adr international Procurement consultants

Fair exchange

With talk of a new breakaway European currency, there has never been a better time to get to grips with exchange rate movements. Robin Jackson highlights some of the issues for procurement people

There was once a time when currency exchange rates were relatively stable, so paying in dollars or yen or other currencies was of little consequence.

Now, following the great recession, things are different. We now live in an age of exchange rate volatility, with the latest developments including both the euro and sterling weakening against the US dollar and the recent announcement by China that it will drop the yuan’s peg against the US dollar, resulting in a strengthening of the Chinese currency.

There is even speculation that the huge pressures faced by Greece and other southern European countries could lead to Germany, France, and others in the north launching a new currency.

Most procurement professionals I have worked with tend to ignore currency movements. They are content to pass the responsibility for exchange rate management to the finance or treasury function within their businesses.

However, there are risks and opportunities resulting from exchange rate movements that procurement people would do well to manage themselves, or at least to understand fully.

There are three ways to pay for products and services from outside your country. You can pay in your own currency, in the supplier’s currency or in a third-party currency. The most appropriate approach is to agree the price with the supplier in their local currency and pay in that. The supplier gets the price he agreed and the management of risk and opportunity falls on the buyer.

Even though a price for a product or service may be quoted in US dollars, for example, the actual costs of production will be in the local currency. A Chinese factory might pay most or all of its costs - wages, materials, taxes and suppliers - in yuan. In the same way, a Japan-based company’s costs will be in yen, while in the US costs will be in US dollars.

So in a scenario where the yuan is strengthening against US currency the supplier will get less for each dollar received. Initially they may absorb this loss of income, but if the exchange rate change is significant or persists in the longer term the suppliers will want to increase their prices.

The reverse would of course also be true. If the supplier is paid in the buyer’s currency and this has weakened against the seller’s currency the supplier will end up with more local currency per US dollar, euro or yen.

In effect the supplier has benefited from a hidden price increase which the buyer, paying in his local currency, may not have picked up.

In a recent case I came across the buyer bought in US dollars and the seller’s currency had weakened considerably against the dollar. As a consequence the seller received nearly 30 per cent more local currency than before the devaluation. He had enjoyed the benefit of a 30 per cent price increase - and the buyer hadn’t noticed.

Another feature of volatile exchange rate movements is the impact on long-term contracts. Imagine, for example, that at considerable time and cost you had resourced the manufacture of a product from a high-cost country to a low-cost country such as China under a ten-year supply agreement - only to find that the cost of buying the yuan had increased by 5 per cent. For you, this is effectively a 5 per cent price increase. Imagine too that the yuan is predicted to continue strengthening by perhaps 25 per cent over the next five years. Clearly, unless your contract took this into account, what was a good decision last year could turn out to be very bad.

Some exchange volatility will always be with us, but recent rapid and significant changes make life challenging for the procurement professional both in the short term, by the need to identify probable price increases or supplier excess profits, and in the long term with the need to avoid contracts that lock you into potentially higher-cost suppliers than you expected.

Predicting the next change is a challenge for the professional buyer. Recently the markets have focused on the debt of the euro zone and the UK with the resulting weakening of those two currencies.

But as we move forward more attention may be focused on the debts and associated default risk of other nations such as Japan and the US. The result will be more volatility and more challenges for procurement. And with the massive implications of a potential new currency in Europe, it’s essential to be prepared.

Robin Jackson is CEO of ADR International

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