Newswise — Foreign exchange rate issues have become more important in recent years, especially in emerging markets, but businesses appear to look through exchange rate volatility to focus on key market opportunities, finds a new, far-ranging study released today by The Conference Board in conjunction with The Group of Thirty, a private, non-profit, international group dedicated to increasing understanding of critical global economic and financial issues.

Global businesses take exchange rates into consideration in making investment decisions, but market opportunity, political risk, and the legal environment are all more important for foreign investment decisions than exchange rate risks.

Global markets are important to growth, and few firms in any geography, including emerging markets, forego foreign investment because of exchange rate volatility. Exchange rate risk may come into play when assessing market opportunity; but it does not appear to be, in and of itself, a deterrent to investment, except in the case of outright currency crises.

"We hear anecdotally that businesses choose one or another country to locate a plant or facility because of exchange rate considerations, but it is hard to identify the magnitude and breadth of these decisions or measure their economic impact," said Paul Volcker, former Chairman of the Board of Governors of the Federal Reserve System, whose concerns about the economic costs of exchange rate volatility in global markets led to this inquiry. Mr. Volcker co-chairs The Conference Board's Global Advisory Council.

Considered the most comprehensive study to date on the key drivers of global business investment by multinational companies, the impact of exchange rates on these decisions, and differences in the strategies that businesses in different global regions use to manage these risks, it is based on a worldwide survey of nearly 400 CEOs and CFOs in 38 countries in every major region of the world.

This study examined an array of business investment drivers to identify the relative role of exchange rates. "Almost two-thirds of the responses indicated that exchange rates were somewhat important in their investment decisions, but global businesses appear to seek profitable markets first and manage the exchange rate risks that come with the territory," said Marina v.N. Whitman of the University of Michigan, who chaired the academic panel that advised The Conference Board on the study.

Over 80 percent of the responding companies indicated that market opportunity was "very important," over 60 percent cited political risk, and 50 percent cited the legal environment, whereas only 20 percent said that exchange rate risk/volatility was "very important" to their foreign investment decisions. "Many of the traditional methods of coping, like financial hedging and/or adjusting prices for exchange rate changes, have significant costs and are undoubtedly a management headache but do not seem to shape the global presence, even of emerging market companies, in a major way," said Whitman.

LITTLE EVIDENCE ON 'BEST PRACTICES' IN MANAGING EXCHANGE RATE RISK

While companies expressed the view that exchange rate issues have become more important, there is surprisingly little consensus on how to manage that risk. Only about 36 percent of the firms replying to the survey indicated that financial hedges (i.e., forwards, futures, or options) were "very important" methods of managing exchange rate risk with another 34 percent indicating that they were "somewhat" important. The responses to the importance of financial hedges did vary significantly by region " with the euro-zone companies seemingly the most intense users of financial hedges and U.S. company views the most polarized. Over 28 percent of U.S. companies said that financial hedges were "very important" while 17 percent said that they were not at all important.

It is striking how few firms seem to adjust prices or production to offset the performance impacts of exchange rate volatility. Less than 20 percent of overall respondents indicate that they adjust prices and very, very few (7 percent) indicate that shifting production is a "very important" strategy for managing exchange rate impacts.

Sixty-two companies indicate that they use exchange rate management as a strategic competitive advantage " and, about 40 percent of these are in emerging markets (compared to 25 percent of the responses in the overall survey.) These firms are twice as likely to use financial hedges as other firms and they appear somewhat more aggressive in managing their balance sheets, but there are relatively few differences with respect to other possible strategies " especially using operational decisions like pricing and production to address FX issues.

BUSINESS MAY BE CONCENTRATING RISK BY USING THE U.S. DOLLAR OR EURO

Probably the most surprising finding of the study and the one with the greatest policy implications is the extent to which businesses do not feel bound by their home currency in international transactions. Over 50 percent of non-U.S. companies use the U.S. dollar in pricing and sourcing and 25 percent of non-euro zone companies (mostly in Europe) use the euro. (Notably, the Japanese yen is almost never used by other than Japanese companies.) "Businesses, not countries, make trade decisions, and they do not appear to feel bound by their home country currency," said Gail D. Fosler, Executive Vice President and Chief Economist of The Conference Board and co-author of the study. "These results are supported by the growth in foreign currency deposits in the global commercial banking system."

The survey shows that over 60 percent of the respondents indicate that five or fewer currencies account for a significant amount of their foreign exchange risk. The use of a reserve" currency like the U.S. dollar or the euro in global business transactions may aggregate and concentrate FX risk, which can then be more efficiently managed using financial hedges.

"To the extent that the U.S. dollar becomes the preferred global currency for international transactions, changes in the value of the dollar will have little direct effect on prices," added Fosler. "This result calls into question the conventional wisdom that a decline in the dollar is the solution to the U.S. trade deficit or that the revaluation of another currency like the Chinese RMB will have real effects. Businesses can simply re-denominate their transactions in U.S. dollars. Indeed, we are witnessing much less impact on non-oil import prices from the recent fall in the U.S. dollar than we have in the past."

OTHER KEY FINDINGS IN THE SURVEY

Among other key findings in the study:

"¢ U.S. and Euro-zone firms share many of the same attitudes about exchange rates. The responses from Japanese firms, however, more closely paralleled those from emerging markets."¢ Globalization is not just an advanced country phenomenon. Despite FX risks, emerging market companies with under $1 billion in revenue are often more global (i.e., have operations in more countries) than their advanced economy country counterparts. "¢ From the perspective of national exchange rate policy, selecting a specific currency regime in order to attract foreign investment is not productive. Businesses from all parts of the world are skeptical about the stability of currency regimes. There is some preference for common currencies (the euro is a leading example) and companies from the developing Asian countries indicate a strong preference for managed floats. "¢ The introduction of the euro has had positive benefits for companies from all regions with operations in Europe. It has not, however, increased the attractiveness of Europe as a place to do business or invest. This result is probably due to the overwhelming importance of market opportunity."¢ There is surprisingly little difference between Euro-zone companies and those in Europe outside the euro-zone on the euro's impact. Many transactions may be already denominated in euros."¢ Japanese companies' responses to many of the questions more closely paralleled the responses of emerging market companies than those of either U.S. or European companies.

POSSIBLE POLICY IMPLICATIONS

These trends suggest at least two important policy implications. First, the tendency of a currency like the U.S. dollar to strengthen when trade deficits were rising, as was the case during the late 1990s, may be partly the result of this incremental transactions demand for dollars. Similarly, as the use of the euro in international transactions widens, the EU may find that it is difficult to impact its trade accounts through currency changes. Second, money growth has been rising relative to GDP, especially in advanced emerging markets, suggesting that local monetary authorities are not offsetting fully the impact of these U.S. dollar and/or euro deposits on their own money supplies. The growth in foreign currency deposits like the U.S. dollar and the euro may thus be creating an unintended increase in global liquidity, which may lead to difficulties in macroeconomic policy management down the road.

Source: Do Exchange Rates Matter?Report #1349-04-RR The Conference Board