Sharp downward moves in a series of EM currencies during the past year have caused pain for corporates that had been under-hedged due to the high cost of carry against the US dollar. Many have now woken up to the risks, but not all are hedged against future shocks Emerging market (EM) currencies can be difficult to predict and costly to hedge. Moves, when they happen, tend to be sharper and more painful than in G-10 currencies, and traditional hedges are often prohibitively expensive due to interest rate differentials. But a series of sharp and sudden falls in several Asian EM currencies over the past year has caused some corporates to rethink how they manage risk. Increased volatility for EM currencies first emerged wholesale just over a year ago in May 2013, when the US Federal Reserve first mooted the possibility of scaling back the economic lifeline of quantitative easing. Feverish speculation over the timing of that move led to a sell-off in multiple EM currencies, with the Indian rupee and the Indonesian rupiah suffering particularly sharp falls. Those currencies may now have normalised, but the surprise fall in the Chinese yuan this year has underlined the importance of hedging such moves. "China continues to dominate every discussion and client meeting we have," says Harry Fung, head of multinational corporate sales for Asia-Pacific at Bank of America Merrill Lynch (BAML) in Singapore. "Many companies had previously left renminbi unhedged because they expected that it would only move one way. While the long-term forecast is for further appreciation, short- and medium-term movements are harder to predict and many are now looking to put on hedges." Since China first began the process of internationalising its currency, the yuan had appreciated steadily, gaining more than 11% against the US dollar between mid-2010 and the start of 2014. But when the currency suddenly started to move in the opposite direction in February, it caught many market participants by surprise. Renminbi's capacity for two-way volatility only increased when the People's Bank of China (PBoC) widened the band within which it could deviate from the daily fixing rate from 1% to 2% on March 17. Having traded at 6.15 on March 17 – already up nearly 2% since the start of the year – USD/CNY rose sharply and was trading at 6.25 on May 30, according to data from Thomson Reuters. Given the large number of multinational corporates with exposure to China, it was inevitable that such a sudden change in the direction of the currency would cause some unrest among treasurers, but many hadn't previously hedged the move as renminbi had appeared to be a one-directional currency for so long. "There has long been an entrenched view locally that renminbi would only ever appreciate so there was no point in hedging it, but that view has taken a jolt with recent events. The problem is that it's a difficult currency to hedge – doing it onshore means you have to comply with certain restrictions and the hedge has to be linked to an underlying transaction, but doing it offshore can leave you with basis risk if you're settling onshore," says Damian Glendinning, group treasurer at Chinese computer manufacturer Lenovo in Singapore. While the recent turn in the yuan is clearly cause for concern, banks report only lukewarm appetite for hedging. Ivan Wong, head of corporate sales, Greater China in the markets division at HSBC in Hong Kong, says the belief that the yuan will appreciate again in the long term is deterring many firms from putting on hedges. "The volatility has certainly caught corporates' attention and there have been a lot of questions, but we haven't yet seen panic. Many have avoided putting on hedges as they wait to see how the Chinese economy develops and whether there will be hints from the PBoC about further FX band widening," says Wong. Non-deliverable forwards (NDFs) in the offshore market have long been a popular product for hedging Asian currencies where exchange controls make it more difficult and costly to trade onshore (see box below: 'Regulation drives NDFs to the brink'). But while the widening of the PBoC band might accelerate the liberalisation of the yuan, it has also made it more difficult for corporates to use NDFs to hedge the currency. The increasingly influential role China is playing in the world economy will continue to carve out a fairly unique position for renminbi in the global forex market, but other Asian currencies such as rupee and rupiah have also caused problems for corporates over the past year, mainly due to the cost of traditional hedging. Forex forwards are priced off the interest rate differential between the two currencies in the transaction, and while interest rates in major economies such as the US and the UK have been at record low levels for several years, they are much higher in emerging markets - rates in India are currently 8% for example. That creates a punitively high cost of carry, which makes forwards on EM currencies against the dollar particularly expensive. "The biggest challenge with hedging emerging market currencies is that there is such a big yield differential and hedges are therefore expensive. Due to the lack of available cost-efficient solutions, corporates often keep EM exposures underhedged compared to their global benchmarks – even though the cyclical nature of EM currencies tends to compound rather than reduce risk. They justify this lack of risk management by arguing that in the very long run they will be better off or neutral," says Jeremy Monnier, head of FX structuring at Deutsche Bank in London. Severe moves But the severity of recent moves has challenged that conventional wisdom. Within the course of just a few days last August, the Indian rupee lost nearly 9% of its value against the dollar. The move in the Indonesian rupiah was more gradual but it fell more than 22% against the dollar in the second half of last year. And with interest rates in India and Indonesia among the highest in Asia, the severity of the moves was compounded by the cost of carry. "Volatility in some Asian currencies can be a little extreme," says Lenovo's Glendinning. "For example, hedging the rupiah with forwards was already very expensive because the interest rate differential is already 10%, but during the crisis last year, Indonesia underwent a sudden liquidity concern and the cost of doing a forward went from 10% to 30% at one point." In 2014, both the rupee and the rupiah have appreciated on a more stable footing and greater confidence that the rise of both currencies will continue is leading some to now consider hedging extreme moves, say banks. "The worst now appears to be behind us and both rupee and rupiah have rallied against the dollar year-to-date and are probably the best performing currencies in the region. This rally has definitely impacted exporter sentiment and they are now looking to increase hedge ratios. Greater certainty around the likely direction of the dollar versus rupee or rupiah has also seen exporters open to putting on longer-dated hedges. In select cases, clients