Foreign exchange risk management strategies and practices

Foreign Exchange Risk Management in the Companies of the Steel Industry in Eastern European Countries

Today, there are some interesting developments taking place in Eastern Europe in general and the Ukraine in particular as well as Turkey that will have an important impact on the global steel industry in the years to come. Following the collapse of the Soviet Union in the early 1990s, the Ukraine emerged as an emerging economic powerhouse in the region and Turkey continues to seek accession to the European Union in ways that are bringing its economy in line with its European neighbors. To gain some additional insights into how these trends have affected the steel industry in the countries of Eastern Europe generally and in the Ukraine and Turkey specifically, this study provides a review of the relevant peer-reviewed, scholarly and governmental literature, followed by a case study of two giants of the steel industry, Arcelor Mittal in the Ukraine and Erdemir in Turkey, both of which are highly representative of the progress being made in these countries. A summary of the research and salient findings are presented in the conclusion.

Review and Discussion

Background and Overview

Companies competing in the transnational marketplace have much to consider when it comes to identifying potential opportunities as well as threats, with foreign exchange risk management being one of the most important for both of these purposes. For instance, Chiang and Lin (2005) note that, "Unexpected fluctuations in foreign exchange rates have been an important concern to firms with international business operations since future cash flows, and therefore the value of firms will be affected" (598). The persistent global economic downturn, though, has caused a growing number of multinational corporations to reassess their foreign investment strategies in an effort to minimize their foreign exchange risks while hedging their bets for future improvements in the marketplace and less fluctuation in foreign exchange rates. In reality, this approach is not surprising given that the overwhelming majority of corporate executives competing in the transnational marketplace agree that foreign exchange risk management is just as important as business risk management and that cash management is even more important for transnational corporations (Rugman & Brewer, 2001). According to these authors, "With increased volatility in financial markets, multinational enterprises (MNEs) have learned that their value has become more subject to the risks occasioned by changes in their financial environment" (Rugman & Brewer 2001, 565). In response, a growing number of MNEs have sought to manage these exchange risks by using a comprehensive strategy for foreign exchange risk management that minimizes the impact of market risk (Rugman & Brewer, 2001). Likewise, Chiang and Lin (2005) report that, "To mitigate the impact of foreign exchange rate fluctuations, firms can employ financial hedge strategies through foreign currency derivatives (FCD) and foreign-denominated debts (FDD)" (598). In other words, by keeping their transnational financial administration keyed to the currencies used in the different countries in which they compete, multinationals can minimize the impact that fluctuations in exchange rates have on their invoicing and payables.

Ukraine. Besides the still-enormous Russian republic, at the time of the collapse of the Soviet Union, the Ukrainian republic represented the most important economic component by far, producing approximately 400% as much output as the next-ranking republic (Ukraine 2010). According to Green (2006), "Slightly smaller than the size of Texas, Ukraine has abundant natural resources and a well-educated population with a literacy rate of 99%" (p. 17). Because of the quality of its soil and advantageous agricultural conditions, the Ukraine has also long been the breadbasket for Eastern Europe and the country's diversified heavy industry sector has provided the steel-based materials needed to develop the infrastructure in former satellites of the Soviet Union (Ukraine 2010). Despite some challenging times immediately following the country's independence from the Soviet Union in 1991, a great deal of progress has been made on both the political as well as the economic front, but the Ukraine remains heavily dependent on Russian oil and gas as essential energy sources, a constraint that continues to create problems for its growing economy (Ukraine 2010). In fact, pursuant to its most recent agreement with the Russian government finalized in 2006, the Ukrainian republic will be required to pay almost twice as much for Russian gas in the future (Ukraine 2010).

