MASTER PROJECT MASTER IN BUSINESS ADMINISTRATION (PART-TIME)

Nguyen Trung Nam Foreign Exchange Risk Management in Vietnam: A Case Study of Petroman Ltd.. This thesis aims to identify the exchange risk exposure associated with business activities

Nguyen Trung Nam

Foreign Exchange Risk Management in Vietnam:

A Case Study of Petroman Ltd

MASTER PROJECT MASTER IN BUSINESS ADMINISTRATION

(PART-TIME)

Tutor’s Name: Dr Nguyen Minh Kieu

Ho Chi Minh City

(2012)

DECLARATION

I hereby declare that I am the sole author of this thesis, and this thesis is the result of

my own and original work and effort and that it has not been submitted anywhere for any award Only the sources cited have been used in this thesis Parts that are direct quotes or paraphrases are identified as such

Signature:

_

Nguyen Trung Nam

First and foremost, I owe my deepest gratitude to Dr Nguyen Minh Kieu for the consistent instruction and guidance through the work, without which this thesis would not have been realisable

I also would like to take this opportunity to express my sincere thanks to my mentor, Ms Ho Thi Dieu Hang, for her provision of useful information and assistance during my research

who have furnished knowledge and inspiration for my study and research

I also owe thanks to my beloved wife, who keeps encouraging my study, and my colleagues and friends, who have supported me in many different ways so that I could finish this time-consuming work

TUTOR’S COMMENTS

TABLE OF CONTENT

ABBREVIATIONS VIII TABLES AND FIGURES INDEX IX

CHAPTER I - INTRODUCTION 1

I PROBLEM STATEMENT 1

II OBJECTIVES AND RESEARCH QUESTIONS 2

III RESEARCH METHODS 3

IV LIMITATION AND CONTRIBUTION OF THE RESEARCH 3

CHAPTER II LITERATURE REVIEW 5

I OVERVIEW 5

II DEFINING EXCHANGE RATE RISKS 6

III TYPES OF EXCHANGE RISK 7

1 Translation Exchange Risk 7

2 Transaction exchange risk 8

3 Economic/strategic exchange rate risk 9

IV EXCHANGE RISK MEASUREMENT AND MANAGEMENT 9

1 Translation risk 9

2 Transaction risk 10

3 Economic risk 12

4 Exchange risk management organization and process in SMEs 13

CHAPTER III RESEARCH METHODS 16

I MAIN APPROACH AND SCOPE OF RESEARCH 16

II METHODS USED 16

1 Desk research 16

2 Quantitative Research 17

3 Qualitative Research 17

4 Other approaches 18

5 Data collection 18

CHAPTER IV FINDINGS AND ANALYSIS 19

I COMPANY BACKGROUND 19

1 Organisation structure 19

2 Business lines and performance 19

3 Pricing structure and strategy 21

II PETROMAN LTD EXCHANGE RISK EXPOSURE 21

1 Translation exchange risk 22

2 Transaction exchange risk 22

3 Economic exchange risk 27

4 Measurement of Petroman Ltd Risk Exposure 32

III PETROMAN S EXCHANGE RISK MANAGEMENT SYSTEM 35

1 Decision Making Process and Organisation 36

2 P E -rate Risk Management Activities 38

3 Critical Evaluation of the Existing System 44

IV SUMMARY OF FINDINGS AND CRITICAL COMMENTS 48

1 Summary of Findings 48

2 Pitfalls of the existing ex-rate risk management system 50

CHAPTER V CONCLUSIONS & RECOMMENDATIONS 52

I CONCLUSIONS 52

II RECOMMENDATIONS ON TRANSACTION RISK MANAGEMENT 53

1 Improving connection amongst the functional departments/management 53

2 Credibility of the inputs and forecast 54

3 Expanding benchmarking operation 55

4 The combination of qualitative and quantitative approaches 56

III RECOMMENDATIONS ON ECONOMIC RISKS MANAGEMENT 57

1 Reducing dependency in foreign supplies 57

2 Diversifying the clients range and business activities 58

3 Changing the operation unit establishment of a foreign-based entity 60

BIBLIOGRAPHY 1

APPENDIX 1 GUIDING QUESTIONS FOR INTERVIEW WITH PETROMAN 4

APPENDIX 2 USD/VND AND GBP/VND EX-RATES DEVELOPMENT (2007 - 2012) 7

APPENDIX 3 PETROMAN S FOR-EX GAIN-LOSS (2010-2012) 9

APPENDIX 4 PETROMAN S GBP VND EX-RATE EXPOSURE VALUE AT RISK (2007-2010) 12

APPENDIX 5 PETROMAN INCOME STATEMENTS (2010-2012) 14

ABBREVIATIONS

TABLES AND FIGURES INDEX

Figure 1 - Typical ex-rate risk management process 15

Figure 2 – Petroman Ltd Organisation Chart 19

Figure 3 - Petroman’s performance 20

Figure 4 - Petroman’s pricing structure 21

Figure 5 - Petroman' loans & supplier credits in USD 24

Figure 6 - Forex buying/selling activities of Petroman 25

Figure 7 – Black (parallel) market ex-rate vs official ex-rate 2008 26

Figure 8 - Supply Chain Structure of Petroman 27

Figure 9 - Petroman’s Cashflows Diagram 28

Figure 10 - Ex-rates movement 2007-2012 30

Figure 11 - Petroman's balance of foreign currencies (2007-2012) 31

Figure 12 - Petroman's exrate gains/losses (2010-2012) 34

Figure 13 - Types of exrate gains/losses 34

Figure 14 - Relationship between the ex-rates movement and NOP (2010-2011) 35

Figure 15 - Petroman's ex-rate risk management process 38

Table 1 - Petroman’s revenue currency structure 23

Table 2 - Petroman's Swap transactions 2011 40

Table 3 - Major banks’ for-ex/derivative services 55

CHAPTER I - INTRODUCTION

In the first months of 2008, for the first time in the Vietnamese banking history lots of commercial banks refused to buy the USD due to its depreciation against VND, other banks only accepted to buy in the USD at the price of between VND 15,300-15,500 against the published USD/VND exchange rate of 15,865 Shortly thereafter, USD suddenly became extremely scarce and the USD in the black market increased by over 13 percent in May 2008 and 16 percent in August 2008, which was said to extremely distort the profits of many Vietnamese enterprises (Hong 2008) Thanks to selling USD at higher prices, an exporter, Gilimex,

