Case study 1: Assessment of Government Influence on Exchange Rates
Recall that Blades, the U.S. manufacturer of roller blades, generates most of its revenue and incurs most of its expenses in the United States. However, the company has recently begun exporting roller blades to Thailand. The company has an agreement with Entertainment Products, Inc., a Thai importer, for a 3-year period. According to the terms of the agreement, Entertainment Products will purchase 180,000 pairs of "Speedos," Blades' primary product, annually at a fixed price of 4,594 Thai baht per pair. Due to quality and cost considerations, Blades is also importing certain rubber and plastic components from a Thai exporter. The cost of these components is approximately 2,871 Thai baht per pair of Speedos. No contractual agreement exists between Blades, Inc., and the Thai exporter. Consequently, the cost of the rubber and plastic components imported from Thailand is subject not only to exchange rate considerations but to economic conditions (such as inflation) in Thailand as well.
Shortly after Blades began exporting to and importing from Thailand, Asia experienced weak economic conditions. Consequently, foreign investors in Thailand feared the baht's potential weakness and withdrew their investments, resulting in an excess supply of Thai baht for sale. Because of the resulting downward pressure on the baht's value, the Thai government attempted to stabilize the baht's exchange rate. To maintain the baht's value, the Thai government intervened in the foreign exchange market. Specifically, it swapped its baht reserves for dollar reserves at other central banks and then used its dollar reserves to purchase the baht in the foreign exchange market. However, this agreement required Thailand to reverse this transaction by exchanging dollars for baht at a future date. Unfortunately, the Thai government's intervention was unsuccessful, as it was overwhelmed by market forces. Consequently, the Thai government ceased its intervention efforts, and the value of the Thai baht declined substantially against the dollar over a 3-month period.
When the Thai government stopped intervening in the foreign exchange market, Ben Holt, Blades' CFO, was concerned that the value of the Thai baht would continue to decline indefinitely. Since Blades generates net inflow in Thai baht, this would seriously affect the company's profit margin. Furthermore, one of the reasons Blades had expanded into Thailand was to appease the company's shareholders. At last year's annual shareholder meeting, they had demanded that senior management take action to improve the firm's low profit margins. Expanding into Thailand had been Holt's suggestion, and he is now afraid that his career might be at stake. For these reasons, Holt feels that the Asian crisis and its impact on Blades demand his serious attention. One of the factors Holt thinks he should consider is the issue of government intervention and how it could affect Blades in particular. Specifically, he wonders whether the decision to enter into a fixed agreement with Entertainment Products was a good idea under the circumstances. Another issue is how the future completion of the swap agreement initiated by the Thai government will affect Blades. To address these issues and to gain a little more understanding of the process of government intervention, Holt has prepared the following list of questions for you, Blades' financial analyst, since he knows that you understand international financial management.
1. Did the intervention effort by the Thai government constitute direct or indirect intervention? Explain.
2. Did the intervention by the Thai government constitutesterilized or nonsterilized intervention? What is thedifference between the
types of intervention? Which typedo you think would be more effective in increasing thevalue of the baht? Why? (Hint: Think about the effect ofnonsterilized intervention on U.S. interest rates.)
3. If the Thai baht is virtually fixed with respect to thedollar, how could this affect U.S. levels of inflation? Doyou think these effects on the U. S. economy will bemore pronounced for companies such as Blades thatoperate under trade arrangements involvingcommitments or for firms that do not? How are companiessuch as Blades affected by a fixed exchange rate?
4. What are some of the potential disadvantages forThai levels of inflation associated with the floatingexchange rate system that is now used in Thailand? Doyou think Blades contributes to these disadvantages toa great extent? How are companies such as Bladesaffected by a freely floating exchange rate?
5. What do you think will happen to the Thai baht'svalue when the swap arrangement is completed? Howwill this affect Blades?