WHILE THE SKIES ARE STILL BLUE
APPENDIX 4.2: How Companies Can Strengthen Funding
Operating on threadbare ICRs is like walking a tightrope; in a financial crisis, it is like walking that same tightrope in a storm. Consequently, it is crucial for companies to not only understand their cash position, but also to reduce their debt burden and strengthen funding sources before the crisis hits.
Emerson, for instance, runs a conservative balance sheet and refuses to increase its debt position despite criticism from some analysts. By minimizing its leverage, Emerson retains the ability to assume debt when attractive acqui- sitions become available. In addition, it avoids getting entangled in burden- some interest payments, which management learned from the recession of the early 1990s can be particularly onerous during economic downturns.1When a crisis hits and revenue streams are disrupted, defaults on interest payments can spell disaster for a company and serve as an invitation for creditors to seize control of assets, especially if its funding sources are not well diversified.
Similarly, the Turkish holding company Alarko prefers to stay away from direct plant, property, and equipment investments as much as possible.
Instead, management prefers to lease buildings and equipment to provide a more balanced cash flow, avoid large upfront cash outlays, and ensure con- tinuous technology upgrades of equipment. It also reflects their attention on the company’s balance sheet, which as we mentioned in the chapter text needs to be managed closely alongside the cash flow and income statements.
Surprisingly, many companies have fundamentally sound businesses but are plagued by significant asset-liability mismatches. Three common mis- matches are interest rate (floating versus fixed), currency, and maturity.
Interest rate mismatches are much more important for banks—for whom managing this type of risk is the bread and butter of what they do—than they are for corporates. Yet, corporates can definitely be exposed to these mismatches, especially in developing markets and especially when operating primarily in non–U.S. dollar, local currencies (e.g., Thailand, Indonesia).
Whereas dollar interest rates may only fluctuate within a narrow range of three to four percentage points over several years, short-term rupiah interest rates jumped from the mid-teens to over 70 percentage points in a matter of months during the Asian financial crisis. In particular, using short-term bor- rowings at floating rates to finance long-term capital expenditures creates interest rate exposure, in addition to currency exposure, if borrowings are in a foreign currency.
Currency mismatches occur when a company’s assets are in one cur- rency while its liabilities are in another. A company might receive revenues in pesos while servicing debt interest payments or supplier purchases in deutsche marks. In Thailand before the 1997 financial crisis, for example, finance companies were borrowing short-term dollar deposits at an annual interest rate of about 7 percent, converting the money into baht, and lending it again on the spot market at interest rates between 12 and 25 percent.2 This was fine as long as the exchange rate remained stable, but when the baht was floated in July 1997 these currency mismatches forced over fifty finance companies into bankruptcy.
Currency mismatches, in turn, are often further aggravated by maturity mismatches. Maturity mismatches can occur when assets are structured on longer timeframes than liabilities, such as when debt interest payment or supplier purchase schedules come due much earlier than accounts receivable or other cash inflows, leaving a company especially exposed to the volatility of financial crises. In Korea, some industrial companies have been known to borrow using short-term, ninety-day promissory notes to fund significant, long-term capital expenditures—an extremely risky approach during the period before a financial crisis hits. In Indonesia before the 1997–1998 finan- cial crisis, some financial institutions borrowed dollars in the short and medium term, swapped the dollars on the spot market for rupiah, and lent the rupiah to Indonesian corporations. In less than a year, the dollar-rupiah exchange rate, which had been reasonably stable for more than a decade, sky- rocketed from less than 2,500 to over 15,000, leading to incredible losses.
To say that the consequences were entirely unexpected, though, would be less than completely fair. Between 1993 and 1997, the average debt- equity ratio in Korea was 520 percent, compared to 253 percent in Japan, 171 percent in the United States, and 120 percent in Germany. In 1997, the
average debt-equity ratio of the top ten Korean conglomerates was just under 500 percent. Only one year later, the average fell to about 320 per- cent. The 1997 financial crisis taught the chaebol a painful lesson on the importance of reducing debt, one that they are still learning. In fact, the gov- ernment—through its restructuring agency, the Financial Supervisory Com- mission (FSC)—mandated that all of the top thirty chaebol have debt-equity ratios of less than 200 percent by December 31, 1999, and prohibited asset revaluations (e.g., raising the value of their real estate holdings).3This was an important step. One executive recalls, “Every individual and manage- ment team got the message loud and clear: If you didn’t meet the 200 per- cent target, you were in big trouble.”
To manage against currency mismatches, management must first exam- ine the asset and liability structures of the company’s balance sheet and identify key exposures. How much of the company’s liabilities are in foreign currencies, and which ones are particularly subject to volatile exchange or interest rates? What are the term schedules for debt-interest or other pay- ments versus receipts? Management should also ask how much is hedged naturally, either in dollar inventories or dollar accounts receivable, or through the use of financial hedging instruments. In the Philippines, Ayala, which operates with a debt-equity ratio of about 90 percent, has about 80 percent of its exposure in dollars, but is virtually completely hedged with a mix of foreign exchange forward contracts and interest rate swaps.
Once management has assessed the situation, it can take action to reduce risks associated with these exposures. For interest rate exposures, manage- ment should consider negotiating fixed rates, if the creditor will consent, or using interest rate swaps. Companies should also consider availing themselves of currency forwards or options, when available. In addition, it can also pur- sue more natural hedges. Management can split up its balance sheet by cur- rency and earmark dollar receivables to dollar payables on its pro forma financial statements. It can also match short-term liabilities to current assets, and negotiate with creditors to lengthen term structures when necessary and feasible.
These options, however, are a function of the depth and sophistication of local currency markets. Banks, for example, might not be willing to lend term rupiah, making it almost impossible to get a five-year fixed rate. In many emerging market economies, most funding comes from bank loans, and corporate bond markets are still relatively early in development. In the 2001 crisis in Turkey, for example, there were few financial instruments for companies to hedge against currency devaluations. Without a local currency forwards market, even the largest companies with private debt are hit hard because of their dollar-denominated debt. If a company recognizes the warning signs of an impending financial crisis, it might want to prepay its
foreign currency liabilities to reduce its exposure—but this depends on its cash position.
Consequently, Alarko responded to the latest crisis in Turkey in 2001 with two changes in company policy. First, the company increased its target ICR by 50 percent to prepare for future financial crises (e.g., if banks call back loans or if receivables become an issue). Second, all new investments have been targeted for a fifty-fifty balance between equity and other financ- ing. Management prefers international to local financing to ensure longer terms (Turkish bank loans are typically on term structures of less than one year due to high inflation and economic uncertainty), and it tries to use local short-term financing for bridge loans only, as necessary.
Because of these risks during financial crises, companies must improve their ICRs and reduce their debt to reasonable levels before a crisis hits.
Companies need to consider shifting at least a portion of their debt from floating to fixed rates, diversifying their sources of funding, and lengthening term structures. All of these actions require an understanding of the com- pany’s debt and funding sources at a group level.
In addition, corporates and financial institutions should review their funding requirements and sources to ensure that they always have access to stable sources of funding at reasonable rates (which means diversifying before a crisis hits). Like Doosan, companies should seek backup lines of credit before a crisis, even though this requires that they pay a premium for the added security. These actions also usually require some asset-liability management experience. If their management skill portfolio is not up to the task, it is crucial to bring in the requisite talent as soon as possible to assume this responsibility.