Exchange Rate Fluctuations and SMEs

Dr. Cathy L. JabaraU.S. International Trade Commission*

*This presentation represents solely the views of the author and is not meant to represent the views of the U.S. International Trade Commission or any of its Commissioners.

Exchange Rate Uncertainty

• Fluctuation in the exchange rate is one of the uncertainties associated with international trade.

• Foreign exchange risk is the probability that the exchange rate will change unfavorably and adversely affect the financial situation of exporters and importers.

• Exchange rate fluctuations affect both large and small businesses.

How do Exchange Rate Changes Affect Businesses? Short and Long Run Effects

• Fluctuations can impact positively or negatively on a firm’s profits or receipts.

• Assume most companies are risk averse—then it is the possibility of financial losses due to an adverse exchange rate change that is of concern.

• Exchange rate changes have short- and long-run effects on businesses:

Short run:Unanticipated changes in exchange rates affect profits/revenues from specific transactions.

Long run:Sustained long term changes in exchange rates affect the demand for imports and exports by changing the prices of traded goods.

Exchange Rate Fluctuations and Trade: Estimated Impacts?

• Economic studies have generally not found significant adverse impacts on trade flows from fluctuating exchange rates (IMF, 2004). – The exchange rate is just one of many factors that affect

the success of companies in international trade;– Firms have options to mitigate exchange rate volatility,

which are reflected in the aggregate trade statistics.

• Studies based on firms, rather than aggregate trade data, have found larger effects (Dekle and Ryoo, 2007).

Anecdotal Evidence• Japan—large company:

– A Wall Street Journal article from last May noted that Toyota has been struggling with a sustained increase in the value of the yen, which has eroded the value of its dollar-denominated earnings and made its Japanese exports less competitive in foreign markets.

• United States—SMEs:– In a 2011 survey of 300 small U.S. exporting firms, businesses cited such

factors as shipping, logistics, storage costs, insufficient margins of profitability as well as fluctuating exchange rates as top trade barriers.

• Vietnam—SMEs:– Vietnamese businesses importing panels from Malaysia cited financial losses

in 2011 due to a depreciation of the Vietnamese dong relative to the U.S. dollar, the invoicing currency for their imports.

• UK—SMEs:– Over a third (36%) of UK SMEs state currency fluctuations as their top

concern when trading internationally (American Express FX).

Impacts on SMEs

• Few if, any, studies have quantitatively examined the impact of exchange rate volatility on SMEs;

• To understand its potential impact, there is a need for information on:– Nature of exchange rate fluctuations; why

exchange rates are uncertain;– How businesses, large and small, cope with ER

fluctuations;– Special characteristics of SMEs.

Nature and Extent of Exchange Rate Fluctuations

• Exchange rate changes are a source of uncertainty depending on the degree they are unforeseen.

• Unfortunately, economists have not had a lot of success in predicting exchange rates.

• Again we look at the short-run and long-run exchange rate changes:

Exchange Rate Determinants

The demand and supply of currencies is constantly changing as banks,

businesses, and individuals enter the markets.

Exchange rates change by the minute, hour, and day.

Exchange rate changes are correlated with macroeconomic

fundamentals:Productivity, demand, monetary

policies.

Difficult to predict;Much of the fluctuation is random noise;

Demand for international capital is important.

Exchange rates and prices move to equalize “real exchange rates (RER).”The RER measures the cost of goods in one country relative to another.In practice, this adjustment takes a

long time.

Short run Long run

So What is the Fluctuation Businesses are Worried About?

• It depends on the time frame of business decisions.• In the short run, businesses cannot react or adjust

prices, so the nominal exchange rate is the source of ER fluctuations.

• In the long run, both prices and nominal exchange rates adjust, affecting the cost of traded goods across countries—so the real exchange rate is important.

• To the extent businesses recognize relationships between prices and exchange rates, they will lessen their uncertainty around ER fluctuations.

