Mitigating currency risks in international trade

A maze of uncertainties is standard when navigating international trade, with foreign currency exchange risks at every turn. For Pakistani businesses aiming to expand their market reach beyond national borders, a deep understanding of these risks is crucial. Effective mitigation strategies are essential not only for minimising potential financial losses but also for ensuring sustained success in the volatile arena of global commerce.

In order to proactively address the challenges of foreign currency risks, Pakistani businesses will need to equip themselves with key management strategies that will help them operate confidently on the international stage and capitalise on new opportunities in emerging markets.

1. Understanding currency risks

The first step to developing and implementing an effective currency exchange risk management strategy starts with understanding what they are and how they form the very foundation for international trade. Currency risks, or foreign exchange risks, arise from the fluctuations in the exchange rates between currencies, which can significantly affect the financial performance of businesses engaged in international trade. The Pakistan Rupee, like many emerging market currencies, can be subject to significant volatility, which impacts the costs and revenues of businesses engaged in international trade.

To effectively manage these risks, it is crucial to grasp the different types of currency exposures: transaction risk, translation risk, and economic risk.

Transaction risk and its implications

Transaction risk, a critical aspect of currency exchange risk management, occurs when there are fluctuations in exchange rates between the time a transaction is agreed upon and the time it is settled. This risk can have significant financial implications for businesses engaged in international trade, particularly those that deal in currencies prone to high volatility, such as the Pakistan Rupee.

Understanding transaction risk involves recognising its potential impact on cash flow and profit margins. For example, if a Pakistani company agrees to sell goods to a foreign buyer at a price set in Euros, and the Pakistan Rupee strengthens against the Euro by the time payment is received, the actual revenue converted back into Rupees could be less than anticipated, affecting the company's profitability.

This scenario highlights the importance of proactive financial strategies to mitigate such risks, especially in light of recent economic events where Pakistan has removed controls on its currency exchange rate, leading to significant fluctuations. This decision, aimed at reviving an IMF bailout, has made the Rupee's value highly unpredictable. On the day the controls were lifted, the Rupee fell nearly 10%, closing at Rs255 to the US dollar, signalling increased volatility and underscoring the need for robust risk management practices in transactions involving the Rupee.

Translation risk and financial reporting

Translation risk, also known as accounting exposure, occurs when a company owning assets and liabilities in a foreign currency must report these in their consolidated financial statements in their home currency. This type of risk arises from the need to convert foreign financial statements into the parent company's currency, which can lead to significant fluctuations in reported earnings and equity due to changes in exchange rates.

Understanding translation risk involves several key aspects:

• Impact on financial statements: When the financial results of an overseas subsidiary are translated back to the parent company's reporting currency, fluctuations in exchange rates can lead to significant variances in reported assets, liabilities, revenues, and expenses.

• Accounting standards: It is crucial for businesses to adhere to the appropriate accounting standards, such as International Financial Reporting Standards (IFRS) or U.S. Generally Accepted Accounting Principles (GAAP). These standards provide specific guidelines for currency translation, including which exchange rates to use and how to treat changes in exchange rates in the financial statements.

• Operational impact: The effects of translation risk are not limited to financial reporting but can also influence corporate decisions and strategic planning. For example, significant changes in reported earnings due to currency fluctuations might affect a company's investment decisions or dividend policies.

• Regular monitoring and reporting: Continuous monitoring of foreign exchange rates and regular reassessment of the company's foreign currency positions are crucial. This proactive approach enables companies to better understand the financial impact of currency fluctuations and to communicate these impacts effectively to stakeholders.

Economic risk and global competition

Economic risk, driven by fluctuations in exchange rates that influence international purchasing power, presents a considerable challenge to maintaining a company's competitive edge in the global market. For Pakistani businesses aiming to thrive in an environment of intense international competition, strategically managing this type of risk is crucial for sustaining profitability and improving market position.

Recently, in response to a severe foreign exchange crisis, Pakistan sought to revive an IMF bailout, which necessitated significant economic adjustments. The government implemented stringent measures, including the imposition of all import restrictions, which were lifted in 2023. This decision was aimed at averting a balance of payments crisis as foreign exchange reserves held by the central bank shrank dramatically, reaching levels barely sufficient to cover a month of controlled imports. The volatility in exchange rates exacerbated these conditions, leading to severe supply-chain disruptions for Pakistani businesses. These disruptions had profound implications on employment and profit margins, impacting pricing strategies and cost management, and ultimately affecting their competitive edge on the international stage.