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How Exchange Rates Affect Business and You

Recently, a headline on page one of the Wall Street Journal read, “U.S. Stands By as Dollar Falls.” In that same issue, there was an editorial entitled “The Dollar Adrift.” However, the headline for an article in BusinessWeek less than a year earlier stated, “What’s Driving Up the Dollar.” So is the dollar going up or going down? What difference does it make anyway? And how will the venerable U.S. dollar fare in the future?

In the next few pages, I’ll discuss: (1) how the value of the dollar affects you, (2) what drives the value of the dollar and other currencies, (3) what the global financial crisis has taught us about the dollar and other currencies, and (4) where the dollar goes from here.

The Dollar and You 

If you’ve ever traveled abroad after the U.S. dollar has fallen in value, you can immediately see the impact as your vacation is suddenly more expensive. Of course, that scenario assumes you are traveling from the United States to a foreign country. The opposite would be true if you are a European traveling to the United States. An exchange rate is nothing more than the price of a currency, just like any other asset. Foreign currency is any currency other than your own, and its value is usually based on supply and demand. 

Let’s say you’re in London and are going to buy some chocolate. You either change money (cash, traveler’s checks, or an ATM withdrawal), or you use your credit card and let the credit card company take care of the conversion from dollars to pounds. When you use your credit cards, you really don’t know what the exchange rate will be until you get the credit card bill or go online to check out the exchange rate for the transaction. 

Businesses have the same issue. If a U.S. company exports goods and services when the dollar is falling, it is likely to sell more products because it takes less foreign currency to get U.S. dollars to pay for the goods. That is why a weak dollar is good for exporters but horrible for importers. If a company imports a BMW from Germany when the dollar is weak, it takes more dollars to buy the euros to pay for the car, so the car is more expensive. If the prices rise fast enough and high enough, consumers might avoid buying expensive imports. Of course, if a U.S. company imports parts and components from countries whose currency is rising against the dollar—something very likely in today’s global supply chain—the imports are more expensive, so costs rise. 

However, life is more complicated with U.S. companies that have foreign operations. Not only do they have to worry about exports and imports, but they also have to worry about earnings from foreign operations. When the dollar is falling, the earnings from their foreign operations are worth more, so the company looks like it’s doing well. On the other hand, when the dollar is rising, their earnings from foreign operations are worth fewer dollars, so it looks like the company is doing poorly. 

The same is true for multinational corporations worldwide. Sony, the Japanese consumer electronics company, illustrates how exchange rates can affect the bottom line. In 2008 when the Japanese yen was rising against the dollar, Sony generated 23.2 percent of its revenues in Japan, 25.1 percent in the United States, 26.2 percent in Europe, and 25.5 percent elsewhere. 

During the global financial crisis, Sony was hurt in three ways. First, the slowdown in the global economy meant that demand fell dramatically, reducing revenues and profits. Second, the strong Japanese yen made Sony’s exports even more expensive, also reducing demand for exports, which caused sales and earnings to fall. Finally, earnings from Sony’s U.S. and European operations were lower due to the weaker dollar and euro. Other Japanese firms had the same problem. In January 2009 Toyota estimated that every time the yen rises by one yen against the dollar, its annual operating profit is cut by 40 billion yen, about $433 million.

A weak dollar can really complicate life for foreign exporters selling in the United States. For example, assume Sony wants to sell a new 54-inch plasma TV in the United States for about $1,200, or 120,000 yen, when the exchange rate is 100 yen per dollar. Also assume that the export value of the TV from Japan to the United States is $600 (60,000 yen at 100 yen per dollar). But if the yen rises to 90 yen per dollar, what are Sony’s options? One option would be to pass on the rise in the exchange rate to the U.S. consumer. The new imported cost would be $666.67 (60,000/90), so Sony could pass on the $66.67 to the consumer and raise the price of the TV to $1,266.67. But the higher price could reduce demand for the product. Another option would be to sell the TV at the targeted price of $1,200 and accept a lower profit margin.

What Drives the Dollar 

First, it is important to understand that the U.S. dollar is one of many currencies, such as the euro and the yen, that is freely floating. That means that a drop in supply or rise in demand for the dollar will cause the dollar to strengthen. The opposite happens with a rise in supply or drop in demand for the dollar. This happens through both the flow of trade and of capital. The key for a freely floating currency is that it is convertible into other currencies with few, if any, restrictions. 

