Incoterms 2010 and International Business - 101
International Business: Environments and Operations, 15e (Daniels et al.)
CHAPTER NINE: THE DETERMINATION OF EXCHANGE RATES
CHAPTER NINE: THE DETERMINATION OF EXCHANGE RATES
OPENING CASE: El Salvador Adopts the U.S. Dollar
[See Map 9.1]
This case describes El Salvador’s move toward dollarization. In 1994, El Salvador pegged its currency, the colon, to the U.S. dollar. In 2001, the government decided to do away with the colon and adopt the dollar as the country’s official currency. This was done because of the close ties El Salvador had to the U.S. economy. At the time of dollarization, over two-thirds of El Salvador’s exports went to the United States. In addition, over 2 million Salvadoreans living in the United States wired home nearly $2 billion a year to relatives. After dollarization, the government and companies in El Salvador were able to get access to cheaper interest rates due to the decreased risk of currency devaluation. Consumers were also able to get lower interest rates and easier access to credit. Ecuador also dollarized its economy in 2000 to control hyperinflation. Dollarization has had some negative effects for El Salvador. The currencies of many of its neighbors have devalued against the dollar, giving those countries a competitive advantage in exporting to the United States and other markets. This has forced many companies in El Salvador to abandon low-end business and develop more advantages based on flexibility, quality, and design.
Questions
9-1 Given the success in El Salvador, do you think the other countries in CAFTA-DR should adopt the U.S. dollar as their currency? Why or why not?
One of the main advantages of adopting of a strong foreign currency as sole legal tender is to reduce the transaction costs of trade among countries using the same currency. Countries with full currency substitution economies can invoke greater confidence among international investors, inducing increased investments and growth. The elimination of the currency crisis risk due to full currency substitution leads to a reduction of country risk premiums and then to lower interest rates. These effects result in a higher level of investment. Official currency substitution helps to promote fiscal and monetary discipline and thus greater macroeconomic stability and lower inflation rates, to lower real exchange rate volatility, and possibly to deepen the financial system. (LO: 2, Learning Outcome: To discuss the major exchange rate arrangements that countries use, AACSB: Dynamics of the Global Economy)
9-2 In Chapter 7, we mentioned that Mexico and Canada have kept their own currency, even though they are partnered with the U.S. in NAFTA. Why do you think they have decided not to adopt the U.S. dollar as their currency, even though El Salvador and Ecuador, who are not members of NAFTA, have adopted the dollar as their currency?
The USD is a currency with a lot of “baggage.” It’s an international reserve currency, which means a lot of governments keep supplies of it, and a lot of commodities are priced in it. In the past, this has boosted the U.S. economy, since other people have been willing to trade goods and services to the U.S. in exchange for money that the U.S. government just prints. This boost also comes with a price in that there are big stores of USD around the world, and if other countries suddenly decide those reserves are not worth keeping, they can flood the market with USD, devaluing the currency at will. In summary, the U.S. benefits from other countries’ faith in the USD but also needs to go out of its way to maintain that faith or there are serious consequences. In contrast, the CAD is not a major reserve currency. Canada does not get that “reserve currency boost” in its economy, but also doesn’t have to answer to the rest of the world as much. And I think the Canadian people prefer it that way. Certainly the last decade has seen a substantially more fiscally prudent Canada compared to the U.S., and I doubt that Canadians would want to have their monetary policy pushed in the U.S.’ direction as a common currency would warrant. Another important argument is that under a common currency regime, Canada would be overwhelmingly dominated by the United States. Inevitably, Canada would lose a substantial degree of control over its monetary policy.
With reference to Mexico, due to their reliance on the U.S. as a destination for exports, adopting the dollar would decrease exchange rate risk, associated with trade and investment. Manufacturers and investors would not have to worry about the peso appreciating or depreciating. However, as exchange rate uncertainty decreases, the rate of imports from the U.S. increases, which will then place pressure on import-competing industries, like automobiles and electronics. (LO: 2, Learning Outcome: To discuss the major exchange rate arrangements that countries use, AACSB: Dynamics of the Global Economy)
CLOSING CASE: Welcome to the World of Sony – Unless the Yen Keeps Rising
This case reviews the impact of the yen on Japan’s Sony. In Sony’s early years (1946-1970), they had the luxury of operating with a weak yen. They also received support from the government and expanded rapidly. This era was followed by the First Endaka (“high yen”). This period (1970-1993) saw the yen very strong against the dollar due to a weak U.S. economy, the Persian Gulf War, a rise in interest rates in Japan, and lack of agreement on the condition of the yen among the G8. A Second Endaka hit in1995. Japanese companies were having trouble remaining competitive and cut costs to do so. The Japanese economy was in recession and the Bank of Japan dropped interest rates, which reduced the value of the yen. Although Sony continued to innovate during these decades, competition from Korean companies, like Samsung and LG, heated up. During the economic crisis, the yen became a safe-haven currency. Sony continues to be geographically diversified and take advantage of production outside of Japan. With the strong yen, Sony’s financial statements were negatively impacted and competition continued. Sony has lots of strengths but continues to face challenges.
Questions
9-3 What were the major factors that led to the drop in Sony’s exports from Japan?
The strong yen caused Sony’s products to be more costly in the world market. When the interest rates were higher in the U.S., investors moved money out of Japan into dollars. The strong yen impacted all exports from Japan but made imports cheaper. Sony responded by moving production to other countries and reducing costs. (LO: 5, Learning Outcome: To show how managers try to forecast exchange-rate movements, AACSB: Dynamics of the Global Economy)
9-4 In what other ways has the strong yen affected Sony’s bottom line? What would be the effect of a weak yen?
A weak yen would have the reverse effect and make Sony’s products more price competitive on the international market. Sony’s need to translate dollars or euros into yen drags down net assets and earnings, reducing Sony’s consolidated results. When Sony’s foreign operations remit dividends back to Japan, they are worth less when converted to yen. (LO: 6, Learning Outcome: To explain how exchange-rate movements influence business decisions, AACSB: Analytical Skills)
9-5 Given the instability in the currency markets, why do you think it is important for Sony to manufacture more products in the United States and Europe and to also buy more from suppliers in other countries in Asia?
When Sony operates in markets where they manufacture, they not only can reduce transportation costs but operate in the same currency. This strategy not only reduces costs but improves margin. Other Asian suppliers also help the bottom line by sourcing components at a cheaper cost. This will be particularly important as Sony faces tough competition from lower-priced competitors such as Samsung. (LO: 5, Learning Outcome: To show how managers try to forecast exchange-rate movements, AACSB: Analytical Skills)
9-6 What are the major forces that affected the Japanese yen over the years? What factors do you think are important to monitor as you try to forecast what will happen to the value of the yen in the future?
The world economy, particularly the U.S. economy, impacts the strength or weakness of the yen. The period between 1970 and 1993 saw the yen very strong against the dollar due to a weak U.S. economy, the Persian Gulf War, a rise in interest rates in Japan and lack of agreement on the condition of the yen among the G8. Also, internal fears of inflation and government intervention have a direct impact on the value of the yen. Initially, during the economic crisis, the yen became a safe-haven currency which benefited the exchange against the euro. Investors also left the emerging markets and returned to Japan, giving strength to the yen. Economic recovery is still very slow and many did not see improvement until the second half of 2010. The yen is still one of the major currencies globally and will remain so in the foreseeable future. (LO: 4, Learning Outcome: To identify the major determinants of exchange rates, AACSB: Dynamics of the Global Economy)
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