The Implication of Foreign currency borrowing on local companies; what you need to know with respect to borrowing.
Foreign currency borrowing and the implications it brings with it on local companies, is in my opinion a very pertinent topic to talk about especially in light of Covid-19 and the impact it is having on local businesses. We have witnessed a number of businesses either having to shut down or pivot into a new direction and pivoting requires funding.
Foreign currency borrowing or foreign currency debt is one method in which businesses obtain funding to pivot and this is the purpose behind our discussion today.
“A foreign currency loan is actually a speculative deal. The borrower hopes for interest and exchange rate advantages. But that is a risky bet. (The Erste financial life park 2020)
I found the above quote very interesting and quite intriguing and I think it encompasses everything that I would like to share today in this master class.
To help me explain in a clearer perspective, let me start off by first sharing a case study showing the impact of foreign currency borrowing on a local manufacturing business:
A local manufacturing company that was performing relatively well in 2008, with an average annual turnover of $12 million , decided to borrow $600,000 at 5% interest rate from a local financial institution when the exchange rate was about k10 = $1.
The purpose of the fund was to use it as working capital to expand the business operations, diversify their product base and also meet the rise in demand. The loan was secured by business assets such as manufacturing plants, equipment, motor vehicles and it was projected that after investing the borrowed money into the business it would give a return of a gross profit margin of about 35% on average for at least 12 months.
Unfortunately a movement in the exchange rate, which caused an increase in the value of the loan in kwacha terms because the business made it sales in kwacha, was not factored into consideration and this led the business to incur liquidity problems.
The exchange rate which moved from k10 per dollar to k15 in a space of 9 months after borrowing caused a currency mismatch and the timing of business payment did not match the repayment profile that was applied to this particular loan. Because the business model did not also account for managing currency movements, no debt management strategy was put in place neither. The expansion process also meant that the business had to start looking for inputs from imported markets in order to produce its new product base leading to high operating expenses for the business.
As mentioned before, the movement in the kwacha meant the repayment of the loan in dollar terms was extremely expensive that it put pressure on the business budget making it difficult to sustain.
And as a result of the movement in the value of the loan, the financial institution was forced to re-price it, restructure it and instigate a margin call. When I say a margin call I am talking about when the bank informs you that the security that you put to support the loan you had in place is actually lower in value than it should be, and so to protect the bank from a lenders perspective they will need additional cash or collateral to protect themselves against you defaulting. Unfortunately for this business, the loan was eventually recalled because of a lack of enough cash or collateral to secure it further and as a result the business failed and went into liquidation.
This is just one impact that I wanted to show you in respect to when you have a foreign currency loan on your books and to equally point out the key issues one should look at when it comes to borrowing in foreign currency.
Below is a graph that compares commercial lending rates in kwacha compared to those in foreign currency rates:
The blue line represents kwacha commercial lending rates at the end of December 2020, of which the rate was at 25% compared to the US dollar which is the red line that had commercial lending rate at 3.25%. The British pound lending rate was been offered at 2% during the same period.
So you can see that there is a large disparity in the commercial lending rate that you will get from a financial institution, and it really depends on the currency and what you will be using the loan for.
Below is a graph that depicts the distribution of foreign currency loans within the financial system in Zambia.
The data is recorded in US dollars by the central bank and they report that total value of loans and advances in foreign currency at the end of December 2020 was at $944 million. This means that according to them, 47% of total loans and advances issued by commercial banks were in foreign currency and the rest in kwacha. Looking at the distribution you can see that the bulk of foreign currency loans go to Agriculture, mining, manufacturing, wholesale and retail trade, as well as the real estate sector and the energy sector.
Pros and Cons of foreign currency loans
Before you decide to take on a foreign currency loan for your business, it is important to consider what advantages and disadvantages exist and the implications involved.
- The advantage of having a foreign currency debt is that it normally has a lower interest rate compared to local currency as seen in previous graph. It really all depends on the foreign currency that you intend to borrow in and what you will be using the money for.
- Foreign currency loans can also be used to hedge against local currency volatilities and inflation and are also a good natural way to hedge (protection) on foreign assets.
- It reduces cross border funding transactions if one has a global based business or an export led business.
- You are subjected to movements in market fundamentals; if there is a change in interest rates it might result in a change in exchange rates and the value of a foreign currency debt.
- Foreign currency loans can also expose the business to currency mismatches if sales are in a local currency.
- Foreign currency loans can also lead to maturity mismatches and possible defaults if long term debts are financed by short term investments or sources of funds.
