Hedging the great fall of China

Ever since China’s exchange rate policy shift caused the renminbi (RMB) to plunge in value last month, treasurers have been grappling with some of the most volatile trading in the currency market in recent memory. In this Insight, an industry expert explains why, when the fog of currency war descends, getting accurate pricing information can be quite a challenge for some.

With talk that emerging markets could be facing a new round of ‘currency wars’ following the biggest RMB depreciation in two decades, hedging foreign exchange (FX) exposures is likely to be high on the corporate agenda right now. As the events of last month showed us, however, hedging is not without its challenges when volatility begins to take hold.

“Treasurers were caught off-guard, just like everybody else in the market,” says Natasha Lala, Head of Exchange Rates at Canadian-based foreign exchange retail broker OANDA. The most difficult moments were most probably in the immediate aftermath of the devaluation. “The first issue they have is whether they are even able to properly monitor the risk, whether they have the data to do that.” But even then the ability to react quickly is likely to be limited if, as we saw in the wake of last month’s turmoil, the FX derivatives market begin to dry up. “Even if they decide to hedge certain exposures, there may not be enough liquidity available to actually do that.”

A more volatile redback will also have implications for other currencies, some of which are now becoming increasingly anchored to the redback. If the yuan falls further in the coming weeks and months, then other currencies are likely to fall too. On Wednesday, the Aussie dollar fell below S$0.70 for the first time in more than six years, while the currencies of other big commodity producers such as the South African rand and the Russian rouble have both suffered falls of at least 2% in the past week. Even the Malaysian ringgit, one of the Asian currencies least dependent on China trade, has seen significant depreciation.

The visibility problem becomes especially acute once other currencies start reacting. “What we see is the market becoming very illiquid, and then there is this sort of ‘fog of war’ where the market is trying to figure out what the real price is. It takes a while to settle,” says Lala. Price competitiveness can be an issue for some in such circumstances. “That’s posing a challenge, especially for those treasurers dealing with a single bank to get pricing information. When the market is in a rapid state of change like that you would need to see more than one source to actually get the right price according to market consensus. To get an accurate rate, you really need a broader view of what is going on.”

New normal

With a more volatile redback going forward now looking increasingly likely, it is worth asking what treasurers should be doing now to protect their emerging market revenue streams in case a wave of competitive devaluations now break out. “My counsel is that it is not a one-time event,” says Lala. In the meantime, she advises that treasurers who are uncomfortable with their ability to assess the risk and lack confidence their FX data and hedging strategies might wish to consider performing a stress test; analysing how their strategies perform over a period of ten or 20 years during various market shock events. That may not cover one completely for all future events, but it can help to instil some confidence in the model and highlight where the gaps are.

“It is just the beginning of other events across the market,” adds Lala. “So there is still time to solve these problems and taking such steps now will almost certainly have an impact on the ability to manage the any further volatility in the next six months to a year.”

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