References to the value of the U.S. dollar and other major foreign currencies by the financial news outlets have become as ubiquitous today as the stock price quotations of our most heavily traded companies. The value of our “greenback” has seemingly garnered even more attention in the past several months as analysts and pundits debate the impact of a rapidly rising U.S. dollar on corporate earnings. However, if you’re like most people, this information comes and goes and doesn’t really stimulate much further thought. Changes to the values of our currencies are much like the proverbial tree falling in the woods without witness – it happens, but if nobody cares does it really matter?
The short answer is clearly, yes!
At the most basic level, changes in the exchange rates represent a transfer of purchasing power. Meaning, if the value of the U.S. dollar is rising relative to the value of the Japanese yen, then the purchasing power of Americans is rising and the purchasing power of the Japanese is falling. A rising dollar enables Americans to buy more goods and services produced abroad with the same amount of dollars. Americans feel richer. A falling yen means that the Japanese will need to spend more yen just to consume the same amount of foreign goods and services. Japanese feel poorer. Purchasing power has been transferred from Japan to the U.S.
The long answer is also yes, but it’s complicated.
If you owned or managed a purely domestic manufacturer – sourcing all of your raw material domestically and selling all of your finished goods domestically – would you care about changing exchange rates? In today’s global economy and global marketplace you absolutely should care. A rising dollar is actually a double-edged sword. Yes, the increased purchasing power is good for consumers, but it's not so good for the domestic producers.
The global supply chain today is extremely complex, but to simplify things for the sake of an example let’s assume that Ford is a purely domestic auto manufacturer in the U.S. and let’s also assume that Honda only manufactures and assembles its cars in Japan. The value of the Japanese yen has fallen by more than 50% relative to the U.S. dollar in the past 2 years. As a purely domestic manufacturer, does that have an impact on Ford? Of course it does. Honda can lower the price of its cars sold in the U.S. market and still receive the same amount of yen and maintain the same yen-based profit margin. Ford will now have a difficult time competing with Honda and any other foreign manufacturers in its home market. Still worse for Ford is the fact that its exports are also becoming less competitive in foreign markets. Japanese consumers have lost purchasing power, so Ford would have to lower its price in U.S. dollar terms, cutting into its profitability in order to appeal to Japanese consumers.
Foreign exchange risk
To complicate the issue of shifting exchange rates even further there are actually three types of foreign exchange risk faced by firms: transaction risk, translation risk, and operating (or economic) risk. The Ford/Honda scenario given above is an example of operating risk.
Operating risk is the most complex of the three types of risks and it’s what drives companies to establish intricate webs of supply chains and distribution channels. Sourcing raw materials from or manufacturing in more than one country greatly reduces the impact of exchange rates in any one country. Likewise, having customers in as many countries as possible will also minimize the risk of any one country having a significant loss in purchasing power. So, when you read or hear stories about the rising dollar negatively impacting the earnings of U.S. corporations you’ll have a better understanding of why that’s the case. More importantly, when you hear of a specific domestic company struggling with the high value of the dollar it may cause you to question the operating strategy of that company.
Transaction risk is the most straightforward foreign exchange risk for companies, but can oftentimes become a conduit for foreign currency speculation. If an Asian airline buys airplanes from Boeing that are to be paid for and delivered in 9 months, then the airline knows that it has a contractual obligation to deliver a certain amount of U.S. dollars to Boeing at that time. As soon as the contract is signed the airline knows with certainty its transaction exposure and will have a variety of tools available to fully hedge that exposure. However, the company may also decide to take a foreign exchange rate “view” that the value of the U.S. dollar will fall in the next 9 months and decide not to hedge the transaction risk. The upside is that a falling dollar would lower the purchasing price for the airline in terms of its domestic currency. The downside of this strategy is that the dollar could rise in the coming months and cause the purchase price to increase. For some, taking such a stance – identifying a risk, quantifying the risk, deliberately ignoring the risk – may be viewed as speculation.
Translation risk occurs when a multinational organization translates and consolidates the accounting statements of its wholly-owned foreign subsidiaries back into its home country accounting statements. For example, GE owns more than $500 billion worth of assets outside of the United States. Those assets are valued by the foreign subsidiaries in local currency terms. However, at the end of each quarter GE must consolidate all of the financial statements of its wholly-owned foreign subsidiaries into one set of U.S. dollar-based statements. In a rising dollar environment the foreign currency-denominated assets will be worth less when translated into U.S. dollars. Should that matter from the perspective of managers or even investors? In the short-run, if there is no plan to dispose of or liquidate the assets the answer is probably no.
So, the next time you see or hear a news story on the value of the dollar I hope that you will pause long enough to consider the types of impacts these changes will have on you and/or your company.
Gregory Van Laeken is an Adjunct Professor and Business Manager & Analyst for Global Programs at RIT