Download Taming your dollar exposure: What Canadian

Taming your dollar exposure:
What Canadian companies can do to combat the rising dollar
Eric Lamarre
Martin Pergler
© January 2008
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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
2002.
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
10
30
50
70
30
-17
-2
+12
+26
50
-33
-18
-4
+10
70
-49
-34
-20
-6
90
-65
-50
-36
-22
* 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.
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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
100
90
Canada
U.S.
30
30
Labour (Canada)
40
30
Suppliers paid in Canadian dollars
Net U.S. $
exposure
(nominal)
30
Suppliers paid in U.S. dollars
70
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
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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.
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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 2007. 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.
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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
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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 2002. 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.