By Roger J Kerr
The spiralling NZD/AUD cross-rate was cited as the reason why the share prices of listed companies such as Fletcher Building, Kathmandu and Michael Hill took a hit last week.
New Zealand companies exporting to Australia or owning substantial Australian businesses are exposed to a rising NZD against the AUD and if the financial risk is material enough to their bottom-line profitability performance, those choosing to buy or sell their shares will act accordingly.
The marking down of their shares by the market pre-supposes that the market is not informed as to their currency hedging policies or positions.
The aforementioned listed companies all consolidate the AUD profits into their NZD Income Statements.
The market is concluding that the dramatic rise of the Kiwi dollar from below 0.8000 to 0.8700 will reduce the expected NZD profits that drive the enterprise value and share price.
If these companies operate a hedging policy on the conversion of their AUD profits then the markets may be miss-informed as to the financial performance impact.
If these companies do not have a hedging policy on such a material currency risk then the share price should be marked down as it is poor financial governance.
The relative good performance of local manufacturing exporters selling into the wider Australian market over recent years has certainly been aided by the low NZD/AUD cross-rate below 0.8000 for most of the time.
New Zealand exporters were competitive on price and made very good profit margins below 0.8000.
It was not all plain sailing for these exporters as in the Australian market they needed to compete against cheap imports coming into Australia from Asia and elsewhere when the AUD was trading well above $1.0000 to the USD.
The NZ exporters into Aussie had ample opportunity to hedge the currency risk forward at exchange rates below 0.8000.
As the chart below shows the NZD/AUD cross-rate traded below 0.8000 for three years (mid-2009 to mid-2012) with the spot rate consistently more than 7.5% below the 7-year average.
Many exporters to Australia operate currency hedging policies that allow for long-term (three to five years forward) hedging under pre-determined conditions (i.e. a “filter-test” of the spot or forward rate being more than 7.5% below the 7-year average rate).
The exporters do not necessarily hedge large percentages of forecast AUD flows in the three to five out-years, however overall hedging can be lifted to between 100% of two and three years forecast AUD receipts.
Those that have followed such “conditional on cyclical lows” hedging programmes in recent years have protected profitability and shareholder value.
It is still surprising to see a number of factors that prevent this form of prudent currency management that insulates the business against the 10% shift up in the NZD/AUD cross-rate witnessed over recent months.
One constraint is the friendly bank who does not allow hedging beyond 12 months for so-called credit reasons. If the bank really understood the long-term strategy, market position and financial risks of their customer they would ensure there was sufficient credit available to allow the company to manage its important risks.
All too often you see banks taking a very short term credit view and panicking when they see customer’s forward exchange contracts go out of the money on a marked-to-market revaluation.
One would think that it would be in the bank’s interest’s that the exporters insures its profitability and product market competiveness.
The other constraint for exporters that sometimes prevents them hedging beyond 12 months is Board directors that have a poor understanding of currency hedging programmes and somehow think that making financial commitments with a derivative instrument beyond the financial year-end is something dangerous. Such companies have no problem spending millions each year on insurance premiums to cover the risk of the factory burning down, however run a mile from buying currency option contracts to protect the firm’s profitability over multiple years.
It is not as if the rise in the NZD/AUD cross-rate to 0.8700 was not well sign-posted, the very dependable lead-indicator of the two-year interest rate differential has been pointing to rates above 0.8500 for some time.
The question from here is whether the FX markets have fully priced-in into the NZD/AUD cross-rate the expected future increases in NZ interest rates and decreases in Australian interest rates?
My view is that somewhere between 0.8800 and 0.9000 the FX market will have built in both interest rates and commodity price differentials.
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Roger J Kerr is a partner at PwC. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com
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