Productivity, the Canadian Dollar and Small Business - A Case Study

Based on a true story one of my clients had to deal with (besides teaching at Ivey, I am a consultant to the chemical industry). The following case explains why there could be, at least in theory, a relationship between productivity levels and fluctuations in the Canadian dollar.

Consider a small company in Brampton that manufactures and fills aerosol containers for chemical companies. A few relevant facts:

1. The market is quite competitive, so the company's pricing power is extremely limited.


2. Americans are as likely to buy the company's products as Canadians. Since the U.S. market is approximately 10 times the size of the Canadian one, 90% of the firm's sales are to the U.S. (and denominated in U.S. dollars) and only 10% are in Canada.


3. Roughly 90% of the firm's competitors are in the U.S. and only 10% are in Canada.

The firm is trying to decide whether or not to buy a new piece of equipment for $1 000 000 Canadian (including financing costs). This equipment would make the company more productive in some way. Perhaps it could either fill cans faster (say 150 cans a minute instead of 100) or perhaps the equipment is a new technology that allows the company to do something it could not do before. (e.g.bag on valve) The money would be borrowed and paid back over 10 years.

For our story, it does not matter where the company is buying the equipment from (either the U.S. or Canada) - it will be financing the purchase through a Canadian bank, so the loan will be in Canadian dollars. For simplicity assume the company pays back $100 000 a year for 10 years and the useful life of the machine is 10 years.

Management has determined that the new system will increase revenues from the Canadian market by $10 000 (Canadian) a year, and in the U.S. by $90 000 (U.S.) a year. It is expected that the Canadian dollar will trade for, on average, 90 cents U.S. during this period - making the value of the U.S. sales revenue increase equivalent to $100 000 Canadian a year. This provides for a total revenue boost of $110 000 Canadian a year; given the $100 000 a year cost, this is a 10% return on invest. Not outstanding, but it seems like an investment worth making.

However, the expected average exchange rate of 90 cents is just that - an expectation. It could be 70 cents or it could be $1.20 or some value if in between. If 70 cents, then the company does quite well, as the machine increases revenue by $130 000 a year ($10 000 + $90 000/.7) for a $30 000 a year profit. However, if the Canadian dollar rises to $1.20, then revenues increase by only $85,000 ($10 000 + $90 000/1.2) and the company takes a $15 000 year loss. The company cannot simply pass along some of the exchange rate exposure to their customers (see point 1) because they cannot raise their prices in response to the change in the value of the Canadian dollar. As with many Canadian companies this one is somewhat risk averse and as such, the investment does not get made.

Note here that a rise in say, aluminum prices, would raise the cost of all firms and as such raise the price to consumers. However only a very small minority of firms in this industry have a significant transactional CAD/USD exchange rate exposure, so a rise in the Canadian dollar should not affect the price received by this firm (see points 2 and 3). As such, a rise in the Canadian dollar is far more significant to the firm than the business risk of a rise in input costs.

How Not to Solve the Problem

If I were presenting this story to my undergraduate class, at some point a student would suggest that the company just buy a bunch of currency options and "hedge the problem away". Easier said than done - that would involve buying a bunch of options today for 8, 9, 10 years out from now. This is going to be difficult to accomplish and fairly expensive. Using currency options and derivatives is a great way to mitigate short-term currency fluctuations, but does little for long-term fluctuations (see Kenneth A. Froot - Currency Hedging over Long Horizons for more on this).

How to Solve the Problem

The problem here is that the revenue stream is almost entirely in U.S. dollars but the expense of buying the machine is in Canadian dollars. The solution is very straight forward - the company should simply borrow in U.S. dollars (or 90% U.S. dollars, 10% Canadian dollars) rather than in Canadian dollars. Instead of paying back $100 000 Canadian each year by borrowing in U.S. funds the firm pays back $90 000 U.S. each year. Since the new machine will increase U.S. revenues by an off-setting $90 000 a year, all that will remain is the $10 000 Canadian increase in revenues from Canada. Now the Canadian firm has zero net currency exposure and a $10 000 (Canadian) a year profit.

