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ECONOMIC EXPOSURE TO EXCHANGE RATES IN JORDAN COMPANIES: THEORETICAL FRAMEWORK AND LITERATURE REVIEW

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ECONOMIC EXPOSURE TO EXCHANGE RATES IN JORDAN COMPANIES:

THEORETICAL FRAMEWORK AND LITERATURE REVIEW

SHOTAR, Manhal M. EL-MEFLEH, Muhannad A.

Abstract

Jordan’s exports and imports represent more than 36% and 81% of Jordan’s GDP respectively. Therefore, not only is Jordan’s economy highly vulnerable to change in the exchange rate, but also individual firm performances are vulnerable as well. The sensitivity of the firms’ future income to exchange rates change is a necessary measure for the risk management of the firm since economic exposure of the firm affects the profit and the value of the firm. Two variants of an exchange risk model for major Jordanian firms are proposed. These models were developed and estimated. There are two major findings of this paper: (1) the models provide useful information on the economic exposure of Jordanian firms; and (2) the firm exchange rate exposure is above the market portfolio exposure.

JEL Classification: F41, F43, E52

Key Words: Economic Exposure, Economic Openness, Risk Management.

1. Introduction

The Jordanian dinar (J.D) has been effectively pegged to the dollar since 1995 (J.D 0.71/$ 1.) The depreciation of the dollar during 2002-2008 as well as the free trade agreement with the U.S. has helped Jordan’s exports. However, the increase of Jordan's exports could slow down if the U.S. dollar appreciates. The Jordanian dinar will also face a potential crisis if a Palestinian currency is introduced. The net impact of an increase in oil prices on the Jordanian economy is not clear since oil prices have a positive impact on labor remittances and grants for Jordan from Arab oil producing states. On the other hand, Jordan is an importer of oil.

The lack of foreign exchange hedging by major firms in Jordan means that the central Bank of Jordan needs to accumulate larger amounts of foreign reserves than needed to deal with the potential of an unexpected bail out of private firms in case of currency attack. The accumulation of foreign reserve by the Central Bank of Jordan is costly and represents a public subsidy for private firms (for more details see El-Mefleh. 2003.) Jordan exports few commodities to their major trading partners in the Arab countries, the U.S., and India. The 2001 free trade agreement between Jordan and the U.S. did increase Jordan exports to the U.S. from less than J.D 10 million in 1999 to more than J.D 750 million by the year 2007. This increase in exports made the U.S. the most important market for Jordanian exports in terms of monetary value. Then again, Jordan’s imports come mostly from European countries, Arab countries, the U.S., and China. Imports from

Manhal M. Shotar, Ph.D. (Contact Author), Senior Finance Economist, Gesellschaft für Technische Zusammenarbeit (GTZ), Amman – Jordan, e-mail: mshotar@hotmail.com

Muhannad A. El-Mefleh, Ph.D., Qatar University, Doha, Qatar, P.O. Box 2317, e-mail: melmefleh@yahoo.com

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China did surpass those of the U.S. for the first time in 2004. The imports from the Arab countries mostly are fuel oil.

Jordan’s small open economy has little influence if any on internationally traded goods and services prices with an estimated GDP of JD 11.352 billion in 2007. Jordan’s exports and imports in 2006 represent more than 36% and 81% of Jordan’s GDP respectively.

The degree of openness measured as the ratio of exports and imports to GDP is 1.17.

Jordan’s economy is highly vulnerable to external shocks. Therefore, not only is Jordan’s economy highly vulnerable to changes in the exchange rate but also to individual firm performances. The sensitivity of the firms’ future income to exchange rates change is a necessary measure for the risk management of the firm since economic exposure of the firm affects the profit and the value of the firm. Consequently, measuring and managing the economic exposure of a firm is essential for strategic management. In addition, understanding economic exposure gives the firm the ability to implement effective hedging strategies. The higher the ratio of foreign sales to total sales for a company, the higher the firm exposure is to exchange rate risk. Examining the market structure that a firm is operating in, both in the local and foreign markets is essential to understanding the impact of economic exposure due to unexpected shifts in the real exchange rate. Changes in real exchange rate could eliminate the profit margin of the importer but increase it for the exporter and vice versa, based on the elasticity of demand facing the firm.

The present paper focuses in its second section on providing a theoretical background and comprehensive review of the relevant literature. Section three discusses the methodology employed as well as the empirical test results. Section four provides final remarks. Finally, section five concludes the paper.

