Published: February 01, 2012
Every treasury department operates within a set of treasury policies that define the conditions within which financing, investment, cash and risk management decisions must be made. These policies have come under scrutiny in recent years as the need to manage liquidity and risk has become more pressing, and in some cases, policies have been found to be inadequate in the face of extreme market conditions.
Another consideration for multinational companies is the issue that every jurisdiction in which they operate has distinct tax and regulatory requirements, different investment and financing conditions, and diverse currency issues. This is particularly the case in ‘emerging’ markets where the financial infrastructure may differ from more established economies. Consequently, while it is tempting to try to establish a consistent treasury policy that can be applied in all countries, the reality is that policies that are devised specifically according to the financial conditions in each market, whilst remaining within an overall liquidity and risk management framework, are likely to meet the needs of the business more specifically.
A key decision before devising treasury policy is to determine the degree to which the treasury organisation will be centralised, in terms of both financial decision-making and execution. In many cases, multinational corporations operate a regional approach, with decision-making often devolved to local entities in more challenging countries such as emerging markets in Asia and Latin America.
In contrast, The Timken Company (NYSE: TKR) has made the decision that all treasury, cash and financial risk management decision-making will be conducted centrally, with execution at a regional level. This approach allows us to concentrate expertise at the headquarters level, in order that all financial decision-making at an in-country or regional level is undertaken in the interests of the group overall, such as balancing risks at a global level, and offsetting movements in emerging currencies against EUR/USD from a risk perspective. At the same time, we can ensure that local and regional treasury, cash and risk management needs are supported appropriately.
To achieve this, treasury maintains bank relationships with emerging market representatives from our global banking partners in order to remain abreast of developments and opportunities. This is becoming easier as some banks are starting to locate expertise on key emerging markets (e.g., Brazil, India and China) in financial centres such as New York. In addition, however, by leveraging regional execution capabilities, we are able to operate within time zones and observe cut-off times more easily.
Taking a centralised approach to treasury management does not imply only repatriating all cash and investing/ borrowing only in the company’s base currency. Instead, by centralising decision-making, we are able to take a global view of the needs of the business whilst leveraging opportunities in each region. This is not the same as speculation; indeed, our decision to take a globally integrated view of risk and cash is motivated by our desire to maintain a conservative approach to financial management, which includes taking into account the economic conditions in each market in which we operate.
The treasury approach outlined above was initially prompted following the financial crisis in 2008. Before then, countries such as Brazil were considered high-risk so we typically avoided investing cash locally. Post-2008, however, it became apparent that banks in Brazil had been largely insulated from the crisis compared with banks in the US and Europe. We therefore decided to explore local opportunities for investment as a way of diversifying our risk whilst also earning an improved yield on cash. We spent a great deal of time looking at the investment alternatives, and developed a local investment programme from scratch. This process was very valuable, and allowed treasury to understand the local clearing system, investment instruments and tax treatment in detail. For example, the credit rating of some banks in Brazil exceeds that of Brazilian sovereign debt.[[[PAGE]]]
We found that the general rule for IOF (Imposto sobre Operações Financeiras – tax on financial instruments) was that 100% of cash withdrawals on day one are due as tax, while the tax requirement reduces to zero after thirty days. We also discovered that we could earn a return of 12-13% on conservative, highly rated instruments. We typically use three types of investment:
Brazil is not the only country in which we have defined specific investment policies in order to leverage advantageous investment conditions whilst remaining financially conservative. For example, in countries such as Romania, EUR and USD investment rates are typically better than investing in Eurozone or US banks, with the USD overnight deposit rate typically around 0.4% higher than in the US. Term deposits and stable balance accounts are often the best investment options in the country. In Poland, PLN term deposits have been providing competitive yields of 3.5% to 5% and sovereign short-term debt is also a good investment option, yielding 4.5-5%.
Investment in overseas markets also brings opportunities to benefit from currency movements. For example, if BRL stays within a range versus USD, yields can be up to 17%. Consequently, instruments such as one-sided deposits can be useful. If BRL/USD stays below a certain trigger, returns are enhanced. If the rate moves above the trigger, increased revenues from exports offset the loss of interest return, so this can be a useful tool for exporters in particular. These instruments can be tailored to the specific risk appetite of each organisation, so overall risk objectives are not compromised.
In other countries such as India, the investment environment is similarly positive but the ways of taking advantage of these opportunities may differ. India has a well-developed local liquidity market, but tax implications of investment are considerable, and consequently, the tax rate on investment can be more important than the return on investment. Interest on term deposits incurs a high tax rate, but short-term (daily) funds may yield 5-7% after tax. In addition, quarterly fixed maturity plans often yield 7-8% and are reported as cash and cash equivalents. Annual fixed maturity plans yield up to 10% after tax but do not offer flexibility should liquidity be required more quickly. Consequently, companies need to consider the tax implications and their liquidity needs as part of a local or regional investment policy.
Investment is not the only area of opportunity when it comes to defining a treasury policy in emerging markets. For example, financing should also be considered, particularly in markets where the flow of capital may be restricted such as China. China is rapidly becoming a key strategic market for many multinational corporations; for example, in Timken’s case, China has now overtaken Europe as its second largest market globally.
