United StatesChange Country

How Exchange Rates Affect Imports and Exports

By Elliot M. Kass

The dollar’s exchange rate continues to strengthen during the first half of 2019, and this could pose challenges to small and midsize enterprises (SMEs) involved in import and export businesses.

The dollar gets stronger when its exchange rate rises relative to other currencies like the Chinese yuan and the European Union’s euro. As measured by the Real Trade-Weighted U.S. Dollar Index published by the Federal Reserve Bank of St. Louis’ FRED database, the all-time high for the dollar was 128.437 in March 1985, when the Fed raised short-term interest rates to 9 percent to combat inflation.1,2 The record low was 80.5207 in July 2011, during the aftermath of the Great Recession. As of April 2019, the index averaged 102.2591, slightly below its most recent peak of 103.2082 in December 2018, but 7.2 percent higher than April 2018 when it stood at 95.4146.3

 

Ways Exchange Rates Affect Imports and Exports

 

A strengthening dollar can spell trouble for U.S. companies that export a lot of goods to other countries. Since their products are priced in dollars, those exports become more expensive for the foreign consumers and businesses that have to pay for them in other currencies. The value of the profits they make on export sales falls, as well, when they convert overseas profits back to dollars.

 

But the dollar’s favorable exchange rate can also hurt U.S. firms at home. That’s because when the dollar is strong, American consumers are able to buy imported goods for fewer dollars, making American-made products more costly in comparison.

 

While this makes it appear that U.S. businesses benefit when the dollar weakens, reality is not so simple. When the dollar falls in value compared to other currencies, the price of imported raw materials like steel go up in price and products like cars that are manufactured in the U.S. can cost more to make.

 

Conversely, if the dollar rises and the cost of imported materials drops, American manufacturers that hold their prices steady will see their margins increase. Alternatively, they have the option of dropping their prices to grab a bigger chunk of the market, without surrendering any of their profits. Moves like this can compensate for the loss of price competitiveness due to a stronger dollar both at home and abroad.

 

Why Exchange Rates Fluctuate

 

So what factors can cause different currencies to rise and fall?

 

The exchange rate is defined as "the rate at which one country's currency may be converted into another.4 Typically, these rates fluctuate daily in response to the forces of supply and demand for different countries’ currencies. Chile, for instance, is the world’s leading copper exporter. If global demand for copper goes up, demand for the country’s currency, the Chilean peso, may also rise since companies may need pesos to buy copper. That would increase the peso’s value compared with dollars, pounds, and euros. If demand for copper falls, the Chilean peso’s value may also take a hit.

 

Other important factors that affect exchange rates include:5

 

  • Inflation rates. Inflation is a major determinant of exchange rates. Countries with low inflation usually see the value of their currency rise compared to others. Those with higher inflation, meaning each unit of their currency buys fewer goods and services over time, usually see their exchange rates fall.

  • Interest rates. Intertest rates are also closely tied to foreign exchange and inflation rates. If the rate a country pays when it borrows rises relative to other countries, more money seeking higher returns will flock to that country, demand for its currency will rise and the currency’s value will rise with it. Likewise, if interest rates fall, money will flee in search of higher returns and the exchange rate will drop.

  • Current account. A country’s current account includes its balance of trade and earnings on foreign investment. Its trade balance reflects its exports versus its imports and foreign debt. A current account deficit may occur when a country imports more than it exports, and this in turn can cause its currency to depreciate.

  • Government debt. When governments issue new debt, interest rates may rise to attract bond buyers, leading to more demand for its currency. But if investors fear that the government has taken on too much debt and may default, they may sell whatever government bonds they hold, undercutting demand for its currency and causing its exchange rate to decline. This, in turn, may cause inflation to spike.

  • Political and economic stability. This is another important factor, since foreign capital will gravitate towards countries where investments are secure and the business landscape offers few surprises. Money flocks to countries where the business climate is predictable and flees countries roiled by uncertainty. This favors the former’s exchange rate and undermines the latter’s currency.

  • Speculation. Investors looking for profits through currency trading can also play a role, especially when a turn of events is deemed likely to have an outsized impact on a country’s currency. If that country is on the brink of a recession, for example, speculators may see its currency as vulnerable and sell it short. This can amplify any decline in its value.

With all these factors at play, an SME involved in import or export businesses could be tempted to simply adjust its prices to compensate for currency exchange rate shifts and leave it at that. Economists, however, suggest thinking first about how a price change will affect the business’ relationship with its customers.6 If import prices rise and the business keeps its prices constant, that may help to grow its market share. If the company has to raise its prices, it may be able to compensate by offering better terms or higher levels of service. If, say, the dollar's rise against the yen makes it harder to sell in Japan, there may be other markets with stronger currencies where the business can pick up the slack.

 

The

Takeaway:

A large number of complex, varied, and inter-dependent factors can influence the dollar’s exchange rate and, in turn, the prices of imports and exports. In the end, experts suggest one important approach SMEs can use to manage the effects of exchange rates on imports and exports is to develop a business strategy that doesn't focus strongly on price.

Elliot Kass - The Author

The Author

Elliot M. Kass

Elliot Kass is a journalist who has covered global business and technology from New York, London, and San Francisco for more than 30 years.

Sources

1. “Real Trade Weighted U.S. Dollar Index: Broad, Goods,” FRED Economic Data; https://fred.stlouisfed.org/series/TWEXBPA
2. “Dollar Strength and Why It’s So Strong Right Now,” The Balance; https://www.thebalance.com/dollar-strength-why-is-it-so-strong-right-now-3305726
3. The Fed’s Real Trade Weighted U.S. Dollar Index reports the monthly average of daily changes, as economists consider daily data to be overly “noisy.”
4. “8 Key Factors that Affect Foreign Exchange Rates,” Compare Remit; https://www.compareremit.com/money-transfer-guide/key-factors-affecting-currency-exchange-rates/
5. Ibid
6. “What Happens to Exports & Imports When the Dollar Appreciates & Depreciates,” Biz Fluent; https://bizfluent.com/info-8221802-happens-imports-dollar-appreciates-depreciates.html

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