Many other currencies, however, are not freely floating and may not be freely convertible. An example of such a currency is the Chinese yuan. The Chinese government does not let the currency float but instead ties its value primarily, but not exclusively, to the U.S. dollar. Many experts believe that if the yuan floated freely, it would rise dramatically against the dollar and the euro, which would choke off China’s exports and result in a significant slowdown in its economy. 

Some countries whose currencies freely float, such as South Korea and Thailand, intervene in the markets to stabilize the value of their currencies. This is especially true when the dollar falls, because a relatively weak dollar would severely damage their export-driven economies. Thus their central banks go into the foreign exchange markets and use their foreign exchange reserves to sell their currencies and buy dollars to try to strengthen the dollar (by increasing demand for the dollar) and weaken their currencies (by increasing the supply of their currencies). 

The problem is that about $5 trillion in foreign currencies trade hands every day, and it is hard for a central bank to have that much influence in the market. But sometimes the signal from the central bank is enough to get traders to move in the direction the bank wants the market to go.

There are many factors that influence the value of currencies, some of which will be discussed in the context of the global financial crisis. But the fundamental, long-term value of a currency is based on inflation. Why is that the case? The exchange rate between two currencies is largely determined by changes in relative inflation between the countries. 

If U.S. inflation, for example, is expected to rise relative to inflation in the European Union, the dollar will weaken against the euro. That happens because over time U.S. goods and services would be too expensive relative to their European counterparts, the demand for U.S. goods and services would fall, and the demand for European goods and services would rise, resulting in a drop in the value of the dollar versus the euro. 

A humorous illustration of this concept is the Big Mac Index, or the “hamburger standard,” published every year by The Economist. On 30 January 2009 when the exchange rate between the U.S. dollar and the Chinese yuan was ¥6.84 per dollar, a Big Mac was selling in the United States for $3.54 and in China for ¥12.5 (or about $1.83). If you divide the price of the Big Mac in yuan by the price in dollars (12.5/3.54), the exchange rate should be ¥3.53, meaning that the yuan was undervalued by 48 percent. Of course, the Big Mac index uses only one product to illustrate purchasing power differences, but the expectation is that long-term a country cannot sustain a relatively high rate of inflation compared to its trading partners without seeing its currency lose value.

Interest rates can also influence exchange rates. The interest rate you see quoted by banks is known as the nominal rate, and we know that the nominal interest rate is influenced by inflation, especially inflationary expectations. On a short-term basis, interest rates are important drivers of exchange rates. A country’s central bank is responsible for interest rate policy, and two important central banks are the Federal Reserve in the United States and the European Central Bank in the European Union. Both are responsible for monetary policy in their respective areas and closely watch inflation and unemployment as key indicators for setting policy. In addition, they examine each other’s interest rate policies and those in the rest of the world. 

For example, if the European Central Bank were more concerned about inflationary expectations than unemployment, it would establish a restrictive monetary policy, which would drive up interest rates. If the Federal Reserve were more concerned about unemployment, it would pursue an expansionary monetary policy, which would drive down interest rates. Thus if interest rates went up in Europe and down in the United States, investors would be inclined to invest in Europe in the short-term, where they could generate higher returns than in the United States. This increased demand for euros would cause the euro to rise in value against the dollar. 

A good example of this occurred in October 2009 when nominal interest rates around the world were very low due to the global financial crisis. The Australian Central Bank was more concerned about inflationary expectations than economic growth since Australia had not been affected by the global financial crisis as much as the United States and Europe. So it decided to increase interest rates before the central banks of other major countries. As a result, the Australian dollar soared in value against the euro and the U.S. dollar.

Long-term interest rates, however, are often good indicators of the future direction of exchange rates. The nominal interest rate is the real interest rate plus inflationary expectations. If inflation was zero, the nominal and real interest rates would be the same. As inflation is introduced, however, the nominal interest rate rises so that it reflects the real interest rate plus inflation. For example, if the real interest rate were 2 percent and the rate of inflation 5 percent, the nominal interest rate would be 7 percent. If you were to compare interest rates around the world, you might assume that the countries with the highest long-term interest rates would also have the highest inflationary expectations. However, countries with the highest inflation will eventually find their exports dropping and their imports rising, which will cause their exchange rates to fall in value. 

