Last reviewed 12 November 2020
The effect of currency exchange on an exporter’s bottom line is just one of the many risks that can severely affect the potential profitability of a sale. For just about every business outside of the eurozone, trading with someone in another country means that one party has to do business in a currency that isn’t their own.
The effect of exchange rate fluctuation is often hidden in a transaction, particularly if the amount is modest. In these circumstances, an immediate payment might be made by bank transfer or credit card at the rate shown by the bank. The buyer knows what they’re going to pay and the seller knows what they’re going to get. It’s not always the most cost-effective way of making the transaction, but it does at least take out the uncertainty for both parties.
In a turbulent year like 2020, there has been quite substantial movement between some major currencies. In mid-November, sterling was enjoying exchange rates against most major currencies that were close to highest seen all year, which is interesting given the imminent end of the implementation period, when the UK leaves the European Single Market and Customs Union (31 December). During the calendar year, sterling fluctuated by more than 16% against the US Dollar and Japanese Yen. Compared to the euro, Swiss franc, Australian dollar and Chinese yuan the movement was much less severe; it was around five percent in all cases.
But as with the stock market, historical information doesn’t give us any guarantee about what the future will be like, and it’s the future that’s going to affect the value of our export sales. If sterling is relatively high in value right now, does that mean it’s due for a fall? Your guess is as good as mine, frankly.
The prospect of a major exchange rate moving by 15% or more in just a few months can potentially make a serious dent in the profitability of a sale. So how can an exporter protect their interest? Well, the most obvious way is to price everything in the exporter’s currency. That’s fine for the exporter, but it just shifts the risk to the buyer, and in a competitive market, that might make the exporter’s products less attractive. Does it help to protect our margins if it comes at the cost of losing business? Is the mere possibility of losing out enough to put the buyer off?
Exposure to currency fluctuation
The extent to which an exporter is exposed to currency fluctuation depends largely on the length of time between agreeing the price and getting paid. In many businesses, the production of a bespoke order for a customer could easily take six months or more. Some contracts would see that final payment reaching the exporter up to 12 months after the price was agreed, or even longer. The exporter needs to manage the risk of not getting paid at all as well as the impact of an adverse currency movement.
In some circumstances, payment in advance may be quite acceptable to the buyer. For example, if the contract is in US Dollars and the buyer has to exchange his local currency for the transaction, the buyer may actually be keen to complete the payment before there’s any risk of the currency he holds being devalued. In transactions with currencies where exchange rates are particularly volatile, it’s worth exploring the possibility.
If payment in advance is not on the cards, a compromise may be staged payments, which is widely used in delivery of high value bespoke projects. For example, a contract might stipulate 25% payment on signing of the contract, 25% on completion of production, 25% on delivery and the final 25% three months later. This can give assurance to both parties. The exporter is going to receive half the money before the goods leave their premises and the buyer only pays the third tranche when the goods have been received. Assurance of payment is closely linked to exchange rate risk in most cases.
In large contracts, an exporter may propose a currency fluctuation clause, meaning that the exporter has the right to revise prices with a fixed margin if the relevant exchange rate changes by more than an agreed amount prior to payment. The buyer may insist that the clause works both ways of course, giving him the right to negotiate the price downwards if the exchange rate moves the other way. In cases of large value contracts, or where there is a regular flow of business, this can be a sensible precaution that can also give protection to both parties.
Managing exchange risk
One of the easiest and perhaps smartest ways of managing exchange risk is not to exchange the currency at all. Most exporters are also importers, sourcing their materials and components from suppliers who may be in the same country or use the same currency as the exporter’s customers. The euro has made this much more common, with 19 countries now officially in the eurozone, the exporter has more cards in his hand. So, an exporter who knows he will be invoiced by suppliers in euros can have euro payments made into a euro account to settle those payments when the time comes. This can avoid the costs of exchanging currency as well as remove some of the exposure to risk. The same can be said of the US dollar, which is a common transaction currency with many parts of the world, especially in Asia. A business that sources materials from China and exports to the USA can limit its risk in much the same way.
If these practices aren’t enough to reduce the risk, exporters have the option of making forward purchases from a bank. What happens is, when an exporter is agreeing a contract with a customer, they make an arrangement to buy sterling with the received currency at or around the expected date of receipt. The rate may be a relatively safe bet for the bank, that’s to say it’s a somewhat pessimistic expectation, but it does give the exporter some security, and the exporter can build this agreed rate into their price calculations.
Living with risk
And of course, the final way of dealing with the risk is to live with it. As with the stock market, exchange rates can fluctuate in both directions, often without apparent logic. A business that can command large margins on its products may feel it’s better to take the consequences. They may lose some profit here and there, but they may also gain. The do-nothing approach does have the merit of minimising bank charges (such as for arranging a forward purchase) while keeping the customers happy because they know what they are paying.
As with so much in exporting, there’s no single answer to managing the risks of currency exchange. A lot depends on the circumstances of the business, the nature of the business they’re in, and crucially, the attitude of the business to talking risks.