Question

Decko Co. is a U.S. firm with a Chinese subsidiary that produces smartphones in China and sells them in Japan. This subsidiary pays its wages and its rent in Chinese yuan, which is stable relative to the dollar. The smartphones sold to Japan are denominated in Japanese yen. Assume that Decko Co. expects that the Chinese yuan will continue to stay stable against the dollar. The subsidiary’s main goal is to generate profits for itself and reinvest the profits. It does not plan to remit any funds to Decko, the U.S. parent.

a) Assume that the Japanese yen strengthens against the U.S. dollar over time. How would this be expected to affect the profits earned by the Chinese subsidiary?

b) If Decko Co. had established its subsidiary in Tokyo, Japan, instead of in China, would the subsidiary’s profits be more exposed or less exposed to exchange rate risk?

c) Why do you think that Decko Co. established the subsidiary in China instead of Japan? Assume no major country risk barriers.

d) If the Chinese subsidiary needs to borrow money to finance its expansion and wants to reduce its exchange rate risk, should it borrow U.S. dollars, Chinese yuan, or Japanese yen?

Answer 1

(a) If the Japanese yen strengthens against US Dollars and Chinese yuan remains stable (as given in the question) then this implies that Japanese yen has strengthened against yuan as well. Since the phone is sold in Japanese yen, this implies that the Chinese subsidiary will get less Japanese yen for a yuan as compared to before (since Yuan is still stable), thereby leading to lower profits.

(b) If the subsidiary had been in Japan, the subsidiary''s profits would be more exposed to exchange rate risk as Yuan is expected to stay stable compared to Japanese Yen. Further more, if Yen appreciates over time like it has in part (a), the firm will be getting lesser US dollar amount for each Japanese yen, if it decides to remit back the profit in future.

(c) Decko Co. established the subsidiary in China instead of Japan, because of stable exchange rate compared to USD. Exchange rate volatiltiy can erode value creation, specially in cost items. Hence, most of the manufacturing units are located in areas of low exchange rate volatility since, the company can decide to sell products in multiple countries and earn revenue from them but it cannot shift its manufacturing units that rapidly, if the exchange rates fluctuate too often.

(d) It is always better to borrow the money in local currency i.e Chinese Yuan, if there isn't much difference in interest rates on borrowing. Transacting in local currency eliminates exchange rate risk due to changes in the currencies over time.