DISTINGUISHED Tufts University law professor Jeswald W. Salacuse, in his lecture at the Harvard Program on Negotiation that I attended, said the existence of so many currencies creates a potential barrier in international business negotiations.
Salacuse advised us on how money affects negotiations and what solutions are available to handle the problems is creates. Unlike purely domestic deals, international business transactions take place in an arena where there is no single global money for making payment.
“Bear in mind,” he said, “that the relative value of the world’s currencies fluctuates in relation to one another. This factor creates special risks and other problems in making global business deal or restructuring existing ones.”
Not only that. Many countries’ currencies are not freely convertible; consequently, the dealmaker or negotiator who is to be paid in nonconvertible currencies must worry constantly about ways to move the value stored in them into more usable funds.
This relative value is known as exchange rates. Money, like any other commodity, responds to the forces of supply and demand. Supply and demand for currency in any country depend on many factors, including inflation rates, prevailing interest rates, economic growth, system of taxation and political stability.
The foreign-exchange risk
For a negotiator, a deal in foreign currency creates a special risk. Between the time an agreement is signed and the time payment is received, the value of the foreign currency in relation to the company’s national or desired currency may decrease so that the company ultimately receives, after conversion, less of its own currency.
Similarly, if a company has to pay in foreign-currency, the value of that currency may increase so that the company has to spend more of its own money than it intended in order to buy the foreign currency necessary to make payment.
A foreign-exchange risk is always present for one of the parties in an international business transaction. The longer the term of a deal, the greater is the risk.
Because the foreign-exchange risk is present in any international deal, negotiators faced the challenge of coping with it. Various techniques exist, and Salacuse’s three basic choices are quite instructive: (1) give the risk to the other side; (2) accept the risk but protect yourself; or (3) share the risk.
One simple strategy is that the side that is better able to handle the foreign-exchange risk should be the one to bear it. Thus, if you have substantial costs in a specific currency, you can argue that you should be paid in that currency, and that the other side should bear the foreign- exchange risk.
Many times, however, this technique of allocating the risk to the other side is unusable, either because the other side has the bargaining power to resist it or that the transaction does not allow for it. Take for instance an American and a Japanese company negotiating a joint venture to establish a plant in Japan. The American company, by the very nature of the deal, assumes a foreign-exchange risk since its assets in Japan will be valued in yen and any profit will be earned in yen.
Accept the risk, but protect yourself
A second technique of dealing with foreign-exchange risk is to accept the risk but take special measures to protect yourself against adverse fluctuations in exchange rates. One of the simplest applications of this approach is for the party bearing the risk to estimate the cost of foreign- exchange fluctuation likely to occur before completion of payment and build that cost into the transaction.
A commodity seller who agrees to pay in a foreign currency might increase the price of the product to take account of expected adverse changes in exchange rates. However, that party still bears the exchange risk because the actual exchange rate may be different from what was expected.
One of the most common approaches to protecting against the exchange risk is to shift the risk to a third party or institution not directly involved in the deal that you are trying to put together. A variety of insurance-type techniques exist to achieve this goal.
One method, said Salacuse, is to make a contract to purchase currency at a specific price and date in the “forward market” or “future market.” Another is to secure a foreign currency option to buy or sell currency for a fixed price during a specified period in the future.
Large businesses may use other techniques such as establishing foreign currency accounts or purchasing foreign currency bonds. Both of these may protect yourself against adverse changes in rates, but they may also require you to divert working capital from more profitable uses.
A company with substantial international business can manage its risks of currency fluctuations by arranging offsetting transactions—often called exposure netting—in which the risk of loss in one transaction would be counterbalanced by a gain in another. In this way, an American company’s risk stemming from an obligation to pay yen in the future might be offset by a debt in yen owed to that company and payable by another company at the same future date.
All these techniques though have associated costs. Therefore, sound financial advice by experts in the field is necessary to use them effectively.
To reach the writer, e-mail cecilio.arillo@gmail.com.