Currency Fluctuations in the New Economy
Helen Mallovy Hicks
Vanessa Iarocci, a former vice-president in the Corporate Finance practice and editor of PwC's Capital Markets Flash, and Rozanne Kibel, a director in the Corporate Finance practice, talk about the ups and downs of currency in these challenging economic times.
Dean: Welcome to Strategy Talks with Dean and Helen, part of the PricewaterhouseCoopers Managing in a Downturn podcast series. I'm Dean Mullett, co-head of our Restructuring and Distress Strategy Group, and a member of our Credit Crisis Task Force.
Helen: And I'm Helen Mallovy Hicks, a Partner in the Advisory Practice of PricewaterhouseCoopers in the Dispute Analysis & Valuations group.
Dean: The current state of the economy is understandably of great concern for most Canadian businesses. This series of audio podcast discussions with a variety of subject matter and industry guests are designed to help your business weather the storm by exploring some of today's hottest issues related to the economic crisis.
Helen: Today we have with Vanessa Iarocci, vice president of PwC's corporate finance group. Vanessa is also the editor of PwC's Capital Markets Flash. As well we have Rozanne Kibel a director in PwC's corporate finance group. Vanessa and Rozanne will be discussing the ups and down of currency fluctuations in today's volatile economy. Welcome Vanessa, welcome Rozanne.
Dean: Maybe to start off we can talk a bit about a brief overview on recent currency fluctuations and what the impact is on the Canadian marketplace.
Vanessa: You know, in the early days of the economic crisis we saw a temporary flight US dollar safety and appreciation in the green back but since February on a trade weighted basis the US dollar has depreciated by close to 15 percent, and in contrast, the floating rate currencies of it's main trading partners with the exception of those in Europe have appreciate in come cases as the Canadian dollar close to 20 percent. There are two key devastating impacts for Canada. Firstly Canadian dollar appreciation makes if difficult for the bank of Canada to achieves its 2 percent inflation target, which frustrates monetary policy and secondly while we may view ourselves a commodity rich country it is important to remember that 54 percent of our merchandise trade is still generated by the manufacturing sector.
Dean: Wow, that's a big number. So when the US dollar does what it's been doing in the last few weeks, that really makes us loose a lot of competitiveness and exporting.
Vanessa: Yes it does, Rozanne actually has quite bit of experience in the manufacturing sector and can speak to some specifics.
Rozanne: Before we jump into the answer of how it's affected Canadian manufactures, I think it's important to understand just how big a piece the economy manufacturing is. We hear a lot about commodities, we hear that Canada is a commodity based country but the reality is that the manufacturing accounts for 14 percent of GDP. It's the second largest segment and then if you contrast that to commodities you account for 4.5 percent.
Dean: Wow and most people would not know that especially when you read the press.
Rozanne: So it's a big part of the Canadian economy. I think that when you look at the median and you look at overall comments and sentiment in the country, I think that everyone's missing a really big part of the picture.
Dean: So if you play that out and you look down the road even two, three, five years — oil going up in prices is obviously going to benefit the west. But if the Canadian dollar strengthens side by side there is an argument there that there is a direct correlation.
Rozanne: The petro Looney.
Dean: The petro Looney. Ontario, probably Quebec, which are both big manufacturing bases are going to feel a lot of pain created by that correct?
Rozanne: Exactly, if you look at the simple number you look at the Canadian dollar that historically has traded around 70 cents so convert that Canadian to US is about $1.43.
So if someone was selling something into the US, they are getting paid a dollar for it, US and they were converting that worth $1.43, but the dollar rises and it's at par, all of the sudden that company is loosing a big chunk of what was their revenues. That goes back to how Canadian manufacturers historically have been able to inflate their profits or their revenues based on the currency.
Now the middle to end of 2007 I think a lot of companies were knocked right off their feet, with that phenomenon, but there are still companies who managed to scrape by and managed to stay in business. But the reality is that if you want to be able to make up that gap from 70 to 92 cents that means that 26 percent drop in your revenues. So effectively, unless you have an operating profit of over 26 percent you're now loosing money.
Helen: And it drops straight to the bottom line.
Dean: There is no other input around it right? Unless you can look at your inputs coming from the US and match them up perhaps, hopefully mitigate some of it I guess. But in general, your labours, it's going to be Canadian dollars because it's located here, your overhead located here. So how do companies get around that? Because not too many companies can loose 25 percent of their profitability and still be around.