- They can also lead to loan re-pricing (this is actually not just subjected to foreign currency loans but applies to all debt). Re-pricing because of market movements can lead to margin calls, and margin calls mean additional cash or collateral to support the loan facility with the financial institution from which you borrowed from. As we saw in the case study, this can have some serious effect if the foreign currency loan is not managed properly.
Foreign currency loan risk management
|Risk Type||Impact||Mitigation Measure|
|Translation Risk||•Risk comes from currency conversion •Financial Reporting and accounts||•Report income and assets in the same currency as the loan to prevent currency mismatches •Recognize the increase/decrease in loan value via exchange rate losses or gains in your accounts|
|Transaction Risk||•Affects loan contract •Impacts outstanding loan repayments •Short term impact||•Convert the loan to local currency •Change earnings to foreign loan currency via exports if possible|
|Economic Risk||•Changes in the value of foreign currency or interest rates affects future payments •Long term impact||•Hedge against currency and interest rate changes using derivatives, options and futures contracts to protect transactions|
There are three types of foreign currency risk:
- Translation Risk; this is a risk that comes about from currency conversions and has an impact on your financial reporting and accounting. A good way to mitigate against this risk is to report your income and assets in the same currency as the loan to avoid currency mismatches. You could also recognize the increase and decrease in loan value via exchange rate losses or gains in your account.
- Transaction Risk: this is a risk that can affect your loan contract and have an impact on your outstanding loan repayments. One way to mitigate this risk is to convert your loan to local currency if it makes good business sense and is feasible. Another way to mitigate this risk is to change your business model to include foreign currency earnings so that you are able to pay your foreign currency loan in the same currency.
This is something that would be very interesting to see right now with local businesses especially with the African free trade agreement being enacted, and Zambia signing and becoming a member of it. There are very good benefits that will come out of this because it provides local businesses with new markets and opportunities to expand your business into new areas.
- Economic Risk: this comes about in the change of foreign currency or interest rates and it affects future repayments especially on a long term basis. A risk mitigation you could put in place is to hedge against currency and interest rate changes by using derivatives; financial instruments used by financial markets to protect the value of future transactions in the near future, you could use options, futures and other types of contracts in order to protect your business. This is a common instrument used by commodity trading companies, as well as equity trading companies that you see in most places.
Debt Management Strategy
Now that you have decided to get a foreign currency loan, it is important to have some kind of plan in place to be able to manage the situation if things were to go a different direction.
Listed below are some of the things you can do to try and manage the situation:
- Try and restructure the loan that you have in place; loan restructuring means you get to change the interest rates, the tenure or the repayment profile. You could also just go ahead and refinance the loan in its entirety.
- Convert your foreign currency loan to a local currency loan and revalue the loan to maintain debt sustainability. If the debt is still unsustainable you might want to reconstruct your balance sheet. Reconstructing the balance sheet might involve changing the capital structure of the business and also considering increasing your share of equity through shareholder equity contributions or seeking strategic partnerships from an investor that can capitalize your business.
- Another way as eluded to earlier is to consider pivoting your business model to include exports that will allow for foreign exchange earnings in the currency of the loan. Just make sure that the timing of payment is in line with the timing of the loan repayment profile that you choose to get.
And if all fails, well, you have no choice but to sell your business to a company that is looking to acquire something in line with yours, but if that does not work out too then it just means that you have to liquidate your business and possibly shut it down.
There are many factors to consider when borrowing in foreign currency. I believe that the interest rates that you get in foreign currency are definitely better than what you will get in local currency. It is just a matter of timing and putting the right risk mitigation measures in place to make sure that you manage your loans or exposure in the right way. Consider weighing pros and cons before borrowing in foreign currency i.e. choose the right currency at the best interest rate and at the right time. I say this because it makes sense to have a trade finance facility for example in Euros if you are going to be exporting to the euro Dan, if you’re going to be doing a dollar denominated transaction, borrow in that currency and so on and so forth.
Foreign currency loans also tend to have cheaper interest rates as seen in earlier graph but can easily be negated by a movement in exchange rates related to local currency.
The good thing to remember is currency mismatches can occur but revenues are not recorded in the currency of the loan and if possible you can change your business model into an export oriented business in order to allow earnings in the currency of the loan.
You might also want to consider the risk mitigation measures and hedging solutions required to manage exposure of foreign currency changes. Make sure you have the debt management strategies in place and use them as a right guide to take when it comes to controlling the outcome of being exposed to changes in foreign currency.