Taming your dollar exposure: What Canadian companies can do to combat the rising dollar. Eric Lamarre Martin Pergler

Transcription

1 Taming your dollar exposure: What Canadian companies can do to combat the rising dollar Eric Lamarre Martin Pergler January 2008

2 1 The U.S./Canadian dollar exchange rate went on a roller coaster ride in 2007, with the Canadian dollar first increasing by nearly 30% from its US $0.84 low in February, and then retreating by nearly 10% from its early November peak at US $1.10. This degree of change within 1 year is unprecedented in the past half century. Even more significantly, it comes against a backdrop of roughly 8% average annual increases for the Canadian dollar over the past 5 years an appreciation of approximately 50% in total versus the US dollar since The impact of this value shift on Canadian companies has been dramatic. For an unprotected Canadian manufacturer whose business model depends on US exports, this trend easily translates into profit erosion of more than 30% each year (see Exhibit 1). Only a sustained combination of truly heroic strategic and operational improvement efforts can compensate for an effect of this magnitude over the span of several years. At the very least, management ability to take a long-term view of the business is severely impacted. What is more, investors quite rationally begin viewing such companies as a bet on the future evolution of the dollar rather than on the operational and strategic prowess of each company itself. Exhibit 1: PROFIT EROSION FROM CURRENCY MISMATCH Change in profit due to an 8% strengthening of the Canadian dollar versus US dollar Percent Share of revenues in USD Percent Share of costs in USD* Percent * Assumes a profit margin of 10% What can Canadian companies do to combat this situation? The drivers of changes in exchange rates are complex and impossible to predict well enough to get rid of the issue altogether (see Appendix for a high-level discussion). However, by better understanding their currency exposures and by exploiting proven risk management strategies, Canadian companies could manage their currency risk much more effectively, allowing the focus to return to their strategic and operational prowess. Nominal versus economic currency exposures In our experience, most companies, in Canada and elsewhere, do not have an accurate understanding of their true exposure to currencies. The challenge resides in differentiating between nominal exposure and economic exposure. These are two fundamentally different views which lead to quite different insights.

3 2 Nominal exposure is the simple difference of revenues and expenses by currency denomination. Exhibit 2 demonstrates this for a hypothetical Canadian company with $100 million in revenues, $70 million in U.S. dollars. The same company has only $30 million of costs denominated in U.S. dollars. The nominal exposure to the Canadian/US exchange rate is simply $40 million, or $70 million $30 million (all calculations done at U.S./Canadian dollar parity for simplicity). Exhibit 2: CALCULATING NOMINAL EXPOSURES Millions of dollars Canada Labour (Canada) U.S Net U.S. $ exposure (nominal) Suppliers paid in Canadian dollars Suppliers paid in U.S. dollars Revenues Costs This simple calculation is how most companies derive their currency exposure when they consider hedging. Unfortunately, however, the thinking behind the method is often flawed and can leave a company exposed to substantial financial surprises. To understand why, consider instead a firm s true economic exposure that is the exposure that will truly reflect by how much a company s financial situation will improve or deteriorate with currency movements. To make this calculation, one must pay close attention to the micro-economic responses of suppliers, competitors and customers. 1. Suppliers response. Canadian companies often request that their supplier contract be denominated in US dollars, thus offsetting their US dollar revenues. But if the cost base of these suppliers is not in US$, they will inevitably be seeking contract price increases to offset their own negative currency movements. Many Canadian companies have recently had to accept price increases from their suppliers, increasing their cost base where they thought they were protected. 2. Competitors response. When competitors gain a cost advantage because of favorable currency movements, they often try to gain market share by offering a more attractive price for their product. This can take many forms but in the end, the impact on Canadian companies is either lost customers or reduced prices to meet the new level set by the competition. A well-publicized recent example has involved U.S. car dealerships increasingly selling cars direct to Canadians, in response to the increasing