Figure 1 Nominal (ER) and real (RER) dollar exchange rates move together in the short run

1973-02 1975-04 1978-02 1980-04 1983-02 1985-04 1988-02 1990-04 1993-02 1995-04 1998-02 2000-04 2003-02 2005-04 2008-02 2010-04-0.12

-0.1

-0.08

-0.06

-0.04

-0.02

0

0.02

0.04

0.06

0.08

U.S. Dollar RER U.S. Dollar ER

Log

first

diff

eren

ce

Source: Federal Reserve Board. Note: An increase is a dollar depreciation.

Figure 2 Nominal currencies are correlated with prices changes over time (trend in the nominal (ER) and real (RER) dollar vs.

major currencies)

1973-01 1975-03 1978-01 1980-03 1983-01 1985-03 1988-01 1990-03 1993-01 1995-03 1998-01 2000-03 2003-01 2005-03 2008-01 2010-030

20

40

60

80

100

120

140

160

f(x) = 0.06792606555085 x + 102.383095101479R² = 0.0705154035093024

f(x) = 0.218101404455101 x + 89.0767036633961R² = 0.428990376666197

RER Linear (RER) Linear (RER) ER Linear (ER)

Inde

x M

arch

197

3=10

0

Source: Federal Reserve Board

ER Changes and Businesses: Focus on Exporters

• Start with a basic price equation: Pf x Et

= Ph where:

Pf is the selling price (importing country), Et is the nominal exchange rate (per unit of foreign currency);

Ph is the domestic price or cost.

• If Pf is fixed, when the importer’s currency depreciates (Et↓),

actual revenue falls below the expectations of the exporter when converting receipts :

Pf x ↓E t = ↓Ph

Exchange Rates and Exporters

• As new contract prices are negotiated, exporters may have the option to factor in new exchange rates:

↑Ptf x ↓Et

= Pt

h

or Pt

f x ↑ Et

= ↑ Pth

or ↓ Pt

f x ↑ Et

= Pth

• If the importer’s currency depreciates (Et ↓), exporters might raise prices to make up the difference,

• In the event of an appreciation (Et ↑), they might chose to lower contract prices, or capture the difference themselves..

Table 1 Adapting to exchange rate fluctuationsShort run

Medium-to-long run

Hedging strategies: Lock in future exchange rates through forward

contracts; Purchase an option to exchange currency at a

specific rate. Other hedging strategies.

Pricing-to-market: Lower or raise export prices; but Competitive pressures in specific markets may

limit pricing opportunities.

Currency invoicing: Set contracts in the currency of the exporter;

transfers risk to the buyer; Set contracts in a currency that is perceived to

be more stable (vehicle currency).

Adopt globalized strategies:

Purchase inputs from different foreign suppliers; Restructure production to lower costs, including

moving to foreign countries.

Cross Subsidize: Sell into various markets where exchange rate

changes tend to offset each other.

Specialized products: Export niche products with low price elasticity of

demand.Source: Compiled from industry and academic sources.

Challenges to Managing ER Fluctuations• Hedging:

– Hedging leads to additional fixed contract costs.– Prior experience and knowledge. – Typically insufficient or too expensive to address large and long-

term exchange rate shifts.

• Currency-invoicing:– Useful when the exporter’s currency is commonly accepted in

international trade. – Trade between advanced countries is often invoiced in the

exporter's currency, while trade between advanced and developing countries is generally invoiced in the advanced country’s currency .

• Price fluctuations are more easily managed when the firm is a market leader with high-technology products—limits market switching.

United States Korea China* Thailand Canada Australia India Japan

0

20

40

60

80

100

dollar invoice U.S. export share

Source: Jabara, 2010.

Figure 3 The dollar is a common vehicle currency: Dollar export invoicing, various countries,2003-2007 and U.S. share of exports, 2007

*Data are for Chinese exports of textiles only

ER Fluctuations and SMEs

• SMEs face specific constraints in foreign markets.• The USITC (2010) identified such factors as:

– Small size and lack of economies of scale;– Limited access to working capital and export finance,– Limited information on foreign markets,– Limited managerial time, skill, and knowledge.

