One of the most important components of country risk is foreign exchange (FX) risk. TowerXchange spoke to Wells Fargo’s FX expert Scott Gooch to learn how companies investing and operating in Africa could hedge to “lock in” an FX rate, or range of rates, thereby controlling exposure to FX risk in their budgets and transactions.
TowerXchange: Please tell us about the FX risks related to investing in African countries.
Scott Gooch, Director, Corporate Foreign Exchange, Wells Fargo:
When making a decision to invest or grow business in an African country there are several key risks that companies must weigh including their overall business model risks, economic risk, and geopolitical risk. Once a company has made a decision to investment in a business, then FX risk becomes another key risk factor that must be addressed.
FX risk encompasses everything from the basic ability to successfully manage cross-border cash transactions to hedging future cash expenditures. Converting from one currency to another and delivering cross border can create operational and market risk.
TowerXchange: Please explain the cross border transaction risks and the steps that can be taken to mitigate that risk.
Scott Gooch, Director, Corporate Foreign Exchange, Wells Fargo:
The initial FX risk factor is to determine how to successfully wire funds from the country of origin to the bank within the African country, and which currency to transact business in order to facilitate the transaction.
On the surface this sounds simple, but within the African continent there are over fifty different countries and most have their own local currency. While many of the local currencies are liquid and fairly easy to deliver, others may be very illiquid or even restricted. An analysis is initially needed to determine the best currency to transact business (i.e. local currency or an acceptable base currency such as Euros (EUR), US Dollars (USD), or South African Rand (ZAR)). Successful delivery of funds to an in-country bank must be timely, as these funds are often time sensitive as they relate to closing a business transaction (ie. fund an acquisition, invest in capital expenditure), maintaining ongoing operations, funding payroll, et cetera. So it is important to select a financial partner that has experience delivering currencies into the African country of focus. Electronic wires are the most widely used method of transacting business.
Paying for most transactions generally involves a basic Spot FX trade, which is a market exchange of one currency for another currency which is agreed upon at a rate at a fixed point in time. The spot rate is the agreed upon rate to exchange one currency for another currency with the actual exchange generally occurring between two banks two business days later.
Once the best currency to transact in has been determined, then a company must understand its ongoing FX risk which can create changes in value. This risk to value is due to potential changes in the underlying FX rates between the time a future transaction is identified and the time that transaction actually closes. The economic value of the transaction will change with the change in the underlying FX rate between the time a decision is made to invest and the future date that the investment is actually made.
To give an example of the FX risk due to changes in the underlying spot rate: at time of writing the ZAR is trading in the FX market at 9.2 ZAR/USD, which means a company can buy 9.2 ZAR for each $1.0 USD.
Thus, a US company contracts to buy towers priced in ZAR for 920 million ZAR in a transaction which will close in three months.
The company uses the current spot rate of 9.2 as its budget rate, which at the time the contract is signed equates to $100million USD.
Assume that three months later when the transaction is closing the ZAR is then trading at 8.0 ZAR/USD. The USD cost required to close the 902 million ZAR transaction would then be $115 million. Thus, it would cost the company 15% more in USD terms to buy the equipment which it had budgeted at only $100 million.
Such a move could create funding issues if the company only budgeted to fund $100 million.
We have started a similar project in Kenya. We are in the final stages. During the negotiation phase, we try to sort out the maximum of issues in order to decrease the risks during the migration phase
FX currency risk or market exposure can often be mitigated by utilizing a hedging tool
TowerXchange: How can companies mitigate FX risk by hedging?
Scott Gooch, Director, Corporate Foreign Exchange, Wells Fargo:
This FX currency risk or market exposure can often be mitigated by utilizing a hedging tool. In the financial world, Hedging is a term describing the act of utilizing a financial contract or instrument to mitigate future financial market risk, by fixing the underlying market variables. In this case the underlying market variable is the unknown future spot rate compared to the initial spot rate. In the example above, the spot rate changed unfavorably for the client from 9.2 ZAR/USD to 8.0 ZAR/USD. When the company originally ordered the equipment it budgeted for the cost of the ZAR at the then-current spot rate of 9.2 ZAR/USD. When the equipment was delivered the then current spot rate was 8.0 ZAR/USD. The company could have considered Hedging by locking in a future ZAR rate for purchasing its ZAR three months into the future. This type of hedge is known as a “forward rate.” These hedging products are generally offered by FX banks to clients if the banks are comfortable with the underlying credit exposure of the company.
If the company had been able to work with a bank that was comfortable with the company’s credit risk and able to provide the company with a forward rate, then the company could have locked in a forward rate contract to buy its ZAR in three months. When the then-current spot rate was 9.20, the then-current forward rate the company could have locked in to buy 920 million ZAR in three months was 9.25 ZAR/USD*. Thus, if the company entered into a forward hedge with the bank, it would be agreeing to buy 920 million ZAR at a rate of 9.25 ZAR/USDS in three months for $99,460,000, regardless of the future spot rate. In this example the company has hedged its risk to changes in the underlying spot rate over the next three months, and the forward rate it locked in is actually more favorable than the then-current spot rate.
For many emerging market currencies the forward rate is often more attractive than the initial spot rate. This is because forward rates are based on the spot rate adjusted for the interest rate differential between the two underlying courtiers and adjusted for the company’s credit risk. Because interest rates in most emerging markets are higher than in the US this means that the forwards will generally be equal to or more favorable than the underlying spot rate.
