CHAPTER FIVE

Managing Currency Exposure

OLD AND AMPLY TESTED WISDOM holds that unless a company’s business is primarily the trading of currencies or commodities, the firm inevitably will lose, and heavily, if it speculates in either. Yet the fluctuating exchange rates of the current world economy make speculators out of the most conservative managements.

Indeed, what was “conservative” when exchange rates were predictable has become a gamble against overwhelming odds. This holds true for the multinational concern, for the company with large exports, and for the company importing parts and supplies in substantial quantities. But the purely domestic manufacturer, as many U.S. businesses have found to their sorrow in recent years, is also exposed to currency risk if, for instance, its currency is seriously overvalued, thus opening its market to foreign competition. (On this see also chapter 1: “The Changed World Economy.”)

Businesses therefore have to learn to protect themselves against several kinds of foreign-exchange dangers: losses on sales or purchases in foreign currencies; the foreign-exchange exposure of their profit margins; and loss of sales and market standing in both foreign and domestic markets. These risks cannot be eliminated. But they can be minimized or at least contained. Above all, they can be converted into a known, predictable, and controlled cost of doing business not too different from any other insurance premium.

The best-known and most widely used protection against foreign-exchange risks is hedging, that is, selling short against known future revenues in a foreign currency and buying long against known future foreign-exchange payment obligations. A U.S. maker of specialty chemicals, for instance, exports 50 percent of its $200 million sales, with 5 percent going to Canada and 9 percent each to Japan, Britain, West Germany, France, and Italy. Selling short (that is, for future delivery) Canadian dollars, Japanese yen, British pounds, German marks, French francs, and Italian lire (or buying an option to sell them) in amounts corresponding to the sales forecast for each country converts, in effect, the foreign-exchange receipts from future sales into U.S. dollars at a fixed exchange rate and eliminates the risk of currency fluctuations.

The company that has to make substantial future payments in foreign currencies—for imports of raw materials, for instance, or for parts—similarly hedges by buying forward (that is, for future receipt) the appropriate currencies in the appropriate amounts. And other expected revenues and payments in foreign currencies—dividends from a foreign unit, for instance—can be similarly protected by hedging.

Hedging and options are now available for all major currencies and, for most of them, at reasonable costs. But still, selling short the Italian-lire equivalent of $8 million could be quite expensive. More important, hedging only ensures against the currency risk on revenues and payments. It does not protect profit margins. Increasingly, therefore, companies are resorting to foreign-currency financing.

The specialty-chemicals company cited previously incurs all its costs in U.S. dollars. If the dollar appreciates in the course of a year, the company’s costs appreciate with it in terms of the foreign currencies in which it sells half its output. If it raises its prices in these foreign currencies, it risks losing sales, and with them profits—and, worse, permanent market standing. If it does not raise its prices in the foreign currencies, its profit margins shrink, and with them its profits.

In a world of volatile and unpredictable foreign-exchange fluctuations, businesses will have to learn to hedge their costs as well as their receipts. The specialty-chemicals company, for instance, might raise its total money requirements in the currencies in which it gets paid, that is, 50 percent in U.S. dollars and the rest in the currencies of its main foreign markets. This would bring into alignment the reality of its finances with the reality of its markets. Or an American company exporting 50 percent of its output might raise all its equity capital in dollars on the New York Stock Exchange but borrow all its other money needs short term in the “ECU,” the currency of account of the European Common Market. Then if the dollar appreciates, the profit in dollars the company makes as its ECU loans mature may offset the currency loss on its export sales.

“Internationalizing” the company’s finances is also the best—perhaps the only—way in which a purely domestic manufacturer can protect itself to some degree against foreign competition based on currency rates. If a currency is appreciating so fast as to give foreign competition a decided edge—the most recent example is the rapid rise of the dollar in 1983–84 vis-à-vis the yen and the mark—a domestic manufacturer may borrow in the currencies of its foreign competitors or sell those currencies short. The profit the company makes in its own currency when buying back the amount it owes in the foreign currencies then enables it to lower its domestic price and thus to meet the competition that is based on the foreign-exchange rate.

This is, however, a tricky and dangerous game. It straddles the fine line between hedging and “speculating.” The amounts risked, therefore, always should be strictly limited and the exposure time kept short. The successful practitioners of this strategy never sell short or borrow for more than ninety days at any one time. Yet it was this strategy that protected many West German manufacturers against losing their home market to the Americans when the dollar was grossly undervalued during the years of the Carter inflation. And although the strategy might be speculative, the alternative, to do nothing, might be more speculative still.

With currency fluctuations a part of economic reality, business will have to learn to consider them as just another cost, faster changing and less predictable, perhaps, than costs of labor or capital but otherwise not so different.

Specifically this means that businesses, and especially businesses integrated with or exposed to the world economy, will have to learn to manage themselves as composed of two quite dissimilar parts: a core business permanently domiciled in one country or in a few countries, and a peripheral business capable of being moved, and moved fast, according to differentials in major costs—labor, capital, and exchange rates.

A business producing highly engineered products might use its plants in its home country to produce those parts on which the quality, performance, and integrity of its products depend—say 45 percent or 50 percent of the value of the finished product. And if the company has plants in more than one developed country, it might shift this core production among those plants according to exchange-rate advantages. The remaining 50 percent or 55 percent of its production would be peripheral and quite mobile, to be placed on short-term contracts wherever the costs are lowest, whether in developed countries with favorable exchange rates or in Third World countries with favorable labor rates.

The volatile foreign-exchange fluctuations of today’s world economy demand that managements, even of purely domestic businesses, manage their companies as “international” companies and as ones embedded in the world economy. It might even be said that exchange-rate instability means that there are no more American or German or French businesses; there are only Americans or Germans or Frenchmen managing world-economy businesses, at least in manufacturing, banking, and finance. This is the most paradoxical result of the shift, nearly fifteen years ago, from fixed to floating exchange rates.

One of the major advantages then claimed for floating exchange rates was the strengthening of the national character of business by eliminating, or greatly lessening, differentials in comparative costs between major economies. But we also were promised then that floating exchange rates would eliminate, or greatly lessen, international short-term capital movements.

Exchange rates were supposed to adjust themselves automatically to the balance of trade between countries. And, indeed, economic theory still preaches that foreign-exchange rates are determined by the balance of trade in goods and services. Instead, with liquid short-term funds amounting to $3 trillion sloshing around the world economy, short-term flows of capital have come to determine exchange rates and, largely, the flow of goods and services.

Floating exchange rates were also expected to eliminate, or at least to curtail, government manipulation of foreign-exchange rates by imposing fiscal discipline on governments. But surely the United States would have had to face up years ago to its government deficit had the American government not been able to postpone the day of reckoning by keeping the dollar’s value high. Above all, however, floating exchange rates were expected to promote currency stability and to eliminate volatile currency fluctuations: the exact opposite of what they actually have achieved.

But the fact that the economic reality of a floating-exchange-rate world economy is totally different from what it was expected to be does not change the fact that it is reality and will continue to be reality for the foreseeable future. Managements have to learn to manage currency instability and currency exposure.

(1985)