American companies should prepare for the U.K. entering the euro system.
The first weeks of 2002 witnessed the introduction of euro currency and coin, and the goal of a single currency for virtually all European countries became a reality. The United Kingdom still continues to resist replacing its pounds and pence for euros, however, so the successful introduction of the euro on the continent reinforces Prime Minister Tony Blair's drive to bring Britain into the single currency group. At present, 12 countries constitute the euro zone: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain.
This article outlines the rationale for U.K. entry into the single currency system and the likely timetable to be followed. It then discusses how U.S. companies and financial institutions will be affected -- now, while the U.K. is not a member of the euro system, and afterwards, if the U.K. does decide to join it. We consider the size and types of American business exposure, special interest in the United Kingdom, and the probable risks associated with the U.K.'s adoption of the single currency. Finally, we pinpoint suitable strategies for American multinationals in the run up period to U.K. entry to the euro zone.
Rationale and Timetable
Since the national elections in June 2001, Britain's Prime Minister Tony Blair has reiterated his objective of bringing his country into the single currency group. His motives are a blend of political zeal, statesman-like altruism and economic pragmatism. On the political side, he wants Britain to have a full voice in the manner by which the European Union (EU) achieves eastward expansion and in the evolution of administrative governance as the EU searches for a streamlined structure with an expanding East European membership.
But Blair is a pragmatist, and recognizes the need to subdue the fears of multinational companies, given the high price of the pound sterling in euro terms, and the problems that this has brought to companies like Honda and Toyota, which have been using Britain as an export platform toward Europe. The first three years of experience with the single currency witnessed a strong pound -- weak euro pattern that cost British-based manufacturers in terms of lower profits and reduced market share. We expect this trend to be maintained as a structural aspect of the U.K. environment during the period that the U.K. remains outside the euro zone.
Following Labor's victory in the mid 2001 elections, a series of steps was formulated by Mr. Blair and his Chancellor of the Exchequer, Gordon Brown:
1. The U.K. Treasury will assess the possible effects of membership on the British economy, in terms of: economic stabilization and growth goals; labor market flexibility and employment; and possible effects on profits in general, and the U.K. financial sector, in particular.
2. Subsequent to meeting these criteria, the British electorate will be given an opportunity to vote on a referendum to join the single currency system.
3. Assuming a favorable vote in the referendum, the government will undertake negotiations with the EU to become a full member of the single currency group.
When might the U.K. gain membership in the single currency system? There is no simple answer. It is possible that this could take place as early as 2003, but the process could take longer. We should appreciate that the decision to proceed is essentially a political one, although the criteria to be met are largely economic in nature.
Corporate America in the U.K. and the Euro Zone
U.S. direct investment in the U.K is sizeable in all broad industry categories relative to U.S. investment in the euro zone countries, as seen in the following table.
U.S. DIRECT INVESTMENT IN THE U.K. AND EURO ZONE * IN 2000 (billions of U.S. dollars) United Euro U.K. as % Kingdom Zone of Euro Zone All Industries 233.4 323.0 72.3 Petroleum 15.8 9.1 173.6 Manufacturing 51.0 112.6 45.3 Services 135.4 194.3 69.7 * U.S. Department of Commerce, Bureau of Economic Analysis, International Investment Data. Excludes disclosure sensitive Information.
In manufacturing, direct investment in the U.K. is 45% as large as the total of the 12 nations that presently constitute the euro zone. In the services industry, this proportion is higher, approximately 70%, due in large part to the importance of London as an international financial center. Paris and Frankfurt are now emerging as centers for euro finance. As this occurs, U.S. financial service-related investment in France and Germany can be expected to expand. North Sea petroleum extraction activities by U.S. oil companies account for the prominence of petroleum industry investment in the U.K relative to the euro zone countries. The primary focus of this article is on U.S. company investments in the manufacturing and service industry sectors.
Exposures and Risk Profile
The exchange rate exposure of a multinational corporation (MNC) includes transactions and economic exposure components. Transaction exposure refers to the effects of exchange rate risk on specific identifiable currency cash flows. This form of exposure, which typically has a short-term time dimension, arises because the value of the foreign currency may change from the time a transaction is contracted until the time it is actually settled.
Because of this contractual dimension, transaction exposures can be more effectively hedged. For example, if the British subsidiary of a U.S. firm sells a product priced in euros to a company in France, the value of that cash flow receivable in sterling terms would depend on the euro/pound exchange rate. Should that rate rise (as it would if the value of the euro falls), the sterling value of the cash flow will be decreased. To guard against this possibility, the U.K. subsidiary may sell the euro receivable forward in the exchange market This hedge may not fully eliminate foreign exchange gains or losses because the forward rate will usually differ somewhat from the spot rate. However, the hedge achieves certainty of value in the currency desired. Transaction exposure may also be managed using a variety of financial instruments and approaches, including options, factoring and invoicing practices.
If the U.K. does not enter the euro zone, Britain will continue to operate under the sterling-based monetary system. The costs associated with transaction exposure will continue to be borne by the U.K. subsidiaries of U.S. firms that transact business in the single currency area.
In contrast to transaction exposure, economic exposure typically has a longer- term time dimension and encompasses the competitive effects of exchange rate risk. This exposure arises from changes in the cost of inputs, sale price and sales volume of the firm and its competitors as a result of exchange rate changes.
Because economic exposure effects are longer term and also more uncertain, it is unclear whether financial hedging is useful in this case. Exposure managers assert that economic exposure can be reduced by geographically positioning production, sales, sourcing and financing operations. However, relocating operations solely to hedge exchange rate exposure can be expensive. Managing economic exposures also typically requires cross-functional coordination within the MNC, which is frequently difficult to achieve, given the different professional orientations of such disparate groups as the treasury department, marketing and production management within the MNC (1).
