The COVID-19 pandemic has prompted high levels of volatility on the world’s foreign exchange markets – manufacturers must manage this risk with great care, writes Nathan Hutchings.
COVID’s currency crunch UK manufacturers continue to face significant supply chain challenges in the face of the global Coronavirus pandemic – and the logistical problems caused by the crisis are not their only headache. In addition, manufacturers sourcing everything from raw materials to advanced components from overseas suppliers are having to deal with significant foreign exchange (forex) volatility.
The uncertainties of the pandemic have plunged currency markets into turmoil, with investors selling currencies in countries and regions they perceive to be suffering most seriously at the hands of the virus, often in favour of safe-haven assets such as the US dollar.
The result is huge cost uncertainty for manufacturers with international supply chains. his year the pound has moved in a 12% range against the euro and a 16% range against the dollar.
Managing this risk must now be a key priority for manufacturers and their finance teams. Unexpected currency volatility threatens their margins, potentially undermining their sustainability and comes with adverse impacts on cash flow, liquidity and financing costs. Identifying the right strategy to counter forex risk is therefore crucial, both for dayto-day operations and longer-term growth.
In practice, there are different ways to manage currency risk, each with its own advantages and disadvantages.
For example, some overseas suppliers offer sterling invoicing on their transactions with UK manufacturers. This may be attractive in that it appears to take forex volatility out of the equation.
In practice, however, the detail of such arrangements requires close scrutiny. For example, does a sterling invoice come at the cost of uncompetitive pricing to encompass the forex risk that the supplier is taking on?
What happens when underlying prices change as the market moves – and how quickly are such changes, whether in the manufacturer’s favour or to its detriment, passed on when the initial agreement lapses?
Given such complexities, many manufacturers may prefer to manage their currency exposures directly, with suppliers invoicing in the local currency and finance departments then taking responsibility for managing the forex risk.
This comes with its own challenges, but finance teams may be able to hedge against this risk at a lower cost than a sterling quote from the supplier would generate. There may also be opportunities to offset individual forex risks against exposures to other suppliers, as well as customers, elsewhere in the business.
One important question for finance teams will be to assess over what periods they should seek to manage currency risk – and then how to address the transition from one period to the next.
Events such as the expiry of a sterling invoicing facility or the maturity of a financial instrument can leave businesses vulnerable to significant volatility, creating a pinch point, particularly where such arrangements are enduring.
It’s therefore important to put arrangements in place to make sure such trigger points won’t become crises. In practice, this requires finance teams to run overlapping strategies that smooth out volatility rather than resetting forex risk management periodically.
Given the current elevated level of uncertainty, it’s also important to consider whether the tools finance currently has in its armoury are sufficient.
Pre-Coronavirus pandemic currency risk management strategies may no longer be sufficient for the job. Manufacturers that didn’t previously feel the need to use financial instruments, for example, may now benefit from a fresh approach.
Nor should manufacturers overlook the potential for the unusual market environment to create problems that would previously have seemed unlikely. For example, high levels of volatility may trigger financial institutions’ right to ask for additional margin payments when manufacturers are holding certain instruments; these reflect the changing risk dynamic.
Manufacturers may decide that potential counterparties – both financial institutions and suppliers – are no longer an acceptable credit risk.
Given all of these considerations, it’s vital that manufacturers review their treasury policies, assessing whether current risk management policies are fit for purpose in this fast-moving environment – and whether they’re too exposed to ongoing currency market volatility.
Many finance teams will want to take specialist advice on these issues, optimising their financial risk management practices and the facilities they have available in order to ride out the crisis.