What it means
A currency is weak or strong only in comparison with another currency. If one unit of a currency buys less foreign money than last year, it has weakened against that currency.
The causes include high inflation, low interest rates, large trade or budget deficits, political uncertainty and falling investor confidence. For exporters, a weak currency is often welcome.
Their goods become cheaper for foreign buyers, which can increase sales, and foreign revenue converts into more home currency. A company selling in dollars but paying costs in a weak local currency can see profit margins improve.
Importers face the opposite problem. Raw materials, equipment and fuel bought from abroad become more expensive in local terms, which can reduce margins or force price increases.
If the country imports a lot of its energy or food, the weakness can push up inflation across the whole economy. Debt in foreign currency is a major risk.
A company that borrowed dollars but earns in a weak local currency finds that each dollar of repayment costs more local money. This has caused serious problems for businesses and governments, and it is why treasurers often use hedging (contracts that fix an exchange rate in advance) to reduce the risk.
Weakness is not always a sign of poor health, and a central bank may even encourage it to support exports. The nuance is that a weak currency discourages foreign investors, who see their returns eroded when converted back.
Finance managers need to understand which side of the exchange rate their business sits on. Forecasting and budgeting need extra care when a currency is falling.
A budget agreed at one exchange rate can look very different three months later, so many companies set a planning rate and review it often. Showing results at constant exchange rates also helps separate genuine performance from currency movement.
In practice
Real-world examples.
Example
A garment factory in a country with a weakening currency sells most of its output to buyers in Europe and the US. Its prices in dollars become competitive and orders increase. Its costs, such as wages and rent, are in the weak local currency, so its margins widen.
Example
A local bakery imports flour and equipment from abroad, priced in a stronger currency. As the local currency weakens, the cost of flour rises 12% in a few months. The owner raises bread prices to protect the margin.
Example
A property developer borrowed $5,000,000 in dollars but earns rent in a weakening local currency. Each monthly repayment costs more local currency than planned, which squeezes cash flow. The finance director asks the bank about converting the loan to the local currency.
Formula
Calculation
Percentage change in currency value = (New exchange rate - Old exchange rate) / Old exchange rate x 100
Suppose a currency was worth $0.050 per unit and falls to $0.040 per unit. The change = (0.040 - 0.050) / 0.050 x 100 = -0.010 / 0.050 x 100 = -20%. A US buyer ordering goods priced at 2,000,000 local units paid 2,000,000 x 0.050 = $100,000 before the fall. After the fall, the same order costs 2,000,000 x 0.040 = $80,000, a saving of $20,000, although the foreign supplier now earns 20% less in dollar terms.Case study
Seen in the real world.
Lantern Hill Electronics is an illustrative, fictional manufacturer in a country whose currency lost 25% of its value in a year. It assembled devices from imported components priced in dollars and sold them locally.
Component costs rose by a quarter in local terms, while customers could not afford a matching price increase. The company's gross margin fell from 30% to 18% in two quarters.
In this illustrative story the CFO responded by negotiating local suppliers, buying forward contracts to fix the exchange rate for six months, and passing on part of the increase in prices. The lesson is that a weak currency is a risk for any business with costs in a different currency from its revenue.
Watch out
Common mistakes.
- Assuming a weak currency is always bad, when exporters and tourism businesses often benefit from it.
- Ignoring the currency of debt, when borrowing in a foreign currency can become much more costly if the home currency weakens.
- Treating weak and strong as absolute, when a currency can be weak against one currency and stable against another.
Questions
People also ask.
What causes a currency to weaken?
Common causes are high inflation, falling interest rates, large deficits, political instability and a loss of investor confidence.
How can a business protect itself?
Companies use hedging tools such as forward contracts, match costs and revenues in the same currency, or adjust prices to pass on the effect.
Is a weak currency the same as devaluation?
Not exactly, because devaluation is a deliberate lowering of a fixed exchange rate by a government, while a currency can also weaken through market forces.
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