For South African businesses involved in international trade, currency risk is often treated as something for the finance team to worry about when a large payment is approaching. A forward contract is taken out, a rate is locked in and everyone moves on until the next transaction comes around.
The problem is that this is only one small part of managing currency exposure. In my experience, a surprisingly large proportion of South African importers and exporters still do not actively manage their foreign exchange exposure as part of a broader financial strategy. Given how volatile the Rand can be, this should be on the radar of any leadership team with meaningful international revenues, costs, assets or ambitions.
The recent strength of the Rand provides a useful reminder. During August, the currency traded around the R16/$ level, supported by a combination of international factors, including a weaker US Dollar, as well as improving sentiment towards South Africa and expectations around the country’s economic outlook.
There is no suggestion that businesses should attempt to predict where the Rand goes next. In fact, the point is that businesses should be structured so that they are not overly dependent on getting that prediction right.
The famous Big Mac Index provides an interesting thought experiment. It is certainly not the tool you should be using to determine your hedging strategy, but its purchasing-power comparison suggests the Rand is significantly undervalued against the dollar. On a like-for-like Big Mac comparison, the implied exchange rate is currently somewhere around R9.50/$.
Nobody is suggesting the Rand is suddenly going to R9.50 to the dollar – but it does create an interesting “what-if” for your team to war-game. The more useful question for a leadership team is what would happen to the business if the Rand strengthened even a third of the way towards that level. Would margins remain intact, or would the business suddenly discover how dependent its profitability has become on a weak currency?
This is particularly relevant for South African exporters. A weaker Rand can make locally produced goods more competitive internationally and translate foreign earnings into more Rand. Over time, however, it can also hide inefficiencies in the underlying business. Costs can creep upwards, and margins can appear healthy because the exchange rate is doing some of the heavy lifting.
When the Rand strengthens, those inefficiencies become much more visible. That is why managing currency exposure needs to go further than simply hedging contracts or buying forward cover.
Where is your cash working hardest?
One of the areas that deserves more attention is how businesses structure their cash. As South African banking products have evolved, businesses increasingly have the ability to hold cash in US Dollars, Euros and other major trading currencies.
There can be perfectly good reasons for doing this, particularly if the business knows it has future liabilities in that currency. The problem arises when a foreign currency account effectively becomes a hedge against Rand weakness without management necessarily recognising it as such.
A South African business may decide to keep a large amount of cash in dollars because it is concerned that the Rand will weaken. If the Rand strengthens instead, the business has taken the opposite side of that currency movement and may find that the value of those funds falls materially when translated back into Rand.
There is also the question of what that cash is earning while it sits there. Depending on the institution, balance and product, a US Dollar call or deposit account can offer a materially lower interest rate than an equivalent Rand-denominated account. The business, therefore, needs to weigh the currency protection it believes it is getting against the return it is giving up.
This is a broader treasury question than simply asking whether the Rand will strengthen or weaken. Where is your cash working hardest, what future liabilities are you matching, and how much currency exposure are you comfortable carrying?
International growth changes the conversation
The discussion becomes more complicated when a South African business starts expanding internationally. Many entrepreneurs build intellectual property locally, gain traction in international markets and then start considering whether that IP should be housed elsewhere.
At this point, decisions that might initially appear relatively simple can have significant financial consequences. The externalisation or licensing of South African intellectual property needs to be considered carefully from a valuation, tax and regulatory perspective, particularly where transactions take place between connected parties.
The same applies to where international profits are housed. Jurisdictions such as the US, UK and Ireland remain popular with South African businesses, while we are currently seeing considerable interest in Dubai because of its accessibility and positioning as an international business hub.
For businesses looking to trade more extensively across Africa, Mauritius is another familiar option, while Botswana is often underrated. Botswana has no exchange controls and has developed a relatively robust financial environment, which can make it worth considering depending on the nature and footprint of the business.
None of these jurisdictions should simply be selected because they appear to offer a favourable tax rate or because another South African business has chosen them. Transfer pricing, withholding taxes, double taxation agreements, the location of employees, where value is actually being created and how profits ultimately return to shareholders all need to form part of the discussion.
Getting these decisions wrong can become expensive very quickly. A structure that appears efficient on paper may look considerably less attractive once the full tax, currency and regulatory consequences are understood.
Currency management starts long before the transaction
Too often, we think about currency movements at the point of transaction. An invoice arrives, somebody checks the exchange rate, and the finance team decides whether to convert the funds or take forward cover.
Sound financial strategy is developed long before that point. Leadership teams should understand which currencies the business is naturally exposed to, how margins respond to different exchange-rate scenarios, where cash is being held and whether international structures still make financial sense.
The Rand is simply too volatile for businesses with meaningful international exposure to leave these questions to chance. A relatively small currency movement on a large contract, cash balance or offshore revenue stream can very quickly translate into hundreds of thousands, or even millions, of Rand.
Hedging remains an important part of managing that risk, but it is not the be-all and end-all. Currency exposure ultimately touches cash management, profitability, tax, intellectual property, international expansion and the overall structure of the business.
The real question for leadership teams is therefore not where they think the Rand is going next. It is whether their business is financially prepared for wherever it goes.
Written by Rowan de Klerk, CEO of the CFO Centre South Africa