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The World According to Jeff Wallace

Jeff Wallace is managing partner at Greenwich Treasury Advisors, a consulting firm he founded in 1992. He served as a vice president at American Express, where he managed the company's debt and foreign exchange exposures, as well as assistant treasurer at Dunn & Bradstreet and Seagram. Wallace advises the treasurers of multinational corporations on a wide range of issues, often adapting the arcane risk management concepts pitched by dealers into the practical realities of the treasurer's office. He has long argued for a more global portfolio approach to treasury management, with a centralized world-wide treasury function, and for integrating treasury expertise into a company's business units. He spoke with editor Joe Kolman in January.

Derivatives Strategy: The EMU has been discussed ad infinitum, but I'm not sure corporates have a grasp on what it really means. Do you think corporates are prepared for a radically new version of Europe?

Jeff Wallace: Most American multinationals are completely denying the reality of what's coming. They've got too many things on their plate right now to worry about something that's going to happen in 1999. Up until recently, they could have had doubts about whether it was going to happen. But now it's clearly going to happen and there are a number of things American corporate treasuries should be doing.

The first thing is that it's obvious now that hedging the European currencies one by one instead of on a portfolio basis is a wasteful practice. If you're short Deutsche marks and long French francs and you're hedging both separately, you're wasting your company's money, because they are both moving in tandem and they effectively offset each other.

DS: But there are still some remaining correlation issues to deal with.

JW: That's right. And the best way to manage them is not by what I call naive proxy hedging—where you take the current exchange rate and do a one-for-one offset—but to manage the currencies on a portfolio basis and use JP Morgan's RiskMetrics to manage the correlation. RiskMetrics data were designed for portfolio hedging and take into account the less-than-perfect correlation between the currencies. We have one major multinational client who's managing all of his global exposures (which are largely European) on a portfolio basis, and they're seeing savings in hedge costs vs. 100 percent individual currency coverage of more than $3 million dollars a year.

DS: Why do you think people are hesitant?

JW: First, the proxy hedging that many did in 1992 turned out to be a real disaster and a number remember how badly their fingers got burned. Second, many corporate policies mandate individual currency hedging. Third, most companies will assign the foreign exchange gains and losses back to the individual units generating the exposures. When you manage things on a portfolio basis, allocating individual-unit foreign exchange profits and losses relating to the hedging becomes a more complex accounting problem.

DS: Is it impossible?

JW: Absolutely not. There are a number of approximations and ways to do this. It just shows how an accounting process performance evaluation can conflict with appropriate hedging techniques. The best way to do it is to hedge the affiliates perfectly with internal contracts so they get the benefit of the 100 percent hedge. That's the way most companies like to operate. With the exposures transferred via the internal contracts into the centralized foreign exchange center, often an in-house bank, the center manages them on a portfolio basis. The center either keeps the hedge savings or reallocates the savings back based on the size of the original underlying exposures. $3 million will pay for a lot of accountants.

DS: What percentage of the Fortune 500 multinationals do portfolio hedging?

JW: Of the Forbes Multinational 100, I'd bet 85 percent hedge foreign exchange on a centralized basis, but I'd bet no more than 20 percent are hedging on a portfolio basis. The rest are still hedging currencies one by one.

DS: How is monetary union going to affect cross-border cash management in Europe?

JW: The implications are profound. The largest multinationals are now consolidating their European units' cash on a daily basis. The subsidiaries send their daily excess cash to an in-house bank in the local currency, which is then swapped into dollars and reswapped to fund the cash deficit subs. The major pan-European cash management banks—Citibank, Bank of America, ABN-AMRO—can handle the difficulties of setting all of this up, but it takes large volumes to make it worth the effort. With the euro, all the foreign exchange swapping, value dating and lifting charge problems just disappear. It will be as easy as sending dollars from New York to Chicago. Everyone will be doing it.

DS: Sounds> like some people are going to lose their jobs.

JW: You won't need as many people. Your European regional treasury staff will be able to manage Europe on a classic American cash management model. They'll use their local operating banks to continue to collect from customers in local currencies. Then they'll convert the local currency to euros and transfer it to the in-house bank's euro account, which will then fund each subsidiary's disbursement accounts.

DS: The big three pan-European banks can do this for their clients, but what about the others?

JW: The second- and third-tier European banks don't have the systems expertise. They're preoccupied with the year 2000 problem, and when you add euro capabilities on top of them there's a serious question about whether they'll be able to get their acts together.

DS: Is there enough capacity to handle the demands American and European multinationals are going to put on the big three banks when the euro arrives?

"If you're short Deutsche marks and long French francs and you're hedging both separately, you're wasting your company's money.”