More recently, growth or declines in the country's gross domestic product (GDP) have been directly affected the global demand for steel. According to U.S. analysts, "Real GDP growth exceeded 7% in 2006-07, fueled by high global prices for steel - Ukraine's top export - and by strong domestic consumption, spurred by rising pensions and wages. The drop in steel prices and Ukraine's exposure to the global financial crisis due to aggressive foreign borrowing lowered growth in 2008 and the economy contracted more than 14% in 2009, among the worst economic performance in the world" (Ukraine 2010, 3). In response, the Ukrainian government finalized an agreement with the International Monetary Fund in November 2008 in the form of a $16.5 billion credit that could be used to offset the impact of the economic downturn; ongoing political dissension in the country though has adversely affected the nation's ability to sustain an economic recovery (Ukraine 2010).

Turkey. Long known as a "crossroads" because of its geographic proximity to Asia and Europe, Turkey stands at quite another crossroads today as it seeks to gain full membership in the European Union while balancing the demands of its increasingly vocal Muslim population concerning the need to proceed cautiously in terms of adopting Western styles and traditions.

Like the Ukraine, Turkey remains highly dependent on its agricultural sector that represents approximately 30% of the country's employment, with a slightly smaller percentage competing in the textiles and clothing industry (Turkey 2010).

The march towards modernization during the first half of the 20th century resulted in the mining, energy, iron-steel industry and railways in Turkey being nationalized but with assurance that privatization would quickly follow (Altunisk and Tur 2004). These assurances did not materialize by the 1950s, but progress has been made since that time (Altunisk and Tur 2004). Although the Turkish government has been actively pursuing divestitures of its previous state-owned enterprises, it still holds significant interests in many of the country's industries. In addition, and also like its counterpart in the Ukraine, Turkey's economic performance in recent years has outpaced some its neighbors and the global performance rates as well, with real GDP growth surpassing 6% in many years, but the worldwide economic downturn has impacted the Turkish economy but not as sharply as in the United States and other industrialized countries; in fact, inflation stands at a 34-year low and international investments are strong (Turkey 2010). Despite these accomplishments, the Turkish economy remains characterized by a high current account deficit and high external debt but continuing economic and judicial reforms and the country's potential entry into the European Union have continued to attract foreign direct investment (Turkey 2010).

In sum, U.S. analysts note that Turkey has much going for it today, but some significant obstacles stand in the way of further progress in the future: "Economic fundamentals are sound, but the Turkish economy may be faced with more negative economic indicators in 2010 as the global economic slowdown continues to curb demand for Turkish exports. In addition, Turkey's high current account deficit leaves the economy vulnerable to destabilizing shifts in investor confidence" (Turkey 2010, 3). Notwithstanding the importance of the agricultural, textiles and clothing industries to the Turkish economy, recent trends suggest that Turkey is well situated to become a major actor in the global steel industry as well. According to Green (2006), "Turkey is a big market in itself, but it also serves as an export platform to Europe. There is a misperception that it exports small, cheap products. But it is increasingly exporting items like auto parts and cars to Europe" (28). These trends will undoubtedly affect steel-producers in Eastern Europe, including Arcelor Mittal, and these issues are discussed further below.

Steel Industry in Eastern Europe and Ukraine.

The steel industry in Eastern Europe struggled under the state-controlled policies of the former Soviet Union in ways that created lasting problems. "What proved to be a more lasting problem was the fact that steel was needed as a base for other industries, yet there was not adequate consumer demand to support either a viable steel industry nor a domestic industrial market using steel as an intermediate product" (Mangum, Kim and Tallman 1996, 37). By 1955, the countries of Eastern Europe and the Soviet Union were exporting just 10.6% of the world's supply of steel altogether compared to 14.2% for the U.S. And 9.9% for West Germany alone (Mangum et al. 1996). By the 1990s, though, things had changed in major ways for the eastern European steel producers. For starters, an increasing number of European Union members in Eastern Europe have adopted the euro as their currency, including the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Romania and Slovenia, thereby minimizing the impact of foreign currency fluctuations on their financial administration with other countries using the euro; the Ukraine is scheduled to formally adopt the euro as well in 2012 (Kubicek 2007). In addition, a series of joint ventures in which West German steel firms joined with East German firms and Krupp, Klockner, and Thyssen of Germany was pursuing other developmental initiatives in eastern Europe as well. Likewise, Arbed of Luxemburg was involved in steelmaking facilities in the former East Germany. According to Mangum et al., "The rising market for improved galvanizing for automobiles, appliances, canning, and other uses is producing a rash of joint ventures throughout the world. Some of these are internal to various countries and others involve international partners" (p. 74).

