INFLATION AND FOREIGN-EXCHANGE RISK MANAGEMENT
INFLATION AND FOREIGN-EXCHANGE RISK MANAGEMENT
The discussions of global cash management have focused on the flow of money for specific operating objectives. In addition, an important objective of the financial strategy of an MNE is to protect against the risks of investing abroad. The strategies that a firm adopts to protect against risk may involve the internal movement of funds as well as the use of one or more of the foreign-exchange instruments described in Chapter 7, such as options and forward contracts.
In examining the risk encountered in international business, it is important that firms consider the nature of the risk, the circumstances under which it can occur, the implications for the firm, and the best defense against it. Risks related to currency, commercial, and political factors are the major ones. Currency risks include both inflation and exchange-rate changes. Commercial risks involve the problems of extending and receiving credit and the difficulties of collection or payment of accounts in different currencies. Political risks
Inflation
Inflation occurs in varying degrees in nearly every country in which MNEs operate. Inflation tends to erode the value of financial assets and make financial liabilities more attractive. The attractiveness of liabilities is softened somewhat by the high interest rates that often accompany loans in countries with high inflation such as Brazil and Argentina.
High rates of inflation often bring a variety of problems that influence the way an MNE operates. The most important ones are (1) accelerated depreciation or devaluation of the local currency or a maxidevaluation, (2) tighter capital controls and import restrictions, (3) scarcer credit and higher borrowing costs, (4) a buildup of accounts receivable and lengthening of collection periods, (5) price controls to help bring inflation under control, (6) economic and political chaos and labor unrest, (7) capital flight, (8) and greater difficulty in evaluating the performance of foreign subsidiaries.22
Many companies faced with price controls need to get around controls through imaginative product development and pricing strategies. This may involve slight product or packaging modifications and brand-name changing in order to effect price increases. Quite frequently, MNEs are so brand-conscious that they refuse to exploit this strategy. Coca-Cola, for example, would never consider changing its product name in order to get a price increase. The importance of the brand name outweighs the advantage to be gained by changing it.
One multinational cosmetics firm operating in Brazil got around price controls by changing the container size of a brand-name product to a smaller container but listing the product at a significantly higher price. However, it would sell the product for considerably less than list price in order to attract sales. Then it could increase the price according to inflationary trends up to the upper price limit established by price-control authorities.
One of the major problems the firm faced was trying to estimate inflation correctly. If it predicted inflation at 200 percent and priced accordingly, it would be in serious trouble if inflation was actually 500 percent. It would have underpriced its products and sold them for less than the replacement cost of raw materials. On the other hand, if inflation came in at less than 200 percent, the firm ran the risk of pricing itself out of the market.
It is evident that a firm operating in an inflationary environment needs to manage receivables and payables carefully. Receivables must be collected on a timely basis through a well-trained credit and collection department and a sophisticated and reliable reporting system.23 Once it is collected, idle cash should be kept at a minimum. Funds should be remitted to the parent cash pool, as noted in the previous section, or invested in income-producing assets that provide a return in excess of inflation.
Exchange-Rate Changes
If all exchange rates were fixed in relation to one another, there would be no foreign-exchange risks. However, rates are not fixed, and currency values change frequently. Instead of infrequent one-way changes, currencies can fluctuate either up or down; this has especially been the case with the dollar since the mid-1980s.
A change in the exchange rate can result in three different exposures for a firm: translation exposure, transaction exposure, and economic exposure.
Translation Exposure Foreign currency financial statements are translated into the reporting currency of the parent company (assumed to be U.S. dollars for U.S. companies) for a number of reasons, such as consolidation, perfor-mance evaluation, creditors, and taxation. Exposed accounts—those trans-balance sheet or current exchange rate—either gain or lose command over dollars. For example, assume that a subsidiary operates in
Mexico. The Mexican peso, weakened by inflation, depreciates in relation to the dollar from P3000:$l to P3600:$l. The subsidiary's bank account of P300,000,000 would be worth only $83,333 after the depreciation instead of the $100,000 original value.
The combined effect of the exchange-rate change on all exposed assets and liabilities is a gain or a loss. If the foreign currency financial statements are translated according to the temporal method, the gains or losses are taken directly to the income statement. If the statements are translated according to the current rate method, the gains and losses are taken to a separate component of stockholders' equity. No matter which method is used for translation purposes, this gain or loss is not an immediate cash-flow effect. The cash in the bank in Mexico is only translated, not converted into dollars.
