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Riding the currency swing

Currency markets can have an integral, yet often underestimated effect on the pharmaceutical industry

Playground swings containing the currency symbols for pounds and dollarsFrom research and development (R&D) to supply chain all the way through to product pricing, volatility in the currency markets can have a significant impact on a company's bottom line. 

One of the biggest problems since the global economic crisis hit has been the huge movements that we have seen on the currency markets. Sterling has lost around 16 per cent against the US dollar in the last 12 months and around 11% against the euro, with fluctuations of over 26 per cent and 14 per cent respectively, during the same period. The strength of the US dollar has been of particular significance for pharmaceutical companies.

A pharmaceutical company will tend to have bank accounts in several different currencies. This enables a company to pay research costs, suppliers, manufacturing expenses and to receive payments in various currencies, depending on the market in which they are operating. The key with these accounts is the exchange rate at which the funds are converted back to the organisation's base currency. A significant change in the value of a currency could dramatically devalue the funds held in the given account. 

 

USD exchange rate movement, Sept 08 to Sept 09

Chart showing USD exchange rate movement, Sept 08 to Sept 09

 

For example, let us look at the hypothetical case of a UK pharmaceutical company that outsourced an R&D project to Germany, commencing in January 2008 and due to run for one year. The project cost is €5m, which at the time the project starts equates to £3.74m. By January of 2009 the pound had lost 22.28 per cent against the euro, the project expense remains €5m but now costs £4.78m, an increase of £1.04m through currency fluctuation. The increased expense of the project could mean that it is no longer financially viable.

The uncertainty of exchange rate movement can be avoided by booking currency on a 'forward' basis. In this example the pharmaceutical company could have booked a one year forward contract for €5m when the project commenced (you can book forward for up to two years in advance). This way the cost of the project cannot spiral out of control through adverse currency movement, allowing the pharmaceutical company to concentrate on cost control, research efficiency and results. Stop and Limit Orders can also be utilised in order to minimise risk caused by market fluctuations.

Currency market movers
The currency markets move on rumour as much as fact, which makes predicting future movement extremely difficult. However, there are four main factors to consider that influence and drive today's global currency markets; economic strength, political stability, terrorism and acts of God.

If a country has a strong economy and is politically stable then as a general rule the currency will be a sound investment. If however one or both of these elements become unsound or unstable, the converse may apply.

The main area of focus on a day-to-day basis tends to be economic data releases. This can range from an interest rate change from a country's Central Bank to a business confidence survey from an influential industry voice. Some information is clear and quantifiable while other data may be more opinion led. Some data releases may cause short-term peaks or troughs while other information, like interest rate changes, can cause longer-term trends in the market. This will all depend on how information is interpreted by the markets.

Factors influencing Sterling
At present the UK economy is under significant scrutiny as the economic downturn has had an alarming effect on the financial sector. As a result the pound has lost value against a host of major currencies. 

The main area of focus is likely to look at when, and how quickly the UK economy recovers from recession. The quantitative easing (QE) programme undertaken by the Bank of England (BoE) is intended to kick start the economy, while this in theory is good news for UK business it is uncertain how well it will work. Couple this uncertainty with the extra £175bn pumped into the economy and sterling has suffered since QE was announced. The increase in supply of sterling reduces the value of the currency, following basic rules of supply and demand. If the BoE announces further funds for QE we could see additional falls in the value of the pound.

The latest figures released have showed that the Government's overall debt now stands at £804.8bn, a staggering 57.5 per cent of Gross Domestic Product (GDP). Because repaying this debt is likely to be a huge strain on the taxpayer and UK economy this is having a negative effect on the pound.

US economic recovery weakening the US Dollar
The US dollar (USD) is the world's reserve currency and as such is traded in huge volumes; this means that trends can develop as we have seen over the last year. In September 2008 the dollar strengthened significantly as the financial markets went into turmoil following the collapse of Lehman Brothers.  

Investors moved their funds to what was perceived as a 'safe haven' currency - the US dollar. We are now seeing an unwinding of those positions and movement toward more risky stocks and shares across the world. 

There have of course been many other factors influencing the price of the US dollar, from falling oil prices strengthening the US dollar, to rising gold prices causing weakness, however the general trend can be attributed to increased risk appetite in the world economy.

This is an unusual situation as we are finding that positive US economic data is actually causing US dollar weakness - the opposite of what we would expect. This is because, with each piece of positive news about economic recovery in the US, investor confidence is increased and funds held in the 'safe' US dollar are moved to more risky assets.

How to make the most of currency moves
If the weak pound is having a negative effect on an organisation's funds, the company can use Stop and Limit Orders to set a desired maximum and minimum exchange rate; whichever is reached first. These allow a company to take advantage of market spikes but avoid significant losses if the market drops. When the market does spike, a forward contract can also be used to lock into the higher rate for a date in the future. 

Because the pound is so volatile at present, any company looking to undertake a long-term project with costs or revenue in foreign currency, may be best off securing a Forward Contract for the duration of the project. This will ensure that exchange rates will not cause costs to spiral out of control and profits to be eroded away.

 

Euro exchange rate movement, Sept 08 to Sept 09

Chart showing Euro exchange rate movement, Sept 08 to Sept 09

 

Single currency now second currency?
The euro has now overtaken the pound as the world's second currency, strengthening 16 per cent against the US dollar since March 2009. These gains can be largely attributed to the Eurozone economy, as a whole, avoiding the serious economic plight experienced in the UK. Both France and Germany have announced GDP growth in the last quarter. The European Central Bank has also undertaken far less quantitative easing and invested less in stimulus packages compared to both the US and the UK. Despite receiving less help, the Eurozone economy has fared reasonably well and this casts a positive light on the single currency.

One of the few advantages of the weakness of the pound is that anyone holding foreign currency that needs to bring funds back to the UK can enjoy favourable rates. Just as a Forward Contract can be used to prevent future losses it can also be used to take advantage of the strength of other currencies. 

You can book Forward Contracts for up to two years in advance. Anyone doing business in Australia at present will find that the pound is close to an 18-year low against the Australian dollar (AUD), if you are holding AUD and will have a regular revenue stream from Australia it could be a great time to book a Forward Contract to move Australian dollars.

The Author
Aidan Meikle is senior executive dealer at Foreign Currency Direct, voted 'best currency provider' by The Sunday Times for the past three years. To find out more about their services, call +44 (0)800 328 5884.
To comment on this article, email webeditor@pmlive.com

27th October 2009

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