4 3 disparity between U.S. and Canadian prices created by the exchange rate shift. In response, Canadian dealers needed to increase incentives to maintain volume, and several manufacturers have ultimately decreased their Canadian pricing. While this example reflects pricing differentials for the same car on either side of the border, the result is precisely what is also happening to Canadian-based manufacturers who compete with US-based players with different cost structures. Because this type of effect can affect both volume and margin, its impact is always far greater than the figure suggested by an assessment of nominal exposures. 3. Customers responses. Even if currency movements don t change relative competitiveness based on cost, they can impact customer demand or the demand of your customers customers. A good example is the overall reduction in the number of US tourists in Canada, which impacts companies that depend on this industry such as hotels and transportation. If your company sells hotel furniture in Canada, you implicitly have a US dollar exposure even if all your sales are in Canada. That s right: a company can have a substantial US dollar exposure even if all its sales and all its costs are in Canadian dollars! True economic exposures are only felt when everyone in the value chain has adjusted their behavior to optimize their own economics under the new exchange rate regime. The three responses described above combine to create a more complex, and often worse, long-term exposure than a nominal calculation typically suggests. This is what is affecting many Canadian companies today, especially those who thought they were protected or hedged. A firm s true economic exposures can be determined by systematic analysis of how currency movements influence the key players in the relevant industry. This requires a full value chain approach, looking at the impact on suppliers, competitors and customers and understanding the feedback loops at play. That in turn means harnessing expertise throughout the business, from purchasing and finance to sales, marketing and operations to develop a holistic picture of how profit will really be impacted by currency movements. The six classic risk mitigation strategies Once a company understands its true economic exposure, it can choose among several potential options for mitigating the risks its faces. 1. Pass the currency risk on to customers This is the simplest and most obvious approach and it should always be the first option considered. This works particularly well in situations where competitors are similarly impacted by currency movements. Obviously, however, this strategy has its limitations, as specific market dynamics often preclude full or even partial application.

5 4 2. Hedge the currency exposure Financial hedging is one of the most common risk mitigation strategies because it is relatively easy to implement and typically low cost. This is probably why the majority of companies make use of financial derivatives to hedge some or all of their currency exposure. Financial hedging can help to combat transient or short-term volatility, but it is less effective against long-term currency drifts. Most companies hedge their currency exposure inside a 1-3 year window. Very few hedge beyond this timeframe because they fear that they will be locked into an uncompetitive cost position if the currency moves in their favor (i.e., against the hedge). It is important to remember that if a company inaccurately assesses its economic exposure, it risks dramatically under- or over-hedging. Many companies have seen their hedging strategies fail because they neglected to account for hidden economic exposures and were lulled into a false sense of security, believing they were fully covered. 3. Realign cost and revenue currency exposures More and more companies are exploring approaches that involve changing their business itself in order to align currency exposure on the cost side with that on the revenue side. For Canadian exporters, this can mean investing in growing domestic sales of their products, replacing the least attractive US sales with the currently next-best Canadian ones. On the cost side, the realignment may involve deliberately shifting to a greater use of USbased suppliers or performing more of the final assembly in the United States so that the level of cost exposure is better matched with the revenue exposure. Finally, this realignment approach can also entail changing corporate financing to so that the currency exposure of debt (and therefore interest costs and principal repayments) is more closely aligned with revenues. 4. Diversify supply and revenues Increasingly, companies are using the value erosion of the US dollar as a forcing mechanism to break out of the Canada-to-US exporter business model altogether. This can be as simple as just pursuing international supply and sales opportunities at an accelerated pace joining the globalization party with a bit of extra enthusiasm. Doing so offers natural currency diversification and, hence, limits exposure to the US dollar in particular. It can also build additional flexibility to respond to currency and other risks globally as they arise, whatever they may be. For example, the average annual CAD-Euro exchange rate has stayed within an approximately 10% band between 2002 and If our illustrative Canadian company in the introduction had diversified its sales to be one-third each in Euros, US, and Canadian dollars (true economic exposure), it would have experienced almost zero total reduction in its margin between 2002 and 2007.

