RDP 2006-09: Limiting Foreign Exchange Exposure through Hedging: The Australian Experience 4. Measuring Foreign Currency Exposure

As foreign capital has always flowed into Australia, at least in gross terms, since the early 1970s, this has allowed investment to outpace domestic saving. This process has continued in recent years. As a result, net foreign liabilities rose from around 30 per cent of GDP in the mid 1980s to around 60 per cent of GDP by March 2005 (Figure 7). This has been mainly in the form of net foreign debt, with net foreign equity relatively stable over the period.

The net foreign debt position of a country is often used as a crude measure of its external vulnerability, particularly to exchange rate depreciation. However, an accurate understanding of the exposures to foreign currency fluctuations requires a detailed examination of gross assets and liabilities, by debt and equity, their respective shares denominated in local and foreign currency terms, and finally the extent of hedging provided by off-balance-sheet derivative instruments.

4.1 Gross Foreign Assets and Liabilities

An examination of Australia's gross external position indicates that the accumulation of foreign debt has been most important in explaining trends on the liabilities side (Figure 8). However, as at March 2005 a considerable proportion of total liabilities (around 40 per cent) consisted of foreign claims on domestic equity. Since the claim on domestic firms' equity by foreigners is in Australian dollars we can infer that these liabilities are unaffected by exchange rate fluctuations.^[21] Around 60 per cent of foreign assets consist of equities, and these are denominated in foreign currency terms.

A considerable proportion of foreign debt liabilities are denominated in local currency terms, as foreigners are willing to hold a portion of their foreign assets in Australian dollars. This reflects Australia's status as a mature industrialised economy with favourable credit ratings for the public sector and many large private firms. In the case of foreign debt assets, some proportion of these is also denominated in Australian dollars. These represent purchases by domestic residents of Australian dollar-denominated securities issued by foreign borrowers.

Identifying the value of local and foreign currency denominations for both assets and liabilities reveals a crucial point about Australian residents' overall foreign exchange exposure (Figure 9).

Gross foreign currency-denominated assets were $533 billion as at the end of March 2005, exceeding gross foreign currency-denominated liabilities of $428 billion. That is, the economy as a whole had a positive net foreign currency asset position. Therefore, a depreciation of the Australian dollar would actually result in an overall reduction in the value of net foreign liabilities of Australian residents, other things equal.

This result is illustrated in more detail in Table 3, where the interaction between foreign currency assets and liabilities for a given exchange rate depreciation is shown. Total foreign assets amounted to $625 billion as at the end of March 2005.

Of this, $360 billion was in equity, and therefore in foreign currencies. The remainder was in debt, of which the external accounts show two-thirds were denominated in foreign currencies, with the remainder in Australian dollars. Foreign liabilities amounted to $1,180 billion. The equity claims of foreign residents are denominated in Australian dollars. Almost 40 per cent of debt liabilities were also in local currency terms, with the remaining 60 per cent in foreign currencies.

The overall net foreign liability position was $555 billion as at the end of March 2005. However, looking only at assets and liabilities denominated in foreign currencies, there is a net foreign asset position of $105 billion. The impact of depreciation in the local currency is to boost only the Australian dollar value of amounts denominated in foreign currencies. As a result of a 10 per cent depreciation of the Australian dollar, foreign currency-denominated assets would rise by $59 billion (from $533 billion to $592 billion), but foreign currency-denominated liabilities would rise by only $48 billion (from $428 billion to $476 billion). Hence (other things equal) a 10 per cent depreciation would have lowered the overall net foreign liability position by $12 billion (or 1½ per cent of GDP).^[22],^[23]

This estimate of the valuation effects of a depreciation can be further refined to take into account off-balance-sheet derivatives.

4.2 International Adjustment Augmented for Hedging Practices

The latest hedging survey shows that firms sought to limit their foreign currency exposure on debt assets and liabilities by converting around 79 per cent back into local currency terms, while around 21 per cent of foreign equity assets were hedged back into Australian dollars as at 31 March 2005.

The last column of Table 4 shows the estimated values of residents' exposures denominated in foreign currencies after accounting for hedging activities. On the asset side, hedging acts to limit the valuation gains from depreciation as it shifts some foreign currency-equity assets back into Australian dollars. However, this dampening effect is more than offset by the fact that derivatives convert a much larger proportion of foreign currency-denominated debt liabilities back into local currency terms, thus reducing the increase in the value of the liabilities which would have otherwise been brought about by exchange rate depreciation. Overall the net foreign asset position subject to exchange rate fluctuations increases to $232 billion with hedging. In other words, residents have an even larger net long position in foreign currency after accounting for hedging.

