Rajveer Berar
What could falls in sterling mean for UK firms’ ability to sustain foreign currency (FX) debt obligations? The value of sterling began falling around two years ago and dropped further after the EU referendum – remaining around these lower values ever since. There is every possibility that sterling may stay low for the foreseeable future – creating both potential winners and losers. In this piece, I investigate one particular channel for losses related to sterling weakness: whether UK firms could find meeting their FX debt obligations more challenging. By reviewing market intelligence, market prices and derivatives databases, I find limited evidence that sterling weakness has yet produced any significant changes to UK firms’ ability to manage their FX debt obligations.
Sterling depreciation
The sterling exchange rate index is around 15 percent lower than it was at the beginning of 2016, with around 9 percent of the fall occurring between 23 June and 1 July 2016. However, it is not always clear whether it is the direction, size or persistence of a currency change that impacts most on the outlook for the UK corporate sector – as there will be both potential winners and losers in each case. Exporters might do well in the short-term, while it may impose cost pressures on UK consumers and firms reliant on imported goods and materials (provided they are unable to offset these costs via higher income generated from abroad). The dispute between Tesco and Unilever in October 2016 over the latter’s attempt to raise prices for a number of well-known food brands (‘Marmite-gate’) was a high-profile example of how sterling weakness can have an impact on UK firms’ supply arrangements. But as the cost and price effects of weaker sterling are covered quite extensively in regular UK inflation assessments (see Section 4 of the November 2017 Inflation Report), I instead focus on risks to the UK corporate sector from FX debt mismatches. In particular the non-financial corporate sector, because for major UK financial firms (who often bear the ultimate FX risk), UK regulatory supervisors have detailed firm-by-firm information on their vulnerability to FX risks – so my motivation here is to focus on an area where data analysis is considered to be more challenging.
UK firms and FX risks
FX movements can impact multiple measures of corporate health, for example through mismatches between revenue and costs (“transactional FX risk”), when converting higher value of foreign costs into domestic currency (“translational FX risk”), or when foreign currency debt is unhedged (“economic and structural balance sheet FX risk”), to name a few. When a firm borrows in FX, or has FX liabilities which exceed its FX assets, a fall in the value of its domestic currency can leave it facing higher debt service costs, and hence, lower its profitability (all else being equal). While such risks can and frequently are hedged, these carry a cost (particularly at longer tenors) and may only imperfectly hedge the underlying risk. This can raise the credit risk for those firms, with potential implications for banks’ potential loan losses. And the effects may also reverberate via bond and equity prices, increasing the cost of financing for firms.
The November 2017 Financial Stability Report (page 24) includes an estimate for the stock of foreign currency debt collectively issued by UK private non-financial corporations (PNFCs) to be around £300 billion, which is estimated to exceed the stock of their foreign currency assets by about £100 billion. This would suggest that balance sheet mismatches within the sector are likely to be significant, at least before debt hedges are taken into account. Of this debt, it is estimated that around £200 billion is in the form of foreign currency bonds and the remainder is in the form of foreign currency bank loans.
In aggregate, the average maturity of UK PNFC foreign currency bonds is estimated to be around nine years, and of the foreign currency loans originated from UK banks, around 60% have original maturities of over one year (see Bankstats Table B2.1.1). This reflects the relative balance in corporate demand for term loans (which are frequently structured using tenors of up to six years) versus firms’ demand for shorter-tenor revolving credit facilities (often structured as 364 day renewable loans). And there is little evidence that typical corporate borrowing tenors have changed significantly in recent years.
Should we be worried?
Looking at aggregate data can miss potential pockets of risk, as some firms are more exposed to FX mismatches than others, although obtaining firm-level data to an appropriate degree of granularity and/or time specificity can be challenging. So, to understanding FX risks beyond relying on macro data and (micro) financial statement analysis data, I instead rely on: (1) market intelligence; (2) analysis of trade repository (TR) data related to FX derivative transactions; and (3) a review of signals from firms’ market prices.
1. Evidence of FX risk management from market intelligence
Intelligence from the BoE’s Agency network suggested that higher input price inflation, more than FX debt servicing, has been the main channel by which firms, particularly SMEs, have been affected by recent sterling depreciation. Figure 1 illustrates the results of a short survey facilitated by the Agency network of around 80 domestic, largely mid-sized, firms (40% of respondents had turnover of less than £25mn or fewer than 250 employees, which is the formal definition of an SME), showing that the main use of FX hedges by firms is to hedge short-term input costs.
It is widely known that larger firms with foreign currency borrowings (whether bond or loan) typically seek to hedge through “natural hedges” (using FX income to service FX debt) or through FX swaps and forwards. Cost-effective access to foreign exchange hedges will therefore be important for firms. Speaking with market intelligence contacts, they suggest that a variety of factors may have increased those hedging costs in recent years, particularly for smaller firms and at longer tenors. One factor, for example, has been the response of banks to regulatory changes to capital and funding costs. Higher hedging costs may have inhibited some smaller bond issuers from choosing to access non-sterling bond markets. And uncertainty over the future path of sterling may have also added further hedging costs.
2. Evidence of FX risk management from the Trade Repositories (TR) database
With market intelligence suggesting that the cost of hedging has gone up, I would have expected to see fewer firms using hedging. As a result of EMIR implementation, I can now investigate whether this effect has been large using the BoE’s access to TR databases. By using transaction-level data for derivative contracts placed by non-financial companies (NFCs), I can monitor the level of FX hedging activity – for both input price hedging and debt hedging. Figure 2 shows that, with the exception of a short-lived increase around the time of the EU referendum, the number of NFCs placing foreign currency hedges (black line), as well as the volume of those forward FX contracts, has remained broadly flat.
Figure 2 also shows that the vast majority of FX hedges are booked for less than six month maturities. Once those hedges expire, firms are exposed to higher FX costs. From the data, however, it appears that the level of firms’ hedging activity has been maintained.
3. Evidence of FX-related risks from share prices
I also sought to identify potential vulnerabilities within listed UK companies by examining how individual firms’ share prices taken from the FTSE All-Share index, have responded to sterling volatility.
Figure 3 plots firms’ sensitivity to sterling exchange rate movements (after controlling for movements in the wider market) against the size of individual firms’ foreign currency borrowing once the effect of firms’ relative export orientation has been removed. Here, the share of international sales within total sales is used as a simple proxy for firms’ ability to put “natural hedges” in place.
Figure 3 does not show a positive relationship between firms’ sensitivity to falls in sterling and levels of their foreign currency bond financing, suggesting that the market is relatively unconcerned about firms’ ability to continue financing themselves in this manner.
Conclusion
Overall, there is little evidence to suggest that risks associated with the foreign currency debt obligations of UK firms are currently a significant concern.
Data from the TR database shows that there has not been any material disruption to firms’ ability to hedge FX exposures, despite the significantly lower values of sterling. And market signals and market intelligence do not suggest wide-spread FX concerns within the UK corporate sector. This should, in theory, give some comfort in the near-term, but prolonged sterling weakness could still put sustained pressure on UK firms’ business models.
Rajveer Berar works in the Bank’s Macro-Financial Risks Division.
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