A variety of businesses whether small
or large often have to trade with other businesses and customers in
many different countries. In process of trading abroad, they will frequently
either sell goods and services to foreign countries for which they will
receive payment (referred to exporting), or the company may buy goods
and services from foreign countries, and in turn they will have to pay
for those goods and services (referred to as importing).
If an English business is involved
in exporting goods and services abroad, it will typically look to be
paid in pounds. Foreign purchasers will therefore probably have to change
their domestic currency into pounds in order to make the payment. Similarly,
if an English business is importing goods and services from abroad,
the foreign seller will expect to be paid in their currency. The English
business, therefore, has to change pounds into that currency.
For businesses that trade abroad,
they face the problem of changing exchange rates. The demand and supply
of currencies on the foreign exchange markets - all the businesses,
banks and individuals who are looking to buy and sell different currencies
- is constantly changing. As a result, the exchange rate changes minute
by minute, hour by hour, day by day.
For businesses trading abroad, this
has a significant effect on them.
- Firstly, it is difficult for a
business to plan ahead if they are not sure what the exchange rate will
be at any one time.
- Secondly, changes in exchange rates
affect the demand for both imports and exports because they change the
apparent price of both imports and exports.
An example of international trade,
a mobile phone retailer in the UK buys mobile phones from a manufacturer
in Germany. The German manufacturer sells the phones for €40. If the
exchange rate is £1 = €1.50, the UK business has to exchange £26.66
to buy the phone (40/1.50).
Now assume that the exchange rate
changes and the rate goes down to £1 = €1.40. This is referred to
as a fall in the value of the pound because you are now getting less
Euro for every pound. The price of the phone in Germany has not changed
- it is still €40. The UK importer, though, now has to exchange £28.57
to buy the phone from Germany (40/1.40).
Whilst the phone price has not changed
in Germany, the effect of the fall in the exchange rate is to give the
impression that the price has risen. The UK phone retailer finds that
the cost of buying mobile phones has risen by £1.90 - a rise of 7.12%.
The retailer will find his costs
of production rising and will have to either increase prices to the
consumer - risking a fall in demand - or accept lower profit margins
(the difference between the price charged and the cost of production)
If the exchange rate of the pound
and the Euro rose, it would mean that a UK trader would get more Euro
for every pound exchanged. For the importer this would mean that they
would have to give up less pounds to get the same amount of Euro and
so prices would appear to fall.
It is important to remember the following:
- For businesses trading abroad who
are both buying imported goods in and selling to foreign markets, the
position can get very confusing especially if you are dealing with a
number of different countries! You can perhaps start to see why some
businesses would welcome the UK joining the Euro!
- For importers, the problem is that
exchange rates affect their costs of production, which will in turn
have an impact either on the price they have to charge customers or
their profit margins.
- For exporters, changing exchange
rates may lead to a rise in the demand for their products or make it
much harder for them to be able to compete in foreign markets.