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Currency swings may raise rating red flag

Few companies will be immune from the impact of steep exchange rate falls late last year, which could raise a warning signal for some credit ratings, Moody's Investors Service said in a research note.

Sterling, for example, suffered a virtually unprecedented drop in its exchange rate late in 2008, while the euro and US dollar and some emerging market currencies were also very volatile.

This volatility could mean deteriorating operating margins and cash flow-ratios for some companies.

Emerging market companies that have borrowed in dollars, but have to repay debts in local currencies will face a mismatch between earnings and debt.

“Any resulting deterioration in leverage and cash-flow ratios raises a real red flag for credit analysts,” Philip Robinson, analyst at Moody's, said in the research report.

The agency highlighted companies with particular mismatches between revenues and costs in different currencies. These included European auto manufacturers and European airlines.

Some firms have yet to feel the full impact of the big exchange rate gyrations.

Moody's said UK retailer Next Plc, for example, highlighted in January that it anticipated significant upward pressure on prices and downward pressure on margins in the autumn/winter of 2009 as a result of sterling's weakness.

But for some firms, the currency volatility could send misleading signals in terms of their creditworthiness, Moody's said.

“Foreign exchange volatility could raise false signals that credit metrics are deteriorating when in fact underlying fundamentals are unchanged,” Robinson said in the report.

Companies' foreign operations often borrow in the currency of the country where they are located, but these borrowings are then converted into another currency for inclusion in consolidated accounts.

Moody's said this could give rise to unusual distortions in leverage and cash-flow ratios because of the big fluctuations in exchange rates last year.

This currency translation effect could be a “red herring” rather than a “red flag” in terms of assessing the creditworthiness of the company, Moody's said.

But there are also some “red flags” associated with the effects of currency translation.

The fall in sterling against other currencies at the end of 2008 could mean much higher debt levels for UK companies versus cashflow, income and earnings before interest, tax, depreciation and amortization.

“In the cases where companies had limited headroom under covenants and foreign exchange volatility is not allowed for in the covenant wording, covenants could be breached unexpectedly,” Robinson said. (Reuters)