Allowing for the same 10 per cent depreciation of the Australian dollar and taking account of hedging, foreign currency-denominated assets would rise by $36 billion (from $322 billion to $358 billion), while foreign currency-denominated liabilities would rise by only $10 billion (from $90 billion to $100 billion). The decline in net foreign liabilities would therefore be twice as large with hedging at around $26 billion (or 3 per cent of GDP), indicating the important role that hedging of foreign currency exposures plays in the Australian economy.

With the overall balance sheet position of Australian residents long in foreign exchange after hedging is taken into account, there would be valuation losses associated with Australian dollar appreciation. But since periods of exchange rate appreciation are usually those when the economy overall is performing strongly, the impact of such losses should generally be of less significance.

4.3 Residual Risks to Consider

Given its external position, Australia has often been thought to have a large balance sheet exposure to exchange rate depreciation. The sections above show this not to be the case in 2005, due to the currency composition of the external accounts as well as hedging. However, this is not to say that the economy is unaffected by exchange rate fluctuations. The exchange rate remains an important macroeconomic price, and a number of exchange rate-related considerations remain. Several of these are outlined below.

At the outset of this paper we defined its scope as dealing with directly quantifiable financial gains and losses on balance sheets and capital flows from exchange rate changes, rather than more commonly debated macroeconomic effects such as competitiveness. Nonetheless, these effects remain important, and insofar as hedging has implications for the degree of pass-through from the exchange rate to economic activity and inflation, they are related.

While hedging using derivatives is able to insulate balance sheet positions from exchange rate swings indefinitely once in place, hedging is more limited in its effectiveness in insulating trade flows. The practice of hedging trade positions over an average horizon of one year smooths cash flows, but does not provide full cover against adverse exchange rate movements given that cycles in the Australian dollar typically last for several years. For example, a one-year export contract denominated in US dollars may be hedged with derivative instruments that guarantee a given Australian dollar-denominated revenue stream over that period. However, at the time a new contract is agreed the hedge may have to be renewed at a less favourable exchange rate if the Australian dollar has appreciated in the interim.

A further source of risk arises from the ‘rollover risk’ associated with renewing existing hedging contracts or creating new positions in derivatives contracts. If non-residents were no longer willing to be counterparties to the hedging instruments that create an exposure to the Australian dollar, it would not be possible for residents to continue to pass their foreign currency risk onto the rest of the world. Given that the banking sector is the largest single source of foreign currency exposures before taking into account hedging, the rollover risk is most relevant to this sector. The potential concern is whether it is likely that for one reason or another Australian banks would not be able to swap their foreign currency debt back into local currency terms, and if so, what the consequences would be. However, such risks appear to be well-contained as there is a wide base of international investors who hold a proportion of their portfolios in Australian dollars. This is also reflected in the depth of the Australian dollar swaps market with average daily turnover of around $45 billion, of which $25 billion per day is between domestic and overseas banks (Figure 10).^[24]

The impact on banks of a sudden shift in sentiment which limited their ability to raise debt in offshore markets would depend on the context in which this occurred. One could envisage such a change would be most likely to occur when the economy was subject to an adverse shock. The main impact would be a decline in the exchange rate. This, of itself, would not have any significant effect on banks because, as noted, banks have no net foreign currency exposure on the existing stock of debt. There would be some rise in spreads on bank debt, both overseas and in domestic markets, but the main impact on banks' interest costs would depend on what happened to inflation, as this would be the major influence on the level of interest rates. While some might argue that a fall in the exchange rate would be inflationary, it is not clear that this would in fact be the case. This is because the underlying cause of the fall in the exchange rate would most likely be a deflationary shock.

Footnotes

Relatively minor exceptions are American Depository Receipts and dual-listed company structures. [21]

Other industrialised countries, such as the US, are in a similar position (see Appendix A). It is worth noting that this example is deliberately stylised to focus only on the direct sensitivities to a change in the exchange rate. Other things are unlikely to remain equal in the event of a sharp depreciation, the most obvious being the listed share prices of Australian firms in the tradables sector. [22]

Emerging-market countries are often characterised by their inability to access international capital in their local currency. The resulting foreign exchange exposures create vulnerabilities often summarised by the term ‘original sin’ (see also Hausmann et al 2002). [23]

From Table 2 we know that the net position of banks in derivatives is $153 billion. The Australian foreign exchange swaps market is therefore sufficiently deep for this position to be turned over more than 3 times a month, or around 45 times a year once turnover in cross-currency interest rate derivatives is also taken into account. [24]