previous quarter On the contrary, enterprises having loans in USD or import business such as SHC, Cang Doan Xa JSC, or Tan Binh Cultural JSC suffered

financial report of many companies listed on HOSE and HAX such as PLC, ONE, DDM and VIP shows that exchange rates had caused exceptional income or losses

to their business results (VNEconomy, R i Ro T giá Gây Khó Doanh Nghi p Niêm Y t (Exchange Rates Risks Causes Trouble to Listed Companies) 2010) These are typical examples of how exchange rate movements become a major source of uncertainty for Vietnamese companies involving international activities such as import or export of goods and services

The SMEs account for 90-95 percent of total enterprises in Vietnam (GSO, 2009)

In the context of further liberalisation of the economy in Vietnam, many

for-ex rates risk (which most of them have been unfamiliar with) may become

vital to their business This problem provides the rationale for the study in this thesis, which is to review the exchange risks management practice of these SMEs This thesis will identify and measure the for-ex risks and review the corporate

operating in the oil and gas manpower services industry With its core business of providing [expatriates] manpower agency services, it was said by the management

volatility during the past three years Therefore to understand, measure and eliminate the exchange rates risks is a critical task for the management

This thesis aims to identify the exchange risk exposure associated with business activities of a non-financial firm, Petroman Ltd and to examine the exchange risk management process in the firm For this purpose, the author sets out four objectives to be achieved in the thesis:

Ltd’s business activities;

eliminating or limiting such risks;

management system based on theoretical literature and actual situation and business environment of the firm

To obtain the above objectives, several questions of the problem will be identified and resolved Firstly, what types of exchange risks are affecting the business performance of Petroman Ltd? Secondly, what have the management of Petroman Ltd done to measure and mitigate these risks and are they successful? The last question is how could Petroman Ltd management improve their exchange rate

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This is a fictitious name to ensure the anonymity of the real company

management? By answering these questions, the thesis will help to understand the exchange risk management process in Petroman Ltd and to recommend some practical solution to the exchange rate problem of Petroman Ltd

This thesis will use two major research methods (see CHAPTER III for more details):

Case study: the main approach of this thesis is a single case study of a business management in real-life context, Petroman Ltd, using multi-sources of evidence Secondary data/desk research: the author will collect and use all the firm data and figures made available by Petroman, public information of exchange rates and forex policies and offers by the major banks, Vietnamese laws and regulations regarding forex control, in order to summarise and analyse the key figures and factors supporting the answer to the research questions

The thesis also applied some qualitative method (interviews with different members of the firm) and quantitative method (linear regression) to support the case study method

Limitation: The qualitative case study approach has various advantages since it allows insights and explanation for particular phenomena It is suitable to the focus of the study in the operational, economic and strategic exchange risk of a business sector (SMEs in Vietnam) in a competitive environment, which are quite pre-mature in terms of exchange risk management The qualitative approach also permits the organisational settings of the firm, the reporting process and the management decisions on the exchange risk control However, it is not without certain limitations Firstly, the reliability of the research is questionable due to possible bias as result of the direct personal contact between the researcher and the interviewees Though the researcher has tried to enhance the objectiveness of the

research by interviewing different management and staff persons, or looking at different available data and information of the firm, the preset themes and values

of the interviewees will inevitably create reflexivity and subjectivity in data gathering and case analysing

Secondly, given the limited scope and resources of Petroman Ltd as an SME, a number of financial information reported in the firm is whether incomplete, informal or short of reliability Moreover, the reporting procedures in the firm are unorganised and insufficient, which make it hard to analyse the case with a high precision This problem itself is an obstacle for the firm to identify and measure the extent of the problem

Finally, the research results may lack generalisation since the case is a particular firm in a particular business sector and operating environment, whose solutions might not be readily applicable to other cases This limitation, however, could be compensated by the richness and depth of the case analysis, which could provide better understandings and insights of the problem

Contribution: Beside providing insights of the exchange risk management in

background and practical issues of exchange risk management in Vietnam in order

to suggest the practical solutions applicable to this SME for the improvement of its exchange risk management By this thesis, the author hopes to contribute an original case study to the limited collection of researches on exchange risk management in Vietnamese SMEs

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Some brief information of the company is described in section I of CHAPTER IV hereunder

CHAPTER II LITERATURE REVIEW

In this chapter, we will review the literature of the exchange risk management, including defining and measuring the risk, various techniques and methods for managing the currency risks The chapter will also summarise prior scholars’ insights, findings and recommendations for exchange risk management

Since the Bretton Woods system of administering fixed for-ex rates collapsed in

1971 and a new fluctuating exchange rates system was introduced, enterprises involving in international transactions have had more and more concerns about the exchange rates volatility (Bartov, Bodnar and Kaul 1996) The recent booming globalisation process has resulted in an increase in foreign currency transactions with more uncertainty in international market