As a result, nearly 30% of the world's steel supply is now produced by plants belonging to companies that did not exist just 3 decades ago (Ahlberg, Pitkanen & Storsch 1999). As these authors point out, "Such upstarts have entered a global market that since 1980 has grown by less than 1% a year -- an average combining annual growth of 4.7% in the developing world, 0.5% in the developed world, and -5.5% in Eastern Europe and the former Soviet Union" (Ahlberg et al. 1999, 83). During that period, the rates of operation for steel producers in Europe, Japan, and North America averaged just 80% of capacity, a production rate that provides razor-thin profit margins and creates a pressing need to reduce operating costs and become more energy efficient (Ahlberg et al. 1999).

Ukraine. A report from Green (2006) suggests that the Ukraine has been dealt its fair share of political and economic challenges in recent years that have affected its steel industry in profound ways. In 2006, for example, the Ukraine experienced a costly dispute with Russia concerning the price of its gas supplies, followed by parliamentary elections that produced inconclusive results that mired the country in a lengthy political showdown for some time (Green 2006). Although these political issues have been resolved to some extent, the main perception among some international investors remains one of "wait-and-see" before they make the leap into formal investment commitments. In this regard, Green advises, "Some believe it will take much longer for most investors to gain the clear economic picture they need before they will sink money into this resource-rich nation of nearly 50 million people" (16). Moreover, there are some distinct foreign exchange risk management issues at work in the Ukraine that will likely contribute to the "wait-and-see" mentality as well. For instance, one industry analyst reports that, "Ukraine saw the biggest increase in wage inflation of 23%. However, the depreciation against the Pound is also the highest. Hryvnia's devaluation is 15%, which gives an overall estimated increase cost of 4% in both wages and other costs. Even though the wages were lowered in November 2008 by 4%, the projected wage inflation for 2009 is 17%, the highest compared to other locations" (Inflation and currency fluctuation 2009, 2). In addition, the Ukraine has experienced some disputes with export partners such as Egypt concerning the massive amounts of cheap steel being imported that has adversely affected their domestic steel producers. According to the editors of The Middle East, "In 1996 imports from Russia, Ukraine, Romania, Moldova, Belarus and Latvia amounted to in the region of 250,000 ton and rigid quality controls did little to stem this flood of cheap steel, although a quarter of Ukrainian shipments were turned away from Alexandria" (25).

Turkey. Turkey's entrance into modern steel production can be traced to 1932 when the country's first state-owned integrated steel mill was completed with technical assistance from the German firm Krupp (Amsden 2000). The first steel plant was an enormous facility but was poorly situated with regards to sources of raw materials and the coal deposits it needed for energy (Amsden 2000). This enterprise enjoyed a domestic monopoly until the middle of the 20th century when there was a growing movement for the Turkish government to privatize these large state-owned enterprises. There was also a push at that time to increase the export market for Turkish steel. According to Amsden, "Turkey tried to promote exports starting in the 1960s, making them a condition for capacity expansion by foreign firms" (151).

Despite the efforts of foreign corporations and industry leaders to provide the technical and technological assistance needed by Turkey during the 1960s, the fact that the steel industry remained under government control was a sticking point for many foreign investors. In this regard, Amsden notes that, "Any capital increase required the consent of the Turkish government. It also became a policy of the Turkish government to agree only to a capital increase by forcing companies to take on export commitments. The government maintained that, in general, any profit transfers abroad had to be covered by exchanges through exports" (151). Because Turkish output of steel was inefficient by global standards, the export sales of steel products failed to cover the costs incurred; however, over time, the Turkish government implemented a functional export promotion system that provided Turkish companies and international joint ventures with the incentives they needed to improve operating efficiencies and export profitably (Amsden 2000). Today, Turkey is a major steel producer (Jewel in the crown 1999).

