Construction is a high-risk enterprise. Competition is plenty and profit margins are thin. Cash flow is critical in the industry and the slightest delay in payments has the ability to disrupt and causing the entire supply chain following to chaos. The success or failure of a construction project is often determined by the effectiveness of the identification, assessment and mitigation of the risks. Therefore, it is important when contractors tender for a bid to identify and come up with strategies to mitigate the risks involved.
In this paper, three of the risks - that is currency risks, inflation and material prices will be discussed.
Mitigating currency risks
International investments are faced with considerations of a country's local currency. Currency value is determined in foreign exchange markets, impacted by foreign exchange movements. These fluctuations can be precipitated by fiscal and monetary policy decisions of governments, such as currency devaluation. They are also vulnerable to external factors such as insecurity or perceived insecurity. A foreign investor loses when the host currency depreciates in value relative to the investor's home currency. This prompts foreign investors to minimize risk or require compensation for the risk in higher returns. Although like a coin with two sides, the opposite has the possibility of occurring too. That is, if the host currency appreciates, the investor will make more money. But contractors are not businessmen who strive to make money out of the fluctuating currency. They are more likely to be concerned with preventing currency risks.
There are several mitigation strategies which could be undertaken by the contractor.
Denominate the deal.
Agree to get paid the contractor's home currency and not the host's currency. This would eliminate the risk for the contractor.
However, if the agreed base currency is in another currency, the risk of currency fluctuation can be shared between the contractor and the other party by coming into a concession. For example, an agreement such as if their currency doesn't fall by more than a certain X% by the time of payment, payment would be in their currency. However, if their currency has fallen by more than X%, they would be responsible to make up for the loss in currency value in the contractors home currency. Through this method, there would be a minimum value in which the contractor would lose due to currency fluctuations mitigating the risk of currency fluctuation.
The same might be expected from the contractor. That is, if the other party's currency rises against the dollar, the contractor would have to assume the same role. From insider information gathered during an in class presentation, this strategy was used by Keppel company during the construction in Hanoi, Vietnam.
When tendering for a bid, estimate the risk in momentary terms and include it into the bidding price so that in the case of currency fluctuation, some extra margin would still be earned.
Pay the subcontractors with the host country's currency. Even though the contractor will still lose money if the host currency falls against the home currency, but loss will only be factored in the gross profit and not on total revenue.
Currency Hedging.
Depending on the size and length of the contract. Hedging techniques such as buying an insurance against currency risk could be employed by the contractor depending on the size and length of the contract. A bigger and longer duration of the project would have a greater risk and hence buying insurance would be wisely recommended. Currency hedging is a process that removes the effect on investment returns of fluctuations in the value of the foreign currency. A currency hedge preserves the exchange rate, between the home and the foreign currency, at a known value.
Consult the bank on tools which they can deploy on the contractor's behalf. Consulting a larger bank might be more helpful especially if the sum involved is large.
Check with the bank to see the charges for conversion of currency. Wire fees can be significant.
Of the above options which are non-exhaustive, currency hedging would be the more well-known and popular strategy used to mitigate risks. It should be noted that a hedge not only offset any potential losses but also gains.
A study by Bob Doyen compares risk and return from hedged and unhedged currency portfolios.
Jan 1960 to Jun 1999
Annualized return
Volatility
Unhedged return in US$
13.48%
17.52%
Hedged (US$) return
13.51%
15.29%
As can be seen from the study, though the annualized return between hedged and unhedged currency are about the same, however its volatility differs with unhedged scenario having a higher volatility. Furthermore, even though this study illustrates the zero impact of currency movements on asset returns over the long run and usually construction projects lasts for several years (depending on the project size), it may seem as if the construction industry need not worry about the risk of currency risks. However, it should be noted that the mobility of cash flow in a construction projects is important and crucial and henceforth, hedging does seem to be an attractive strategy. Hedging will too help deliver value to investors. The main benefit of a full hedge would be in the form of a reduction in portfolio volatility.
However, when considering currency hedging, the cost, availability and utility of currency hedging should be considered, as should the stability of the local unit. Pegged currencies may alleviate some of this risk but will not extinguish the need to consider hedging. Some consideration should also be given to the possibility of currency restructuring, for example the potential dissolution of the Euro or when there is a change in government policy etc.
Mitigating inflation
Inflation refers to an increase in the average price level of the economy. Essentially, inflation means that a dollar buys fewer goods than before. When inflation occurs, the contractor when receiving payments at the end of the project will find that its purchasing power has decreased.
Different approaches are required to mitigate inflation risks depending on the type of sector. For cyclical sensitive sectors such as construction materials, it tends to respond to inflation. The price of materials will rise with inflation. This point will be discussed more in the next section under mitigation of material costs.