• High fixed costs of exporting can have a significant impact on the limited financial resources of small firms.

Figure 4 The majority of exports from the United States are by large companies (percent of exports and number of exporters by

company size, United States, 2009 )

Unknown 1-19 20-99 100-499 500+0

10

20

30

40

50

60

70

80

Known export value No. exporters

Company size (employees)

Percent

Source: U.S. Census BureauNote: SME < 500 employees.

SMEs and Exports

• The results for the United States are illustrative of the situation in many other countries.

• The USITC reported that, in various years, SMEs accounted for:– Nearly 36 percent of total merchandise exports for Canada,– 29 percent for Thailand,– 18 percent for Indonesia,– 17 percent for the Philippines, and – 16 percent for Singapore.

• Additionally, SMEs (≤ 500 employees) accounted for 32 percent of U.S. imports in 2009.

Figure 5 The larger the firm, the more export markets (percent U.S. exporters by number of markets and exporters/importers, 2009 )

Source: U.S. Census Bureau

SME Characteristics/ER ChallengesCharacteristic Challenge

Lack of access to finance

Financial constraints:• Limit opportunities to expand exports when the exchange

rate is favorable,• SME’s vulnerable when the exchange rate is unfavorable.• Hedging requires collateral/credit line with banks.• Informal finance may limit hedging opportunities.

Lack of knowledge, skills, management

• Are SME’s aware of hedging opportunities ? • SME’s may not have the resources to track exchange rates

and costs in different markets.

Small scale of production

• Do SME’s have the flexibility to adjust costs and suppliers ?• Selling in only a few markets limits ability to offset ER losses

in one market with gains in another.• Opportunities for global ER strategies more limited.• Exports of “commodity type” products increases

vulnerability to ER fluctuations.

Figure 6 Many SME exporters are wholesalers (percent of SME and large company exports by company type, United States, 2009)

Unknown 1-19 20-99 100-499 500+0

10

20

30

40

50

60

70

80

Manufacturer Wholesaler Other

Company size (no. employees)

percent

Source: Census Bureau

Figure 7 Do SMEs export more “commodity” type products? (percent of chemical manufacturing exports by company size, NAICS

325, and chemical manufacturing as percent of total, United States, 2008)

Basic ch

emicals

Pesticid

es/ferti

lizers

Pharmace

uticals

Other chemica

l man

All chemica

ls0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

45.0

50.0

0-1920-99100-499500+ P

erce

nt

Employees

Source: Department of Commerce

Anecdotal Evidence: SMEs and Hedging

• Deutsche Bundesbank (2008): – Most larger companies hedge exchange rate risks.– Most medium-sized firms do not usually hedge due to lack of

experience.

• New Zealand (2008): – The existence of fixed costs for hedging means that large firms are more

likely to hedge.– Large firms hedge more than small firms, but small firms hedge more

than medium-sized firms.

• United States (2005):– Survey of SME exporters in New Hampshire– Most SME exporters did not hedge (dollar invoiced)– Some U.S. importers billed in foreign currencies: most did not hedge.

Final note

• If small firms are entrepreneurial, and not risk averse, exchange rate volatility could expand trade and provide opportunities for profits from risk taking (IMF, 2004).

Selected Studies

• U.S. International Trade Commission. Small and Medium-Sized Enterprises: U.S. and EU Export Activities, and Barriers and Opportunities Experienced by U.S. Firms, USITC Publication 4169. Washington, DC: USITC, 2010.

• Dekle, Robert, and Heajin H. Ryoo. “Exchange Rate Fluctuations, Financing Constraints, Hedging, and Exports: Evidence from Firm Level Data.” Journal of International Financial Markets, Institutions & Money 17 (2007): 437-451.

• Clark, Peter B., Natalia Tamirisa, Shang-Jin Wei, Azim Sadikov and Li Zeng. “A New Look at Exchange Rate Volatility and Trade Flows.” International Monetary Fund, Occasional Paper 235, 2004.