In the hours after the UK voted to leave the European Union, sterling slumped to a 30-year low against the US dollar, crashing from $1.50 to $1.30 – a level at which it has more or less remained ever since.
Such sudden currency devaluations (or revaluations, for that matter) are not unusual: in January 2015, the Swiss National Bank stunned markets by removing a peg of CHF 1.2 to the euro, prompting the franc to rise 14% against the euro in a morning. Consequently, the Swiss stock exchange slumped 10% as investors worried about the impact on Swiss multinationals, such as Credit Suisse, UBS, Novartis and Nestlé.
Extend the timescale and currency exchange rates are even more volatile. Against the dollar, for instance, sterling rose from $1.40 in 2002 to $2.10 in October 2007, a significant appreciation in just five years. But turn the clock forward a further two years to 2009 and sterling was back to where it started, having plunged 35% to reach $1.40 again.
When currency exchange rates exhibit movement on such a scale, the problems faced by procurement organisations are obvious. Movements in currency exchange rates of a few percentage points are one thing; movements of 15% to 50% are quite another. Movements of that scale are significant enough to hit profit margins and call both sourcing and sales decisions into question.
But what is less obvious is what procurement organisations can do about movements of currency exchange rates on such a scale.
While short-term volatility can be weathered, a longer-term shift in a currency exchange rate is a different matter.
Hedging, for instance, only offers protection for the duration of the hedge and takes a bite out of margins, even as it protects them.
Moreover, hedging – generally in the form of forward-buying a currency, or buying an option to buy at a given currency exchange rate – rarely extends further than one year ahead, at most, two years.
“With a 100% hedge, you’ve got the security of having locked in the profit implied by your cost and sales price, but it’s very unusual for customers to come to us for hedging instruments over a timescale that is longer than a year,” says David Lamb, head of dealing at corporate currency broker FEXCO Corporate Payments.
Martin Mulligan, head of consultancy at independent treasury advisers Clear Treasury, agrees.
“There’s certainly a market for financial instruments of up to two years’ duration, but the reality is that most businesses’ planning cycles don’t extend that far,” he points out.
“Typically, hedging takes place over periods of three to 12 months.”
Which is why, it appears, UK consumers have yet to see the post-Brexit fall in the pound affect their shopping bills: recognising that a large proportion of what they sell is imported, British retailers are typically heavily hedged, with Marks & Spencer, for instance, hedging up to 18 months ahead.
So, if hedging won’t work, what else can businesses do to protect themselves for the long term from abrupt changes in currency exchange rates? More than might be imagined, it turns out.
Milan Panchmatia, managing partner at procurement consultants 4C Associates, sees dislocated currency exchange rates as a definite opportunity: a seismic shock that affects a wide swathe of businesses and one that holds out the promise of a competitive advantage to those that are fleet of foot in exploiting it.
“Work backwards from the sales price and the required margin, and that tells you what price you need to be buying at – so you start looking at different sourcing options,” he urges.
“For the past 15 years or so, the world has been locked into a mindset of buying from China. But there are alternatives to China, especially now it is becoming less competitive, and especially in terms of buying labour-intensive products and lower-tech products.
Some of the alternative countries have the advantage of being closer, holding out the prospect of lower freight costs and enhanced agility through being closer to Europe.”
The concept of natural hedging – which came to prominence in the mid-1980s when the pound and US dollar were almost at parity – is also an option, adds Emile Naus, technical director at supply chain consultants LCP Consulting. The idea is to match the currencies that a business sources in to the currencies in which it sells and earns revenues.
“When the currencies involved in sourcing and selling are in balance, it can ease a lot of pain: a currency-induced rise in sourcing costs will be matched by an equivalent rise in revenues,” he observes.
“But the reality is that it’s very rare to achieve 100% balance, and most companies have to settle for a lot less than that.”
Matthew Bardell, vice president of consulting at procurement specialist GEP, concurs, pointing out that natural hedging does not necessarily involve dealing with suppliers physically located in a currency zone. It can be enough to simply denominate procurement contracts in the relevant currency.
That said, he adds, the procurement function must recognise that natural hedging involves procurement decisions being made on grounds that are not necessarily procurement related, or in situations where procurement does not necessarily have the relevant expertise.
“The logic is simple: if your revenues are heavily biased towards US dollars, or the euro, then you should either physically buy materials from the US or Europe, or have purchasing contracts denominated in dollars or euros. But a clear steer from an organisation’s treasury function is vital: they’re the people who should really be making the decision as to what
currencies the organisation’s procurement contracts should be denominated in.”
Indeed, suppliers can welcome such arrangements, using them as a way of building closer ties with buyers.
“In general, they see it as providing a degree of reassurance that movements in currency exchange rates aren’t going to suddenly make them expensive, prompting buyers to look elsewhere,” adds Bardell.
Moreover, building multiple sourcing relationships in various regions allows businesses to play currency exchange rates proactively rather than reactively, notes Richard Wilding, professor of supply chain strategy at Cranfield University School of Management and Europe’s first professor of supply chain risk management.
“While hedging via financial tools is always an option in the short term, businesses can hedge more effectively over the longer term by appropriately structuring their supply chains, and switching suppliers as currency exchange rates shift,” he explains.
That said, it can be a mistake for businesses to overly fixate on currency exchange rates when
making sourcing decisions, stresses Hugh Williams, managing director at supply chain consultants Hughenden Consulting.
“As with globalisation, you have to look at the total cost of supply to see the whole picture, and currency exchange rates are just one piece of the puzzle,” he points out. “The trick is to use the present currency turmoil as a chance to take a considered view of the available sourcing options, of which there will be many. The important thing is to take the time to research those options, rather than making any knee-jerk reactions.”
This is precisely the tack being taken by global domestic appliance manufacturer Electrolux, according to Oscar Palacios, purchasing director for the company’s North American dish care and fabric care division. China, he notes, is a major source of raw materials and components, but as the Chinese yuan has appreciated relative to the US dollar, attention has turned to ways of mitigating that increase in costs.
“We saw an opportunity a couple of years back to develop supplier capabilities in Mexico, where the peso tends to track the dollar. Ultimately, the intention is to bring back manufacturing to North America, with Mexico as our number-one source of components and materials, and China as our number-two source,” he explains.
Moreover, he adds, Electrolux is aware of the broader opportunities that will open up, with components manufacturing and suppliers located on the same continent as Electrolux’s manufacturing plants.
“It’s not just about currency and costs. We can also see benefits in terms of agility and responsiveness, but the currency effect will be the tangible benefit that shows up in the project’s return on investment,” he says. “It’s a long-term plan and will take five years or so, but it’s one that will be very worth the effort we’re investing.”
This article is a piece of independent journalism, written by an experienced journalist and commissioned exclusively by Procurement Leaders.