Movement In Sterling Rates And Shpl Profits Economics Essay
Shrewsbury Herbal Products Limited, (SHPL) is a U.K based producer of herbal teas and allied products with markets across the U.K and in many countries of continental Europe. Generally invoicing its exports to Europe in sterling it has recently received a large order for its products from a buyer in central France. The terms of the order require delivery to be made three months hence and billing in Euros.
The forward deal offered by the company’s bankers, based upon selling Euro receivables, will enable the company to protect its inflows from adverse exchange rate fluctuations, which could be caused by the pound appreciating against the Euro over the coming three months. Whilst such a transaction would not provide the company with the benefits of positive swings in the Euro – Pound exchange rates, it would nevertheless protect the company’s inflows for a small set up cost and is thus a recommended course of action (Clarke & Ghosh, 2004, P 7).
The other concerns raised by the senior management of SHPL are taken up for discussion in the following sections of this report.
1. Impact of Movement in Sterling Rates on SHPL Profits
Companies like SHPL who engage in substantial international transactions are exposed to foreign exchange risks in various ways. Whilst the proceeds from the domestic sales of the company, be they in England, Scotland or Wales, will remain unaffected by the fluctuation in currency rates, the company’s sales to other countries, in Europe or elsewhere, will be exposed to both the risks and the benefits of exchange rate fluctuation until and unless such sales are denominated only in sterling (Miller & Reuer, 1998, P 493+). With most importers likely to do business either in the dollar or in the Euro, SHPL’s prospects of increasing exports will depend significantly upon its readiness to accept dollar or Euro denominated sales deals.
Depreciation in the rate of the pound sterling against the other currencies will automatically increase the company’s export revenues and have a beneficial effect on its profitability (Miller & Reuer, 1998, P 493+). Whilst the extent of benefits would depend upon the relative percentage of exports in its total sales portfolio, such an amount is expected to be significant. Appreciation in the sterling against the dollar or the Euro will conversely affect the sales profitability of the company adversely (Miller & Reuer, 1998, P 493+). Whilst such phenomena affect the commercial operations of business firms by making the prices of competing international products cheaper or more expensive, such developments are generally out of the control of individual business firms (Miller & Reuer, 1998, P 493+). The risks of fluctuations in exchange rates of local or external currencies can however be guarded against by a range of hedging options in the forward and in the futures market, as well as by engaging in bespoke swap deals (Clarke & Ghosh, 2004, P 32).
2. Use of Forward Exchange Rates to Hedge against Exchange Rate Risk
Foreign exchange risks can affect business organisations in a number of ways, for example, through changes in the financial impact of overseas transactions by conversions of currencies on balance sheets or through alterations in the competitive positions of business firms in the market (Sarno & Taylor, 2002, P 31 to 72). Regardless of the sources of such risks, their consequences can impact the operations of companies significantly by reducing profits and putting stress on relationships with clients and partners (Sarno & Taylor, 2002, P 31 to 72).
Whilst exchange rate fluctuations continue to occur, many CFO’s shy from engaging in hedging transactions because they believe them to be forms of speculation, or that foreign exchange movements even out over time (Sarno & Taylor, 2002, P 31 to 72). Both these assumptions are incorrect and can lead to heavy losses for business firms who refuse to guard against foreign exchange fluctuations (Sarno & Taylor, 2002, P 31 to 72).
The right mix of hedging products can significantly reduce the chances of business distress by offsetting exposure of hedged transactions. Forward contracts are utilised to lock in currency exchange rates for specified dates (Sarno & Taylor, 2002, P 31 to 72). They are frequently used to neutralise the effect of adverse movements in exchange rates and safeguard profits by fixing a forward exchange rate (Sarno & Taylor, 2002, P 31 to 72).
The objective of forward transactions is to lock in the local currency value of receivables or payables in foreign currencies regardless of the movements in the spot exchange rate between the time when a transaction is completed and when its receivables or payables become due (Miller & Reuer, 1998, P 493+). The foreign currency is purchased forward for payables and sold forward for receivables (Miller & Reuer, 1998, P 493+). This enables the hedging firm to fix the local currency value of the amounts due or payable on the future date, independent of the spot rate on such future date (Miller & Reuer, 1998, P 493+).
