Published: March 01, 2008
This article discusses new ideas and challenges in treasury management, especially how companies can maintain long-term profitability within changing global and emerging market dynamics. Under the current volatile market conditions, it becomes critical for corporate treasurers to identify the appropriate liquidity and risk management strategies to generate maximum value in the long term. The world is experiencing one of the biggest economic revolutions in history, as economic power shifts from the developed world to emerging markets. As the developing economies contribute less to global growth, emerging economies have been rising as the key driver behind global trade and expansion. Operations in emerging markets need to be assessed carefully bearing in mind the multiple challenges and the various profit opportunities identified. There are many lessons to be taken from best practice investment decision-making practices in emerging economies which can be adapted to the corporate treasury processes of developed economies.
Following an ongoing series of market reforms, emerging economies are growing much faster than the developed ones. According to IMF, this year they are growing almost four times as fast. Emerging economies account for 30% of the world GDP at market exchange rates and over half are using purchasing power parity to take account of price differences. There is also ample global liquidity to fuel global economies, as well as emerging economies. Over the past year, broad money supply has increased significantly. The surplus of money growth over and above the growth in nominal GDP, a crude measure of the money available to be invested in financial assets, has been growing at its fastest pace for years.
Emerging economies have been rising as the key driver behind global trade and expansion.
Operational efficiencies, positive market and liquidity conditions led corporate cash levels and short-term investments to rise in all world economies. Only in US, the surge reached USD 5.4 trillion corresponding to 7.5% growth in 2006. It is important to note that it has been primarily mid-sized companies which have driven the overall growth in corporate cash levels. Cash balances have built up and the quality of balance sheets improved with free cash flow yields significantly increasing in both emerging market currencies and over 4% for major hard currencies like USD, Euro and GBP. Appreciating emerging market currencies since 2002 adds further value to the financial performance of companies with operations in emerging markets.
For some companies in developed markets, treasury departments have been a source of profit, but they remain purely a support function for many corporations in emerging markets. In line with emerging markets’ integration and growing contribution to the global economy, corporate treasuries in emerging markets have started to take more a strategic role in the company and add significant value for corporate shareholders. [[[PAGE]]]
In recent years, there has been profound change in the role and responsibilities of the corporate treasurer. During the 1970s, only the largest companies would have had separate treasury departments. Small and medium-sized companies would have had one or more members of the general finance function undertaking treasury duties which would mostly be part-time. Over the years, traditional treasury duties have evolved and changed into more value driven functions.
For the past few years, corporate treasurers have been developing their range of skills and areas of responsibility. Their focus on cash flow, working capital and risk has placed them at the center of corporate strategy. The forward-looking nature of their role, delegation of CFO duties and better visibility of cash and data elevates the strategic role of corporate treasurers. Corporate finance, enterprise risk management and M&A have been areas of responsibility on which corporate treasurers would like to focus more.
To deal with the competition, treasurers are getting more involved in the differing stages of the M&A process.
There were over 15,000 M&A deals globally in 2006, worth USD 2.5 trillion. This matches the previous peak seen in 2000. Small and medium-sized companies have been the major targets. In the first half of 2007, global M&A volume surged to USD 2.9 trillion, up 55% from the same period a year ago, according to Dealogic. It is important to note the average deal size, which rose 58% to USD 298 million. Rising numbers and scale of M&A deals have necessitated more time and effort from corporate treasury.
Ease of access to a widening range of target companies in an ever-shrinking world is stimulating the global appetite for M&A, which is keeping treasurers increasingly busy. To deal with the competition, treasurers are getting more involved in the differing stages of the M&A process. Reviewing the financing alternatives for the purchase of the company is a big focus. A close alignment of the M&A process and the financing process is the key to success.
Within a company, the treasurer is among the best-positioned to make long-term assessments. The role of the corporate treasurer is to extract the value of the current cash flows. Cash flow forecasting is considered good practice within the financial industry, yet many corporate treasurers struggle to achieve accurate and reliable forecast figures. Treasurers need to spend more time on cash forecast analysis in order to improve the overall decision-making process. Continued improvement in the quality, reliability and accuracy of the data collection process using integrated workflow and data technology will minimize treasurers’ time and maximizes efficiency in this process. Cash flow forecasting will continue to evolve, however there will be a need for more defined analytical modelling capabilities and analysis as well as projection tools. However, many treasurers are still unsatisfied with the focus and success in cash flow forecasting, with a lack of appropriate data and incorrect data continuing to plague results and leads to lack of motivation of staff.
