April 6, 2015 / 7:19 AM / in 2 years

Battered by currency swings, European firms unpick global production model

A picture illustration shows U.S. Dollar and Euro banknotes on a pair of scales in Vienna March 11, 2015.Heinz-Peter Bader

LONDON (Reuters) - A dramatic fall in the euro has created an opportunity for European manufacturers to enjoy cheap production costs at the bases from which they can supply world markets.

But after months of sharp shifts in foreign currencies, many of these companies are simultaneously reworking strategy in the hope that by the time of the next sudden tilt they will be operating in more diverse local markets around the world.

Sweden's Volvo Cars is one such firm embracing regionalization. Last month it announced plans to build a $500 million plant in the United States, looking past the dollar's current strength to build in a longer-term protection.

"We're eliminating short-term currency fluctuations, which are never good for long-term commitment to customers in different regions, and we're creating a natural hedge," explained Volvo Chief Executive Hakan Samuelsson.

"Natural hedges" occur when a business's structure protects it from exchange rate volatility, such as when suppliers, factories and customers operate in the same currency.

That kind of model is typical for makers of perishable food and drinks that need production bases close to their delivery addresses, but it's less common for manufacturers of more durable goods like automobiles, electronics or clothing that often prioritize cheap labor and economies of scale - at least until recently.

In recent months their model has been challenged by big moves in the euro and the dollar as the European Union and the United States' economic outlooks diverged sharply. Last October the U.S. Federal Reserve announced it would halt the massive bond-buying program launched five years ago to prop up its battered financial system, because an economic recovery was on track. But in January the European Central Bank kicked off its own program of so-called quantitative easing in an attempt to revitalize the zone's moribund economy.

As a result the dollar and euro currencies sharply diverged too, and in the last nine months the cost of hedging against future volatility between them has roughly tripled. While that means far more players in the $5 trillion a day market have been actively guarding against swings in currencies, it also shows it is three times more expensive to do so.

"When an exchange rate is particularly volatile it can become too expensive to hedge financially," said Brandon Leigh, chief financial officer of soap manufacturer PZ Cussons (PZC.L). Cussons' biggest market is Nigeria, where the naira has lost 18 percent of its value over the past nine months as a result of a plunge in crude oil prices that hammered Africa's biggest oil producer.

Thus, while "natural" hedging has long been popular in some areas of business, "clearly with more volatility in FX markets it makes even more sense now than ever," said Robert Waldschmidt, a consumer goods equity analyst at Liberum.

"HOLY GRAIL"

British online fashion retailer Asos (ASOS.L), which has been hurt by the strong pound, said this month it had decided to start sourcing garments for the euro zone in euros and those for the United States in dollars.

"Our ultimate aim here is to capture the maximum natural hedge available to the business," said Asos Chief Operating Officer Nick Beighton. "Our panacea would be to match currency receipts, currency outflows, hold product in that currency and price in that currency."

Sourcing locally has other benefits, especially in emerging markets like Africa, where using local suppliers can fuel economic development - and buying power - of the communities in which manufacturers operate.

Food and drink makers including Nestle NESN.VX, SABMiller SAB.L and Unilever (ULVR.L) have all worked to develop local suppliers, which also helps to secure supply and make products more affordable.

Nestle Russia CEO Maurizio Patarnello cited local sourcing as part of the reason his business was only minimally impacted by last year's ban on imports of many Western goods in retaliation for sanctions over the crisis in Ukraine.

"Of course there are certain things that we will never be able to localize, like coffee or cocoa," Patarnello told reporters last month. "For the rest, there is a continuous effort to develop new suppliers."

Local sourcing may be driven by operational concerns but its additional advantage of helping firms to circumvent foreign exchange rates makes company treasuries "the happy beneficiaries from a risk management perspective," said SABMiller's SAB.L head of risk and funding, Philip Learoyd.

He added that SABMiller, the world's second-largest brewer, would keep looking for opportunities to offset exposure to currency volatility. The company already also protects against swings in raw material costs with financial hedges and keeps its debt denominated in currencies broadly proportionate to operations to avoid swings between amounts received and owed.

Over at Dutch electronics firm Philips (PHG.AS), emerging markets account for some 35 percent of revenue but only very little production.

As a result the company's profit margins were squeezed last year by adverse swings in various emerging market currencies, most notably the Russian ruble and the Argentinean peso.

"A natural hedge is of course the holy grail because then you're less exposed," said Philips Chief Executive Frans van Houten.

Additional reporting by Emma Thomasson in Berlin, Toby Sterling in Amsterdam, Laurence Frost in Paris, Maria Kiselyova in Moscow, Ludwig Burger in Frankfurt and Patrick Graham, Tom Pfeiffer and Tom Bergin in London; Editing by Sophie Walker

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