3. Determination of Exchange Rates.
Currency exchange rates are notoriously volatile (Streissler, 2002, P 9). Movements in exchange rates, regardless of their being immediate, short or long term, are essentially caused by changes in demand and supply conditions prevailing in exchange markets (Streissler, 2002, P 19).
Global markets for foreign exchange currencies are truly enormous with many hundreds of billions of dollars, Euros, pounds, and yen being traded every day (Streissler, 2002, P 19). The markets are open 24 X 7 for individuals, organizations and governments who require foreign exchange (Streissler, 2002, P 19). Aided by advances in computer technology and progressive elimination of exchange controls across countries, money now flows through the international system at lightning speed (Streissler, 2002, P 18).
Whilst speculative activity is a major determinant of modern day currency fluctuations, such fluctuations are essentially caused by alterations in the demand supply scenario (Miller & Reuer, 1998, P 493+). Sterling for example can be required for a number of reasons. Organisations in other countries need sterling to buy U.K products (Sarno & Taylor, 2002, P 101to 110). Such demand for sterling should logically increase the cost of the currency, which in turn should adversely affect the demand for U.K products and set off a negative movement in sterling exchange rates (Sarno & Taylor, 2002, P 101to 110). Companies might want to invest in production and computing facilities in the U.K and require pounds to do this (Sarno & Taylor, 2002, P 101to 110). Overseas investors could likewise wish to place deposits in U.K banks because of their attractive interest offerings (Sarno & Taylor, 2002, P 101to 110). Speculative traders who buy and sell pounds to make profits also increase demand by buying pounds when its value is low and by selling them when their value is high thus triggering short term spikes or dips in exchange rates (Sarno & Taylor, 2002, P 101to 110).
Sterling is again sold for a range of similar reasons, like purchasing of imports from other countries, purchase of investments by U.K citizens, and funding of education of UK citizens in other countries (Sarno & Taylor, 2002, P 101to 110). Such demand and supply pulls on a currency lead to the establishment and maintenance of an ever changing equilibrium, which can essentially be stable (i.e. remain within limits) for long periods, or even be extremely volatile (Sarno & Taylor, 2002, P 101to 110).
Apart from supply and demand conditions a number of other phenomena also drive exchange rate equilibrium (Streissler, 2002, P 32to 45). These include movements in internal interest rates, economic growth, inflation, the balance of payment positions and other special factors like political events, business disasters or inter-country disputes and resultant aggression (Streissler, 2002, P 32to 45).
Movement in interest rates can affect demand supply considerations significantly in the modern day globalised economy where movement of financial capital between countries can occur freely and without hindrance (Streissler, 2002, P 32 to 45). Countries with high interest rates attract capital because of the desire of investors to obtain better returns on their money and can create positive demand and exchange rate appreciation (Streissler, 2002, P 32 to 45). Decisions by central banks to reduce interest rates drastically, whilst motivating production and GDP growth, can lead to flight of capital kept in local banks in the form of interest earning deposits (Streissler, 2002, P 32 to 45).
Countries experiencing growth in production and exports often find their currencies appreciating (Streissler, 2002, P 32 to 45). The appreciation of the Japanese yen in recent years reflects the companies progressively improving export performance (Hauter, 2008, P6+). Countries experiencing recessionary conditions on the other hand often find their currencies slipping sharply. The erosion of the pound against the dollar in 2008 brought home the impact of the economic downturn as starkly as deserted supermarkets and spiking unemployment figures. Countries like Pakistan and Sri Lanka which have experienced years of difficult economic conditions have found their currencies crashing against all major world currencies, making it difficult for them to import foreign equipment, modernise their infrastructure, or send their children abroad for foreign education(Clark & Ghosh, 2004, P118).
Countries with persistently high inflation again experience downward movement in exchange rates because of reduced international competitiveness and falling exports (Streissler, 2002, P 32to 45). Such countries sometimes resort to currency devaluation to kick-start exports and improve their competitive advantage (Streissler, 2002, P 32 to 45).