JW: I think it's a real serious question. When the rest of the world wakes up to what's really possible in 1999, are they really going to be able to go to their banks and get service from them? It may well be that the pan-European banks will have so much business with their current clientele that they won't be that eager to add new companies. So you could see a big rush and a long queue at the big three banks.

DS: Everything we've been saying assumes EMU will happen. But there are several different ways it could work and not work.

JW: There's no doubt that it will happen, but the real question is how long it will last. There are a number of areas where you'll need to be concerned. We're going to have a European central bank that will have to develop its credibility in the market. It will likely be raising interest rates sooner and holding them longer than it would otherwise. This has to hurt economic activity.

At the same time, the members of the euro will continue to have a straitjacket fiscal policy—the 3 percent annual deficit rule will be in effect as well as other rules. So in a recession, governments will have to raise taxes to minimize the effects the recession would have on the government's deficit. As we have seen in Japan recently, raising taxes in a recession only exacerbates the problem. With this lack of flexibility, you have to wonder how long the euro will last when the economies hit a tough patch. I think the euro will endure, but we'll have to go through some painful trials as the European Union works out the appropriate flexibility.

DS: Some countries could just drop out.

JW: Well that's just it. That's why we think there's a good opportunity to hedge against that risk at no cost. Since a forward euro/Deutsche mark rate must equal a spot euro/Deutsche mark rate, all of the EMU member interest rates will have to be exactly the same because of interest rate parity considerations. This means that at the time the rates become effective, on January 1, 1999, two-and-a-half-year Deutsche mark interest rates will be identical to two-and-a-half-year Italian lira interest rates. So you could go long Deutsche marks and short the ITL in either the cash or forward markets. You could do this until June 2002, because on July 1 of that year, all the European currencies that are part of the EMU will lose their legal tender status. So, on June 15, 2002, the contracts mature and you'll be long Deutsche marks and short lira and it won't have cost you anything. If the euro exists and continues, you just convert the Deutsche marks to exactly cover the short position. If the euro disappears or if the Italians have opted out of the euro, you're in exactly the right position. You spot some of the Deutsche marks to pay your ITL, and keep the excess Deutsche marks for a nice profit.

DS: It sounds almost too easy.

JW: That's the conundrum that they've created. It's been noticed that there's quite likely to be a Deutsche mark overhang because of the way the rules were written. There is no cost in holding Deutsche mark assets and having liabilities in the weaker currencies. One of the real questions is what happens when the Bundesbank wakes up looks at the Deutsche mark overhang. How happy are they going to be? Perversely enough, it gives the Germans an incentive to stay with the euro, because otherwise they'll end up back with an inflated currency supply that could lead to inflation.

DS: Now that the FASB controversy seems to be winding down, corporates will have to start getting ready to implement it. What advice are you giving them?

JW: Well, there's good news and not-so-bad news. It's favorable for foreign exchange hedging, because you'll be able to use forwards as well as options to hedge anticipated exposures. The not-so-bad news is that the Federal Accounting Standards Board (FASB) seems now to be shifting toward allowing some form of synthetic debt accounting. Previous drafts, for example, said that if you issue a fixed-rate bond and swap it to floating, you'll have to mark the interest rate swap to market quarterly, with the net change hitting net income, whereas if you had originally done a floating rate bond, nothing would get marked-to-market. Many critics used this as a great example of the FASB being an ivory tower, applying a reasonable principle—derivatives should be marked-to-market—and carrying that to an illogical conclusion.

"[Some] companies should seriously consider early adoption of the FASB proposal so they can take advantage of the foreign exchange hedging flexibility.”

It is still not clear how much synthetic debt accounting they will allow, however. As a result, when the standard is finally announced in March (or so says the FASB), there may be a lot of income-management opportunities between now and 2000, when it will be effective. The first thing that companies should do is calculate the catch-up impact on their current foreign exchange and interest rate derivative positions. This catch-up adjustment must flow into profit-and-loss when the standard is adopted. If the adjustment is a gain, you might want to close out the positions now and recognize the gain in 1998. If there's a loss, your CFO will need to know it to manage better the results from 1999 and 2000. The major banks will be happy to help you close out your positions, perhaps in such a way as to benefit both 1998 and 1999, as they now do with specialized derivative products for tax planning.

Finally, companies that do not have much of a catch-up adjustment should seriously consider early adoption of the FASB proposal so they can take advantage of the foreign exchange hedging flexibility.

DS: You mean in 1999?

JW: Yes. Lots of companies would much rather hedge the anticipated exposures with forwarDS than with options. Why not start as soon as possible?