Their importance, purpose and role in translation

Exchange rates: Their importance, purpose and role in translation

Amrhein, Denise Guithues

The recent Asian currency crisis demonstrates how critically exchange rates impact economic developments. A key factor leading to the crisis was the maintenance of pegged exchange rate regimes which encouraged external borrowing and resulted in excessive foreign exchange risk exposure. Wide swings of the yen/dollar exchange rate also contributed to the crisis. Since the international business environment has no universal medium of exchange, exchange rates are a necessity for international trade. Presently, both translation and conversion of foreign currency involve the use of exchange rates. Therefore, in order to gain a more through understanding of foreign currency translation, it is important to examine the nature of exchange rates and the critical role they play in the international economy.

INTRODUCTION

The recent Asian currency crisis demonstrates how critically exchange rates impact economic developments. Stanley Fischer, First Deputy Managing Director of the International Monetary Fund (IMF), noted that one of three key factors that led to the crisis was the maintenance of pegged exchange rate regimes for too long which encouraged external borrowing and led to excessive exposure to foreign exchange risk in both the financial and corporate sectors. Also contributing to the crisis were wide swings of the yen/dollar exchange rate over the past three years. Fischer explained that the crisis erupted during the summer in Thailand and the contagion to the regions other economies appeared relentless. As currencies continued to slide, debt service costs rose. This led domestic residents to hedge their external liabilities and intensified exchange rate pressure. One of the problems the IMF has faced in trying to help stem the crisis is that it took months to gauge the magnitude of the problem in the face of Asia’s opaque accounting and financial secrecy. This was compounded by a “crazy quilt” of currency regimes and financial systems in the region (Bremner and Engardio 1998). The key to stemming the crisis remains restoring confidence in and stabilizing the regions currencies.

In the January 15, 1998 issue of the Wall Street Journal, China’s yuan was described as a rock of stability amid the continuing turmoil in Asian currency markets. However, concern mounts that China could devalue its currency to keep its exports competitive and thereby trigger another round of competitive devaluations reminiscent of the 1930s – thus worsening Asia’s currency crisis (Smith and Wessel 1998). Asian currencies in general have experienced a dramatic decline since June 30, 1997 as depicted in Table I. The dramatic decline in Asian currencies have some economic commentators concerned that the recent financial crisis has wiped out the economic gains of an entire generation. When measured using exchange rates as of February 4, 1998, Indonesia’s gross domestic product (GDP) is projected to decline from $226 billion in 1996 to $50 billion for 1998. Using the same measurement process, the economies of South Korea and Thailand could be almost 50% smaller than in 1996. These numbers are deceptive. While devaluation makes it more difficult to repay loans denominated in a foreign currency, it does not directly reduce the volume of output. Devaluation can have an indirect effect on output by increasing the local currency cost of imported raw materials and capital; thus, affecting the financial capacity of a business to purchase the inputs needed for a given level of production. Consequently, the expected drop in volume of output is only in the range of 1-3%. The Economist points out how misleading it can be to convert a country’s local-currency GDP into dollars at market exchange rates. First, wild swings in the rates make a mockery of such conversions. Second, market rates rarely reflect the relative purchasing power of currencies. For this reason many economists prefer to use purchasing-power parities (PPP), which account for variations in price levels, to measure the relative size of economies. As shown in Table II, if measured in terms of PPP, the GDPs for most of the Asian economies have increased since 1996 rather than decreasing as the exchange rate measurements indicate.

Since the international business environment is one in which there is no universal medium of exchange, exchange rates are a matter of necessity for international trade. As a result, when transactions are denominated in foreign currencies two basic needs arise. First, there is the need for translation. That is, the transaction which is stated in terms of a foreign currency must be re-expressed or restated in terms of the local currency before it can be recorded in the local accounting records. Second, settlement of the transaction requires conversion. This means that when payment is due, a sufficient amount of the local currency must be exchanged for the stated amount of foreign currency so that payment can be made.

At present, both translation and conversion of foreign currency involve the use of exchange rates. Therefore, in order to gain a more thorough understanding of foreign currency translation, it is important to examine the nature of exchange rates. The questions which will be discussed here include: What is an exchange rate and what is its intended purpose? What determines an exchange rate? Do exchange rates provide the most efficient translation mechanism, or is there something preferable to them?

EXCHANGE RATE DEFINITIONS

An exchange rate has been defined as a relative price of two national monies (Frenkel and Johnson 1978). More specifically, it can be stated that the exchange rate is “the ratio between a unit of one currency and the amount of another currency for which that unit can be exchanged at a particular time.” (FASB 1975) As such, it can be seen that exchange rates are designed to facilitate the actual exchange of one currency for another. It would appear that exchange rates are relatively straightforward. However, this is unfortunately not the case.

