Dr. P.V. Viswanath

pviswanath@pace.edu

The importance of financial flexibility

GREGORY BROWN. Financial Times. London (UK): Sep 9, 2005. pg. 3
By Gregory Brown

Financial risk management is not something that should be considered in isolation. If they are to respond effectively to changing conditions, executives need to incorporate financial flexibility into overall corporate strategy.

The financial success of today's major economies is unparalleled in history. In the broadest sense, the success of economies in the developed world is attributable to corporations specialising in their areas of comparative advantage. Few would argue that the operational strategies of businesses are not the primary source of profits. However, a growing academic literature suggests that corporate financial strategy, as well as fundamental characteristics of the financial environment, can also play an important role in the success of business. For example, recent research has shown that access to developed capital markets is crucial to determining which companies are able to obtain external financing - even in their home country. Since rapidly growing businesses usually rely on outside capital, access to these markets (whether debt or equity) is essential.

For corporations in developed economies, there is little or no problem. But for those in newly developed and developing economies, accessing lower-cost foreign capital markets is both a challenge and a potential source of comparative advantage. The tactics used by emerging market companies to access developed capital markets, such as foreign equity issuances and collateralised foreign currency debt, are just simple examples of the sometimes very sophisticated financial strategies employed by modern companies. Other common examples include exotic types of structured financing, operational hedging and strategic applications of derivative securities. The watchword that is emerging from both practioners and academics is financial "flexibility".

In the old days, chief financial officers and corporate treasurers spent much of their efforts on cash management and minimising the cost of capital. While these are still important activities, there is a growing appreciation for the broad range of financial activities that can have a real impact on a company's bottom line. Consequently, chief financial officers are increasingly important in top-level strategic decisions - and not just to run the numbers for a proposed project, but to understand the strategic implications of a particular decision.

PoGo's predicament

Consider the hypothetical company PoGo Industries, a US-based manufacturer and distributor of children's toys. PoGo ships some of its products overseas but this revenue has never accounted for more than 10 per cent of sales. Consequently, PoGo has not considered foreign exchange (FX) risk to be a major concern. However, last year PoGo started to lose significant US market share to lower quality, but cheaper, toys produced in China. Although PoGo was clearly being affected by foreign competition, the company's CEO and CFO differed on the fundamental source of the problem. The CEO believed that low labour costs in China were the issue, whereas the CFO believed that the undervaluation of the Chinese renminbi was at fault.

In reality, both are potentially important and related issues facing the company. Understanding these types of non-trivial financial and operating problems requires a deep understanding of financial risk management strategy. Just as importantly, it demonstrates the importance of financial flexibility. Large corporations have become accustomed to hedging FX risk. This process usually involves quantifying the exposure in an appropriate way and then using some combination of operating and financing policies to mitigate the risk. These might include carefully choosing the location of production, the currency denomination of debt and the use of FX derivatives, such as forward contracts or options. If we apply this logic to PoGo's predicament, it becomes necessary to determine PoGo's exposure to the Chinese renminbi versus US dollar exchange rate. Because PoGo has no sales, costs or operations in China, traditional accounting methods for calculating FX exposure are not useful. Even non-standard techniques, such as correlating earning or stock returns with exchange rate movements, will be fruitless, because the renminbi (until recently) has not fluctuated in value against the US dollar. What should PoGo do?

Management must rely on its expertise in the US toy market to trace out the effect on their business of a variety of future exchange-rate scenarios. For simplicity, we will consider just two here. The first possibility is that the recent announcement of a renminbi revaluation is a largely political move that will have little effect on the future exchange rate. The second possibility is that the renminbi will appreciate 30 per cent over the next two years as the Chinese monetary authorities bring the exchange rate more into line with commonly cited estimates of the currency's market value. PoGo faces some tough choices if the exchange rate does not change. Ignoring the problem will likely lead to bankruptcy as the company continues to get priced out of the market. Simple financial hedges such as issuing foreign-currency denominated debt or trading derivatives provide no solution, since the FX risk comes from exchange rates remaining fixed, not exchange rate fluctuations. For PoGo, the best outcome is likely to be a political bail-out if somehow management could convince the US government to put protective tariffs on Chinese toys. However, PoGo management's survey of the political landscape suggests that this is unlikely.

Another option is to build a factory in China, which could considerably lower the marginal cost of toy production. However, management identifies several drawbacks to this option. First, the company has historically been very loyal to its employees. Making redundant the majority of its local workforce could result in low morale among those remaining. In addition, other US-based manufacturers moving production to China have endured unflattering public criticism that has permanently eroded the goodwill of strong brands. Finally, and perhaps most importantly, building a Chinese facility is a costly affair and exposes the company to new risks. These include the uncertainty of operating in a new business environment and even government expropriation.

Outsourcing

PoGo considers one other option under the assumption that the exchange rate remains unchanged. This entails partnering with a Chinese company that would undertake manufacturing under contract. Outsourcing has the advantage of low committed capital (including low capital risk). In addition, PoGo would have the ability to change suppliers or use multiple suppliers. However, this flexibility will come at a cost, since PoGo will lose some control over the production process, and logistics will become more complex. In summary, PoGo's senior management perceives substantial financial risks, even in a scenario where FX rates remain unchanged. PoGo's management also needs to consider its options if the renminbi appreciates by 30 per cent. On the surface, this seems like a considerably more positive scenario. An internal study suggests that a 30 per cent move in the exchange rate more than levels the playing field for PoGo since the company has a highly productive US workforce, a strong brand and economies of scale in the US market (compared to the relatively diffuse Chinese producers). In this scenario, PoGo decides the best thing it can do is nothing - simply continue doing business as it always has and reap the rewards of the FX adjustment.

