Hedging, Acquisitions, and Managing Risk and the Chinese Market
Hedging by non-financial means or internal hedging is simple to use and cost effective. This type of hedging could minimise exposure to foreign exchange risks and can be applied irrespective of changes in the market. Internal hedging techniques may include leading and lagging the exchange transactions, local currency invoicing, a natural hedge, currency diversification, currency offsets, and mark-ups or could be in the form of counter-trades. By invoicing in the local currency, the primary motive of avoiding foreign exchange exposure is achieved with all risks being effectively transferred to the other party or the customer in the transaction. However, a higher price may be charged by the other party as compensation for the additional risk taken. Hedging by means of a natural hedge involves offsetting foreign exchange receivables and payables on the basis of timing, currency and the quantum of the transaction involved. However, disadvantages with this hedging include a sort of imperfect hedging, i.e., either party could be in loss or one of the parties could incur additional costs from borrowing in unknown markets or business and the products imported could be of inferior quality at relatively higher prices. In currency diversification, MNCs are involved in diversifying transactions among various countries in different currencies, thereby diversifying the associated risks. Thus the effects of adverse fluctuations in currencies would be minimal as many currencies are involved. In the case of currencies with perfect negative correlation, diversification could be very effective. Hedging by way of leading involves changing the timing of payment before the date of agreement based on the anticipated movement of depreciation in the foreign currency. Lagging involves the companies stalling the cash flow after the foreign currency appreciates. The leading and lagging strategies involve varied payments and hence they are not easily predictable; moreover, the costs involved and the effects of such strategies need to be considered. Hedging by means of mark-ups involves the simple application of a price increase on the goods traded to cover the fluctuations in exchange rates and both parties must agree to this. While an exporter may increase the price of goods exported, the importer may increase the domestic price of goods imported. As a result of mark-up, the parties in the transaction may end up losing their market share due to competition. Counter-trade involves product for product exchange similar to the barter system with the only difference being that the products exchanged would be of same value without any time difference. Currency offsets take into consideration the time and the quantum of both receivables and payables in one currency and are applicable to transactions within the firm and between outside firms (Stanger, 2007).
For the attention of the Director of Finance:
In the year 2007, the People’s Bank of China (PBC) increased interest rates by six times and reserve requirements by 10 times to curb the effects of the existing exchange rate system; however, such amendments in the monetary policy do not seem to work for China and it is facing pressure from the world economy to indulge in a drastic revaluation of its exchange rate rather than ‘monetary tightening’. It is perceived that revaluation could possibly free the economy and bring the books of trade to equilibrium rather than have huge surpluses in current and capital accounts. The PBC in its monetary policy in February 2007 expressed its aim to strengthen the renminbi with a view to rectifying the trade imbalances and surviving inflation (Lambe, 2008). Significant trading partners with China have frequently wanted the government to appreciate the value of renminbi faster in relation to US dollar; however, it has been falling since July 2008. In the year 2009, it initially appreciated and later fell; it is expected that the government will make a few policy amendments in 2010 enabling the renminbi to grow steadily against the US dollar. The Chinese economy has grown stronger in the world and this puts more pressure on its currency. Imbalances in the global economy are attributed to the surplus in the capital accounts and the current accounts of China and such imbalances could be made good by the appreciation of the renminbi (www.proquest.com). However, the Chinese Premier during the last European Union-China summit in December 2009 stated that the renminbi would continue to be stable at a ‘balanced level’. In spite of maintaining foreign currency reserves at US$2,273 billion in September 2009, the exchange rate of China has been kept down and this is quite strange in terms of the history of the world’s economies. With the largest surplus in its current account, China’s growth in the world economy is at a faster pace, but the value of its currency has fallen by 12% in the last seven months. Large imbalances in the current account could be vulnerable in the asset markets, as opined by the Bank of Canada’s governor. China has managed its exchange rate system very differently from that of other large economies. The whole world is witnessing the current scenario and is very worried about the exchange rate system and policies of China (Wolf, 2009). Since the financial crisis in August 2007, the UK exchange rate has depreciated drastically. Although there was an appreciation of 10% in the initial phase of 2009, it was found that by June 2009, there had been no real appreciation in the index and it was lower than that of August 2007 by 20%. Prior to the financial crisis, the sterling rate was relatively stable and the current scenario suggests that the monetary policy needs to be re-examined. Any upward or downward movement in sterling would necessarily have an impact on the prices involved in foreign trade and asset prices (Astley, Smith & Pain, 2009).
