I previously
discussed the need to cut thru the foreign exchange veil when evaluating
foreign investments. This post focuses on the flip side of the problem; namely
the risks involved when borrowing in a currency different from your home
currency. This issue has become topical given the recent surprise Chinese Yuan devaluation
relative to the U.S. dollar (USD).
Chinese firms were attracted to USD denominated debt for two
reasons. First, nominal USD interest rates are lower than Yuan rates. For
example, the current Chinese one year base rate is 4.85%-down from 5.6% in
January; whereas the one year U.S. Treasury is 30BPs and the prime rate is
3.25%. The second factor is Chinese credit to certain borrowers (e.g. property
developers) had tightened forcing these firms to seek alternatives.
Foreign currency borrowing mechanics are simple; borrow USD
and then spot back into Yuan. The nominal USD interest expense is lower than
Yuan denominated debt. Of course, this is incomplete as it ignores possible
foreign exchange losses.
Ignorance is bliss is fine provided the exchange rate of USD to Yuan stays
unchanged. If the Yuan weakens relative to the dollar, then it takes more Yuan
to service the same amount of USD debt. Essentially, you face giving up in the
future the benefits of the lower USD rates (AKA-there is no free lunch).
Whether the firm borrows USD or Yuan there is no value effect on a covered
basis. This is the teaching of interest rate parity
which Chinese firms are relearning.
Of course the Chinese firms could have avoided the Yuan devaluation
risk by hedging (e.g. cross currency swap).
The hedging cost would, however, offset the benefits of lower USD interest
rates. Many Chinese firms believed they did not need to incur hedge costs
because the Yuan would remain strong relative to the USD. This belief turned
into a delusion when the inevitable black swan event
occurred.
I experienced something similar when I was a banker. Swiss
rates were low compared to the USD at that time. My client borrowed in Swiss
and spotted into USD to fund his U.S. operations-all un-hedged. He received a
bonus on his ability to keep borrowing costs low. He argued his ability to forecast
exchange rates precluded hedging (which would have eliminated the illusory low interest
cost scheme and his bonus). Well, you guessed it, the USD weakened, losses
occurred, the CFO was fired, and the loan needed to be restructured.
Foreign currency debt can make sense is you have assets in
the country from which you are sourcing the debt. You have a natural hedge because the foreign assets produce, hopefully, enough foreign cash flow to service the debt. Thus, you are somewhat insulated from foreign exchange movements. This is why firms acquiring companies in other countries tend to
fund a portion of their foreign investments in the countries where the assets
are located.
My recommendation is not to speculate in exchange rates with
your firm’s balance sheet. If you think you can forecast exchange rates-then
join a hedge fund or do so thru liquid exchange trade instruments after
receiving your Board’s approval. Many Chinese firms are facing an extended
period of indigestion following their un-hedged USD borrowing “free lunch” adventures.
J
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