Describe the exchange rate problems Toyota, Nissan, and GM face while manufacturing in Britain and propose a long-term strategy for these companies.

Content

ABBREVIATIONS

FIGURES

1. THEORETICAL BACKGROUND
1.1 Theories on exchange rate risks
1.2 Theory on Purchasing Power Parity

2. EXCHANGE RATES UK VERSUS CONTINENTAL EUROPE

3. IMPACT ON CARMAKERS
3.1 Exchange rate between home- and foreign currency
3.2 Exchange rate between Euro and Pound

4. LONG-TERM SOLUTION

BIBLIOGRAPHY

LIST OF APPENDICES

Abbreviations

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Figures

Figure 1 - DM / Great Britain Pound

Figure 2 - Euro / Great Britain Pound

1. Theoretical background

Theories on exchange rate risks and the closely related theory of Purchasing Power Parity (PPP) provide the basis for the analysis of the exchange rate problems the three car producers face while manufacturing in the UK.

1.1 Theories on exchange rate risks

The exchange rate risk represents one of the most important risks for companies operating in international industries.¹ There are three kinds of exchange risks: transaction risk, translation risk and economic risk. Transaction exposure is the risk of changes in the value of currency occurring between the time of the settlement of the transaction and the maturity of it.² The second and most important type of exchange risk is economic risk. Economic exposure occurs when currencies, that are involved in the actual or potential competitive situation, become over- or undervalued.³ It can heavily affect current and future cash flows of domestic and foreign operations.⁴ The third type of risk is called translation exposure. It refers to the risk that exchange rate fluctuations may change the value of current assets and liabilities of the balance sheet of a foreign affiliate in case of consolidation.⁵

Whereas translation risk does not really hurt the company⁶ if the accounted assets remain in the country, transaction and economic exposures represent a real threat for the company, because they change current and future inflows -outflows of money.

Fortunately, strategies exist to help the firm to control those risks. In general, transaction risk can be controlled by financial hedging while economic risk can be reduced by operational hedging. Examples for financial hedging are forwardcontracts and options, which both provide the possibility to protect future cash flows of determined transactions against exchange rate fluctuations. Operational hedging means to build manufactures in several countries, in order to be less affected by fluctuation of the partner countries' currencies.

1.2 Theory of Purchasing Power Parity

The theory of Purchasing Power Paritiy (PPP) states that the nominal exchange rate between two countries' currencies should equal the ratio of the two countries' overall price levels.⁷ In accordance to the theory a country's currency thus must depreciate in case of an increasing domestic price level relative to a foreign country's price level in order to return to PPP.⁸ If the exchange rate does not return to PPP the domestic currency is overvalued. This leads to an increase in the domestic currency's purchasing power (PP) in the foreign market and simultaneously to a decrease in PP of the foreign currency in the domestic market.

Due to the decreased PP of the foreign currency, companies located in the country where the currency is overvalued suffer both from decreasing market share in the domestic market and from export cutbacks.⁹ Consequently, with regard to economic risk, exchange rate fluctuations only affect companies in case of an exchange rate deviating from PPP.

2. Exchange rates UK versus continental Europe

The UK being one of the three EU members, which have not joined the Economic and Monetary Union (EMU) has still the Great Britain Pound (GBP) as the national currency.¹⁰

Figure 1 - DM / Great Britain Pound¹¹

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Source: Statistisches Bundesamt (editor.), Internationaler Vergleich der Preise f ür die

Lebenshaltung, Fachserie 17, Reihe 10, 4/2002 p. 7 and (Internet) X-rates (editor) - Exchange rates. Figure designed by authors.

Both figures disclose an important appreciation of the Great Britain Pound (GBP) against the DM and the Euro.¹² Furthermore it is shown that the nominal appreciation is not caused by an increase of PP of the Pound against the Euro.¹³ This leads to an overvaluation of the Pound relative to the Euro and hence to an undervaluation of the Euro relative to the Pound. In April 2002 the Pound was 27% overvalued relative to the Euro.¹⁴

Consequently exports from the UK to the Euro Zone become more expensive for Continental importers who pay in the undervalued currency Euro. Moreover exports from the Euro Zone to the UK become cheaper for UK importers who pay in the overvalued currency Pound.

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¹ See: Punett, Betty J. / Ricks, David A., 1994, p. 305

² See: Grosse, Robert / Kujawa, Duane, 1992, p. 447

³ Over- and undervaluation are expressions that will be explained under the point 1.2 "Theory of Purchasing Power Parity".

⁴ See: Czinkota, Michael R. / Ronkainen, Ilkka A. / Moffett Michael H., 1992, p.542

⁵ See: Grosse, Robert / Kujawa, Duane, 1992, p. 447

⁶ The translation risk will therefore be neglected in the following.

⁷ See: (Internet) OECD (editor) - About Purchasing Power Parity

⁸ See: (Internet) Pacific Exchange Rate Service (editor) - Purchasing Power Parity

⁹ Explanation for economic risk.

¹⁰ See: Johnson, Debra / Turner Colin, 2000, p. 297

¹¹ Since there is until 2000 no data available for the PPP between the UK and the Euro Zone, the exchange rate between DM and GBP and the PPP between Germany and the UK shall serve as representative data.

¹² In the following the currency Euro stands also for DM.

¹³ That means there was no decrease in UK's price level relative to the Euro Zone.

¹⁴ Statistisches Bundesamt (editor.), Internationaler Vergleich der Preise f ür die Lebenshaltung, Fachserie 17, Reihe 10, 4/2002, p. 7