Lees and Mauer report the results of a survey of the effects of the single currency on company operations in the euro zone, for a sample of U.S.-based MNCs (2). All companies in the study have a major business presence in Europe, with 20% or more of their total sales in that geographic region. Twenty of these companies follow an internationally integrated approach in conducting their operations in Europe. All of the companies in the sample have a significant market presence in the U.K.
The typical modality for the U.S. companies is that the U.K. subsidiary is integrated with assembly, sales and/or service subsidiaries in several euro zone countries. Where these companies have product and service flows going from the U.K to the euro zone, the expectation of a continued overvalued pound vis a vis the euro will present U.K subsidiaries with an ongoing situation of economic exposure that threatens to reduce the competitive position of these companies in euro zone markets.
If the U.K does not come into the euro zone, company operations that involve product and service flows from the U.K to the euro zone will be facing a long term exchange exposure disadvantage. Such companies should rethink the structure of their European operations and consider shifting these company operations into euro zone countries. At the same time, companies that rely on sourcing inputs and services from euro zone locations will be gaining as a result of the British independence from the euro zone.
With regard to risk dimensions other than foreign exchange risk, the Lees-Mauer survey of integrated U.S.-based MNCs operating in Europe shows that there is a perception of an improving business risk environment for companies operating in the euro zone. Most of these U.S. companies indicate an expectation of lower risks in a number of areas: country risk/sovereign risk; counterparty credit risks; legal/documentation risks; and capital market financing risks. None of the companies reports an expectation of higher risks in these risk dimensions as a result of euro zone membership. If the U.K does not join the euro zone, these risk dimensions will continue to apply to companies located in the U.K.
Appropriate Strategies for U.S. MNCs
As indicated above, there are a number of forces which are pushing the U.K toward joining the euro zone. These emanate from the highest levels of the British government and clearly reflect a complex of political and economic forces and motivations. The question of whether the U.K will take this action is posing a dilemma for companies operating in Britain, including British subsidiaries of American MNCs. The primary focus of this dilemma arises from foreign exchange exposure management issues.
For companies that use the U.K as an export platform to the euro zone markets, these companies bear additional costs from transaction exposure management as a result of the U.K remaining outside the euro zone. If the U.K were to join, clearly this source of uncertainty, and the costs associated with it, would be removed.
The management of economic exposure -- the other source of exchange exposure -- is a good deal more difficult and, in the view of many observers, is associated with substantially higher costs. With the persistence of the pound's overvaluation against the euro over the past three years, some MNCs have announced their intentions of shifting production operations from the U.K to countries within the euro zone. Honda and Toyota have declared this through well-reported company press releases. However, many other companies, including American MNCs with operations in Britain, have simply proceeded to undertake this shift without fanfare. Companies that are shifting to the euro zone from the U.K are primarily motivated to control their economic exposure; however, it is also clear that in doing so, the companies also avoid costs associated with the transaction exposure dimension.
For most companies with a U.K base, the shift to the euro zone allows these companies to benefit from the reduction in costs associated with exchange exposures. However, as an offset to these benefits, the shift to the euro zone may also entail acquiring an additional source of costs. For many of these companies, production activities in the U.K have been developed to serve the full European market, including the U.K Goods produced in the U.K location thus are able to achieve economies of scale that cannot be duplicated when establishing separate facilities in the euro zone to serve the euro zone markets.
Should the U.K join the euro zone, the structure of costs associated with exchange exposure and its avoidance will be inverted. Firms that retained operations in the U.K will benefit from the elimination of both transaction exposures and economic exposures. At the same lime, firms that shifted operations into the euro zone may no longer have a business rationale for remaining in the euro zone location.
This essentially is the source of the dilemma facing U.K companies, including subsidiaries of U.S.-based firms. Companies therefore need to understand their foreign exchange exposures, both transaction exposure patterns and economic exposures. Company managers must reach conclusions on their strategic assumptions regarding the likelihood (and timing) of the U.K joining the euro zone.
The business logic in support of shifting operations from the U.K into the euro zone is compelling as long as the pound remains overvalued relative to the euro. Most U.S. subsidiaries in the U.K feel this pressure intensely, and many have undertaken to shift to the shelter of the euro. In order to minimize the disruption to company operations should the U.K join the single currency area, companies should be very careful in designating production and marketing activities to be transferred to euro zone locations.
Company units and activities maybe viewed in terms of their mobility. One polarity is the low mobility, or demand driven activities, which are oriented to the needs of customers, and the aftermarket of services to those customers. At the opposite end of the spectrum are the high mobility, or supply driven activities, which tend to be more technically oriented and will tend to have a closer proximity to the wholesale markets. U.S. MNCs will be in their strongest position if the transfer of business activities to the euro zone is focused more on business units and activities that have a higher preponderance of high mobility aspects. As this guideline is followed, we believe U.S. companies will be best able to address the dilemma of the timing of U.K membership in the euro system.
(1.) A methodology for identifying these exposures is found in: Martin, A. and L Mauer. "A Cash-Flow Approach to Measuring Foreign Exchange Exposure Management." Corporate Finance, vol.4, no. 6, May/June 2000, pp. 15-18.
(2.) Lees, F. and L Mauer. "The Eurozone Formation: MNC and International Bank Reactions." Thunderbird International Business Journal, forthcoming, 2003.
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|Title Annotation:||United Kingdom|
|Author:||Lees, Francis; Mauer, Laurence|
|Publication:||Review of Business|
|Date:||Sep 22, 2002|
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