SMPs and SMEs need to work together to ensure FX risk is kept to a minimum

accapr —  4 September 2013 — Leave a comment

P Gelis

By Philippe Gelis, CEO at Kantox Peer FX

Earlier this year, the Edinburgh Group published evidence on the international activities of SMEs and the advice they get from small and medium sized accountancy practices (SMPs). More than seven out of ten SMPs have internationalised SME clients and 17% depend on these for more than 25% of their fee income.

This may sound like a lot but actually the figures should be much higher. SMPs need to look after ambitious SMEs and help them to grow into bigger business – it’s in the interest of both the accountancy firm and its clients. SMEs with international aspirations tend to deliver better performance and higher growth rates and hence make lucrative and prestigious clients for SMPs. Sooner or later, especially as they create deeper ties with their new markets, these international SME will build up substantial exposures to foreign currencies that could threaten the business’ profitability.

We know this from earlier research Kantox carried out with ACCA – internationalised SMEs and mid-market companies are typically exposed at a level of around 19% of revenue – of which possibly less than half is hedged in any way and even less is managed in an active manner. Frustrated by complexity and cost, and with only limited resources and access to relevant skills, some SMEs may be resorting to overly expensive hedging methods or taking their chances with the markets.

Even domestically-focused SMEs are not immune to foreign exchange risks. In regions heavily exposed to foreign banking sectors, like South East Asia in the 1990s and much of Central and Eastern Europe pre-crisis, businesses have been known to borrow in foreign currencies, thus taking on risks they were often ill-prepared for. Having access to good advice can, for such firms, be a matter of not just profit and loss, but life and death.

Yet ACCA and Kantox’s careful review of the Edinburgh Group data shows that SMPs aren’t always up to speed when it comes to SME clients’ exposures. Less than a quarter of SMPs with clients exposed to FX risk are involved in managing this. As a rule, in countries where volatile exchange rates make frequent headlines, practitioners are more alert to the potential problems than their clients; the opposite tends to be true in countries where SMEs deal in stronger currencies.

Resource is of course an issue for SMPs that do not have access to extensive professional networks or overseas partners, and thus have to solely rely on in-house staff to help internationalised small businesses. Anyone can buy and sell currency, but managing FX risk is a specialist skillset and not all practices can justify the up-front investment it requires. Typically, SMPs get drawn into FX risk management by one or two critically exposed clients, or when a critical mass of clients turns out to have exposures in need of monitoring. The more proactive ones make a point of building their brand around advising international businesses, and realise that FX is a natural part of the portfolio of such an adviser.

While FX hedging will always be highly dependent on context, including both company-specific factors and market dynamics, six simple rules can help business owners, and the practitioners who advise them, to approach the task correctly.

  1. Define an FX hedging policy that is based on your risk appetite. If you want to hedge successfully, everyone in your company – board of directors, CEO, CFO, treasurer(s), accountant(s), etc – needs to know and share common targets and rules. Personally check that each board member has clearly understood the potential risks of the hedging policy previously defined. In some cases, board members prefer not to hedge the FX exposure to minimise costs and benefit from potentially favourable currency movements. Calculate worst case scenarios and present the results to them.
  2. Identify your FX position and decide, on the basis of the hedging policy previously defined, whether they have to be hedged. It may seem obvious but to hedge successfully you need to know, at every moment, your exact FX exposure and its potential impact on your company’s profitability and competitiveness.
  3. Don’t try to forecast currency movements or, at least, do not base your hedging decisions on currency movement forecasts alone. Do not forget that no one, including leading banks, is able to predict currency movements consistently, let alone forecast potential high-impact disasters on FX markets (think of Bear Stearns, Lehman Brothers, loss of the US AAA credit rating, Greece’s sovereign debt crisis).
  4. Never speculate with your corporate cashflows. Do not forget that hedging FX exposure is not the core business of your company. This means that in managing corporate FX risk you should aim to make neither profit nor loss but rather maintain a zero balance. Do not forget that not hedging FX risk is similar to speculating.
  5. Buy only what you understand. Make sure you fully understand the financial products you use to hedge corporate FX risk (forward contracts, futures, options, exotics, etc). Buying derivatives is quite easy but understanding how they are built and the hidden related costs and risks is much more complex.
  6. Avoid ad hoc data manipulations. It is so easy to add or forget a ‘0’ when filling in data into a spreadsheet. Implement a treasury-management system. It may seem expensive, but only until your first big data mistake.
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