Executive Summary: Foreign Exchange Hedging by Canadian Corporate Accounts
In December 2004, the Bank of Canada sent those banks who are members of the Canadian Foreign Exchange Committee (CFEC) 1 a questionnaire that focused on the foreign exchange hedging activities of their corporate customers. The questionnaire was similar in structure to one that was circulated to CFEC members in January 2004. The purpose of the December questionnaire was to gain a better understanding of the degree to which hedging activities have insulated firms from movements in foreign exchange rates, whether through natural hedges or by using financial market instruments. The Bank followed up the questionnaire with individual meetings with all twelve respondents during the second week of January 2005.
The evidence collected by this study was anecdotal in nature, reflecting the banks' estimates of the hedging activities of their clients and how the stronger Canadian currency was affecting them. Responses to the questionnaire varied significantly because of differences between the client bases of the banks and variations in the nature of the hedging activities transacted. The subjective nature of the questionnaire also accounts for some of the variation in responses. Nonetheless, there were common themes among the responses, as highlighted below.
The results obtained through this survey of banks were broadly consistent with those from the Bank of Canada's Winter 2004-05 Business Outlook Survey (in the supplement Adjusting to the Appreciation of the Canadian Dollar). Both surveys found that approximately half of Canadian firms have been adversely affected by the stronger Canadian dollar, and that most of these adversely affected firms are concentrated in the resource and manufacturing sectors. Similarly, both surveys found that the ongoing appreciation of the Canadian dollar has left many such firms less optimistic about their prospects.
(1) Banks estimate that, on average, more Canadian firms are negatively affected by the strength of the Canadian dollar over the past year than are positively affected. As was the case in the survey conducted a year earlier, the estimated proportions have remained relatively stable despite the unexpected strength of the Canadian dollar.
- Banks estimate that about half of their clients have been negatively affected by the appreciation of the currency during 2004. The other half of the banks' client base is roughly split between those affected positively and those who experienced no material effects from the strength of the currency. For the remainder of 2005, banks feel that, on balance, the proportion of their clients that are "positively," "neutrally," or "negatively" affected by the strength of the Canadian dollar will not change very much. Some banks indicated, however, that the proportion of their clients that were being "very negatively" affected was beginning to increase, given the continued strength of the Canadian dollar.
- The Canadian dollar was far stronger through 2004 than many had anticipated. Nonetheless, the client base fared better than a number of banks had expected, given that several respondents to the January 2004 survey had indicated that a Canadian dollar above Can$1.25 (80 cents U.S.) would have negative ramifications for many of their clients. Comparing the expected 2004 results of last year's survey with this year's realized 2004 results revealed no significant shift in the proportion of firms that were "positively," "neutrally," or "negatively" affected by the strength of the Canadian dollar.
- The results of the December 2004 survey of banks are broadly similar to those reported in the supplement to the Bank of Canada's Winter 2004-05 Business Outlook Survey, which described the adjustment of Canadian firms to the appreciation of the Canadian dollar. Both surveys indicate that approximately half of Canadian firms are being adversely affected by the appreciation. 2
(2) Many firms have been shielded from the stronger Canadian dollar by a combination of natural and financial hedges.
- The role played by natural hedges, especially higher commodity prices, in shielding many firms from the stronger currency cannot be underestimated. Higher-than-expected commodity prices have been a major factor in moderating the more serious negative effects from the stronger-than-expected Canadian dollar. Other natural hedges also played a role, such as relatively firm ongoing growth in the North American economy and a modest increase in the use of U.S.-dollar-denominated debt issuance (U.S.-dollar coupon payments hedge U.S.-sourced cash flows).
- Moving production offshore was reported less frequently than other natural hedges. Although some firms have undertaken this outsourcing approach, most banks felt that the Canadian dollar would have to appreciate to, and hold, higher levels before such a broad-based realignment of business models would occur (the time frame for such strategic planning is usually longer than the typical currency cycle).
- Many firms were also partially shielded from the strength of the Canadian dollar through 2004 by the protection afforded by existing financial hedges. The retracement of the Canadian dollar to weaker levels heading into May 2004 provided a large number of firms with the opportunity to fill many of their hedging requirements at that time.
- Nonetheless, banks reported that, on balance, the duration and coverage ratios of their clients' financial hedges were modestly less than what might be considered typical. This partly reflects the speed of the Canadian dollar's appreciation (especially between May and the end of November 2004), which exceeded the ability of many firms to respond in a timely and effective manner. This under-hedging also reflects the belief held by some firms that the Canadian dollar may be approaching a peak, and will end 2005 at a lower level. For these reasons, some firms have let the duration and coverage of their financial hedges diminish in the hope of taking advantage of a retracement of the Canadian dollar.
(3) Although most firms are managing to adjust to the stronger Canadian dollar, a minority are having significant difficulty.
- A minority of corporate clients are having significant difficulty dealing with the stronger Canadian dollar. Such firms have usually not benefited from the natural hedges of higher output prices. At the same time, the financial performance of such negatively affected firms has often been further impaired by higher input prices, particularly for energy and base metals. This erosion of profit margins has made it more difficult for these firms to upgrade productivity.
- Most banks noted that those firms experiencing "very negative" currency effects were concentrated primarily in specific sectors, such as pulp and paper or small manufacturing concerns. The broader client base—even within the overall export sector—was still managing to deal relatively successfully with the stronger Canadian dollar, despite the pressure on their profit margins.
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