Zimbabwe’s economic problems have been long related to inflation and the exchange rate. While it is difficult to determine the extent to which the one leads the other in this case, it is clear that both the volatility and dramatic change in prices and exchange rates are the results of a real economic meltdown.
Risk management breaks down
Over the last seven days, the value of the Zimbabwean Dollar (as traded on the black market, rather than the fixed and mostly irrelevant government-sanctioned rate) has halved. Inflation measures are in the thousands of percent (3,000% to 9,000% depending on who you ask and what statistics you read) and some prices are almost irrelevant as there are no goods to trade. Queues for fuel have become the norm for years now, and it can only be a matter of time before there is no fuel left at all. Bicycles, along with the money-counting machines needed to count the tens of thousands of banknotes used to pay for basic items are possibly the only products seen more often than five and ten years ago.
What currency risk management tools are usually available?
So, as a business in Zimbabwe, what options are available? Usually, protection against unexpected or adverse changes in currencies can be hedged in large quantities in the OTC forward market. Increasingly, this sort of currency hedging is becoming available to smaller businesses through banks around the world. Although the price reflects the near-retail nature of the transactions, the protection is available to companies and industries particularly sensitive to exchange rate movements (any industry where a large portion of costs are in a different currency from revenues, or more subtly, where substitute products and complementary products are priced in a foreign currency).
But in Zimbabwe, quite understandably, no such protection is available. Anybody foolhardy enough to take a position in the current market would be unlikely to survive for long and thus the contracts issued would be exposed to tremendous credit risk. In effect, we have a failed market and the sophisticated risk management available elsewhere in the world has long fallen by the wayside as commercial transactions are increasingly based on the South African Rand or even simple barter arrangements.
So, if you are lucky enough not to be doing business in Zimbabwe, and these instruments and techniques are available, you should seriously consider using them for a competitive advantage. Better risk management leads to increased focus on operational results, better risk-adjusted returns to shareholders and a better quality of sleep.
Five Basic Steps To Currency Risk Management
The five basic steps in assessing currency exposure are:
- Risk identification – identify areas or currency exposure (including the non-obvious ones such as substitute and complementary products as mentioned above). All risks should be entered into a risk register, which should be updated at regular intervals. The risk register should become an integral part of managing the business.
- Develop risk measures for each risk identified. These can be qualitative, but quantitative is more useful to make management decisions. A single metric may not be sufficient, as high-probability-low-impact risks should be discernible from low-probability-high-impact risks that could be catastrophic for the business in the rare case when it happens. Which is more critical for your organisation? A one-day 5% increase in the exchange rate? Or a five-year consistent slide in the exchange rate that erodes your competitive advantage?
- Gather information regarding the risk management tools available to you. Although expert advice is useful at every step of this process, “you don’t know what you don’t know” and thus independent, expert advice can be critically important here. Your bank may not be the ideal advisor here – if they have an incentive to sell you a product, their advice may not be independent. Even if it is, you may be tempted to second-guess it because you perceive them to be biased towards the risks that they are in a position to help you manage. Is Value At Risk useful to you? Can you understand the number in a management context?
- Choose the optimal risk management strategies based on the expected costs, expected benefits, and risk adjusted return on the investment. Usually, considering expected costs and expected benefits results in a “no purchase” decision since under expected conditions, the protection acquired looks very expensive. Buying protection via options is more expensive than locking in current prices with forward contracts, but for some the upside profit potential is worth the price. Here is where you need to do some scenarios, and some hard number-crunching. Good decisions require good analysis, and good analysis requires a thorough understanding of the problems, the business, and the financial economic theory behind it all.
- Continually monitor the risks through the risk measures and the risk register. Major changes may require a significant rethink in risk management strategy. Smaller changes may require tweaks and refinements. Part of the process can be to identify trigger levels at which the risk management strategy needs to be revisited. This saves management time by not diverting excessive attention to small changes that won’t have a significant impact on the optimal strategy.
The more thoroughly thought-through the process is, the more likely your organisation is to achieve above average risk-adjusted returns on capital.