Monday, August 24, 2015

Foreign Currency Debt: Free Lunch or Expensive Banquet?

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.


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