Importers with substantial Chinese purchases must be careful about hedging the currency risk. Naive strategies can lead to losses, and also to hedges which are possibly not compliant with IFRS requirements.
Are you interested in knowing when you should hedge currency risk, and when you should manage it as a profit-making business risk?
If so, please see my article here: When hedging currency risk is shooting yourself in the foot
The CNY is not a convertible currency. Typically, Chinese exporters invoice in USD. A European importer therefore sees a USD/Euro risk, and hedges accordingly. It is quite easy to meet the requirements for the hedges to have fair value changes kept on the balance sheet.
However, the risk is that often the purchasing contract with the Chinese party allows for USD price changes should the CNY/USD rate change. The current context is one where the CNY is expected to strengthen over time, and there exists the possibility of dramatic changes in exrate should the Chinese authorities be unable to contain revaluation pressures.
In this case, the European importer holding forward contracts in USD is vulnerable. If we assume a revaluation of the CNY matching simply a decline in the USD, so that the CNY/Euro rate remains unchanged, we can see a loss coming, a real cash out. For example, imagine in January 2007, the CNY/USD rate is 0.10 and the USD/Euro rate is 0.70.
A product costs CNY 10, giving a price of USD1. The importer plans to buy 100 units in December 2007, and in January takes a forward contract to buy 100 USD for 70 Euro (I'll keep the forward rates the same as spot rates).
At sometime during the year, the USD falls by 10% against both the Euro and the Yuan. The Chinese exporter takes advantage of the currency clause in the contact, and increases the USD price to compensate (let's say by 10%).
In December, the forward contact is executed. The forward contract is a loss of course, since the USD are purchased against an exchange rate which is now too expensive. Normally, this is of no concern, since the same exchange rate development makes the purchased items, also in USD, cheaper. The net effect is neutral. However, this time, the USD prices have increased by 10%. So the importer makes a loss on the hedging, and on the invoice price.
Obviously, this is because the hedging contract did not hedge the real risk, which is Euro/CNY. For this reason, I question that these hedges can meet the requirements of accounting standards (eg IFRS 7).
At this stage, hedging solutions for CNY risks need careful investigation: there are no simple solutions.
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