Not surprisingly, this problem has received much attention of scholars and practitioners in business administration For example, many studies optimised the questionnaire approach for analyzing exchange rate exposure management in non-financial firms (Bodnar, Hayt, & Marston, 1998; Bodnar & Günther, 1999; Ceuster, Durinck, Laveren, & Lodewyckx, 2000; Mallin, Ow-Yong, & Reynolds, 2001; Marshall, 2000) Others applied the interviews/case study approach with non-quantitative nature to provide insights of the risk management practices in the corporate sector (Belk & Glaum, 1990; Brown, 2001; Dhanani, 2003)

Another interesting approach is event study methodology, e.g Dewenter’s study

on the exchange rate exposure of US multinational firms during Asia’s financial crisis (Dewenter, Higgins and Simin 2005) In the absence of clear-cut theoretical answers to the question of how corporate risk management should be organized, these studies provide managers with information on the current practices of other firms, which allows them to critically assess their own strategies (Glaum 2005) Most of the literature, however, have to date concentrated in the for-ex risk management of multinationals in Western countries, most notably in the UK

(Dhanani, 2003; Dhanani & Groves, 2001; Belk & Glaum, 1990), the US and Germany (Glaum, 2005; Carter, Pantzalis, & Simkins, 2004; Bodnar & Günther, 1999; Brown, 2001), Swedden (Nydahl 1999), and Romania (Balu & Armeanu, 2007; Armeanu & Balu, 2007; Armeanu, Balu, & Obreja, 2008) Some exceptional but scarce efforts have been made in analysing exchange risk management on global scale (Bartram 2006) or in developing countries such as India (Sivakumar and Sarkar 2008) and Malaysia (Yazid and Muda 2006), but very little literature targets at SMEs (Aabo, Hoeg, & Kuhn, 2009 is an exception), and except for very limited newspaper articles and commentary notes, no research has been seen on exchange risk management for Vietnamese SMEs

According to Dhanani (Dhanani & Groves, 2001; Dhanani, 2003), the term

financial performance of firms as measured by conventional financial statements and/or corporate cashflows Some factual examples of exchange rate risk and exposure can be illustrated below:

In March 2008 Toyota faced very tough conditions caused by an excessive appreciation of the JPY against the USD (Nakamoto 2008) The currency jumped from Y105 to Y102 to the USD in just few days, while the firm said every rise of Y1 to the USD cuts Toyota’s annual operating profits by Y35bn ($341bn) As the

the appreciation of the yen can make the yen value of the deal ―evaporate before its eyes‖ (Nakamoto 2008) Similarly, Nitendo, a large Japanese videogame producer, reported in October 2003 its first-ever £16 million loss as result of the strength of the yen (Pike and Neale 2009)

4 In his definition, Dhanani did not follow the definition by Adler and Dumas (1984) who distinguished between currency risk and currency exposure, whereby the term risk refers to the volatility of exchange rates without any specific implications for firms, while exposure referred to the actual change in a firm’s financial performance as a result of a movement in a rate of exchange, which definition is less used nowadays

For the managment of any corporation containing exchange risks, deciding to hedge or not to hedge is a headache issue, which depends on various factors, e.g their analysis/speculation of the market, their risk management approach and strategies In 2004, BMW announced that it would, while seeing an end to the dollar’s two year decline, stop all the long-term hedging of the dollar (against the euro) and gamble on a fall in the euro from its level then of $1.30 per euro The policies turned out to be misguided, as by 1 April 2008, the euro stood at $1.56, creating great losses to BMW during those years

Based on prior theoretical literature, there are three main types of exchange rate risks: (1) translation or balance sheet risk, related to the conversion of the positions in the balance sheet into foreign currencies; (2) transaction risk related to commercial or international financing activity of the firm; and (3) economic or strategic risk related to long-term movements in exchange affecting expected future cashflows of the firm (Pike and Neale 2009) Some authors also mentioned competitiveness risk, which is related to the relationship of the firm with foreign competitors and could be classified as part of strategic risk (Balu and Armeanu 2007) We will now look at each type of exchange risk in details

Translation exchange risk is the result of the restatement of financial statements of foreign subsidiaries into parent currency terms for consolidation purpose The translation of the foreign currencies into the local currency, together with the

financial statement, in particular the balance sheet values and to a lesser extent, the profit and loss account

In measuring the risk and booking the gains or losses, under the Vietnamese

must be initially accounted by applying the exchange rate between VND and the

foreign currency on the date of the transaction (spot exchange rate).5 In the balance sheet, monetary items of foreign currency origin (including liabilities) should be reported at the closing exchange rate; but the non-monetary items of foreign currency origin (e.g fixed assets) must be reported at the exchange rate on the date of the transaction Imagining that a Vietnamese firm gets loan in USD to finance a fixed asset purchase (which is paid in USD), the above booking structure will create a gap between the foreign currency liabilities (which will fluctuate

asset value (which is fixed in VND regardless of the ex-rates movements between

sheet if such ex-rate movements are volatile To avoid the harshness of this method the Circular 201/2009/TT-BTC issued by the Ministry of Finance on 15 October 20097 modified the rules that such losses (but not applicable for gains) could be distributed to the financial costs for a maximum 5 years

Transaction exchange risk is a most obvious and identifiable/measurable form, which is concerned with the exchange risk involved in sending money over a currency frontier It exposes when the firm seek to convert their committed foreign currency cash flows into parent currency, and the ex-rates at the date of conversion are not certainly known Prior literature generally encourage the management of transaction exchange risk, because it can ―easily eliminate a company’s profit margin‖ and ―inflict substantial losses‖ (Pike and Neale 2009) Though movements in currency may create unexpected gains, the general view is pro a

