Coronavirus and currency risk: What to do?

Updated: Apr 19

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Coronavirus will change the way we do things for years to come.


The current environment is a source of volatility


Trade war between the United States and other major economies, collapse of oil prices following the disagreement between Russia and Saudi Arabia; in Canada, there was also a railway blockade, and now we add a powerful exogenous shock such as the Coronavirus. Even with less, the markets would have been in difficulty.


Over a few days, a complete reversal of economic and monetary policies was observed. Central banks are back in emergency mode, while governments must find money to support sectors in difficulty.


They need to bring in all the cash they need to prevent the failure of healthy businesses. Widespread rate cut and addition to the money supply. In addition, the U.S. Federal Reserve makes agreements with several other central banks around the world to ensure the availability of the U.S. dollar to avoid too strong an appreciation of the reserve currency, the U.S. dollar.


Coronavirus


Hygiene is on all the radars. This pandemic is unprecedented in terms of the type of uncertainty it generates, and the social and economic impact associated with it. The closest example of a similar outbreak is the SARS (Severe Acute Respiratory Syndrome) epidemic in 2003, when a rush to reduce risk by investors led to significant market declines.


However, the magnitude of the outbreak is much greater both in terms of its geographic distribution and the way it is spreading. The fact is that no one really knows the extent of the problem. The market hates uncertainty.


In short, the government still does not know how far the coronavirus has spread across America (and the world) and it will take time to contain it. Large-scale testing, quarantines and "social distancing" appear to have significantly reduced the increase in new cases based on the experience in Hong Kong and South Korea.


A large part of the economy, - workplaces, schools, sports leagues, cultural venues, restaurants, gyms, stores, etc. - is likely to remain closed or operate on a very limited basis. A social safety net, even if only temporary, will allow people and businesses to pay their bills and support consumption. “Social distancing'' will have to be maintained for a while. The next few months are certain to look like a recession.


‘‘The Legacy’’


Each of the economic shocks we have experienced has left a "legacy". This time, it is an unprecedented public health crisis that is shaking the global economy.


What can we think of our « legacy »?


Changes in the organization of health care will come quickly as more and more basic exams will be done online to avoid the risk of contamination in overcrowded waiting rooms.


Chances are that governments will increase spending on health care in order to avoid the catastrophic cost of such a crisis in the future; rich countries will have to help less-wealthy countries. Government deficits will increase.


Consumers will be encouraged to shop online instead of exposing themselves in malls; tele-working will become more prevalent among white-collar workers.


Programs will require, for example, the introduction of new mandatory cleaning standards within companies; tighter border controls and increased insurance coverage requirements; and changes to travel arrangements for both people and goods.


It is almost certain that global manufacturing supply chains will be challenged and, de facto, business development strategies as well. This crisis once again highlights the risk of having a single source for its components or a single source to have its products manufactured. China, not to name it.


In fact, the "trade off" between focusing on short-term efficiency (short-term value creation) versus long-term economic resilience of the company as a driver of value creation will have to be rethought. The "just-in-time" approach to manufacturing is very vulnerable to supply chain shocks and puts the sustainability of the company at risk; a new "black swan" is being discovered.


These changes will have a lasting impact on production and distribution processes. It is conceivable that the desire to simplify the supply chain (search for parts and components made in Canada, or at least in America) will eventually stimulate the Canadian economy even more; but as with the development of new business, it takes time and resources.


In fact, this list is far from being exhaustive and the impact of these changes to the microeconomics of trade will persist long after the coronavirus. We must hope that once the outbreak has been contained, which is not for tomorrow, we will be able to see market values rebuild themselves again.


What about currencies in all this?


In the meantime, the U.S. dollar is appreciating against all other currencies. It is useful to remember that large movements in the reserve currency can send strong ripples through the global economy, especially for countries and companies whose debt is primarily in U.S. dollars.

Moreover, in terms of dollar, the recent strength of the US currency implies a decline in the global money supply, a phenomenon that strongly counters the need for an even more accommodating global monetary policy. This is what central banks have been aiming for by intervening so strongly for some time now, they want maximum liquidity in the market and therefore an expansion of the money supply.


A strong U.S. dollar brings us back to a weaker Canadian dollar by 10 / 15 cents, rapidly increasing from 1.30 to 1.45 CAD for 1 USD. It is more than likely that the stability of exchange rates will be greatly tested in the coming months. An increase in the amplitude and frequency of currency movements is expected..


