Foreign Currency Valuations -- Ups and Downs in International Business

A recent post entitled "US Business Leaders Think Chinese Currency is Unfairly Valued" on the PanAsianBiz blog raised the issue whether the pegging of the Chinese currency to the U.S. dollar hurts or helps the American economy.  The standard argument here is that the renmimbi (RMB) is undervalued relative to what it would be if the currency were left to float freely on open foreign exchange markets, and that this under-valuation allows Chinese goods to trade at cheaper prices in foreign markets giving the Chinese an uncompetitive advantage in the balance of trade.

My own take on this particular issue as outlined in a comment to the PanAsianBiz post is that the wage differential between China and the U.S. is of such a magnitude at present that the indicated change in the value of the RMB would not be sufficient to suddenly cause Chinese goods to trade at a par with goods from the U.S. or other developed markets.  For a more scholarly analysis of the correct valuation of the RMB, you can read the paper published by the Institute for International Economics entitled "Adjusting China's Exchange Rate Policies." 

When it comes to international trade and operations, however, the question does highlight one of the potentially significant variables that must be dealt with that does not present itself so long as your business remains wholly domestic.  The greatest challenge comes when a financial crisis causes the currency of a particular country to be significantly devalued overnight.  If a U.S. company has outstanding sales commitments denominated in the foreign currency, then losses will be in store when those sales are translated into dollars.  In addition, it would be hard for a country exporting to the devalued market to effect and enforce price increases sufficient to offset the change in currency valuation while still remaining price competitive with locally manufactured goods.  This effect can gut a company's entire market share rapidly if the devaluation is severe enough.

On the upside of all this, if the currency in a country or region is increasing in relative value, foreign operations in those countries become increasingly profitable when the earnings are repatriated.  For example, as the Euro was running up in value against the dollar over the past couple of years, the quarterly financial report of more than one American company with significant operations in Europe hit a bright spot as the profits earned in Euros were translated into increasingly more dollars.

Is there a strategy to play these movements in relative currency valuations to mitigate risk and increase returns?   My experience would suggest that unless you are in the foreign exchange business, probably not.   Certainly some companies use hedge strategies in an attempt to smooth out these vicissitudes, but I imagine that if you control for luck, in most cases they are as apt to lose money as gain money as a result.

If a market is strategically advantageous to locate operations, you should locate them there with the understanding that your profits will face tail winds and head winds over time as they return to headquarters.  You may want to consider projections for valuation fluctuations as one of the variables in setting your annual operating plan, but I don't see it being a major driver in the strategic decision regarding the location of the operations in the first instance.   Of course, as part of the due diligence in examining any new market opportunity, whether for a sales investment or a plant location, one should examine whether economic indicators might foretell a major devaluation in the offing, and if so, then that might impact the timing of making the move.

As with everything else in this business, it comes down to understanding the market in which your interested and knowing the ways in which it is similar and the ways in which it is different from your home market in which you are used to operating successfully.