5

However, enterprises may use an exchange rate that approximates the actual exchange rate on the date of the transaction E.g the average exchange rate of a week or a month may be used for all transactions in each kind of foreign currency arising in such week or month If the exchange rate fluctuates greatly the enterprises must not use the average exchange rate for the accounting work in the accounting week or month involved (clause 9, VAS Standard No 10)

6 In this case the net-book value of the fixed asset does not necessarily reflect its market value Because the fixed asset must be purchased using USD, the translation of the value at the closing date would arguably reflect its actual value, and the losses or gains due to the ex-rate movements are not real

7

Circular 201/2009/TT-BTC Section B, Article 6, clause 2.2(a)

hedging strategy to fix the ex-rates for the dates that the companies have foreign currency exposed (Dhanani 2003) There are arguments against the extremes of leaving uncertainty to the market or speculating the market and actively hedge for exchange profits

3 Economic/strategic exchange rate risk

Economic exchange rate risk exposes when the value of the firm changes due to the forex-induced changes in the projected future cashflows of the firm Economic exchange rate risk can be described as an extension of transaction exchange rate risk in that it extends to cash flows in the future, not those materialised However,

a key difference between the two types of risk is that economic exchange rate risk look into the long term movements of the exchange rates, which may have profound effect on the future cash flows of the firm by influencing the level of sales, prices and input costs In other words, this type of risk deals with the movements in real rates of exchange (taking into account general level of inflation) (Dhanani 2003)

1 Translation risk

The question whether this risk is a real loss has been much debated during the last

30 years A large number of scholars and practitioners have been of the opinion that translation risk should not be hedged or even managed, for it is concerned with the external reporting of pass events and has no impact on the economic value of the firm or meaningful implications for the future cashflows and market values of firms (Dufey, 1972; Srinivasulu, 1983) As Dhanani correctly put it, the use of derivatives to create balance sheet certainty simply transfers volatility from the balance sheet to the firm’s cashflow since the loss/gain has no cash base (Dhanani 2003)

However, this risk may become a problem if there are plans to realise assets held

overseas, or if the parent firm wishes to repatriate earnings when they cannot be profitably reinvested in the location where they arise Moreover, the changes in the values of reported assets and liability values may have impact on analysing key performance measures and ratios of the firm (e.g EPS) via overseas earnings, gearing, etc (Pike and Neale 2009) This impact has important implications in two aspects: (1) the exchange rates movements may adversely amend the firms’ gearing ratios quoted in parent currency, and thus will create concerns to those firms using gearing ratios for funding arrangements; (2) the translation profit and loss exchange risk, which however is not materialised, can reduce the actual profit reported in parent currency compared to the expected profit reported previously Not surprisingly, a case study research by Brown of an American manufacturer, HDG plc, witnessed that the firm’s senior managers wanted to manage translation exchange risk, as they believed that the volatility in ―reported accounting numbers‖ as a result of exchange rates movements would have adverse effect on share price In another study on sixteen UK companies, Belk and Glaunm found that 81% considered managing translation exposure as important (Belk and Glaum 1990)

2 Transaction risk

Transaction risk can be easily calculated from the realised cashflows of the firm which are also shown on the financial statements of the firm Transaction exposure can be hedged (neuturalised) easily by setting up counterbalancing positions using hedging tools For example an importing firm having a future payable cash outflow in USD (for paying foreign suppliers) may purchase the USD today (or using a forward contract) to fix the purchase price in VND as of the date it need USD and avoid fluctuation of the USD/VND exchange rate The management of transaction risk has been the centerpiece of most firms’ exchange risk management system (Glaum 2005) The following financial hedging tools/instruments are the most commonly used (Sivakumar and Sarkar 2008):

a Forwards: a made-to-measure agreement between the firm and another party

to buy/sell a specific amount of a currency at a specific rate on a particular date

in the future The main feature of this tool is that it can be tailored to the specific hedgin needs of the firm but the contract is binding and not marketable

or assigned to another party if the firm want to drop in the middle

b Futures: a future contract is similar to the forward except that it is done

through an organised exchange market Therefore it can eliminate the problem

of double coincidence Futures only require a small initial outlay but a significant amount of money can be gained or lost However, the talorability of future contracts is limited becaused they are highly standardised

c Options: a currency option gives the right, but not the obligation to buy (call

option) or sell (put option) a specific quantity of one foreign currency in exchange for another at a fixed price (Exercise/Strike Price) Options are usually used for contigent cash flows, e.g in bidding processes

d Swaps: a swap is a foreign currency contract whereby the buyer and seller

exchange equal initial principal amounts of two different currencies at spot rate At maturity, the principal amount is effectively re-swapped at a predetermined exchange rate so that the parties end up with their original currencies, in addition the parties will exchange fixed or floating rate interest payments in their respective swapped currencies during the contract period Swap allows firm to hedge apart or in full of its exchange risk without changing its underlying borrowing position

e Increase/decrese borrowing level in foreign currency: borrowing in foreign

currencies can be used to hedge for-ex exposure by taking advantage of the International Fischer Effect relationship If an export firm is going to receive some amount in USD in the next few months and there’s a risk that the USD will depreciate against local currency, it can get a loan in USD and convert the same into local currency at current ex-rate and the interest gains of local

currency will cover the costs for interest of the loan in USD while the firm is protected against ex-rate fluctuation This is a very commonly used tools as per literature (Keloharju 2001)

f Other internal extra-contractual techniques: this includes the management

of the risk at the firm level using extra-contractual techniques such as chosing the contract currency; re-pricing the contract adding the ex-rate risk elements; synchronisation of encashment and payment in the same currency; lead/lag receivables/payables; seeking credit terms from suppliers; altering credit terms

to customers; payment date game, etc (Balu and Armeanu 2007)

