Operating Exposure
A real exchange rate change affects a number of aspects of the firm’s operations. With respect to dollar (HC) appreciation, the key issue for a domestic firm is its degree of pricing flexibility—that is, can the firm maintain its dollar margins both at home and abroad? Can the company maintain its dollar price on domestic sales in the face of lower-priced foreign imports? In the case of foreign sales, can the firm raise its foreign currency selling price sufficiently to preserve its dollar profit margin?
The answers to these questions depend largely on the price elasticity of demand. The less price elastic the demand, the more price flexibility a company will have to respond to exchange rate changes. Price elasticity, in turn, depends on the degree of competition and the location of key competitors. The more differentiated (distinct) products a company has, the less competition it will face and the greater its ability to maintain its domestic currency prices both at home and abroad. Examples here are IBM and Daimler (producer of Mercedes-Benz cars), both of which sell highly differentiated products whose demand has been relatively insensitive to price (at least historically, but competition is changing that). Similarly, if most competitors are based in the home country, then all will face the same change in their cost structure from HC appreciation, and all can raise their foreign currency prices without putting any of them at a competitive disadvantage relative to their domestic competitors. Examples of this situation include the precision instrumentation and high-end telecommunications industries, in which virtually all the important players are U.S.-based companies.
Conversely, the less differentiated a company’s products are and the more internationally diversified its competitors (e.g., the low-priced end of the auto industry) are, the greater the price elasticity of demand for its products will be and the less pricing flexibility it will have. These companies face the greatest amount of exchange risk. For example, in the wake of the Asian currency crisis, Chinese exporters suffered from intense price competition by Asian producers whose currencies had fallen by 40% or more against the yuan. The main culprit was the nature of the products they were producing—commodity-type products such as polyester fibers, steel, textiles, and ships that sell almost exclusively on the basis of price. On the other hand, when the yuan fell against other Asian currencies during 2003 (because it was tied to a falling dollar), Chinese manufacturers benefited greatly while other Asian manufacturers were hurt.2
Application Product Differentiation and Susceptibility to Exchange Risk of the U.S. Apparel and Textile Industries
The U.S. textile and apparel industries are highly competitive, with each composed of many small manufacturers. In addition, nearly every country has a textile industry, and apparel industries are also common to most countries.
Despite these similarities, the textile industry exists in a more competitive environment than the apparel industry because textile products are more standardized than apparel products. Buyers of textiles can easily switch from a firm that sells a standard good at a higher price to one that sells virtually the same good at a lower price. Because they are more differentiated, the products of competing apparel firms are viewed as more distinct and are less sensitive than textile goods to changes in prices. Thus, even though both textile and apparel firms operate in highly competitive industries, apparel firms—with their greater degree of pricing flexibility—are less subject to exchange risk than are textile firms.
To cope with their currency risk, American textile manufacturers have slashed their production costs while concentrating on sophisticated textile materials such as industrial fabrics and on goods such as sheets and towels that require little direct labor and are less price sensitive.
American producers are also competing by developing a service edge in the domestic market, which enables them to differentiate even commodity products. For example, the industry developed a computerized inventory management and ordering program, called Quick Response, that provides close coordination among textile mills, apparel manufacturers, and retailers. The system cuts in half the time between a fabric order and delivery of the garment to a retailer and gives all the parties better information for planning, thereby placing foreign manufacturers at a competitive disadvantage. In response, Japanese companies—and even some Korean ones—are looking to set up U.S. factories.