Developments in South Africa over the last few days present an opportunity to stress the essence of risk management in corporates of any size.
Daniel Ngwira,Chartered accountant
The rand tumbled 7% intra-day to close at 6% on Friday as the market disapproved the sacking of Pravin Gordhan as Finance minister, widely seen as a safe pair of hands at the national treasury in South Africa.
Markets were immediately sent into turmoil as news filtered that the national treasurer had been relieved of his duties. Standard & Poor’s subsequently downgraded South Africa’s credit rating to junk status on Monday. The country had last been in this status 17 years ago.
While street protests and spontaneous national and regional discourse ensued as a result, given South Africa’s importance on the continent and on the emerging markets lists, corporates and spot traders who were “long” on the rand were feeling the pinch. Writers of American currency options may have incurred unexpected losses. An American option is an option which can be exercised anytime during its life as compared to a European option which can only be exercised upon maturity.
Though mild compared to the market situation on Friday, the rand was under pressure in early trading. This came about as the new Finance minister Malusi Gigaba echoed the new economic concept he calls “radical economic transformation”.
Gigaba said: “The issue of radical economic transformation arises from a criticism that for quite a long time the structure of the South African economy has not been changed. We have not paid sufficient attention to the real economy, to industrialising the economy, to ensuring that we create entrepreneurs and industrialists, particularly among black people.”
Of course, South Africa is fortunate in that they will go into this with open eyes given that there are case studies in the form of Zimbabwe and Mozambique. The results are simple: a country scares away foreign capital.
In this paper I will not go into the economics of the minister’s statement except to focus on the financial risks that are posed by the developments in the most important economy in Africa. The immediate risk which is visible from President Jacob Zuma’s decision and the statement by his new appointee is the foreign exchange risk. It is a complex financial risk which arises due to changes in foreign exchange rates. Even before the recent developments in South Africa, foreign exchange risk was always there albeit amplified this time around due to the market shock.
Perhaps no over-the-counter market is as active as the foreign exchange market, supported by trades of over US$5 trillion daily. Foreign exchange rate changes affect all businesses in the global village we live in. They have an effect on the long-term survival of businesses, asset values and the cashflows of an entity. In reporting, accountants cover this risk through International Accounting Standard (IAS) 21 — The Effects of Changes in Foreign Exchange Rates.
The most common form of exchange rate risk is called transaction risk. In simple terms, it is the risk of adverse changes in foreign exchange rates on the cashflows of the business following a transaction where foreign currency is involved and payment is at a date other than the transaction date. There must be two important dates between the exchange rate fluctuations; the date a foreign currency transaction is entered into and the date the transaction is settled.
A simple example is when a sale is made on a given date in foreign currency with the settlement being made say after 30 days. Suppose a South African manufacturer, ABJ, had on March 1 sold some units to a Zimbabwean-based company, Zanorashe Enterprises, when the exchange rate was US$1=ZAR10.
Let’s suppose the South African entity has US dollar obligations to settle on the same date, whereas it would have received sales proceeds of US$100 at the rate of US$1=ZAR10, it can now receive US$94,33 at the new exchange rate of US$1=10,6. It means the company would have incurred an exchange loss of US$5,66.
Another form of foreign exchange risk is called economic risk. It is also known as strategic foreign exchange exposure. The present value of expected future cashflows from business streams will change due to fluctuations in foreign exchange rates and the result is economic risk. Even a company that does not make transactions in foreign currency can be affected by this risk for as long as its competitors are operating in a different currency environment.
There is a tendency, by entities that do not have foreign currency transactions, to ignore this very important risk. When changes in foreign exchange rates impact on a competitor who is in a different currency environment, they make adjustments to their business model, costs or prices. This affects the competitors in that cashflows
are altered as a result of the changes in the new operating environment as defined by the new exchange rates.
There are instances where an entity has to commit to a price before entering into transactions. This happens with export sales and when corporates enter into tenders.
For export sales, the company has to publish prices in the currency of the local market in some instances. With tendering, there may be costs which are denominated in foreign currency; however, the tender prices may be in a different currency. The tender board will expect prices in the currency of their country. In such instances what arises is called pre-transaction risk.
