Currency Risk
I’ll keep reducing my trading size as long as I’m losing… My money management techniques are extremely conservative. I never risk anything approaching the total amount of money in my account, let alone my total fund. (Randy McKay, Learn To Trade The Market)
Currency risk is generally the possibility of losing money due to unfavourable movements in exchange rates. The risk is integral to how a country manages its monetary matters and the economy as a whole (sovereign or country risk). This risk affects all sectors of the economy and revolves around the key monetary and fiscal policies of the country.
In Zimbabwe, there has been use of a multi-currency framework, that is use of a basket of currencies, like the Zimbabwean Dollar (ZWL), United States Dollar (USD), South African Rand (ZAR), Euro, British Pound (GBP) etc. Currency risk mainly arises from the variation in the price of one currency against another currency. The exchange rate mechanism is, therefore, a vital cog in management of currency risk and this revolves around the ageless economic principles of supply and demand of currencies as well as the transacting stakeholders’ confidence in a particular currency. The USD has been a comparatively dominant currency globally because the world views it as a more stable currency.
The impact of currency risk is at two levels, i.e. financial reporting and actual transactional losses.
Financial reporting concerns arise from the fact that entities are expected to report in one currency, mainly referred to as the functional currency (mainly ZWL for Zimbabwean entities). The challenge comes when an entity mainly earns in foreign currency, hence revenue translated to ZWL using the official exchange rate whereas some of the entity’s expenses are incurred in ZWL, with the cost mainly derived from USD costing base which is translated to ZWL using the parallel/alternative market rate, which is ordinarily higher than the official exchange rate. The indexing of the ZWL pricing of goods and services entails that depressed profitability will be reported, which gives a distorted representation of an entity’s performance to stakeholders interested in an entity’s financial reports. Entities also have a significant burden of maintaining financial records in the transacting currencies, instead of just the functional/reporting currency, since the resultant taxes are expected to be paid in the transacting currencies. The impact of exchange rates used in recording of entities’ financial records is, therefore, of paramount importance as far as the reported financial performance and position as well as tax matters are concerned.
At transactional level, entities’ earnings have been mainly a mix of local and foreign currencies. Entities’ dilemma has been getting the correct and legal pricing that will result in the same real gross margin level being attained for both foreign and local currency pricing. This is mainly because the local currency costs are heavily impacted by parallel market rate indexing of prices by suppliers of goods and services, hence increase in foreign currency pricing to match the local currency pricing at the official exchange rate for those entities that charge their goods and services in both local and foreign currencies. Managing currency risk has become a focal point of entities, similar to management of productivity itself, as ignoring this critical risk has dire going concern consequences.
The mining sector is not spared from this critical risk as entities’ statutory financial reporting is expected to be in the ZWL functional currency. The sector has to also deal with currency switches to facilitate some of their local transactions. In instances that entities in the sector converts their foreign currency earnings to local currency, they are expected to convert the foreign currency at a formal exchange rate, which is lower than the parallel market rate used by supply for indexing their ZWL pricing to USD base prices, hence exchange losses incurred. The risk of currency volatility is, therefore, high in instances where an entity earns in one currency and make payments to service providers in a different currency.
Management of currency risk begins with measurement of an entity’s foreign currency position in each currency it deals with. With such a measurement, it will be easier to ascertain the impact of movement in foreign exchange rate on an entity’s foreign currency position for each currency. This also assists in quantifying adverse financial performance purely coming from movement in exchange rates from entities’ depressed productivity levels. Without proper foreign exchange position tracking, it will be difficult to diagnose an entity’s overall depressed performance, i.e. whether they depressed performance is emanating from purely depressed productivity or it is mainly due to the macroeconomic matter of currency risk.
In recent weeks there has been observed stability of the USD/ZWL parallel market exchange rate. The hope is that the relevant policy interventions will sustain the notable respite from parallel market exchange rate premium spikes to close the gap between the official exchange rate and the parallel market exchange rate. This will go a long way in removing pricing distortions emanating from the differences between the formal and parallel market exchange rates.
About the Author
Jeremiah Ndhlovu is a Certified Expert in Risk Management (CERM). He has acquired extensive risk management insights in the mining sector through outsource projects including enterprise risk management, combined assurance, process and controls standardisation, internal auditing and external auditing.
