Right now it’s no secret that selling merchandise to Americans is pretty lucrative. We also know that it hasn’t always been this way. A relative of mine who sells lighting products to customers the U.S. is a case in point.
My brother-in-law built a very successful business with his wife from the ground up. Their decision to sell to markets in the US worked fine, but the real boost to sales occurred when their son joined the business and talked them into selling on the Internet. Online sales boomed, but of course so did their company’s vulnerability to exchange rate risk.
A few years ago, he was struggling to make his usual margins (which are not that big at the best of times) when the CAD/USD exchange rate approached par. In other words, a C$ was pretty much equal to the US$. Cross-border shoppers from the Canadian side of the border were in heaven (myself included), whereas exporters were beginning to panic. After all, their costs were still in Canadian dollars, which was an advantage when they received sales revenue in a much stronger $US. Converting back into Canadian currency provided a substantial bonus to their profits and quality of life.
Things are great once again, but how can a smaller business owner(s) plan ahead to make sure that currency risk doesn’t threaten their livelihood?
The graph below illustrates the impact currency can have on a business. Imagine a fictional Canadian company that began selling a specialty cheese to the U.S. marketplace in June of 2006. The sale price stays the same (due to competitive pressures) at US$ 2.50. Costs are steady in C$ 1.98 range. Sales made in US dollars must be converted back to Canadian dollars.
It is easy to see how just the exchange rate can wreak havoc on a businesses revenues and profitability. Is it possible to anticipate or prevent this volatility? When companies are accustomed to very large orders, it is possible to contact your bank and make arrangements to use the currency forward markets in order to ‘hedge’ your profits. For instance, if one expects to have to convert a significant amount of foreign currency into one’s domestic currency once the order is delivered, you can arrange to lock in the forward exchange rate today, thereby knowing exactly what your margin is (and will be).
However, the orders for most small businesses aren’t large enough to make hedging a viable option. Can you plan for currency fluctuations? Experts agree that there is no robust way to forecast exchange rates. Experts have been frustrated trying to predict exchange rates for years, and the forward markets/futures markets are not very good predictors of the exchange rate that will actually occur in 3 to six months.
One approach that has been around (seems like forever) is the purchasing power parity theory. The price of a consumer product (same materials, can be sourced locally or at same prices) should be the same in different countries, once adjusting for the exchange rate. Below, the table compares the price of the rather ubiquitous iPhone in Canada, Europe and Asia. The price of the iPhone 6s 16GB (unlocked) in the U.S. is about $699, and should be more or less the same in Nanjing, China (their currency (is the remninbi or RMB) adjusting for the exchange rate as it is in Berlin Germany (euros). As you can see from the table, this is not the case (the prices and exchange rates are not 100% accurate due to rounding).
Because Germans and the Chinese have to pay an even bigger price, it suggests the the USD is overvalued relative to those currencies. The Canadian dollar on the other hand, based on this overly simple approach is actually still a bit overvalued compared to our neighbour to the south even at these depressed levels. Of course, our proximity to the US might simply give Canadians a great deal on iPhones not available in other countries.
We should therefore expect the USD to depreciate relative to both the EUR and RMB in due course – the forces of supply and demand (for products, services and therefore currencies) should cause disparate prices to equilibrate. The mobile device in theory should cost the same to the consumer no matter where he/she lives. Should the USD decline significantly (perhaps even compared to the Canadian dollar) then the margin on good and services businesses in those countries are earning today with decline.
The problem, is that historically purchasing power parity is also a poor predictor of exchange rates. The game of international finance is extremely complex. Not only are exchange rates determined by differing interest rates in countries, balance of payments, trade balance, inflation rates and perceived country risks, the rates are also influenced by expectations associated with these variables and more. The bottom line for smaller businesses is that when it comes to foreign exchange risk – they are completely exposed.
So what can be done? Planning. It is tempting to become overly optimistic when exchange rates have drifted in your favour, encouraging further investment to facilitate more sales in the stronger currency. Buying equipment, hiring permanent labour and leasing more space introduces higher fixed costs that might dampen or destroy profitability when the tide turns the other way. It is important to consider ‘what if’ scenarios frequently – and especially before laying out more capital. For entrepreneurs the biggest mistake is to take for granted that the status quo will continue. All of a sudden, you might be buying yourself a bigger house, a fancier car and sending the kids to private school – all based on current income which is linked to the current prosperity of your business.
Currency instability is a fact of life, and the best way to be prepared is to expect the inevitable. Rather than rush to spend more on expanding the business put aside a ‘safety’ cushion during good times that can be drawn upon during bad times. If your commitment to the US, European or other markets is firm, then park the cushion into currencies you are vulnerable too. For example, invest your cushion in US dollar denominated assets – U.S. Treasury bills will provide a natural hedge for your sales. Similarly, if a significant volume of your sales are in Europe and the company borrows funds for operations, borrow some funds in euros as a hedge – then if the euro appreciates you’re able to pay those obligations in the same stronger currency thanks you your euro receivables.
It is widely believed today that the USD is likely to depreciate relative to a number of other currencies, and perhaps imminently. Today might indeed be the ideal time to begin considering ‘what if’ scenarios and the actions you can take to plan ahead.