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International Reading
GLOBAL BUSINESS AND
FOREIGN EXCHANGE RATES
INTRODUCTION
For a business to sustain its growth and sales revenue, it is often compelled to seek new markets for its goods and services. When McDonald's began to saturate the U.S. market with its fast-food restaurants, it pursued a growth strategy that involved opening restaurants in foreign countries. McDonald's 2000 annual report to shareholders reported that over 50 percent of its sales revenue and income were derived from operations outside the United States. McDonald’s generates revenues in 119 foreign countries. Its non-U.S. revenue grew faster than that of its U.S. stores.
U.S. corporations have been engaging in international business for quite some time. Ford Motor Company built its first overseas factory in England in 1911. In 1999, Ford purchased the auto manufacturing division of Volvo. Ford now operates in over 25 foreign countries. Some of these operations are in the form of joint ventures. A joint venture is a partnership of two or more entities that pool a part of their resources to pursue a new business opportunity. Some of Ford's joint ventures include establishing the production systems for the Chinese auto industry and partnering with Volkswagen to design and build a sport utility vehicle for the European market.
In 1998 the German auto manufacturer Daimler-Benz acquired Chrysler Corporation for $42 billion. Although both companies were transacting business on a global basis at the time of the merger, their respective shareholders agreed to consolidate the two companies to better compete in various world markets.
GLOBAL BUSINESS RISKS
Tariffs, trade restrictions, and cultural differences can make it very difficult for a company to engage in profitable commerce in a foreign country. Recently there has been much criticism by U.S. government officials of Japan's unwillingness to allow U.S. products to be sold in Japan. Complex political issues such as free trade and reduced tariffs heighten the risks associated with international business. Moreover, economies of foreign countries often are not as stable as the U.S. economy. During the 1980s Japan’s economy was one of the world’s strongest. Beginning in the 1990’s and continuing through the next decade, Japan’s economy has become stagnant. Its stock market has declined 60 percent from the highs attained in 1990. Its banking system is in crisis due to huge loan losses, which are estimated to approach $1 trillion.
An example of foreign business risk is the 1994 devaluation of Mexico’s peso and the 1999 devaluation of Brazil’s real as shown in Exhibit 5-1.1. The currency devaluation left both country’s currencies worth only half of their previous value in U.S. dollars or other currencies. For investors holding assets in either of these countries, the losses were large. The value of their investments depreciated in proportion to the drop in the value of the currency. For the Mexican or Brazilian consumer, the devaluation meant that imported foreign goods cost much more than before. Conversely, consumers in importing countries found that Mexican and Brazilian goods were considerably less costly than before the devaluations. The abrupt devaluations created uncertainty. Participants in international trade need additional time to assess the new economic environment posed by devaluation.
Exhibit 5-1.1
Devaluations of Brazil and Mexico Currencies
Source: Courtesy of Professor Werner Antweiler, University of British Columbia, Vancouver, British Columbia, Canada.
In 1997 and 1998 a domino pattern of currency devaluations was triggered by the collapse of Thailand’s currency, the bhat. As illustrated in Exhibit 5-1.2, neighboring countries in Southeast Asia, as well as Korea and Japan, saw their currencies drop in value relative to the world’s strongest currencies, the U.S. dollar, the German deutsche mark, and the Swiss franc. For residents of these countries, the price of imported goods soared. Foreign banks lending money to businesses in these countries experienced huge losses because of the reduced value of the loan portfolio they held. The stock markets of these emerging industrialized countries also collapsed, leaving foreign investors fearful of making further investments.
Exhibit 5-1.2
The Collapse of Southeast Asian Currencies
Source: Courtesy of Professor Werner Antweiler, University of British Columbia, Vancouver, British Columbia, Canada.
Toward the end of 1998, the devaluations spread to other countries. Russia was particularly hard hit. Because Russia is an exporter of natural resource commodities, the devaluations of other countries that export the same commodities lowered the prices Russia could get for its exports. Russia’s inability to acquire adequate foreign exchange from exports, along with other structural problems in its economy, caused many to sell the Russian ruble in favor of owning other stronger currencies. The effect of these actions are shown in Exhibit 5-1.3. The crisis did not stop at Russia’s borders. A large U.S. investment fund, Long-Term Capital Corporation, was forced to liquidate as a result of trading losses precipitated by Russia’s economic problems.
Exhibit 5-1.3
The Devaluation of the Russian Ruble
Source: Courtesy of Professor Werner Antweiler, University of British Columbia, Vancouver, B.C, Canada.
In the United States, the ripple effect of currency devaluations around the world was manifested in decreased corporate profits. Year-to-year comparisons of some of the largest corporations’ earnings showed a decline from 1997 to 1998. Many companies experienced “pricing pressures,” meaning that competitors exporting to the United States made products available to consumers at lower prices. For example, if an electronic component made in Malaysia cost $10 before the devaluation of that country’s currency, it might have cost only $6 afterward. Thus, for example, the U.S. manufacturer competing with the Malaysian manufacturer would consider lowering prices even though its costs would not decline. This would put a severe squeeze on profits.
