Exchange rates are the determinants for profitability for exporters, yet they are poorly understood because of the complexities and uncertainties of the markets. But it is a crucial consideration, even though exporters have no control over this variable. Have you thought what would happen to your sales if the dollar appreciated against the currency of your export market?
Many small exporters say “I don’t worry about exchange rates because my sales are all in dollars.” That begs the question. The exchange rate determines the price competitiveness of your product versus domestic products and imports. In other words, how are your priced versus your competitors? Let’s take an example:
- The dollar ($) is currently worth 0.75 Euro (€). Let’s say you are exporting California Merlot that is $100/case. That is the equivalent of €75.
- If the dollar appreciates (becomes stronger against the Euro), the price becomes higher in Euro terms. Thus if it reached parity ($1 = €1), the price in Euros would be €100.
- If the dollar depreciates (becomes weaker against the Euro), the price is less in Euros. If the dollar dropped to $2/€1, the price in Euros would be €50.
Thus in the example, nothing has changed from the exporters standpoint – he still is charging $100 per case. There is no exchange rate risk but there is market risk. The price competitiveness of the California Merlot has shifted against French Bordeaux or Argentine Malbec. Under the stronger currency model, US products are less competitive. I always wonder why our politicians are so fond of arguing that the US needs a strong currency.
The Dollar versus Other Reserve Currencies
The world of exchange rates can be loosely divided into reserve currencies (Dollar, Euro, Yen and English Pounds) and all others. The reserve currencies are the currencies that are kept by Central Banks as the backing for other currencies (much as gold used to be) and are the most widely traded. The reserve currencies have no restrictions on trading and are market determined. Others, for example Chilean pesos, have restrictions on trading and the rate is (partially) set by the central government.
In International Economics classes, you will hear the professors (me included) talk about how exchange rates are determined by supply and demand. One component of supply is the current account – is more or less money flowing into/ out of the country due to trade. A component of demand is monetary policy – is the government creating too much money and artificially stimulating demand?
The cold truth is that for the reserve currencies the key determinant is interest rate differentials. Pay less attention to trade deficits or political strains. In the $4 trillion daily foreign exchange market, less than 10% is related to trade. The rest is due to the global virtual floating crap game called foreign exchange markets. Money fund managers shift around money tens of billions each night to take advantage of slight interest rate differentials between London, Tokyo and New York.
Thus for the major currencies the key factor you should keep your eye on is interest rate policies. For example, if Chairman Bernanke announces an end the Quantitative Easing program, the markets will react by assuming that US interest rates will rise and the money managers will put their funds into dollars. That will lead to an appreciation of the dollar and bad news for US exporters to the Eurozone.