Sensible forex policy critical to profitability

There has been a bit of comment recently about meat companies failing to take advantage of the high dollar for foreign exchange gains, as though it’s a guaranteed route to increasing profits which would of course be reflected in livestock payments. If only it were that simple!

Like any export business, foreign exchange control is an important part of a meat company’s business activity, just as important as procurement, processing and marketing. Without it, financial performance would fluctuate wildly, causing both substantial gains and losses. But there seems to be confusion among at least some in the farming sector between foreign exchange cover as risk mitigation rather than currency speculation.

In the recent edition of Heartland Beef, Rob Kirk, Regional Chair of the Sheep and Beef Council, was quoted as suggesting meat companies should take advantage of the exchange rate when the NZ dollar is strong in relation to the currencies of our major trading partners, by buying foreign exchange as a hedge against a weaker dollar. Delegates at a recent Federated Farmers agribusiness seminar expressed much the same thought.

A chat to a couple of meat company senior executives confirmed this wasn’t a great idea and could quite probably mean they would breach their banking covenants. One tongue-in-cheek question was whether farmers would be prepared to wear the losses, as opposed to gains, when the exchange moved in the opposite direction to that expected. As a matter of interest, one meat company, long since absorbed by industry rationalisation, used to have a currency trading function within its treasury department which one year made virtually all its reported profit. That’s an example of speculation that worked, but it could just as easily have gone the other way.

A quick look at the exchange rate over the last 16 months shows the Kiwi has strengthened by 24% against the US dollar, 21% against Sterling, and 33% against the Euro, but 12 months earlier the US dollar was actually stronger than it is today. The main problem is it’s impossible to forecast when and how far currencies will move against each other; in fact it’s only with hindsight anyone can be certain, so anything else is speculation. The other big problem is the cost of foreign exchange cover which is roughly equivalent to the interest rate, so in effect companies must factor in a holding cost in return for the certainty of locking in the exchange rate applying to their sale contracts.

The major, perhaps only, purpose of foreign exchange cover should be to ensure the cost of what is procured and processed is matched to a sale, either at the time of sale or the point of procurement. This ideally means the actual market prices received on sales can be factored into costings when arriving at the required gross margin and affordable price for livestock. This was certainly the method AFFCO used in the 90s when setting its livestock schedule, before recognising the devastating impact of procurement competition which meant the company was hardly ever able to buy at the theoretical schedule.

However today when an increasing number of livestock is bought on forward contract, companies must employ a variety of methods to measure and cover their exposure. Keith Cooper, CEO of Silver Fern Farms, told me suppliers have a couple of options, if they want to benefit from the potentially positive impacts of foreign exchange cover. First, and most sensibly, they can sign up to forward contracts such as the Backbone contracts which have an inbuilt hedging component; second, any farmer is at liberty to go to a bank and take out their own hedge contract. This second option should at least create full awareness of the hedging process and its cost; it might also, in the words of one meat company executive, mean the farmer in question would stop trying to tell meat companies how to do it!

This whole issue arises from farmers’ frustration with lower prices than they need to run a profitable farming enterprise and their belief meat companies are selling too cheaply. The exchange rate at current highs only serves to underline their struggle for profitability, but speculating in foreign exchange would be likely to cause more not less damage.

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Tags: Currency hedging, currency speculation, Foreign exchange