It is not easy to predict exchange rates, especially in the short-term. Markets not only react to economic fundamentals such as inflation but also to news releases. When the announcement came in December 2009 that state-controlled investment firm Dubai World wanted to reschedule payments on around $26 billion in debt, the U.S. dollar initially jumped against the euro since most experts felt that European financial institutions were more exposed.

Even something as simple as the release of earnings reports by U.S. companies can affect the value of the dollar. In the fourth quarter of 2009, many analysts were expecting good earnings reports by U.S. companies, which put downward pressure on the dollar. Why? Because that was a sign that the global economy was recovering and that investors were more willing to put money into the stock market instead of investing in dollars.

The Financial Crisis and the Dollar 

The collapse of the housing market in the United States created a crisis in confidence in the global economy. After Lehman Brothers filed for bankruptcy on 15 September 2008, the global financial markets came unglued. The Dow Jones Industrial Average dropped by 500 points, followed by an even bigger drop on 29 September. Stock markets around the world went into a free fall. How did that affect the dollar? 

Even though the crisis began in the United States, which seemed to shoulder the blame for the crisis worldwide, the dollar actually rose against every other major currency except the Japanese yen—even against the euro. As the crisis unfolded, the dollar became a safe-haven currency. That has happened before during global political crises, and now it happened during an economic crisis. Investors were fleeing to safety, and that meant U.S. Treasury bonds. Money came in from all over the world. 

Investors pulled money out of the emerging markets, even though they didn’t seem to have the same housing and credit problems as the United States. The euro fell, as did the Brazilian real, the Russian ruble, and the Indian rupee. The Japanese yen was the one major exception, rising against the dollar due to what is called “carry trade.” Japanese investors who had put their money into emerging markets pulled the money back home, raising the value of the yen.

As long as the global economy was in question, the dollar remained strong. But 2009 was an up and down year. When the global economy began to recover, investors cautiously left the safety of the dollar and regained their appetite for risk. Risk meant emerging markets and stock markets. As the U.S. stock market began to recover, so did the euro. We learned an interesting lesson in the process. The euro, which is one of the most traded currencies in the world, is not considered to be a safe-haven currency but one that responds to risk. The recovery of the global economy and the stock market also saw capital flowing back into the emerging markets. 

Brazil is flying high again, and their currency, the real, rose 25 percent against the dollar in 2009, the largest rise of any major currency in the world. In fact, one is hard pressed to find any major currency that has fallen against the dollar. The Chinese yuan has remained unchanged against the dollar, in spite of having the largest foreign exchange reserves in the world, strong economic growth, and a massive trade surplus. 

What’s Next?

It is clear that the dollar is in trouble, but as with most economic questions, it’s hard to predict the future. What is clear is that as the global economy continues to recover, the dollar is likely to remain weak. High unemployment means that interest rates will stay low relative to those in Europe and some other areas, so there will be no incentive to buy dollars given their relatively anemic return. Money will flow into the stock market, which is good for the U.S. economy. 

However, looming on the horizon is inflation, driving the fear about the future of the dollar. The massive federal stimulus package and potential future impact on the U.S. budget deficit and federal debt could lead to significantly higher inflation, which could weaken the dollar. As the U.S. Federal Reserve shifts its focus from stimulus to inflation fighting, interest rates will rise, and the dollar will regain some of its allure. 

One advantage of a weak dollar is that U.S. exporters should see a greater demand for U.S. goods, which should reduce the trade deficit and help create U.S. jobs. The weak dollar should also make imports more expensive. Although most imported commodities are priced in dollars, their prices could rise as the global economy recovers and demand for commodities rises as well. 

Whether you’re shopping abroad, purchasing a television made in Japan, or waiting in line to buy a burger, you’re affected by the mix of variables that results in the dollar’s strength. And with inflation looming in the future, the dollar’s stability may further fluctuate. Being aware of these factors can help you make wise consumer decisions no matter where you are. 

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Article written by Lee Radebaugh

About the Author
Lee Radebaugh is a Marriott School accounting professor and director of the Whitmore Global Management Center/CIBER.