How MSMEs can benefit through the Forex market
For many MSMES in the country, operating overseas has become a norm since the wave of globalization kicked in during the latter part of twentieth century. As information and communication technologies boosted connectivity among nations and MSME industries, hosts of enterprises started expanding their boundaries to begin businesses in different parts of the world. Lesser availability of raw materials and human capital at home, high cost of transportation, political instability and a limited home market necessitated some companies to set camp outside national borders.
Some of the more visible advantages for medium and small scale industries were higher profit margins, expanding production capacities, growth in market share, product differentiation and economies of scale. As we expand the business to include overseas markets, the fixed price comes down because the quantity of manufactured goods increases. This helps economies of scale to set in, giving the company cost advantage over its competitors and improving its scale of operations. Large companies can also utilise the excess production capacity effectively in new markets with comparable demand and suitable avenues of expansion. Apart from expansion in international markets in the form of licensing, franchising, partnerships and joint ventures, companies can also have FDIs (Foreign Direct Investments) that are directly affected by exchange rate fluctuations.
After the business has expanded overseas, or even otherwise, selling and procurement from foreign lands would inevitably involve the company's interest in the trading nation's respective exchange rates. The exchange rate has an impact on the trade surplus (country's exports value more than its imports) or the trade deficit (country's imports value more than its exports). There is a feedback loop between exchange rate and trade deficit or surplus, with both affecting the other. The thumb rule is that a weaker currency boosts exports and hampers imports, while a strengthening one does just the opposite. What this implies is that an exporting firm benefits from a depreciation in currency and the same phenomena makes costs higher for raw materials importing firms. When the value of the currency appreciates, expensive exports reduces the competitiveness of exporting firms, while at the same time makes raw materials cheaper for importing firms. Also, there is a belief that productivity of an exporting MSME enterprise is hampered due to depreciation as it automatically increases its profits, the firm having to do much to cut costs or improve production.
A short look at the actors in foreign exchange market exposes the following main characters according to their function or type of transaction they manage:
· Exporters and Importers: they (MSMEs) have receivables or payables in foreign currency. The exporting firm's earnings depend upon the foreign currency conversion, while an importing company has to make payments in foreign currency.
· Investors: an investor uses a foreign currency to make a purchase and then converts the earnings from the purchase into his home currency. International diversification effects are the main cause of gains in an international investment portfolio · Speculators: speculators generally act on the market trends and their beliefs on the basis of current happenings. They will buy a currency if they believe it will rise in value and sell the one whose value they believe will depreciate.
· Authorities: authorities in each country are usually represented by their central bank, and partially the government. There are two main types of currency risks involved. Direct currency risks influence the MSME company's result of the present operational year, whereas the impacts of indirect currency risk have consequences on the result later. Direct currency risk occurs when companies export and import in foreign currency, obtain monetary obligations and assets in foreign currency and have foreign investments (or foreign subsidiaries that pay returns in foreign currency).
Indirect currency risk occurs when companies work in domestic and international markets with domestic competitors who have costs that are exposed to foreign exchange rates, or with foreign competitors who have diverse capital cost structures. Indirect currency risk also occurs when companies' domestic prices are affected by currency fluctuations.
There are a number of causes because of which traders are wary of foreign exchange markets, despite its clear benefits while expanding the borders of trade. Fear of loss, fear of missing good trade and fear of being wrong provide the biggest hesitation while entering forex markets. Also, there is a strong belief among businessmen about greater complexity, disproportionate costs involved and a visible lack of resources and relevant skills, because of which many SMEs resort to expensive hedging mechanisms to reduce forex risks. The best way to combat exchange rate fluctuations for any global business would be trade hedging, where the company takes a stance in order to minimize the risk of future price changes in case something unexpected occurs. But hedging as a rule need not be an expensive affair. Tactical hedging can be achieved by:
· Doing nothing
· Use a forward contract
· Use the money market
· Use an option
One of the reasons why MSMEs dismiss hedging is the expenses related with hedging. Sometimes the costs involved exceed the advantages of hedging. It is subsequently every company's and individual's objective to find the most ideal approach to deal with their exposure to currency risk. There are multiple strategies for this reason and not just a single approach. How a business best deals with its currency risks will depend on the organization's objectives and which currency exposures it views as the most applicable.