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In the 2007 Strategic Treasury Survey, nearly 40% of respondents identified the lack of authority over key areas and insufficient staffing levels limiting treasury’s contribution to profitability. As treasury’s role has expanded from the transactional to the strategic, the quest to find and retain suitably skilled, talented people has become more difficult. In specific areas like investment management, the role of treasury is moving more towards the buy side and competing with money managers over compensation packages is getting tough.
The board and senior management must develop an understanding of market risk management in order to provide direction.
One big issue for many treasuries is that while their staff is underpaid, they need to come up with concrete performance measures to prove they are adding value and supporting profitability. While their role is broadening, treasurers have to develop more quantitative measures of success to capture treasury’s impact on the company with reference to global benchmarks.
Hiring experienced treasurers and educating a talent pool for new generation corporate treasurers allows companies to sustain the effectiveness and profitability in the long term. Developing and implementing a new treasury model takes a long time - at least two to three years. One factor that can ease and shorten the whole process is a strong commitment from the board and senior management.
It is interesting to note from the latest 2007 Strategic Treasury Survey that while 83% felt that treasury and the corporate treasurer have become more strategic in the past three years, only 72% felt that their senior management had recognized that fact. It is important to involve the board and engage senior management’s full commitment to challenging treasury policies. Treasury policies mean little unless the board and senior management fully understands and supports the strategic role and decisions carried out by the treasury, not only in the global arena but also in the volatile emerging markets. As corporate treasurers move into more value added roles and responsibilities, this involvement with senior management will guarantee the sustainability of the treasury profitability.
The creation of a treasury unit with clear treasury and market risk management roles that follows best global practices, is a critical step in gaining this understanding. Centralizing the treasury and streamlining business, support and control processes are part of the vital body of profitable treasury unit. Unless the board and senior management is well educated in the advantages of the new treasury model and confidence in it, all may fade away. The board and senior management must develop an understanding of market risk management in order to provide direction, while senior executives must acquire a new mindset as well as the necessary tools and staff to implement it. Ideally, senior management shall review and approve the treasury policies, which shall be reviewed and amended at least annually, as a form of formal vote of confidence. This will legitimize the documents as the terms of reference both within the treasury department and throughout the rest of the company.
To sustain long-term profitability, the foremost requirement is to implement an effective decision-making process and culture from top to bottom, where everyone starting from the board member to senior management and further down to all treasury team members to commune and support the treasury management policies and targets, to understand how the company identifies and manages market risks and then participates to sustain profitability.
The board and senior management need to communicate clearly their risk and return appetite, investment horizon, performance benchmark upon which the treasury can shape and adjust its strategies on an annual basis in line with the treasury policies. Especially in emerging markets, where local currencies are yielding significantly higher than G3 hard currencies, currency performance may be misleading. High yielding emerging market currencies also offer high volatility and noise for corporate earnings. It becomes more challenging for companies in emerging economies to meet financial performance indicators at the end of the reporting periods with over or under achievements due to currency and interest volatilities. Hence real performance of the core business can be difficult to present to shareholders and investors.
To sustain profitability, companies can maximize the benefits of centralized treasury in its long-term roadmap but they also need to face and adapt to unique local market opportunities and restrictions. Centralization brings the most advantages in the long term where the company believes the pooling or aggregation of activities or positions offers a distinct benefit. There might also a need for local knowledge and flexibility to maximize these benefits. [[[PAGE]]]
Ether at the local offices or at the centralized offices, corporate treasuries systematically identify, mitigate and profit from market risk, cash and liquidity management. Risks associated with changes in interest rates, exchange rates and the value of securities and commodities are part of the areas of opportunity to create significant value for the corporate. To convert the treasury function into a profit center, the corporate must develop a clear business plan, educate its capacity to manage market risks and get treasury more involved with senior management and company strategies.
As one of the major components of market risks, foreign exchange is a complex and difficult process to manage using old school thinking and methods. With the right application of systems, processes and staff, corporate treasurers will quickly adapt to control over the impact of foreign exchange on the financial performance of their company. For companies that step up and tackle this challenge, they can expect to have sustainable reduction in earnings volatility, lower costs, improved productivity and lower compliance costs.
Relying on ‘cliché’ technologies and processes would not satisfy investors, auditors and board members for missing earnings due to foreign exchange. As more emerging economies switch to floating exchange regimes, volatility of emerging currencies need special treatment and care from corporate treasurers. A company not actively managing its foreign exchange exposures is simply hoping the company will not get an unpleasant surprise in the next earnings report. Companies need to develop a set of best practices and currency risk management policies that reflect the business and market environment. Corporate treasurers are the knights to make sure to manage and adapt these policies dynamically.
Innovations in the financial markets have been supporting treasury's evolving roles in the past few years.