TowerXchange: Are there alternative methods for mitigating against FX risk?
Scott Gooch, Director, Corporate Foreign Exchange, Wells Fargo:
The other common way of hedging FX risk is to protect yourself with a “currency option”. This is more like a company buying insurance. The company pays an up-front premium to the bank, and the bank agrees to provide currency at no worse than a specific future exchange rate. So if you win a major project generating revenue a year from now, you could pay to take a currency option to protect your budgeted FX rate. If the currency you’re exposed to weakens, then you simply let the contract expire. The more FX risk you can take, the cheaper that up front premium.
TowerXchange: What are the risks involved in hedging?
Scott Gooch, Director, Corporate Foreign Exchange, Wells Fargo:
There are risks involved in hedging which should be closely considered prior to entering into any hedge. The primary risk of hedging with a forward hedge is that even if the currency weakens and it would be more favorable for the company to purchase the ZAR in the then-current spot market at an all-in lower price, it must still honor its forward hedge with the bank. In the example above we outlined the risks to the company if the ZAR strengthened against the USD and the company was not hedged. In similar fashion, if the company does hedge and for example the future spot rate is 10.0 ZAR/USD it would have proven more beneficial with the benefit of hindsight not to have hedged. Additionally, if the underlying transaction to purchase the towers for 920 million ZAR is terminated for unforeseen reasons, the forward hedge is still in place and must be terminated with the bank which could result in a loss. Because of these potential risks the company should work with its FX bank closely to consider these and other risks that could be created by hedging.
We have started a similar project in Kenya. We are in the final stages. During the negotiation phase, we try to sort out the maximum of issues in order to decrease the risks during the migration phase
manage the risks that are easy to manage, and mitigate at least the risks that you can mitigate
TowerXchange: What happens in extreme examples, such as the crash of the Zimbabwe dollar in 2008-9?
Scott Gooch, Director, Corporate Foreign Exchange, Wells Fargo:
Sometimes the degree of political risk restricts your options to mitigate FX risk. It’s very hard to hedge currency exposure in volatile circumstances such as we saw in Zimbabwe, so it becomes critical to limit your exposure as much as possible by not holding cash in country, and by knowing the risk-return profile.
The general rule of thumb is to manage the risks that are easy to manage, and mitigate at least the risks that you can mitigate.
African currencies and any restrictions*
Algeria -- Algerian dinar (DZD)
Angola -- Kwanza (AOA)
Benin -- West African CFA (XOF)
Botswana -- Pula (BWP)
Burkina Faso -- West African Franc (XOF)
Burundi -- Burundi franc (BIF)
Cameroon -- Central African franc (XAF)
Cape Verde -- Cape Verdean escudo (CVE)
Central African Republic -- Central African Franc (XAF)
Chad -- Central African Franc (XAF)
Comoros -- Comorian franc (KMF)
Cote d’Ivoire (Ivory Coast) West African Franc (XOF) Restrictions*
Republic of the Congo -- Central African CFA (XAF)
Democratic Republic of the Congo -- Congolese franc (CDF) Restrictions*
Djibouti -- Djiboutian franc (DJF)
Egypt -- Egyptian pound (EGP)
Equatorial Guinea -- Central African Franc (XAF)
Eritrea -- Nakfa (ERN)
Ethiopia -- Ethiopian birr (ETB)
Gabon -- Central African Franc (XAF)
Gambia -- Dalasi (GMD)
Ghana -- Cedi (GHS)
Guinea -- Guinean franc (Franc Guineen) (GNF)
Guinea-Bissau -- West African Franc (XOF)
Kenya -- Kenyan shilling (KES)
Lesotho -- Loti (LSL)
Liberia -- Liberian dollar (LRD)
Libya -- Libyan dinar (LYD) Restrictions*
Madagascar -- Malagasy ariary (MGA)
Malawi -- Malawian kwacha (MWK)
Mali -- West Africa Franc (XOF)
Mauritania -- Ouguiya (MRO)
Mauritius -- Mauritian rupee (MUR)
Morocco -- Morrocan dirham (MAD)
Mozambique -- New Mozambican metical (MZN)
Namibia - Namibian dollar (NAD)
Niger -- West African Franc (XOF)
Nigeria -- Naira (NGN)
Rwanda -- Rwandan franc (RWF)
Sao Tome and Principe -- Sao Tome Dobra (STD)
Senegal - West African Franc (XOF)
Seychelles -- Seychellois rupee (SCR)
Sierra Leone -- Sierra Leonean leone (SLL)
Somalia -- Somali shilling (SOS) Restrictions*
South Africa -- South African rand (ZAR)
Sudan -- Sudanese Pound (SDG) Restrictions*
South Sudan -- South Sudanese Pound (SSP) Restrictions*
Swaziland -- Lilangeni (SZL)
Tanzania -- Tanzanian shilling (TZS)
Togo -- West African Franc (XOF)
Tunisia -- Tunisian dinar (TND)
Uganda -- Ugandan shilling (UGX)
Zambia -- Zambian kwacha (ZMK)
Zimbabwe – U.S. Dollar (USD) Restrictions*
* Currency Restrictions may apply - OFAC Sanctions Programs and Country Information provided by the U.S. Department of Treasury at http://www.treasury.gov/resource-center/sanctions/Programs/Pages/Programs.aspx (Information correct as at 20 March 2013)
