For producers in a country like Brazil, where commodities like soybeans, coffee and sugar are frequently exported and are usually valued on a global market in U.S. dollars, understanding foreign exchange risk is crucial.
Because they are selling their commodities in U.S. dollars, producers often take on debt in dollars, too. As both their debt and future projected revenue are in the same currency, they believe they are naturally hedged in case the exchange rate between their local currency and the U.S. dollar fluctuate.
But there can be unforeseen risks, expenses and complexity created by taking on debt in dollars. The point at which producers are considering taking on debt can be a good time to look closer at how they are hedging their risks and whether they have unaddressed exposures. Here are some things to think about.
The true cost of borrowing in other currencies
For many producers looking to fund their operations with short-term debt, the dollar is often available to them at what seems to be a lower interest rate than their local currency. However, this sticker price can hide the costs and complexity of borrowing in dollars.
What are those other costs? First, producers now need to hedge the foreign exchange rate between the dollar and their local currency, which is not free. Second, they will need to develop internal accounting and risk programs. This could mean additional cost and complexity to meet the need for expertise on accounting, tax rules and other issues.
Only when these additional costs are quantified will a producer be able to truly compare “apples to apples.” In some cases, it may be more expensive to borrow in dollars, even if the interest rate is lower, due to the added complexity.
The myth of the natural hedge
By borrowing in dollars, a producer creates new sources of risk in their operations. Of course, there is the risk of the commodity price on the producer’s revenues, but there is also now a foreign exchange risk on the debt that will have an additional impact on the producer’s balance sheet.
Many producers believe that because both the debt and the future receivable are in U.S. dollars that they are naturally hedged. This isn’t necessarily true. Often, commodity prices and exchange rates move inversely – meaning that a strengthening of the dollar could coincide with a drop in the commodity price. That would leave the producer with a less valuable commodity to generate cash and repay debt.
Instead, producers must be sure to hedge the commodity separately first, before hedging the foreign exchange rate. Unless they do that, they don’t truly have a receivable defined in dollars to cover that debt. Many producers don’t do this because hedging their funding costs can be quite expensive; however, not doing it can be even more expensive.
For instance, say a sugar producer in Brazil borrows $1 million with the exchange rate at 3 reais per dollar, on the assumption that they will produce and sell $1 million worth of sugar. Then, say the rate goes from 3:1 to 4:1, and meanwhile the price of sugar drops 20%. If the producer hasn’t separately hedged both the commodity price and the foreign exchange rate, they will be trying to repay a debt of 4 million reais with just 3.2 million reais from their realized cash flows.
In other words, assuming that a natural hedge is effective could be a big mistake – in this case, a mistake that costs $200,000.
So with a clear incentive to find true protection, what can be done? Structured risk products can lock in a producer’s floor for both a commodity price and an exchange rate, while allowing them to capture any upside that may occur in the market.
Yes, these products do have a cost, but is that cost higher than the loss that may result from assuming that a natural hedge will work out?
Expertise to manage foreign exchange decisions
Finding the best solution to manage both debt and operations across currencies is not easy. Cargill has extensive experience in this area. We operate in 70 countries as a dollar-denominated company and manage our funding costs across currencies in complex operating environments.
Every year, we also move millions of tons of goods around the globe from where they are produced to where they are consumed. We can help provide insights and solutions to producers in Brazil and other major exporting countries, managing risk for both foreign exchange rates and commodity prices along the way.
Sometimes, the cost and complexity of managing foreign exchange risks can feel so overwhelming that it seems easier to count on a natural hedge. Doing so can lead to a painful surprise if there are exposures that go unaddressed.