The UK’s scheduled exit from the EU is as unclear as ever. The process, triggered by a June 2016 referendum, has lurched from one possibility to another with little predictability. As such, financial management professionals are juggling a range of unknowns: When will the UK leave the EU? What will trade and business relationships be like? Will there be a delay, a revote, or a hard Brexit? So much is still uncertain.
As the Brexit process has unfolded, the pound sterling has experienced some volatility, dropping sharply in the wake of the referendum, and responding with increased sensitivity to political events. Depending on what happens over the next few weeks, the pound could plunge further — potentially to parity with the euro for the first time — or strengthen considerably.
FM magazine spoke with Christopher Turner, head of fx strategy at ING; Yael Selfin, chief economist, KPMG UK; Eric Peterson, CPA, director of corporate treasury services at KPMG UK; and Rajarshi Guha, corporate treasury services manager at KPMG UK, about how businesses can manage the potential foreign exchange (fx or forex) outcomes of the coming weeks.
What are the possible — and most likely — Brexit outcomes, and what effect might they have on sterling?
Turner: In terms of the possible impact on sterling, we’ve already seen sterling rally 4% this year on a trade-weighted basis as [UK Prime Minister Theresa] May’s initial deal was rejected and paths to a delay and even a second referendum started to emerge. Of the [potential] outcomes, a no-deal Brexit would be the worst for sterling and could see a 10%–15% depreciation. The best outcome for sterling would be a delay in Article 50 [of the Lisbon Treaty] and a path emerging to a second referendum. While there would be no guarantee of a different referendum outcome, we suspect that sterling could rally 5% on at least the opportunity to reverse the 2016 vote.
Selfin: Our central scenario assumes that Brexit preparations evolve relatively favourably, with an agreed transition period followed by a permanent agreement that amicably resolves the potential serious frictions to ongoing business relationships and trade between the UK and the EU. In these circumstances, where the possibility of an abrupt exit is removed and businesses are in a better position to make more targeted contingency plans, we expect a slight improvement in overall GDP growth in 2019 to 1.6% (from a forecast 1.3% in 2018), followed by growth of 1.5% in 2020. More clarity around the Brexit deal would ease some of the restraints that we have witnessed in businesses’ investments this year.
What can companies do to hedge against the uncertain sterling/forex outlook?
Turner: Given the huge uncertainty, corporate treasurers are naturally taking a very conservative approach to managing their treasury risks. Instead of longer-term fx hedges, for example, out to the two- to three-year horizon, they are operating off a much shorter time frame, such as three to six months.
Hedging products exist such as fx forwards and fx options. Fx forwards provide an opportunity to hedge fx risk at a precise future date — but clearly require confidence that the fx transaction will take place. Forwards will typically be used to manage contractual obligations. Fx options provide the right but not the obligation to transact. These would typically be used if future cash flows aren’t certain — for example, expected future revenues. Fx options can be considered as an insurance product to protect against future fx moves without the obligation. Options premiums are, however, more expensive now because of the high uncertainty.
Peterson: Irrespective of the nature of assets and liabilities, corporations in the post-Brexit world are looking at a period of uncertainty in the forex market. The impact on the pound vis-à-vis other major currencies is more likely to depend upon the nature of an exit deal than central bank monetary policy in developed economies. In order to tide over this uncertainty in the short term and ensure minimal disruption to earnings and profits over the longer term, it is imperative for corporations to have a properly designed and well-adhered-to forex risk management framework. Since the objective of risk management is to insulate earnings from volatility in market risk factors, only a consistent approach to risk management will yield results.
So often in our experience in consulting with treasuries of all sizes, we see that during periods of relative calm, traders and risk managers are tempted to take an ad hoc approach to hedging. This strategy is partly driven by the need to capitalise on market stability with an intention to either maximise profits due to currency movements or minimise hedging cost. The fallibility of this strategy, however, is that when the hedging programme is revisited during sudden and prolonged periods of volatility, the results often turn out to be suboptimal.
