Saturday, May 3, 2008

Foreign Exchange and some Mental Strain.

I wrote this as an email to a coworker from Accounting. I'll post this in mostly unmodified form to this group, because I think it brings up some interesting issues. I'd love to hear your thoughts on the facts or theories behind the issue, or on my conclusions about the issue.


Some time ago, we talked about going over a balance sheet, so I could learn a little bit about how to read one.

Well, this is a doozy. It's the 20F yearly report for LDK Solar. Not particularly a good one for a beginner, so I'm just wondering if you can take a look at the following excerpt and think about it. If you can come up with a good way to understand it, I'd love to hear. Don't worry about the specific numbers. I'm thinking along the lines of trying to work out the relationship between stock price in US Dollars and the relative valuations of the Dollar, the RMB, and the Euro, where the RMB and Dollar are largely pegged, and the business assets are split between all three currencies.


Note: I think I'm starting to get it. I'm putting some notes at the bottom of this email.


From: http://www.sec.gov/Archives/edgar/data/1385424/000114554908000792/h02099e6vk.htm#118


Here's the Relevant Section:


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ITEM 11. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK


Quantitative and Qualitative Disclosure about Market Risks

Foreign currency risk

Our financial statements are expressed in U.S. dollars but the functional currency of our principal operating subsidiaries, Jiangxi LDK Solar, Jiangxi LDK PV Silicon and Jiangxi LDK Polysilicon, is Renminbi. To the extent our principal PRC operating subsidiaries hold assets or liabilities denominated in foreign currencies, any appreciation of Renminbi against such foreign currencies denominated assets or depreciation of Renminbi against foreign currencies denominated liabilities could result in a charge to our income statement. See note (2)(c) to our audited consolidated financial statements for more information on foreign currency translations for our financial reporting purposes under Item 18 in this report.

A significant portion of our sales is denominated in Renminbi. Our costs and capital expenditures are largely denominated in U.S. dollars and euros. The Renminbi is not freely convertible into other currencies and conversion of the Renminbi into foreign currencies is subject to rules and regulations of foreign exchange control promulgated by the PRC government. In July 2005, the PRC government introduced a managed floating exchange rate system to

allow the Renminbi to fluctuate within a regulated band based on market supply and demand and by reference to a basket of foreign currencies. The PRC government has since made, and may in the future continue to make, further adjustments to its exchange rate system.

Generally, appreciation of Renminbi against U.S. dollars and euro will result in foreign exchange losses for monetary assets denominated in U.S. dollars and euro and result in foreign exchange gains for monetary liabilities denominated in U.S. dollars and euro. Conversely, depreciation of Renminbi against U.S. dollars and euro will generally result in foreign exchange gains for monetary assets denominated in U.S. dollars and euro and result in foreign exchange losses for monetary liabilities denominated in U.S. dollars and euro. Fluctuations in currency exchange rates could have a significant effect on our financial stability due to a mismatch among various foreign currency denominated assets and liabilities. Fluctuations in exchange rates, particularly among the U.S. dollar, euro and Renminbi, affect our operating and net profit margins and would result in foreign currency exchange gains and losses on our foreign currency denominated assets and liabilities. As of December 31, 2006 and 2007, our monetary assets denominated in U.S. dollars and euro were primarily related to cash and cash equivalents, pledged bank deposits and prepayments to suppliers, and our monetary liabilities denominated in U.S. dollars and euro were primarily related to short-term bank borrowings, long-term bank borrowings, advance payments from customers, trade accounts payable and other payables. Our exposure to foreign exchange risk primarily relates to foreign currency exchange gains or losses resulting from timing differences between the signing of the contracts and the settlement of the contracts. As of December 31, 2006 and 2007, our principal operating subsidiaries held the following amounts of monetary assets and liabilities denominated in U.S. dollars and euro:


[TABLE REMOVED, See Link, Page 121]


We incurred a foreign currency exchange loss, net, of approximately $1.3 million and $1.7 million for the years ended December 31, 2006 and 2007, respectively. Since 2007, we have entered into certain foreign exchange forward contracts to reduce the effect of our foreign exchange risk exposure. However, we cannot assure you that we would be able to effectively manage our foreign exchange risk exposure.