The renminbi as against sterling was quite steady before the end of 2007 when there was a sharp downward shift until 2007 year end. Between August 2006 and March 2008, there was a 5.79% appreciation in the renminbi against sterling. Overall, there were smooth movements in the renminbi-sterling exchange rate carrying a standard deviation of 2.70.
Exchange rate volatility published by China in August 2006 showed that sterling had the smallest variance against the renminbi, in relation to China’s other trade partners. The table above shows that sterling maintained the smallest variance against the renminbi even in the year 2008. As this variance is the smallest this may mean that there is scope for sterling to play a vital role by becoming the invoicing currency for Chinese exports. Having said that, it is worth noting that the UK and China are involved in significantly less volume of trade relative to China’s other trade partners and hence the scope for sterling being the invoicing currency in Chinese trade may be limited (Yi, 2008).
Hedging is undoubtedly a judicious way to manage risk (www.proquest.com). Exchange rates are highly volatile in this globalised economy and, as a result, the transaction exposure in the form of foreign exchange exposure is significantly amplified. Owing to the high amount of perceived risk, MNCs are formulating suitable hedging techniques to keep losses incurred to a minimum or to enjoy abnormal gains from transaction exposure. Anticipated returns and the associated fluctuation in cash flows from dealings in foreign currencies primarily depend on hedging such investments. MNCs may hedge or resort to a no hedge position if that would leave the company in a better position, or they may decide to hedge in spite of prospective gains from an unhedged position. However, the ultimate goal would be to increase the return to shareholders by reducing the risks and the financial managers would employ many derivatives in order to hedge risks on payables and receivables transacted in foreign currencies. The managers concerned would be involved in numerous decisions prior to deciding whether or not to hedge the risk arising from foreign exchange rate fluctuation. As part of risk assessment, they would answer a few questions as to whether the company can increase the product’s price as a result of the increase in production costs that are associated with depreciation in the foreign currency value; whether market share would be lost with the costs being passed on to customers in the form of increased prices; whether competitors are exposed to similar risks and have hedged such risks; whether the company anticipates depreciation, appreciation or no change in the value of foreign currency in a given period of time; or whether the share price of the company would reduce as a result of volatility in income due to non-hedging. The managers would then decide to hedge with optimal techniques. They must adopt suitable hedging strategies based on the nature of transactions and quantum of risk involved. A few common instruments include futures, forward hedge, currency swap, currency options and money market hedge. Although many hedging tools are available, the money market hedge and the currency options hedge are quite popular. The money market hedge for receivables is possible by determining the present value of receivables and borrowing them in the foreign currency (e.g., Chinese currency) and later converting into the home currency (e.g., UK currency). Put Options, on the other hand, could be used to hedge receivables by selling a particular currency at a specific price; however, the owner is under no obligation to sell the currency at a specific price. The owner can, in fact, sell the currency at spot rate if the spot rate of the currency is more than the specific price. To avail themselves of this option, the seller would have to pay a premium. In contrast to the money market hedge, firms have flexibility with the options hedge since the right to exercise an options contract may be utilised when it favours such a transaction or else they could drop the put option and still avail themselves of the currency at a guaranteed price or the exercise price. However, if there is interest rate parity with transaction costs at nil, then the results from the money market hedge and forward hedge would be the same. Economic variables like differentials in income, interest rates and inflation and the time frame would have to be considered in the long run prior to deciding upon the hedging strategy (Khazeh & Winder, 2006).
