How to hedge your exposure to the Eurozone by Economist Intelligence Unit

February 12, 2013 10:59 AM | Deleted user
Companies are sharpening their risk management skills to thrive in the European marketplace

The euro zone may be the biggest drag on global growth, but it’s also a critical market for many international companies. The Eurozone is the world’s second-largest economy, accounting for 17% of global GDP in 2012. Companies around the world have substantial exposure to the region through trade, finance and foreign direct investment.


Photo: lillisphotography

Although the risk of a break-up of the Eurozone has eased markedly since the European Central Bank announced a sovereign-bond buying program in mid-2012, demand in much of the euro area remains weak. The sovereign debt and financial sector crises of the past three years have squeezed credit markets and fuelled political instability.

With unemployment in double digits in the EU as a whole, and several European countries (Italy, Spain, Ireland, Portugal and Greece) in deep multi-year recessions, many companies in North America are rethinking their risk exposures.

Taking a longer view of the supply undefined and demand undefined chain

First and foremost, the euro crisis is leading companies to consider whether they should be shifting towards emerging markets and away from the more-established Western markets, particularly Europe, according to Bill Murphy, National Leader, Financial Risk and Regulatory Management at KPMG.

As importantly, the crisis has increased the emphasis on risk management. “More specifically,” says Murphy, “companies are looking beyond their own credit facilities to those of their customers and suppliers.” Put another way, firms operating in the euro zone are making sure they understand who has the ultimate obligation for paying for shipments. “For example, if they’re selling to a European manufacturer, they’re beginning to look at who that company’s customers are to determine whether there’s an indirect credit risk further down the chain that would limit their customers’ ability to pay,” he says.

Similarly, companies are trying to get a better sense of whether European banks will be reducing their credit facilities to European businesses, which again could affect their customers’ ability to pay. When it comes to managing risks from European suppliers, “that again requires a deeper understanding of the supplier’s financial situation,” says Murphy.

Clearwater Foods, a Canadian seafood company that derives 38% of its annual sales from the Eurozone, is adopting a combination of diversification, hedging and demand-chain intelligence to mitigate risks in its European operations. With a large international fishing fleet and processing plants, the company is redoubling efforts to minimize its exposure to a potential downturn in sales should the worse-case scenario in the region unfold.

In the first place, Clearwater is mitigating foreign-exchange risks by adopting strategies to diversify its sales internationally. Says Tyrone Cotie, finance director at Clearwater: “What diversification meant to us over the last year, and into the next five years, is to move more into China. We’ve seen some big growth last year and this year in our Chinese sales. Over the next five years I expect we’ll also be tipping our toe into India.”

Clearwater also builds pricing models that hedge against possible losses stemming from increases in the value of the Canadian dollar against foreign currencies. This effort is facilitated by another hedging initiative, which entails limiting the majority of sales to short-term contracts, typically less than six months. This enables Clearwater to forecast cash flows (and exchange-rate fluctuations) over shorter periods of time.

Another strategy that may seem like basic common sense, but can make a significant difference to profitability in a difficult environment, is having a sound knowledge of the price charged to consumers in each market: this helps Clearwater ensure that it extracts the best margin it can. “Understanding mark-ups is critical,” says Cotie. “It’s knowing the profitability through the whole chain, so when we price products we understand how much Clearwater is making, how much the distributor is making and how much the retailer is making, so that we get our fair share of the profit pie.”

Payment in installments and settlement in dollars are two more strategies for mitigating credit risk being adopted by some companies. Of course, it helps to be offering an essential service rather than one more dependent on discretionary spending decisions. U.S.-based TCT Ltd., for example, is the world’s largest licensed repair and overhaul facility for the industrial gas turbine engines manufactured by Rolls-Royce and GE that are used in the power generation and oil/gas transmission markets around the globe. As an essential supplier of repair services to the utilities sector, TCT has not faced the sharp drops in demand affecting companies such as auto manufacturers, automotive suppliers and producers of consumer durables.

From this position of strength, TCT has instituted a staged payment program in order to minimize default risk. As Bev Stewart, CFO of TCT, explains, “When these engines come in to be fixed, they’re usually here between two weeks and three months and we’ll be getting probably 80% of that paid before the engine even leaves the shop.” As she notes, “Ten years ago staged payments in this industry were unheard of.” The company now also insists on payment in US dollars. “There are very few contracts accepted in euro nowadays,” says Stewart.

Buy on the dips?

Should Europe pull through this current crisis, it could be all good news for international companies looking to make a play in the region at this time. As KPMG’s Murphy puts it, if risks are being overstated, there may be an opportunity to acquire companies and facilities in Europe at bargain prices. “Industry players as well as institutional investors, particularly pension plans, might think it’s a good time to buy an active business in the EU, or real estate and infrastructure assets as well.”

According to the EIU, Eurozone governments’ willingness to make compromises to keep the euro area intact, and to consider far-reaching institutional reforms, suggests that over time member states will address some of the fundamental weaknesses threatening the currency area. Yet doing so will take many years and could require a series of popular referendums on treaty changes, the outcome of which would be highly uncertain.

Meanwhile, the risk management folks will continue to sharpen their strategies to make the best of the current uncertainty undefined and limit the possible collateral damage should the EU and Eurozone remain on shaky ground.

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Reprinted from EIU article published February 12, 2013 posted at Business without Borders website. To view article, go to http://www.businesswithoutborders.com/industries/others-industries/how-to-hedge-your-exposure-to-the-eurozone/

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