2. The Critical frame work literature review.

The end of the Bretton Woods system in March 1973 did create new challenges for firms. One of the new challenges is managing real operating exposure due to unexpected changes in real exchange rates. The change of real exchange rates and price requires firms to engage in short-term hedging and long term strategic planning so that the firms can protect themselves and stay competitive in the international market. The long term planning will include strategies for expected and unexpected currency exchange rate influence on sourcing and plant location.

One would expect that the financial sector is the most vulnerable to exchange rate risk, but there is no known data on whether the banking sector engages in foreign exchange hedging or not. The firm that faces exposure to exchange rate fluctuation can adopt financial hedging, operational hedging, or a combination of both. The objective of the firm is to decrease the degree of its exposure to foreign currency fluctuation. One way of managing exchange rate exposure is to enter into foreign exchange forward contracts which can protect the firm from the short-term fluctuation of exchange rates but not from the deterioration of its competitiveness when domestic currency appreciates. Forward contracts can be designated as cash flow hedge or fair value hedges of liabilities or assets denominated in foreign currency by accounting departments.

There are three strategies to exchange rate risk: the do nothing strategy, a passive strategy, and an active strategy. The “do nothing” strategy is a simple and straight- forward one, converting foreign currency into local currency at the spot market rate. The passive strategy of the importer is one in which hedging all expected foreign exchange

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positions in the forward market or all payments for futures of imported inputs are negotiated for payments in the local currency (suppliers assume the exchange rate risk.) The active strategy is based on the firm selectively hedging its exchange rate risk based on forecasting. Therefore, the firm may hedge, not hedge (maintaining an open position) or negotiate payments in the local currency intentionally based on its forecast of the movement of exchange rate. There is value in an active strategy if the forecasting of the exchange rate by the firm (or the forecast purchased by the firm) is superior to relying on forward rate alone.

Another way of managing exchange rate exposure is the use of foreign sourcing which has become an essential part of any multinational/global firm strategy during the last 20 years. Foreign sourcing enhances the competitive advantage of the firm in producing components, assembly, marketing, services, and design. The foreign sourcing can be from subsidiaries located outside the country or from suppliers from abroad. In theory, one would expect the decision for foreign sourcing to be motivated by easier access to foreign consumers and cheaper input factors, as well as avoiding tariff barriers, non-tariff barriers, and exchange rate risk.

Japanese firms set up production facilities in the U.S. because of the depreciation of the dollar during the last 20 years, vis-à-vis the yen. Consequently, Japanese firms increased the purchase of standardized parts and materials from the U.S. suppliers not only for their operation in the U.S. but for their operations in Japan. Most companies are not willing to outsource their core competency due to economic rent but that does not prevent corporations, especially multinational firms, from exploiting comparative advantage of different countries by establishing subsidiaries around the globe.

Subsidiaries give firms the ability to exploit economies of scale and keep the benefits of global strategy.

The extent of a company’s involvement in foreign markets can be estimated by using the ratio of foreign assets to total assets, foreign profits to total profits, and foreign sales to total sales of the firm. One would expect that the higher the previous three ratios the more sensitive the firm profit would be to exchange rate fluctuations. Malindretos and Tsanacas (1995) have argued that based on their survey, the chief financial officers (CFOs) of small sized multinational corporations (MNCs) have a better understanding of transaction or translation exposure than they have of economic exposure. Also, they find that diversification of the financial base is the hedging technique used against translation exposure, the forward hedging technique is used against transaction exposure, and the diversification of finance and operations technique are used against economic exposure.

According to Khim and Liang (1997) most firms in Singapore are engaged significantly in hedging transaction exposure with forward contracts, but economic exposure is not hedged in any significant measure. Economic exposure cannot be hedged using matching fund techniques, but it requires the use of marketing, production, and financial strategies.

Flood and Lessard (1986) have divided the cash flows of the firm into two categories that have different sensitivities to exchange rate changes. The two categories are the operating cash flows and the nominal flows such as accounts receivable and most debt.

They divide the operating exposure into conversion effect (translation effect) and competitive effect (dependence effect) where competitive effect is dependent on the exchange rate of the domestic currency and the structure of the markets in which the firm sells its products or/and buys its inputs.

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Allayannis and Ihrig (2001) have found that 4 out of 18 industrial groups in the U.S.

are subject to exchange rate exposure. The exchange rate movement impacts the competitive positions, export shares, and imported input shares of the four industrial groups. However, the extent of the impact is dependent on the market structure. In a highly competitive market, the impact of unexpected exchange rate could be devastating relative to an oligopolistic market structure. A firm in an oligopoly market structure has a price above marginal cost (markup) which gives the firm the ability to deal with exchange rate movement effectively by following a discriminatory price structure for each market.