Exchange rates are normally quoted in terms of a buying rate, a flat rate, and a selling rate. The buying rate is that which a bank will pay for a foreign currency, the selling rate is the rate a bank will charge for the currency, and the flat rate is an average of the buying and selling rates. In addition, the exchange rate which is quoted will often depend on various factors such as the market sector and type of foreign-exchange instrument involved. The foreign-exchange market can be divided into four main sectors: (I) retail–dealings with the general public; (2) wholesale–tradings among banking institutions and, where permitted, between large firms and brokers; (3) foreign–dealings between domestic and foreign banks; and (4) supranational–dealings among large multinational corporations and large private banks. The basic types of foreign-exchange instruments include foreign currencies, bank transfers, bills of exchange, letters of credit, and forward exchange contracts.

These varied circumstances call for different exchange rates, which can usually be classified into three main categories: spot rates, forward rates, and differential rates. Spot rates are the rates quoted for immediate delivery of a currency (usually two days). Forward rates are those quoted for delivery of a currency at a specified future date (usually within one year, but after the period for the spot rate). Differential rates may be either preferential or penalty rates which are limited to special markets or customers. They are normally found in economies where the government controls foreign exchange and differ from the spot and forward rates. In such cases, the government will often establish exchange rates based on the status of the transaction involved. If the government considers a transaction to be economically favorable, the exchange rates attached to it will often reflect that fact. That is, the government will often establish more favorable exchange rates for those transactions that it wishes to encourage. On the other hand, the government will also establish less favorable exchange rates for those transactions that it wishes to discourage. “Where controlled rates differ widely from the free-market rate for a currency, black-market rates usually appear as an equalizing mechanism. Consequently, the mere existence of a black-market rate is evidence of an overvalued currency.” (Miller 1979)

HISTORICAL DETERMINANTS OF EXCHANGE RATES

Answering the question of what determines an exchange rate is by no means a simple task. This is because there are no clear-cut relationships on which to rely. The best that one can do is to examine some of the factors that play a part in this determination. The first step in this examination will address some of the underlying theory of exchange rates. This will be followed by a more detailed analysis of some of the factors involved in exchange rate determination.

In modern times, the operative system of exchange rates has evolved from a gold bullion standard to a system of floating exchange rates with several alternative systems used in between.

The gold bullion standard prevailed from about 1870 until 1914, and intermittently thereafter until 1944. Under this system, central governments defined their currencies in terms of a specific amount of gold bullion and agreed to redeem their currencies at the set rates (mint parities). However, as a commodity, the international market price of a currency (the exchange rate) would fluctuate above or below parity based on the supply and demand of that currency relative to others. If excessive demand forced the market price of a currency above the parity band, external debtors found it cheaper to pay their debts in gold. Conversely, if insufficient demand for a currency lowered its market price below the parity band, external creditors demanded payments in gold. Under this system, unless a country maintained a reasonable trade balance over time, continuing trade deficits would drain its gold reserves. The lower level of gold reserves would, in turn, result in a shrinkage of that country’s money supply and a lower internal price level. Lower domestic prices would eventually make the country’s products more competitive in the international marketplace. As exports increased, the demand for the country’s currency wou!d also increase resulting in an inflow of gold reserves. With a self-balancing system such as this, the governments’ role was a passive one in which they would merely permit the free flow of gold to stabilize economies and exchange rates. Thus, the gold bullion standard acted as an automatic stabilizer, at least in theory.

Unfortunately, there were inherent problems with the gold bullion standard, which eventually caused it to be abandoned. These problems stemmed mainly from several invalid assumptions upon which the system was based:

1. The worldwide gold supply would increase yearly in the same proportion as the net growth in the supply of goods and services and in the proper locations.

2. Each country’s available gold supply would be such that trade imbalances would bring about the necessary changes in its money supply and price level in a reasonably short time.

3. International trade and competition would be free of all artificial restrictions.

4. Scare outflows of gold, such as those resulting from fears of political instabilities, would not occur. (Miller 1979)

In addition, governments generally preferred to take a more active role, especially in matters influencing their internal economies.

In 1944, following World War II, the United States and most of its allies ratified the Bretton Woods Agreement which set up an adjustable parity exchange-rate system under which exchange rates were fixed (pegged) within narrow intervention limits (pegs) by the United States and foreign central banks buying and selling foreign currencies. This agreement, fostered by a new spirit of international cooperation, was in response to the financial chaos that had reigned before and during the war.

