East West Bank Senior Managing Director and Head of Foreign Exchange (FX) Risk Management Michael Hayashida and Senior Vice President and Regional FX Sales Manager John Kimm help companies in the United States and China do business across the Pacific. Here they share specific tips on how to handle FX risks in order to get the most out of your cross-border business dealings.
Hayashida: That largely depends on whether we’re dealing with an importer or an exporter, and it also depends on which side of the market to which they’re exposed, and on the relative value of the renminbi to the dollar at any given moment in time.
There has been a depreciating trend of the RMB relative to the USD over the past number of weeks. A lot of that could be attributable to the perception of overall unrest in the global economic landscape, a perception that the Chinese economy is slowing down, global geopolitical unrest, etc. – all of these things can contribute toward uncertainty in the market. Greater uncertainty leads to greater volatility, which is why we always work with our customers to understand what their specific situation is, and what their “pain points” are. Right now, the renminbi is relatively weak against the dollar, which potentially allows U.S. companies importing from China to get more “bang for their buck,” so to speak. The flip side would be the best scenario for a U.S.-based exporter to China, because a stronger renminbi means that there’s more value when the exporters convert their renminbi receivables into dollars. Our job as FX advisers at East West Bank is to really monitor the markets proactively on behalf of our customers and to offer them guidance on favorable market conditions, in an effort to help them time their payments appropriately.
Unfortunately, we can’t predict the future. There’s actually a running joke in the world of FX that I’ll share with you guys. There are 10 FX advisers together in a room; how many opinions do you get? [PAUSE]. The answer is 20, because everyone can argue both sides of the market, and they are always hedging their own bets! The fact of the matter is, no one really knows. If we did, with all due respect, we wouldn’t be here working right now – in fact, we would be out there somewhere enjoying “the good life!” It’s market uncertainty that creates an opportunity and need for our services and solutions, which ultimately are geared toward risk management. We’re in the business of helping our customers make sense of marketplace uncertainties, and strategically positioning them in the hopes that they may effectively capitalize on both market upswings and downswings.
"Dual-currency invoicing…is a fantastic tool to determine which currency (USD or RMB) would be advantageous to make a payment in."
Kimm: If you have a contract to buy or sell products in China – let’s say you’re an importer of a product in the U.S. with a provider in China – the U.S. client should ask the Chinese provider for two different invoice quotes. Once you get the two currency quotes for a given period of time in which you’re buying the product, what you can do next is to do a synthetic dollar pricing using the derivative market. This way, we can see what the equivalent dollar price is for the renminbi quote and also get a dollar quote to do a dollar-to-dollar comparison. This is a sure way you’ll be able to immediately see which currency will work best for you. While this is an option feature that the supplier doesn’t easily agree to, it’s a good way to decide clearly which currency to use for payment. It could be for an invoicing period, or it could be for a long-term purchasing period. Whatever period it is, you want to lock in the cost and ascertain your operating margin. This will make your transaction and business sustainable for that period of time. It’s not rocket science.
Hayashida: What John [Kimm] just referred to was what we call in industry jargon “dual-currency invoicing.” I think it’s a fantastic tool because it can put businesses in a position of control to determine which currency (USD or RMB) would be more advantageous to make a payment in, depending upon prevailing market conditions.
Kimm: One of the elements of dollar pricing is that the Chinese provider may have some, what I call “transmission cost,” which is padding or cushion built into the dollar price. So if you ask them for the price in renminbi, those transmission costs will evaporate. The synthetic dollar equivalent of renminbi pricing should be lower than the dollar price for the most part, because the Chinese supplier has a tendency to build in other costs into the dollar price that aren’t always transparent to the client.
Hayashida: Another thing to consider when you’re dealing with the whole notion of a “dual-currency invoice,” in addition to the control factor, is visibility and transparency in the price component. By requesting an invoice indicating totals in RMB, in addition to USD, what you’re simply asking as an importer is to receive the local currency price tag, as if you were a local customer. That way, the importer is communicating that they would be willing to potentially take the foreign exchange risk away from the supplier. It puts importers in a position where they could conceivably negotiate better pricing with their supplier, depending upon market conditions.
Also, I think what we’ve failed to mention here is the flip side – to highlight the potential benefits for exporters as well. By dealing with the local currency, a U.S.-based exporter dealing with China can potentially position itself to be more competitive in the marketplace. Say that a U.S. exporter wants to deal in dollars – that puts the onus on the overseas customer in China to deal with the FX risk. The Chinese customer has to deal with conversion costs on its end, while dealing with the administrative burden of managing the FX risks too. Furthermore, nine times out of 10, it’s more costly to conduct FX management overseas than it is to do it here in the U.S. – especially given the benefit of “economies of scale” resulting from higher trading volume and overall access to liquidity. So, if a Chinese customer dealing with a U.S.-based exporter has to deal with dollars as opposed to renminbi, it could potentially diminish its purchasing power because of all the fees, costs and risk management efforts involved. By allowing Chinese customers to deal with their local currency, not only can it create the perception that the U.S. exporter is more competitive in the global marketplace; it could also enhance their relationship with their Chinese customers, and might even encourage more sales.