have started to buy vanilla options and pay a premium to hedge their worst-case scenario," says Rahul Badhwar, head of corporate sales Asia Pacific, ex-Greater China, in the markets division at HSBC in Hong Kong. Violent swings in EM currencies have not been limited to Asia, and recent political unrest in parts of Eastern Europe prompted significant depreciation in the Turkish lira and Russian ruble earlier this year. As the cost of carry in hedging those currencies is also very high, banks have been pitching products other than forwards as a means of mitigating the tail risk of extreme moves in a more cost-effective way. One product that has been particularly popular is the risk reversal or 'collar', whereby the corporate would buy a euro or US dollar call option, while selling a call on an emerging market currency. If the spot rate remains between a pre-determined cap and floor at maturity, the option does not have to be exercised, offering greater flexibility than an FX forward in the event of a favourable market move. Collars have not been as widely adopted in Asia as in Europe, partly due to restrictions on what products can be traded, but some banks report take-up in certain markets. "In countries such as Brazil, Turkey and India, there is an available derivatives market that allows you to mitigate tail risk but keep skin in the game, which is what a lot of clients are looking for. If they have the right tenor and accounting treatment, collars can be very effective in protecting the balance sheet from sudden moves in these currencies," says Deutsche Bank's Monnier. For many companies, the problem is a steadfast internal belief that a single risk management strategy should be applied to all currencies, despite the clear differences between the behaviour and costs of hedging emerging market and G-10 currencies. But for multinational corporations with exposure to multiple EM currencies, it clearly makes sense to align hedging with the nuances of individual markets. "For clients that need to buy dollars to hedge Asian emerging market currencies, the interest rate differential may imply a significant forward premium," says BAML's Fung. "Corporates have started to explore the derivatives markets again as they revisit their risk management policies. Certain vanilla products work particularly well for Asian currencies because they offer a lower cost of hedging while still offering protection against adverse currency moves." Looking forward, the FX market as a whole looks fairly benign in 2014, with record-low volatility causing widespread frustration among both banks and investors at the lack of tangible trading opportunities. The concern is that in in such an environment, corporates may relegate currency risk further down the agenda, which could cause problems when the next EM currency falls. "There is a general feeling among our corporate clients that the current low volatility environment will continue. Despite potential pockets of emerging market risk on the horizon, they remain complacent and don't see the need to think about hedging. My view is that a low-volatility environment is a good time to put on hedges because once volatility has spiked it is often too late," says Mark Webster, global head of FX sales at Standard Chartered in Singapore. But such advice may be falling on deaf ears in some quarters and Webster acknowledges that the recent two-way risk in renminbi has not driven the kind of hedging activity that might have been expected. One driver could be regulation, which he believes is driving many to shorten tenors and look at simpler products as they assess the implications of new trading and clearing requirements. But it also boils down to the size and sophistication of each individual firm, which naturally impacts on the appetite for hedging. "There is often a big difference in the sophistication of hedging between large multinationals and smaller local corporates. Multinationals may look at risk reversals and rolling structures, but local corporates are mainly sticking to simpler, more vanilla forex," says Webster. Regulation drives NDFs to the brink In many Europe and North American markets NDFs account for such a small proportion of daily turnover some don't even report trading figures for the intrusment. In the UK, for example, an average daily volume of $43 billion was traded in NDFs in October 2013, according to the Bank of England's semiannual survey. That is less than 2% of the overall $2.2 trillion daily FX turnover in that month. But Asia's markets are different: with explicit, or implicit, capital controls a feature of pretty much all economies outside the main four financial trading centres of Hong Kong, Singapore, Tokyo and Sydney, NDFs have become a crucial hedging instrument for many corporates. Instead of going through the costly and resource-intensive process of accessing the onshore market corporates with exposure to capital-controlled economies in Asia can instead hedge their risks out offshore in large financial centres such as Singapore or Hong Kong via NDFs. The problem for corporate treasurers is that regulators are clamping down on the NDF market, making it a less viable instrument for hedging. The removal of benchmarks used to settle NDFs following concerns over bank manipulation has made the product much more expensive, while the international move towards central clearing as part of G-20 driven reforms of the derivatives market could make the product completely unviable, say treasurers. The recent move by the People's Bank of China (PBoC) to widen the trading band in which the yuan can deviate from the daily fixing rate has also had an impact. "In the past we did most of our renminbi hedging in the NDF market but now that the PBoC fixing rate can vary by up to 2% from the onshore spot rate, there is a potential basis mismatch of up to 2% and we don't use NDFs at all for renminbi. Central clearing is also going to have a whole series of negative impacts on the NDF market, including increased costs and reduced liquidity," says Damian Glendinning, group treasurer at PC manufacturer Lenovo in Singapore. Central clearing of NDFs could still be some way off; regulators in the US have yet to issue a mandatory clearing determination for the product and it will take European and Asian regulators some time to replicate such a move when it does occur. But Glendinning believes the comparatively low levels of liquidity in NDFs will kill the product if it has to be centrally cleared. "Ultimately regulation means we either have to deal with the inconvenience of onshore regulations or we have to go through a centrally cleared mechanism, neither of which are very appetising scenarios and both of which are going to be significantly more expensive. The onshore market is probably the route we will take, simply because to do central clearing we would have to install a whole set of processes we don't have today and it is not clear NDFs are sufficiently liquid to support central clearing," says Glendinning....
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