Giddy: Waterford Foods Case Study

Waterford Foods

A case study on devaluation risk

Prof. Ian Giddy

Tel 212-998-0426; Fax 212-995-4233

E-mail: ian.giddy@nyu.edu Web: http://giddy.org

The Situation

"Will the Irish punt devalue? And if so, when? And what can we do to protect ourselves?" asked Michael Maddock, Treasurer of Waterford Foods, one of Ireland's better-known companies with operations in the United States, Britain and elsewhere. Maddock was discussing the advisability of hedging the German mark debt that Waterford had incurred a year earlier.

"What dare we do?" replied his deputy, David Lane. "I know our first responsibility is to Waterford's shareholders, but if it becomes known that we are shorting the punt we may find ourselves branded as unpatriotic speculators. Look at Tuesday's Evening Press (Exhibit I). Do we want to be accused of 'putting Irish jobs at risk in the pursuit of a quick profit'? Take a look at how Davy Stockbrokers economist Jim Davy put it:

"The battle for the Irish Pound is becoming increasingly like a siege and the mentality of its defenders increasingly lie a siege mentality. In a siege, notions of normalcy go by the way, the overwhelming objective becomes the avoidance of surrender,and the longer the siege the more desperate the need to avoid surrender becomes.The great hope of the besieged is that some outside force will come to their rescue and their greatest hatred is directed at internal dissenters."

"With the unemployment rate at 20% and rising, it seems that jobs are being lost because of the government's unwillingness to allow the punt to devalue," said Maddock. "Thirty percent of Ireland's trade is with the U.K., and since sterling dropped out of the European exchange rate mechanism last September, the pound sterling has fallen 15% against the Irish punt. Admittedly the country would lose face by asking for a realignment of our exchange rate within the ERM, especially after paying such a high price to defend the punt during the past few months, but do we want to be nailed to a cross of ECU? All exporters and import-competing companies are hurting, and they are beginning to make their voices heard in the Dail. The industry body, IBEC, is saying openly that it does not see how companies can trade their way out of difficulties at current sterling rates. The Small Firms Association says that small firms face a crisis because of the overvalued punt and is demanding government assistance (Exhibit II). Banks paying 18-20% for interbank money will eventually have to raise mortgage rates, and homeowners are already facing severe financial hardship with a home loan rate of 14%. After all, with inflation at about 2%, they are not making it up with capital appreciation."

"My friends in the Dublin money market are telling me that some sort of relief for the banks and building societies is imperative," said Lane. "Some are talking about a three percent rise in mortgage rates, but currency dealers seem to have concluded that such an increase is politically impossible and that the Government would devalue before they would allow it to happen. The big banks' hands are tied, for the Central Bank has cut off their access to the discount window whenever Central feels that the funds would be used to sell punts and buy foreign currencies. As you recall, the credit squeeze wrought by the Central Bank has forced some institutions to pay as much as 100% per annum for overnight money to cover their short positions in recent weeks."

"High short term interest rates and the fact that the punt has been pushing against the bottom of the ERM band are certainly indications that the currency has problems. In recent months the pound sterling, the Italian lira, the Spanish peseta, the Portuguese escudo, the Norwegian krone and the Swedish krona have all undergone similar pressures and all have eventually been forced to devalue. (Sweden had to lift its official rate to 500% before its currency succumbed.) Only the punt, the Danish kroner and the French franc have held out, and the latter has been with massive help from the German Bundesbank."

"I agree it's touch and go," his colleague responded. "Yet pressures may be easing as one after the other the speculators, having been burned, are dropping out. They've had to pay exorbitant interest rates day after day to short the punt, else they've sold punts in the forward market at a tremendous discount. In either case they lose money when the authorities succeed in resisting a devaluation. The financial community in Ireland is small and the number of players willing to stake big money and jeopardize their relationship with the Central Bank is diminishing. Moreover the fundamentals, such as Ireland's positive trade balance, seem much more favorable to the punt than, say, the British or Italian currencies."

"Clearly it's of great importance to us to determine whether or not the punt will devalue within the next three months. We should systematically assemble the evidence and views on spot and forward exchange rates, on interest rates, inflation and other economic variables and decide what will happen (Exhibits III to X). In particular, what's the probability of a devaluation in the next three months, and how much? Then we must decide whether it's worth covering our DM exposure, given the forward premium and relative interest rates."

Background Materials

Selected Exhibits

Exhibit I. "Punt: Bertie Has Blacklist" Evening Post, Tuesday 19 January 1993, p.1.

Exhibit II. "Small Firms Crisis Call" Irish Independent, Friday 22 January 1993, p. 4.

Exhibit III. "Five Months of Ups and Downs for the Pound" Irish Times, 23 January 1993, p.7.

Exhibit IV. "Trapped Between a Rock and a Hard Currency Place" Irish Times 8 January 1993, Business Agenda, p.3.

Exhibit V. "Reserves Fall Over Ł200m in Month" Irish Times 8 January 1993.

Exhibit VI. "Money and Currency Markets" Weekly Market Monitor, Davy Stockbrokers, 4 January 1993.

Exhibit VII. Excerpts from The Irish Interest Rate Outlook, Davy Stockbrokers, January 1993.

Exhibit VIII. "Devaluation is Not the Answer" Finance December 1992, p.3.

Exhibit IX. "Corporate Hedging Now" Finance September 1992, p.17.

Exhibit X. Excerpts from the Financial Times January 25, 1993

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