Significant exchange rate fluctuations can also be caused by the balance of payment positions of individual countries (Manzella, 2005, P 94). Countries with strong trade surpluses (where exports lead imports by substantial margins) witness increasing demand for their currencies and progressive appreciation in exchange rates (Manzella, 2005, P 94). Net importers on the other hand witness reduced demand for their currencies with negative effects on their exchange rates (Manzella, 2005, P 94).
A million forces constantly work towards enhancing and putting pressure on the exchange rates of different currencies (Sarno & Taylor, 2002, P 101 to 110). On many occasions such phenomena can first improve demand for a currency and then later have a completely opposite effect (Sarno & Taylor, 2002, P 101 to 110). Apart from these numerous economic forces which constantly play against each other, exchange rates are also affected significantly by pan global speculative activity, which often leads to sudden and apparently inexplicable spikes and dips (Sarno & Taylor, 2002, P 101 to 110).
Such exchange rate fluctuations can lead to substantial changes in the behaviour of exporters, importers and consumers in different countries. The appreciation of the dollar against the pound in 2008 made British goods and holidays substantially cheaper for Americans and led to a increase in tourist interest in the country, as Americans found the costs of holidaying in Britain to have reduced by more than twenty percent. U.K citizens, on the other and found all American goods, be they automobiles, white goods or food items substantially more expensive during 2008 than in the past. American retailers like Abercrombie and Fitch reported sharp declines in the sales of their U.K outlets (Abercrombie, 2009). American cars found much fewer takers and unsold cars piled up at docks and dealer showrooms, leading to cancellations and scaling down of future orders (American cars, 2009).
4. The Role of Multinational Corporations
Multinational corporations are large business firms with operations in a number of countries (Nizamuddin, 2007). Whilst most multinational corporations (MNCs) have headquarters in one specific country, known as the home country, they have production, marketing, and R&D facilities in other nations (Nizamuddin, 2007). Models for MNCs differ from firm to firm (Nizamuddin, 2007). A largely followed model is that of the MNC locating the executive headquarters in a specific country to take advantage of local incorporating benefits, even whilst it locates its production and service facilities in similar quality but lower cost areas (Nizamuddin, 2007). Another structural set up comprises of basing the parent company in one country and establishing subsidiary companies in other nations across the world (Nizamuddin, 2007, P 149 +). In such a model, the subsidiaries are provided with significant operating autonomy, even as they continue to be essentially controlled by the parent companies (Nizamuddin, 2007, P 149 +).
SHPL, with its headquarters in the U.K and markets across Europe does not essentially qualify to be termed an MNC because all its facilities lie within England. It can be suitably categorised as a small U.K manufacturer and exporter of teas and allied products.
The idea of an MNC is not new and whilst historians trace the first MNC to be the Poor Knights of Christ and the Temple of Solomon, which operated in the 12th century, the modern concept of transnational companies started with the formation of the British East India Company and the Dutch East India Company (Nizamuddin, 2007, P 149 +). Both these organisations, which were floated as joint stock companies in London and Amsterdam, were headquartered in England and the Netherlands but had facilities and operations across nations and continents (Nizamuddin, 2007, P 149 +). Apart from catalysing global trade, they played significant roles in the growth and spread of colonialism, developed into powerful and rich corporations, and assumed numerous economic roles (Nizamuddin, 2007, P 149 +).
Multinational corporations have become focal points of economic and political power in the modern day global economy (Tolentino, 2000, P34 to 41). Essentially accountable to their shareholders and responsible for maximising their wealth, they can and do play significant roles in terms of influencing the political, economic and social environment of the many host countries in which they operate (Tolentino, 2000, P34 to 41).
An important economic role of MNCs is to canalise financial and physical capital to nations with capital inadequacies (Tong & Reuer, 2007, P216 +). The wealth which is consequentially created results in additional jobs, increased tax revenues and greater governmental capacity for improvement of physical infrastructure, education, poverty alleviation and strengthening of human capital (Tong & Reuer, 2007, P216 +). Such improvements in capital flow efficiencies lead to reduction in global poverty levels, especially in the developing world, and by extension encourage countries to work towards seeking peace oriented solutions in areas of internal and external conflict (Tong & Reuer, 2007, P216 +).
