Xian-Janssen Pharmaceutical (China) and the Euro How can the Chinese subsidiary of a multinational company both hedge its currency risks and still meet the sales and profitability objectives directed by leadership? Paul Young was the financial controller of Xian-Janssen Pharmaceutical Ltd. (XJP), the Chinese subsidiary of the U. S. -based multinational, Johnson & Johnson.
Paul was preparing for a meeting with his CEO, Christian Velmer, which would focus on the business plan for the coming 2004 fiscal year. XJP was expected by leadership (corporate) to generate 1.
2 billion renminbi in earnings in 2004, a 20% increase over a highly successful 2003 year This would be a challenge given that XJP was suffering from a number of rising expenses and foreign exchange losses XJP of China
A joint venture, produces and marketed prescription and over-the-counter (OTC) medications to mostly hospitals in China (which made up roughly 80% of sales) Most sales in the Chinese market were through tender sales, reverse auction markets in which companies produced bids for sales to individual hospitals and were awarded sales on the lowest cost bids (also termed a Dutch Auction in some places in the world) XJP had closed 2003 with a 98% success rate on tenders XJP purchased nearly 95% of all its product from Europe
Most product purchases from Europe were from J&J Europe, and therefore the prices were transfer prices – prices set internally within the company Paul Young believed that most of the transfer prices XJP was paying were relatively high, increasing the profitability of the European business but increasing his costs in China (and therefore decreasing his profitability) All European purchases were priced and invoiced in euros, and the euro had been rising significantly in value against the Rmb (since the Rmb was fixed to the dollar, and the dollar had been falling against the euro, the falling Rmb was a certainty) All XJP payments for product from Europe were made to the European Treasury Center J&J’s corporate policy required that XJP hedge 80% of all anticipated exposures Hedging could not exceed 100% of anticipated exposures (this restricted management from taking speculative positions on currency movements) Hedging alternatives were limited; the company attempted to net all payments possible, and then used forward contracts on the identified exposures 1.
How significant an impact do foreign exchange gains and losses have on corporate performance at XJP?
What is your opinion of how they structure and manage their currency exposures? 2. J& J has roughly 200 foreign subsidiaries worldwide. It has always pursued a highly decentralized organizational structure, in which the individual units are responsible for their own performance from the top to the bottom line of the income statement. How is this reflected in the situation XJP finds itself? 3. What is the relationship between actual spot exchange rate, the budgeted spot exchange rate, the forward rate, and the expectations for the Chinese subsidiary’s financial results by the U. S. parent company? 4. If you were Paul Young, what would you do? Exhibit 2 Xian-Janssen Pharmaceutical (China)
How significant an impact do foreign exchange gains and losses have on corporate performance at XJP? What is your opinion of how they structure and manage their currency exposures? The income statement for the business unit shows foreign exchange losses of Rmb 60 million in 2003 and another Rmb 75 million forecast for 2004, about 5. 7% and 6. 9%, respectively. Although many people may first see these as relatively small losses, a reduction in the operating earnings of an individual business unit from foreign exchange changes alone like this would be considered significant. One way to note this is to consider that the average return on sales (ROS) for the Fortune 500 in the second quarter of 2005 was about 7. 7%.
If these bottom line profits were chopped an additional 6%-7% on a consolidated basis, a lot of companies – and shareholders – would be considerably upset. The pure use of foreign exchange forwards is most likely the result of a series of factors: 1) limited availability of other foreign exchange derivatives or risk management alternatives; 2) corporate policy on the part of J&J; 3) regulatory restrictions in China on the use of derivative and currency products; and 4) the unwillingness of the parent company to either carry the risk itself or allow more breadth in management (including remaining uncovered as the euro seemingly peaks) of the foreign exchange exposures of its Chinese unit.
J& J has roughly 200 foreign subsidiaries worldwide. It has always pursued a highly decentralized organizational structure, in which the individual units are responsible for their own performance from the top to the bottom line of the income statement. How is this reflected in the situation XJP finds itself? Although it is not unusual for a multinational firm to make foreign exchange gains and losses the responsibility of its foreign subsidiaries, it is not typically considered very efficient. The subsidiary business unit is typically just that, a business unit, and does not ordinarily possess the resources of skills sets necessary for good exchange rate risk management.
That said, the strongest argument for placing foreign exchange responsibilities on the subsidiary unit is that it creates those exposures, and who better to charge with their minimization and management? What is the relationship between actual spot exchange rate, the budgeted spot exchange rate, the forward rate, and the expectations for the Chinese subsidiary’s financial results by the U. S. parent company? Nearly all multinational companies, like all organizations, operate off of budgets. The Chinese subsidiary of J&J is no different. Paul Young must put together a strategic business and marketing plan, combined with a budget, for Xian-Janssen’s coming year.
That is the reality of the situation. The forecast exchange rate for the coming year, the budget rate, is typically either generated exclusively by corporate or in combination with input from the specific business unit. Regardless of the process, the final budgeted rate will the be used for all planning, purchasing, and worst of all – formation of expectations. As is the case with all forecasts, it will prove wrong. Paul Young just hopes it will not be “too wrong,” and that the direction of the error prove in his business unit’s favor. Once the budget was set and accepted by the U. S. parent, Paul Young and Xian-Janssen’s results for the coming year would be carved in stone.
They would then be managing the business to meet the parent company’s expectations, in this case, of 20% growth. The forward rate is calculated by financial service providers from the current spot rate and interest differentials. Since the Rmb was fixed to the dollar at this time, and the euro was continuing to appreciate versus the dollar, Xian-Janssen’s financial results were looking at weaker and weaker euro results. The forward rate was costing Xian-Janssen more and more money. Paul Young would feel increasing pressure to forego the hedging in order to reduce the cost. If you were Paul Young, what would you do? This is a very interesting situation.
If Paul Young actually has the ability to not hedge his European cost of good sold, many students will argue that it is worth “the risk” of going unhedged. One might argue, however, that there should be greater risk associated with running a business unit without hedging its primary cost of goods old as opposed to the declining margins on properly hedged purchases. In the case of going hedged and suffering the higher costs, the primary downside is the wrath of not meeting the parent company’s expected sales or profits for the year. The downside of going unhedged, and then suffering some significant adverse exchange rate changes, could very well be much much worse. matemate11
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Xian-Janssen Pharmaceutical (China ) and the Euro. (2016, Nov 12). Retrieved from https://graduateway.com/xian-janssen-pharmaceutical-china-and-the-euro/