The art of adapting your exchange rate policy in times of crisis
In times of crisis, some companies survive (or even prosper) while others, exposed to the same circumstances, unfortunately go bankrupt…
Although many factors can explain the success or failure of a company, it is still possible to identify some major strategic principles that can make the difference between the survival and the disappearance of a company; first and foremost: the ability to adapt.
To illustrate this point, let’s develop in this article the example of the exchange rate risk and the way in which such or such a company will be able (or not) to adapt its exchange rate policy to the economic crisis in order to survive.
The accounting “window dressing” (or the illusion of security)
While the quest for accounting perfection may be legitimate in times of economic prosperity in order to reassure investors and fine-tune financial communication, it can be totally superficial, and even dangerous in times of crisis.
Indeed, although it starts with a good intention, trying to smooth out (or even eliminate) accounting exchange rate gains and losses in financial statements represents a cost.
First of all, there is a direct cost (linked to the implementation of hedging operations), but also and above all a significant opportunity cost (since the attention given to the fight against accounting losses is no longer available to fight against economic losses).
In times of crisis, the top priority is obviously to preserve the company’s cash flow and profitability at all costs, rather than to take care of the cosmetics of its balance sheet.
Too many companies still give unreasonable importance to vanity metrics, whose monitoring and eventual improvement certainly flatters the ego of the financial management, but whose fluctuations have no deep interest for the health of the company.
Despite its share of bad news, the economic crisis offers the opportunity to lift our heads from the handlebars for a moment to question the validity of the hedging strategies in place (sometimes mechanically renewed for years).
Are your hedging strategies primarily aimed at preserving the company’s profitability? Are your hedges correctly sized to obtain the best cost/benefit ratio ? Is the coverage of your accounting losses a priority for your company in normal times ? Is it still a priority in times of crisis?
As you will have understood, if the coverage of accounting exchange losses can indeed (and rightly) be the icing on the cake in times of peace, it should never be at the expense of the coverage of economic exchange risk.
Refocusing on the essentials, a question of survival
“To survive and prosper, a company must be profitable. In order to respect this truth of La Palisse, your company must first and foremost focus on preserving its margins. And this is even more important in times of crisis, when the pressure of the decrease of the customers’ purchasing power weighs on your commercial results.
To do this, the company must obviously take the time to understand its pricing structure and the way it generates margin in its business. But the company must also protect itself against the hazards that could erode its margins (such as variations in raw material prices or exchange rate fluctuations).
While most companies have understood the benefits of hedging against currency and commodity price risks, the size of hedging operations sometimes leaves something to be desired.
Some companies find themselves in trouble in times of crisis for having underestimated the volatility of currency pairs and/or commodities, while others find themselves entangled in overly complex hedging operations (exceeding their real needs and creating at the same time a useless and dangerous over-exposure).
Moreover, other companies sometimes have the wrong objective by trying to predict in one way or another the evolution of the quotations, thus falling into an extremely risky speculation activity.
Where does your company get its profitability from? To what extent is this profitability exposed to the vagaries of the financial markets? How much do you need to protect it to reduce your risk exposure while maintaining your margins?
Here are some of the questions that need to be answered in order to define your financial risk management policy; answers that may change depending on your company’s situation and the economic context.
Economic approach vs. accounting approach : what to choose ?
While priority must obviously be given to the economic approach in order to protect your company’s profitability over the long term, everything is never black and white.
Indeed, finding the right balance between the economic approach and the accounting approach requires fine-tuning between margin protection and financial communication.
While an unlisted family-owned SME financed entirely with equity capital will have no particular interest in looking after its accounting exchange gains and losses, a large listed group will have a greater need to look after its image in order to obtain better financing conditions, particularly in times of crisis.
Therefore, for all companies (ranging from family-owned SMEs to large groups), taking the time to weigh the pros and cons of each approach is essential in order to position the cursor correctly.
Finally, a foreign exchange policy is neither unique nor set in stone forever, but rather a framework tailored to the specific situation of your company and the economic context of the moment; a framework that should be updated regularly, especially when a crisis occurs.