A global story in International Management context

The going exchange rate, analyzing currency value as a global financial indicator

1. About the foreign exchange market

Most currencies are traded freely and openly on international markets. It means that the value of currencies shifts according to peoples perceived value and the rules or supply and demand.

• United States currency has dipped recently
• People are seeing the economic trouble and value the $ less

• China's currency is fixed - such that it does not shift according to market fluctuations or perceived value
• Most would perceive their value more than what it is currently valued at

Why does a flexible currency value matter? What are the most recent diplomatic grumblings about?

• The U.S. imports a significant amount from China (because it is so cheap)
• The trade relationship is very biased. U.S. consumers buy more from China than China from the U.S.
• The U.S. wants the Chinese RMB to appreciate against the USD in order to correct the trade imbalance

Why do they think this will work?

2. Impact of currencies fluctuations in a global economy

• An example

The US currently manufactures and sells high quality goods. We will use the John Deere tractor for an example. China still relies on low cost manufacturing, like plastic toys.

1 tractor = 100,000 USD. If 1 USD = 6.5RMB, 1 tractor costs 650,000 RMB in China. \

Later, the Chinese government allows its currency to appreciate to 1USD=4RMB. So now, 1 tractor will only costs a Chinese firm 400,000 RMB in China. With this currency fluctuation, Chinese can consume more U.S. goods, the U.S. exports increase.

1 plastic toy = 10 RMB. If 1 USD = 6.5 RMB, a U.S. company can buy 650 toys with 1,000 USD. After the appreciation to 1USD=4RMB, the U.S. company can only buy 400 toys. With the appreciation, the U.S. imports and consumes less Chinese goods.

As a summary, if Chinese currency appreciate, U.S. would be able to export more to China, but will consume less Chinese goods. Chinese import more from the U.S., and consume more U.S. goods.

• The Chinese on the otherhand want a more gradual appreciation of the currency and to keep light control of currency supply
• Why?
• Because China's economy is still extremely dependant on the manufacturing industry (low-cost).
• This relies on low cost to keep demand high
• Slowly the Chinese will adapt their economy to be a high quality producer as well as service based (like U.S.)
• China knows that people want to invest in its economy
• This means an increase in foreign cash circulating in the market
• More money available to buy the same amount of goods creates high inflation
• High inflation is bad for the economy
• Hot money - foreign investors can take their money out of the economy quickly
• Only short term loans

Video: US position about Chinese currency "manipulation"

3. International trade theories and trade protectionism

As explained in Dan Brutto's speech 'Globalization 4.0 and the new Logistics', the US "recent economic performance has been poor, and one reason is lack of trade. More specifically exports. [...] Major developed nations are threatened to raise barriers to commerce. The United States is a case in point. Trouble signs of protectionism include new tariffs on Chinese aluminium" (Dan Brutto, 2010).

As they use tariffs, countries use the currency as a barrier to trade. Exchange rates 'disputes' can generate protectionism pressures. Currently, the world is focused on currencies fluctuations in the US, China, or developing countries like Brazil or Poland. As we have explained previously, each country is trying to devaluate/evaluate the currency in order to control the price of their goods abroad and most of the time to protect exports. For countries like China, this seems absolutely vital for other countries that it loses competitive ground. In most cases, if the country wants to make its goods cheaper abroad and devaluate the currency, it is also followed by tariffs or quotas, in order to block the imports of the competitive good on the national market and preserve the competitiveness of domestic companies.

How do these barriers affect International Trade?

Example: effect of import tariff in Home country:

In the case of a depreciation of the currency at home, exports have tendency to increase, as the foreign country can now buy more from home country than before, and imports to decrease, as the price for foreign goods increases. The effect is the same than a tariff, as shown on the previous graph (except that tariff generates government revenue).  
Barriers to trade in large countries affect the world prices. A currency fluctuation or tariffs in countries like the US or China will change the world price, because imports and exports are large enough to affect it. 

