National currency is defined as any money declared by a particular government to be a legal tender (Lagos, Ricardo; Wright, Randall 2005). In 1994, following the Bretton Woods Conference, currency exchange rates in the globe was pegged against the US Dollar. Also, the gold standard was introduced, whereby a fixed amount of gold could be exchanged for a certain amount of US Dollar.
Even though this gave US dollar the de facto world currency status, in 1971,following the Smithsonian Agreement , collapse of gold standard and fixed exchange rate regime and regain of floating exchange rates the significance of US Dollar as a standard began to diminish. Nevertheless, since USA remained a superpower in world economy, most transactions continued to be in US Dollar up to this date. (Triennial Central Bank Survey, 2007)
With the popularity of Japanese Yen and, in 1999, with the emergence of Euro, the focus has begun to divert to different currencies and with the increased globalization and expansion of Multinational organizations, the question of currency exchange rates and use of a possible regional or global currency to avoid currency risk( O'Sullivan, Arthur; Steven M. Sheffrin, 2003)
Currency risk is a form of risk that arises from the change in price of one currency against another due to fluctuations.Volatility in long-term and short-term exchange rates is a significant factor in the financial soundness of a firm. Although the firms have made use of several strategies to minimize the effect of such risks (eg: forward contracts, hedging) these variations affect the financial soundness of any company which is engaged in international business.
In the present economies, currencies are affected by market trends, either by domestic or foreign economic factors, In a highly competitive global economic environment, the margins of profits have increasingly become smaller. Thus, any negative fluctuation could result in eroding the margin and making the firm's financial position weaker and unpredictable. (Peter C., Natalia T. et el, 2004)
With the increase use of internet, emergence of new and more transparent marketplaces for individuals, the international commerce has already gone beyond the limits of regional boundaries to conduct international business and trading activities, leaving less control for the individual governments. Significant changes in the international economic and political landscape, however, have often resulted in uncertainties on the direction of foreign exchange rates (Maurice O, 2001) Such uncertainties give rise to the argument of seeing the national currencies as a barrier and the need of exploring the possibility of a regional or global currency.
Barriers created by National Currencies in International business
Each firm and/or individual, that has engaged in international business has exposure to foreign exchange rate risk. Foreign exchange rate risk exposure is common to almost everyone who conducts international business and/or trading. Most commonly, buying and selling of goods or services involving more than one national currency can immediately expose the business activity to foreign exchange rate risk. In practice, if a firm price is quoted ahead of time for a business using a current exchange rate, at the time of the actual agreement or performance of the contract, the predetermined foreign exchange rate may not be appropriate resulting in a gain or loss for either party. (Neil Record,2001)
Such changes in exchange rates could be explained in two fundamental theories. (1) Interest parity model states that if , for example, the rates of interest in UK increases while that of USA remains the same, the value of GBP should depreciates against the US dollar. (2) Balance of payment model states that the exchange rates are a result of equilibrium for national current account balance in which a country with trade deficit is deemed to be short of its foreign currency reserves. Therefore, its own currency value depreciates. These can be a result of inflation rates in each country with the above factors (Dalimov R.T.,2008)
In international business, foreign Direct Investment is viewed by many investing firms as a way to diversify an investment or seek a large return on investment. Such decision to go international may be to leverage the advantages in the services and resources in a foreign county as well as to gain absolute or comparative advantage. (Porter M,1998) However, investing in foreign stocks or markets exposes the investor automatically to foreign currency exchange rate risks and uncertainties. As an example, if an investor buys stock in a foreign market, he will be facing two major risks. One is that the price of the stock in the foreign market may depreciate or appreciate. Second, the rate of currency exchange may fluctuate. At the time of investment, the investor has to convert his domestic currency value to a foreign currency for buying in the foreign market. Afterwards, if the foreign currency of that particular country is subject to devaluation, the investor will not gain the expected value in return. Moreover, if the investor decided to exit the foreign market at a later stage, since the currency has depreciate in value, even if he converts that amount back to his domestic currency, he will be at loss compared to the actual amount invested at the beginning. A foreign exchange hedge, can help to manage this foreign exchange rate risk. However, at a time when free market economies and seeking more liberalization, such uncertainties creates a barrier in international business activities discouraging the free trade.