Finally, there is translation risk. This relates to non-cash exposures. It is best understood as relating to an entity’s accounting processes. No cash transaction is entered into and so it may appear like this risk does not matter. It is called translation exposure because it is about financial reporting rather than cash flows.
A UK company with a subsidiary operating in South Africa would note that the value of its assets in South Africa have fallen at March 31 2017 following the weakening of the rand. Modern organisations consider this a major risk in that it can alter the borrowing capacity of an entity; financial ratios which are in many instances included as debt covenants do change as a result of changes in foreign exchange rates.
While all banks are compelled to employ a treasurer, companies do have an option of not doing so. Increasingly, though, the role of the corporate treasurer is being amplified by the global crisis and shocks that have occurred over a period of time. This has also contributed to the evolution of treasury from liquidity management to incorporating the broader aspects of financial risk management.
Modern treasury covers financial management, capital markets and funding, cash and liquidity management, risk management and treasury operations and controls as core elements. Large corporates have elaborate treasury structures which report to the chief financial officer or the finance director. In many instances the treasurer is an accountant though it does not necessarily have to be like that.
In many entities, the corporate treasurer is a professional accountant. Unless they have related experience to treasury, they will be limited in scope as treasury is a highly specialised area which requires experience and expertise not normally found in traditional accounting roles and qualifications. In the United States, the chief financial officer is likely to have a treasury or banking background as most of the issues they deal with at that level are bound to be treasury related (finance).
Nonetheless, whoever is the corporate treasurer must prepare their companies for shocks such as the ones seen in South Africa since Friday and the developments of April 3 where S&P downgraded the country’s credit rating to junk status.
The corporate treasurer can do so through playing a leading role in crafting the necessary policies to protect the business. The importance of so doing is that financial risks have an impact on the business as they affect costing, pricing and the going concern status of an entity. A well-trained corporate treasurer would have prepared for events as witnessed in South Africa in the last few days.
While no one can be fully prepared, the corporate treasurer, through his skill and experience, may have assisted the company minimise the damage through hedging mechanisms. The employ of an experienced corporate treasurer does not in any way eliminate risks but it ensures that damage is minimised through employing best practice as such professionals are likely to be members of professional associations like the Association of Corporate Treasurers.
For instance, a corporate based in South Africa which imports raw materials from the US may have entered into a forward contract to lock the rate at which it would buy dollars. While the hedged rate may turn out to be unfavourable compared to the market rate, what is called an opportunity loss, the corporate treasurer would have achieved certainty in the cost of inputs. This would help assure the company of certain margins.
In the next installment I will cover how the corporate treasurer could help the entity manage the various forms of financial risks. The corporate treasurer (as distinct from a bank treasurer) is a key partner to the chief financial officer. Under normal circumstances the corporate treasurer will ensure that the firm has committed lines of credit which stand as backup cover should the company have a need triggered by unforeseen circumstances. The shocks brought by the recent developments in South Africa are likely to trigger unforeseen demands for liquidity. In the short run, liquidity is more important than profitability in that a profitable business without liquidity has a higher chance of failing while an unprofitable business with liquidity can survive.
Only companies who are prepared can survive the test without denting their businesses of affecting their going concern status. Following the downgrade of the country’s credit rating to junk status, what is likely to follow is a spike in the cost of capital. In the modern world, treasury plays a key role in the management of financial risks particularly foreign exchange rates and interest rates volatility.
Treasury is concerned with risks that could have an adverse impact on the cashflows and financial assets of an entity. Proper risk management is therefore paramount in order to reduce the impact of the risks. Management of cashflows involves an active programme of managing assets and liabilities; balance sheet management. Thus,
insofar as treasury focusses on the management of the financial health of an entity, it is a key function. The misconception is that treasury is a function that is only important in banks and not corporates.
In corporates, treasury plays a support role for the commercial business. Businesses need to interact with financial markets and banks and they can do so through treasury.
Ngwira is a chartered accountant, former bank treasurer and former university lecturer. He holds finance and business qualifications. — firstname.lastname@example.org, +267 73 113 161.