Managing FX in Times of Uncertainty for Mechanical Engineering Companies
7 July 2020 · 4 min read
Mechanical Engineering companies can be classified into two main business models: producers of standard machinery and tools, and makers of tailor-made equipment and user-oriented engineering solutions.
Companies in the first group face wide volume-based and price competition, and tight profit margins. Meanwhile, makers of tailor-made equipment have more differentiated product lines and higher profit margins. In both types of businesses, spare parts and maintenance services complement a fairly diversified source of revenue streams.
In a special Kantox webinar, we assess FX risk management policies for Mechanical Engineering companies in the context of their specific business models, pricing dynamics and revenue streams. We also outline a set of best practices for foreign currency management in the industry. As Kantox FX Chief Growth Officer, Antonio Rami, argues: “There is a first-mover advantage for firms that speak the language of their customers by embracing currencies while streamlining and automating their FX risk management processes.”
A variety of pricing dynamics
Mechanical engineering firms deriving a majority of their revenue from standard machinery and tools tend to run campaign-based businesses where prices are kept stable for each campaign. This ‘low-frequency’ pricing-update model is also prevalent in the spare parts and maintenance services part of the industry. To the extent that these businesses incur costs in a different currency than the currency their sales are denominated in, adverse FX movements need to be absorbed if selling prices are not updated.
Speciality machinery firms have different pricing dynamics. Their prices are negotiated per sales contract, and adverse FX movements can be passed on to clients. Given their negotiating power, European firms tend to price mostly in EUR. The more differentiated the product line, the more prevalent this type of behaviour. These participants argue that pricing in local currencies would entail too many internal changes in terms of commercial teams’ habits, invoicing processes, and cash management methods.
We think this is a mistake.
Embrace currencies and speak the language of customers!
Pricing in a handful of currencies —EUR, USD, GBP— does not eliminate currency risk. It merely transfers risk (and the responsibility to manage it) onto the shoulders of customers and suppliers. By pricing in local currencies, commercial teams can improve customer experience and add promising new markets to a firm’s portfolio. And that is not all. By capturing the mark-up usually applied by clients who receive quotes in foreign currencies, companies in the mechanical engineering space can increase profitability and take control of their own competitiveness.
The challenge is to reap these benefits while keeping currency risk under control. When this is achieved, FX risk management ceases to be a purely financial, accounting or administrative task. Instead, it becomes a key strategic factor in fostering companies’ growth. As François Masquelier, Honorary Chairman of the European Association of Corporate Treasurers, noted during the webinar, “It is important to have a business-driven Treasury in order to help the company to grow by selling in more currencies”.
How to deal with currencies that trade at a forward discount
Firms selling in emerging markets need to consider the impact of the ‘cost of carry’, the interest rate difference between EUR and emerging markets’ currencies. And they need to do so in different dimensions: pricing, credit risk and FX risk management. Using ‘forward points’ —the difference in interest rates— allows them to price competitively. But there is a reason why interest rates are higher in emerging markets’ currencies: risk. A firm selling in EUR in Brazil to a client might face unexpected problems in the event of a sharp BRL devaluation.
A Brazilian client in that position might consider extending paying terms, as its managers seek a better exchange rate to settle their bills. “But speculation, says Antonio Rami, is not a good business strategy”. In other words: by pushing currency risk onto customers, firms that sell only in EUR may be inadvertently creating more credit risk for themselves—something that could be easily avoided by selling in local currencies in the first place. Eliminating this unnecessary risk is yet another example of what companies can achieve by taking control of FX.
The last point to consider when selling in emerging markets is the impact of ‘forward points’ in hedging. Managers are naturally reluctant to sell currencies that trade at a forward discount. But this is counter-productive. Currencies with a high cost of carry tend to be highly volatile, and refusing to hedge can lead to severe losses. The solution is to calculate a weighted-average rate of all individual pieces of exposure and to build a ‘tolerance’ (in % terms) around that benchmark rate. Then, ‘take-profit’ and ‘stop-loss’ orders are set that allow the firm to effectively delay the execution of the trades, and thus to take shorter-maturity hedges that create savings on the carry.
Key takeaways: gain first mover advantage!
A variety of hedging programs —and combinations of programs— are available that allow firms in the mechanical engineering space to manage currency risk in accordance with their pricing dynamics and business needs. Whether they operate with calendar-based pricing, contract-based pricing or stable prices across many periods, firms can adapt their hedging to create a smooth hedge over time rate if needed, or to hedge their ‘firm commitments’ (SO/POs, sales/purchase orders), or any other need or combination of needs.
The apparent complexity of dealing with currency risk can be easily handled by streamlining and automating these processes to the maximum extent. By dealing in the currency of their clients and suppliers, companies become more profitable, and they gain control over their competitiveness. This is how they can gain ‘first mover advantage’. It is no small achievement.
If you’d like to find out more about specific hedging programs for the speciality chemical industry, check out our webinar on this topic: