by Alan Cordova

Mike in South Korea has watched the local currency, the won, get weaker against the dollar over the past year. He writes:

As an indicator, what does the exchange rate say about the relative strength or production of a country's economy?

Although changes in exchange rate matter greatly, the exact ratio of South Korean won-to-dollars matters less than you might think.

 

Exchange rates tell companies how to price their products when selling in overseas markets. For example, if an American company decided a year ago that it wanted to make $5 in revenue for each t-shirt sold in South Korea, it could price them at 4670 won. The number of won for which each t-shirt is sold doesn't matter, as long as the company can convert that number into $5.

The fact that a year ago each Korean won was worth one-tenth of a penny did not mean that the economy was necessarily weaker than America's. Currencies vary widely in how they fare against the dollar, from the Kuwaiti dinar, worth $3.66, to the Zimbabwean dollar, whose infinitesimal value has reached exponential proportions. When economists compare countries, they use a single currency for the statistics — regardless of whether that currency is actually used by any of the countries being compared.

What does matter a great deal, however, is change in the exchange rate. If the company had kept the price of 4670 won, it would today only make $4.50 for each t-shirt. Currency depreciate hurt the bottom line.

From Mike's perspective, the South Korean won lost value relative to the U.S. dollar. But from the company's perspective, the dollar appreciated relative to the South Korean won. The company must either:

  • Lower its expectations for revenue of $5 per t-shirt, which means accepting lower per t-shirt profits.
  • Raise local prices to the South Korean equivalent of $5, which risks attracting local competition capable of undercutting the company.