Summary of the CFEC Survey on Foreign Exchange Hedging

In December 2005, the Bank of Canada sent those banks that 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 to surveys that had been circulated to CFEC members in 2003 and 2004. The purpose of these questionnaires is to gain a better understanding of the degree to which hedging activities are evolving in the face of movements in foreign exchange rates, whether through reliance on natural hedges or through the use of financial market instruments. The Bank followed up the December 2005 questionnaire with individual meetings with the twelve respondents during the second week of January 2006.

The evidence collected from this survey was anecdotal and reflected the banks' evaluations of their clients' hedging activities and the effects of the stronger Canadian currency. Responses to the questionnaire varied significantly because of the differences in 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 a certain amount of the variation in responses. Nonetheless, common themes emerged, as highlighted below.

Results

(1) Banks reported that, on average, the appreciation of the Canadian dollar was having a negative effect on about half of their client base. The estimated proportions have remained relatively stable over the three surveys, despite the ongoing strength of the Canadian dollar.

Banks estimated that about half of their clients have been negatively affected by the appreciation of the currency in 2005. The other half of their client base was experiencing either neutral or positive currency effects, in roughly equal proportions. (These proportions are essentially unchanged from those reported in the surveys of previous years.) Several banks reported, however, that the stronger Canadian dollar was starting to have an increasingly negative impact on clients who have not been able to adapt swiftly enough to the new currency levels.

(2) Many firms have been shielded from the stronger Canadian dollar by a combination of natural and financial hedges.

The most important factor cited behind this apparent resilience to the appreciation of the Canadian dollar was the natural hedge afforded by rising commodity prices. (The importance of this natural hedge was cited repeatedly by respondents, as it had been in previous surveys.)

Other hedges cited by respondents include:

1. the residual protection afforded by existing financial hedges, although these have often been allowed to wind down;
2. the increased use of U.S.-dollar-denominated borrowing; and
3. the movement to U.S.-dollar-based accounting, although this is not seen as having accelerated in 2005.

Additional factors that shielded firms from the effects of the stronger Canadian dollar included the ability to upgrade productivity and/or shift production to higher-value-added products, as well as the ability of some firms to transfer currency effects through surcharges to customers or by negotiating cost reductions with suppliers.

Some respondents also cited production shifts to either the United States or to lower-cost jurisdictions, but this was not a predominant reaction to the strength of the Canadian dollar. (For many firms, shifting production offshore is a core business decision based on a multi-year planning horizon—longer than the typical currency cycle—and often involves other considerations than those related solely to currency movements.)

(3) Most firms negatively affected appear concentrated in specific sectors.

The firms reported by banks to be experiencing difficulty with the stronger Canadian dollar appear, for the most part, concentrated in specific sectors. The forestry sector—particularly pulp and paper firms in Eastern Canada—was reported to be the most severely affected, as it has been in past surveys. Smaller manufacturing concerns, primarily in central Canada, were also mentioned as experiencing difficulty with the stronger Canadian dollar.

(4) Financial-hedging ratios and terms have generally been declining.

Almost all survey respondents reported that, on balance, the degree of coverage by financial hedges, as well as the term of the hedges, was declining. This was often associated with exporting firms that were experiencing negative currency effects from the stronger Canadian dollar, but that were unwilling to lock in the exchange rate at current levels.

Several factors were cited for this:

1. a belief that the Canadian dollar rally would peak in 2006 and then retrace, and, hence, better currency levels for hedging would present themselves in the future;
2. a belief that because these firms were unprofitable even at current levels, it would be pointless to lock in a loss by hedging;
3. an unwillingness by some firms to lock in a level for the Canadian dollar that was stronger than their 2006 budgeted levels; and
4. the fact that forward contracts traded at a discount (in terms of Canadian dollars per U.S. dollar), which would lock in an even stronger Canadian-dollar level than would current spot levels.

In comparison, importers are looking to increase the tenor and coverage ratio of their U.S.-dollar-buying hedges and to lock in what they see as reasonable long-term levels for the Canadian dollar. However, such U.S.-dollar buyers typically represent only about 5 per cent to 20 per cent of the clientele of the banks surveyed.

The majority of firms that hedge were reported to still prefer "plain vanilla" structures that can obtain hedge treatment under current accounting regulations. Interestingly, some survey respondents reported an increasing use of currency options as hedging instruments. These would allow firms to hedge their downside currency risk, but at the same time be able to achieve better hedging levels should the Canadian dollar depreciate (given their implied currency forecast, cited above). The fact that forward contracts traded at a discount made the payment of up-front option premiums relatively more attractive. A number of respondents also reported some willingness, at the margin, to take on more "exotic" option-driven hedging structures.

For further information, please contact:

William Barker
Principal Analyst
613 782-7875

Wally Speckert
Funds Management Adviser
613 782-8102