Because You Asked For It: Small Business Strategy and the Canadian Dollar

Reader westslope recently asked:

BTW, does your company top brass pay attention to your MERT model and, perhaps, strategically plan and hedge accordingly?

That's an easy one for me to answer because I am charge of the finances for Nexreg (a small Canadian company that makes the majority of their sales in the U.S.). What insight can MERT provide that is useful for small business strategy?

The answer: Unfortunately very little. While the Canadian dollar and the MERT estimate of the Canadian dollar eventually converge, MERT has nothing to say with how they converge. Suppose the Canadian dollar is at 97 cents and the MERT estimate is 90 cents. We cannot infer from this that the Canadian dollar will fall to 90 cents. Perhaps the price of oil will rise, raising the MERT estimate to 97 cents. Or perhaps both the price of oil and the Canadian dollar rise and converge at 99 cents. We cannot say for certain if the Canadian dollar will rise or fall. The data provides little predictive value in this area, a topic which will be left for another post. There appears to be a weak-form of the efficient market hypothesis at play here. The Canadian dollar can deviate from the fundamentals (if you consider MERT to be 'the fundamentals'), but the return path to the fundamentals appears to be entirely unpredictable (and as such there is no free money on the table). That being said, I tend to be hesitant to switch our U.S. dollars into Canadian ones when MERT suggests the Canadian dollar is overvalued. Superstition more than anything else, I guess.

There are other ways we attempt to insulate ourselves from exchange rate exposure. We do not use the borrow in U.S. dollars method because we have no real debt to speak of. We could still take out such a loan (provided we could get access to one) in order to gain access to a U.S. dollar expense stream, but given that we would be paying interest on capital we have no real need for, it seems hardly worth it.

We could hedge use currency options, but that strategy is more appropriate for insulating against short-term fluctuations and our concern is more with a long-run depreciation of the U.S. dollar. As such, we do not bother.

The one thing I try to do, as much as possible, is to have our expenses denominated in U.S. dollars. Fluctuations in the exchange rate are of little consequence if both 80% of our revenues and 80% of our expenses are in U.S. dollars. Naturally it is going to be difficult to get 80% of our expenses in U.S. dollars - our employees are not going to accept being paid in U.S. dollars, our rent and utilities are paid in Canadian dollars and with many companies those are our two biggest sources of expenses.

For everything else, we try to pay in U.S. dollars whenever possible. In practical terms, this means that if we are choosing a service provider, we will choose an American one unless there is some overwhelming reason why we should not (e.g. the Canadian provider is of higher quality or significantly lower price). Occasionally we can negotiate a deal with a Canadian provider to pay in U.S. dollars (shifting the currency risk from us to them), but this is only possible when we have a fair amount of bargaining power. But if we have that bargaining power, we could have negotiated more favourable terms in some other area (e.g. lower prices, net 45 instead of net 30, faster turn-around times), so there is an opportunity cost in paying a Canadian company in U.S. dollars.

That's what our small exporting business does to deal with currency risk. I would love to hear what yours does!

Comments

[Nick Rowe]

The surprising thing to me, on reading your post, is that currency risk seems to have a significant real effect. Because you export to the US, you want to import from the US, to reduce the currency risk.

[Sam]

Yeah, but as Mike says, it's hard to import your most significant expenses (labour, rent) from the US. I suppose, if you have a need for short-term technical contractors, you could prefer to hire hire US contractors on NAFTA visas.

What do we do about currency risk? Mainly, cry in our beer.

[jsalvati]

Could you find an importer (or an exporter to canada) and sign a contract that transfers wealth based on the exchange rate movement? There should be other companies (in America probably) who have the exact opposite problem. I am surprised there is not some sort of standard contract for this type of thing.

[Andrew F]

Seems to me that employees ought to be willing to receive some of their pay in USD. A decent percentage of costs of consumption are tied to USD denominated prices, such as tourism to the USA/Caribbean, electronics, cars, etc.

[westslope]

Great post Mike! Thanks! I'll have to ask more goofy questions in the future. -lol- Before I read this thread I posted the following to the original:

westslope: How would company top brass use the model? From what I understand, it doesn't predict future exchange rates, just what the current one should be - or am I missing something here? -Just visiting

Good call; you are absolutely correct. My bad. I'm the one reading too much into the model's potential application. And though I suspect that oil prices are easier to predict than exchange rate movements, I have no empirical proof that is the case. (Future prices might be unbiased predictors but that doesn't mean that oil prices can be cost-effectively forecast.)

Now an employee in Mike's position could do some extra research, go to the bosses and say: Well it looks like oil (and other commodity) prices are going higher, we should prepare for a stronger Canadian dollar. But the model by itself contains no such potential insight.

Posted by: westslope | April 10, 2010 at 06:03 PM

As to hedging strategies, isn't the most common strategy to allow capital income to take an enormous hit until responses to exogenous foreign exchange shocks work through the market or the firm lowers unit costs? Presumably there are efficiency gains because labour is risk averse.

For those interested in the macroeconomics of oil prices, I highly recommend Prof. James D. Hamilton's econbrowser.com blog post April 10, 2010 Do rising oil prices threaten the economic recovery? Hamilton concludes that current oil prices may slow but do not otherwise threaten the economic recovery.