3 Economic risk

The measurement of economic exchange risk exposure remains incomplete to date because the true nature of economic exposure and its impact on the value of the firm remains largely a mystery to financial executives and thus was traditionally ignored (Khoury and Chan 1988, 137) However, more and more scholars and practitioners believed that economic exchange risk should be the most appropriate basis for corporate exchange risk management (Belk and Glaum 1990) and a multitude of factors, including international locations of a firm’s plants, competitors, key buyers and suppliers are usually considered when assessing economic exchange risk

Economic exchange risk is difficult to measure and manage, and it is well established by previous literature that conventional financial hedging tools help little to protect firms from such future/long term risk (Dhanani 2003, 40) Two theoretical approaches (qualitative and quantitative) have been developed by the economists to deal with this problem The qualitative approach considers economic risk a kind of business risk,since it affects the strategic/competitive profile of the firms (Dhanani and Groves 2001) The approach, therefore, focus on

structure to eliminate/manage the effects in movements of the ex-rates

The operational strategies are not limited within the financial executives but are rather considered a task for the management, which may include the following (Dhanani 2003, 41) (Dhanani and Groves 2001, 280):

a Contract strategies: Using contractual clauses calling for assumption of

exchange risk by the customers

b Sourcing adjustment: Changing the sources of supply by changing suppliers

from different countries, establishing new production sites or relocating the production sites, etc

c Marketing and pricing strategies: Changing the client portforlio or market of

sales to target new less competitive markets having favourable rates; adjusting prices in response to movement in ex-rates

On the other hand, quantitative approach seeks to measure economic risk with statistical regression techniques and make use of financial hedging instruments to manage such risk (Adler and Dumas 1984) Quantitative approach calculates economic exchange risk by assessing the firm value’s sensitivity to ex-rate movements, using partial derivative function where the dependent variable is the firm’s value and the independent variable is the exchange rate (Aabo, Hoeg and Kuhn 2009) Then the basis of risk management strategy will be to use financial instruments (see section IV.2 of this Chapter) to generate sufficient gains at

Ealier imperical studies indicated that companies either did little to manage economic risks or applied strategies which deviated greatly from theoritical literature (Belk and Glaum 1990) However, recent researches showed that companies tend to take elements of both qualitative and quantitative theoretical frameworks in their exchange risk management (Dhanani 2003) (Brown 2001)

4 Exchange risk management organization and process in SMEs

Many empirical researches have dealt with the organisation of the exchange risk

management in MNCs (Belk and Glaum 1990) (Glaum 2005) and most of them shown that the risk management of MNCs is highly centralised, including the notable finding by Yazid and Muda on Malaysian MNCs (Yazid and Muda 2006) Though there has been no literature on the organisation of exchange risk management in SMEs, it can be assumed that SMEs generally apply a centralised exchange management system, given their limited resources and expertise

Economists and consultants have summarised the basic process of exchange risk management of a firm as follows (Sivakumar and Sarkar 2008):

a Forecasts: to develop a forecast on the market trends and the future direction

on the for-ex rates

b Risk estimation: based on the forcast, the value at risk (the actual profit/loss

for a move in rates based on the forecast) will be meatured and the propability for the risk should be ascertained, taking into account market-specific problems (such as market disruption or foreign currency policy changes) and system risk due to inadequacies (such as reporting gaps)

c Benchmarking: based on the risk estimates, the firm will set its limits for

handling for-ex exposure, including the decision whether to manage its exposures on the basis of cost-center (i.e to ensure that cash flows are not adversely affected beyond a point) or profit center (i.e to generate possible profit on its exposure)

d Hedging: based on the limits set above, the firm will then decide an

appropriate hedging strategy with the selection of one or combination of a number of hedging tools

e Stop loss: the decisions made by the firm are based on forecasts which some

time turn out to be wrong The firm will need to establish a monitoring system

to detect critical levels in the for-ex rates at which point appropriate measure must be taken to rescue the firm

f Reporting and Review: all risk management activities must be subject to

periodic reports and reviews The reports will reflect the performance of the risk management activities and the reviews analyses whether the forecasts of market trend are relatively correct, the benchmarks set are effective in controlling the exposure, and whether the overall strategy needs change/adjustment

Some researchers develop this process in a more detailed synthetical making process as per the Diagram below:

decision-Figure 1 - Typical ex-rate risk management process

Source: Balu and Armeanu 2007

The above theoretical frameworks shall be considered together with the analysis of this thesis using the methods described in CHAPTER III below

CHAPTER III RESEARCH METHODS

The main approach of this research is a single case study of a business management matter in a real-life context Petroman Ltd was selected as an appropriate case based on the fact that (1) Petroman Ltd is a typical case of local SMEs which encountered extensive exchange risk exposure; and (2) the author had access to the executive management of the firm The scope of research is the empirical investigation of the ex-rate management progress within Petroman

during the period between 2007-2012

With the major approach of case study method, this research is based on a mix of multiple sources of quantitative and qualitative evidence:

1 Desk research

The following information have been sought, collected and developed via desk research:

 Financial costs of Petroman Ltd, including currency purchase costs during 2007-2010 period on yearly basis;

 Summary of for-ex gain-loss during 2010-2011 period on monthly basis;

 Summary of commercial contracts and transactions made by the firm using forexs during 2007-2010;

