With a high Australian dollar, companies should revisit their risk management strategies and implement good hedging policies, writes Craig Donaldson
While the high dollar is generally good for Australian tourists overseas, the flip side of this is that the high dollar makes Australian exports more expensive – presenting a significant number of risks to some sectors of the local economy.
Manufacturing, tourism and agriculture are some obvious sectors that suffer from a high Australian dollar, and companies operating in these sectors would do well to revisit their risk management strategies and make sure they have sound hedging policies in place, according to experts.
“The rising Australian dollar is a complete disaster for the manufacturing/exporting sector,” according to Richard Hughes, founding director of Visual Risk, a software and consulting company which specialises in market risk management.
If the Australian dollar is sustained at its current high levels it will fundamentally damage a lot of Australian exporters who produce goods, he says. “We don’t have enough manufacturing exporters as it is because our manufacturing sector is already in long term decline, so we really don’t need that.”
For the resources sector, Hughes says that the high dollar is eroding profitability, although resources companies are picking up the benefit of high commodity prices which significantly offsets the cost of the rising dollar. “The fact of the matter is the high Aussie dollar is hurting them a lot as well because they’re selling commodities denominated in US dollars. So when they bring those dollars home it costs them a lot to buy the Aussie,” says Hughes.
“But if, for example, you get an unusual situation where commodity prices collapse and the Aussie dollar stays high, they would get hit with a double whammy. In this nervous market, anything could happen right now.”
Global forces at play
While the dollar usually drops if commodity prices collapse, Hughes says the world “is a little bit different now. Nobody knows what the ‘new normal’ will actually be.”
The main issue now is extreme risk in the world’s strongest currencies, which are the US dollar, the Yen and the Euro, because of government deficit problems. The strongest countries on the planet all want their currencies to be weak to make their exports cheaper, boost trade and subsequently stimulate growth in their economies.
“The world’s financial markets are very unstable at the moment, and with most major currencies weak, our strong Aussie is collateral damage from that. This aberration is not a function of Australia’s strong economy so much, but rather a function of US dollar weakness, and that is our big problem,” says Hughes.
The Australian dollar is currently around the fourth or fifth most traded currency in the world, whereas the Australian economy is about the 13th or 14th biggest economy in the world. This anomaly indicates that “we are, as a currency, punching way above our weight in terms of popularity with global investors”, says Hughes.
“The only reason that the currency’s traded as much as it is because Aus is seen as a relatively stable economy, but the AUD is seen as a good commodity/China market play. So it’s a highly risky currency and it’s prone to fairly violent swings.”
Currency risk management
As such, Australian companies need to be careful of currency shocks and keep a close eye on overseas markets. “Risk managers shouldn’t only look domestically for risk factors, because the real danger lies offshore. I think there’s a dangerous level of complacency in Australia right now in terms of risk management,” says Hughes.
“Many people think we’ve dodged a bullet from other market shocks quite often in the past and, fingers crossed we can continue to do that, but I think it’s a very dangerous assumption. My takeaway comment is that companies should take care.”
Companies should spend more time on their risk management than they have been in the past because “right now they are facing more risk than they have ever faced in the past”, says Hughes.
“My advice to senior management is to focus more attention onto risk management and make sure that their cashflows that are exposed to market risk are hedged sufficiently so they can deliver some certainty as these are the cash-flows needed to sustain the business.”
Hughes adds that he is very nervous of the current markets. “I don’t believe anyone of our generation has seen a combination of financial risks of this nature before, so my key message to business is to take great care.”
Currency risk management planning
There are six basic principles organisations should have in place to manage market risk:
1. Understand and quantify the organisations’ risk exposures (worst and best case). It is useful to perform scenario models and sensitivity analysis on worst and best case situations.
2. Determine the organisations’ risk tolerance. Determine its need to take risk.
3. State the organisations’ risk management objectives and hedging approach. What are the risk management objectives of the organisation and how will credit, operational and market risk of the business be managed? When deciding upon a hedging strategy the core problem is to strike a balance between uncertainty and the risk of opportunity loss. In establishing the balance, consider the risk aversion and the risk preferences of shareholders.
4. Define risk metrics and policy guidelines. Risk metrics are a set of financial models used by the organisation to measure financial risks. These include: standard deviation, value at risk, expected shortfall, marginal VAR, incremental risk, coherent risk measures and assessing risk measures.
5. Monitor, measure and report the risk. For more strategic and longer term risk management, it is time to go back to basics: measure, monitor, mitigate and report.
6. Review, stress-test and refine the approach.
Source: Corporate Financial Risk Management update, KPMG