Exchange Rates Don't Matter
January 29, 2015
Most managers have at one time or another spent hours painstakingly crunching numbers on a financial statement only to discover that the result just doesn't make sense. What went wrong? Was there a typo? Decimal in the wrong place? Often, it just comes down to one fact:
Foreign Currency can really mess up a financial statement. I wrote in my previous essay that the wise manager holds the conflicting notion in his mind that currency both is and is not money (Foreign Currency Is Money... and it's Not Money), and I want to talk now about how to handle currency changes as they occur.
If you’re selling within China, for example, and 80% of your sales are done in Renminbi (RMB, often symbolized as CN¥) and the other 20% is made up of US Dollars ($), European Euros (€), and Japanese Yen (JP¥), then you need to use conversion factors to put everything into your base currency, CN¥ in this example. That doesn’t sound so difficult, but applying it in the real world gets tricky, and because of the complexity, business leaders often jump to simplistic conclusions that lead them in the wrong direction.
Let’s start with the simple math.
- CN¥6.00 = $1.00. So a purchase in China of $200 equals CN¥1,200. Simple.
- Let’s say you booked a sale of 30 pieces with a cost of CN¥40 each, a total purchase of CN¥1,200.
- You wanted to make 25% profit, so you planned to sell it for CN¥1,600. But the customer wanted to pay in US dollars. With an exchange rate of CN¥6.00 = $1.00, the total sale price was $267.00
- You then made the shipment and the customer paid you $267.00, but the exchange rate had changed in the four weeks between sales order and shipment to CN¥5.00 = $1.00. When you exchanged the money, you received only CN¥1,335 from the bank.
CN¥1,335. That stinks. You had planned on getting CN¥1,600, but you only got CN¥1,370 because of the change in exchange rate. Instead of 25% profit, your net profit was only 12%. Yikes!
Exchange rates impact the financial report, both favorably and unfavorably. Anyone doing international transactions must become accustomed to changing currency rates and learn to live with them. Like the weather, we can complain about changing rates, but we cannot do much to affect them.
Now, let’s get to the complexity of changing exchange rates. As currency rates go up and down, your balance sheet results are affected, as we just saw above. But in the long run, currency rates have no effect on your business. None. (Well, almost nothing. See wages below.)
"What? That’s crazy. Either something matters or it doesn’t. It can’t both matter in the short run and not matter in the long run," an old friend once told me. But I disagree, and let me explain. Let’s look at wire and cable as an example, and I want to break out a commodity product, like copper, from the rest of the product cost.
The price of copper remains the same around the globe. It may be $3.00/lb. in the USA, and it will be the same in Europe expressed in Euros (let’s say $1.00 = €1.25, so copper is €2.40/lb. or €5.28/kg), in Japan expressed in Japanese Yen, in England in British Pounds, etc. As the exchange rate moves in Europe, the price of copper on the international market also moves. So as the exchange rate changes from $1.00 = €1.25 to $1.00 = €1.50, you would expect the price of copper in Europe to go down from €2.40/lb. to €2.00/lb. This is exactly what would happen. That means that copper feels cheaper in Europe (the price went down), so all of the European cable manufacturers can buy inexpensive copper and can sell more cable to Americans.
Yes, copper became less expensive to buy in Euros, but no, they cannot sell more to the Americans. The price of copper did not change in the USA—it is still $3.00/lb. But the Americans can sell their products at a lower price in Euros to Europeans. The Europeans have more Euros to purchase American stuff because everything in the USA just got cheaper. A $500 cable which cost €400 just went down to €333. So, for a seller of cable in the USA, many Europeans are purchasing all of the cable capacity. The American seller cannot continue to serve regular customers and the new European customers, too. The selling price slowly increases until it gets to $570 (€380). This is all good, right? The Europeans were paying €400 for the cable, and now they are paying only €380. The Americans were selling the cable at $500, and now they are selling it at $570. Everyone is happy.
No, really nothing changed. It wasn’t just the market driving that pricing change. It was also the cost inputs, like copper, that were driving the change. As demand shifted toward American manufacturers, the price of copper went up. First it was $3.00/lb. and then it slowly went up to $3.60/lb. forcing the American manufacturers to sell their products at a higher price. Meanwhile, the European price of copper went up from €2.00/lb. to €2.40/lb. forcing them to raise their prices in Euros, and returning them to the original market price in the USA--$500. What was originally €400 went down to €333 because of exchange rate, and went back to €380 due to copper. In the long run, things returned to their original costs in spite of the change in currency.
These cost changes are not “straight-line” calculations. There are very many different factors moving simultaneously, and so it is impossible to know how one thing like currency change affects all the other things like pricing, capacity, politics, and market demand. But in the long run, a change of exchange rate balances out pricing across free markets as demand shifts to take advantage of lower costs. In the long run, nothing really changes.
Does that mean nothing is affected? How about the laborer who takes home €1,000/month? As the Euro currency changes from $1.25 to $1.50 per euro, the French auto laborer can purchase more California wine. (Banish the thought!) Even though the price of grapes (think copper) may change, the wage of the American vineyard worker will likely not change in dollars, and so the total cost of California wine will be cheaper in France. So, the exchange rate really did make a difference! Yes, this is true, even over the long run. It is only over the very VERY long run where wage rates balance out.
In fact we are seeing such a re-balancing of total cost happen in China right now where their wages are slowly rising driving up costs and making laborers in other countries look more attractive. Over the very long run even wages find parity. (This assumes all other things remain equal—like markets remain free, wars do not erupt, economies are stable, etc. It is far from reality.)
Exchange rates, just like commodity price changes, affect many other parts of the market. However, there is a fundamental difference between the way we should look at commodities and exchange rates. One of them is local input (exchange rate) and the other a global input (a commodity, copper in this example). Where the change in cost of the copper may drive some customers to drastic changes such as using other commodities; for example using aluminum in power cables rather than copper. The change in the exchange rate does not alter any behavior in the long run (with the exception of labor rates as described above) because the forces across free markets return exchange rates to balance. The global inputs, commodities, force the change of the local inputs, currencies. Exchange rates have little effect, in the long run, on how businesses operate.