Exchange Rate Risk: The Dollar vs Yuan
Exchange Rate Risk: The Dollar vs Yuan
Introduction
In 2011, the United States trade deficit was 248 billion dollars with China accounting for 37 percent (Reuters, 2012). It is not a question that China’s currency is a manipulation. China acknowledges that its desire is a gradual appreciation of Yuan, and, so, it intervenes whenever the currency experiences a sudden, sharp rise in value. A high magnitude increase in Chinese currency could cut the United States trade deficit significantly (Barton, 2004). It could reduce the deficit by a third and create sufficient jobs to induce a modest reduction in the American unemployment rate.
However, caution is inevitable because job creation and trade deficit reduction will occur at the expense of the Chinese economy. Trade war might ensue that will drag the world economy into a recession. It is a consideration, which lawmakers should take into account as they think of sanctions and political pressure against china. The undervaluation of Yuan gives China an unfair trade advantage and hurts the United States economy.
Devaluation of Yuan: Impact on Wal-Mart and Yum! Brands
The director of Peterson Institute for International Economics, Fred Bergsten, estimates that a20 percent rise in Yuan can reduce the United States current trade deficits by 50 to 100 billion dollars (Orlik, 2012). A 40 percent rise would imply a 200 billion dollar reduction. According to Bergsten, approximately half of the reduction would come from the consequent rise in American exports to China and countries, in which China is a dominant trader. Reduction in imports from China would cover the other half. Wal-Mart is cardinal importer of Chinese products. If China devalues its currency by 20%, Chinese exports will be cheaper by 20%.
Therefore, Wal-Mart and other large importers of Chinese products will import more at low prices, depending on the price elasticity of the American demand for Chinese products. In simple terms, a devalued Yuan implies that an importer requires fewer dollars to buy products priced in Yuan than the current value (Reuters, 2012). Therefore, Wal-Mart will find Chinese products less expensive to purchase. This also implies that Wal-Mart will have an unfair advantage over enterprises trading in America manufactured products.
Yum! Brands Corporation imports the food products that it sells in its stores from China (Orlik, 2012). However, its case is different from Wal-Mart. China’s favorable exchange rate favors American companies that manufacture and trade from china such as Apple, General Motors, and Yum!Brands. In relation to Yum! Brands, more than half of its global sales come from its China division. In 2011, it made 908 million dollar profits from China. In the past years, the profits of such companies have largely come from the rising Yuan.
Since 2005, china allowed Yuan to rise until 2011 when it rose 31% against the dollar. However, 2012 may prove a drop in earnings for these companies because China began to adjust Yuan downwards against the dollar (Reuters, 2012). In the first quarter of 2012, Yuan dropped 0.9 percent against the dollar. The American food, automobile, technology, and beverage firms face the prospect of earning little from the slowing growth of Chinese currency.
Currency Exchange Calculation
a) Current Exchange Rate.
Yum! Brands want to transfer ¥3,727,280,625 to the United States. As at November 8, 2012, UTC, 1.00 CNY (¥) is equivalent to 0.160143 USD ($) (XE, 2012). Therefore, ¥3,727,280,625 is equivalent to (¥3,727,280,625 × $0.160143 ÷ ¥1) = $596,897,901.129375. This is equivalent to $596,897,901.13 when corrected to two decimal points.
b) The April 1, 2012 Exchange Rate.
As at April 1, 2012, 1.00 CNY (¥) traded at 0.1588057805 USD ($) (XE, 2012). Therefore, ¥3,727,280,625 would fetch Yum! Brands (¥3,727,280,625 × $0.1588057805 ÷ ¥1) ═ $591,913,708. 7956528. This is equivalent to $591,913,708. 80 when corrected to two decimal points.
c) Comparison of the April 1st and November 8th Rates.
The November value of Chinese Yuan is higher than the April rate. The approximate value of Chinese Yuan in dollars is 0.16 and 0.15 for November and April, respectively. This implies that Yuan fetched less of the dollar in April than it can fetch in November. The difference in the amount of dollars that Yum! Brands could get for ¥3,727,280,625 in November and April is ($596,897,901.13−$591,913,708. 80) ═ $4984192.33. At the current exchange rate, the Yuan earns more dollars than it did in April 1st, 2012.
The Magnitude of the Exchange Rate Risk
Multinational corporations with commercial dealings in foreign countries have concerns over foreign exchange fluctuations (Barton, 2012). Profits derived from a foreign country may easily undergo a translation into losses with a sharp appreciation in the United States Dollar. The effect is different for importers and exporters. Wal-Mart relies utilize Chinese imports to acquire cheap products for its global stores (Reuters, 2012). Therefore, a strong value of Chinese Yuan raises prices of Chinese products while a devalued Yuan reduces prices.
The effect is opposite for corporations that have sales divisions in China (Orlik, 2012). These include Yum!Brands, Apple, and General Motors. In relation to these corporations, a devalued Yuan implies reduced value of profits, and, so, a strong Chinese currency suits their businesses. The risk associated with foreign exchange is significant for corporations, a 20 percent rise or fall in value of a currency implies equivalent rise or fall in international prices and profits.
Managing Exchange Rate Risk
A cardinal factor in international trade is the currency exchange fluctuations (Barton, 2004). The nature of global currency movements is that it is impossible to predict future values. Oil prices and interest rates are the crucial drivers of currency exchange rates. However, corporations can protect their business against undesirable currency fluctuations. One way to do currency hedging is trade currency in tranches implying that a corporations exchange currency in parts (Orlik, 2012).
This facilitates spreading the exchange rate. Another method of currency hedging is forward contracting. In this method, a corporation such as Wal-Mart agrees to exchange currency in the future at the current rate (Ibid). The advantage of forward contract is that it guards against unfavorable exchange rates. However, it may be a disadvantage if future exchange rates are more favorable than current rates. Trading currency in tranches spreads the risk, but limits the opportunity to maximize profits.
Lesson
A significant lesson from the assignment is that currency exchange is a significant factor influencing commercial dealings of global corporations. Currency exchange fluctuation affects the price of products as well as the value of profits accumulated in foreign currency (Reuters, 2012). It is also essential to note that countries such as China apply currency manipulation to earn an unfair trade advantage over other countries. The United States economists are aware of the Chinese trend and are urging the government to pressure China to allow Yuan to float.
However, this requires a balance as such action may cause massive consequences in China’s economy. China relies heavily on exports to grow its gross national product; exports amount to a third of China’s gross national product. Therefore, allowing Chinese currency to float may cause disastrous economic consequence that may harm America’s exports. The cascade of consequent events may cause a global depression. Therefore, allowing Yuan to float suddenly may not be the solution. However, China must implement a gradual increase in the value of Yuan.
Conclusion
In Conclusion, it isAmerica’s desire for China to let its currency to float, in order to reflect Yuan’s true value and make Chinese products and labor more costly than it is now (Barton, 2004). A low-value Yuan accords Chinese manufacturers and traders an unfair trade advantage. In this regard, manufactures in foreign countries are unable to compete and match China’s low-priced exports. The United States continue to negotiate for a rise in Yuan, but China seems unlikely to allow Yuan to float. China runs a managed float system for its currency, in which the State Council and not the Central Bank sets the value of Yuan.
Evaluation of the Assignment
This assignment is an excellent tool for learning the principles of international trade and the global economy. The U.S. and China are the principal players in global trade. Therefore, analyzing the exchange rate of the two countries and the influence on both economies provides knowledge of the dynamics of the currency exchange risk. The assignment also provides an overview of international business and why multinational corporations prefer some locations.
References
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