Rozanne: The way companies have to get around that is increasing efficiencies. They've got to get smarter about the way they do business, they have to control their costs, and they can do soft natural hedges, like you just mentioned. Matching their costs with their sales, matching buying inventory and the currency that they're selling in, things of that nature, but I think the largest focus that they should be looking at is how to make their business more efficient.
Helen: Yeah because a hedge contract is a temporary solution and it's only going to as the currency fluctuates, a hedge isn't going to fix it, and it's not going to take you back.
Rozanne: That's exactly it. And if you're using a synthetic hedge, some kind of financial instrument like an option, a forward, a future contract, those work well in a predicable environment. When you look at fluctuations, getting caught on the wrong side of that hedge could be more damaging then not having a hedge at all.
Helen: And what is the outlook for foreign exchange, is the expectation that is going to be more wild fluctuations? Is it going to stay where it is? Is it going to get worse? Vanessa?
Vanessa: Well undoubtedly we are in store for further volatility, the quantum however is difficult to predict at this point because there are four forces at play that are arguing for continued volatility. The first driver is a return to risk, due to improved economic data; the second driver is quantitative easing, specifically in the US and the UK. The third driver is competitive devaluation, specifically by the trading partners of the US and the fourth is the phenomenon of commodity currencies, such as the Canadian dollar or the Australian dollar.
The first is the roles of the US dollar as a safe haven, interestingly in times of economic uncertainty global investors typically sell out of foreign denominated positions and out of foreign markets and buy US dollar denominated assets, such as treasuries and we saw in the early days of the crisis quite a run up in US dollar because of this phenomenon. In recent days global equity strength is resulting in the opposite. So capital is flowing out of the US back into global equity and debt markets and as the economic data hopefully continues to improve we may see further downward pressure on the US dollar due to this force.
Dean: So this so I understand, we're at the height of the crisis, even though the US was the epicenter of the crisis people flooded into it. So basically it seems like you're running into the storm, to some degree.
Dean: But the risk, if I'm hearing you correctly was the other economies around the world were either emerging or whatever, they thought there was more risk in those economies failing than the US, even though the US was riding all kinds of new debt.
Vanessa: Exactly and there was a general capital outflow out of equity markets and in terms of debt securities the US currently offers quite a plethora of safe, US dollar denominated treasuries and treasure bill notes and such. The second driver is competitive devaluation and with few interventions tools left, and what I mean by that is we're hitting the lower bound of, as low as interest rates can go, there is very little left to do.
Dean: You can't go negative?
Vanessa: That would be very bad. So with few tools left, some countries are simply coming right out and saying that they will intentionally devalue their currencies. So in March this year, Switzerland officially announced that they were going to devalue the franc because they had lost a big piece of their trade competitiveness. Just last week, South Korea, which is entirely dependant on exports, announced that they would likely be engaging in competitive devaluation strategy as well.
Helen: Doesn't that get to be mug's game, because one devalues their currency the next jumps in and now we're...
Dean: Spiral down...
Vanessa: Exactly, this is why it's difficult, perhaps an over simplification to suggest that you can quantify which way what currency will go when, it's a little bit of a race to the bottom.
Helen: Yeah and with a country like Switzerland jumping in that really sets a precedent.
Vanessa: Exactly. The third driver of further volatility is quantitative easing and this is a term that probably until recently had been relegated to economic text books and now we see it on the front page of newspapers. What quantitative easing or QE is, in simple terms, is an increase in the size of a central bank's balance sheet and accompanied by an increase in the supply of money. How this is achieved in normal circumstance is the central bank going out and buying assets and injecting into the system.
Practically speaking, most recently what's happened is the US and the UK central banks have gone and bought mortgage back securities and Fannie Mae and Freddie Mac debt so they've provided financial institutions with liquidity and taken all those assets back onto their balance sheet. So theoretically what should have happened was that money should have circulating in the system, should have been an increase in the velocity of money, we should have inflation, which is a devaluation of the currency.
But banks have no increased their lending; they've increase their reserves, so we have yet to see the inflationary impact of the stimulus activities of the US and the UK have been engaging in the last 15 months. Now should these banks actually inject back into the system, we will see start seeing some inflation and perhaps even more seriously should the US and UK central banks be unable to reserve their QE, unable to sell back those assets in the market and take the money out of the system, then inflation spirals out of control.