MNC’s have been vigorously attacked by and continue to bear the brunt of criticism from individuals and organisations who accuse them of (a) engaging in harmful competition and treacherous plots to exploit weak economies, (b) systematically eliminating local firms in order to strengthen and establish their monopolies, (c) exporting high wage jobs to low income nations, (d) harming the global environment, (e) increasing the external debt of the developing nations, (f) increasing income gaps and perpetuating global poverty and (g) exploiting child labour (Tong & Reuer, 2007, P 216 +). Spokespersons for MNC’s however have vastly different opinions (Tong & Reuer, 2007, P 216 +). They assert that competition is not destructive; such competitive activity helps in generating products that are of high quality and low price (Tong & Reuer, 2007, P 216 +). In an environment of free trade, competition leads to gains from exchanges that are mutually beneficial and motivates nations to optimise their business operations (Tong & Reuer, 2007, P 216 +) . Recent research reveals that whilst multinational investment has led to some reduction in local investment in Latin American countries, it has actually spurred such investment by 1.5 to 2.3 times in Asia (Tong & Reuer, 2007, P 216 +).
Again, whilst MNC’s are subjected to intense criticism by the left and right wing parties, (by the former for their exploitation of the poor and for increasing income divides and by the latter for undermining national sovereignty), they are actually subjected to immense monitoring, both in their home country and in their host nations (Groenewegen, 2006, P 853+). Numerous laws on investment, taxation, employment, labour and foreign direct investment are in place to ensure that such organisations do not let their profit motives overcome their corporate social responsibility objectives (Groenewegen, 2006, P 853+). It is also a fact that (leave alone harming the global environment) MNCs have led the movements for spreading of environmentally friendly technologies and products (Groenewegen, 2006, P 853+). Whilst their socially responsible and environmentally friendly activities have often been influenced by market forces, namely customer pressure and antipathy, activist lobbying and reputational concerns, their actions have helped substantially in curbing carbon emissions and reducing ocean contamination (Groenewegen, 2006, P 853+).
Whilst the truth always lies between two extreme positions, it is undeniable that MNCs have added millions of direct and indirect jobs in the developing countries, pumped in billions of dollars into long term and productive projects, improved the quantity and quality of available goods, (both in the local and international sense) and improved the GDP of their host nations (Bhagwati, 2004, P 25 +). Very possibly much more can be done by them in areas relating to consumption of tobacco and alcohol, elimination of child labour, improvement of worker’s wages and bringing in of greater fairness between genders in work places (Bhagwati, 2004, P 25 +).
5. Impact of Globalisation on Small Businesses.
Economic globalisation, a term now closely associated with most current economic developments, refers to the meshing of national market places, which were at one time distinct and separate, into one enormous global entity (Brennan, 2003, P 27). As discussed threadbare by millions of publications the phenomenon owes it spread to (a) advances in human communication, (b) sharply increased travel of people between nations (c) dismantling of physical, trade and economic barriers, (d) economic deregulation, (e) the creation of a huge online marketing space, and (f) free movement of physical and financial capital between nations. Globalisation whilst providing immense opportunities in areas of business, trade, education, health, and poverty reduction, has also brought with it a number of threats (Brennan, 2003, P 27).
