Why do so many manufacturers wilfully ignore the behaviour of currency? Daniel Harden, senior commercial dealer at Global Reach Partners ponders the question.
With manufacturing now a global competition, times are tough. There is a downward-spiralling demand, as well as continually rising input prices. UK manufacturers are not only faced with this reduced demand but margins are becoming increasingly tight due to other countries being able to produce far more cost-effectively.
In a busy global marketplace one of the biggest and most unpredictable variables of a manufacturer’s bottom line is currency. But, it is astonishing to see how many manufacturers I come across who don’t see or more importantly realise how crucial currency movements can be. Sterling is by fact one of the most volatile currencies, making it so difficult to predict. In fact this is where many exporters go wrong.
Every day I speak to clients about their FX exposure and how they plan on protecting against adverse movements. Initially many think they know where the currency is going and will simply ‘hold off’ until they see that particular level. Fact: no one knows where the currency is going. If I knew where Sterling was heading, I would be writing this article from a tropical location rather than my desk in the City.
Once we have realised just how important currency is to our business, the next step is to adopt a strategy of how best to tackle this issue of currency volatility. Sure, times are good for manufacturers when you look at how steeply the GBP has depreciated against its trading pairs. Revenues denominated in foreign currencies are suddenly worth more in GBP terms. Don’t become complacent; as evidenced by history, the currency world is a rollercoaster. What goes up must come down and vice versa.
GBP is close to a 17 year low on a trade-weighted basis. We are at record lows against the Kiwi and Aussie. Against the Euro we are at 15-month lows and not far off all-time lows. Against the USD we are currently sitting 24% lower than the daunting high of only a few years ago. All manufacturers should now, if they are not already, be hedging against a turnaround. Most of the manufacturers I speak to on a daily basis work on tight margins, in many cases less than 5%. A 2.5% move in currency therefore has a 50% impact on profits for a manufacturer working on a 5% gross margin.
The first step to hedging is to adopt some form of treasury policy. Forecast what your requirements will be going forward and then implement a mechanism for protecting these requirements. One such example is by way of a Flexi-Forward Contract, whereby you fix a forward exchange rate for a future date from which you can drawdown as and when you receive income. A forward contract provides certainty and protection against an appreciation in Sterling. You can then budget appropriately and you have eliminated the risk of diminishing margins resulting from adverse currency fluctuations.
Another approach is to allow for participation in continued moves lower, whilst remaining hedged by way of currency options. A participating forward allows for 100% protection at a rate slightly worse than a forward rate, but will allow for 50% participation in favourable moves. Not only are you able to participate in favourable moves but should you require less cover than forecasted, you only have an obligation on half.
In this current world of monetary expansion, many would argue that things have been made easier for manufacturers. There are lower interest rates globally, and in some cases the much talked about Quantitative easing which stimulates the economy through the Central Bank. Lower interest rates mean firms are able to borrow more cheaply, thus financing capital for far less. While this may be true for many companies, the opposite can also be argued.
Costs of raw materials and commodities begin to rise as the inflationary effects of monetary and credit expansion work through the system. With inflation now above the annual 3% threshold here in the UK, soon the Bank of England will have to start raising rates again.
Global demand is down, and this is sadly a major factor that can’t really be controlled. Manufacturers should be looking at what components of their business can be influenced. Price stability by way of hedging currency exposure should be high on the agenda, especially given where Sterling currently trades.