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Learning the art of juggling foreign exchange woes while on tight rope
An employee works beside stacks of $100 notes.
What you need to know:
- Foreign exchange risk arises mainly due to currency differences in a company's assets or liabilities and cash flow differences.
- The latest Central Bank of Kenya data shows that Kenya’s import cover has declined to the lowest level in seven years.
Former governor of the Reserve Bank of India Raghuram Rajan said “monetary policy is like juggling six balls…it is not interest rate up, interest rate down. There is the exchange rate, there are long-term yields, there are short-term yields, and there is credit growth.”
Where the exchange rate is concerned, foreign exchange risk is a key factor to consider. Foreign exchange risk is the losses an international financial transaction may incur due to currency fluctuations. Former chairman of the Federal Reserve of the United States Paul Volcker once said “a nation’s exchange rate is the single most important price in its economy’ it will influence the entire range of individual prices, imports, and exports and even the level of economic activity.”
In recent years, Kenya like many other countries across the world, which import goods in larger quantities as compared to exports, has suffered further balance of payment disparities due to exchange losses. Here, imports of goods and services as a percentage of GDP is 20.16 percent. Exports of goods and services as percentage of GDP is 11.26 percent.
According to CEIC data, Kenya’s total Imports grew 42.4 percent year on year in June 2022. What about our currency? As per spot exchange rate history, In February 2020, Sh100 would get 1 US Dollar. In January 2022, 1 US Dollar was equivalent to Sh112.9 and at the beginning of October, Sh120.90 is the rate for 1 US Dollar.
Due to lower exports and high quantities of imports, the latest Central Bank of Kenya data shows that Kenya’s import cover has declined to the lowest level in seven years. The high oil prices and hard currency demand from the energy and manufacturing sectors as well as the reduction in exports and inflation have all contributed to the weakening of the currency against the US Dollar.
Every country with foreign debt has exchange rate risk which must be carefully managed. Likewise, every company that has exposure to foreign exchange risk must prudently manage and control its exposure together with the management of other risks. Foreign exchange risk employs the exposure of a company to the potential impact of movements in foreign exchange rates. The risk that is caused by adverse fluctuations in exchange rates may result in a loss to the company or country.
Foreign exchange risk arises mainly due to currency differences in a company's assets or liabilities and cash flow differences. Such risks continue till the foreign exchange position is settled. This risk arises because of foreign currency cash transactions, foreign exchange trading, and investments denomination in foreign currencies and investments in foreign companies. The quantum of risk is derived by multiplying the magnitude of exchange rate changes with the size and duration of the foreign currency exposure.
Assets and liabilities
Michael Adler and Bernard Dumas defined” exposure and sensitivity of changes in the real domestic currency value of assets, liabilities or operating incomes due to unanticipated changes in the exchange rate”. Thus it measures the extent to which the value of something in terms of domestic currency is changed due to the unanticipated change in the exchange rate.
It takes into account inflation-adjusted value. The value of foreign currencies denominated assets or liabilities change their values because of fluctuations in foreign currencies. These changes are primarily unanticipated and it may be because of variations and short-term adjusted interest rates, inflation, tax equity market, return expectations and so forth. The Power Parity (PPP) theory explains that the movement in the exchange rate is matched by the movement in price.
Therefore suggesting that any talk about exchange rate exposure is irrelevant. Suppose a country is facing a high rate of inflation, it will lead to the depreciation of the currency in terms of other currencies. This will lead to a high import bill on account of the depreciation of the currency. The picture of high inflation is exactly matched by the high import bill.
That would lead to a constant competitive position between the importing firm and the domestic firm even after the movement in the exchange rate. Therefore this argument goes against the relevance of foreign exchange exposure. For the relevance of exposure, this argument is based on the output of some good empirical research on the applicability of Purchasing Power Parity (PPP) in both the short run and long run. However, theories do not always provide a simple fail-proof solution to complex situations.
Transaction exposure occurs when a company trades, borrows or lends in a foreign currency or sells fixed assets off at subsidiaries in a foreign country, all these occasions involve a time delay between the commitment of the transaction that the sale of an asset for example, and the receipt or delivery of the payment. During this time interval, exchange rates will most probably change if the company is exposed to a risk that could be positive or negative.
Imagine the case of a local importer and a foreign supplier. If the importer pays in the currency of the supplier then it is the importer who carries the risk or who has to buy dollars in order to pay the supplier. Alternatively, if the importer pays in their own currency then the exporter is the one who carries the risk or they must change local currency to dollars.
Home currency
Translation exposure arises from converting financial statements expressed in foreign currencies into the home currency. When a company is consolidating the results of all its foreign subsidiaries it has to present a final report to the shareholders and the numbers in this document should be expressed in one currency. All foreign currency-denominated assets and liabilities as well as revenues and costs have to be translated in one base currency.
Assets, liabilities and equity on the balance sheet are expressed in historical values in the exchange rate in which the currencies trade at the end of the accounting period. Economic exposure measures the change in the present value of the firm resulting from any change in the future cash flows of the firm caused by an unexpected change in the exchange rates. Future cash flows can be divided into cash flows resulting from contractual commitments and cash flows from anticipated future transactions. In a way, economic exposure includes transaction exposure.
Developing nations have large quantities of foreign debt. Sri Lanka, which was declared bankrupt by Prime Minister Ranil Wickremesinghe in June 2022 has huge foreign borrowings and the nation's currency value deteriorated swiftly against the USD.
In January 2020, 181 Sri Lankan Rupees could get one US Dollar. Currently, 1 US Dollar is equivalent to 369 Sri Lankan Rupees. Since the beginning of 2020 Sri Lanka’s demand for foreign currency has increased while its ability to earn foreign currency through exports, loans and other capital inflows has declined.
Many countries have faced crises due to the management of finances and the exchange rate risk makes matters more worrisome. In a world so intertwined with exchange rate pitfalls, one needs to learn how to walk the tightrope while juggling.
Ritesh Barot is a business and financial analyst. [email protected]
