Foreign Exchange Risk faced by local SMEs: Navigating the Challenges and Mitigating Risks

In today's global economy, businesses are more interconnected than ever, with small and medium-sized enterprises (SMEs) often involved in cross-border transactions. While these international dealings present growth opportunities, they expose businesses to foreign exchange (FX) risk.

Understanding and managing FX risk is crucial for SMEs in Singapore, especially as currency fluctuations can directly impact profit. This article explores what FX risk is, how local SMEs are affected by it, and practical strategies for managing and mitigating this risk.

What is Foreign Exchange Risk?

Foreign exchange risk, also known as currency risk or FX risk, refers to the potential financial losses that arise from fluctuations in exchange rates. For businesses engaged in international trade, FX risk occurs when the value of one currency changes relative to another, affecting the cost of imports and exports.

For example, if a business in Singapore imports goods from Europe or the US, the cost of these goods will be affected by the exchange rate between the Singapore Dollar (SGD) and the Euro (EUR) or US Dollar (USD). A weakening of the SGD against the EUR or USD will increase the cost of imports, which could lead to higher prices for consumers or squeezed profit margins for businesses.

Why and How SMEs Are Susceptible to FX Risk

SMEs in Singapore are particularly susceptible to FX risk due to their increasing involvement in international trade. Many SMEs import raw materials, components, or finished goods from neighboring countries like Malaysia, China, or even further afield, and in many cases, they deal with foreign currencies.

Case Example: SGD/MYR

Illustration adapted from: https://www.xe.com/currencycharts/?from=SGD&to=MYR

SGD/MYR was once traded at an exchange rate of 1 SGD : 3.5 MYR (Feb 2024), but it reached its lowest rate of 1 SGD : 3.21 (Sep 2024).

Case 1

Let's start with a simple example. You are an SME and are planning to buy a machine that costs 500,000 MYR from Malaysia in September 2024.

Assuming you had obtained MYR in February 2024, you would have to pay SGD 142,857 for MYR 500,000. You hold the MYR in your bank and pay the machine supplier when you purchase it in September.

MYR 500,000 / 3.50 = SGD 142,857

In the same situation, Mr ABC, another Singapore SME who is your competitor, wishes to buy the same machine from Malaysia in September 2024, too. However, he waited only during September to obtain the MYR. Mr. ABC would have to pay SGD 155,763 to obtain MYR 500,000

MYR 500,000 / 3.21 = SGD155,763

In both situations, you notice that Mr. ABC would have paid nearly SGD 13,000 more than you!

Case 2

In a separate scenario, assuming Richard is the owner of a Singapore SME and will be required to purchase some goods from Malaysia today (Nov 2024). The goods will cost MYR 1,000,000. There is a 60-day credit term, which means Richard will only be required to pay the suppliers in January 2025. Assuming Richard only has SGD now and intends to exchange MYR only in January 2025, let's observe how FX Fluctuation will affect Richard and his business:

Richard initially thought that he got a good deal. In Nov 2024, he thought he had secured the goods with only SGD303,030. However, the FX movement can be a massive risk for him! Should the rates become 1 SGD to 3.0 MYR, he would have to fork out SGD 333,333 instead!

Figures are used solely for illustration and are non-factual. For simplicity, all costs of holding/opportunity costs/Interests are ignored.

What Can SMEs Do to Prevent or Hedge FX Risk?

Fortunately, there are several strategies that SMEs can use to prevent or hedge foreign exchange risk. By implementing appropriate risk management tools, businesses can protect themselves from the negative financial impact of currency fluctuations.

1. Currency Hedging

Hedging is one of the most common ways to protect against FX risk. Several hedging instruments are available, including forward contracts, options, and swaps. These financial instruments allow businesses to lock in a specific exchange rate for future transactions, reducing the risk of currency movements.

2. Diversify Currency Exposure

Another strategy is to diversify currency exposure. SMEs can mitigate FX risk by negotiating contracts in their home currency (SGD) wherever possible, thus avoiding the need for currency conversion altogether. If dealing with multiple suppliers or customers across different regions, negotiating multi-currency pricing or using a currency basket (i.e., a mix of various currencies) can help spread the risk.

3. Natural Hedging

Natural hedging involves structuring the business's cash flows so that income and expenses are in the same currency. For instance, if an SME imports goods from Malaysia but also exports products to Malaysia, it can use the revenue from its Malaysian sales to offset the cost of Malaysian imports. Assuming that both imports and exports are denoted in the same currency, the reliance on currency conversion will be reduced, and only the excess portions will be susceptible to FX risks.

4. FX Risk Management Policies

SMEs should establish clear FX risk management policies that outline how the business will deal with currency fluctuations. This could include setting limits on exposure to certain currencies or establishing procedures for reviewing and hedging currency risk at regular intervals.

How We Can Help SMEs

At OakTree Accounting and Corporate Solutions, we understand the challenges SMEs face in Singapore when managing foreign exchange risk. Our team of financial experts is equipped to help businesses navigate the complexities of FX risk through tailored strategies and solutions.

We offer:

• FX Risk Assessment and Analysis: Our team can evaluate your current exposure to FX risk and recommend specific strategies to minimize potential losses.

• Hedging Solutions: We can recommend suitable tools for hedging depending on the risk area, quantum, frequency and characteristic

• Consultation on FX policies: Our experts can help you develop a comprehensive FX risk management plan, ensuring your business is prepared for future currency fluctuations. This could be in the form of FX policies so your business can have directives to mitigate its exposure to FX risks.

  
  

By partnering with us, your business can gain greater control over foreign exchange risk, allowing you to focus on growth and expansion confidently. Contact us today to learn how we can help you manage foreign exchange risk and secure your business's future!

-----------------

DISCLAIMER: The views and opinions expressed in this article are those of the author and do not necessarily represent the views and opinions of any individuals or organizations with which the author may be affiliated, either in a professional or personal capacity, unless explicitly stated.

-----------------