China has witnessed tremendous advancements that have attracted more foreign direct investment. Many countries are involved in significant competition with manufacturers in China and tend to get attracted to enter the Chinese market. However, a lack of pragmatic understanding of the opportunities and the innate trade-offs in the Chinese market could pose a serious threat to a few firms. In spite of being among the greatest economies in the world, China’s per capita income continues to be low and was 100th in the global ranking in 2008. Factories owned by Western countries in China manufacture export items of high value. Low unit labour costs and an abundant supply of labour have been major driving factors for foreign expansion into China. However, China is currently facing labour shortages with increasing wage rates. Hence, prior to investing in China, companies have to carefully identify their motives for entry; is it to minimise expenses because of the low labour costs and attain competitive advantage, is it to develop a multinational customer base in Asia, or is it to compete in indigenous trade? Foreign entrepreneurs must fix their operations near the coastal region; otherwise they may end up incurring high transportation costs and staff training costs. Moreover, companies resorting to expansion in China to minimise labour costs must be aware that there could be a likely trade-off in the skill set, level of productivity and the quality of the resulting output. To illustrate, not even 10% of the total engineers that graduate each year in China could work in tandem with the international standards of engineering. Expansion in China may not be suitable for companies interested in a short-term venture. On the other hand, companies with the intention of competing on a long-term basis in the local market would have to deal in products of superior quality, as the consumers in China welcome international brands that are highly reliable. Product size dealt with by companies could depend on the nature of consumers, as the majority of Chinese consumers fall in the low-income groups and live in compact living spaces. Lifestyle, infrastructure and the regulatory framework in the domestic markets of China vary from region to region. Hence, it could be really challenging for firms to formulate an appropriate strategy suited to each region for marketing, advertising and distributing their products. Failure to implement the right strategy may result in losing customers to competitors. Companies that initially enter into Chinese market for sales may gradually be tempted to manufacture and sell to gain the benefits of low-cost labour. While designing products suited to Chinese consumers, entrepreneurs must take into consideration the intense competition in the local market as well as the heavy investment and overcapacity due to high involvement from the government. Moreover, local companies do not generally resort to restructuring; they would rather continue with the business unit in the same form. This could result in the pricing of products below reasonable rates in many industries, thus creating price wars. Hence it is suggested that MNCs need to have a ‘nuanced view’ of China and its market prior to deciding on exploiting or implementing the opportunities (Bruton, Ahlstrom & Yuan, 2009).
For the attention of the Managing Director:
Expanding organically results in the creation of innovative business opportunities. By organic expansion, firms ensure their operations are wide ranging. Healthy competition is highly achievable. Diversified operations could bring in the benefits of increase in market share through market penetration (Bousquin, 2005). Internal expansion is highly possible along with improved relationships with existing customers, apart from expanding the new customer base. Financial markets welcome organic expansion (Dalton & Dalton, 2006). By expanding organically, a firm could devise a strategy that guides growth in the long term; for example, Tesco achieved organic growth in Korea in the year 2002 by opening up new stores, unlike Carrefour. Organic expansion brings in efficient and quick expansion (www.proquest.com). Specialised services may be provided to suit customer needs and organic growth can fit businesses that attract a niche market. Exorbitant growth may not be possible by way of expanding organically. Additional capital requirements and a firm’s capacity to open up various locations could be significant barriers to expand. In the absence of effective management practices and performance monitoring measures, expansion could be unsuccessful (Deenitchin & Pikul, 2006). It may not necessarily favour entrepreneurial growth in the long run (Salvato, Lassini & Wiklund, 2007).
In case of acquisition, large-sized acquiring firms can benefit from simple integration with minimal supervision from managers (Verbeke & Yuan, 2007). Growth by means of acquisition could lead to long-term benefits of entrepreneurship. It could give new vigour to a firm with improved ability to foresee and respond appropriately to external changes. Acquisition enables firms to constantly refresh their knowledge base, duplicate past activities that contributed to survival and steady growth, and develop the traits required for improved growth to survive in the future. Large-sized firms are mostly involved in acquisition to partially eliminate the competition.