For comparison purposes, the respective populations and per capita GDP for the Ukraine and Turkey are show in Table 1 and Figures 1 and 2 below.

Table 1

Respective Populations and Per Capital GDP for Ukraine and Turkey

Country

Population

Per Capita GDP

Ukraine

45,700,395

$6,400

Turkey

76,805,524

$11,200

Source: Based on data from CIA World Factbook 2010 entries for Ukraine and Turkey

Figure 1. Respective Population Rates for Ukraine and Turkey

Figure 2. Respective Per Capital GDP Rates for Ukraine and Turkey

Source: Based on data from CIA World Factbook 2010 entries for Ukraine and Turkey

Case Studies:

A case study methodology was deemed especially suitable for this analysis because of its ability to provide a synthesis of relevant information from a wide variety of sources. For instance, according to Neuman (2003), the case study approach is "research in which one studies a few people or cases in great detail" (530). Therefore, the ability to develop an in-depth analysis of a specific topic makes the case study methodology a highly suitable technique for this study. In this regard, Feagin, Orum and Sjoberg (1991) point out that, "The study of the single case or an array of several cases remains indispensable to the progress of the social sciences" (p. 1). These authors also note that, "The case study offers the opportunity to study these social phenomena at a relatively small price, for it requires one person, or at most a handful of people, to perform the necessary observations and interpretation of data, compared with the massive organizational machinery generally required by random sample surveys and population censuses" (Feagin et al. 1991, 2). Based on the foregoing considerations, the case study methodology represents a useful framework for providing the researcher with increased validity of the findings that result for two main reasons:

1. Conclusions that are related to a certain aspect of a phenomenon under study need not be based solely on one data source.

2. Case studies generally rely on a variety of data sources (Benz & Newman, 1998).

Finally, as Mangum and his associates emphasize, "Intensive examination of case studies should both serve to enlighten the steel industry to its own performance as well as offer other industries a number of useful lessons from the steel experience" (74).

No. 1: Arcelor Mittal.

Arcelor Mittal is the world's largest steelmaker and the sole steel-producer in Zimbabwe and largest steel producer in South Africa (Guerrero 2009).

The company's official Web site states that, "ArcelorMittal is the world's number one steel company, present in more than 60 countries. It has led the consolidation of the world steel industry and today ranks as the only truly global steelmaker. ArcelorMittal is the leader in all major global markets including automotive, construction, household appliances and packaging" (ArcelorMittal 2010, 1). Like Erdemir which is discussed further below, Arcelor Mittal also holds substantial reserves of minerals in the countries in which it competes and has an enormous distribution network in place (ArcelorMittal 2010). Unlike Erdemir, though, Arcelor Mittal is faced with two realities when it comes to foreign exchange risk management. On the one hand, the company enjoys the resources that it needs to weather fluctuations in currencies in the various countries in which it competes. For instance, Healey (1995) notes that, "Exchange rate flexibility has an asymmetrical impact on firms. It is significantly more difficult for small and medium-sized firms to absorb the costs of foreign exchange risk management than it is for large corporations" (89). On the other hand though, because it competes in more than 60 different countries, the company's foreign exchange risk management assumes some truly daunting aspects. Despite the latter constraint, according to Ford, while the organization is headquartered in Luxembourg and headed by UK-based Lakshmi Mittal, Arcelor Mittal is widely considered to be well poised to take advantage of emerging markets wherever they may be, but particularly those located in Africa. For instance, in February 2007, Arcelor Mittal revealed that it had completed a $2.2 billion agreement to invest in Senegalese iron ore and Arcelor Mittal representatives suggested they intended to develop a mining hub in West Africa (Ford 2007). These efforts have been due in large part to sustained high prices in the international steel market which have not shown any indication of decreasing in the near future (Ford 2007).

