The hot economies of major developing countries such as China,Brazil and India are all experiencing inflation, and their stilldeveloping banking systems and currency restrictions make itdifficult to use traditional methods to hedge that risk.

That situation is exacerbated in China by the appreciation ofthe renminbi, which has ramped up production costs in recent years,along with the country's rising wages. China's government appliescurrency controls that limit renminbi inflows and outflows, and soinhibit the use of traditional forward contracts that require thedelivery of the currency.

Non-deliverable forwards (NDFs) have become standard hedginginstruments for restricted currencies, because they do not requirethe delivery of currency. Instead, an international bank acts asthe counterparty, offsetting any foreign exchange losses or gainswith a net settlement in U.S. dollars.

“NDFs should be available to any company that can use adeliverable forward contract,” says Anthony Capozzoli, a directorin the strategic finance group at Credit Suisse.

NDFs and other financial instruments are, nevertheless, onlyshort-term solutions.

Ron Chakravarti, managing director in Citibank's globalliquidity and investment unit, says NDFs and other financialinstruments can aid companies seeking to meet earnings andcash-flow projections for the current fiscal year. “But it's notsomething that can go on for years and years,” he says. “Theindications are that with inflation and currency appreciation,these trends will continue.”

To address longer-term trends, companies must ultimatelyconsider reshaping their supply chains, Chakravarti says.

In the short term, however, choosing to hedge, or not hedge, canprovide advantages. “Most non-financial companies will say thepurpose of the treasury department taking a hedge is to protect thecompany, and it's not speculative,” says Chakravarti. “But when aclear trend is recognized, a company may choose not to hedge allexposures, such as when it's importing into China while therenminbi is appreciating.”

Capozzoli says markets for financial hedges in China aredeveloping. For example, a domestic foreign exchange market hasdeveloped that can be used by companies with a local presence. So acompany that anticipates payments in six months could establish acontract at today's exchange rates, rather than risking futurerenminbi strengthening. “It's not an unrestricted market by anymeans, since a company still needs to apply for permission toestablish a hedge,” Capozzoli says.

Just last month, the Chinese government announced that as ofApril 1, banks and companies can begin to use renminbi options inChina, giving companies another choice for hedging. China sayscompanies can only use options to hedge, not to speculate, and canonly use call options, not put options.

And in July 2010, the Chinese government allowed internationalbanks to offer Hong Kong-domiciled renminbi accounts and foreignexchange, with the code CNH. This new market allows a companylocated in China–whether Chinese-owned or foreign-owned–to sell arenminbi-denominated bond to international investors. “Investorscan establish a Hong Kong bank account to hold the bonds, andcoupons are paid in CNH,” says Capozzoli.

The new type of bond, which only a handful of multinationals sofar have issued, is not primarily a hedging instrument, Capozzolisays. But it gives issuers a way to raise capital and useonshore-generated cash flow to service debt without the need tofirst repatriate profits.

And in China's fast growing economy, that could be a boon tocompanies, many of which already have stockpiles of cash that, dueto Chinese government restrictions, are difficult to repatriate.“Now that there's such fast growth in China, companies are going totend to use that cash for local capital expenditures and M&A,”Chakravarti says.