What Is Foreign Exchange Policy?

What Is Foreign Exchange PolicyWhen discussing foreign exchange policy, it’s important to distinguish between its implementation at a macroeconomic level and its microeconomic applications. Macroeconomically, of course, the concept of foreign exchange policy relates to sovereign governments and the measures that they undertake to support their national currencies, to be discussed below, while microeconomically, foreign exchange policies can and should be implemented by companies doing cross-border business and needing to either plan for the payment of costs and expenses overseas, or to hedge against these costs, or against potential losses associated with these costs. Fundamentally, the implementation of foreign exchange policy both macroeconomic and microeconomic serves the same function, namely, to ensure financial stability while protecting the home country’s (or home company’s) fiscal interests.

The foreign exchange market is a system under which banks, businesses, governments and even individuals, assisted by a network of financial institutions and brokers, are able to buy and sell currencies in order to finance their overseas operations, to invest, or to engage in international trade; to a smaller extent, many participants—typically retail investors—engage in foreign exchange trading for purely speculative purposes, a practice not generally entered into or encouraged by either governments or legitimate international businesses. Transactions taking place in the foreign exchange market usually take the form of either a so-called “spot transaction”, wherein a contract is entered into for the purchase of one currency and the simultaneous sale of another at the currently-quoted exchange rates, or the form of a so-called “forward transaction”, in which the participants obligate themselves to buy and sell currencies to and from each other on a set future date, at a predetermined exchange rate. Traditionally, and in a reflection of their standard foreign currency needs, governments, through either their central banks or their treasury departments, will enter into spot currency transactions, while businesses will almost always enter into future currency transactions.

In the United States, foreign exchange policy is set by The Federal Reserve Bank in tandem with the Department of the Treasury, who intervene in the foreign exchange markets only when deemed necessary and whose interventions have decreased dramatically in the course of the last two decades in comparison to earlier periods. As is the case with most western governments practicing sound fiscal policy, the US tends to intervene in the foreign exchange market only when Federal Reserve believes that there is sufficient need to support the price of the dollar against a particular foreign currency, or, conversely,  to reduce the value of the dollar against a specific foreign currency. Such decisions are not made lightly and are always underscored by the desire to keep the delicate balance between inflation, interest rates and international trade in check. As a general example, it would be in the best interests of the Federal Reserve to support a weak dollar against a major international currency (such as the euro or the yen) in order to avoid too radical a change in the exchange rate between the two currencies: if the weakening trend would be allowed to continue, imports from the stronger currency’s home country will become more expensive, leading to potentially higher inflation. Investor capital would be naturally drawn away from the US dollar to the perceived stronger currency, leading to higher interest rates abroad and lower interest rates in the US and ultimately, potentially disrupting the balance of trade.

US Dollars MoneyDespite the fact that a weak dollar most likely would result in increased US exports and a corresponding increase in domestic employment, the US must keep in mind the negative effects of the increased price of the stronger currency-denominated exports on its home country, which would include a decrease in exports and a rise in unemployment. In our interdependent modern world, in which monetary policy, foreign policy, trade policy and even military policy are so thoroughly interconnected, measures must be taken to avoid upsetting the status quo, and in this case, the Federal Reserve’s traders would likely intervene, buying dollars and selling the stronger currency by entering into spot contracts, while informing the central bank of the stronger currency’s home country of their intentions and obtaining their tacit blessing.

Companies engaged in international business have an analogous need for foreign exchange, and for foreign exchange risk hedging strategies; their foreign exchange policy is set by their boards and implemented by their senior management, embodied typically in their Chief Financial Officer and their Treasury Management personnel. Corporations’ foreign exchange strategy is aimed at maintaining cash flow while hedging  earnings and minimizing corporate risk and exposure by ensuring that foreign currency payment obligations can not only be met, but can be met at the most advantageous exchange rates possible. These obligations are typically quite predictable, and arise out of either the corporation’s fundamental import/export activities, or out of their need to meet international payroll or investment-related obligations; because of their predictable nature, therefore, corporations can plan for their payment in advance by entering into forward foreign exchange transactions, allowing the company to hedge their risk by locking in a more favorable exchange rate now if the foreign currency appears to be trending strongly against their home currency. Such forward contracts can even be entered into as options, wherein the company pays a small premium today, but has no obligation to complete the forward contract in the case that their own currency strengthens against the foreign currency, or vice-versa. As in the case of a sovereign government, the international corporation recognizes the value of maintaining its strong economic status quo and protects its international monetary interests by standing ready to take measures aimed at promoting its continued fiscal health through optimizing its foreign currency-denominated transactions.

Foreign exchange policy is not formulated in a vacuum; rather, it is arrived at after careful consideration of the future value of currencies and the effects that a change in currency value can potentially instigate. In essence, the formulation of successful foreign exchange policy is a function of economic forecasting combined with a heavy dose of linkage, and its correct implementation is a matter of timing and diplomacy. In an increasingly global and cross-cultural economy, neither nations nor businesses can afford to forego the adoption of their own foreign exchange policies. Visit www.lucrorfx.com today to find out more.

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One Comment

  1. damilola
    Posted May 23, 2012 at 3:31 am | Permalink

    This is a good kind of policy

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