Transaction Exposure The treasury difficulty from a transaction denominated in a foreign currency arises because the company has accounts receivable or payable in foreign currency that must be settled eventually. For example, assume that a U.S. exporter delivers merchandise to a British importer at a total price of $500,000 when the exchange rate is $1.9300/£. If the exporter receives payment in dollars, there is no immediate impact to the exporter if the dollar/sterling exchange rate changes. If payment were to be received in sterling, however, the exporter could be exposed to an exchange gain or loss.
For example, using the above exchange rate, the sale would be carried on the exporter's books at $500,000, but the underlying value in which the sale is denominated, as explained in the previous chapter, would be £259,067. If the rate moves to $1.9000 at the time the receivable is collected, the exporter would receive £259,067, but that would be worth $492,227 a loss of $7773. This is an actual cash-flow loss to the exporter.
Part 7 Functional Management, Operations, and Concerns
Economic Exposure Economic exposure includes such issues as the pricing of products, the source and cost of inputs, and the location of investments.
The economic impact on the firm is difficult to measure, but it is crucial to the operations of the firm in the long run. Aside from the immediate impact described earlier, there is a long-term impact that involves pricing strategies. The inventory sold to the British importer just discussed probably was sold to final users before the exchange rate fluctuated, but future sales would be affected. The following example using different exchange rates illustrates what could happen from an economic standpoint. Assume that the exchange rate before the change was $1.80:£ and after the change was $1.85:£.
If the merchandise had been invoiced in sterling, the strengthening of the sterling would have resulted in a gain of revenue to the exporter of $50. If the merchandise had been invoiced in dollars, the cost of the product to the importer in Britain would have decreased to £973. In the first case, the exporter must decide whether to reduce the price in pounds to maintain the same level of dollar revenues and (hopefully) increase market share. In the second case, the importer must decide whether to pass on the savings to consumers by reducing prices or keep the price the same and increase profit margins.
There are lots of good examples of how currency movements have affected corporate profits and strategies. In 1990 the German mark strengthened significantly against the U.S. dollar. German firms like Deutsche Airbus, which invoices its export sales of aircraft in U.S. dollars, were having a difficult time generating profits, because their costs were in high Deutsche marks, but their sales were in relatively cheap dollars. Some industries, like aircraft, operate in dollars worldwide, even though the exporters may be from other countries, such as Deutsche Airbus in Germany. German exporters that invoiced their sales in Deutsche marks were also having problems but of a different nature. Their sales prices were so high that they were losing business to exporters from other countries. For example, in September 1990, Germany exported 7.5 percent fewer goods to other EC countries than it did a year earlier, even though exports of other EC countries to Germany actually increased 10.8 percent over the prior year. Some German companies, such as Continental AG, the huge tire manufacturer, were benefitting from the strong mark. Continental AG purchased General Tire in the United States, so it is able to service its U.S. market and some global markets from cheaper U.S. production. Continental is also losing money in the United States, so the cheaper dollar makes the loss less of a problem than if the dollar were really strong.24
In 1990, the situation of U.S. companies in the face of a weak dollar was also mixed. Due to the weak dollar, Hurco Cos., an Indianapolis manufacturer that sells 40 to 45 percent of its machine tools and electronic controls in Europe, increased its market share (an economic impact) and raised its prices in dollars to yield greater sales revenues. However, Hurco also has found that some of its European buyers have cut back their purchases since
business volume is down due to stronger local currencies and relatively weak economies. In addition, Hurco's imported parts and components have increased in cost due to the weaker dollar, a transactions impact. Thus the impact of the weak dollar is mixed.25
The impact of the weak dollar on Black & Decker and Coca-Cola is very different from that of Hurco. In the case of Black & Decker, the weak dollar has allowed it to sell some of the assets of Emhart Corp., one of its recent acquisitions, to foreign buyers who have relatively strong currencies. As a result, B&D has been able to eliminate some of its heavy debt. Coca-Cola, which generates 80 percent of its earnings abroad, benefits from strong foreign currencies, because those profits are translated into dollars at favorable exchange rates, helping to increase sales and profits (a translation impact). Coke management issues twice-daily updates of key currencies to its senior managers in order to assist in developing strategy. When the dollar is relatively weak, Coke tries to increase its reinvestment abroad (an economic impact).26
A final example of exchange-rate changes on strategy involves the Japanese auto companies. In 1986-1987, when the dollar plunged from its highs of the early 1980s, the Japanese automakers were forced to increase prices in order to make money. However, the fall of the dollar in 1990 did not seem to have the same impact. There were two reasons for that. The first is that many of them restructured their business through significant cost-cutting measures to allow them to operate at stronger yen values. In addition, some of them, like Honda, restructured their businesses to insulate them a little more from rate changes. Honda increased its U.S. manufacturing capacity so that only 25 to 30 percent of its content comes from Japan. They figure that if the dollar does not fall to below 125 to 130 yen, they can operate reasonably profitably without having to raise prices.27
The discussions of global cash management have focused on the flow of money for specific operating objectives. In addition, an important objective of the financial strategy of an MNE is to protect against the risks of investing abroad. The strategies that a firm adopts to protect against risk may involve the internal movement of funds as well as the use of one or more of the foreign-exchange instruments described in Chapter 7, such as options and forward contracts.