Despite the gradual liberalisation of the RMB, and the development of an offshore market, treasury management in China remains challenging. There are techniques for managing liquidity, such as cash pooling and entrustment loans, and RMB debt issuance by multinational corporations is currently growing rapidly. As in any other market, long-term bank relationships and a company’s credit history are vital factors in securing future liquidity, so for many companies, it makes sense to issue a certain amount of debt in China even if the company is cash-positive globally.
There are, of course, specific considerations when issuing debt in China in the same way as any other market. For example, treasurers need to take into account its foreign debit quota. While the short-term foreign debt quota is renewable following approval by SAFE, the long-term foreign debt quota is non-renewable. However, leveraging the maximum foreign debt quota may allow a company to create a loan conduit (intercompany loans) for future cash repatriation and in some cases will constitute a valid FX strategy for exporters.
In India, another key market for future expansion, INR loans are generally available but may be expensive, and tax treatment will vary depending on the reason for seeking financing. While intercompany loans are possible, these must be approved for a specific purpose, as opposed to providing working capital. Typically, these are three year term loans. In addition, intercompany borrowing may help to prevent ‘trapped’ cash that is subject to dividend tax. Loans from shareholders typically do not require approval, and USD short-term funding (up to 6 months) may be available through export packing credit.
Other emerging markets too present financing opportunities. For example, in Central and Eastern European economies such as Poland and Romania, credit lines are generally available with backstop guarantees, and intercompany loans are also permitted. These are considered as hedging due to high currency volatility. These countries also have few dividend restrictions. In South Africa, while ZAR funding is usually available, it can be expensive, and committed facilities carry high facility fees. However, to avoid commitment fees when funding is not needed, it is possible to negotiate and sign a facility letter and agree on prompt execution when the need for financing arises, with drawdowns on the facility then possible within five to ten days.[[[PAGE]]]
In addition to financing the business and investing surplus cash in emerging markets, risk hedging is a vital activity for every company. In our experience, traditional hedging techniques such as using FX forwards to hedge a fixed proportion of exposures may not be appropriate for more volatile currencies, or where currency movements may offset movements in currencies such as EUR/USD. It is also important to understand in detail the specific business risks in each country and structure a hedging strategy accordingly. Using India as an example, exports are a risk for most companies. Deliverable and non-deliverable FX contracts are highly liquid, and companies can switch quickly between on-shore and non-deliverable forwards. Consequently, we have designed our hedging programme in India to monitor the onshore/offshore matrix and to allow 25% and 75% exposures to be hedged according to market conditions, with a defined breakeven point such as INR 44 per USD. Typically, we have found it beneficial to hedge a lower amount in the long term, and also to take advantage of onshore pricing which is more favourable to exporters that the offshore market at present.
In China, the RMB has been appreciating steadily, a trend that we expect to continue, which is an important consideration for Timken as a net exporter. The way in which local operations are funded can be key to efficient hedging in China. We have found that leveraging our foreign debt quota by funding with non- hedged foreign debt has helped to offset the strengthening RMB; however, this approach requires the offset to be reviewed regularly.
In Eastern Europe, most FX instruments are available, and local clearing systems are efficient. During crisis economic conditions, the performance of Central and Eastern European currencies can help to offset a weakening euro, which therefore requires an integrated approach to hedging.
Taking a more bespoke approach to defining treasury policy, particularly in emerging markets, would appear to be essential in the current climate, with market trends often havng a different impact on borrowing, lending and FX rates. The concept of risk has also expanded in recent years. While counterparty risk has always had a place in treasury policy, it is more important than ever to identify the banks who can be relied upon, and to seek assurances from counterparties on their long-term viability. At Timken, for example, we review our investment holdings and authorised counterparties on a monthly basis, using a variety of criteria including credit default swaps, which we would not have considered in the past. Furthermore, we are taking a more integrated view of our total exposure to each counterparty across all financial instruments.
Another implication of our approach is that our hedging is more proactive and responsive to market movements. For example, if a currency is weak, we may choose to reduce our hedging levels and vice versa. This is not speculative activity, but instead, we are adding value by observing the market and protecting the company’s position based on the true market risks as opposed to theoretical risks. This approach requires timely execution of a larger volume of hedge transactions. We have reviewed different ways of achieving this, including telephone dealing, third party and bank-proprietary electronic dealing systems. Based on this analysis, we found that competitive bidding through an independent electronic dealing system was the best approach, by allowing us to achieve the most favourable rates whilst still transacting business with authorised counterparties with whom we have an available limit. We have achieved enormous savings by transacting FX deals competitively through an online dealing platform, which have enabled us to justify an additional person in treasury.
Timken is a conservative company with a highly disciplined approach to financial policy. However, by centralising our treasury decision-making, developing a high level of expertise in the markets in which we operate and defining a detailed treasury policy that recognises that emerging markets may provide opportunities as well as risks, we are better able to satisfy the needs of the company. As the global markets continue to be volatile, traditional markets remain relatively static and growth is generated in recently emerged or emerging economies, an increasing number of companies will recognise that a single approach to a diverse range of market conditions is not necessarily in the best interests of the company.
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