Managing Currency Risk in Procurement
The adage that the only constant is change is especially true in regards to currencies. It is important for procurement professionals to periodically revisit their contracts and ensure they are not caught off guard.
Global sourcing is a given today, as procurement continually looks for suppliers around the world for goods and services. As a consequence, currency risk is one of the major barriers faced by global sourcing initiatives aimed at achieving incremental cost savings. Procurement efforts in getting that prized deal may yield zero or even negative results if this key aspect is overlooked. So what can procurement do?
Firstly, you should have fair idea of your firm’s risk appetite; closer ties with finance will help you better understand the level of oversight needed. Also, figure out if you are able to pass your increased costs to customers, and if not, know that managing currency risk will become even more important.
Finance departments typically employ currency hedging. But how much to hedge? This is also determined by your risk appetite. Companies in commodity or agriculture businesses will hedge as much as 80% of forex exposure. The number will be much lower for technology firms that sell propriety software. Remember, hedging may also result in lost opportunities as currencies can move in either direction, but it is primarily a tool for risk aversion to avoid unpleasant surprises. Even the most mature organizations use hedging as a means to improve their bottom line.
Procurement should know who holds the currency risk – is it the buyer or the supplier? Consider the case of a U.S. company buying from a supplier in China and paying in USD. In this case, the supplier holds the currency risk. A clause in the contract that states the USD price will change per the exchange rate will shift that risk to the buyer.
In either case, there is a premium associated with this risk. If you are unsure of the premium you can have your supplier quote in both currencies. We have seen Chinese suppliers adding premiums of up to 3%, which means the buyer is paying 3,000 USD more for a 100,000 USD purchase. It is for you to decide if you are willing to take on the risk and save your company this premium. Your finance team will be a good resource for advice in these situations.
Contract escape clauses that allow a party to opt out of an agreement are sometimes required by finance and legal departments. This is more common for repeating purchases and it is unlikely a supplier building a custom piece of capital equipment will be willing to enter to such a contract. In these cases, formal currency reviews at preset times or for special events can be employed. The party taking on risk will typically agree to a range of currency movement (say up to +/- 5%) and also charge a nominal premium for the same, but both entities agree to share currency risk if it moves beyond the accepted bandwidth.
Understanding your suppliers’ operations can also help. Buying from a Swiss supplier today could be expensive, but knowing that the supplier is in turn buying from non-Swiss firms and paying them in their local currency can be useful ammunition in your negotiations.