Dean: Sort of hyper inflation comments that we've heard the risk in that.
Vanessa: Right and I'm not sure if there is exactly a line up of buyers for Fannie Mae and Freddie Mac securities, so it is quite a risk.
Helen: I think there is a huge uncertainty in the market right now how those assets are going to be sold back.
Vanessa: That's right. In fact the only situation in which the QE strategy that the US and the UK have embarked on, the only way that that won't effect the currency is if the central bankers were somehow magically able to inject the exact amount of liquidity into the system that was lost via financial institution losses and I think that would be quite the feat if that turns out to happen.
Dean: It's like a genie in the bottle thing. So I guess we're running down on time here but if we're a Canadian company and we're operating in this environment, this volatile, foreign exchange environment, what kind of things would we suggest they start looking and thinking about to make sure that they're doing the best they can to manage the impact of FX volatility on their business?
Rozanne: I think that they place were you want to start is really looking at your true exposure and that means taking a good look at where your selling to and where you're buying from and seeing if you can match those up.
Dean: In your experience do you find that companies do a good job of evaluating that?
Rozanne: No I don't, I don't think they do a good job of evaluating and I don't think that a lot of companies do regular sensitivity analysis just to see what the impact of a sudden move could be and I think that's what people should be turning their attention to. To understand and recognize that we're in volatile times and there are wild fluctuations, up 20 percent, down 20 percent in the last little while and being able to recognize how that's going to impact your business whether it's happens or not puts you on a firm forte of being able to deal with the situation when it does happen, if it happens.
An appreciation of the Canadian dollar is going to bring more competitors to the market, so it's a problem for everyone and it's not just a problem for companies that are exporting goods outside of Canada, it's a problem for companies that are manufacturing goods for people inside of Canada. It's not a one size fits all, it's not just one sector of market that needs to be worrying. I think it's a Canadian issue, it's a Canadian manufacturing issue and I think that everyone should address the concerns that are out there.
Helen: What are we seeing out there? Are we seeing companies react or be proactive to this?
Rozanne: I think we're seeing companies at the moment still be reactive, just to the issues. I think companies are still trying to deal with what they've been thrown into over the last few months. But I think companies are starting to think smart about it.
Dean: One of the things that we've seen is sometimes the biggest changes are born out of necessity. So if you want to survive you have to do things perhaps you were uncomfortable doing in the past. I think the currency be a thing that actually might make people make some of these changes that they haven't made in the past. So that maybe Canadians manufacturers do become more world class than they may have been in the past and they had a pretty good comfort zone.
Rozanne: That's an interesting point. If you look at some of the big earnings announcements that have come out through this downturn, you'll see revenues are down 10 percent, income is up 15 percent and that's all about managing your costs and managing your businesses correctly. And it's true when people are pushed to the wall, it's time to come to the party and it's time to do what you have to do to make sure your business is viable. You know a little bit of bad news, it weeds out the weak players; it brings out the whole standard of business in Canada and of manufacturing in Canada. It actually leaves the stronger more viable future. I think that's important to note.
Dean: Yeah in particularly, when we start looking at global competition that's out there and everyone always thinks about all the manufacturing that's going to places like China, India etc. but you know we can get a share of that market if we can compete naturally that's what it comes down to.
Rozanne: And another great news story with the depreciating dollar is the fact that a lot of the technology and a lot of the state of the art machinery that's coming out of the US and guess what it's on sale, so why not go down and have a look?
Dean: That's actually a very valid point and it turns a negative into a positive which I think for Canada I think we get a lot of headlines talking about the dollar, talking about the downturn and the economy but there are opportunities to reposition our place in the world economy. I think Rozanne's last point is a great one to end and really take that and try to seize it and try to build the better business base for the future.
Helen: Thanks Vanessa and Rozanne for joining us today. For more information please download our latest capital markets flash from our Managing in a Downturn webpage at pwc.com/ca/managinginadownturn.
Dean: This concludes this episode of Strategy Talks, part of the PricewaterhouseCoopers Managing in a Downturn podcast series. I'm Dean Mullett, thank you for listening.
Helen: And I'm Helen Mallovy Hicks. We hope you'll join us again soon for another episode. To download or to subscribe to this podcast series or to find more information on this topic, please visit our Managing in a Downturn website at pwc.com/ca/managinginadownturn.
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