A ‘potential synergy’ or the phenomenon to revitalise the abilities of two firms could act as a motivating factor that resizes a firm from a small to a medium or a large size post acquisition (Salvato, Lassini & Wiklund, 2007). The requirement of large amount of capital could be a significant limitation for acquisition (Deenitchin & Pikul, 2006). Acquisitions involve employing talents with similar views to management and entrepreneurs in collaboration; however, the structural ability of the acquiring firm could be unsuitable. There is a perceived notion among firms that acquisition might deter the existing goodwill and hence they refrain from such activity. Small-sized firms may not be involved in acquisitions owing to a lack of potential synergy (Salvato, Lassini & Wiklund, 2007). A greater number of acquisitions in a period could lead to more managerial efforts and complex processes to integrate the acquired firms (Verbeke & Yuan, 2007).
Joint ventures are mostly considered when two companies aim to contribute and gain benefits from undertaking a project. Firms involved in a joint venture could enjoy the benefits of cost-cutting designs and market competitiveness (Bis, 2009). Joint ventures reflect a oneness with the goals of the parent companies with good inter-relations. The success of joint ventures could be enhanced by the extent of involvement of partners in strategic decisions (Rod, 2009). Joint ventures with international partners could help companies acquire useful skills to enhance cross-cultural rapport. Moreover, the experience of such international joint ventures could guide foreign acquisitions in the future, thereby enhancing the growth prospects of firms (Nadolska & Barkema, 2007). The less developed countries in a liberalised economy welcome joint ventures as they are a major source of foreign direct investment. However, joint ventures are mostly unstable and involve conflicts with the parent firm interfering too much in mutual activities (Chowdhury, 2009). Differences in the methodology and philosophy adopted by researchers could act as barriers to further advancements in the field. Ambiguous and conflicting views among the joint venturers could be detrimental. Lack of trustworthiness and pragmatic expectations may also strain the relationships. Differences in the cultures of the management and the nations could often result in conflicts (Rod, 2009).
Country risk analysis is an efficient tool to measure the emerging risks associated with a country in terms of various factors, namely, political, social, economic and financial factors that might deter the anticipated return from investing or undertaking a business proposal in another nation. Imbalance in these factors in respect of nations is attributed to investment risks. Various analysts have designed risk ratings for countries based on a comprehensive list involving risks in the form of economic risks, exchange rate risks, sovereign risks, political risks, transfer risks, environment risks. The root cause of risks, and the extent and likeliness of these risks altering the quantum of expected return, are identified by means of a ‘Country Risk Analysis’ (Meldrum, 2000). Political risks in the form of stability of government, conflicts within, concentration of power, corruption and accountability could be major determinants of business expansion (Bussea & Hefeker, 2007). A research based on Spanish multinational enterprises has resulted in a finding that MNEs resort to the ‘localisation of subsidiary firms’ throughout the world based on perceived corruption levels, restrictions of the host government, bureaucracy and the extent of liberalisation (Jiménez, Herrero & Corchado, 2008). Market entrants are more likely to expand internationally in countries that feature masculinity and individualism based on national culture (Rothaermel, Kotha & Steensma, 2006). Country risk ratings have an impact on innovative activities carried out in nations to a greater extent (Hoti & McAleer, 2006). MNCs tend to invest in countries that show considerable economic growth irrespective of high risks (Feinberg & Gupta, 2009). A high risk of terrorism in a country and foreign investment are negatively associated. An increase in the risk level of terrorist activity by a standard deviation could result in the decline of investment position to around 5% of GDP (Abadie & Gardeazabal, 2008). Country risk measures could at times be unreliable and significant investment opportunities might be lost owing to conservative strategies (Gregorio, 2005). Fluctuation in exchange rates is a major determinant of foreign expansion (Brandta, Cochraneb & Santa-Clarac, 2006). Inflation rates, deficits in budget, consumption, taxes and similar forms of political instability are positively related to capital flight (Lea & Zak, 2006).
