• Transfer prices can be manipulated to move funds out of a country whose currency is expected to depreciate.

• Local debt financing can provide a hedge against foreign exchange risk.

• It may make sense to accelerate dividend payments from subsidiaries based in countries with weak currencies.

• Capital budgeting techniques can be adjusted to deflect the negative impact of adverse exchange rate movements on the current net value of a foreign investment.

Reducing Economic Exposure

Reducing economic exposure requires strategic choices that go beyond the realm of financial management. The key to reducing economic exposure is to distribute the firm's productive assets to various locations so the firm's long-term financial well- being is not severely affected by adverse changes in exchange rates. The post1985 trend by Japanese automakers to establish productive capacity in North America and Western Europe can partly be seen as a strategy for reducing economic exposure (it is also a strategy for reducing trade tensions). Before 1985, most Japanese automobile companies concentrated their productive assets in Japan. However, the rise in the value of the yen on the foreign exchange market has transformed Japan from a lowcost to a high-cost manufacturing location over the past 10 years. In response, Japanese auto firms have moved many of their productive assets overseas to ensure their car prices will not be unduly affected by further rises in the value of the yen. In general, reducing economic exposure necessitates that the firm ensure its assets are not too concentrated in countries where likely rises in currency values will lead to damaging increases in the foreign prices of the goods and services they produce. An example of how Black & Decker has pursued strategies for reducing its economic exposure is given in the accompanying Management Focus.

Developing Policies for Managing Foreign Exchange Exposure

The firm needs to develop a mechanism for ensuring it maintains an appropriate mix of tactics and strategies for minimizing its foreign exchange exposure. Although there is no universal agreement as to the components of this mechanism, a number of common themes stand out.¹⁶ First, central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies. Many companies have set up in-house foreign exchange centers. Although such centers may not be able to execute all foreign exchange deals--particularly in large, complex multinationals where myriad transactions may be pursued simultaneously--they should at least set guidelines for the firm's subsidiaries to follow.

Second, firms should distinguish between, on one hand, transaction and translation exposure and, on the other, economic exposure. Many companies seem to focus on reducing their transaction and translation exposure and pay scant attention to economic exposure, which may have more profound long-term implications.¹⁷ Firms need to develop strategies for dealing with economic exposure (see the Management Focus about Black & Decker).

Third, the need to forecast future exchange rate movements cannot be overstated, though, as we saw in Chapter 9, this is a tricky business. No model comes close to perfectly predicting future movements in foreign exchange rates. The best that can be said is that in the short run, forward exchange rates provide reasonable predictions of exchange rate movements, and in the long run, fundamental economic factors--particularly relative inflation rates--should be watched because they influence exchange rate movements. Some firms attempt to forecast exchange rate movements in-house; others rely on outside forecasters. However, all such forecasts are imperfect attempts to predict the future.

Fourth, firms need to establish good reporting systems so the central finance function (or in-house foreign exchange center) can regularly monitor the firm's exposure positions. Such reporting systems should enable the firm to identify any exposed accounts, the exposed position by currency of each account, and the time periods covered.

Finally, on the basis of the information it receives from exchange rate forecasts and its own regular reporting systems, the firm should produce monthly foreign exchange exposure reports. These reports should identify how cash flows and balance sheet elements might be affected by forecasted changes in exchange rates. The reports can then be used by management as a basis for adopting tactics and strategies to hedge against undue foreign exchange risks.

Unfortunately, some of the largest and most sophisticated firms don't take such precautionary steps, exposing themselves to very large foreign exchange risks. In 1990, the treasury department of the British food company Allied-Lyons apparently entered the forward foreign exchange market, not so much to hedge against future currency movements as to profit from placing large speculative bets that currencies would move one way or another. Unfortunately for Allied-Lyons, the treasury department made the incorrect speculative bets and it incurred losses of $240 million. Similarly, Showa Shell Sekiyu, the Royal Dutch/Shell group's Japanese affiliate, revealed in February 1993 that its treasury department had incurred some $1 billion in unrealized foreign exchange losses.¹⁸