So, let us review. PoGo has an atypical, but major, FX risk. If the exchange rate remains at near current levels, PoGo must find a way to compete with lower-cost manufacturers in China. Most likely, this will entail producing some or all of its toys in China. If the renminbi appreciates, PoGo should keep production in the US. So, for PoGo, the preferred operating decision, and potentially the viability of the company, depends crucially on the future exchange rate.

The rub

While each exchange rate scenario has a possible solution, there is no simple strategy that works in both scenarios. For example, committing to building a facility in China would be a horrendous mistake if the renminbi appreciated significantly. The company would have invested considerable (hard as well as soft) resources and ended up with a less productive and more logistically complicated production process. Likewise, if the company chooses to do nothing and the renminbi maintains its current level, the company will die a slow and agonising death. So what can the company do?

In theory, it must devise a strategy that enables it to be profitable in both exchange rate scenarios. The simplest possibility it could consider is to move some, but not all, of its production to China. This would soften the blow compared to an all-or-nothing strategy. However, it almost certainly will lead to lower profits than the company has obtained historically. A better strategy will allow the company to prosper in each scenario. Obviously, a more comprehensive solution is necessary. PoGo's management must ask themselves what their comparative advantage is and how they can maximise profits utilising that advantage. Compared to its import competitors, PoGo is a household name in the US. Furthermore, the few sales it has outside the US come from high-end retailers with customers who value the quality associated with the PoGo brand. The answer to PoGo's FX problem is likely to come from exploiting its brand name in foreign markets, including China. If PoGo can aggressively expand sales in undertapped European and growing Asian markets, it could satisfy the greater demand by creating a production facility in China in addition to its existing US facilities. With multiple facilities, PoGo can react to exchange rate movements by shifting some production to the location where it is most profitable. The academic literature would describe this as using an operational FX hedge to create a "real option." But this is not the end of the story.

Flexibility is the key

Simply identifying a possible solution is not the same as being able to implement it. Rapidly expanding overseas sales while at the same time building production capacity in China is likely to be a financially exhausting endeavour for PoGo. The company has only a small amount of debt but, as a consequence, it also has little access to the public bond markets. An equity issue is always possible but could be costly in terms of the impact on existing shareholders. In retrospect, the company should have maintained access to the capital markets. For example, the company could have kept at least one public debt issue outstanding. It also could have developed better relationships with global and foreign banks instead of relying on its primary relationship with a regional bank. Ideally, PoGo would have identified its risk years ago and obtained the necessary financial flexibility to execute a variety of operating strategies. This means that PoGo needs to find some creative solutions to a major financial constraint.

To diversify the sources of funding, PoGo might consider joint ventures with foreign producers or distributors. Accessing Chinese debt capital markets is a challenge because of the lower level of development. In addition, borrowing in renminbi coupled with a significant appreciation of the renminbi, would lead to a substantial increase in the US dollar value of liabilities. In this case, foreign currency debt could actually increase FX risk if revenues are denominated in (or highly correlated with) the US dollar. An exotic solution to the financing problem could come from structured debt where interest and principal payments are tied inversely to the renminbi exchange rate, so that an appreciating renminbi lowers the value of liabilities. An instrument like this might be sold publicly, negotiated as a private placement or created synthetically with derivatives by a major bank or derivatives dealer.

A general lesson

The real lesson to be learned from PoGo's predicament is that FX and other financial risks are not a concern because of what they might do to the next quarter's earnings. Instead, financial risks can fundamentally alter the viability of a business model. As a consequence, senior managers as well as financial managers must fully understand the long-term effect of financial risks and develop the financial (and operating) flexibility to hedge these risks dynamically. In this article, we have considered just FX risk in detail. However, there are many examples of other risks that businesses must carefully consider. For example, the financially troubled US airlines did not understand the long-term financial risks posed by an increase in oil prices combined with a decline in demand. An exception was Southwest Airlines, which did and protected itself accordingly. Some analysts even believe that Southwest bludgeoned the weaker airlines by increasing its hedging when other airlines were forced out of the jet fuel derivatives market. Another example comes from examining the relationships between interest rates, aggregate economic activity and a company's bottom line. For example, financial managers in businesses where high interest rates lead to weak sales (such as the consumer durables and construction industries) should have dynamic financing strategies that lower the cost of capital in the event that interest rates rise. Financial risks are usually correlated with the fundamental business risks of a corporation. As a result, financial risk management is not an activity that should be left to the corporate treasurer alone. Managers need to incorporate financial flexibility into a corporate strategy that allows for a variety of responses to changing financial conditions. As the world becomes a more integrated marketplace, the fortunes of global companies, economies and consumers will become even more interwoven. Financial managers who understand the complexities that arise from such interactions will be able to help lead their companies through trying and uncertain times.