Foreign Currency Contract Agreement Risks
This case study reveals the importance of deciding on and making a foreign currency agreement with an international business partner.
When a negotiator embarks on an negotiating an international agreement with a foreign partner, they have to give serious consideration to which currency is going to be used in their financial transactions. There is a certain amount of risk that a company might have to assume as even veteran skilled negotiators consider whether they are going to issue or receive payments in a foreign denomination. It occasionally happens that between the time when a contract is signed, and when payment begins to flow, the currency of the foreign partner’s company could either increase or decrease dramatically. Any company that handles foreign currency faces the hazard of paying more or receiving less than it projected. The risk increases proportionately in relation to the duration or longevity of the contract agreement.
The value of any country’s currency typically depends on supply and demand. Any currency is affected by various factors. This includes the rate of inflation, economic growth, the internal political stability of the country, and interest rates, just to name a few. Many newer countries use their central banks to allow their currency to rise and fall within a narrow band, and may peg their currency’s value to a leading international currency such as the Euro, or British Pound.
Back in the 1980’s a small U.S. company signed a long term agreement with a Japanese manufacturer to purchase a brand of adhesive that was much cheaper than could be obtained in the U.S. The Japanese negotiating team was adamant that they were to be paid in Japanese yen. The American company, eager to lock in this cheap supply of this particular adhesive, agreed. This meant that the U.S. company would now assume any risk in currency fluctuation against the Japanese yen, and it’s rational to be risk averse.
At the time the agreement was signed the value ratio between the yen and the U.S. greenback was 185 yen to $1 U.S. dollar. For awhile the U.S. company prospered even more as the exchange rate fell from 250 yen to $1 U.S. It was looking like a really good bargain. Unfortunately, the tide shifted the other way and by 1988, the yen was valued at 140 yen to $1 U.S., much to the dismay of the U.S. company.
Needless to say, the U.S. company began to lose money and this jammed the company between the proverbial ‘rock and the hard place’. The U.S. company faced the additional burden in that they were facing such stiff competition from their competitors that they had no latitude to increase their prices. The agreement did not include any provisions to renegotiate the contract if faced with such a dramatic shift in the value of the rate of currency either, which was another serious drawback.
A negotiator who conducts an international negotiation has 4 choices to make regarding foreign currency risk contractual agreements when concluding an international joint venture. 1) They can both share the risk. 2) The foreign partner assumes the risk (Lose-Win). 3) Your side assumes the risk (Win-Lose). 4) One or both parties stipulate in the contract that the currency denomination is an area open to renegotiation, allowing for a certain percentage of rate fluctuation to occur.
Always remember that the longer the lifespan of the agreement – the greater the foreign currency risk component.