The Effects of Speculation on the Value of Capital Expenditures

Published on Tuesday, 12 November 2013 09:17:07    Written by Marc
It has already been 16 years; however, the day still rings fresh in many peoples’ minds. On July 2, 1997, a cascading effect caused by the sudden devaluation of a handful of currencies across Asia caused the debt-to-GDP ratios of those economies to balloon between 100% and 167%. The subsequent result was the doubling of corporate debt caused by companies heavily leveraging their assets using foreign denominated loans. Therefore, many projects that had capital allocated to them were shelved, stalled, or scrapped altogether.

The Effects of Speculation on the Value of Capital ExpendituresTo understand how this affected businesses, we should first look at what caused the crisis at the onset. During the period immediately preceding the crisis, companies were leveraging assets using foreign denominated loans while assuming that their currency would gain in strength versus the foreign currencies. When a real-estate property bubble popped in July of 1997, much in the same way that the 2008 financial crisis started in the United States, the values of properties crumbled, and thus, so did the value of the currencies. Governments who pegged their currencies to the US Dollar could no longer maintain this effort and thus saw their currencies devalue by as much as half.

How did this affect capital-planning projects? Non-US based businesses would sometimes/often fund large capital projects with foreign denominated loans by speculating on the exchange rates. If all factors work in their favor, the exchange value of the loan decreases as the local currency appreciates against the US dollar. This happened much throughout the 90s. For example, if a company wants to speculate that the Philippine Peso, for example, would improve from 25 pesos to the dollar to 23 pesos to the dollar on an initial $5,000,000 project at P 25/$1, the appreciate of 2 pesos would save the company about $434,782. That amounts to saving of 8.6%!

That makes good financial sense if you are relatively certain about the direction of the currency. The problem; though, is that markets do not always move in the direction that companies or individuals want them to move. For example, in the Philippines, prior to the Asian financial crisis, the value of the peso was P 25 to $1. After the Asian financial crisis, the value of the peso dropped to P 50 to $1. For the same example listed above, the value of the $5,000,000 debt suddenly became $10,000,000. Bear in mind that the compounding interest of the loan still applied meaning that not only did the principle double, but the amount of interest to be paid (not the interest rate) also doubled. This, subsequently, caused many capital projects to fail.

The bottom line is if you are planning a capital expenditure and are thinking about funding it using foreign denominated loans, you should examine many factors including the state of the economy, the expected direction of the currency pair, the volatility of the markets, whether the local currency is pegging their currency to the dollar, and how the local real-estate market Is doing to make sure that it is not bubbled. Taking these factors into account can help protect your capital project against speculative currency predictions that do not come to pass.