Foreign exchange rate adjustments in monthly bills

The author is associate chairman of the Department of Economics of the Ateneo De Manila University.

Could foreign exchange rate adjustments in consumers’ monthly bill have
been avoided? Should government prohibit utility companies from
charging foreign exchange rate adjustments?

Practitioners of international financial economics mainly use foreign
exchange derivatives to avoid the negative consequences of foreign
exchange uncertainties. There are different types of derivatives. These
include forward, futures, options, swaps, swaptions, etc. For the sake
of simplicity and in the interest of space, this essay concentrates on
forward contracts.

In exploring, here is an example. In the early 1990s, the National
Power Corporation (Napocor) financed much of its upgrading and power
infrastructures by dollar-denominated loans.

Back then, the foreign exchange rate were approximately P25 per $1.
This implies that for every dollar that it borrowed, it had to pay back
P25. That is: if the foreign exchange rate remained the same at P25/$.
But it did not, does not, and will never. For this reason, it risked
paying less or more than P25. That is: if foreign exchange became
P10/$1, Napocor will have to pay only P10. If it became over P50/$1 and
it did, Napocor will have to pay more than P50.

This is where forward contracts come in. In this contract, a company
may deal with a financial institution to sell dollars at a
predetermined rate and at a predetermined time. For example, in 1994,
Napocor could have approached Citibank, agree to buy $1 billion at a
predetermined exchange rate of P30/$1 and a predetermined year of 2003.
This way, regardless of what happens to the exchange rate – be it
P10/$1 or P50/$1 – it assured itself of paying P30 per dollar it
borrowed.

Obviously, the example set is simpler than in reality. Amortization is
usually more complicated. Currency denomination of debts may be
diversified. Financial institutions may not commit to dealing with such
lucrative and long-term contracts with Philippine utility institutions.
And so on. But in reality, there are also more complicated derivatives
meant to deal with the complications of international finance.
Therefore, derivatives could have been used to avoid risks in foreign
exchange fluctuations.

In effect, foreign exchange rate adjustments in consumers’ monthly bill could have been avoided
The next puzzle becomes the solution to avoid this from happening
again. If the market for utility as water and electricity were
competitive to begin with, firms would have worked harder in finding
ways to cut present and future costs just to get an edge of the market.

For example, firms would have been more creative in finding ways not to
pass foreign exchange adjustment to consumers, in particular the one
that households see on their monthly bills. If government utility
companies where competent and responsible enough, they would have
insured that their foreign-denominated debt do not bloat due to peso
depreciation.

This implies that competition is the most lasting solution. With
competition, individual utility firms out-grab others for market share
by lowering price and costs. Firms may reluctantly absorb significant
amount of exchange rate costs. They would eventually hire the most
competent international financial economists to hedge.

Ultimately, they are compelled to behave responsibly for their clients’ welfare – the consumer welfare.
The catch is: converting natural monopolies to competitive firms is
easier said than done. For example, in a forum Power Issues and
Promoting Competition under the Electric Power Industry Reform Act
(sponsored by the Department of Energy, in cooperation with the
National Association of Electric Consumers for Reforms
, and hosted by the Ateneo Center for Economic Research and Development
on June 19), the consensus among participants is that the process takes
years. Therefore, raising the level of competition will not get rid of
foreign exchange risks in the short run. This calls for a short-run
solution that forces companies to hedge. The easy answer seems to
create a law that directly obliges utility companies to hedge. However,
utility companies might hedge inefficiently and not competitively
enough. The reasons follow. First, utility companies do not have much
to gain from hedging. This is because consumers bear all the risk in
foreign exchange volatility. If the exchange rate goes against
companies’ favor, they simply transfer the cost to consumers in form of
“foreign exchange adjustment.”

But if it goes in companies’ favor, there is no concrete mechanism that
forces them to refund the gains. Second, as in any insurance, hedging
carries a premium and premiums impose additional cost. In sum, utility
companies have no incentive to hedge efficiently, and in this regard,
no motivation to lower consumers’ foreign exchange costs.

As remedy, government must transfer the motivation from consumers to
firms. That is: government must force utility companies to absorb
foreign exchange cost adjustments.

This way, utility companies have everything to lose and gain from
foreign exchange fluctuations. They pay the price for gambling, and
receive the sense of certainty for hedging.

In other words, government should prohibit utility companies from charging foreign exchange rate adjustments.

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