Kimm: The key point to focus on as an exporter is to make sure that your buyer is making their purchasing decisions with some degree of confidence. Your export needs to be competitive and that comes from being able to compete in the same currency as your competitors. One point to remember is to choose the currency that pervades in the retail market. What is the final currency of the purchase of that product? If you’re an exporter, at some point, there’s going to be a buyer in China using renminbi so, theoretically, you should sell in that currency. The other larger point is to think about currency risks. In the spectrum of conversion rates and risks, the entity that has a better balance sheet and stronger financials should bear the burden. In an extreme case, if the weaker business partner takes the hedging burden and ends up not being able to have enough credit or lacks cash flow, they might risk going out of business. As sales involve other entities, you don’t ever want to risk losing a business partner and, hence, sales.
"Your export needs to be competitive... One point to remember is to choose the currency that pervades in the retail market."
Hayashida: It’s a matter of timing. Let’s say you have an importer sourcing supplies from China. They may have regular and recurring needs when dealing with a supplier, and they know that there’s going to be a certain amount of exposure. Generally, we encourage importers to be thinking about managing their FX risk simultaneously when negotiating their purchase orders with their suppliers.
For example, if there’s going to be a firm commitment exposure, meaning that there’s a penalty for nonperformance, then the parties involved have to make good on this transaction or else there will be some type of consequence – usually financial and/or legal. There are specific FX risk management tools, all of which ultimately enable a customer to lock in an exchange rate today in anticipation of a future payable or receivable need. Particularly if the payment terms are extended from 30 to sometimes even 90 days or beyond, the customer could be sitting on a pretty significant period of exposure where the renminbi relative to the U.S. dollar could move quite a bit.
There could also be other situations where the underlying renminbi exposure isn’t quite as firm. Maybe there’s an ongoing negotiation and there’s a distinct possibility that the exposure may completely evaporate, or the deal itself may not ultimately be consummated. There are other types of hedging instruments that we can offer in this case to confer greater flexibility to the customer, giving them the right but not the obligation to buy or sell currency at a specific rate of exchange at some point in the future.
So, really, a lot of it comes down to understanding what the customers’ ultimate objectives might be, what their risk tolerance or appetite might be, and to the extent that we can get involved with our customers’ international payment needs as early as possible – whether it’s during the contract negotiation phase, or when customers are still just trying to delineate their cash flows and budgets – that’s where we, as FX risk management advisers, feel like we could add the most value to our clients. Timing truly is everything when it comes to FX exposure management.
Hayashida: We’ve now touched upon the basic aspects of FX risk management. The basic hedging instruments used most commonly are the Forward Contract, the Non-Deliverable Forward and the FX currency option. Think of the Forward Contract like a credit card. It’s the whole concept of buying now and paying later, and it’s built on the notion of locking in an exchange rate today in anticipation of a future payable or receivable need. The benefits, of course, are: 1) It helps to ease some of the cash-flow burdens for our customers, since they’re not required to make full payment up front – not until the final settlement date, and 2) It can provide certainty for budgeting and calculation purposes by allowing our customers to deal in fixed quantities.
The currency option, which is on the opposite end of the spectrum as far as FX risk management tools are concerned, can be likened more to an insurance policy, where you have to pay a premium up front for that peace of mind protection – whether or not you use or need the protection. It’s one of those things where you want to protect yourself against a potentially disastrous scenario, but no one takes out an insurance policy in the hopes that they will ever have to make that claim. The option allows customers the flexibility and the holder gets the right, but not the obligation, to buy or sell one currency for another at a specific agreed-upon rate of exchange, for settlement or delivery at some specified point in the future.
So, somewhere along this spectrum, depending upon what the customer’s needs might be, we try to work with them to understand their objectives and risk appetites, and ultimately create a customized FX risk management solution for our customers.
Hayashida: It does, because it’s really part of a broader expansion effort known as the International Trade Settlement Scheme propagated by the Chinese government and the People’s Bank of China. What this indicates is that China is trying to encourage more companies to use the renminbi for cross-border transactions for anything with a trade-related settlement component, but this mechanism also applies to cross-border services with China. As long as there exists a legitimate business reason for a cross-border transaction with China that is ultimately approved by China’s State Administration of Foreign Exchange (SAFE), we can help facilitate these cross-border transactions through our FX services and solutions.
Often, our customers would need to submit supporting documentation as evidence that there is a legitimate trade or service underlying the requirement to justify payment in RMB. That’s the first step. Businesses need to understand the regulatory environment, and for someone who is uninitiated, it can seem very intimidating and overwhelming. So, by having that initial consultation with us, we can provide the appropriate guidance to our customers, and better understand their risk and cash management objectives. As we are able to further drill down to understanding the customer’s specific situation, such as payment frequency, cash flow needs and exposure amounts, we are then able to eventually guide businesses toward a higher-level discussion on how to effectively manage all the currency risks associated with their proposed cross-border transactions.
It really comes down to understanding what the customer needs are, what their objectives are and ultimately helping them to appropriately align those within the framework of an often complex Chinese regulatory environment.