In examining the risk encountered in international business, it is important that firms consider the nature of the risk, the circumstances under which it can occur, the implications for the firm, and the best defense against it. Risks related to currency, commercial, and political factors are the major ones. Currency risks include both inflation and exchange-rate changes. Commercial risks involve the problems of extending and receiving credit and the difficulties of collection or payment of accounts in different currencies. Political risks
Inflation
Inflation occurs in varying degrees in nearly every country in which MNEs operate. Inflation tends to erode the value of financial assets and make financial liabilities more attractive. The attractiveness of liabilities is softened somewhat by the high interest rates that often accompany loans in countries with high inflation such as Brazil and Argentina.
High rates of inflation often bring a variety of problems that influence the way an MNE operates. The most important ones are (1) accelerated depreciation or devaluation of the local currency or a maxidevaluation, (2) tighter capital controls and import restrictions, (3) scarcer credit and higher borrowing costs, (4) a buildup of accounts receivable and lengthening of collection periods, (5) price controls to help bring inflation under control, (6) economic and political chaos and labor unrest, (7) capital flight, (8) and greater difficulty in evaluating the performance of foreign subsidiaries.22
Many companies faced with price controls need to get around controls through imaginative product development and pricing strategies. This may involve slight product or packaging modifications and brand-name changing in order to effect price increases. Quite frequently, MNEs are so brand-conscious that they refuse to exploit this strategy. Coca-Cola, for example, would never consider changing its product name in order to get a price increase. The importance of the brand name outweighs the advantage to be gained by changing it.
One multinational cosmetics firm operating in Brazil got around price controls by changing the container size of a brand-name product to a smaller container but listing the product at a significantly higher price. However, it would sell the product for considerably less than list price in order to attract sales. Then it could increase the price according to inflationary trends up to the upper price limit established by price-control authorities.
One of the major problems the firm faced was trying to estimate inflation correctly. If it predicted inflation at 200 percent and priced accordingly, it would be in serious trouble if inflation was actually 500 percent. It would have underpriced its products and sold them for less than the replacement cost of raw materials. On the other hand, if inflation came in at less than 200 percent, the firm ran the risk of pricing itself out of the market.
It is evident that a firm operating in an inflationary environment needs to manage receivables and payables carefully. Receivables must be collected on a timely basis through a well-trained credit and collection department and a sophisticated and reliable reporting system.23 Once it is collected, idle cash should be kept at a minimum. Funds should be remitted to the parent cash pool, as noted in the previous section, or invested in income-producing assets that provide a return in excess of inflation.
Exchange-Rate Changes
If all exchange rates were fixed in relation to one another, there would be no foreign-exchange risks. However, rates are not fixed, and currency values change frequently. Instead of infrequent one-way changes, currencies can fluctuate either up or down; this has especially been the case with the dollar since the mid-1980s.
A change in the exchange rate can result in three different exposures for a firm: translation exposure, transaction exposure, and economic exposure.
Translation Exposure Foreign currency financial statements are translated into the reporting currency of the parent company (assumed to be U.S. dollars for U.S. companies) for a number of reasons, such as consolidation, perfor-mance evaluation, creditors, and taxation. Exposed accounts—those trans-balance sheet or current exchange rate—either gain or lose command over dollars. For example, assume that a subsidiary operates in
Mexico. The Mexican peso, weakened by inflation, depreciates in relation to the dollar from P3000:$l to P3600:$l. The subsidiary's bank account of P300,000,000 would be worth only $83,333 after the depreciation instead of the $100,000 original value.
The combined effect of the exchange-rate change on all exposed assets and liabilities is a gain or a loss. If the foreign currency financial statements are translated according to the temporal method, the gains or losses are taken directly to the income statement. If the statements are translated according to the current rate method, the gains and losses are taken to a separate component of stockholders' equity. No matter which method is used for translation purposes, this gain or loss is not an immediate cash-flow effect. The cash in the bank in Mexico is only translated, not converted into dollars.
Transaction Exposure The treasury difficulty from a transaction denominated in a foreign currency arises because the company has accounts receivable or payable in foreign currency that must be settled eventually. For example, assume that a U.S. exporter delivers merchandise to a British importer at a total price of $500,000 when the exchange rate is $1.9300/£. If the exporter receives payment in dollars, there is no immediate impact to the exporter if the dollar/sterling exchange rate changes. If payment were to be received in sterling, however, the exporter could be exposed to an exchange gain or loss.