Depreciation of the currency, or appreciation, have to be used very carefully, because they can both produce important loss for the consumer or for the producer side. For instance a tariff for a large country will benefit the local producers at home, but create job losses for the foreign country. The world price will be higher at home, and lower for the foreign market, then the local consumer will lose.


Moreover, the country impacted by the currency fluctuation and/or tariff is likely to respond the same. For instance, if China does not appreciate their currency, the US may put tariffs on China, and then China may put a tariff on the American imports. This is going to hurt the US producers. In addition, protective actions like devaluation, or import tariff, or production subsidies, might reduce the level of trade globally, as the countries choose to consume more domestic products than before.

On the other side, China fears that an appreciation of yuan would hurt Chinese exporters. The level of the balance of trade in all countries is really sensitive topic, on the economic level, but also political. It can raise some governance issues between nations. 

For instance, the US has a negative balance of trade, and China has a positive one. They are major trading partners; however any protectionist measure from one of them can create international tensions. 

Video: "There's a wave of protectionnism"

4. Risk management and corporate governance

For international management, currency issues also mean risk evaluation. All international companies consider currency issues in their risk management, and build some strategies when they have to deal with different currencies. For instance, a HK based international agency organizing events all around the world will have to convert all the receipts in HKD. Each different currency in each country has an uncertain rate.

Given the currencies daily fluctuations, the payments, or making orders, or choosing the production place or even building some partnerships need to be considered also on a currency level. Companies need to develop a tailored strategy around currencies’ fluctuations, of capital control and exchange control:

• Currency hedging (forward contracts, options, pricing schedule…)
• Adjustment of prices and target profits
• Cash-flow hedging (matching foreign A/P with A/R in the same currency)
• Shifting sourcing and procurement
• Shifting production
• Cutting costs / Improving productivity

One of the most common tool is the forward contract. A seller and a purchaser sign a contract, where the exchange rates are fixed before the transaction. Thanks to this contract, if the exchange rate changes before the trensaction, both parties are not affected. In order to use this kind of tool, companies have to analyze the market properly. Sometimes, they use some financial products very risky in order to hedge the currency, speculating on currencies fluctuations, and without securing the company situation in case of loss.

The international managers have to use these tools very carefully. Trying to control the exchange rates through contracts or different sorts of financial products (derivatives) can lead to big losses, speculation, and ethical issues like frauds. The whole corporate governance of a company can be questionned.

 

An example of derivatives use and ethical issues: Citic Pacific, in Hong Kong

Detailed article: http://www.chinesestock.org/show.aspx?id=23699&cid=28

References: 

Chinese Currency Policy: No Easy Answers. (2010, April 5). Economics21. Ed. Staff.

White, G. (2010). Why The Current Currency Conflict Could Spiral Into A Protectionist Trade War.  Retrieved from the World Wide Web: http://www.businessinsider.com/currency-war-to-protectionism-2010-9

Eichengreen, B., & Irwin, D. (2010). How to prevent a currency war. China Daily. Retrieved from the World Wide Web: http://www.chinadaily.com.cn/opinion/2010-10/15/content_11415147.htm

Currency devaluation, a covert alternative to protectionist measures? (2009). Retrieved from the World Wide Web: http://marcotradenews.com/feature-articles/16072/Currency-devaluation-a-covert-alternative-to-protectionist-measures

Eliot, R. (2010). Currency Risk Management. Retrieved from the World Wide Web: http://www.florin.com/valore/currencyrisk.html

Currency Risk Management. Retrieved from the World Wide Web: http://www.hedgeforeignexchange.com/

Webster Tarpley: "There's a currency war!". You Tube. Retrieved from the World Wide Web: http://www.youtube.com/watch?v=NBuiX-UAD3E

Santini, L. (2008). Citic Pacific Sees $2 Billion Bad-Bet Hit. The Wall Street Journal. Retrieved from the World Wide Web: http://online.wsj.com/article/SB122460075958054287.html


Brutto, D (2010). Globalization 4.0 and the New Logistics. Speech delivered to the Foreign Press Association, New York.