One big problem, though. In my experience (and those of my clients) it is nearly impossible for small Canadian companies to receive U.S. dollar denominated loans. The U.S. banks typically will not make loans to small out-of-country businesses and Canadian banks rarely, if ever, make loans to small businesses denominated in foreign currencies. As such, it is a solution that works better in theory than it does in practice.

There are clearly gains to Canadian productivity to be had by making it easier for Canadian business to access U.S. dollar financing. However, I am not sure what the public policy implications are. Are there any changes in regulations or new government programs here that would solve more problems than they create?

Comments

[Laurent GUERBY]

Your company banker is the one taking the FX risks if he doesn't want to lend in USD, if your banker is not completely incompetent he should be the one begging your to hedge the FX risk in some way :).

I looked around and at least on paper it seems that this canadian bank has all you want:

http://www.desjardins.com/en/entreprises/solutions/services-internationaux/financement/pret-terme-us.jsp

In France there's a state backed institution called COFACE that offers all sort of services for french exporters and importers, including FX risk insurance:

http://www.coface.fr/CofacePortal/FR_fr_FR/pages/home/pp/assurchange/interet

Otherwise most french banks offer tools for FX:

http://entreprises.bnpparibas.fr/Commerce-international/Risques-de-change

[Mike Moffatt]

Hi Laurent,

Thanks for the link, particularly the Desjardins one! My experience (and that of my clients) is naturally just anecdotal - I have no hard data on how easy/hard it is to actually obtain U.S. dollar financing (and how much the rate premium would be if one were able to obtain it). It would be great data to have, but I suspect nobody has collected it.

[Nick Rowe]

Neat! I hadn't thought of the "borrow in US$" solution. It's obvious now you mention it. Of course, borrowing in foreign currency is normally a recipe for increased risk, hoping to take advantage of lower interest rates. But not in this example.

[Fred Thompson]

How about an interest rate swap?

[Stephen Gordon]

You have to think that if you can walk the bank through the story, it should be able to see that this is a way of reducing risk. Or put it another way: if it was willing to lend in CAD, it should be even *more* willing to lend in USD. It can hedge its own forex risk much more easily and cheaply than the small business can.

Very cool anecdote.

[Adam P]

The issue for the bank though is that it also finds 10 year FX options/forwards expensive. It would only be more willing to make the USD loan if it can borrow short in USD, if it has no USD deposits this means relying on US money markets. The ones that got run somewhat recently.

[Andrew F]

Really? Banks can issue debt on the US market pretty readily, no? And at least some banks offer USD accounts. Not sure how these are treated by CDIC, etc.

[Mike Moffatt]

Thanks for your comments everyone - much appreciated!

Nick: Thanks for the kind words. Like investing in commodity futures borrowing in foreign currencies can either increase risk or decrease existing risk. In my course at Ivey one of our classes is devoted to types of exchange rate risk (transactional, translational, competitive) and ways to reduce that risk. Borrowing in a foreign currency is often the easiest and cheapest way, though it is one that is typically overlooked.

Fred: In theory an interest rate swap could work. We're talking about a small (3-4 million dollar a year in revenue) company that probably isn't all that savvy when it comes to financial markets - and there are hundreds, if not thousands, of companies in Southwestern Ontario alone that fit that description. I'm not sure an interest rate swap is an option for them.

Stephen, Adam and Andrew: Many Canadian banks offer USD accounts and typically USD overdraft protection and small lines of credit in USD, however it is extremely difficult (at least in my experience) to get larger loans in USD. I am not sure how much deposits a branch would have at any one time in USD. Overall if this company goes to the Royal Bank in Brampton and received a 900 000 USD loan, it largely is just shifting the forex risk from themselves to the bank. I would think that should not be that large a problem as the branch should be far less risk averse than a small company and the parent company should have all kinds of tools on hand to manage the risk.