Fig-1: Euro vs US$ Exchange rate variation for 2010
The economic consequences of the fluctuation of exchange rates, and the risk associated strongly affects many firms in a number of ways. In the case of national currency regime, individual governments ( or central banks) have rights to set the interest rates and this leads to unexpected variations from time to time (Kiley, Michael J.,2008) Also, as seen in recent credit crunch, the economic situations in major economies can create major instability in maintaining the average levels of fluctuations. As a classic example, the rigid monetary policy of the Fed in the early 1980's resulted in higher rates of interests in the USA, as compared to other countries. This in turn resulted in a higher value of the US dollar compared to other currencies of those countries.
The following are real examples of how the national currencies have created difficulties or profitability to some major international businesses in foreign currency transactions.
British Petroleum (BP)
In, BP 424B5 filed Mar 13, 2009, it was highlighted that BP has always been exposed to currency exchange risks due to the fact that crude oil is traditionally priced in US dollars while all the refined oil products are priced in many national currencies. Therefore, the fluctuations result in variations in underlying costs (www.bp.com,2010)
Caterpillar
World renowned heavy duty machine producer, Caterpillar found itself at a disadvantage in competition with its main competitor Komatsu, which is a Japanese manufacturer of excavators. This was a result of the higher value of the dollar in 1980's. However, in late 1980's, with the fall of interest rates, the value of US dollar dropped. (www.cat.com, 2010)
As consequence of this trend, in 1986, Caterpillar had a US$100 million profit on foreign exchange gain helped it turn US$24 million operating loss into a US$76 million profit for the same year. With this experience, Caterpillar established a special company unit to manage currency risk
Chrysler
Before 1970's Chrysler had widespread overseas operations in many countries. With the re structuring in late 1970's, it sold out its Latin American, Australian and European, subsidiaries. However, this strategic decision left it with negligible assets in foreign markets. The remaining foreign exchange exposure was almost entirely limited to the yen on its market share in the USA automobile market. With the higher value of dollar against Yen, Japanese car manufacturers, at the time, had a cost advantage of about $2000 per each car sold. These shocking figures made Chrysler management realise they could not compete with the Japanese competitors who were operating in USA. This led Chrysler enter into contract with Mitsubishi for the production on V6 engines between 1983 and 1984. Chrysler expected this would help them produce V6 engines at a low cost and compete with Japanese automobile manufacturers. However, this contract, where Dollar and Yen transactions involved, became a major aspect of Chrysler's foreign currency exposure once again.
When the contract was made it was agreed that Mitsubishi would absorb the entire cost of an exchange rate from 240 to 220 Japanese Yen to US Dollar. Further, Mitsubishi and Chrysler equally divided the cost of exchange rate shifts between 220 to 190 yen to the US dollar. Between 190 to 130 exchange rate shifts, Chrysler and Mitsubishi bore 75% and 25% respectively. Below 130 Chrysler agreed to absorb the entire cost of exchange rate shifts. However, when the value of the yen dropped Chrysler had to make use of Hedge funds to a large extent. Chrysler made many efforts to predict the possible exchange rates for next 10 years. However, with the increase of prospective costs involved, ultimately, Chrysler decided to manufacture V6 engines within the company.
Strategic attempts to overcome those barriers and their limitations:
Firms and government institutions who are engaged in international business require many strategies to minimise the effect of exchange rate changes in different national currencies. However, these are always having their limitations and disadvantages to one party or the other.
(a) Hedging is considered to be the most popular method of reducing or cancelling out the risk in another investment due to exposure to an unwanted business risk such as currency exchange rate changes. In inflationary economies, this still allows business to profit from an investment activity. As an example, a UK company intends selling US Dollars in 3 months' time. In order for a guaranteed a sale at a predetermined rate, which it considers satisfactory, the company may require a hedge ( security) Also, with national currencies, banks and financial institutions require hedging to control their mismatch of asset and liability, including loans and short-term deposits (Bob Noyen,1991)
However, this will not cover all the risks in the long run where cost of labour and other changes interest changes are concerned
(b) Forward exchange contract may help the firms to agree , at the present time, on a fixed exchange rate which will be applied at the time when the contract is performed in the future. it is possible to hedge against the risk of the rate for a currency rising or falling.
This has a disadvantage to either party depending on if the actual value of one currency appreciate or depreciate against the other.
(c)Invoicing in home currency- if a USA firm invoice the buyer in UK in dollar. It has the opportunity of obtaining the full amount irrespective of currency changes
However, this has a risk of UK buyer moving away from the business with the USA company due to the fact that the risk is with the buyer for any changes in currency rates. Also, it creates a disadvantage for the USA company against its competitors who may be operating in UK.
(d)Leading and lagging determines whether money should change hands at the time of performing the contract or at the end.