 Summary of loans in foreign currencies which Petroman has made during 2007-2011;

 Exchange rates of USD and GBP against VND published by Vietcombank

8 It should be noted that the profit and loss figures of Petroman during 2007-2009 period are only available

on yearly basis Since 2010 the firm’s reporting procedures have been improved significantly and the author has got access to the profit and loss reports on monthly basis

during 2007-2011 period (data retrieved on the 1st of each month);9

 Some major banks’ exchange policies, offers and practice of selling/buying forexs and derivative products in Vietnam market;

 Vietnamese laws, regulations and guidance letters regarding exchange management and control

2 Quantitative Research

In order to evaluate the impact of the exrate gains/losses on the business performance of the firm, the author has developed a simple linear trendline to evaluate the relationship between Petroman’s Net Operating Profit (NOP)10 and

during the period In order to exclude any biases related to the fluctuation of the

costs in prorate to the monthly revenue The division into two periods is to

had a significant change in April 2011 which turned Petroman from a net USD receiver to a net USD payer Given the fact that the 2007-2009 statistics are not made available, the above analysis is deemed sufficient as of the measurement of the for-ex risk exposure

With regard to economic exchange risk, the author proposes qualitative approach (see the next section) and the quantitative analysis of economic ex-rate risk is not within the scope of this paper

10 The use of NOP will avoid biases due to the exceptional financial costs and revenues (which are included

in the EBT or profit after tax

 Contracting strategies of Petroman Ltd, the situation of exchange in the contracts Petroman Ltd signs with clients, suppliers/subcontractors, the viewpoint of management on exchange risk management;

 The organisation of exchange risk management and the decision-making process of the management in buying and selling of exchanges and general exchange risk management;

 The interaction between Petroman Ltd and its banks with regards to the exchange related activities (the for-ex services and derivative products made available by the banks, the costs and terms and conditions of the same)

4 Other approaches

Beside empirical approach, by reference to academic concepts in corporate finance, risk management by doctrinal research described in CHAPTER II, the author has also investigated the possibility to apply these concepts in the SMEs operating in Vietnam, in particular Petroman Ltd The concepts will be referred to the case at hand by looking at their advantages and disadvantages and their applicability and appropriateness to the case

5 Data collection

All data and information are collected either from open public resources or disclosure by the executive management of Petroman Ltd A number of personal interviews with the executive management, the F&A manager of Petroman Ltd and some officials of major banks in Vietnam (including HSBC, Standard Charter Bank, BIDV, Vietcombank, Techcombank, Asia Commercial Bank) have been implemented for this research, using the Guidelines described in APPENDIX 1

CHAPTER IV FINDINGS AND ANALYSIS

Petroman Ltd is a private company established in Ho Chi Minh City in 2005 with the goal to become a leading supplier of manpower and particular equipment and services for the oil and gas industry in Vietnam Managing about 30 expats and 20 Vietnamese engineers and with the average annual turnover of USD 9 Million, the firm is now among the top ten market leaders in manpower agency services of Vietnam oil & gas industry

1 Organisation structure

Being a new ventured SME, Petroman started its business with a minimum and optimised organisation of three persons Currently the firm has 10 office staff working in three functional departments With the registered office in Ho Chi Minh City, in 2007 Petroman established a branch in Vung Tau to facilitate logistics for its expats workers and marketing activities in Vung Tau

Figure 2 – Petroman Ltd Organisation Chart

Source: Petroman Jul 2012

2 Business lines and performance

Petroman is a net importer of equipment and labour-related services Its business lines originally included:

PETROMAN LTD ORGANISATION

HEAD OFFICE (BOARD OF MANAGEMENT)

LOGISTICS DEPARTMENT

ADMIN-ACCOUNTING DEPARTMENT

FINANCE-CONTRACT DEPARTMENT

SALES-VUNG TAU BRANCH

LOGISTICS HUB FOR EXPATS

• Supply of highly qualified (expats and local) manpower, technical consulting services for the oil & gas industry;

• Equipment & materials for the oil & gas industry;

• Trade agent services;

• Logistic services and supply chain management

In its first year of operation (2006) the firm focused on equipment supplies which was not successful until it started the business of manpower agency The supply of manpower (most of them are expats) has gradually taken a greater part in the whole business of the firm and since 2011 it has become the only business of Petroman

Since 2007, the revenue of the firm has grown steadily at the average growth rate

of 66% (see chart 2 below), except in 2009 when the firm lost its major contracts

in a traditional client, BP

Figure 3 - Petroman’s performance

Source: Petroman Jul 2012

150,000

200,000

250,000

Petroman's performance 2006-2012

3 Pricing structure and strategy

In order to assess the exchange risk exposure of Petroman, we have analysed its pricing structure as per the below chart

Figure 4 - Petroman’s pricing structure

From this figure, we find that the imported services (salary payment to expats and other imported services) account for 66% of the total price of the firm’s service offered to its clients This portion also represents the value-at-risk of exchange rate gain/loss, which will be further discussed in section II below

Operating in a highly competitive market, it was noted by the management of Petroman that the firm always offer to clients a gross mark-up of 5-10% over the net salary paid to the expats (equivalent to 3.5-7% of the total Cost of Good Sales This will give the firm a net profit of around 1% over the total revenue, which could easily vanish if an exceptional cost (such as an exchange loss or financial costs increase) incurs

In this section, we will analyse Petroman’s exchange risk exposure from the available sources of Petroman and further development of the figures by the author

PIT payment (COGS)

CV purchase+training (COGS)