Consequently, the impact of exchange rate movement on revenue is smaller than that of a firm in a competitive structure.

Bodnar and Wong (2003) argue that measuring exchange rate exposure or elasticity of the exchange rate exposure of a firm by the standard approach of regression analysis of stock returns on an exchange rate change and on market portfolio return produces primarily unsatisfactory statistically significant coefficient of exchange rate change. This measure creates a dilemma for the practical usefulness of these models. Bodnar and Wong conclude that the longer the horizons of the return measurements are for the U.S.

firms, the more statistically significant the exchange rate exposure coefficient estimates are. This result is contradicted by the findings of Oh (2004) which were that daily data has better explanatory power than the monthly data for the Korean firms.

Bradley and Moles (2002) study has found that more than 75% of UK firms consider the impact of the exchange rate when adopting operational decisions. Also, the operation decision is based on other factors, such as competitive market conditions, comparative advantage, and economies of scale in production and distribution.

Hakkaraineen, Kasanen, and Puttonen (1997) have investigated Finnish firms’

responses to globalization and the adoption of a floating exchange rate regime in October 1992 by the Finland Central Bank. Their findings indicate an active management of exchange rate risk. Their survey also shows that various hedging instruments are used.

3. Methodology, data, and empirical results.

A firm’s rate of return is a function of rate of return of the domestic market portfolio, the weighted rate of return of the domestic market, the rate of change in the exchange rate index, or the price of the same product by major competitor. The rate of return is also a function of other variables, such as the number of foreign competitors, input prices, substitute prices, technological variable, government policy variable, and number of domestic importer. If the historical rate of return is not available, then one has to rely on indirect measure to calculate the rate of return by using the following formula:

Rt = (vt + dt - nst -vt-1) / vt- (1)

Where Rt is the rate of return for a firm at time t, vt is the expected value of the firm at time t, dt is the amount of dividend during at time t, and nst is the value of the public offering of new shares by the firm at time t.

Globalization and the increase of international trade as a percentage of the world GDP during the last 30 years has made a larger percentage of corporation performances vulnerable to unexpected exchange rate movement. The increase in the value of foreign currency has an economic and accounting impact on the firm, especially on multinational

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corporations. The following model is a similar model to that of Chan-Lau (2005), Oh and Lee (2004), Loudon (2004), Bodnar and Wong (2003), Domingues and Tesar (2001), Aabo (2001), Pantzalis, Simkins, and Laux (2001), Miller (1998), and Adler and Dumas (1984).

One way to measure the economic exposure is by estimating the coefficient of changes in the exchange rate.

Rit = ai+ biRmt + ciEt + di Pj t + eit (2)

Where Rit is the rate of return of firm i, Rmt weighted rate of return of the domestic market or domestic market portfolio, Et rate of change in the exchange rate index or relevant exchange rate, Pjt is the price of the same product or similar product by major competitor, bi is the firm beta, ci is the exchange rate impact on the rate of return (exposure risk), and eit is the error term. The inclusion of market portfolio return is to capture the impact of all other macroeconomic factors.

One must be careful when using market value of the firm over time by adjusting for dividend payments, which reduce the value of the firm, and public offering of new shares, which increase the value of the firm. The exchange rate Et is the rate of local currency in terms of the foreign currency. Et is expected to be negative when local currency depreciates and positive otherwise. The expected sign of ci is dependent on the expected inflows (revenue) and outflows (costs) of foreign currency. Interest rate is not included in the equation because interest rate is incorporated in the return of the market. If ci is zero, then the firm has the same level of exposure as the market exposure (or market portfolio exposure.) A positive value for ci implies that the firm value or return on the firm i increased with the appreciation of the domestic currency. A negative value of ci implies that the firm value declined due to appreciation of the domestic currency. Using the equal weight market portfolio tends to increase the importance of small, mostly import-oriented firms in the portfolio. The above firms will see that their cash flow decreases when domestic currency depreciates but increases when the domestic currency appreciates.

Using a value-weighted market portfolio gives more weight to large, most likely export- oriented, firms in the portfolio. These large firms will see that their cash flow decreases when domestic currency appreciates and increases when domestic currency depreciates.

Therefore, one would conclude that the construction of market portfolio would impact the empirical result of the regression.

Data:This paper uses the monthly general stock exchange price index, published by Amman Security Exchange for the period of May 2004 until March 2007. Also, the monthly closing price of a share of “The Arab Potash” is taken at the start of each month from Amman Security Exchange. The average price of Potash per ton in $ is calculated from the data provided by the Jordan’s ministry of industry and trade.