In addition to setting up fixed exchange parities (par values) of currencies in relationship to gold, the agreement established the International Monetary Fund (IMF) to act as the “custodian” of the system. Under the system, member governments were obligated to defend the exchange rates within a narrow band of about I percent above or below parity (the official exchange rate). The revaluation or devaluation of a currency was called for only in the case of “fundamental disequilibria” (chronic surpluses or deficits in a nation’s balance of payments). Despite the fact that the IMF expressed currencies in terms of gold, in practice currencies were expressed in terms of dollars, and the Bretton Woods Agreement became a rigid dollar standard. This situation arose because the United States was the only country that agreed to redeem its currency for gold.

Naturally, the dollar could not serve as both a national and an international currency, since under these conditions international liquidity (total trade financing potential) could be expanded only through larger balance-of-payments deficits on the part of the United States. The ensuing massive United States balance-of-payments deficits led to an erosion of confidence in the dollar as a store of wealth, the cancellation of the gold convertibility of the dollar in August 1971 by the United States, and the signing of the Smithsonian Agreement in December 1971 by the major trading nations, referred to as The Group of Ten. This was an attempt to restore monetary order by devaluing the dollar and establishing a wider parity band (plus or minus 2.25 percent). Despite this effort, the United States continued to experience balance-of-payments deficits. In early 1973, an additional 1 percent devaluation of the dollar, along with agreement of several European Economic Community (EEC) member nations to let their currencies float against the dollar, dealt the death knell to the Bretton Woods and Smithsonian Agreements.

Allowing exchange rates to float in the midst of financial chaos was like setting a boat adrift in the middle of a storm–smooth sailing was next to impossible. To make matters worse, the tripling of oil prices by the Organization of Petroleum Exporting Countries (OPEC) during 1973 hit the foreign exchange markets like a hurricane, causing global inflation to rise with the tide. However, the circumstances under which floating exchange rates were introduced are by no means the only problem with the system. The lack of an official common denominator and the diminished authority of the IMF have not helped matters. Money has become a commodity that is bought and sold at market prices. In the international economic sense, money has become a circular concept–defined only in terms of the price that each currency will bring in other currencies (Miller 1979).

In addition, three important trends developed that contributed to the problem. First, there was a persistent increase in liquid resources available to the private sector relative to the monetary reserves held by the central banks. (The money supply was no longer tied to a country’s gold reserves and the multiplier effect allowed for this growth.) Second, there were constantly improving techniques permitting market participants to shift large amounts of capital rapidly from one currency to another. Third, there were improving communication methods making information available instantaneously to a growing number of analysts throughout the world (Teck 1976).

CONTEMPORARY IMPACTS ON EXCHANGE RATES

As a result, the main theme of the modern view of exchange-rate determination emphasizes that the exchange rate, being a relative price of two national monies, is determined primarily by the relative supplies and demands for these monies (Frenkel and Johnson 1978). Four of the main reasons for holding money are: (1) for the purpose of conducting transactions, (2) for the purpose of speculating, (3) for the purpose of saving and earning a return, and (4) for precautionary purposes. On the other hand, the main determinants of the money supply are government policies and actions, which can take many forms.

Planned transactions can also affect exchange rates by affecting the demand and supply of different currencies. If a United States company plans to purchase goods from a Japanese company which requires payment in yen, the United States company’s demand for yen will increase. Over time, all of these items will affect the supply of and demand for currencies, thereby, affecting the exchange rates.

According to John E. Rule, it is the views of participants in the foreign-exchange markets that result in the daily buying and selling pressures on currencies. The views of these participants, such as traders, bankers, and businessmen, are in turn influenced by political, economic and psychological factors.

Political Factors

The political factors influencing exchange rates include the established monetary policy along with government action or inaction on items such as the money supply, inflation, taxes, and deficit financing. Active government intervention or manipulation, such as central bank activity in the foreign currency markets, also have an impact. Other political factors influencing exchange rates include the political stability of a country and its relative economic exposure (the perceived need for certain levels and types of imports). Finally, there is also the influence of the International Monetary Fund.

Economic Factors

Economic factors affecting exchange rates include hedging activities, interest rates, inflationary pressures, trade imbalances, and Euromarket activities. Irving Fisher, an American economist, developed a theory relating exchange rates to interest rates. This proposition, known as the Fisher Effect, states that interest rate differentials tend to reflect exchange rate expectations (Ketell 1978).

