevens, managing director of GAIN Capital, a provider of foreign exchange services, including online trading and asset management, says the trend toward active currency management began with hedge funds and has been adopted by a growing number of portfolio managers, who realize they can add 300-400 basis points to annual returns by actively managing their currency exposures.

Major corporations are now joining this move toward active management of currency positions, and a cottage industry has sprung up to serve their needs, he says.

GAIN Capital, based in Warren, New Jersey, is a leading non-bank foreign exchange dealer and market maker, with an average transaction volume of more than $60 billion a month. While many of GAIN Capitals clients use its online currency trading facilities to speculate

in the foreign exchange market, a growing proportion of users are hedgers who have existing exposure, such as fixed-income portfolios in another country, Stevens says.

As investors diversify their portfolios internationally, the need for active currency management will continue to grow, he says.

When a corporate CFO or treasurer has a strong view on the likely direction of a currency, it makes sense to take action on this conviction, Stevens says.

Dollar at Crossroads

The dollar is at a crossroads and the pieces are in place to support a major rally,
following more than two years of a downward trend, according to Stevens, who was managing director and head of North American currency sales and trading at NatWest Bank in New York prior to joining GAIN Capitalin 2000.

The dollar rallied sharply in early January, forcing many of those who were expecting the dollar to fall further to cover short positions in the greenback. This was followed by a period of relative stability in the dollar later in January and early last month.

The stabilization is over and the dollar is likely to rally as US interest rates continue to rise, while the European Central Bank is either unable or doesnt want to raise rates, and neither does Japan, Stevens says.

Meanwhile, the US economy is likely to continue to grow at a faster rate than the economies of Europe or Japan, which will give the dollar a further advantage, he says.

There continues to be a tremendous appetite by international investors to buy US debt, and this appetite is likely to increase as interest rates rise, Stevens says. So the US current account deficit is not an issue, at least for the next few years, because it is going to be funded, he says.

Greenspan Hopeful

Federal Reserve chairman Alan Greenspan, in London for the Group of 7 meeting last month, said market forces and budgetary discipline in the US should allow global economic imbalances to be reduced over time.

Market forces appear poised to stabilize and, over the longer run, possibly to decrease the US current account deficit and its attendant financing requirements, he said.

According to Greenspan, European companies may decide to protect their profit margins, rather than seeking to cut prices to preserve market share if the dollar weakens further. He also suggested that US exports may begin to rise as a result of the dollars depreciation since 2002.

In contrast to Greenspans upbeat remarks, former US treasury secretary Robert Rubin, who is now a senior Citigroup executive, says he fears the US fiscal and current account deficits may have a tendency to get worse rather than better.

The US imbalances could have serious bond market effects and also raise very complex questions about our currency, Rubin told a conference on enterprise and productivity hosted by UK chancellor of the exchequer Gordon Brown on the sidelines of the February Group of 7 meeting.

The conventional view is that there is probably a fairly good chance that the dollar could decline over some period of time, Rubin said.

Underbelly Exposed

David Gilmore, economist and partner at Essex, Connecticut-based Foreign Exchange Analytics, says that the track record of US presidents in cutting budget deficits is not encouraging.

By making credible deficit reduction the metric for valuing the dollar, the Group of 7 has exposed the underbelly of the currency and invited new selling, Gilmore says.

Even if the Bush administration has made a complete turnaround on fiscal policy and really does want to impose politically painful spending cuts, Congress may not go along, he says.

This is one dollar metric you would not want to wish on your worst enemy, Gilmore says. It could bring the dollar to its knees much faster than even the Congressional Budget Office has imagined.

The non-partisan CBO, a government think tank, has concluded that the dollar will weaken in the next two years, as foreign investors shun US assets.

Progress on trimming the budget deficit has historically relied on raising taxes, Gilmore says. While I am not eager to send my earnings to the Treasury, higher tax rates and cuts in entitlements are the hard reality of balancing the budget, he says. I just dont think that Washington and the public, for that matter, are ready to face hard choices.

An expected inflow of repatriated profits under a tax provision in the Homeland Investment Act could help to make a dent in the US current account deficit.

Whether or not such inflows actually occur will depend on how the government rules on the mechanics of the new tax law, according to analysts at Brown Brothers Harriman in New York.

We would not get carried away with this factor as a dollar positive, however, because the possibility is still hypothetical, they say.

China Pressured

Meanwhile, G-7 officials are keeping the pressure on China to allow its currency to strengthen to help narrow the US current account deficit.

Despite mounting pressure from Europe and the US to revalue the yuan, China isnt likely to succumb to these demands and compromise its economic engine for the sake of prematurely liberalizing its financial markets, says Ashraf Laidi, chief currency analyst at MG Financial Group, an online currency trading firm based in New York.

The Bank of Japan could begin to lighten its holdings of US treasury securities in anticipation of an eventual move by China to revalue its currency, most likely in the first half of 2006, Laidi says.

Japan leads the world in holdings of US treasury debt, with about $715 billion.

A gradual Japanese retreat from US-dollar securities into non-dollar assets is inevitable in order to avoid massive losses on the central banks dollar portfolios, Laidi says.

Several central banks already have started shifting their reserves into euros and away from dollars, and Japan has no choice but to follow suit, Laidi says.

The ongoing lack of intervention by the Bank of Japan in the foreign exchange market, combined with improving prospects of a Chinese yuan revaluation, have created a bullish opportunity for the yen, he says.

According to Laidi, market participants expect Japans inflation to regain positive territory in 2005, following seven years of deflation.

New Ruble Baske


The Russian central bank, meanwhile, unveiled a new ruble basket last month comprised of 90 US cents and 10 euro cents.

The proportion of euros was lower than the central bank had led the market to believe it was considering, according to analysts at HSBC Bank USA in New York.

The central bank is giving itself the leeway, however, to increase the euro share as it sees fit, the analysts say.

The Bank of Russia was forced by market appreciation pressures last year to abandon the nominal peg of the ruble to the dollar and to allow it to rise. The bank says it will continue to intervene as needed, however, to smooth market fluctuations in the ruble.

While the new basket applies to the nominal exchange rate of the currency, the central bank also targets a real effective exchange rate of the ruble against a broader trade-weighted basket of currencies.

Russia enjoys a current account surplus as a result of high oil prices. Its gold and foreign exchange reserves rose to a record $128 billion at the end of January and were the sixth-largest in the world.

In announcing the dual-currency basket, the Bank of Russia said it was taking into account the increasing role of the European Union in the system of foreign economic relations of Russia, and the growth in the role of the euro as the second world currency. The change will bring currency policy closer in line with trade flows.

Currency Forecasts


Gordon Platt