Small businesses face threats from highly increased competition from international products, price cutting and dumping even as they are provided with access to new markets (Manzella, 2005, P34)). Globalisation of production is leading to the migration of production facilities from the UK to low cost areas, increase in production scales and sharp reduction inn product costs (Smith & Debrah, 2002, P37 to77). The emergence of China and India as producers of high quality and low cost products and services has led to extreme competition in the U.K market, increased unemployment and closures of production and service centres (Smith & Debrah, 2002, P37 to77). Even a little known business area like fireworks is now dominated by Chinese companies, and imports outsell local production by a wide margin (Smith & Debrah, 2002, P37 to77). Service oriented jobs like those associated with call centres, insurance, and banking have migrated, in thousands, from the U.K to Bangalore, Hyderabad and Ghaziabad (Smith & Debrah, 2002, P37 to77). U.K companies being Shanghaied or Bangalored are not difficult to find (Smith & Debrah, 2002, P37 to77). Small companies like SHPL need to realise the complexities of globalisation, forecast future developments and take proactive and reactive action. The company could face significant competition from Chinese and Indian herbal tea companies in its local and overseas markets. It should respond to such threats by taking carefully thought out and radical measures to improve production efficiencies in order to reduce costs, and seriously look at purchasing teas cheaply from the Chinese and Indian markets. Much of the economic benefits of globalisation have flowed from the advantages provided by the internet. The global online marketing space provides a huge opportunity for small companies like SHPL to communicate with people across the world and sell products to distant locations (Manzella, 2005, P 74). As businesses move forward the real challenge for smaller firms will be to move efficiently through the complexities of an ever changing market place (Manzella, 2005, P 74). SHPL will have to globalise its operations more effective and efficiently. The senior management of the company will have to institute systems for constantly assessing and absorbing market place changes and taking appropriate responsive action, both in areas of sales and production (Manzella, 2005, P 74). The company’s area of core competence will need to be strengthened significantly in line with global demands, both in its local and its external markets (Manzella, 2005, P 74).
6. Nike and Sweatshop Labour
Nike Inc is the largest sports goods manufacturer in the world (Dionne, 1998, 7). A true MNC, it has numerous factories and markets across the world, even as it continues to be headquartered in and managed from the United States (Dionne, 1998, 7). Despite having annual sales turnovers that run into billions of dollars and approximately 550,000 people working on its products, the company does not own a single manufacturing unit (Dionne, 1998, 7). All its factories are owned by local contractors who make products strictly in line with the company’s requirements (Dionne, 1998, 7). Situated mostly in the developing countries of Asia these factories employ workers at wages that are around the minimum wage level of these countries and make them work in sweatshop conditions (Dionne, 1998, 7). Sweatshops essentially represent working environments that are poor, difficult and dangerous (Dionne, 1998, 7). Workers in sweatshops are routinely exposed to possibly harmful material, difficult temperatures, employer abuse and other hazards (Dionne, 1998, 7). Such units are also routinely associated with poor pay, violation of labour laws and child labour.
Nike, routinely associated with very expensive sports gear, and endorsements by celebrities like Michael Jordon, came into the news in the early 1990’s when investigative reporters found that its factories in the developing nations paid wages which were at the minimum wage level of those countries and had abysmal working conditions (Bigelow, 1997, P 112+). Some factories, especially football stitching units in Pakistan employed child labour. In some cases factory owners in Vietnam had even asked for easing of minimum wage requirements on the plea that the company was providing much needed employment (Bigelow, 1997, P 112+). Public appreciation for the company’s product quality soon turned to distaste when it was revealed that a product that sold for a hundred dollars did not cost more than sixteen to make; leaving the company with enormous money to spend on expensive advertising and celebrity endorsements and yet record very handsome profits (Bigelow, 1997, P 112+). It also came to light that the company, which originally located its manufacturing units in Japan and Thailand moved them out to other countries like Vietnam when labour laws became stricter in such countries, minimum wages increased and labour empowerment improved (Bigelow, 1997, P 112+). With factory workers in Vietnam being paid a dollar a day, it was not very difficult for the company to pay Tiger Woods 28 million dollars and Michael Jordan 45 (Bigelow, 1997, P 112+). Other celebrities paid huge sums of money include Andre Agassi, John McEnroe, Monica Seles and Carl Lewis (Bigelow, 1997, P 112+) In totality, the company spends more than a billion dollars every year on advertising and promotion (Bigelow, 1997, P 112+).
The Economist reported in 1993 that workers in Vietnam were routinely subjected to physical punishment such as “being hit on the head and forced to kneel on the ground with their hands in the air for periods of time” (Bigelow, 1997, P 112+).
Faced with intense condemnation from activists in western countries the company responded in the beginning with strident assertions of its beneficial role as an employment provider to hundreds of thousands of people, supporting such clams with pictures of happy groups of Vietnamese workers and public presentations about its philanthropy in countries in which its products are manufactured (Bigelow, 1997, P 112+). It also took action to eliminate child labour from its contractor’s factories and adopted an internal code of conduct that provided for respecting the environment and the dignity of its workers (Boje & Khan, 2009, 9 +). The code of conduct also recommends the payment of minimum wages, a minimum age of sixteen years for workers, a ban on forced labour and minimum safety standards (Boje & Khan, 2009, 9 +).
