With the global economy experiencing some very unusual developments, I would like to put on my basic economics hat and convey to you what I think is happening in the global economy and how to use simple foreign exchange risk strategies. But first, let me mention a little about the euro and dollar currency exchange rates.
As you all have most likely heard, the euro and the dollar are now virtually at a one-to-one exchange rate. The last time this happened was about 20 years ago and in essence it means that the European and American economies are valued at almost the same amount.
A currency’s exchange rate can be a reflection of its economic power, and for quite some time now Western and Central Europe’s prospects for economic prosperity have been fading. Without question, higher energy prices and record inflation are mostly to blame. Europe is far more dependent on Russian oil and natural gas than the U.S. to keep their industries operating and to generate electricity. Russia’s war on Ukraine has led to a loss of Russian oil on global markets, which have pushed oil prices higher. In addition, Russia has been cutting back natural gas supplies to the European Union as retaliation for sanctions and weapons deliveries to Ukraine. European governments are making plans to ration natural gas to industries like steel, glassmaking, and agriculture if Russia further reduces or shuts off the gas taps completely. If the war in Ukraine is not over by late fall, as temperatures drop, the European consumer will most likely be paying exorbitantly to stay warm during the winter months.
Furthermore, energy prices have driven up the eurozone inflation rate to a record 8.6% in June, making everything from groceries to utility bills more expensive. This is still however a tad lower that the 9.1% inflation rate in the U.S., our highest rate since November of 1981.
Moreover, as our own federal government raises interest rates, the rates on interest-bearing investments tend to rise as well. If the Fed raises rates more than the European Central Bank, higher interest returns will attract investor money from euros into dollar-denominated investments. Those investors will have to sell euros and buy dollars to buy those holdings, which drives the euro further down and the dollar up.
So, who are the winners and losers in this euro to dollar currency exchange parity?
American tourists in Europe will definitely find traveling to Europe to be a bargain at this time. The stronger dollar will give the American traveler more euros and make hotels, restaurants, and venues significantly cheaper.
The weaker euro could also make European export goods more competitive in the U.S. market. A weaker euro means lower prices on imported goods, which includes cars, computers, medical equipment, and machinery. All of this could help to ease inflation.
Conversely, American companies that do a lot of business in Europe will see their revenue from those businesses shrink when and if they bring those earnings back to the U.S. However, if earnings in euros remain in Europe to cover costs there, the exchange rate becomes much less of an issue.
A key worry for the U.S. is that a stronger dollar makes U.S. made products more expensive in overseas markets, widening the trade deficit and reducing economic output, while giving foreign products and their companies a price edge in the United States. This all comes down to which party will do the currency buying and take on the foreign exchange risk.
Foreign exchange (FX) is a risk that is often overlooked by small and medium-sized enterprises (SMEs) that wish to enter, grow, and succeed in the global market place. Although most U.S. SME exporters prefer to sell in U.S. dollars, foreign buyers in the eurozone who are creditworthy are increasingly demanding to pay in euros.
Depending on whether the sale is denominated in the buyer’s or seller’s currency (or even a third country’s currency), the buyer or seller may incur additional costs if the value of the two currencies changes between the time the goods are sold and the time the goods are paid. For this reason, a decision to accept payment in a foreign currency can harm the seller’s profit margin if the movement of the currency is in the wrong direction.
There are a two fairly safe and simple strategies available to all exporters that will help to eliminate or minimize the FX risk as follows:
1) Quote, sell and get paid in U.S. dollars
The simplest way for any U.S. exporter to avoid a foreign exchange risk is to quote foreign customers in U.S. dollars and require payment in U.S. dollars. In this way, all the risks associated with fluctuations in foreign-exchange rates are borne by the foreign entity.
2) Non-Hedging FX Risk Management Techniques
The exporter can avoid FX exposure by using this simple non-hedging technique, which is to price the sale in a foreign currency. The exporter can request cash in advance and the current spot market rate will determine the U.S. dollar value of the foreign proceeds. A spot transaction is when the exporter and the importer agree to pay using that day’s exchange rate and settle invoices within two business days.
Another non-hedging technique is to net out foreign currency receipts with foreign currency expenditures. For example, a U.S. exporter who exports in euros to a buyer in Europe may want to purchase supplies in euros from a different European trading partner. If the company’s export and import transactions within the eurozone are comparable in value, the FX risk between the two transactions will be offset. The risk is further reduced if those euro-denominated export and import transactions are conducted on a frequent basis.
There are a few other FX strategies that involve understanding how to hedge your sales through the FX options market which require a great deal of experience and expertise, but for most credit professionals, I believe the above two strategies will definitely get you started.
From my humble perch, I hope the above has been helpful to you in understanding our current global economy.
Your questions and comments are most welcome (email@example.com).
Nancy Seiverd, President, CMI Credit Mediators, Inc.