The Importance Of Foreign Exchange Rates

Published Date: 02 Nov 2017

The importance of foreign exchange rates for the Japanese automotive industry

Background and academic context

Research topic

1. Introduction

The Japanese yen has kept appreciating against other major currencies and it hasn’t been this strong against the US dollar since nearly 15 years as it was in September 2012. There were strong concerns that the rapid appreciation of the yen had a negative effect on the Japanese economy, which is strongly dependent on export. It was said that the government should urgently deal with the exchange rate of the yen towards other currencies because Japanese products were becoming less competitive overseas and revenue sent back to Japan were diminished recently. The recent governor of Bank of Japan, Haruhiko Kuroda, took immediate steps towards depreciation of the Japanese currency. According to Reuters, Mr Kuroda said on 15th April 2013 that financial system of Japan is stable and capital markets have been improving. Kuroda emphasised the BOJ's goal is to achieve 2% inflation target within the next two years, if not sooner, and he also said that already some economic indicators are underpinning that this goal is realistic and inflation expectations are starting to pick up.

Such a strong yen as it was at the end of 2012 causes a huge influence on both the business performances of the Japanese companies in the short run and the corporate strategies including the placement of the production base in the medium to long run. The aim of the proposed dissertation is to explain the importance of foreign exchange rate for a country hugely depending on export, focusing on effects of the strengthening Yen on the Japanese automotive industry. The Japanese economy, mostly the automotive industry is strongly depending on export. When a company is so much depending on exports as the automotive industry does in Japan, the role of exchange rate is crucial due to it is one of the key factors that are determining the profitability of the company. According to recent calculations of Bloomberg, which were published on 31st December 2012, "Every one-yen move against the dollar will have 20 billion yen ($232 million) and 35 billion yen impact on Nissan and Toyota’s annual operating profits, respectively, according to the companies." This shows how important the role of exchange rate of this sector is. No wonder that the major Japanese car making companies started to decrease the productivity in Japan and on the other hand increase in other parts of the world. Furthermore Carlos Ghosn, the head of Nissan-Renault group, suggested that Japan takes further monetary steps in order to weaken the currency even more, otherwise Nissan will minimalize the productivity in the country which means making a lot of recent workers unemployed. Truth is, not all firms are volatile to the same extent to exchange rate fluctuations. Mostly it depends on exchange rate risk management of each company. Companies are combining financial hedges and operational hedges in order to minimise their currency exposure. Financial hedges are using foreign exchange derivatives in foreign exchange market in order to decrease currency exposure. Operational hedges are tools used among the international subsidiaries of the company in order to decrease currency exposure. Companies can use financial hedging strategies such as forward, currency swap and currency option however these can only cover a part of the earnings in yen in a given period but they are not entirely capable of avoiding the effect of the appreciation of the yen. Since 1995 as a reaction on the strong appreciation of the yen, Japanese companies started to increase their overseas production and started to import even the components from overseas in order to increase profitability. One of the main reasons why strong yen against US dollar could cause economic and political issues in Japan is that the majority of Japanese firms decided to invoice the exported goods in US dollars. If the yen is getting stronger the overseas sales income of those companies decreases by converting the earnings in US dollars into yen. In case the firms would choose to invoice the exported goods in yen, then they would not be affected by the fluctuation of the yen in the short run. However it has to be mentioned the invoicing currency is always chosen by the given firm and they make that decision based on what would be the best for exchange rate risk management purposes.

Some companies might make price revisions according to foreign exchange fluctuations to simply pass on the changes in exchange rate to the customers however quick changes in prices are not really feasible in case of companies in the automotive industry.

Literature review

Effect of Japan establishing free trade agreement with US

McAlinden and Chen (2012) states that in addition to currency intervention there are other measures recently called by Japanese automobile executives to reverse the effects of the high yen. One of these measures for Japan is to enter more free trade agreements (FTAs) with markets that would eliminate tariffs on Japanese automotive imports. If the tariff rates on Japanese automotive products would decrease, their profit margins would increase since tariffs are assessed by customs officials on declared values in the import market. The effect of such tariff reductions almost always results an increase in exports of the products subject to tariff reversal. Free trade agreement is made by a number of states that implement little or no price control in any form of tariffs or quotas between each other. Nations that have been bounded together in FTAs can focus on their competitive advantage and they can also trade those goods freely that they lack the experience at making, and it also allows them to increase the efficiency and profitability of the country.

Choice of Japanese companies in invoicing currency regarding exports

"Importer currency invoicing is prevalent in Japanese exports to advanced countries because most of their exports are destined to local subsidiaries that face severe competition in local markets. In this case, Japanese parent firms have a strong tendency to take exchange-rate risk by invoicing in the importer’s currency, which is consistent with the pricing-to-market behaviour discussed in the literature. It also makes economic sense to concentrate currency risk at the headquarters, since it is better equipped with risk management expertise and with scale economies." (Takatoshi Ito, et al., 2010)

Japanese companies which export products that are highly differentiated or have a significant share on the global markets usually choose yen invoicing even if they export to developed countries.

Although a lot of Japanese companies have moved their production lines to Asian countries and they would still issue the invoices in dollars in case the final destination market is the United States even from these Asian bases. The Japanese companies shift currency risk from those subsidiaries in Asia to the headquarters for the currency risk management to be more efficient by invoicing exports to the Asian subsidiaries in dollars.

