Economic Exposure in Foreign Exchange
Exposure determination in the accounting sense points out those items which will have a negative effect on consolidation if the currency in which they are denominated should change in value.
Whichever translation convention is used, the resultant consolidation merely indicates the reported position of a group at a given point in time, based on historical events. However, this does not necessarily show the opening impact of a parity change on any single member of the group or the effect on future flows of income in the group.
Both of these are included in the term "economic exposure," which attempts to give management an additional means of analyzing effects of foreign exchange movements on operations, profits, and net worth. It can be important to identify economic exposure from the very beginning of foreign exchange policy determination.
Cash is a typical example; it is among those current assets always translated at current rates and affected by devaluation. The group position may show, due to hedging or offsetting, a neutral position in a particular currency. A subsidiary's ultimate liquidity position, however, can be significantly different depending upon the expected disposition of its cash balances when its own currency devalues.
If liquid balances have been built up for imports or dividend payments, a local devaluation will have an impact on the subsidiary not always identified by the parent.
Even if the group is covered against the currency in question, the liquidity of the subsidiary is impaired; the parent may not be able to augment it. A similar effect on liquidity can arise from parity changes involving accounts payable, accounts receivable, or short-term debt or the local subsidiary.
The realization of inventory presents a further example. Inventory to be sold in only one market may be considered an exposed asset if its price cannot be raised after a local devaluation.
It is, however, important to identify the price elasticity of inventory and its ultimate destination (hard currency markets, for example) to determine which portion is exposed and which is not. This should be included in the identification of economic exposure; knowing the elasticity element can allow the group to raise prices before the event.
After the initial data gathering and consolidation, the corporate policy vis-à-vis its foreign exchange position should be established, usually by a senior management committee with representatives of treasury, controller, and sales divisions.
Foreign exchange policy must be consolidated with the general financial policy of the company. Short-term borrowing by a subsidiary for working capital purposes and anticipated future borrowing will affect both corporate liquidity and exchange exposure. Short-term investments in several currencies both have exchange and liquidity, as well as risk, aspects.
At the senior management level, the company will determine whether its foreign exchange policy should be basically cautious or aggressive. If it is to be cautious, management essentially wishes to remain covered against foreseeable exchange risk and devote managerial attention to more basic areas such as product development and marketing.
Under a cautious policy the attitude is that the firm's operations should basically be protected against risk of loss in foreign exchange that is, insulated from the international environment in that regard.