Exchange rates also affect the amount of profit a company earns from its international subsidiaries. The earnings of international subsidiaries are typically integrated into the parent company’s financial statements in the home currency. Translating subsidiary earnings from a weak host country currency into a strong home currency reduces the amount of these earnings when stated in the home currency. Likewise, translating earnings into a weak home currency increases stated earnings in the home currency.
Sudden, unfavorable movements in exchange rates can be costly for both domestic and international companies. On the other hand, stable exchange rates improve the accuracy of financial planning, including cash flow forecasts. Although companies can insure (usually by currency hedging) against potentially adverse movements in exchange rates, most available methods are too expensive for small and medium-sized businesses. Moreover, as the unpredictability of exchange rates increases, so too does the cost of insuring against the accompanying risk.
Managers also prefer movements in exchange rates to be predictable. Predictable exchange rates reduce the likelihood that companies will be caught off guard by sudden and unexpected rate changes. They also reduce the need for costly insurance against possible adverse movements in exchange rates. Rather than purchasing insurance, companies would be better off spending their money on more productive activities, such as developing new products or designing more efficient production methods.
As we saw in this chapter, not only are a company’s financial decisions affected by events in international financial markets, but so too are production and marketing decisions. The next chapter begins our in-depth look at the main aspects of managing an international business. Our understanding of national business environments, international trade and investment, and the international financial system will serve us well as we embark on our tour of the nuances of international business management.
1. Explain how exchange rates influence the activities of domestic and international companies.
■ When a country’s currency is weak (valued low relative to other currencies), the price of its exports on world markets declines (making exports more appealing on world markets) and the price of imports rises, and vice versa.
■ A company can improve profits if it sells in a country with a strong currency (one that is valued high relative to other currencies) while paying workers at home in its own weak currency.
■ The intentional lowering of a currency’s value by the nation’s government is called devaluation; this lowers the price of a country’s exports on world markets and increases the price of imports.
■ The intentional raising of a currency’s value by the nation’s government is called revaluation; this increases the price of exports and reduces the price of imports.
■ Translating subsidiary earnings from a weak host country currency into a strong home currency reduces the amount of these earnings when stated in the home currency, and vice versa.
2. Identify the factors that help determine exchange rates and their impact on business.
■ The law of one price says that when price is expressed in a common currency, an identical product must have an identical price in all countries.
■ The concept of purchasing power parity (PPP) can be interpreted as the exchange rate between two nations’ currencies that is equal to the ratio of their price levels.
■ Inflation occurs when money is injected into a static economy, or when employers raise wages to attract employees and then pass increased labor costs on to consumers.
■ Interest rates affect inflation by affecting the cost of borrowing money: Low interest rates encourage spending and higher debt, whereas high rates prompt savings and lower debt.
■ Because real interest rates are theoretically equal across countries, a rate difference between two countries must be due to different expected rates of inflation.
■ A country that is experiencing inflation higher than that of another country should see the relative value of its currency fall.
3. Describe the primary methods of forecasting exchange rates.
■ A forward exchange rate is the rate agreed upon for foreign exchange payment at a future date.
■ The efficient market view says that prices of financial instruments reflect all publicly available information at any given time; meaning forward exchange rates accurately forecast future exchange rates.
■ The inefficient market view says that prices of financial instruments do not reflect all publicly available information, meaning forecasts can be improved by information not reflected in forward exchange rates.
■ One forecasting technique based on a belief in the value of added information is fundamental analysis, which uses statistical models based on fundamental economic indicators to forecast exchange rates.
■ A second forecasting technique is technical analysis, which employs charts of past trends in currency prices and other factors to forecast exchange rates.
4. Discuss the evolution of the current international monetary system and explain how it operates.
■ The Bretton Woods Agreement (1944) created an international monetary system based on the value of the U.S. dollar and used the gold standard to link paper currencies to specific values of gold.
■ The most important features of the Bretton Woods system were fixed exchange rates, built-in flexibility, funds for economic development, and an enforcement mechanism.
■ The World Bank funds poor nations’ economic development projects such as the development of transportation networks, power facilities, and agricultural and educational programs.
■ The International Monetary Fund (IMF) regulates fixed exchange rates and enforces the rules of the international monetary system.
■ The Jamaica Agreement (1976) endorsed a managed float system of exchange rates in which currencies float against one another with limited government intervention to stabilize currencies at a target exchange rate.
■ In a free float system currencies float freely without government intervention.
■ Within today’s managed float system, certain countries try to maintain more stable exchange rates by tying their currencies to another country’s stronger currency.
Talk It Over
1. Describe briefly the advantages and disadvantages of both floating and fixed exchange-rate systems. Do you think the world will move toward an international monetary system more characteristic of floating or fixed exchange rates in the future? Explain your answer.
2. Do you think an international monetary system with currencies valued on the basis of gold would work today? Why or why not? Do you think implementing a global version of the old European monetary system would work today? Why or why not?
3. The activities of the IMF and the World Bank largely overlap each other. Devise a plan that reduces this duplication of services and assigns distinct responsibilities. Would you have them assume a greater role on the environment and corruption? Describe and justify your proposed solution.