[Net] financial expenses

in conjunction with the qualitative findings

1 Translation exchange risk

We found that Petroman is not subject to translation exchange risk due to the fact that Petroman has a single business unit located entirely in Vietnam, which uses VND as the only currency basis for accounting purpose

However, due to the fact that under some contracts (e.g with BP, Talisman) Petroman is paid in USD and all the cost/revenue and profits are calculated in USD, exchange gains/loss may arise and be recorded in a similar way as translation exchange exposure (see further explanation in section 2(a) below)

2 Transaction exchange risk

As explained by the account department of Petroman, the firm is exposed to transaction exchange risk on permanent basis This risk may come from the following sources (which realises when the firm receives or makes payment, selling or purchasing foreign currencies):

a) The currency gap between client payment and salary payment:

Most of its clients are Vietnamese entities, which usually want to make payment to the suppliers in VND (and sometimes even to fix the prices in VND) (see Table 1 - Petroman’s revenue currency structure) Meanwhile, the firm must pay the salaries

to its expats in foreign currencies (USD or GBP) within 10 days upon the completion of each month of services While the revenue is recorded in VND using the exchange rate on the invoice date, Petroman must purchase USD or GBP

to make salary payment to expats at a different exchange rate and the gap between these two would create unpredictable exchange gain/loss

For any amount paid to Petroman in USD, exchange gain/loss would incur when the exchange rate stipulated at the invoice date and that realised on the actual payment date are different For contracts with neutral USD cashflows (such as

BDPOC, PVMTC), the exchange gains (if the USD/VND ex-rate increase during the time of invoicing and the time of payment by clients) are usually be offset by the amount of ex-rate losses incurred by the financing (in USD) of the salary payment The exchange gains/losses in this case have a similar nature of a translation exchange risk where Petroman has its cashflows (revenue and salary payment) in USD but only realise the same in VND for accounting purpose

Table 1 - Petroman’s revenue currency structure

income tax (PIT)

Mark-up and receivables

USD balance

2010), Petroman usually obtain excessive exchange gains due to the fact that the value of USD increases from time to time but some cost elements are in VND (e.g PIT) and has no ex-rate risk (see also section II.4 of this Chapter and APPENDIX

3 for examples)

Source: Petroman Jul 2012

payment in USD (or payment of USD loan obtained for salary payment) with the higher ex-rate than that on the date of the contract with client (or the ex-rate determined in the invoice to client if the contract is priced in USD but paid in VND) would cause the ex-rate loss

b) USD loans and supplier credits:

To execute its contracts Petroman has to maintain substantial working capital in both VND and foreign currencies on monthly basis to make salary payment and personal income tax (PIT) for the expats (see also section d)(a) below) Given the scarcity of USD in domestic market, the firm usually has to raise working capital

Figure 5 - Petroman' loans & supplier credits in USD 11

However, the repayment of principal and interests are made in USD and the rate at the time of repayment is always higher than that at the time of the loan disbursement (due to the depreciation of VND against USD) This has caused

ex-11 This figure represents Petroman’s outstanding loans (offshore and onshore) and supplier credits in USD

at the end of each year

Shareholder WC loan (averg/month)

Onshore WC loan (averg/month)

Offshore WC loan (outstanding at year end)

Source: Petroman Jul 2012

significant exchange losses as recorded by Petroman in 2010 and especially 2011 (see also APPENDIX 3)

c) Forex buying and selling activities:

The shortage and redundancies of USD in different periods has resulted in a lot of for-ex buying and selling activities of Petroman, which certainly realise ex-rate

over USD 2.2 million and GBP 856,731 and sold USD 2.25 million The selling of USD during 2010-2011 brought VND 200,000,000 exceptional profit to Petroman

Figure 6 - Forex buying/selling activities of Petroman

d) Informal banking transaction costs

rate is that the USD has become a scarce commodity in the currency market in the past 7 years and USD buyers had to pay informal transaction fees for purchasing USD As analysed above, Petroman has both currency purchasing and selling

1,180,542

387,500

292,000

5,100 45,000

USD purchased USD sold

Source: Petroman Jul 2012

manager, when there is a need for USD it has to negotiate the informal banking transaction fees (in addition to the bank’s official exrates) with the banks from time to time based on the black market price and the banks’ availability of USD These costs are not reimbursable by the clients in any circumstances because they are not officially recorded and Petroman’s foreign competitors would never have such costs The informal banking transaction costs became extremely high during

Figure 7 – Black (parallel) market ex-rate vs official ex-rate 2008

Source: Nguyen Tran Phuc 2009

To avoid the excessive banking transaction costs, Petroman has tried to obtain offshore loans in USD for its working capital needs (in USD) and tried its best to negotiate with client to receive payment as much payment in USD as possible to offset these offshore loans However, the obtainment of offshore loans and suppliers’ credit created another source of exchange risk as mentioned in

further discussed in section III below

3 Economic exchange risk

Economic exchange risk is the most evident type of risk which has been made aware by the Petroman’s management since the early days The following

a) The Supply Chain structure of Petroman:

While Petroman has a simple client portfolio with a handful of oil & gas operators and EPC contractors, its suppliers structure are rather complicated with a range of foreign headhunters, manpower agents and CV database providers from UK, Singapore, Malaysia, Thailand, and expat engineers from all over the world

Figure 8 - Supply Chain Structure of Petroman

requires substantial working capital in both foreign currency (for salary payment) and VND (for PIT payment) Under the labour contracts with its expats, Petroman must make payment to the expats within 5-10 days after the end of each month of services The firm also has to pay Personnel Income Tax for these expats on the

12 Petroman also acts as a head hunter in some contracts/projects but the revenue from head-hunting business account for less than 1% of the company’s total revenue Therefore we do not analyse the supply chain and exchange risk exposure of this activity

