How does the relatively high inflation rate in southern Europe add to the problems created by a strong euro?
Questions
1. Why are southern European countries particularly vulnerable to a strong euro?
2. How does the relatively high inflation rate in southern Europe add to the problems created by a strong euro?
3. In contrast to southern Europe, northern Europe, especially Germany, exports more complex and brand-name manufactured items, such as automobiles, machine tools, and specialty chemicals. Would you expect German exports to be more or less sensitive than southern European exports to pricing pressures from a strong euro? Explain.
4. It turns out that Italian companies exporting food products such as Parma ham and Parmigiano cheese have not seen a drop in exports, nor have high-fashion exporters such as Armani and Valentino despite the strong euro. Explain
Another important determinant of a company’s susceptibility to exchange risk is its ability to shift production and the sourcing of inputs among countries. The greater a company’s flexibility to substitute between home-country and foreign-country inputs or production, the less exchange risk the company will face. Other things being equal, firms with worldwide production systems can cope with currency changes by increasing production in a nation whose currency has undergone a real devaluation and decreasing production in a nation whose currency has revalued in real terms.
With respect to a multinational corporation’s foreign operations, the determinants of its economic exposure will be similar to those just mentioned. A foreign subsidiary selling goods or services in its local market will generally be unable to raise its local currency (LC) selling price to the full extent of an LC devaluation, causing it to register a decline in its postdevaluation dollar revenues. However, because an LC devaluation will also reduce import competition, the more import competition the subsidiary was facing prior to the devaluation, the smaller its dollar revenue decline will be.
The harmful effects of LC devaluation will be mitigated somewhat since the devaluation should lower the subsidiary’s dollar production costs, particularly those attributable to local inputs. However, the higher the import content of local inputs, the less dollar production costs will decline. Inputs used in the export or import-competing sectors will decline less in dollar price than other domestic inputs.
An MNC using its foreign subsidiary as an export platform will benefit from an LC devaluation since its export revenues should stay about the same, whereas its dollar costs will decline. The net result will be a jump in dollar profits for the exporter.
The major conclusion is that the sector of the economy in which a firm operates (export, import-competing, or purely domestic), the sources of the firm’s inputs (imports, domestic traded or nontraded goods), and fluctuations in the real exchange rate are far more important in delineating the firm’s true economic exposure than is any accounting definition. The economic effects are summarized in Exhibit 11.5.
A surprising implication of this analysis is that domestic facilities that supply foreign markets normally entail much greater exchange risk than do foreign facilities that supply local markets. The explanation is that material and labor used in a domestic plant are paid for in the home currency, whereas the products are sold in a foreign currency. For example, take a Japanese company such as Nissan Motors that builds a plant to produce cars for export, primarily to the United States. The company will incur an exchange risk from the point at which it invests in facilities to supply a foreign market (the United States) because its yen expenses will be matched with dollar revenues rather than yen revenues. The point seems obvious; however, all too frequently, firms neglect those effects when analyzing a proposed foreign investment.