How Depreciation of a Currency Affects Foreign Investment

QUESTION

You own an electronics company in the United States, and you also have a components manufacturing facility in Mexico that you finance with funds from the United States. Your assembly operations and headquarters are in the United States. You hear that the Mexican peso is expected to depreciate by 25% against the dollar on the foreign exchange market within the next year. Analyze this situation by using indicators learned in class and recommend measures that can be taken to avoid losses.

Directions:

• Support your recommendation with some of the indicators and information discussed in the module, the textbook, and in your research.
• Your assignment should be a paper two to three pages long, not including the required title and reference pages.
• Adhere to the CSU-Global Guide to Writing and APA.
• Include at least three scholarly sources (you may use the recommended readings) to support your answers. The CSU-Global Library is a good place to find these sources. Remember to use in-text citations as appropriate and to include your sources in your reference page.

ANSWER

How Depreciation of a Currency Affects Foreign Investment

Effects of the Appreciation of the US Dollar against the Mexican peso

The American-based company dealing in electronics sale relies mainly on its components manufacturing facility placed in Mexico. The facility is tasked with the production of the elements in Mexico, and transportation for their assembly and sale (in America), to make a profit. The components manufacturing facility is financed from the company’s headquarters in the United States, using the American dollar. Financial advisors, however, forecast a 25% depreciation of the Mexican peso, against the American dollar, within the next one year. This will have several effects on the company’s costs. It will result in an appreciation of the US dollar, meaning that the currency will have increased strength over the Mexican peso. One unit of the US dollar will have the ability to purchase a more significant quantity of goods in Mexico, compared to the current situation (Bresciani-Turroni, 2013).

A depreciation of the peso will result in a decrease in the cost of Mexican imports into the United States. This will lead to an increase in imports into the US. This may affect the electronics company’s sales, as more electronics will be imported from Mexico by competitors. The imported electronics may even be cheaper than the locally available ones, resulting in very steep competition for customers (Ćorić, Pugh, 2010). Competitors may take advantage of the lower costs of importation to sell their commodities at meager prices, attracting more buyers. Because the electronics company manufactures its electronics components in Mexico, then transports them to the US for assembly and sale, their cost of production in Mexico will not change as a result of the forecasted depreciation. However, they may incur losses because more quantities of components made in Mexico at a specific cost will attract a lesser amount of price in the US, compared to the current value. Let’s say, presently the company’s components manufacturing facility already has components that were made at a total cost of 300 Mexican pesos. At the current exchange rate of about 1:19, the goods will attract $16. However, with a 25% depreciation of the peso, the rate will be about 1:23. Hence the same components will only attract $13. This shall result in losses as the production cost of those elements remains the same.

However, the components that will be manufactured after the depreciation shall be cheaper to produce, because the components manufacturing facility is funded using the American currency. With the strength of the US dollar increased, more components will be manufactured at a lower cost. This could result in a decrease of the company’s manufacturing and importation costs, resulting in higher profits. Wages of the employees at the facility will also cost the company less, assuming they are all paid in Mexican pesos.

A depreciation in the currency will also increase the cost of exported commodities. The expected depreciation of the Mexican peso will require the Mexicans to pay more for goods from the US (Dincer, Kandil, 2011). Taking the current exchange rate at 1:19, a television set produced by the company and priced at $40 attracts 760 pesos. However, with the depreciation, the rate will change to 1:23. The same TV set will attract 920 pesos. The number of exports will therefore decrease. This may result in losses or lesser profits for the company. The aggregate demand for the company’s electronics will fall, resulting in slower economic growth and lower inflation.

Minimising the Possibility of Making Losses

The electronics company requires focussing on how to deal with the expected depreciation of the peso to minimize probable loses and avoid unseen reductions in its profits. First, the company needs to plan for future investment in other countries that have strong, rising currencies. This will greatly reduce the chances of future losses occurring as a result of currency value fluctuations (Lane, Shambaugh, 2010). The company should also focus on setting up components manufacturing facilities in other regions, to diversify and ensure that the effects of a currency devaluation in one country do not affect the operations of the entire business. It should also not task the manufacture of all its components in foreign markets. A smaller facility could be put up in the US, which could shoulder the losses resulting from currency fluctuations in Mexico.

The company should consider hedging risks with derivatives to avert future losses. By employing the use of ‘forward’ contracts, the company can lock in the current exchange rate to ensure that any future changes will not change the cost of the contracts (Breeden, Viswanathan, 2016). It may also consider passing on its costs to the customers. If the changes in exchange rates result in a 5% rise in production or export cost, they may increase the final cost of the commodity by 5% to avoid making a loss. This should, however, be done considerably to avoid overpricing goods, which may lead to lower sales and loss of consumers (Valenzuela, Thimmapuram, Kim, 2012).

References

Bresciani-Turroni, C. (2013). The Economics of Inflation: A study of currency depreciation    in post-war Germany, 1914-1923. Routledge.

Ćorić, B., & Pugh, G. (2010). The effects of exchange rate variability on international trade: a meta-regression analysis. Applied Economics, 42(20), 2631-2644.

Dincer, N., & Kandil, M. (2011). The effects of exchange rate fluctuations on exports: A sectoral analysis for Turkey. The Journal of International Trade & Economic Development, 20(6), 809-837.

Lane, P. R., & Shambaugh, J. C. (2010). Financial exchange rates and international currency exposures. American Economic Review, 100(1), 518-40.

Breeden, D. T., & Viswanathan, S. (2016). Why do firms hedge? An asymmetric information model. The Journal of Fixed Income, 25(3), 7.

Valenzuela, J., Thimmapuram, P. R., & Kim, J. (2012). Modeling and simulation of consumer response to dynamic pricing with enabled technologies. Applied Energy, 96, 122-132.