However, actual changes during the performance of contract still will affect one party or other and, perhaps require hedging to cover the risks.
(e) Netting is another method used by , especially, multinational companies(MNC's) where only the balance from several transactions will be transferred from one currency to another, thus minimizing the scale of exposure.
However, this may not be possible for companies who are into one way transaction only. Also, even for MNC's, there is a limit upto which it can hold the money in one location without transferring to the other.
Replacing National Currencies with regional currencies?
As seen above, the individual national currencies and their fluctuations have always created a barrier to the international business. Also, the methods used to minimize the effects have their own limitations. Such methods may also require additional hedge funds etc making the companies less competitive in terms of cost reduction.
Therefore, in order to avoid such barriers, it may be a favourable decision to replace the national currencies with regional currencies and then look for the possibility of a global currency (Muller K, 2007)
In order to analyze the pros and cons of such a move, it may be worthwhile to investigate the effects of recent moves such as introduction of Euro.
Benefits:
Stronger financial position:
In 1992, euro was established by the provisions in the Maastricht Treaty and has become the currency of 16 out of 27 member states and the EU institutions. Since the introduction it became a stronger currency in world economy and the second largest reserve currency, second only to US Dollar. The reserves increased from 17.9% in 1999 to 26.5% in 2008, at the expense of the US dollar This has given the member states a better position in financial markets as a preferred and wide spread currency as compared to individual fluctuating national currencies. As evident in 2009, Zimbabwe gave up its own currency and started using US Dollar and Euro instead. (FT.com, April 2009) Also, 23 countries outside euro zone has pegged their own currencies against Euro including CFA franc. This move can be considered as a reason to seek the possibility of a global currency in the future (COFER,2009).
Reduced Exchange rate risk
Since the transactions between the member countries take place in a single currency, the firms no longer need to incur additional expenses for hedging. This improves their margins and help them become more competitive. Also, it provides greater certainty for the governments and firms. (Söhnke M. Bartram, 2006)
Increased trade and investment
Since the risk of exchange rate risks are avoided, it creates more favourable environment for the investors, and ease the trade barriers. Studies have found that with the introduction of Euro, foreign direct investment (FDI) has risen by 20% during the first 4 years of European Monetary Union with Euro. Notable benefits were received by countries which previously had weaker currencies by obtaining 22% of such investments from other intra- eurozone countries due to the ease of financing. Also, a notable increase in tourism can be expected in a single currency regime. With the introduction of EMU, tourism inflows in eurozones has increased by 6.5% . Also, the regional currencies provide more transparency in the light of government financial authorities for assessments and decision making. (Baldwin R,2004)
Integration
With a single currency, it will be easier for the financial institutions to integrate their assets. Also, this results in reduced cost for trade bonds , equities etc. This help most large financial institutes lend and borrow from each other than going outside the currency zone where financing becomes crucial. However, in Eurozones, such integrations have met with policy barriers in most cases.
Convergence of Prices
Law of one price holds that the difference is prices creates speculative trade across region purely to gain price advantages. This ultimately results in price convergence (Central Bank of Iceland, 2008) In euro zone, this has been evident in car market in particular. However, this process has not been linear due to other economic factors .
Inflation/ Interest rates and Economic stability
In economic stability, levels of inflation have a significant role as higher inflation is considered to be undesirable and discourages investment. (J.H. Boyd, 2008) With the introduction of Euro, rise of prices of the cheaper goods were experienced with the increase of value of currency and economic activities However, the major indices which determine the inflation has not been affected by this. Jump of such prices have actually been caused by the retailers with the introduction of euro and waited to understand how it affects their business activities. (Robert B,1994)
Regional currencies will also increase the value of firms who were in weaker national currencies before. In Ireland, Greece and Italy this was seen with the introduction of Euro and helped them lower the interest rates (Lewis D, 2010).
Disadvantages of Regional currency
Fig-2:Euro exchange rate against USD, JPY, & GBP
Initial sharp fluctuations
Introduction of a regional currency must be managed very carefully at the initial stages. When the Euro was introduced, the rates against the US Dollar decreased sharply. From initial US$1.18/€, it dropped as low as $0.8252/€ in 2000. It was not until 2002 that it regained its parity against US dollar. (EC No 2560/2001, 2008)
Loss of independent monetary policy
Governments prefer to enjoy a degree of freedom in deciding the interest rates adjustments required to control the financial market at times. However, in the case of a regional currency it has to depend on interest rates set by a main body such as European central bank, these may be inappropriate for some economies (Buti M, 2010).