The actions of companies like Nike represent the worst of what globalisation can bring to the peoples of the developing world. It enables hugely rich MNCs to get their products manufactured in low cost areas, paying wages that allow employees to barely eke out a living; thus allowing such companies to make exorbitant profits on sales highly priced products to privileged global populations (Groenewegen, 2006, P 853+). Many companies engage in substantial rhetoric about their corporate social responsibilities and triple bottom line efforts even while they fundamentally continue to exploit and undermine underprivileged humans (Groenewegen, 2006, P 853+).
A number of large companies now adopt specific corporate governance methods and assume social responsibilities that aim to reduce or eliminate the adverse effects of their working on the environment, their employees and their customers (Groenewegen, 2006, P 853+). Much of this is still thought to be nothing more than sophisticated and devious public relations efforts. Economists like Milton Friedman have gone on to categorically assert that corporate managers have no other responsibilities than to make profits (Groenewegen, 2006, P 853+).
Current times are however witnessing a change in such chauvinistic ideology. Increasing customer awareness, vociferous social activism and an increasingly strident media are forcing MNCs to adopt more responsible working methods (Nizamuddin, 2007, P 149+). In most cases such methods lead to enhancement of costs and reduction of profits and thereby go against the interest of shareholders, the most important of company stakeholders (Nizamuddin, 2007, P 149+).
Whilst such change will be slow and, in most cases, will occur because of external pressure rather than internal intentions, responsible managements need to constantly work towards achievement of such social objectives.
7. The UK’s Decision to Adopt the Euro
The decision to join the Euro, whilst confronting the U.K for the last decade, continues to provoke intense and emotional debate.
Although much of the emotional objections to adopting the Euro arise from national fears of dilution of sovereignty and even of nationhood, the issue has a number of positive and negative economic features.
Adopting the euro will eliminate exchange rate risks between the U.K and European countries that use the euro (Minford, 2004, P75 +). Such a step will remove an important barrier for U.K companies to trade with as well as produce and invest in such countries (Minford, 2004, P75 +). With such countries offering a total market of 300 million people, U.K businesses could well be provided with significant opportunities for increasing their growth and profitability (Minford, 2004, P75 +).
Adopting the currency will also provide a better foundation for business planning and enhance the size of the market for all U.K businesses that deal with European countries (Minford, 2004, P75 +). Joining the euro will also eliminate all hedging costs that are part of transactions between countries with different currencies and lead to net saving in costs for U.K firms and individuals (Minford, 2004, P75 +). Tourism, one of the country’s most important industries should gain significantly from such a union (Minford, 2004, P75 +). Monetary union increases the competitiveness of an economy and makes it easier for firms to build scale economies and reduce unit costs (Kampfner, 2005, P6). Specialisation should lead to greater economic dynamism (Kampfner, 2005, P6). The ability to compare prices in so many countries should increase the efficiency of U.K businesses (Kampfner, 2005, P6). A single currency also creates a large financial market and leads to enhancement of efficiency in capital allocations (Kampfner, 2005, P6).
On the other hand, joining the euro could well be costly for many business firms (Kampfner, 2005, P6). The physical conversion from one currency to the other will lead to sizeable increase in costs, particularly in the banking and retailing sector (Kampfner, 2005, P6). A common interest rate for the U.K in line with that adopted by the Euro land could well be inappropriate and lead to poorer growth (Kampfner, 2005, P6). The country could also be affected with the huge pension liabilities that are associated with European countries (Kampfner, 2005, P6). While the U.K cannot be forced to pay for Italian pensions, it could suffer because of greater interest rates. The growth and stability pact inside the euro could be particularly harmful for the country (Kampfner, 2005, P6). The U.K government’s fiscal initiatives could conflict with such agreements and create fiscal problems for the nation.
The relevant issues for and against joining the euro are extremely complex. While taking any steps to join the euro could open the country to a number of risks, staying outside also exposes the nation to significant hazards. The short term risks in this case must be assessed carefully and controlled before any decision to join the Euro can even be considered.
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