01 Mar 2010
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Economy
Currency Exchange Rates - Moving with the Current
Currency fluctuations can have a significant effect on a company’s profits. Heather Connon explains how exchange rates may affect equity investors
Although the oil giant BP has paid the same dividend for the last six quarters, the amount that British investors have actually received has varied from just over 7p to 9.8p a share. The reason is that BP declares dividends in US dollars, translating them into sterling before paying them to UK-based shareholders. And the dramatic fluctuations in the dollar-sterling exchange rate over the last two years means the income for the 42 per cent of its shareholders who are based in Britain has fluctuated dramatically.
A growing number of British companies now report their results and declare their dividends in US dollars. The list includes other oil companies like Royal Dutch Shell, the pharmaceutical company AstraZeneca, commodities business Rio Tinto and global bank HSBC. These are some of the largest companies on the UK stock market so a large proportion of the dividend income to UK shareholders now depends not just on the performance of the company, but also on the relationship between the dollar and the pound.
OVERSEAS INVESTING
Dividends, however, are not the only thing to be affected by currency fluctuations. Any company which operates in, or buys supplies from, outside its own country will have to take exchange rates into account when they are doing business (most businesses these days do). Analysts at investment bank HSBC calculate that as much as 60 per cent of the total sales of FTSE
100 companies are earned overseas.
The issue is not confined to the UK. All international companies, whether from Belgium or Brazil, America or Australia, will also be vulnerable to the vagaries of currency markets.
That makes currencies a key factor for company managements to consider in running their business. The financial crisis has already made currency movements more volatile. Iceland’s currency plunged in value as its banks collapsed, while our own pound is under pressure because of the scale of the debt the government has had to assume to finance its bailout of the banks. The adoption of the euro by 16 European countries has also put pressure on sterling, which has no such backing, as well as offering a real alternative to the dollar.
FORWARD THINKING
But longer-term trends, such as the emergence of China, India, Brazil and other developing countries as key players in the global economy, will also have an impact on exchange rates. Already, some experts are suggesting that the dollar’s role as the global currency of choice will eventually end and it will be replaced by the Chinese renminbi. While that will not happen overnight, it does add a further layer of uncertainty over currency trends.
Company managements cannot influence what happens to exchange rates but they have to be able to monitor and, where possible, control the effect currency fluctuations have on their business.
Assessing the impact of currency changes is not as straightforward as the effects can be. It could be positive or negative depending on which way the exchange rates are moving. If sterling strengthened, Europe could be perceived as being of better value again, depending on what side of the transaction you are on.
SHOPPING VALUES
As anyone who has visited Europe recently knows, sterling has been falling sharply against the euro in recent years – at the start of 2007, every pound would buy 1.52 euros and by the end of 2009 it fell to only 1.13, a fall of 25 per cent. That cannot be productive for companies who purchase raw materials in euros, as these goods will have become more expensive. On the other side, however, it should be good news for those that are selling their products into the European markets as European consumers will find them cheaper, and so should buy more of them. Indeed, London stores have been enjoying a mini boom as European shoppers have headed to Britain to take advantage of the weaker pound.
European companies, however, are suffering as their currency has strengthened not just against the pound but against the dollar too. That has made their products far more expensive in these countries, making it harder to compete with local manufacturers. BMW and Mercedes, the European car manufacturers, calculate that every one cent rise in the euro costs them about €50m of profits a year.
The key for investors is to ensure that the companies they are investing in are aware of the potential risks from currency exposure and of any steps taken to minimise them. There are a variety of ways of doing this. Companies can use forward contracts to lock themselves in to a particular exchange rate or asset price. The discount airline Easyjet, for example, will feel the impact of the euro on the travel plans of its European customers as well as the higher cost of using airports on the continent, and on the dollar rate on its fuel costs. In its accounts, it makes a clear statement of how it deals with these, outlining in detail how much of its exposure is hedged, and what impact that has had on its profits.
PLACING YOUR BETS
Some companies are also using a technique known as ‘natural hedging’ (a position that establishes assets or borrowings in a currency that provides an offset to any expected cash-flows); a seemingly corporate illustration of the adage ‘If you can’t beat them, join them’. So instead of using derivatives to control their currency risk, they structure their business appropriately. BMW is a good example.
For the carmaker, ‘natural hedging’ means increasing its production in the US, the UK and China, which means that more of the costs of manufacturing will be borne in the countries in which the cars are sold. It is also increasing the amount of raw materials and components it purchases outside Europe, and particularly in US dollars.
Companies can also arrange their debt so that they borrow money in the currencies in which they hold assets or do business. In other words, any foreign exchange losses on the assets will be offset by profits on the borrowings.
Currency fluctuations can bring greatly increased risk for companies and their shareholders. But provided both parties are aware of the risks, and take steps to control them, these risks should not affect investment decisions.
CURRENCY RISK AND INVESTMENT TRUST COMPANIES
Each trust’s board will discuss currency and associated risks with the trust’s managers. The approach can vary from trust to trust.
Managers will consider currency influences when selecting investments. A collective decision is usually taken with boards about the currency denomination of borrowings, and at times on decisions about whether or not to hedge currency exposures.
Some trust boards will decide that currency exposures cannot be managed with precision and that the effect of currency movements will balance out over the long term. However, by using currency hedges, some boards and managers try to reduce risk or increase returns although predicting currency movements accurately requires nerve and expertise.
Annual Reports and Accounts will include details of geographical exposures and the denomination of any borrowings. Currency exposures do not always match listing exposures: a company can be listed in one country but do business elsewhere.
Investors in trusts that invest in companies with overseas exposure should bear in mind that returns will be influenced by currency movements.
Heather Connon is a financial journalist and is a regular contributor to Trust magazine.