Financial instruments for reducing foreign exchange risk are available but have rarely been used…until recently. The National Bank of Serbia has taken a series of actions to promote the use of financial derivates, and for the first time is loosening up its typically restrictive, formal approach.
Foreign exchange risk
As many other countries in transition, in an effort to keep stabile, low inflation, Serbia has a floating exchange rate. For Serbian companies involved in international trade, this means even higher foreign exchange risk. Doing business on the international market involves use of different currencies and a time gap between conclusion of a transaction and fulfilment of its obligations. Companies are facing uncertainty as to the final result of their transactions. They are unsure how to price their products to cover exposure to the foreign exchange risk. As a consequence, creating a stabile, realistic business plan be-comes very difficult.
Instruments for reducing risk
The floating exchange rate will not be eliminated any time soon, and a natural hedge is not an option for most of the Serbian international trade companies. However, foreign exchange risks can be mitigated with the use of financial derivates.
In Serbia, the legal framework allowing the use of financial derivates was established in 2006, by the Foreign Exchange Act (the F/X Act) and the Law on Securities' Market and Other Financial Instruments . The necessary by-laws were adopted in the middle of 2007. However, the actual practice started only in 2009 – 2010. Even then, they were used very rarely, and users were mainly large multinationals companies who were already familiar with these instruments. Small and medium size companies were either not interested or unfamiliar with currency hedging. Most of their scepticism stems from a lack of knowledge.
In order to improve the current situation, the National Bank of Serbia (NBS) started a major campaign promoting hedging instruments, educating about their characteristics, appropriate use and benefits. In July 2010, the NBS started organising conferences and lectures and has created a special internet service. At the same time, more banks started including financial derivates in portfolios of services they offer. Currently 17 out of 33 banks in Serbia are offering various FX hedging instruments. They started raising awareness about the options local companies have when trading on international market from their side as well.
Main financial derivates currently available on the Serbian market are: (i) forwards, (ii) swaps and (iii) options. The pricing of forwards or swaps is based on the current exchange rate of the currency being bought/sold and the difference in the interest rates of the two currencies involved.
The NBS also adopted additional bylaws in 2010 in order to loosen the requirements for documentation proving the obligation to pay in foreign currency, and regulated the spot sale/purchase of foreign currency between banks and the NBS. It also proposed amend-ments to the F/X Act which would provide for a more precise and wider definition of fi-nancial derivates, and which would enable free and easy performance of transactions in-volving hedging instruments, with very limited and exceptional interference from the central bank. The legal procedure of amending the F/X Act is currently on the way, but information as to the final version of the text and the time estimate when it will be adopted is still not available.
It is interesting to note that NBS is regarded as extremely cautious and conservative regulator. Generally, its regulators still base their work on the principle that everything that is not explicitly allowed in the laws or by-laws and regulated in detail is deemed pro-hibited. However, when it comes to derivatives, its approach is surprisingly liberal.
The effects of the latest action taken by the NBS are yet to be seen in the months to come. There is a lot of space for improving the level of sophistication of the current regu-lations and it is expected that higher demand will result in banks offering even better conditions for hedging instruments. However, it will ultimately be up to the companies to decide how to conduct their business and their readiness to rely on financial derivates when trading internationally.
This article was originally published in the schoenherr roadmap`11 - if you would like to receive a complimentary copy of this publication, please visit: www.schoenherr.eu/roadmap