As an Exporter or an Importer, at one point you will have to face the question of the currency choice and whether or not you should accept to trade in a foreign currency.
It worthwhile pointing out that, international companies which accept to operate in foreign currencies are exposed to both potential risks and potential benefits.
Let me explain.
If you are an importer who has been invoiced in a foreign currency, you can either be harmed by its appreciation, or benefit from its depreciation since you will need less of your local money for paying the seller.
Conversely, if you are an Exporter who has a deal invoiced in a foreign currency, you are likely to be worse-off in case of an exchange rate depreciation (less money) and better-off in case of depreciation of your local currency.(more money for you)
Therefore, the central questions are :
If you are ready to accept a certain dose of risk, I strongly recommend that you have a look at other technics that I have detailed by clicking here.(such as options for instance)
For the remaining part of this article, I will mainly focus on what are the factors that must be taken in consideration during the bargaining stage where the invoice currency will be chosen.
Obviously, the easiest way to avoid currency risks, is to operate in your domestic currency. Indeed by doing so, the Exporter or the Importer transfers the risk to the counterparty.
From this standpoint, currency invoicing negotiation is a kind of zero sum game where the trade partners will have to decide whether to adopt the “producer currency Pricing” (PCP) of the Exporter or the “Local Currency Pricing “(LCP) of the Importer.
Naturally, as an International trader and a businessman ,your goal must be to win this bargaining game.
However, the ability to influence or impose the currency invoice to your trading partner, depends on many factors that must be assessed and that we will be developed below.
Generally speaking, the Importer is in a better position to negotiate the currency terms when he has “deep pockets” as this tends to increase his power of negotiation (don’t we say that customer is king).
For this reason, an Importer must determine whether he is a strategic client or just an average customer?
By distinguishing between the absolute and the relative size of one or several deals that a given Importer has with his supplier, one can have a clear picture of who is in the best position to lead the negotiation about the currency choice.
In short, what is the proportion of everything that I purchase from a given supplier in comparison to his overall turnover ? The more important it is, the stronger my bargaining power will be.
If you’re the Importer has a limited company, he normally has the obligation to file a copy of his financial statements. If you can have access to this public information, you will have a better sense of how important you are for your Trade Partner .
You might also consider whether your country as a whole, has a high intensity of importers as it can indicate that you are living in a dynamic market for International sellers.
If this is the case, this might mean that sellers might be more likely to accept importers’ currency invoicing terms in order to increase their market share in your country.
Off course, one should have a more fine-grained analysis by also considering the type of industry , the type of products etc..
When a given Seller who operates essentially in his domestic market has to deal with only a handful of foreign customers, invoicing in his local currency is probably the best option. In this case, the seller can serve foreign customers (Importers) without developing specific management processes.
However, it must be pointed out that this method is characterised by a low degree of commitment, which is likely to represent an obstacle to international trade development.
Moreover, by invoicing in his local currency, the Exporter is likely to see his competitiveness impacted by the appreciation of his domestic currency.
Given that the International Trade environment is characterised by a high level of competition, flexibility is a prerequisite that often makes the difference between failure and success.
This why this method must be limited to the early stage of International development.
Are you competing on the basis of price or do you sell products that are differentiated?
If the products sold are homogeneous, they tend to be substitutable and as result ,competition tends to be based on price. From this perspective, an adverse exchange rate move can have a significant impact on Exporter’s profit margin and therefore, invoicing in a foreign currency is not reasonable in this case.
Similarly, if an Exporter evolve in a niche market where the intensity of the rivalry is by definition low, he will be more likely to pass-through the effect of the exchange rate variation to the Importer.
Indeed, as the demand for niche products tends to be relatively inelastic , customers are more likely to accept price increases.
In other words, since the demand for differentiated products is less sensitive to price variation , the exporter is in a good position to impose his currency.
By the same token, even if the Importer is affected by an adverse exchange rate variation, he will still be able to enforce price increases among his customer base insofar as differentiated products can hardly be substituted.
If you are a manufacturer or an assembler, you are likely to need to import products and commodities for manufacturing or assembling your products. If you are in this situation, it can be interesting to neutralise part of the currency risk that you bear, by using a technique called nettings.( For more on netting click here)
Let’s take the example of a European manufacturer who has a 60 000 USD deal with a trading partner from the United States. However , in order to manufacture the products that will be exported he needs to import 30 00 USD of raw material from several other countries.
In this case, we can see that the European seller has many options:
He can either use half of the amount for paying his suppliers (60 000 USD -30000 USD), in which case he will remain exposed to a currency risk of 30 000 USD.
Alternatively, the European Exporter can ask his customer to divide the order in two separate parts , one denominated in EUR and the other in USD in order to neutralize or share the currency risk.
Order num 1= 30 000 USD
Order num 2 = 30000 USD (if 1 Eur = 0.89 USD ) = 26 700 EUR
Here as we can see, the currency risk has been completely neutralised for the European exporter as the 30 000 USD dollars will be used for paying the raw materials(or Input) and the 26 700 EUROS will become a Bank Deposit.
Furthermore, for the American Importer, the risk to bear is limited to half of the sales contract amount (26 700 EUR) . In this case, we can see that the risk has been equally shared by the Importer and the Exporter.
While this 50/50 risk sharing scenario might appear too idealistic, it can nevertheless give an idea of how to share the risk between trade partners. We can imagine many other scenarios where the risk is shared (70/30 , 20 / 80 etc…..)
If your production costs go up, you might consider either:
– Invoicing your export in the same currency of the input that you imported
– Denominate your sales in a currency which tends to appreciate.
To put it in a different way, your currency invoicing choice can be used as an hedging technique against potential currency fluctuations.
This technique is easy to implement. However the extent to which this could be interesting, depends on how much imported inputs does the manufacturer or the assembler depends on.
Needless to say, that the foreign exchange market is by definition a place where a variety of currencies are traded daily where some currencies are more demanded than others.
As a general rule, the more a currency is traded the more it is perceived as secure and reliable.
In other words, if you have the chance to operate in a country with a currency widely traded such as but not limited to the US dollars and the Euro for instance ,you are more likely to impose your currency to your business counterpart.
If neither your domestic currency nor the currency of your trading partner is stable enough for doing business, you might also consider using a vehicle currency .
Let’s take the example of an exporter from Argentina who wants to export goods to a country such as Sudan example. In this case both currencies are unstable and unreliable (at least in 2019).
In this case, using a third a vehicle currency such as USD or EUR can be interesting as the value of your transaction is protected by the stability of the mentioned currencies.
When you have been able to gain the trust of your trading partner, you are in a better position to fine tune the way your transactions are settled.
From this perspective, in case of an adverse exchange rate fluctuation, postponing the payment can be an option that can be helpful.
This technique is called leads and Lags and has been developed here
Clearly, this option could only be implemented if the exporter trusts his client and if he can afford to receive this payment at a later date.
Moreover, if the trade partners have a high frequency of business transactions (monthly or quarterly for instance), postponing payments might be more bearable for the Exporter.