Increasing demand in emerging Asian economies, especially India and China, has been responsible for much of the increase in demand; however, demand is also increasing in developing and industrialized regions as well (Ford 2007). In this regard, the company's profile emphasizes that, "Its industrial presence in Europe, Asia, Africa and America gives the Group exposure to all the key steel markets, from emerging to mature. ArcelorMittal will be looking to develop positions in the high-growth Chinese and Indian markets" (ArcelorMittal 2010, 3). The financial performance of ArcelorMittal has been equally impressive, with revenues for 2008 of almost $125 billion and crude steel production of more than 103 million tons, amounts that account for fully 10% of the global steel output for the year (ArcelorMittal 2010).

In addition, ArcelorMittal has continued to efforts to ensure that it has sufficient reserves of needed raw ore supplies available from company-owned mines. As Ford points out, these initiatives are direly needed: "At present, it is forced to rely on mining giants BHP Billiton, Rio Tin to and Vale to supply much of the iron ore that it uses in steel production; however, it hopes to control about two-thirds of the ore it requires by 2010 as the result of investment in Africa, Latin America, Russia and elsewhere" (Ford 2007, 55). Besides a healthy financial sector, the Ukraine offers several other advantages for ArcelorMittal. For instance, Ford reports that in 2006, Kryvorizhstal, the largest steel mill in the Ukraine, was purchased for $4.8 billion by Mittal Steel which acquired a 93% interest in the company together with an iron ore mine (Ford 2007). This acquisition represented a major economic catalyst for the Ukraine as well. In this regard, Ford notes that, "Representing 6% of Ukraine's GDP, the sale price dwarfs the $1.5 billion in foreign investment in Ukraine for all of 2004. Metal products are a big industry, and it [Kryvorizhstal] was attractive. Mittal Steel wanted to have an interest in eastern Europe, and it was the biggest remaining steel industry in eastern Europe" (55). The purchase price paid by Mittal Steel in 2006 was also 500% more than the price that was paid for the steel mill just 2 years previously; however, that sale was marked by nepotism and allegations of corruption and the sale was overturned by a Ukrainian court in February 2005 (Green 2006, 17).

Pursuant to the company's efforts to ensure it has access to sufficient reserves of raw materials, Arcelor Mittal, announced that it had entered into a memorandum of understanding with Societe Nationale Industrielle et Miniere (SNIM) of Mauritania to develop iron ore supplies in a region known as El Agareb in a joint venture that would provide ore to the companies operations in the Ukraine. Concerning the joint venture, the chief financial officer for Arcelor Mittal, Aditya Mittal, noted that, "Mauritania's strategic location in West Africa makes it an ideal choice for iron ore supplies to Arcelor Mittal's European steel mills" (quoted in Ford at 55). The original joint venture involved an acquisition of 30% in SNIM by Arcelor Mittal with an option to purchase an additional 40% interest at a later date (Ford 2008). This was a significant initiative for both Arcelor Mittal as well as Mauritania, with the El Agareb deposit being estimated at 1 billion tons of magnetite; however, this deposit has been the source of the iron ore provided to Arcelor Mittal for some time and the venture was built on this established relationship (Ford 2007)

Even though it is the largest steel producer in the world, Arcelor Mittal has not ignored its marketing efforts but has rather expanded them in recent years, perhaps due to its ongoing efforts to expand its operations and raw material sources. For instance, a consulting firm, World In Motion, provides services to Arcelor-Mittal on a worldwide basis concerning the company's sponsorship of sports teams and is currently collaborating on sponsoring teams in a number of emerging markets, including China, India, the West Indies and Eastern Europe. A company spokesman for World In Motion stated, "Thus far, we have completed deals in the Czech Republic, Ukraine and Poland on their behalf. Mittal Steel officially backed the Ukraine and Poland's successful joint bid to host Uefa Euro 2012 as headline sponsor. Moreover, we have been involved in putting together a sponsorship and activation program in China on behalf of Mittal Steel, which will then be rolled out across Asia through 2007/8" (quoted in Revill 2007 at 9).