All The World’s A Stage For (Prudent) FX Risk Management

Risk has rewards in all parts of life, but especially in business, where shrewd risk-taking and planning accrues to the bottom line.

In an interview with Karl Schamotta, chief market strategist of Cambridge Global Payments, the executive weighed in on the risks and rewards of business done across borders, where growth far outpaces the rate seen in the United States. However, managing foreign exchange (FX) risk is part of the territory — and, as he told PYMNTS, a calculated approach to currency exposure is key.

Why has it become attractive, and even necessary, for firms in the United States to look beyond domestic markets, not just for revenue opportunities, but to build out supply chains — and, in the process, assume at least some exposure to FX risk?

For much of U.S. history, businesses were relatively sheltered from changes in the currency markets. Most agricultural and manufactured goods were bought and sold within the country’s boundaries — and when products were exported internationally, the dollar was the invoicing currency of choice.

After the Cold War ended, billions of workers and customers were thrust into the global economy, and vast new opportunities were created for companies, which broadened their scope. Improvements in logistics and communications enabled businesses of all sizes to expand supply chains across oceans, to partner with others around the world and to begin selling to customers in places once considered unreachable.

Yet, this growth comes with a downside. Companies that import or sell products internationally become vulnerable to fluctuations in the value of their cash flows — from the moment they make their first sale or purchasing agreement until the settlement date. Businesses that set up operations, raise debt or make investments in other jurisdictions can experience devastating valuation shocks as exchange rates change.

Perhaps most importantly, unexpected currency volatility can make it impossible to plan for the future.

If currency swings can be (and sometimes are) so extreme, what can firms do to navigate that volatility?

Can businesses predict currency movements well enough to protect themselves against these fluctuations? The short answer is: no. Many try, of course. Thousands of finance teams across the United States engage in annual forecasting exercises, using historical numbers, forward contract prices and consensus forecasts to establish budget rates. They get it wrong, though, year after year.

A number of factors tend to influence currency values over the long term, including fiscal and monetary policies, inflation and interest rates, and trade and investment flows. Ultimately, exchange rates are determined through a process that involves billions of decisions, made by millions of participants pursuing different objectives in real time — with limited information, using flawed processes and within an incredibly complex system that contains a small margin of safety.

This means rates can deviate from historical or fundamental levels for years, if not decades, at a time. Forward rates simply represent the prevailing spot rate, adjusted for differences in interest rates. Bank forecasts can be useful for understanding the consensus, but not in planning for the future.

Speaking of the future, what risks, broadly defined, may lie ahead?

Given the United Kingdom’s decision to exit the European Union, as well as the inauguration of President Donald Trump and the election of President Jair Bolsonaro in Brazil, it is clear that the populist and nationalist movements that emerged from the global financial crisis remain a powerful force in many countries.

The level of policy uncertainty has risen sharply, and has begun to exert a drag on consumer consumption and business investment levels around the world. This is unlikely to change in the near term.

A long-dormant backlash against globalization burst open in 2018, and many observers are concerned that a “trade war” could derail global growth. The frictional costs of moving goods across borders are likely to continue rising. Yet, with the Chinese economy facing a major exogenous shock, and financial markets telling Donald Trump that trade wars are neither “good” nor “easy to win,” it’s also sensible to consider the possibility that short-term compromises could emerge.

Counterintuitively, this could trigger big moves in the FX markets. Safe-haven units, like the Japanese yen and Swiss franc, might experience a sell-off in the event of a stalemate between China and the United States — and long-suffering, emerging market currencies could rebound sharply.

In China, with ongoing financial-tightening efforts and trade war uncertainties weighing on the outlook (and raising the odds on a stimulus effort), the fate of the country’s economy will unquestionably play a significant role in global markets this year. Growth fell to the lowest levels in almost three decades during the fourth quarter of 2018, with business investment, factory activity and consumer spending dropping sharply as sentiment turned overwhelmingly negative.

In most major economies, unemployment levels are historically low, inflationary pressures remain well-contained and consumer sentiment is firmly in expansionary territory. Recent projections from the Organization for Economic Cooperation and Development (OECD), World Bank, International Monetary Fund (IMF) and other major institutions have suggested that recession risks are minimal, and that global growth will slow only modestly in 2019 and 2020.

However, a shift in psychology could yet destabilize the outlook. Sentiment took a turn for the worse in the last months of 2018, with fears about trade wars, political uncertainty, monetary policy and Chinese growth combining to drive equity market indices down sharply. Should this continue, the world risks falling into a self-reinforcing “doom loop” — in which a confidence-level drop triggers a contraction in the credit cycle, causing an economic slowdown that impacts the currency markets.

Which opportunities can be embraced through prudent FX risk management, and how?

The financial infrastructure available in the United States is among the most advanced in the world. The average business has access to tools and tactics that are completely inaccessible in many foreign markets. Companies that leverage this to effectively manage risk can build a key competitive advantage by making international transactions simpler, safer and far more profitable over the long run.