In a series of posts, we are exploring how buyers can add more value to their organizations by getting involved to currency risk management. On part 2, we will examine the specifics of currency risk related to purchase contracts. On previous part, we made a brief introduction for buyers to currency risk. We discussed what currency risk means in general for the company.
BUYER’S GUIDE TO CURRENCY RISK – Part 2
Procurement professionals should be aware of risks and opportunities from one end to other end of value chain. They should understand not only risks at own organization, but also risks at their suppliers’ organization, and even risks at suppliers of their suppliers.
Developing local suppliers
A rule of the thumb is buying locally as much as possible. Buyers should continuously look for local sources of supply. In an attempt to decrease dependency on imports, organizations may consider investing to supply partnering programs and develop quality and service of local suppliers through a long-term and supportive relationship.
Challenges of global marketplace
Sourcing locally does not guarantee having purchase contracts in local currency. Local suppliers may also be interested in concluding contracts in foreign currency. This is particularly the case with distributors that import goods from abroad and sell locally, but not only. There are some other companies besides companies importing trading goods that prefer to sell in foreign currency. This is because they rely partially on imports or otherwise USD-denominated goods and services while manufacturing their products or providing their services. Such companies experience increase in their production costs when local currency depreciates, and they often try to reflect those additional costs to their customers.
Even more interesting is the case with companies exporting their products or services. These companies may also be interested in selling their products or services in foreign currency, because their alternative to local sales is exports, which is usually in foreign currency. Important factors are recognition of brands in global markets, logistics and foreign trade regulations. Note that capacity utilization is also important factor to consider. If capacity utilization is low, these companies would be interested in domestic sales even at margins lower than with export sales.
Commodities
Many commodities are priced in US Dollars around the world regardless of where they are sourced. It is particularly true if value is high and logistics is insignificant. For example, regional price differences and arbitrage possibilities are very limited for gold or other precious metals. In fact most businesses refer to the prices quoted at leading metal exchange institutions, such as NYMEX (New York Metal Exchange) and LME (London Metal Exhange). Note that quotations on LME are also in US Dollars, although the institution is located in the UK.
However there is a subtlety with currency risk for commodities. It is true that an organization sourcing commodities will always face higher costs when local currency depreciates against US Dollar. On the other hand, it does not necessarily mean that organization will face higher cost for a certain commodity, if US Dollar appreciates. US Dollar has its own supply demand dynamics and its value also fluctuates compared to other currencies and commodities. The buying organization will have the same cost for a certain commodity in local currency, if US Dollar appreciates at the same rate against that particular currency and commodity.
Moreover not all commodities are traded at the same price all over the world. There may be regional differences in commodity prices due to logistics, if commodity value is not as high as with metals or if there are foreign trade barriers. In such cases, trading may be taking place partially or fully in local currency.
Hidden costs and lost opportunities
You might have convinced your supplier to contract in local currency and might be quite happy about it. But here is the bad news: Just because you do not see it openly on your contract does not mean that currency risk is totally eliminated. It is possible that the supplier embedded additional risks in proposal and the pricing has a certain buffer. That is why buyers should always clarify baseline foreign exhange rate when a supplier makes a proposal for a FX-denominated goods or service in local currency. Under certain circumstances, buyers may prefer to contract in foreign currency, because they might want to enjoy cost benefits if currency rate moves in their favour or they may think their organization will hedge currency risk at a lower cost than the supplier builds into contract pricing.
KEY LEARNINGS
- Understand currency risks at your supplier and at the suppliers of your supplier.
- Look continuously for local sources of supply.
- Decrease dependency on imports by developing quality and service of local suppliers
- Monitor import and export options of your suppliers.
- Clarify baseline foreign exhange rate when a supplier makes a proposal for a FX-denominated goods or service in local currency.
- Compare cost of hedging currency risk in your organization with the cost which supplier embeds to contract pricing.
Way forward
Understanding and measuring is pre-requisite to managing. I will talk more about measuring and managing currency risk in our next post on 29 July.