Derivatives-related exposures in the corporate sector: the case of Mexico and Brazil
8 June 2009
(Extract from page 55 of BIS Quarterly Review, June 2009)
In Latin America, on-balance sheet foreign currency mismatches have decreased substantially since the implementation of flexible exchange rate regimes during the 1990s (IMF (2008)). However, the low currency volatility and the nominal appreciation trend observed in several countries before August 2008 led some corporations to increase their off-balance sheet foreign exchange exposure through derivative positions. As a consequence, a number of companies in Brazil and Mexico started betting against the depreciation of their currencies by selling foreign exchange options in the offshore market. These contracts allow corporates to sell US dollars at a favourable rate when the exchange rate rises above a "knock-out" price (ie the domestic currency appreciates), but force them to sell dollars at an unfavourable rate if the exchange rate falls below a "knock-in" price (the domestic currency depreciates), offering financing and currency trades at favourable rates, but with the drawback of having to deliver dollars at a loss if the domestic currency depreciates past a certain threshold.
The sharp currency depreciation observed in Latin America after mid-September 2008 resulted in large losses for some of the top companies in Brazil and Mexico when the exchange rate triggered the "knock-in" provision, forcing them to sell double the amount of US currency at the higher price.1 In Mexico, derivatives losses reached $4 billion in the fourth quarter of 2008, while in Brazil, where official figures have not been released yet, losses are expected to be as high as $25 billion. A major food retailer (Comercial Mexicana), which sought bankruptcy protection on 9 October 2008, lost up to $1.1 billion on non-deliverable forward (NDF) contracts it had made with international banks.2
The complexity of such deals and the fact that they were done privately highlights the lack of transparency in these markets, as many of these companies did not disclose any information on their derivative positions.3 One result was a review of derivatives exposures across the region as policymakers realised that these exposures could pose systemic risk. Looking forward, policymakers will need to balance financial stability against market development in considering possible regulation of corporate derivatives risk.4, 5
1 One month after the Lehman Brothers default, in Mexico and Brazil the currency depreciated by more than 30%.
2 Gruma SA, the world's largest maker of corn flour, and Alfa SAB, the world's largest maker of aluminium engine heads and blocks, also suffered from considerable mark to market losses on derivative instruments during this period. On 10 October glass maker Vitro SAB announced that a large part of its $227 million of derivatives losses had come from natural gas forwards.
3 Comercial Mexicana was rated AAA on a local scale when it first filed for bankruptcy.
4 In Colombia, for example, the central bank established in May 2007 a maximum leverage position on forwards over the financial entities' net worth, a measure that was widely criticised but later proved to reduce the impact of the crisis.
5 In some cases corporate derivatives have contributed to reducing financial vulnerabilities, as shown by the use of oil price hedge and currency swaps by the Mexican state-owned petroleum company (Pemex), which helped it to stabilise its 2009 budget.