STRATEGY
Trading With China: Foreign Exchange Hedging Strategies
March 15, 2007
Daniel W. Galhardo, Travelex

As trade with China continues to grow, so do several key business issues, including prospects for growth, the immense consumer market, the vast labour pool, and intellectual property protection. In addition, the value of the Chinese yuan continues to receive special attention from governments and financial institutions, which believe the yuan may be undervalued by as much as 20%. However, due to the current stability of the yuan relative to the US dollar, few CFOs, corporate controllers and treasurers are concerned with protecting themselves from the risk of a sudden yuan revaluation; or they simply have not been introduced to financial instruments to mitigate such risk.

The Yuan

The Chinese yuan (currency code: CNY), also referred to as the renminbi (which translates as 'people's money'), was pegged to the US dollar at a ratio of about 8:1 for 11 years, beginning in 1994. In July 2005, China responded to trade pressures from the US and Europe and re-pegged the yuan to a basket of currencies in a 'managed float' that has since produced a 3.5% appreciation.

China has tightly controlled its currency since its initial 1978 opening, in support of national economic, trade and political objectives. Exchange rates are managed by the People's Bank of China, and the only institutions that have access to converting currency, through one of the designated foreign exchange banks in China, are those that have been granted a license by the State Administration of Foreign Exchange (SAFE), and show a verifiable need for foreign currency. Otherwise, converting large sums of Chinese currency into US dollars, and vice-versa, is complicated if not impossible.

Is the Yuan Undervalued?

It is generally accepted that the yuan will appreciate in the next few years, but the timing and extent are nearly impossible to predict. As former Federal Reserve Bank chairman Alan Greenspan said: "No model projecting directional movements in exchange rates is significantly superior to tossing a coin." This represents a major decision to businesses that trade with China, as they must decide to either protect themselves with hedging instruments such as non-deliverable forwards, or engage in a 'coin-tossing' gamble and see on which side the yuan lands.

Different estimates and claims represent diverse biases on the real value of the yuan. The Economist's famous 'Big Mac Index', which is based on purchasing power parity, estimates the current value of the Chinese yuan could be undervalued by as much as 58%; US government economists suggest the yuan is undervalued by at least 25%; experts in China think the undervaluation is around 20%, and other sources vary between 15-35%. China's US$925bn in foreign-exchange reserves, 10% annual GDP growth, WTO membership and lack of currency convertibility all exert combined pressure for a stronger yuan.

Recently, the People's University of China released a study entitled 'Development of the Chinese Economy', which stated the yuan could appreciate by between 2% and 8% annually during China's 11th Five-Year Plan (2006-2010). Many Chinese officials make comments on the future direction of the yuan's value to appease the requests of China's major trading partners. However, no comments can really be taken to heart, nor taken for granted.

Foreign Exchange Risk

All international businesses incur foreign exchange (FX) risk - exposure to unpredictable changes in the value of foreign currencies, even if overseas payments are denominated in US dollars. FX exposure may be a result of import and export transactions (receivables from customers, or payments to foreign suppliers); foreign operating expenditures (branches, call centres, R&D centres, manufacturing plants, etc.); and any assets and liabilities held in foreign currencies (e.g. real estate, loans and royalties). In addition, risk may be apparent as in the case of an invoice denominated in foreign currency. Or it may be concealed, as when a foreign supplier invoices its US customer in US dollars. It's important to keep in mind that somewhere the currency will need to be converted. To manage foreign exchange risk, a company can hedge its exposure by offsetting foreign currency liabilities with assets in the same currency. Alternatively, the company can opt for using currency derivatives - financial instruments whose value derives from the underlying commodity, for example, a Chinese yuan non-deliverable forward.

While not hedging may let companies take advantage of favourable market movements, failure to hedge may translate into material impact to their bottom line. This highlights the importance of hedging foreign currency exposure. According to a survey published by Travelex in May 2006, 80% of respondents said they had 'significant exposures' to foreign exchange risk yet only 42% hedge their foreign exchange risk, despite 25% of respondents having reported that foreign exchange exposure 'has had an adverse impact on earnings in the last year'. The same survey also revealed that only 22% of respondents were concerned with the volatility of the Chinese yuan, compared to 73% concerned with the euro volatility.

A separate consideration for US companies involves the invoice format itself. Typically, suppliers invoicing in US dollars may choose to 'pad' the invoice to protect themselves from foreign exchange risk. Such padding can add as much as 10% to the invoice total value. This practice is best addressed by requesting that invoices be quoted in both US dollars and foreign currency amounts so that a choice can be made about which currency value to use. While all payments to China must still be sent in US dollars, simply negotiating the invoice in Chinese yuan can help companies develop a better relationship with their business partner in China by using their currency terms. This will also eliminate extra invoice 'padding', and allow the US firm to opt for hedging alternatives.

Risk Protection Through Non-deliverable Forwards

China's futures market is inaccessible for non-Chinese residents and non-Chinese firms, leaving few payment options and even fewer hedging instruments available outside of the country. US firms looking to hedge their foreign exchange exposure with China must make use of non-deliverable forwards (NDF) and non-deliverable options (NDO). These instruments eliminate risks when transacting with the Chinese yuan as well as with other exotic currencies that don't offer a futures market to foreigners, or currencies that are not very liquid, such as the Brazilian real, Indian rupee, Korean won and Taiwan dollar, among others.

The NDF is the more popular of the two instruments because no premium payment is required. However, like an outright forward contract, the NDF does not offer participation in the upside of favourable currency movements as an NDO does. The NDF is a contract that predetermines the exchange rate that a buyer will pay at a future date, but with no exchange of the underlying currency. Instead, NDFs are 'net cash settlement' forward contracts, settled in a convertible currency, typically the US dollar. On the date specified in the contract, exchange rate profit or loss is adjusted between the company and Travelex, based on the difference between the contracted NDF rate and the prevailing spot rate on an agreed notional amount. With an NDF, a business's net payment obligation will always be known ahead of time.

The NDF concept can be illustrated in the following example. ABC Optoelectronics has a scheduled payment of ¥4m to its Chinese research and development (R&D) centre in six months. To hedge against a possible yuan revaluation, it enters into an NDF contract agreement to purchase the ¥4m in six months at the NDF rate of CNY7.98/US$, which is largely based on interest rate differentials between the US and China. This translates into a contract notional value of US$501,253.13 (=4,000,000/7.98). Six months later, the yuan spot rate appreciates by 10% to CNY7.2/US$. With no contract, ABC Optoelectronics would send its R&D centre the equivalent of US$555,555 (=4,000,000/7.2). With the contract, it still sends its US$555,555 payment to China but is immediately reimbursed US$54,301.87 for a total net payment obligation of $501,253.13.

The use of hedging strategies brings predictability to the financial operations of a company. With an NDF, the net payment obligation is always known in advance and is protected through the contract. In the event the yuan were to depreciate, an unlikely scenario at the moment, the buyer of the contract would take advantage of the lower spot rate but would have to reimburse the foreign exchange provider the difference between the contract rate and the spot rate at time of payment. Nonetheless, the net payment obligation would always be known ahead of time.

We believe education in this aspect of international business is vital to supporting a sustainable economy in the US. Thus, in addition to efficiently moving money around the world, it is important to introduce international payment resources, such as the NDF and the NDO, to both small and large companies.

Copyright © ChinaForum 2007