Empirical results:

Rit = 2.6Et – 0.016Pj t F=4.87 (2.3) (1.67)

Rit = 0.43Rmt + 2.8Et + 0.01Pjt F=4.04 (1.4) (2.5) (1.19)

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Two models are estimated. The estimated equations represent satisfactory statistical fits of the t-value, f-value, and expected sign of the coefficients of regressions. One model is without the market portfolio. The coefficient of the real exchange rate of model one is the total exposure elasticity of the firm. The second model which includes the market portfolio variable improves the explanatory power of the regression and gives the decision makers extra information about the exchange rate impact on the value of the firm and the exposure of the firm to real exchange rate fluctuation. A significant positive coefficient of the exchange rate (2.8) implies that the firm exchange rate exposure is above the market portfolio exposure.

The test results in this paper contradict with other researchers. Kroon and Van Veen (2004) have examined more than 2600 stocks from more than twenty countries and have found that the exchange rate exposure impact on an average company’s stock value in most cases is zero. The reason is that most exchange rate impact is NOT reflected through the general market movements.

Final remarks:

Jordan needs to foster foreign exchange risk management in the private sector. The development of a foreign exchange derivatives market will promote the financial stability of the country in the absence of financial distress. But the availability of foreign exchange derivatives will accelerate and deepen the financial instability of the country during financial crisis. The ability of speculators to take positions in the forward market and swap market will reduce the ability of the central banks to defend the exchange rate.

Jordan exports a few commodities to their major markets in Arab countries, India, and the U.S. which may strengthen the argument for moving toward a flexible exchange rate system. A flexible exchange rate system may help export to new markets, protect the country’s competitive advantage, and reduce the impact of real shock, not monetary shock on the economy. The persistent high rate of unemployment in Jordan indicates inflexibility of wages downward, even with Jordan’s lack of strong labor unions, unemployment benefits, and intensive regulations. Movement toward a flexible exchange rate regime may create doubts about the ability of the monetary policy to stay disciplined and keep inflation rates low. The inability to predict a stable inflation may create a decrease in demand for Jordanian currency and may increase the demand for other currencies instead. The level of dollarization in Jordan may create a problem for the monetary authorities if it shifts toward a flexible exchange rate. The increase of currency substitution will make it difficult for the monetary policy to control the money supply and increase the volatility of the exchange rate, especially when the monetary authority lacks credibility in the eyes of the public.

4. Conclusion.

Jordan’s exports and imports represent more than 36% and 81% of Jordan’s GDP respectively. Therefore, not only is Jordan’s economy highly vulnerable to change in the exchange rate, but also individual firm performances are vulnerable as well. The sensitivity of the firms’ future income to exchange rates change is a necessary measure for the risk management of the firm since economic exposure of the firm affects the profit and the value of the firm. The lack of foreign exchange hedging by major firms in Jordan means that the central Bank of Jordan needs to accumulate larger amounts of foreign

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reserves than needed to deal with the potential of an unexpected bail out of private firms in case of currency attack. Finally, Jordan needs to foster foreign exchange risk management in the private sector.

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On line Annex at the journal Website: http://www.usc.es/economet/aeid.htm

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Annex:

Year Potash st

G SEPI

$/

euro P- potash

Yen/

$

GP Stock 04-5 3,78 1794,6 1,2 119,42 109,56 0,164021 04-6 4,4 1883,6 1,2146 133,52 108,69 0 04-7 4,4 1997,9 1,2266 128,353 111,67 0,009091 04-8 4,44 2064,8 1,2191 137,438 109,86 0,009009 04-9 4,48 2085,2 1,2224 129,497 110,92 0,294643 04-10 5,8 2232,1 1,2507 143,089 105,87 0,467241 04-11 8,51 2384,5 1,2997 140,246 103,17 0,291422 04-12 10,99 2684,6 1,3406 141,739 103,78 0,212921 05-1 13,33 2837,7 1,3123 156,698 103,58 -0,02851 05-2 12,95 3069,7 1,3013 150,728 104,58 0,007722 05-3 13,05 3266,1 1,3185 160,28 106,97 -0,04598 05-4 12,45 3633,2 1,2943 159,445 105,87 0,057831 05-5 13,17 4067,8 1,2697 158,613 108,17 -0,01367 05-6 12,99 4119,2 1,2155 158,582 110,37 -0,02232 05-7 12,7 4706,1 1,2041 158,55 112,18 0,211811 05-8 15,39 4368,4 1,2295 174,873 111,42 -0,01235 05-9 15,2 4616,7 1,2234 170,871 113,28 -0,05921 05-10 14,3 4558,5 1,2022 171,145 115,67 -0,05944 05-11 13,45 4551,4 1,1789 169,547 119,46 -0,03346 05-12 13 4690,7 1,1861 173,276 117,48 0,061538 06-1 13,8 4404,8 1,2126 160,353 117,18 -0,03623 06-2 13,3 4480,8 1,194 173,906 116,35 -0,11654 06-3 11,75 3689,9 1,2028 175,22 117,47 -0,03915 06-4 11,29 3667,9 1,2273 176,516 114,32 -0,05226 06-5 10,7 3815 1,2767 174,516 111,85 -0,13832 06-6 9,22 3643,3 1,2661 171,042 114,66 0,083514 06-7 9,99 3135,1 1,2681 157,942 114,47 0,001001 06-8 10 3177,9 1,281 173,544 117,23 0 06-9 10 3405,5 1,2722 174,203 117,91 0 06-10 10 3293,6 1,2617 169,734 118,01 0,01 06-11 10,1 3264,7 1,2888 175,996 117,23 0,089109 06-12 11 3014 1,3205 174,344 115,57 0,254545 07-1 13,8 3025,6 1,2993 171,521 118,72 0,007246 07-2 13,9 3267,3 1,308 175,132 121,29 -0,03237 07-3 13,45 3397,9 1,3246 168,112 115,86

