FOR importers and exporters, the foreign currency risk involved in trading goods across borders is quite difficult to understand and manage. The risk of loss while imported articles are in transit is easily managed by securing a marine insurance coverage. In case of foreign currency fluctuations, what are the risks and how exactly do you manage them?
To illustrate, a local company which sells its goods locally buys its articles from the US. The imported article is normally denominated in US dollars. At the time the importer ordered the goods from the US, the exchange rate was PhP54 per US dollar. The goods arrived two weeks later and by then the exchange rate was PhP56 per US dollar. Obviously, the importer will pay more in Philippine peso to the supplier. In addition, the importer will have to pay higher taxes and duties considering that the dutiable value will be higher when converted to Philippine peso.
How will the importer recover the higher cost of the imported goods? Normally, the importer will sell the goods at a higher price to recover the higher cost. But this is not always the case. If the importer has previously agreed to sell the goods to a buyer at the old price, the importer will certainly have to incur the added costs as a result of the depreciation of the Philippine peso. In many instances, the importer is likewise unable to increase its price due to stiff competition from sellers of similar goods. How will the importer manage the foreign currency risks inherent in international trading transactions?
Background of Foreign Exchange. Prior to 1984, the Philippines was using a managed float system for its foreign currency exchange, effectively allowing the peso to trade 4.5% below and above the guiding rate set by the Central Bank (CB). In other words, while the exchange rate is allowed to float, it is not allowed to fluctuate beyond the 4.5% range. In 1984, the CB liberalized the foreign exchange market. This resulted in local banks being allowed to trade foreign currency among themselves based on prevailing market conditions and without government intervention.
By 1993, the exchange rate stood at PhP25 to a dollar. The exchange rate remained quite stable until the regional crisis in 1997 which resulted in an exchange rate of PhP40 to a dollar by 1998.
Foreign Currency Risks. There are many types of foreign currency risks but the most typical involves transaction risks in international trade. We have illustrated this in our example above where the peso depreciated from the date the import order was placed to the date of payment to the supplier. It may happen also that the peso appreciates during that period, in which case the importer gains as a result in the lower peso price payable to the supplier and the lower duties and taxes.
For international traders, there are other risks involved. One would be the translation risks involved when a local company has international businesses which would be reported locally. The earnings overseas may increase or decrease when translated to the Philippine peso.
Strategic Risks for Exporters. The other kind of risk refers to strategic exposures that may result from foreign currency changes in other markets. To illustrate, many governments particularly the US is of the position that the Chinese currency is undervalued such that its exports are a lot cheaper than exports from other countries. If China will appreciate its currency, its exports will be priced a little higher such that other countries may be able to compete more.
For international traders, both exporters and importers, foreign currency risks impact not only on specific trading transactions but also on how the company will conduct its purchase and supply strategy both in the medium and long term. For exporters in particular, foreign currency risks will impact not only on the cost of imported raw materials but also on how it will price its goods in the export market. Pricing the goods in the export market not only depends on the costs of inputs but also on the pricing of competitive products from other export markets, particularly China.
Certainly, managing foreign currency risks is a lot more complicated for exporters than for importers who are simply doing business exclusively for the domestic market.
Shifting the Risk Offshore. An importer selling exclusively in the domestic market certainly will not concern itself with currency risks in the export market.
Still, an importer generally has two ways to manage its foreign currency risks. The first strategy is to shift the risk offshore by agreeing with the supplier that the selling price is in peso even if it will be converted to US dollar at the prevailing exchange rates upon payment. To illustrate, the importer can negotiate to buy the goods at PhP100 per piece. Upon arrival of the goods, the supplier will pay the supplier by exchanging the PhP100 into US dollar based on prevailing rate and remitting the converted amount. In this particular case, the risk is transferred to the supplier and the seller may gain or lose from the currency fluctuation depending on the prevailing exchange rate at the time of payment.
Forward Transactions. A second strategy is for the importer to buy foreign exchange through forward transactions instead of buying “on the spot”. Forward transactions refer to an agreed sale of a foreign exchange to be made more than two business days away and at some specified future date. To cover the foreign currency requirements of an importation, an importer may agree with a bank for the latter to provide the foreign currency at a certain date (to pay the supplier) based on a pre-agreed exchange rate. The pre-agreed rate is normally based on the prevailing rate with some adjustments, which may be an addition or subtraction to the prevailing or spot rate.
The author is an international trade, indirect tax (customs) and supply chain expert. He is the Editorial Board Chairman of Asia Customs & Trade, an online portal on customs and trade developments affecting global trade and customs compliance in Asia. He was also Bureau of Customs Deputy Commissioner for Assessment and Operations Coordinating Group (2013-2016). For questions, please email at firstname.lastname@example.org and email@example.com