This depreciation of the loonie is an undeniable price advantage for the exporter except that he finds a buyer on the other side of the border and that he has a sufficient inventory.


However, if the goods you manufacture contain components that are imported (and are available to you), then the advantage of a weak loonie is eroded by the fact that your production costs have increased proportionately.


In addition, if you are new to this market, it takes time to set up some logistics and investment to acquire new customers and establish customer relationships The currency advantage may have disappeared before products incorporating the currency advantage have reached the market.


A weak loonie helps Canada's manufacturing sector. However, the reality is not so linear and has a variety of combined positive and negative effects. They need to be broken down to take advantage of them.


It is difficult to manage the risk posed by exchange rate fluctuations on an ad hoc basis (reactive following an event), hence the importance of having a clear policy that removes emotion from the decision-making process..


The rapid decline in the Canadian dollar has created conditions that can be beneficial to Canadian manufacturers; however, the environment is not without risks and identifying and mitigating them is the best response for the sustainability of your business.


In this context, it becomes essential for the company to approach the financial markets in a prepared way instead of being reactive. This is exactly the objective of a risk management policy. Foreign exchange risk management is repositioned at the heart of the operating cycle, where the risk enters, is transformed and exits the company.


When the risk enters, we manage a margin, a flow; when it exits, we manage the competitiveness, the customer relationship. The complexity of currency risk management cannot be taken lightly. It is never explicit in the financial statements; it is only guessed at. Moreover, the speed at which it makes its impact felt and its unpredictability add to this complexity.


This organized and structured way of managing exposure is designed to provide protection against adverse currency market movements while maintaining the flexibility required for optimal use of the company's operating cycle. Reduce vulnerability to short-term trends and smooth the impact of foreign exchange over the long term.


Undertaking serious risk management efforts takes a few weeks and involves both internal and external resources, but these efforts quickly pay for themselves.


What to do now?


In the meantime, here are a few suggestions to help you get through the current turmoil:


- Clearly identify all major costs and revenues for the next twelve months in order to understand the impact of positive and negative exchange rate fluctuations.

- Timing between costs and revenues

- Differences between costs and revenues

- Determine the impact of a given currency fluctuation on your margins

- Establish the most effective positioning for the company

- Reassess your residual risk (risk that is not covered by specific hedging already in place)

- Determine which of your products or product families are the most at risk (the most profitable)

- Determine profit or loss thresholds in advance and respect them

- Is it possible to cover its thresholds via the forwards market, if so, do it

- Revalidate your hedging ratio


- Contact new suppliers who may offer better pricing options due to their positioning with respect to currency fluctuations.


- Explore the possibility of passing on (in whole or in part) exchange rate fluctuations to customers and/or suppliers, without harming, if possible, key relationships.


- Synchronize the company's foreign exchange position with its operating cycle and the currency market.

- Connect exchange rate fluctuations to operational efficiency and budgeting so you can quickly and accurately reflect your company's true revenues and expenses - at the end of each month, it’s already too late.


- Take a step back and ask yourself questions such as:

- How do we decide to cover ourselves? (or not)

- Do we take advantage of all internal hedging measures?

- Is the cost of our hedges aligned with our potential losses?

- What is the size of our residual (unmanaged) risk?

- Have our recent actions brought the expected results?

- How do we know if we are over or under hedged?

-Is our hedging ratio adequate?

- How far from breakeven are we?


In the end, the company needs to know how much money it will have in its bank account in the coming days, weeks and months under a risk with a very pronounced velocity and impact. Properly integrating the answer to this question into a risk management policy is the basis for determining your hedging ratio and the maturity structure to be used. The risk management policy, even in a context of great uncertainty, refocuses the decision-making process on the company's margins by providing clear guidelines on how to protect against them.


And after the recession, recovery will come

Like any other recession, the important thing will be to get through it. The most optimistic are talking about a recovery in June. Rather, I believe we will see the beginning of a return to normal towards the end of the summer and a recovery by Christmas. Finally, every crisis is also an opportunity. It is a time for concerted global action; interdependence at its best. Tomorrow, however, it will be necessary to review how countries and companies can find a new balance between globalization and protectionism, between interdependence and autonomy.


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