We all recall how the pound reacted to the results of the referendum in 2016. While according to conventional wisdom, currency markets have likely factored in a disruptive no-deal Brexit, the market’s track record of forecasts hasn’t been stellar. Regardless of the outcome after [Brexit], there could be a sustained period of market volatility for the simple reason that businesses will take time to make sense of and adjust to the new paradigm.
While the pound market is relatively calm of late, anticipation of a post-vote upheaval is driving up implied volatilities (IV) — an options markets’ gauge of expected swings in an exchange rate — in short- and medium-dated GBP options. Meanwhile, pound risk reversals — which measure expectation for a currency’s directional movement — have risen in recent weeks, indicating a bearish view of the pound.
The importance of accurate exposure recognition cannot be overstated. For instance, even if a corporation is located in the UK, if substantial trade flows are denominated in dollars, or close integration of its supply chain with Europe means a majority of invoices are raised in euros, it might be worth pausing to reflect if the corporation is truly a pound-denominated business in the first place.
Given the possibilities and their consequences, corporations will be best served with an all-encompassing forex risk management strategy. This could typically be a combination of a staggered hedging approach with greater weights given to currency pairs with greater sensitivity to EBIDTA. Moreover, exposure recognition will become all the more important as corporations realise the benefits of natural economic offsets. This will need to be augmented by strict take-profit or stop-loss levels, and the risk management function must ensure that the treasury is not carrying open exposures beyond its risk appetite and policy approval. As corporate treasuries prepare to wake up to a very different world from April 2019 onwards, prudence and consistency should stand them in good stead.
How can companies change internal cash management in order to manage forex uncertainty over the next year?
Turner: To minimise fx risk, corporates are also looking to better balance assets and liabilities. For example, for those UK corporates with revenues overseas, but with those operations funded out of sterling, the corporate may be considering shifting to a local funding structure. This would reduce the fx mismatch between assets and liabilities.
Guha: Unanticipated currency movements can not only adversely affect cash flows through value-attrition, but also upset calculations of liquidity management due to cash being trapped in foreign currencies. This interplay was evident from the fact that most global corporates (despite reporting strong revenue growth) also lament the impact of forex volatility on operating cash flows. The most critical part of forex risk management, which is also sometimes the most overlooked, is identification and accurate projections of cash flows. Cash positioning or cash flow forecasting, as it is commonly called, is the backbone of effective forex risk management. Once the risk management policy has been set, treasuries need to identify forex exposures to be hedged, which in turn are derived from cash flow forecasts. This is moot, especially if the economic exposure currency is different from the invoice currency.
When it comes to cash management, it is also important to understand the distinction between cash at bank and near-cash instruments such as money-market deposits or funds. While the latter can be relatively easily tracked by the treasury management system, aggregating the former is a greater challenge. Getting each bank to send over a file of account balances every day is manageable through spreadsheets only if both the number of accounts and banks is low. A more sophisticated and recommended way of effectively managing cash at bank is to integrate it with the existing treasury management.
As [Brexit] draws nearer, various corporations will need to decide whether they would stay in the UK or establish a new presence elsewhere and change their base currency. Accomplishing the latter with minimum disruption will require them to review their banking architecture in favour of a strategic global banking set-up that can maximise economies of scale.
They will also need to review existing arrangements around notional pooling, cash concentration, and payments. Having set up operations to pool various currencies into one location, corporations can face doubts over their ability to continue running cash pools as normal. In the eventuality the UK loses direct access to euro clearing and settlement mechanism (CSMs), this would mean rerouting transactions, nostro set-ups, and reviewing charging models.
To navigate this change with minimal fuss, corporations must deliberate on potential future-state designs and engage with their banks, with whom they have hedging and credit lines so as to provide them with a consolidated approach to both fx and cash management. Regardless of the outcome of Brexit negotiations, treasuries will need to start planning in advance and conduct current state assessments while being mindful of the applicable regulatory framework in the new regime.
— Andrew MacDowall is a freelance writer and risk consultant based in France. To comment on this article or to suggest an idea for another article, contact Drew Adamek, an FM magazine senior editor, at Andrew.Adamek@aicpa-cima.com.