Why Kazakhstani businesses do not hedge currency risks, and how much it really costs

Every time the tenge makes another sharp move, Kazakhstani businesses face the same situation. Importers recalculate contracts, companies with foreign-currency obligations hold urgent meetings, and CFOs try to assess how the exchange-rate change will affect costs, margins and the ability to meet obligations.

The same question almost always arises: could the business have been protected from currency fluctuations in advance? In financial terms, this protection is called currency-risk hedging.

Hedging instruments have existed for a long time, are widely used around the world and are available in Kazakhstan. However, they are used mainly by large exporters, financial institutions and corporations. Medium-sized businesses, although their currency risk can also be significant, often continue to act on the principle of hoping that this time they will be spared.

The most common objection from entrepreneurs is that hedging is expensive. There is some truth in this. The forward USD/KZT rate is usually higher than the current market rate, not because of an additional commission from a financial institution, but because of economic mathematics: tenge interest rates are materially higher than dollar rates, especially when the National Bank of Kazakhstan's base rate remains in double digits.

The forward USD/KZT rate is usually higher than the current market rate. The reason is not an extra fee charged by the financial institution but plain economics: tenge interest rates are significantly higher than dollar rates, especially while the base rate of the National Bank of the Republic of Kazakhstan stays in double digits.

An entrepreneur sees the difference in rates and asks: why pay an additional 8-10% per year for an event that may not happen? This logic is understandable, but hedging should be viewed not as an attempt to earn money from exchange-rate movements, but as insurance against currency risk.

When a company insures a warehouse against fire, it does not treat the insurance premium as wasted money simply because the fire did not happen. Insurance is purchased to protect the business from an event whose consequences could be critical. The same principle applies to currency risk.

A mistaken perception of the cost of hedging has already cost Kazakhstani businesses significant amounts during periods of sharp tenge devaluation.

It is not necessary to hedge the entire risk. A company does not have to insure the full amount of its foreign-currency obligations with one contract. It can hedge 30-50% of the currency position, split the volume into several contracts, use different maturities, build a ladder of transactions and revise the hedge ratio as conditions change.

For example, a company can hedge 30–50% of its currency position, split the volume across several contracts, use different maturities, build a so-called ladder of deals and revise the hedged share as the situation changes.

This approach preserves flexibility while reducing potential losses from a sharp exchange-rate move. However, it requires expertise, an understanding of financial instruments and the ability to assess the company's currency position. Medium-sized businesses usually do not have these competencies in-house.

That is why access to hedging instruments is usually provided by professional securities-market participants.

The statement that the market lacks liquidity is also largely fair. The exchange-traded derivatives market for the tenge is still relatively young. Liquidity on the Kazakhstan Stock Exchange, KASE, is gradually developing, but it still lags behind more developed international markets.

Market expectations for the future tenge exchange rate are especially visible in the offshore non-deliverable forward market, or NDF. NDFs are transactions in which the parties fix a future exchange rate, while no actual delivery of currency takes place. Settlement is based on the difference between the agreed rate and the market rate on the contract execution date.

Direct access to such a market is not easy. It may require international banking relationships, professional legal support, access to reliable counterparties, an understanding of international market practice and a developed risk-management system. For medium-sized businesses, this infrastructure is often too complex.

Therefore, investment companies and other professional securities-market participants play a key role in providing access to financial instruments. For example, SQIF Capital JSC specializes, among other areas, in transactions with derivative financial instruments. A developed counterparty network allows the company to find solutions for complex instruments that are not always available to a broad range of investors and entrepreneurs.

Another belief is that the exchange rate will be supported anyway. This no longer reflects current reality. For many entrepreneurs, the tenge is still associated with a stepwise exchange-rate model: the currency is held at one level for a long time and then weakens sharply by several tens of percent.

Against this background, businesses developed a strategy of trying to guess the timing of the next jump instead of managing currency risk systematically. At the same time, there remains an expectation that the state will intervene and support the market in a critical situation.

However, since 2015 Kazakhstan has had a free-floating exchange-rate regime. This means that the tenge exchange rate is formed by supply and demand, external economic factors, commodity prices, global capital flows and market expectations. Reliably predicting short-term exchange-rate movements is impossible.

Currency-risk management should be based not on attempts to guess the exchange rate, but on rules defined in advance.

An optimal approach may include identifying the company's currency position, calculating potential losses under different scenarios, setting an acceptable risk level, determining the share of obligations to be hedged, and selecting suitable instruments and maturities.

This approach helps reduce the impact of currency fluctuations on a company's financial result.

Accounting is another important and often underestimated reason why companies refuse hedging. Derivative financial instruments must be reflected correctly in accounting and financial reporting.

Without hedge accounting under IFRS, the revaluation of a derivative financial instrument may be reflected directly in the profit and loss statement. As a result, the company's financial result becomes more volatile, even if the instrument performs its protective economic function.

This volatility can concern banks and creditors, affect how the company's financial position is perceived, raise additional questions from auditors, complicate reporting preparation and require explanations for tax and supervisory authorities.

These tasks can be solved, but they require specialized competencies in IFRS, derivatives accounting and documentation of hedging relationships. Accountants at non-financial companies may not have this experience. As a result, businesses reject the instrument not because it is ineffective, but because they do not understand how to organize its accounting and support correctly.

As a result, Kazakhstan's hedging market is developing slowly because demand and supply influence each other. Demand from businesses is limited because the instruments seem expensive, complex and not sufficiently clear. Many companies have no practical experience using them, and their teams lack the required competencies.

On the side of financial institutions, supply also remains limited because insufficient demand does not encourage active development of product lines and infrastructure. A closed loop emerges: businesses do not use the instruments because the market is underdeveloped, and the market develops slowly because businesses rarely use the instruments.

Professional securities-market participants can help break this loop by making derivative financial instruments more accessible and translating complex derivatives terminology into language that business owners can understand.

The key question for a business owner. Before finally rejecting hedging because of its cost, a business owner should make a simple calculation: how much will the company lose if the exchange rate moves 10% against it?

It is important to assess not only direct losses, but also possible consequences: lower margins, higher costs, cash gaps, the need to revise prices, breaches of contract terms, weaker debt-load indicators and loss of competitiveness.

Then it is worth asking a second question: why is currency risk not managed as systematically as property, liability or other traditional risks are insured?

Hedging does not guarantee a business the most favorable exchange rate. Its purpose is different: to make the financial result more predictable and protect the company from a scenario in which one sharp currency move wipes out profit accumulated over several months.

This material has been prepared for informational purposes only and is not an individual investment recommendation, a public offer or an offer to enter into a transaction with financial instruments. Derivative financial instruments involve risks and may not be suitable for all companies. Before making a decision, it is necessary to assess the financial position of the business, the nature of its currency exposure and the possible consequences of the transaction, and to obtain advice from qualified specialists.

Author: Olzhas Saltykov, analyst at SQIF Capital JSC. Source: prodengi.kz.