6 5 5. Delocalize production to low-cost countries This approach entails moving production from North America to the developing world. The goal is to build a profit cushion that allows greater resilience to currency as well as strategic risks. Typically, this strategy is not pursued for the currency effect alone. However, currency pressure can well be the straw that breaks the camel s back, driving an earlier or more aggressive pursuit than a company might otherwise take. There is a sixth strategy that many Canadian companies have followed. It is not a classical risk mitigation strategy, but has played a key role. 6. Improve productivity Many Canadian companies are now focusing much more strongly on productivity and operational improvement than they were a few years ago. This is important for helping mitigate the currency effect and for improving Canada s long-term competitive position. However, it takes an ongoing program of very aggressive operational improvement to compensate for the level of currency-driven value erosion that has been occurring, as described in Exhibit 1. In our opinion, Canadian companies cannot rely on productivity improvement as a replacement for proper currency risk management. * * * The increased value of the Canadian dollar versus the US one a dramatic change in 2007, but against a background of a steadily creeping trend for the past 5 years has radically altered the competitiveness of many Canadian companies. While Canadian companies had enjoyed the benefits of a decreasing currency value in the 1980s and 1990s, the reversal of this trend in the past 5 years has driven home the extent to which dollar exposure can overshadow strategic choices and operational improvements. Some companies may decide to remain an implicit short bet on the Canadian dollar, but for the majority, 2007 was probably their wake-up call to undertake a more thoughtful approach to managing currency risk over the short and long-term. If they are to do this effectively, they will need to understand their real economic exposure and then judiciously optimize different risk mitigation strategies to determine their best path forward. Eric Lamarre is a Director and Martin Pergler a Senior Expert in McKinsey s Risk practice

7 6 Appendix: Drivers of the CAD/USD exchange rate Why has the CAD/USD exchange rate changed so much in the past 5 years, and what drives its short term volatility as well? Macroeconomists have a number of frameworks to explain exchange rate trends in general, but in practice conclusively explaining the reason for a specific shift is very difficult, and predicting the timing and magnitude of future changes is impossible. At any given point in time, analysts and the popular press may well highlight one specific cause, but it is really the interplay of several related factors that are relevant: 1. Short-term interest rates. Investors seek the best returns on their money, and so currencies with higher short-term interest rates tend to be stronger due to greater demand. This can be seen, for instance, in periods when U.S. and Canadian short-term interest rates (as set by the central banks) do not move fully in sync with each other. In general, differences in inflation are also a factor, but this has been less relevant for the U.S. versus Canadian dollar. 2. Differences in economic strength. The more robust the economy, the greater the demand for that economy s currency, elevating its value. In particular, this is the case when the current-account balance is affected, reflecting the mismatch between inflows and outflows in that currency. In addition, economic strength impacts central bank policy on short-term interest rates, since the central bank may need to cool an overheating (i.e., inflationary) economy or try to stimulate one to avoid recession. 3. Commodity prices. Canada s economy is not only export-based but also much more resource-driven than that of the U.S. Accordingly, the explosion in energy and basic materials prices in the past few years has increased Canada s economic health, supporting a stronger currency. 4. Flight to safety. Historically, the U.S. dollar has been the world s dominant currency, so in stressful times (e.g., economic downturn, or arguably in the aftermath of 9/11), the value of the U.S. dollar relative to other currencies tends to increase. There is some discussion that this may be less the case going forward, for example to the extent the current credit crisis remains a made-inthe-u.s. phenomenon rather than a worldwide recession, or if indeed a number of Middle East oil-producing countries were to follow through on their idea of reducing their exposure to the U.S. dollar. 5. Investor speculation or anchoring. Behavior on the money markets reflects not only players evaluation of the status quo, but speculation on future fundamentals. It may also reflect anchoring to perceived important thresholds for instance, dollar parity, or the 60 dollar in Opinions vary on the level of importance of speculation and anchoring. 6. Global financial web. Finally, it is worth noting that the CAD/USD exchange rate reflects not only the dynamics of these 2 currencies alone, but the dynamics of worldwide currency markets, including the Euro, Yen, and others. Given the strength of economic ties between the 2 countries, of course their economic interactions are pre-eminent, but there is some truth in the oftenrepeated statement that it is not the Canadian dollar which is (that) strong, but rather the U.S. dollar which is weak.