Without taking into account the effect of the potential use of hedging or other derivative financial instruments, we estimate that a 10% appreciation of Renminbi against U.S. dollars based on the foreign exchange rate on December 31, 2007 would result in net gain of $11.6 million (2006: net gain of $0.4 million) for our assets and liabilities denominated in U.S. dollars as of December 31, 2007. Conversely, we estimate that a 10% depreciation of Renminbi against U.S. dollars would result in net loss of $11.6 million (2006: net loss of $0.4 million) for our assets and liabilities denominated in U.S. dollars as of December 31, 2007.

Without taking into account the effect of the potential use of hedging or other derivative financial instruments, we estimate that a 10% appreciation of Renminbi against the euro based on the foreign exchange rate on December 31, 2007 would result in net loss of $2.5 million (2006: net loss of $0.9 million) for our assets and liabilities denominated in euro as of December 31, 2007. Conversely, we estimate that a 10% depreciation of Renminbi against the euro would result in net gain of $2.5 million (2006: net gain of $0.9 million) for our assets and liabilities denominated in euro as of December 31, 2007.

We cannot predict the effect of future exchange rate fluctuations on our results of operations and may incur net foreign currency exchange losses in the future.


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End of Relevant Section.


Other thoughts:


If you go to page 121 of the linked document, and look at the table that's removed (due to formatting) above, you'll see that, for one thing, their net exposure in Euros is positive, while their exposure in Dollars is very negative. By this they appear to be betting on a strengthening Euro.

Where they say that an RMB appreciating against the Dollar or Euro may cause "foreign exchange losses for monetary liabilities denominated in U.S. dollars and euro." This one is hurting my brain.

Here are some cases that I'm guessing at:

1: If the RMB appreciates against the Dollar or Euro, then given constant operating costs in RMB, all of their operations in China effectively cost more Dollars or Euros to perform, is it that simple? Ok, so over the last couple years, the RMB has appreciated (per a chart somewhere else in the 20F), so their costs are increasing. They've already stated that they've taken over a million Dollars in Foreign Exchange losses.

2: Now, the RMB is largely pegged to the Dollar, so unless the Chinese Government changes the rules, the RMB will float with the Dollar against the Euro. This means that if they sell their product and hold assets in Dollars or RMB, and then those currencies weaken against the Euro, then LDK loses (offset by their gains in the value of their Euro Denominated Exposure).

3: In the case of a catastrophically-falling Dollar against the Euro, it strikes me that one thing that could happen is that China would unpeg the currency from the Dollar in order to protect it's value. In this case, the cost of doing business in China using RMBs would increase dramatically in the number of Dollars that this represents, and the value of their existing contracts in Dollars decreases dramatically. However, those Chinese workers in reciept of valuable RMB have increased their buying power dramatically incomparison to American Consumers in the World Market. In other words, RMB (and Euros) will buy Energy and Food on the World Market, while the Dollar approached worthlessness. Americans in this case will be laboring for Dollars that buy little, but a few Euros or RMB will buy alot of American goods.

4: In the case that the Dollar appreciates against the Euro, then so does the RMB, and at this stage, LDK would benefit by this as they are still largely Dollar Denominated. In this case the real value of their Dollar denominated debt would increase, but so would the value of their Dollar Denominated Signed Contracts (of which there are many).

5: If the Dollar falls to the Euro, and China remains Pegged, then China remains a very cheap producer of goods, but Inflation cuts into the Buying Power of Chinese Workers. Euro Denominated Assets increase relative to RMB and Dollar assets, and the cost of debt in Dollars decreases in relation to the net exposure to Euros.

DOH! It's late. I'm going to pause there for now. Feel free to let me know if I'm thinking about this in the wrong way.



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