Currency and Pricing
How they interact and what it means for your business
One of the most commonly accepted "laws" of economics is that, from an exporter’s perspective, a weakening currency is good for volume since it effectively reduces the price to importing countries, thereby increasing demand. There is a huge body of research that has tried to determine the real impact of Fx movements (or related US monetary policy) on international trade flows — from the Mundell Fleming Model, which demonstrated an inverse correlation between exchange rates and exports - to new research from Jonathan Kearns and Nikhil Patel, of the Bank for International Settlements (BIS), that finds at times a rising currency can be a stimulant to exports and a falling currency a depressant.
The reality is, however, that no matter how many regressions are run and papers written, the impact on your particular business may fall in line with an expected empirical outcome, or more likely, given Murphy's Law, may prove the exception to the norm (in other words, a "statistical anomaly!"). And while some models may prove out at the macro level, individual businesses may be impacted in very different ways based on the exact same conditions. Here are some key considerations as you tackle the issue of exchange rates and pricing for your business:
1. Currency Pricing
Most large, multi-national corporations have groups of professionals dedicated to determining invoicing, payments, and settlements strategy and managing the financial impact of fluctuations in exchange rates. It's called the Treasury. Most small to mid-market exporters, on the other hand, do not have that luxury, and if you’re reading this article, you’re likely employed by one of them. But not having in-house professionals does not reduce the importance to your business of taking a strategic view of whether you price/invoice in $USD or local currency (or an unrelated, neutral currency).
At a high level, advantages of Producer Country Pricing (PCP) include simplicity, reduced Fx risk for the exporter, and lower transaction fees. Local Country Pricing (LCP) can have distinct advantages as well including shifting of Fx risk for customers, marketing value (localization of offering) and pricing flexibility. What’s best for your business? Considerations on best approach include relative transaction size (larger indicates LCP), number of countries served (more indicates PCP), nature of competition (local substitutes indicates LCP), relative customer buying power (high indicates LCP), and industry standard (are you an outlier?).
Regardless of whether your business bills in local currency today, this is one of those areas that can have a major impact on stability and profitability and should likely be assessed with the help of experts in the field. It's worth time and investment (whether you're billed in dollars or yen!)
2. Commodity / Input Prices
Goods that have a high ratio of globally-traded, indexed commodities often have a natural ballast when it comes to the impact of exchange rates on COGS, pricing, and ultimately your company's competitiveness from a pricing perspective. For example, in the lead acid battery industry, nearly two-thirds of the variable cost of finished goods comes in the form of lead. When the dollar weakens against a particular currency, lead becomes more expensive relative to competitors buying lead in the now stronger currency.
Let's put some numbers to it: if the US dollar were to weaken by 10% against the EURO, the cost of goods for a US manufacturer relative to a European manufacturer, who is buying lead in EURO on the open market, would increase by ~6% (2/3*10%). Assuming this differential in lead is passed through to consumers in the form of margin-neutral price adjustments, a European buyer purchasing US-made batteries in $USD will see an effective price decrease, but certainly much less than the 10% assumed by looking purely at exchange rate movements (4% in this case).
The same logic applies to other businesses as well, where key cost inputs are transacted in a non-$USD currency (e.g., market research with a large payroll in India). The fundamental question remains, how is your cost structure impacted by the same movements in Fx relative to your competition? Taking the time to build sound, dynamic models can take the guesswork out of Fx movements, bring rationality to pricing decisions, and ensure real (vs assumed) impacts are driving key commercial decisions.
Despite macro movements in exchange rates and academic assessments of impact on exports, the most important factor in determining risks and opportunities around Fx is your competitive landscape. Here it's important to assess your business on a regional level: who's your competition and how are they structured? Is your key competitor a US company that manufactures in China? Or is it a Chinese company that buys raw materials and manufactures in Europe...and in what currency do they invoice?
Each situation will be unique, and truly understanding the impact of Fx on costs/pricing of your own business -- let alone the competition where your dealing with limited information -- is a challenge, but outlining the impact of material Fx movements on key competitors is a worthwhile exercise in determining your own moves.
To illustrate with another overly simplistic example, with a material gain in $USD vs. RMB, a key US competitor that manufactures in China for its Australian business will likely enjoy more pricing flexibility than you if you're exporting from the US for the same Australian market. Evaluating pricing decisions for your Australia business without accounting for this dynamic may not produce expected results.
Key questions to help frame your strategy:
- How do fx movements impact your cost of goods relative to competitors?
- How does this effect relative price and margin? How should we adjust price accordingly?
- How do Fx movements impact import costs relative to competitors from the customer perspective?
- Is our method of invoicing (PCP vs LCP) based on a thoughtful strategy, or it ‘just the way we’ve always done it’?
To sum up, there’s a ton of insightful research available to help you better understand the potential impact of exchange rates on flows of international trade. At the end of the day, however, there is not an easy, one size fits all answer, and some heavy lifting will be required to understand the practical implications of exchange rate movements on your particular business/industry. Hopefully this article provided a couple takeaways as you define how best to mitigate the risks and capitalize on the opportunities posed by exchange rate movements in international trade.
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