To me the more obvious solution would be for the company to borrow from a U.S. bank - they could drive down to Buffalo and borrow from a branch of M&T. However (again anecdotally) it is extremely difficult for a small Canadian company to borrow from a U.S. bank. There may be some risk to the US bank that a change in Canadian policy could correct. Without knowing *why* U.S. banks are reluctant to lend to Canadian companies (assuming that my anecdote represents a wide-spread phenomenon), it is tough to know what policies or regulations need to be changed.

[Phil Koop]

Mike, I do not truly know the reason why US banks will not make small loans to Canadian companies. But may I draw the following facts to your attention?

1. Relationship banking. Banks believe that they know their customers better than outsiders do, and that this gives them an edge in credit assessment (for today's purposes, I am just the messenger: I am neither supporting nor disputing this belief.) Why then does an unknown customer from a far-flung location come knocking on your door for a loan? Why not deal with their regular bank? There is an implied risk of adverse selection.
2. Default resolution. Suppose the worst happens, and the customer defaults. Bankruptcy will be handled in a foreign court, and whatever assets pledged in credit support disposed of in a foreign market, possibly with unknown tax consequences. Hiring foreign experts to deal with these matters will be expensive compared to the amount of the loan. This effectively reduces expected recovery rates and raises the fair credit spread for the loan.

To me, the greater mystery is the one you dismiss, why Canadian banks will not routinely make USD commercial loans. Isn't financial intermediation the purpose of banks? In effect, the proposed USD loan is just a bundled CAD loan + USD/CAD swap from the bank's perspective. The bank would happily swap 100mm CAD to USD, so why won't it do 100 x 1mm (at a price)?

I suspect that much of the problem here is that banks are not unitary entities, but loose collections of business units with disparate political powers within the organization. Cooperation between these different units always raises the problem of transfer pricing, which is notoriously difficult to get right. You correctly point out that a large company could simply swap a CAD loan to USD; however, a large company would probably not be taking a loan anyway, but rather borrowing directly in the bond market. It is possible to float issues denominated in either USD or CAD on international markets; the question of whether to float in CAD and swap to USD or float directly in USD is purely economic. But note that in doing this the large company would not be dealing with bankers but with investment bankers. The latter usually claim to be more profitable than the stolid lending business, though of course they would be unable to operate if they could not lean on the balance sheets of the commercial and retail businesses. In theory this is reflected in some sort of risk-adjusted capital charge, but as I said, transfer pricing is hard to get right. Anyway, the bottom line is that investment bankers are politically powerful within the bank. The proposed small USD loans made by branches would be aggregated on a book in the treasury and risk-managed there, with the branches being charged for the service. It is just harder for initiatives to come from that direction.

[Andrew F]

It does seem like this is an opportunity for government policy to make USD loans easier to obtain relative to CAD loans. I wonder if BDC is on this issue.

I would also note that a bank that is willing to accommodate a SME on a matter like this is likely to get the firm's other business, including payroll, etc.

[Phillip Huggan]

It doesn't have to be a USA bank, USD is prevalent in lots of countries.

"I would think that should not be that large a problem as the branch should be far less risk averse than a small company and the parent company should have all kinds of tools on hand to manage the risk."

I don't see any difference between SME or bank exposure. I remember when our big banks tried to merge like all the rest of the world's incestuous bank breeding (for some reason our banks get conservative-investor status instead of P.Martin). Won't the banks just be buying the same LEAP-ish instruments as SMEs would have to? Is two currency transactions and currency options more expensive than banking fees and more USD/US-economy bank exposure?
Vancity is only institution to use microfinance. It would be interesting to know how large a Canadian loan must be before banks offer services that generate a decent profit. Somewhere between $50k-$500k sized loans, banks start to offer services. Maybe the mini-SME loans could be pooled and insured by AB or Ont, but why increase USD exposure on Canadian banks now while their banks still inflict meltdown regulations?

[Phillip Huggan]

Just read Laurent already showed the problem is SME lack of shopping skills. As Andrew F's 1st comment already noted, it wouldn't be practical for CDIC to insure USD accounts, no? I'll read comments 1st for now on.