Innovations in the financial markets have been supporting treasury’s evolving roles in the past few years. There are more innovative financial products to use than ever before from which corporate treasurers can benefit. Corporate treasurers will educate themselves and their entity on how to utilize the structured products and services for the benefit of creating shareholder value. It is a continuous process for treasurers to spend time and effort to follow and understand payoffs of innovative, tailor made instruments and services. Where necessary, relevant training and technology support are widely available e.g. from the banks. These tools can only be useful and aim to support corporate profitability if treasurers provide feedback to the banks to help them to improve these products and services. Treasurers who get most out of the innovative products and services will differentiate themselves and their entity’s competitive edge from others.
In unstable and volatile financial markets, for many corporates, liquidity management has evolved into a source of competitive advantage. Although many companies can manage short-term liquidity, they fall short in other activities, such as trading, enhancing yield with structured products and actively managing market risk. Without clear understanding of the market risk, treasurers cannot protect the value of company’s current assets and capital.
Especially in emerging markets, where local currency yields offer significant return, risk and volatility, increases in previous mark-to-market valuations can easily vanish if not carefully managed. Risk and liquidity management need patient care and effort. Despite the attractive return opportunities which are available, liquidity in all asset classes can easily diminish and by the time international operations try to understand possible causes of market turbulence, the competitive and strategic investment decisions would be under spotlight for the emerging market businesses.
Investments in emerging markets have forced finance professionals to deal with many challenges in recent years. High real interest rates translate into more expensive hedging and borrowing costs for local operations - hence cash-rich companies have significant competitive advantage compared with others as their non-operational income starts to contribute more to the bottom line by enjoying high local yields.
Changing emerging market dynamics has led companies to start questioning their borrowing and hedging policies. International companies are increasingly preferring to borrow more in hard currency from the domestic markets, despite imminent currency risk. There are two major reasons behind the shift in policy:
It has been challenging for the companies who maintain old-school hedging tactics for their currency risks in the emerging markets. Full hedging alternatives have been very costly under recent conditions when emerging currencies have been appreciating. Competitive advantage can be lost if the treasurer does not guide the board and senior management on the possible pros and cons on risk management policies and instruments. It is apparent that companies may start to use more structural products to manage their risks as banks are offering more innovative and tailor made solutions. [[[PAGE]]]
Risk management aims to minimize the volatility of the corporate financial earnings but not to weaken its competitive edge. How competitors manage risks and understand the dynamics of the financial markets becomes very important for the treasurers in order to sustain the profitability in the long run. Companies in emerging markets may prefer to participate in and benefit from local currency appreciation and high yielding local yields while managing their currency and interest risks with stress testing, hedging with out-of-the-money contracts on both sides of the currency moves - in other words, protecting the company against over appreciation and against over depreciation of the local currency. Scenario analysis and stress testing enable corporate management to determine their comfort zone with respect to local interest and currency volatility levels. Major fluctuations may cause senior management to miss their key financial performance indicators approved by the board. Treasurers can step into the process to enable management to meet corporate targets by developing and implementing company’s own risk management and hedging strategies within the management’s comfort zone.
As roles and responsibilities broaden, it is important for corporate treasurers to separate and define borders of liquidity management and risk management principles and activities. Cash and Liquidity management needs to be performed with clear international currency benchmarks guided by the board and senior management. Yield enhancing instruments and domestic yield products may be utilized for achieving above-benchmark performance. It is interesting to note that, according to a 2007 European Corporate Treasury Research Program, less than 50% of firms have established performance metrics for treasury and over 70% of European liquidity resides in overnight investment instruments such as bank deposits.
Besides their market risk responsibilities, corporate treasurers act for the company and nowadays they are much more involved in Enterprise Risk Management than in the past. They can also play an important role in protecting corporate capital against the fortunes of a particular currency. Especially for international companies or companies with a diversified international shareholder and investor profile, it is important to benchmark and protect the capital into a single currency pair in the emerging markets.
Enterprise Risk Management has received increasing attention in recent years. ERM addresses a wide spectrum of risks, ranging from strategic to financial risks and to operational risks. Treasurers’ strategic approach to risk management has the ability to reduce earnings volatility, which can translate into a lower cost of capital. The theory behind this argument is that investors demand a premium for companies that have high volatility in their financial results.
An increasing number of well-respected analysts are suggesting that a recession is either already starting or will soon be here, and the list is growing every week. Credit is both harder to get and more expensive. The cost of borrowing dollars in the financial sector is soaring as banks need funds to cover their commitments. Corporate treasurers will be a lot busier dealing with many head and tailwinds in the global economies to support the corporate business and earnings with dynamic liquidity and risk management strategies, which need to be fully shared and supported by the board and senior management.
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