The Variety of Exchange Rate Risk Management

Hedging

Foreign exchange risk management has been examined in a number of researches to find out how firms deal with it. There are two existing ways of hedging the risk of exchange rate, namely financial and operational hedging. Financial hedging is using different financial market instruments as for instance foreign currency debt or exchange rate derivatives. In contrast by operational hedging the exporting firm is changing the operational setup to decrease the risk. The two ways of hedging should’t be separated, on the contrary operational hedges should be built besides to financial hedges, which are the most frequently used ones, for a firm to manage its long term foreign exchange rate risks. There are many studies dealing with currency hedging show how these strategies are working effectively together. One of them is the study of Pantzalis, Simkins, and Laux which was posted in the Journal of International Business Studies in 2001. The authors used a sample of 220 American Multi-National Companies and found that in managing currency risk the two hedging strategies are complementary. In a different study Allayannis, Ihrig and Weston (2001) are also looking at the different strategies of Multi-National Companies regarding exchange rate risk management and they state that shareholders benefit from operational hedging exclusively in the case when it is being combined with financial hedging. However there are different opinions as well among which for example Kim, Mathur and Nam (2006) examine whether operational hedging is a substitute for or a complement to financial hedging and they find that the two strategies are complementary but it is mentioned that companies are depending less on financial derivatives in case they are using operational hedging strategies. An interesting aspect of hedging is being investigated by Döhring (2008). He looked at how the hedging strategies relate to invoicing currency. The survey study shows that derivative hedging including exchange rate forward could be substituted by correct choice of invoicing in order to eliminate transaction risk and companies could choose one of them considering the relative cost regarding these strategies. Döhring (2008) makes the conclusion based on a survey examining hedging techniques of huge companies from euro-area that hedging and domestic currency invoicing could be either complements or substitutes. It is a question of the size of the company, where it is located and where it is exporting to. Bartram, Brown and Minton (2010) examined how does hedging relate to pass-through and their study shows that companies do pass-through some currency changes to their customers and what’s left of foreign exchange exposure is being hedged by using both financial and operational strategies. It is assumed that the usage of both hedging and pricing strategies can reduce the impact of exchange rate fluctuations. A sample of 1,150 manufacturing firms in 16 countries is being used demonstrate that the impact could be reduced by 10-15% due to operational hedging and pass-through moreover a reduction of 40% could be reached by proper financial hedging. In their study Chiand and Lin (2007) were examining non-financial companies in Taiwan in the period of 1998-2005 and their findings show that operational hedging is not successful in reducing foreign exchange exposures in the sample they used, furthermore foreign currency derivatives are being effective in a one-month horizon, but not when the horizon lengthens. The study of Pramborg (2005) contrasts hedging strategies of Swedish and Korean nonfinancial firms and concludes that both sample groups hedged nearly the same amount only using different ways to do so. Korean firms preferred foreign debt while Swedish ones mostly used derivatives. They relate the findings about Korean firms not using derivatives with the immature derivative market in Korea.

FDI

Foreign direct investment plays a hugely important role in the global economy. Multi-national companies are taking advantage of FDI in many ways. Investing in a foreign country can significantly decrease for instance the exchange rate risk and lower the production costs which are crucial for every firm. Japanese automotive companies became also highly motivated in investing in a foreign country due to the recent appreciation of the Yen. A country with depreciating currency is mostly an attracting option for MNCs except if that given currency is volatile and shows huge fluctuations during a short period of time. Japanese car manufacturing firms are investing in developing countries so they can decrease the cost of the parts and finished products produced. The main targets for these movements are Taiwan, Hong Kong and China. In these countries the companies can establish their factories cheaper than in developed ones and the cost of labour is also much lower compared to others. The research of Deseanticov and Akiba (2009) also points out that the level of labour skill is not important for Japanese MNCs which mean that they are looking for cheap and relatively unskilled labour compared to the Japanese manpower. Investments in developed countries like the United States or the United Kingdom are mainly driven by the elimination of exchange rate risk. Companies are trying to increase the production in those countries where there have relatively high sales due to when they transfer the cost of assembly place there the revenues from sales are generated then a significant proportion of foreign exchange risk is eliminated.

The impact of exchange rate risk on exporting firms

Exchange rate risk is being categorised in the literature in different ways. According to Döhring (2008) a broad agreement still exists according to which the relevant categories are the following: I) certain versus uncertain transactions, II) long run versus short run and III) risks concerning the value of cash flows versus risk concerning the valuation of assets.

Transaction risk means basically the effect of changes in exchange rate regarding the value of cash flows that will occur in the future, however the nominal value of them is already known. These usually mean receivables from export or payables from import, contracts and restitution of dividends. Mostly, the time frame for these transactions is rather short. Although sometimes it may happen that it takes several years as well, in case the deliveries are about to take place at a further point in time (e.g. building contracts).

Economic risk means the effect of changes in exchange rate regarding the present value of uncertain future cash flows. It includes the effect of exchange rate deviation on future revenues and expenses over both deviations in volume and price.

Translation risk means the effect of changes in exchange rate regarding the valuation of foreign assets and liabilities on the consolidated balance sheet of a MNC. Translation risk is mostly been measured as the difference between net foreign assets and net foreign liabilities.

Transaction and economic risk could be put into the example of a Japanese car manufacturer. Transaction risk would mean for instance an order received today for a shipment of cars to the US payable in four months. Both the quantity and the US-dollar price are defined already today. The transaction risk only concerns the euro value of the dollar payment in three months.