Costs of Hedging.
If a devaluation is unlikely, hedging may be a costly and inefficient way of doing business. If a devaluation is expected, the cost of using the techniques (like the cost of local borrowing) rises to reflect the anticipated devaluation. Just before the August 1982 peso devaluation, for example, every company in Mexico was trying to delay peso payments. Of course, this technique cannot produce a net gain because one company’s payable is another company’s receivable. As another example, if one company wants peso trade credit, another must offer it. Assuming that both the borrower and the lender are rational, a deal will not be struck until the interest cost rises to reflect the expected decline in the peso.
Even shifting funds from one country to another is not a costless means of hedging. The net effect of speeding up remittances while delaying receipt of intercompany receivables is to force a subsidiary in a devaluation-prone country to increase its local currency borrowings to finance the additional working capital requirements. The net cost of shifting funds, therefore, is the cost of the LC loan minus the profit generated from use of the funds—for example, prepaying a hard currency loan—with both adjusted for expected exchange rate changes. As mentioned previously, loans in local currencies subject to devaluation fears carry higher interest rates that are likely to offset any gains from LC devaluation.