Assuming that companies know the risks involved in international business, why do increasing numbers pursue a global business strategy? The most likely reason is that many areas of the world are experiencing strong economic growth that is resulting in greater disposable income for their citizens. This increased purchasing power creates a rapidly growing demand for consumer products and the prospect of increased sales and profits for companies based in advanced, but mature, economies such as the United States, Japan, and Europe. Emerging economies in Asia, particularly China, are viewed by many industries as important new markets because of the large population of the regions.
Recent developments in telecommunications technology have enhanced companies’ abilities to transact business on an international scale. Nearly instantaneous access to information permits managers to be cognizant of the ever-changing global business environment. As conditions in a foreign market change, quick decisions must be made to stay competitive.
Paralleling the advances in information technology is the evolution of a growing list of financial instruments that can be used to manage risk. For example, if a U.S. company wishes to sell products in France, a member country of the European Union, it would increase its success rate if it quoted its prices in euros, the new currency of Western Europe. Buyers in France would like this because they would not have to worry about the possible drop in the value of the euro versus the dollar between the time they placed an order and the time they had to pay for it. Instead the U.S. company would assume this risk. However, it is possible to mitigate the risk of a loss on the transaction by entering into a forward exchange contract by selling euros for delivery at a later date. This is called a hedge and is intended to reduce the exposure to losses arising out of fluctuating exchange rates. It can be thought of as insurance to reimburse losses. Details of how forward exchange contracts and risk management instruments work are covered in international finance classes.
Beginning in 2002, twelve European countries will transact business using the euro. Citizens and companies holding country currencies will be able to convert them to the euro. Instead of twelve different currencies needed to carry on commerce throughout much of Western Europe, there will be only one. One can think of how complicated it might have been to take a road trip across the United States if each state had its own currency, the value of which changed constantly. That is what travelers in Europe experienced.
From a career standpoint, business professionals will find that an increasing number of positions involve a significant international dimension. Most new job descriptions will include a global component. Exciting career opportunities in international business include logistics and distribution, export and import management, sales and advertising, and finance and accounting. For example, export marketing managers are in charge of selling goods for their firms in a particular part of the world. Their jobs include supervising sales personnel, coordinating contractual and legal matters, arranging for custom agents, and working with financial institutions to obtain letters of credit (financing) and insurance.
EXCHANGE RATES
An exchange rate is the price of one foreign currency in terms of another. Changes in exchange rates result from the trading of currencies in open markets around the world. The supply of and demand for a country's currency can change abruptly, causing its exchange rate in relation to other currencies to change dramatically. Following are some of the factors that influence the supply and demand for a particular currency.
1. Trade balance of paymentssurpluses (deficits). A good example of this is China's present trade surplus with the United States. China currently exports more goods and services to the United States than we export to China. This imbalance is growing rapidly. The aggregate U.S. trade deficit with all countries is forecast to be over $150 billion in 2001. The combination of a U.S. trade deficit and China’s trade surplus is the most important factor in the drop in the value of the dollar relative to the renmimbi, China’s currency unit. In 1994 the cost of one unit of the Chinese currency in U.S. dollars was $.115. At the start of 1998, the U.S. dollar cost was almost $.12, a 5 percent increase in the value of the renmimbi. See Exhibit 5-1.4.
Exhibit 5-1.4
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Source: Courtesy of Professor Werner Antweiler, University of British Columbia, Vancouver, B.C, Canada.
2. Relative rates of inflation. A country experiencing high inflation will see its exchange rate fall relative to a country with low inflation. Brazil’s inflation has been much higher than that of the United States, causing massive devaluation of the real (name of Brazil’s currency, pronounced ree-‘el) in recent years relative to the dollar. In January 1999, Brazil abandoned its policy to maintain the real exchange rate by letting it float to whatever equilibrium level the market found. This action resulted in a 25 per cent devaluation of the real.
3. Relative real interest rates. Central banks, like the U.S. Federal Reserve, set monetary policy and interest rates. Money flows to wherever real returns are maximized. Therefore, if the United Kingdom issued government bonds at yield rates materially higher than another country’s government bonds, the pound’s exchange rate would rise relative to the other country’s currency because of increased investor demand for the British currency needed to buy the higher-yield UK bonds.
4. Political instability or government intervention. If investors fear that a country may be vulnerable to anarchy or civil war, they will be disinclined to own that currency.