Clients

Foreign oil & gas operators Vietnamese oil & gas operators Vietnamese contractors Other service providers

Source: Petroman Jul 2012

20th day after the month end Meanwhile the payment term of the client is net 30

Figure 9 - Petroman’s Cashflows Diagram

b) Contracting and competitive structure:

leaders (based on expat head-counts in the manpower pool) among over 10 local and 20 global manpower agents operating exclusively in oil & gas (expat) manpower supply in Vietnam As the market is highly competitive, it is usually very difficult for a single manpower agent to negotiate contract terms with clients and the contract specimen (including prices’ currency determination and payment)

is usually imposed on the agent since the tender phase Any effort of an agent to pass the exchange risks to the clients (including the determination of payment currency and/or payment term) shall cause the risk of losing its contracts to a competitor

Service payment (30th day)

Petroman

Manpower (monthly/

State Treasury

Other payments

 hunting fees,

Head- CVs data

 Loans

 Logistics PIT payment (20th day)

Source: Developed by the author

It has been a general practice in the oil & gas manpower market that the basis of prices determination is USD and payment is made either in USD (for foreign agents) or VND (for Vietnamese agents) Meanwhile, the salary payment to expats

is usually calculated and made in USD or the currency of the expat’s home country and only the PIT portion is made in VND and the same pricing structure

Compared to its foreign competitors, Petroman is at economic ex-rate risk in the

receive all payment in USD (given the fact that most of the time VND keeps depreciated against USD and during some period USD become very scared in the market) This actually resulted in great market lost in 2009 when Petroman requested two major clients, Dai Hung and PTSC, to make payment in USD for the salary portion because the firm could not purchase USD from banks due to the illiquidity of exchange market Both clients refused the request and terminated the contracts with Petroman accordingly and appointed a foreign agent

pricing structure), the profit margin over the COGS is very low compared to other general management services and even a minor exchange loss may easily eliminate such profit

c) The general depreciation of VND against USD and the impact of the

Government’s for-ex control policies:

Vietnamese manpower agents (including Petroman) are usually required by clients to receive remuneration payment in VND or even determining the contract price in VND This may cause transactional exchange losses and reduce the future cash flow of the firm in the long run especially in the condition that the VND has continuously depreciated

13 The Ordinance on Foreign Exchange Control and the Decree 160/2006/ND-CP of the Government stipulate that all transactions within Vietnam territory must be affected and settled in VND

against USD and other foreign currencies in the last 5 years (e.g the USD/VND ex-rate increased by 31% during 2007-2011 period, see Figure 10 - Ex-rates movement 2007-201) This is a great disadvantage of Petroman compared to its foreign competitors because those foreign agents are not subject to such for-ex

perfectly match with the currency of payment to suppliers

Figure 10 - Ex-rates movement 2007-2012

Source: Vietcombank ’s public rates on <www.vietcombank.com.vn.>

also restrict the local banks from either providing loans in USD to the enterprises (unless they have the USD sources to repay such loans) or offering some fundamental derivative products such as forward contracts, options and swaption

In addition, the depreciation of VND against USD has a negative impact on the firm’s cashflow via offshore loans it obtained in USD to be used as working

capital This could be offset partly by the exchange gains from the USD payment Petroman receives from clients should clients make partial payment in USD

Figure 11 - Petroman's balance of foreign currencies (2007-2012) 14

Source: Petroman Jul 2012

Figure 11 above shows the historical balance of USD and GBP (the two major

foreign currencies) which Petroman has the demand to buy or excessive source to sell during the last 6 years Before June 2008, Petroman received all its revenue in VND and consequently the firm was always short of USD for salary payment During June 2008- March 2011 period, the firm successfully concluded the payment term with its biggest client, BP, to receive all payment in USD As such, Petroman was in a positive/excessive position of USD in 2008 but then the demand for USD increased rapidly in 2009 due to new contracts with PTSC and Dai Hung, making the firm short of USD again Both contracts with PTSC and Dai Hung were terminated in 2009 and the firm had positive USD cash again in 2010

last manpower agent contract (having positive USD balance) with Petroman Meanwhile, since July 2012 it has been engaged by PTSC for the supply of 11 new expats (for 1 year plus extension options) with all quoted prices and payment

in VND As a result Petroman has to purchase around net USD 100,000/month for salary payment at spot rates during the whole contract term

Assuming that there is no informal banking transaction charge imposed by the

corresponding to the depreciation of VND against USD or vice versa

On the other hand, during 2010-2011 Petroman tried to repay all the USD loans and debts by securing new loans in VND and consequently the ex-rate risk the firm was transferred into the VND interest volatility The firm is still enjoying considerable exchange gains from the maintenance of around USD 480,000 working capital with the corresponding payment by PVMTC in USD As explained by Petroman’s management, this is similar to translation ex-rate gain, which is more like a revaluation of USD the firm is keeping, rather than real gains More importantly, the oil field development project with PVMTC will be completed in mid-2013 and when the manpower contracts with PVMTC expire Petroman would not receive USD from any other source

4 Measurement of Petroman Ltd Risk Exposure

a) 2007-2009 period:

During this period Petroman had a very weak financial team with poor reporting system In particular, the exchange gains/losses were not recorded in the ledgers and financial statements, but mixed into the financial costs/revenues As a result, it was unable to draw a meaningful summary of exchange gains/losses and their impact on the earning before tax (EBT) of the firm

However, the author was able to identify and estimate certain aspects of the

15

See further discussion on informal banking transaction fees in section I.2(d) of this Chapter