fluctuations without guarantees
Constancy of economic conditions numbs the imagination and eventually leads to a complete ignorance of history. Asset managers start acting as if the correlations across different assets will always stay the same. Firms start behaving as if the economic stability will linger on forever. Low interest rates available in the foreign credit markets become too tempting to ignore and the exchange rate risks seems too low to factor into calculations. Then a crisis hits out of nowhere. Dollar appreciates and the companies without a dollar denominated income start defaulting on their interest payments...
So what is the lesson here? Should Chief Financial Officers make sure that there is no significant mismatch between the currencies of their liabilities and income? Yes and No. In times of crises even a dollar denominated income may not to save you from defaulting on your dollar denominated liability.
Consider the case of a typical commodity exporter that sells a locally mined good into a dollar denominated international market. The dollar income leads to an ungrounded feeling of security which encourages the company to take on substantial amounts of dollar denominated debt. A worldwide financial crisis unexpectedly unfolds and causes a big stir. Companies who used to depend on the availability of cheap trade finance withdraw from the market. The financially weak ones default on their payments and the increase in counterparty risk results in a scare. Everyone in the sector starts working on a strictly cash basis and the trade volumes collapse. End-users of the commodity start complaining about the price as dollar appreciates against the currencies of their clients. The revenues of our commodity exporter diminish along with the fall in sales volume and prices. Soon or later the result is a default.
Lesson: Currency mismatch is only part of the story. No matter what you do, there is no guarantee that the value of your assets will fluctuate in tandem with the value of your liabilities.
So what is the lesson here? Should Chief Financial Officers make sure that there is no significant mismatch between the currencies of their liabilities and income? Yes and No. In times of crises even a dollar denominated income may not to save you from defaulting on your dollar denominated liability.
Consider the case of a typical commodity exporter that sells a locally mined good into a dollar denominated international market. The dollar income leads to an ungrounded feeling of security which encourages the company to take on substantial amounts of dollar denominated debt. A worldwide financial crisis unexpectedly unfolds and causes a big stir. Companies who used to depend on the availability of cheap trade finance withdraw from the market. The financially weak ones default on their payments and the increase in counterparty risk results in a scare. Everyone in the sector starts working on a strictly cash basis and the trade volumes collapse. End-users of the commodity start complaining about the price as dollar appreciates against the currencies of their clients. The revenues of our commodity exporter diminish along with the fall in sales volume and prices. Soon or later the result is a default.
Lesson: Currency mismatch is only part of the story. No matter what you do, there is no guarantee that the value of your assets will fluctuate in tandem with the value of your liabilities.