The Impact of Changes in Exchange Rates: An Example
To illustrate how one's wealth could be impacted by fluctuating exchange rates, assume that you won a contest for which the prize was a trip around the world. Your itinerary specifies that you will visit the following places:
Week 1London (England)
Week 2Geneva (Switzerland)
Week 3Johannesburg (South Africa)
Week 4Tokyo (Japan)
Your prize pays for airfare, ground transportation, food, lodging, and miscellaneous items. In spite of this all-expense-paid vacation, you decide to take along some money in case of unforeseen events. Let us assume that you leave the United States with exactly $1,000. Also assume that the moment you arrive in a new country, you plan to convert your dollars into the local currency.
Week 1
You have just arrived at London's Heathrow Airport and wish to convert your dollars into the British currency called pounds (£). There are also smaller currency denominations in the United Kingdom like our quarter, dime, and so forth, but these are not relevant unless you purchase items with a price that is not an even number of pounds. The question that is extremely important to you is, "How many British pounds will I get for my $1,000?" To answer this question, we must determine the exchange rate. Suppose that the currency exchange booth at the airport has a sign that says the following:[1]
Pound per dollar rate = .588 pounds per dollar
This means that for each U.S. dollar converted, you will receive .588 British pounds, that is, if you convert your dollars within the next few minutes. The exchange rate could change at any moment. Your $1,000 is thus converted to 588 British pounds ($1,000 × .588). Another way of stating this is that a pound is worth $1.701 ($1 ÷ .588), which is the dollar per pound exchange rate. You can also use this rate to compute how many pounds $1,000 will purchase as follows: $1,000 ÷ 1.701 = 588 pounds.
End of Week 1
Assume that at the end of a magnificent week in London, you decide that you want to convert your pounds back to dollars before departing. You have been a frugal traveler and you have not spent any of your British pounds. The sign at the currency exchange booth now says:
Pound (£) per dollar rate = .597
You are, of course, aware that the exchange rate has changed but you are not sure if the change was in your favor. Let's analyze the data. If each dollar is currently worth .597£, it means that you will get fewer dollars for 588 pounds than at the beginning of the week.
When you arrived in London, you paid $1.701 per pound, as calculated previously. Now, when leaving, you will redeem pounds at $1.675 ($1 ÷ .597)—a loss of 2.6 cents per pound. But we still haven't determined how much your 588 pounds are worth in total U.S. dollars. Using the new exchange rate your 588 pounds will convert into:
$1.675 × 588 £ = $984.90 ($985 rounded)
Your plane to Geneva, Switzerland, is on final boarding call. You have no choice but to exchange your pounds for dollars and accept the $15 loss (about 1.5 per cent for the week).
Week 2
You deplane in Geneva, Switzerland, anticipating an exciting week in this beautiful country. As you proceed to baggage claim, you pass a currency exchange desk similar to the one in London. There is an electronic bulletin board that reads:
Swiss francs per U.S. dollar = 1.500
After being burned by the exchange rate fluctuation in London, you decide to keep your 985 U.S. dollars (the original $1,000 less the $15 exchange loss) to avoid the risk of another loss. You realize, however, that if you converted your $985 upon arrival, you would receive 1,477.5 Swiss francs ($985 × 1.500).
End of Week 2
Your week in Switzerland was spectacular; perfect weather to go along with stunning sights. But now it's time to move on to Johannesburg, South Africa. As you begin your trek to your boarding gate, your curiosity begins to build. You wonder how the value of the Swiss franc has changed, if at all, during the week. As it turned out, you spent no U.S. dollars while in Switzerland, and you still have $985. You wonder whether you could have experienced a gain in the value of your currency if you had exchanged your dollars for Swiss francs.
As you approach the currency exchange desk, the bulletin board now reads:
Swiss francs per U.S. dollar = 1.455
You recall the rate at the beginning of week 2 was 1.500, which made your $985 worth 1,477.5 Swiss francs. With the current exchange rate of 1.455, the 1,477.5 Swiss francs would now be worth the francs held divided by the current exchange rate, or
1477.5 ÷ 1.455 = $1,015.50
Dismayed that you chickened out at the beginning of the week and missed out on the $30.50 gain, you pledge to yourself that your $985 will be converted into South African rands. We assume that our traveler is deciding to “invest” in another foreign currency for reasons other than the lost opportunity just experienced. The factors influencing South Africa’s future exchange rate may be different from those in Switzerland in the previous week.
Week 3
Arriving in Johannesburg, you make a beeline for the foreign exchange desk, where the sign reads:
South African rand per U.S. dollar = 5.000
You convert your $985 into rands. The number of rands acquired is $985 × 5.000 = 4,925. On the second day in Johannesburg, you find yourself in the financial district. The pulse of business activity is high, and you find yourself being caught up in the excitement. You stroll past the Krugger Central Bank. A sign showing interest rates catches your eye. You are astonished to learn that investing money in South African government bonds is extremely attractive. If you buy a one-year government bond, the sign says you will receive 18 percent interest! You recall that back in the "good ole USA," a one-year government bond currently pays only 4 percent.