Potash st: potash stock price

Gpstock: is the growth rate of potash stock price GSEPI: General stock exchange price index P-Potash is the price in dollars per ton of Potah Gpstock: is the growth rate of potash stock price

GGSEPI is the growth of the general stock exchange price index G$/euro is the rate of change in the exchange rates

Gp-potash: is the rate of change in price of potash

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Year GG SEPI

G

$/euro

Gp- Potash

Gyen /$

04-5 0,049593 0,012167 0,118071 -0,00794 04-6 0,060682 0,00988 -0,0387 0,027417 04-7 0,033485 -0,00611 0,070781 -0,01621 04-8 0,00988 0,002707 -0,05778 0,009649 04-9 0,070449 0,023151 0,10496 -0,04553 04-10 0,068277 0,039178 -0,01987 -0,0255 04-11 0,125854 0,031469 0,010646 0,005913 04-12 0,057029 -0,02111 0,105539 -0,00193 05-1 0,081756 -0,00838 -0,0381 0,009654 05-2 0,06398 0,013218 0,063372 0,022853 05-3 0,112397 -0,01835 -0,00521 -0,01028 05-4 0,119619 -0,01901 -0,00522 0,021725 05-5 0,012636 -0,04269 -0,0002 0,020338 05-6 0,142479 -0,00938 -0,0002 0,016399 05-7 -0,07176 0,021095 0,102952 -0,00677 05-8 0,05684 -0,00496 -0,02289 0,016694 05-9 -0,01261 -0,01733 0,001604 0,021098 05-10 -0,00156 -0,01938 -0,00934 0,032766 05-11 0,030606 0,006107 0,021994 -0,01657 05-12 -0,06095 0,022342 -0,07458 -0,00255 06-1 0,017254 -0,01534 0,08452 -0,00708 06-2 -0,17651 0,00737 0,007556 0,009626 06-3 -0,00596 0,020369 0,007396 -0,02682 06-4 0,040105 0,040251 -0,01133 -0,02161 06-5 -0,04501 -0,0083 -0,01991 0,025123 06-6 -0,13949 0,00158 -0,07659 -0,00166 06-7 0,013652 0,010173 0,098783 0,024111 06-8 0,07162 -0,00687 0,003797 0,005801 06-9 -0,03286 -0,00825 -0,02565 0,000848 06-10 -0,00877 0,021479 0,036893 -0,00661 06-11 -0,07679 0,024597 -0,00939 -0,01416 06-12 0,003849 -0,01605 -0,01619 0,027256 07-1 0,079885 0,006696 0,021053 0,021648 07-2 0,039972 0,012691 -0,04008 -0,04477 Gyen/$ is the rate of change in the exchange rate of yen/$

$/euro is taken from: Federal Reserve Statistical Release, G5. Foreign Exchange Rates (Monthly). This release is available at: http://www.federalreserve.gov/releases/g5.

Yen/$ is available at: http://en.wikipedia.org/wiki/Yen#Historical_exchange_rate This is the closing price of a share of “The Arab Potash” at the start of each month.

Amman Security Exchange, Amman Stock Exchange Indices are available at:

http://www.ase.com.jo/pages.php?menu_id=198&local_type=0&local_id=0&local_details=0

*GSEPI: generel stock exchange price indices (Amman Security Exchange) P-Potash is the average price per ton in $.

P-Phosphate is the average price per ton of phosphate rock in dollar

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