For example, using the above exchange rate, the sale would be carried on the exporter's books at $500,000, but the underlying value in which the sale is denominated, as explained in the previous chapter, would be £259,067. If the rate moves to $1.9000 at the time the receivable is collected, the exporter would receive £259,067, but that would be worth $492,227 a loss of $7773. This is an actual cash-flow loss to the exporter.
Part 7 Functional Management, Operations, and Concerns
Economic Exposure Economic exposure includes such issues as the pricing of products, the source and cost of inputs, and the location of investments.
The economic impact on the firm is difficult to measure, but it is crucial to the operations of the firm in the long run. Aside from the immediate impact described earlier, there is a long-term impact that involves pricing strategies. The inventory sold to the British importer just discussed probably was sold to final users before the exchange rate fluctuated, but future sales would be affected. The following example using different exchange rates illustrates what could happen from an economic standpoint. Assume that the exchange rate before the change was $1.80:£ and after the change was $1.85:£.
If the merchandise had been invoiced in sterling, the strengthening of the sterling would have resulted in a gain of revenue to the exporter of $50. If the merchandise had been invoiced in dollars, the cost of the product to the importer in Britain would have decreased to £973. In the first case, the exporter must decide whether to reduce the price in pounds to maintain the same level of dollar revenues and (hopefully) increase market share. In the second case, the importer must decide whether to pass on the savings to consumers by reducing prices or keep the price the same and increase profit margins.
There are lots of good examples of how currency movements have affected corporate profits and strategies. In 1990 the German mark strengthened significantly against the U.S. dollar. German firms like Deutsche Airbus, which invoices its export sales of aircraft in U.S. dollars, were having a difficult time generating profits, because their costs were in high Deutsche marks, but their sales were in relatively cheap dollars. Some industries, like aircraft, operate in dollars worldwide, even though the exporters may be from other countries, such as Deutsche Airbus in Germany. German exporters that invoiced their sales in Deutsche marks were also having problems but of a different nature. Their sales prices were so high that they were losing business to exporters from other countries. For example, in September 1990, Germany exported 7.5 percent fewer goods to other EC countries than it did a year earlier, even though exports of other EC countries to Germany actually increased 10.8 percent over the prior year. Some German companies, such as Continental AG, the huge tire manufacturer, were benefitting from the strong mark. Continental AG purchased General Tire in the United States, so it is able to service its U.S. market and some global markets from cheaper U.S. production. Continental is also losing money in the United States, so the cheaper dollar makes the loss less of a problem than if the dollar were really strong.24
In 1990, the situation of U.S. companies in the face of a weak dollar was also mixed. Due to the weak dollar, Hurco Cos., an Indianapolis manufacturer that sells 40 to 45 percent of its machine tools and electronic controls in Europe, increased its market share (an economic impact) and raised its prices in dollars to yield greater sales revenues. However, Hurco also has found that some of its European buyers have cut back their purchases since
business volume is down due to stronger local currencies and relatively weak economies. In addition, Hurco's imported parts and components have increased in cost due to the weaker dollar, a transactions impact. Thus the impact of the weak dollar is mixed.25
The impact of the weak dollar on Black & Decker and Coca-Cola is very different from that of Hurco. In the case of Black & Decker, the weak dollar has allowed it to sell some of the assets of Emhart Corp., one of its recent acquisitions, to foreign buyers who have relatively strong currencies. As a result, B&D has been able to eliminate some of its heavy debt. Coca-Cola, which generates 80 percent of its earnings abroad, benefits from strong foreign currencies, because those profits are translated into dollars at favorable exchange rates, helping to increase sales and profits (a translation impact). Coke management issues twice-daily updates of key currencies to its senior managers in order to assist in developing strategy. When the dollar is relatively weak, Coke tries to increase its reinvestment abroad (an economic impact).26
A final example of exchange-rate changes on strategy involves the Japanese auto companies. In 1986-1987, when the dollar plunged from its highs of the early 1980s, the Japanese automakers were forced to increase prices in order to make money. However, the fall of the dollar in 1990 did not seem to have the same impact. There were two reasons for that. The first is that many of them restructured their business through significant cost-cutting measures to allow them to operate at stronger yen values. In addition, some of them, like Honda, restructured their businesses to insulate them a little more from rate changes. Honda increased its U.S. manufacturing capacity so that only 25 to 30 percent of its content comes from Japan. They figure that if the dollar does not fall to below 125 to 130 yen, they can operate reasonably profitably without having to raise prices.27
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