Exchange Rates and their Impact

For today’s blog I have decided to talk about exchange rates and how their relative movement can have a significant impact on us all. I will apologize up front for selecting quite a dry topic but I am ‘the numbers guy’ after all and this kind of thing is important to all the bean counters. Aside from factors such as interest rates and inflation, the exchange rate is one of the most important determinants of a country’s relative level of economic health.

The UK may be an island but it has been a long time, if ever, since our economy was unaffected by the global money markets. Your business may not export or import any products or services directly but you will still be impacted by the movement of one currency against another.

Exchange Rates

The British pound (GBP) is a commodity just like any other that people buy and sell. More than $3 trillion is traded on the currency markets on a daily basis. GBP has a value that is measured against the value of all other global currencies and GBP will have an exchange rate set against each currency.

This exchange rate is constantly changing as the currency markets react to a myriad of economic data being received that alters the perceived value of GBP. There are several key factors that influence the value of a currency and therefore its exchange rate with other currencies:

• The level of political stability and the economic performance of a country. The more stable a country and the stronger its economy, the more people want to invest in that country and so this increases the value of the currency.

• The net trade balance. If a country is exporting more than it is importing then it is a good indicator of a strong economy and thus it will encourage investment and increase the value of the currency.

• Generally countries with lower inflation rates have higher currency values as its purchasing power increases relative to other currencies.

• Interest rates. Higher interest rates attract foreign investment which will cause the exchange rate to rise.

• Public Debt. Countries that have high levels of borrowing to fund public sector projects are less attractive to foreign investors as they are perceived as more risky and susceptible to inflationary rises and so have lower currency values.

It is not just the above factors in you own country that can impact the value of your currency but a change in the above factors in other countries, particularly countries with economic clout such as the US, China or the Euro Zone countries, can impact GBP as well. If their economic position improves in relation to yours then that will cause a realignment of exchange rates, with a devaluation of your currency.

From what has been written so far it would be a fair assumption that it would be better to have a strong currency than a weak currency. That is true, but as with most things, that is not the full picture. There is very much a “Yin and Yang” effect.

If a country exhibits economic markers for a strong currency value; low inflation, positive trade balance, low public debt etc. that is generally a good thing. However as the value of a currency increases it makes it harder for that country to export goods as they become more expensive for foreign companies to buy as their foreign currency is now of a relatively lower value and so you have to spend more of it to buy the same level of goods. As exports fall the trade balance worsens and the market responds by lowering the currency value.

With a strong currency, it favours importers of goods as they can buy more with their higher valued currency.

That is a very simple example and there are often multiple factors at play that contribute to the movement in the value of a currency. Mostly these are economic, sometimes political and sometimes even social. Exchange rates can also be affected by currency speculators betting on how one currency will move against another and purchasing large quantities of the currency hoping to make a profit but also helping to fulfill their prediction.

Most countries are likely to want their exchange rates with the major trading currencies to remain within a ‘comfortable’ range. To stray outside of that range, either too strong or too weak a currency causes imbalance in the economy.

Everything that has been discussed to date has been at the macro economic level (Shout out to Mr. Doyle my old economics teacher – best ever Mr D!).

The effect of Macro Economics

So how, do you ask, does all this macro economic ‘mumbo jumbo’ affect me? Well on a corporate level if you both buy and sell abroad then you are directly affected by exchange rate movements. If you buy a product for €15 and the exchange rate is £1: €1.50 then the cost to you is £10. If GBP weakens and the exchange rate moves to £1: €1.30 the same item now costs £11.54. That is a 13% price increase. The opposite effect happens if you are exporting.

As a business you can try and reduce the risk of adverse movements on exchange by buying foreign currency forward contracts at known exchange rates. Even better would be to develop your business strategy so that you both buy and sell product or services in common currencies giving you a natural hedge. What you lose on the Yin you gain on the Yang.

At Vectair as we sell to over 120 countries and have global suppliers so we are in a position where we can achieve that natural hedge to a degree. We still are exposed to exchange rate fluctuations, but not to the extent that we could be. It is a risk we monitor and manage on an ongoing basis.

Even if you are a business that does not import or export directly you still need to be aware of exchange rate fluctuations and try and have a strategy to minimize the risk to your business. It could be that UK suppliers you use buy raw materials from overseas. This could end up impacting on your buying price as they increase prices in response to an adverse movement in exchange rates.

So hopefully you can see that exchange rates, although some would find boring in the extreme, play a very important role in our business lives. Even on a personal level they impact on us from the price we pay for our food and fuel to how much it costs us to go on our summer holiday.

On a micro level we can do little to influence how exchange rates move but we certainly need to consider them and wherever possible minimize the risk of adverse exchange rate movements.

I hope you found this blog useful.

By Colin Davies, Finance Director & CFO | Vectair Systems as part of Directors Blog