On the other hand, the purchasing-power-parity theory relates exchange rates to inflationary pressures. In its absolute version, this theory states that the equilibrium exchange rate equals the ratio of domestic to foreign prices. The relative version of the theory relates changes in the exchange rate to changes in price ratios.

In an article on international money management appearing in the August 24, 1978 issue of Business Week, it was observed that “the gyrations of the currency markets are now dominated mainly by shifts of capital–meaning shifts of stateless money in the Euromarkets. These movements are forcing exchange rates up and down beyond anything justified by accepted economic criteria.”

Other economic factors influencing exchange rates are included in a theory proposed by Dornbush, who presented both a long-run view and a short-run view of exchange rate determinants. According to Dornbush, the long-run determinants of exchange rates are the nominal quantities of monies, the real money demands and the relative price structure. Among the factors that exert an influence on real money demand are interest rates, expected inflation, and real income growth. In the short run, Dornbush theorizes, exchange rates are determined by interest arbitrage together with speculation about future spot rates (Frenkel and Johnson 1978).

Psychological Factors

Psychological factors also influence exchange rates. These factors include market anticipation, speculative pressures, and future expectations. In fact, Frenkel and Musa both emphasize the role of expectations when discussing the determinants of exchange rates.

SUITABILITY FOR USE IN FOREIGN CURRENCY TRANSLATION

In the final analysis, exchange rates are designed to facilitate the exchange of one currency for another. Accordingly, exchange rates represent reasonable mechanisms with which to translate foreign-currency transactions, particularly those that will be settled in the short term. “Attaching more relevance than this to exchange rates and using them as surrogate measures to evaluate past performances or future economic decisions can only be done at great risk.” (Miller 1979) There are a multiplicity of factors that affect the movement of exchange rates. Since exchange rates are not strong proxies for purchasing power parity relationships (Dewenter 1995), another tool such as purchasing-power-parity indexes should be found for use in the translation of foreign currency. However, at present, an acceptable tool of this nature is not available. Until such an index does become generally available, the use of exchange rates in the translation of foreign currency must suffice. Thus, measures should be taken to alert users of the information to the inherent deficiencies resulting from the use of exchange rates. This could be done in part through the use of supplemental explanatory information. One possibility is the use of an informative disclosure model combining matrix presentation of translation effects and management discussion (Guithues-Amrhein 1994).. Such a model would be in conformity with the calls for more informative disclosure from the Financial Accounting Standards Board (FASB) and the Association for Investment Management and Research (AIMR).

REFERENCES

Association for Investment Management and Research (AIMR), Financial Accounting Policy Committee. 1993. Financial Reporting in the 1990s and Beyond. Position Paper. AIMR. Bremner, Brian and Pete Engardio. 1998. What to do About Asia. BusinessWeek (January 26): 2631.

Dewenter, Kathryn L. 1995. Do Exchange Rate Changes Drive Foreign Direct Investment. The Journal of Business, (July): 405-434.

Financial Accounting Standards Board. 1981. Statement of Financial Accounting Standards No. 8, “Accounting for the Translation of Foreign Currency Transactions and Foreign Currency Financial Statements.” Stamford, Conn.: FASB.

Fischer, Stanley. 1998. “The Asian Crisis: A View from the IMF”. Address at the Midwest Conference of the Bankers’ Association for Foreign Trade, January 22, 1998. Washington, D.C.

Frenkel, Jacob A., and Harry G. Johnson, eds. 1978. The Economics of Exchange Rates. Reading, Mass.: Addison-Wesley.

Guithues Amrhein, Denise. 1994. Innovative Reporting of Foreign Currency Translation. Multinational Business Review, (Spring): 65

Ketell, Brian. 1978. Foreign Exchange Exposure. Accountancy (England) 89 (March): 83-84, 86, 89. Miller, Elwood L. 1979. Accounting Problems of Multinational Enterprises. Lexington, Mass.: D.C. Heath and Company.

Rule, John E. 1977. Practical Business Effect of Exchange Rate Fluctuations. Arthur Andersen Chronicle 37 (September): 63-75.

Smith, Craig S., and David Wessel. 1998. Monetary Experts Don’t See China Devaluation. Wall Street Journal, (January 15). “Stateless Money.” Business Week, August 21, 1978: 80.

Teck, Alan. 1976. International Business Under Floating Rates. Columbia Journal of World Business 11 (Fall): 60-71.

Denise Guithues Amrhein Saint Louis University

Copyright College of Business Administration. University of Detroit Mercy Fall 1998

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