Global financing and exchange rates are major topics when considering a venturing business abroad. In the proceeding I will explain in detail what hard and soft currencies are. I will then go into detail explaining the reasoning for the fluctuating currencies. Finally I will explain hard and soft currencies importance in managing risks.
Hard currency is usually from a highly industrialized country that is widely accepted around the world as a form of payment for goods and services. A hard currency is expected to remain relatively stable through a short period of time, and to be highly liquid in the forex market. Another criterion for a hard currency is that the currency must come from a politically and economically stable country. The U.S. dollar and the British pound are good examples of hard currencies (Investopedia,2008). Hard currency basically means that the currency is strong. The terms strong and weak, rising and falling, strengthening and weakening are relative terms in the world of foreign exchange (sometimes referred to as “forex”). Rising and falling, strengthening and weakening all indicate a relative change in position from a previous level. When the dollar is “strengthening,” its value is rising in relation to one or more other currencies. A strong dollar will buy more units of a foreign currency than previously. One result of a stronger dollar is that the prices of foreign goods and services drop for U.S. consumers. This may allow Americans to take the long-postponed vacation to another country, or buy a foreign car that used to be too expensive. U.S. consumers’ benefit from a strong dollar, but U.S. exporters is hurt. A strong dollar means that it takes more of a foreign currency to buy U.S. dollars. U.S. goods and services become more expensive for foreign consumers who, as a result, tend to buy fewer U.S. products. Because it takes more of a foreign currency to purchase strong dollars, products priced in dollars are more expensive when sold overseas (chicagofed,2008).
Soft currency is another name for “weak currency”. The values of soft currencies fluctuate often, and other countries do not want to hold these currencies due to political or economic uncertainty within the country with the soft currency. Currencies from most developing countries are considered to be soft currencies. Often, governments from these developing countries will set unrealistically high exchange rates, pegging their currency to a currency such as the U.S. dollar (invest words,2008). Soft currency breaks down to the currency being very weak, an example of this would be the Mexican peso. A weak dollar also hurts some people and benefits others. When the value of the dollar falls or weakens in relation to another currency, prices of goods and services from that country rise for U.S. consumers. It takes more dollars to purchase the same amount of foreign currency to buy goods and services. That means U.S. consumers and U.S. companies that import products have reduced purchasing power. At the same time, a weak dollar means prices for U.S. products fall in foreign markets, benefiting U.S. exporters and foreign consumers. With a weak dollar, it takes fewer units of foreign currency to buy the right amount of dollars to purchase U.S. goods. As a result, consumers in other countries can buy U.S. products with less money.
Many things can contribute to the fluctuation of currency. A few are as follows for strong and weak currency:
Factors Contributing to a Strong Currency
Higher interest rates in home country than abroad
Lower rates of inflation
A domestic trade surplus relative to other countries
A large, consistent government deficit crowding out domestic borrowing
Political or military unrest in other countries
A strong domestic financial market
Strong domestic economy/weaker foreign economies
No record of default on government debt
Sound monetary policy aimed at price stability.
Factors Contributing to a Weak Currency
Lower interest rates in home country than abroad
Higher rates of inflation
A domestic trade deficit relative to other countries
A consistent government surplus
Relative political/military stability in other countries
A collapsing domestic financial market
Weak domestic economy/stronger foreign economies
Frequent or recent default on government debt
Monetary policy that frequently changes objectives
Importance on managing risk
When venturing abroad there are many risk factors that must be addressed, and keeping these factors in check is crucial to a companies success. Economic risk can be broadly summarized as a series of macroeconomic events that might impair the enjoyment of expected earnings of any investment. Some analysts further segment economic risk into financial factors (those factors leading to inconvertibility of currencies, such as foreign indebtedness or current account deficits and so forth) and economic factors (factors such as government finances, inflation, and other economic factors that may lead to higher and sudden taxation or desperate government imposed restrictions on foreign investors’ or creditors’ rights). Altagroup,2008. The decisions of businesses to invest in another country can have a significant effect on their domestic economy. In the case of the U.S., the desire of foreign investors to hold dollar-denominated assets helped finance the U.S. government’s large budget deficit and supplied funds to private credit markets. According to the laws of supply and demand, an increased supply of funds – in this case funds provided by other countries – tends to lower the price of those funds. The price of funds is the interest rate. The increase in the supply of funds extended by foreign investors helped finance the budget deficit and helped keep interest rates below what they would have been without foreign capital. A strong currency can have both a positive and a negative impact on a nation’s economy. The same holds true for a weak currency. Currencies that are too strong or too weak not only affect individual economies, but tend to distort international trade and economic and political decisions worldwide.