As an example Nature of UK housing market is often coupled with large variable mortgages. This creates a sensitivity of the people to changes in interest rates. As a result, if interest rates are too high it could lead to a more serious recession
Dominance as a global competitor
Further, as seen in the recent recession in 2009, UK manufacturers benefitted from depreciating currency. However, if UK were using Euro, it would not be able to depreciate the value on its own. This could lead to a disadvantage in global competition. However, it must be noted that depreciation of a currency causes uncertainty. Also, recent developments in the global financial market has seen the pressure by the other regions on China to appreciate the value of Yen. However, China decided to set the rates at a lower level in order to attract foreign direct investments and to be seen as a global competitor in pricing. If china were part of a regional currency zone, this would not have been possible and it would see an exit of present investors to other countries.
Reduced Market share for the local Businesses
With the introduction of a regional currency, it is normal that that it attracts the investors from around the region seeking new market places due to the non-risk of currency exchange rates. This however works negatively for the small and medium scale local business who are not able to compete with such greater market players. However, they have the opportunity of merging with such new entrants and making a win-win situation.
Possibility of a global currency
A global currency (also known as world currency or supranational currency) is a currency which can serve as a primary reserve currency as well as all the international transactions can take place with a single form of currency. At present, US dollar and Euro have gained wide recognition for many of the international transactions. Also, many local currencies are pegged against them.
Also, in the strict sense , a global currency can be defined as a hypothetical single universal currency or super-currency, produced and supported by a global central bank and that can be used in any transaction in the world ,irrespective of nationality or other regional, organizational or government boundaries.
In the light of recent economic crisis in 2009,and in connection with G20 summit on 16th March 2009, consideration of a global currency was mooted by Russia and China ( Zhou Xiaochuan,et el., 2009) This resulted in a UN panel of economists proposing to replace present US dollar-based system by Special Drawing Rights (SDR) of IMF.(BBC News, March 24,2009)
Economists also widely debate the possibility of the euro becoming the first international reserve currency. In Federal reserve chairman's statement it was mentioned that ' it is absolutely conceivable that the euro will replace the dollar as reserve currency, or will be traded as an equally important reserve currency' (Alan Greenspan ,2007) However, from 2007, due to the credit crunch, sovereign debt crisis and Special drawing rights, the share of Euro in international reserves declined ( AFP, March 26, 2009)
Also, following the G8 summit in 2009, President Barrack Obama rejected the above proposals in defending the strong position of US Dollar ( AFP, March 25, 2009 )
However, on March 26, 2009, a panel of UN economists proposed a global currency reserve scheme to in place of US dollar-based system. Their report pointed out that the 'Special Drawing rights (SDR) with regular adjustments could contribute to global economic stability, equity and strength'
What will be the cost and outcome of such a global currency
While there are many benefits from a global currency, some economists argue that this is not a possibility given the fact that the distribution of wealth, rich and poor nation's differences in inflation and interest rates etc. These arguments lead to the discussion of following aspects of such a global currency regime.
Compatibility- Smaller states with very sensitive economies find it hard to cope with even present changes of global economy. National sovereignty of such smaller states may be undermined and stronger nations will be able to control them manipulating the financial markets. Also, countries in the different regions have significant differences in inflation, interest rates and prices.
Setting the interest rates- In a single global currency regime, the global central bank will find it difficult to set interest rates due to significant differences in wealth in areas of the world. Therefore, its ability to set interest rate to manage a given country or an area will be compromised and What is right in one region may not be right in another. Risk of lending to the poor nations, institutions or individuals will be far for higher than for the wealthier counterparts. Moreover, it could lead to the conflicts between different countries. Also, some nations will not accept the concept of Interest as it is prohibited by the religions such as Islam. Therefore, within the same currency, how it operates in different countries or regions will be a question.
CONCLUSION
In conclusion, it can be mentioned that with the different currencies used in international businesses at present, there is a barrier for business activities due to exchange rate fluctuations, additional hedge funds needed and uncertainty.
Regional currencies can help ease those barriers to a large extent with many other positive aspects such as integration, improved economic activities and price convergence. However, there is a need for managing the changeover from individual currencies to regional currency to avoid financial shock. And setting of interest rates must be managed properly by a regional central bank as must be fast responsive to the changes in economy.
The possibility of a global currency is a fact that the world economies can achieve one day. However, there is a great deal of preparatory activities necessary for that end. These include the wealthier nations help the poor nations maintain a feasible rate of interest and respect their sovereignty in decision making and financial control.