Private equity such as construction of infrastructure investments due to its physical nature and potential built-in price escalators may provide a measure of inflation protection. That means that when tending for the bid, the risks of inflation has already been accounted for. However, it is hard to be tactical and put a value onto the inflation value as construction projects are have long lifecycle and low liquidity. Therefore, introducing strategies to mitigate inflation can enhance returns.
Below are several ways in which a contractor can use to help mitigate inflation risk.
Inflation-Linked Bonds (ILB)
Inflation-Linked Bonds can also help hedge against inflation. The coupons paid by these bonds fluctuate with inflation A variety of countries issue ILBs. Worldwide, the market for ILBs is $1.3 trillion. Some of the biggest issuers are the United States, the United Kingdom, France, Germany, Japan, Canada, Italy, and Sweden, as well as some emerging market countries. However, it is important to note that while ILB coupons vary directly with inflation, total return on ILBs may not. If interest rates are raised in order to keep inflation in check, it is perfectly possible for ILB prices to go down enough to lead to a negative total return. As with any bond, the prices of ILBs rise when real (inflation-adjusted) interest rates decline and fall when real interest rates rise.
Buy investments with higher returns (like stocks)
One way that could help mitigate inflation is to increase purchasing power such that inflation will be outperformed. Investing in higher return options such as stocks is an option. Although there are risks in these investments, diversification could help in managing these risks. By spreading these risks out and not concentrating them in a specific area helps in mitigating the risks. For big construction companies, they could spread out inflation risks by taking on different projects in different countries. However, for a small construction company trying to start-up, they might not have enough resources and ability to diversity inflation risk through this method. Other forms of investment can be explored. In essence, finding a higher return investments can help curb inflation risks.
Mitigating material prices
The delivery of construction works on time and within budget is dependent upon the availability and timeous delivery of building and construction materials and plant which are incorporated into the work and at an appropriate price and quality. Such materials and plant may be locally manufactured or produced, or imported.
Sometimes, the provision for price escalation in the contract does not adequately compensate the contractor for the actual increase in the cost of certain high value plant and materials. The consequence is that the contractors will suffer financial loss, which in the extreme case can lead to insolvency of the contractor, or the client paying an unnecessary premium for construction works as a result of risk pricing to address the uncertainty in the price escalation of critical plant and materials. Therefore, it is important to find ways to mitigate the increase of material prices.
Below are several ways to mitigate material prices.
Provide contractors with the free issue of critical materials
Critical items of plant or components of the works that have long lead times or which need to be imported should be identified very early in the project. One possible mitigation measure is for the client to procure critical materials and to issue them free of charge to the contractors. This response will require the client to have the responsibility to timeously procure, store and issue materials to contractors. Alternatively, the contractor itself can too procure critical materials before the construction.
However, the disadvantage of this strategy is that there will be considerable cost associated with the procurement storage, handling of the materials and additional transportation costs to sites. Furthermore, there will be risks such as loss of material for reasons including theft, fraud, breakages and time related damages such as rusting.
Place provisional orders for critical materials with materials suppliers
Placing provisional orders for critical materials at an early stage in the project cycle is also another strategy to mitigate material cost. This approach provides suppliers with longer lead times. However, its use is very restricted as it can only work where there is only a sole supplier and a contract has to be clearly written between the supplier and the contractor so as to make sure the supplier is capable of taking on the risk and not fail to produce the material on time. Furthermore, having made the supplier take on the risk will result in having a higher quote for material costs.
Provide industry with short and medium term forecasts of materials and plant requirements.
The availability of reliable information is one of the preconditions for business to be informed of the future demand. This allows industry to gear their production for the demand. Contractors need to review the price of the material in relation to the expenditure for the project and identify the likely quantum and timing of critical materials and plant. This information needs to be made available to the relevant materials and plant supply chains. Regular forecasts of requirements and interactions with these supply chains will enable industry to either gear up their production to meet the demand or to import the required materials or plant or components thereof.
Standardize specifications for materials.
The range of construction materials available in the market is ever increasing. The usage of standardize materials for example a standard size of steel beam available in the market and not a unique steel beam that requires special manufacturing attention will certainly help to mitigate material cost.
Conclusion
There are many different ways to mitigate risks and there is no one absolute correct way. Depending on the location of the project and the environment of the host country, contractors need to be flexible and creative into thinking up ways to help mitigate these risks even if using battering as a form of payment to mitigate the risk. In other countries, using of relationships might be effective in helping to secure a good price for material good for example, as long as it is effective in mitigating the risk. In my opinion it is important to do up research and hire consultations for opinions and ways to mitigate the risk. Steps taking to mitigate risks might be a tedious but it is an absolutely undeniable important process especially for international construction.
