The Hindu Business Line : What drives corporate hedging policy?

The analysis in the above article indicates that steady growth in business volumes and a policy of systematically hedging operating foreign exchange exposures have lowered earnings volatility for the IT sector. The stock market seems to have recognised that and has consistently provided robust valuations for the sector.

The lesson, therefore, for companies with an export bias is to have a proper hedging policy in place and, more importantly, implement the policy.

For instance, if the policy mandates compulsory hedging of revenue flows if the market provides hedging levels (prices) which cover the internally budgeted cost levels, the hedging action should follow almost automatically. Discretion should be allowed only in respect of the instruments utilised for hedging — for instance, forward contracts or options — but not on the price level to be hedged.

Hedging imperatives

Hedging is imperative for companies which have revenue flows with a single-currency bias or that are denominated in a single currency.

In that case, the flexibility and cushion provided by a currency-diversified revenue stream is not available. Official statistics show that Indian exports are still predominantly invoiced in the US dollar. Therefore, Indian companies, by and large, do not enjoy the benefits of the foreign exchange market equivalent of portfolio diversification.

Of course, an alternative in such a situation is to move the cost base itself to the currency in which companies’ exports are predominantly invoiced.

This could involve a shift to imported raw materials from locally procured raw materials and/or financing — both for working capital and capital expenditure — in the currency which causes exposure on the income side. Official balance of payments statistics show that Indian companies are trying out these strategies.

Non-oil and non-consumption imports have registered strong growth over the past few years. (The recent permission for also hedging the price risk on the commodities planned to be imported is another important step towards reducing the overall level of risk on companies’ operating cash flows, as this would serve to fix the dollar or foreign currency price of the commodity being imported). Indian companies have also taken to foreign currency borrowings for their working capital/capital expenditure in a big way.

CRITICAL SCENARIOS

Systematic hedging also becomes critical in scenarios where currencies are subject to secular trends.

The earnings stream of a company with international exposures could remain broadly anchored to its medium-term growth rate if what is lost in one year is made up in another year on account of volatility in exchange rates.

The stock market also may not worry much about companies with currency exposures — even if the exposures are not hedged — in such a scenario.

But where currency volatility becomes minimal or negligible, a company has to methodically hedge its operating exposures.

It will otherwise face considerable erosion of its local currency earnings base or could face pressure on the expenditure side. There is an inverse relationship between the level of currency volatility and the stability/growth of the earnings stream.

The rupee, for instance, appears to be in the midst of a secular and structural run against the dollar. It has risen 4-5 per cent per annum, on average, against the dollar in the past five years, interrupted only by brief reversals.

In other words, volatility in the bilateral dollar-rupee currency pair has been low, though that in the derived currency pairs — such as, say, in the Euro-rupee or British Pound-rupee — has been notable because of the variability in the Euro-dollar or Pound-dollar pairs.

From a capital market perspective, the corporate policy on earnings distribution or the dividend policy, for instance, could have an important bearing on companies’ decision to hedge and the formulation of a hedging policy.

High dividend pay-outs could be considered the managements’ way of assuring its shareholders (and prospective investors) about the inherent strengths and, more important, the growth potential of the earnings stream and operating cash flows.

It then becomes incumbent on the finance manager to minimise volatility in the earnings stream and in the cash-flows generated so that the dividend payouts are serviced smoothly.

The need to preserve the stability and inherent growth potential of the earnings stream could also be strong for those companies that have to, say, carry on R&D operations uninterrupted.

The pharma sector, for instance, could fall in this category. Pharma R&D is a long-drawn-out affair, involving the commitment of considerable amounts of money and time before a product or formula can be commercialised.

Usually, the R&D effort consumes so much resources that local sales alone may not be enough. Wider markets (exports) and the revenues they bring are also necessary to justify the resources consumed in the R&D phase.

There is a mutually reinforcing relationship here. High expenditure during the R&D stage demands very wide markets but the revenue flows from those markets have to be protected/hedged so that the earnings stream/cash-flow remains strong enough to support continued R&D.

A Ranbaxy or a Dr Reddy’s, for instance, would need a comprehensive hedging policy to be in place, given their R&D efforts and the diverse markets in which they sell.

More Stories on : Corporate | Exports & Imports | Forex

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page