Decrease in the ratio of volatility in consumption growth to that of GDP growth has a positive correlation to ‘financial liberalisation’ (Bekaerta, Harvey & Lundblad, 2006). Country risk in the form of higher interest rates is associated with decline in business expansion and vice versa (Neumeyer & Perri, 2005). Sovereign risk is amplified by the depreciation in the exchange rate of a nation that repays debt in foreign currency (Bordoa, Meissnerb & Weidenmierc, 2009). Economies that are politically inconsistent and polarised are often associated with increased default rates and interest rate volatility (Cuadraa & Sapriza, 2008). MNCs perceive definite monetary policies and military accomplishments of nations as determinants of country risk (Sussman & Yafesh, 2000). Research has shown that MNCs initially prefer politically unstable countries that exercise discretionary power in order to capture the market and attain the benefits of economies of scale; however, the tolerance level for political risk diminishes gradually and they tend to be conservative with the passage of time owing to the reversal of policies in the future. During 2005, the Law of Telecommunications was revised in Argentina when Telefonica had an aggressive negotiation with the host government to safeguard it against adverse implications. In spite of this, the firms still hold antipathetic views on other ‘macroeconomic uncertainties’ (Garcia-Canal & Guillen, 2008).
China has established itself by growing faster in the manufacturing sector in relation to any other economy. Various MNCs have already built their own manufacturing sites apart from offshore facilities in China for research and development. Enormous engineering talents have attracted companies like General Electric, Siemens, Toyota to develop their centres in China. ‘Low-cost engineering’ could be a major contributor for GDP growth in China (Eppinger & Chitkara, 2006). Manufacturing in China involve low labour costs while other Asian economies have relatively higher labour costs. Moreover, the compensation paid to city manufacturing employees is often underreported with a view to evade taxes and reduce insurance contributions (Banister, 2005). The domestic market of China is very strong (www.proquest.com). The Chinese economy saw tremendous growth and has recovered from recession and US President Obama opined that Beijing has got a vital role to play to “shape the 21st century”. China is the only growing economy and it has capitalised the market by a greater extent (Powell, 2009). In China, labour productivity grew at a tremendous rate in relation to labour compensation that actually led to a greater reduction in the unit labour cost (Chen, Wu & Ark, 2009). Goods that are manufactured and exported to Latin America by China account for more than 80% of the total exports of China. China has dominated the manufacturing sector so much that the manufacturers of Brazil might be ousted from the local and foreign markets (www.proquest.com). The formulation of appropriate strategies and improvement programmes in the manufacturing sector have been effective in improving the performance of manufacturing units and their financial performance in China. The inclusion of functions like operations, marketing and finance in the formulation of strategy has resulted in lower cost with superior quality, while the involvement of research and development, human resources and information technology is associated with all areas of ‘manufacturing performance’ (Qi, Sum & Zhao, 2009). The manufacturing sector may benefit from the growth of the population in China by way of improved economies of scale and increased returns (Zhou, 2009).
China’s economy has grown to great heights so that it is the second largest country in the world in terms of expenditure on marketing and advertising (Gary Chen, 2009). Its growth has taken root in the form of globalisation and competitive markets all over the world. The government has made an impact on the open market by privatising a few state-owned enterprises that precisely applied skilful management techniques to improve their feasibility and competitiveness (Oswald, Wang & Boulton, 2005). Moreover, the marvellous strategy adopted by the sales force is evident from the fact that the Chinese authorities have now altered the system of air flight plans by allowing customers to buy three hours prior to take-off rather than one day in advance (Perrett & Anselmo, 2009). It is quite apparent that the MNCs are attracted towards projects in China and significant motives involve the extent of diversification, technical expertise, monetary rewards and good interpersonal relationships with the Chinese population. However, firms must possess prodigious traits to undertake projects and survive in an exceedingly competitive Chinese economy. Enterprises with an excellent record of accomplishments, advanced management systems and infrastructure, superior products with exceptional quality of service could initially resist and further enhance skills to suit the global economy. Apart from the above advantages, firms could improve foreign business relations and benefit from economies of scale. By establishing a sales facility in a wide market like China, companies could boost sales and thereby reduce the expenditure incurred on research and development to a major extent (Ling, 2005).
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