Chapter 10 Outline

Implications for Business

The implications for international businesses of the material discussed in this chapter fall into three main areas: currency management, business strategy, and corporate - government relations.

Currency Management

An obvious implication with regard to currency management is that companies must recognize that the foreign exchange market does not work quite as depicted in Chapter 9. The current system is a mixed system in which a combination of government intervention and speculative activity can drive the foreign exchange market. Companies engaged in significant foreign exchange activities need to be aware of this and to adjust their foreign exchange transactions accordingly. For example, the currency management unit of Caterpillar claims it made millions of dollars in the hours following the announcement of the Plaza Accord by selling dollars and buying currencies that it expected to appreciate on the foreign exchange market following government intervention.

We have seen how under the present system, speculative buying and selling of currencies can create very volatile movements in exchange rates (as exhibited by the rise and fall of the dollar during the 1980s). Contrary to the predictions of the purchasing power parity theory (see Chapter 9), we have seen that exchange rate movements during the 1980s, at least with regard to the dollar, did not seem to be strongly influenced by relative inflation rates. Insofar as volatile exchange rates increase foreign exchange risk, this is not good news for business. On the other hand, as we saw in Chapter 9, the foreign exchange market has developed a number of instruments, such as the forward market and swaps, that can help to insure against foreign exchange risk. Not surprisingly, use of these instruments has increased markedly since the breakdown of the Bretton Woods system in 1973.

Business Strategy

The volatility of the present global exchange rate regime presents a conundrum for international businesses. Exchange rate movements are difficult to predict, and yet their movement can have a major impact on a business's competitive position. Faced with uncertainty about the future value of currencies, firms can utilize the forward exchange market. However, the forward exchange market is far from perfect as a predictor of future exchange rates (see Chapter 9). It is also difficult if not impossible to get adequate insurance coverage for exchange rate changes that might occur several years in the future. The forward market tends to offer coverage for exchange rate changes a few months--not years--ahead. Given this, it makes sense to pursue strategies that will increase the company's strategic flexibility in the face of unpredictable exchange rate movements.

Maintaining strategic flexibility can take the form of dispersing production to different locations around the globe as a hedge against currency fluctuations. Consider the case of Daimler-Benz, Germany's export-oriented automobile and aerospace company. In June 1995, the company stunned the German business community when it announced it expected to post a severe loss in 1995 of about $720 million. The cause was Germany's strong currency, which had appreciated by 4 percent against a basket of major currencies since the beginning of 1995 and had risen by over 30 percent against the US dollar since late 1994. By mid-1995, the exchange rate against the dollar stood at $1=DM1.38. Daimler's management believed it could not make money with an exchange rate under $1=DM1.60. Daimler's senior managers concluded that the appreciation of the mark against the dollar was probably permanent, so they decided to move substantial production outside of Germany and increase purchasing of foreign components. The idea was to reduce the vulnerability of the company to future exchange rate movements. The Mercedes-Benz division has begun to implement this move. Even before its acquisition of Chrysler Corporation in 1998, Mercedes planned to produce 10 percent of its cars outside of Germany by 2000, mostly in the United States.³⁴ Similarly, the move by Japanese automobile companies to expand their productive capacity in the United States and Europe can be seen in the context of the increase in the value of the yen between 1985 and 1995, which increased the price of Japanese exports. For the Japanese companies, building production capacity overseas is a hedge against continued appreciation of the yen (as well as against trade barriers).

Another way of building strategic flexibility involves contracting out manufacturing. This allows a company to shift suppliers from country to country in response to changes in relative costs brought about by exchange rate movements. However, this kind of strategy works only for low-value-added manufacturing (e.g., textiles), in which the individual manufacturers have few if any firm-specific skills that contribute to the value of the product. It is inappropriate for high-value-added manufacturing, in which firm-specific technology and skills add significant value to the product (e.g., the heavy equipment industry) and in which switching costs are correspondingly high. For high-value-added manufacturing, switching suppliers will lead to a reduction in the value that is added, which may offset any cost gains arising from exchange rate fluctuations.

The roles of the IMF and the World Bank in the present international monetary system also have implications for business strategy. Increasingly, the IMF has been acting as the macroeconomic policeman of the world economy, insisting that countries seeking significant borrowings adopt IMF-mandated macroeconomic policies. These policies typically include anti-inflationary monetary policies and reductions in government spending. In the short run, such policies usually result in a sharp contraction of demand. International businesses selling or producing in such countries need to be aware of this and plan accordingly. In the long run, the kind of policies imposed by the IMF can promote economic growth and an expansion of demand, which create opportunities for international business.

Corporate - Government Relations

As major players in the international trade and investment environment, businesses can influence government policy toward the international monetary system. For example, intense government lobbying by US exporters helped convince the US government that intervention in the foreign exchange market was necessary. Similarly, much of the impetus behind establishment of the exchange rate mechanism of the European monetary system came from European businesspeople, who understood the costs of volatile exchange rates.

With this in mind, business can and should use its influence to promote an international monetary system that facilitates the growth of international trade and investment. Whether a fixed or floating regime is optimal is a subject for debate. However, exchange rate volatility such as the world experienced during the 1980s and 1990s creates an environment less conducive to international trade and investment than one with more stable exchange rates. Therefore, it would seem to be in the interests of international business to promote an international monetary system that minimizes volatile exchange rate movements, particularly when those movements are unrelated to long-run economic fundamentals.