Question

Visit a construction site almost anywhere in the world, and odds are that the earthmoving equipment you see -- the tractors, dump trucks, excavators, graders, scrapers, and so on -- is made by one of the two companies, America's Caterpillar or Japan's Komatsu. Caterpillar and Komatsu both rely heavily on exports, rather than selling only to their domestic markets, and have been fierce competitors for three decades, with first one company, then the other, seemingly on the ropes. Ask the companies' leaders to explain the course of the seesawing competitive struggle, and they will tell a tale of corporate cultures and management decisions. Caterpillar, the story goes, entered the 1980s filled with complacency thanks to its longtime dominance of the earthmoving industry, only to face a shock from Komatsu that almost drove it to the brink. Then Caterpillar reformed its management practices, regaining the upper hand in the 1990s, and Komatsu found itself in danger of failing, until reinvigorated management stabilized the company again. But is this the whole story? Not exactly. Management decisions were no doubt crucial to both firms, so were movements in the exchange rate. The figure below shows the real exchange rate between the United States and Japan, using consumer prices, from 1980 to 2011. The figure immediately suggest one reason Caterpillar was able to recover from the shock of competition in the 1980s: a sharp appreciation of the Japanese Yen beginning in 1985. And Komatsu's ability to survive Caterpillar's resurgence was surely helped by the slide in the yen after 1995, and especially after 2000. The two companies seemed to have settled into relatively stable positions, with Caterpillar the bigger firm but Komatsu also doing well thanks in part to rapid growth in demand from China. But Japanese executives at Komatsu (and other firms) were getting worried about the effects if a the that was once again on the rise.

Real exchange rate (yen per U.S. dollar) Sharp appreciation of the yen ¥130 120 110 100 90 80 70 60 50 40 Depreciation of the yen Year Source: Federal Reserve Bank of St. Louis.,

1. Why does the yen-dollar exchange rate matter so much for the fortunes of Caterpillar and Komatsu?

2. Why does the figure represent the real rather than the nominal exchange rate? Do you think this makes an important difference to the story?

3. In 2011, Japanese policy makers were discussing possible sales of yen on the foreign exchange market. How would this affect the Caterpillar/Komatsu rivalry?

Answer 1

1. Why does the yen-dollar exchange rate matter so much for the fortunes of Caterpillar and Komatsu?

The Yen-Dollar exchange rate influenced the victor in the competition between Caterpillar and Komatsu due to an agreement called the Plaza Accord.

The Plaza Accord agreement devalued the America dollar thereby weakening (depreciating) the currency. This in turn strengthened (appreciated) the value of the Japanese Yen.

In the exchange rate between two countries, the appreciation of one currency means the depreciation of the other currency.

So, in the 1980s when the dollar was stronger in comparison to the Japanese Yen (trading against the dollar ($1) between ¥200 to ¥270), Caterpillar got the upper hand in the competition. This in essence means that it was cheaper to buy from Caterpillar.

When in 1985 the Dollar was devalued as per the Plaza Accord agreement, the Yen appreciated in value and reached close to ¥80 in comparison to the dollar (1$ = ¥80). So, during the early 90s Komatsu got the upper hand in the competition. This in essence means that it became cheaper to buy from Komatsu

2. Why does the figure represent the real rather than the nominal exchange rate? Do you think this makes an important difference to the story?

To understand if there was a difference to the story, it is important to understand what nominal exchange rate is and what is real exchange rate.

In Layman’s terms,

A nominal exchange rate is the price of one countries’ currency against another.

A real exchange rate (RER) is the price of one countries’ goods against another.

The figure above represents the real rather than the nominal exchange rate because the comparison between Caterpillar and Komatsu is made in terms of their ‘goods’ – The earth mover-equipments.

For Example:

XYZ company wants to purchase one tractor for their farming business from either Caterpillar or Komatsu. The cost of the tractor at Caterpillar is $100 and the cost of the Komatsu tractor is ¥8000.

The following is the calculation of RER.

The RER between two currencies is the product of the nominal exchange rate (the yen cost of a dollar, for example) and the ratio of prices between the two countries.

Note: When the RER=1, the Purchasing Power Parity (PPP) is absolute. This means that the cost of a good in one country is the same as in the other country.

The core equation to calculate RER is RER=eP*/P, where, in our example,

• e is the nominal dollar-yen exchange rate,
• P* is the average price of a Caterpillar tractor in the United States,
• and P is the average price of the Komatsu tractor in the Japan.

Solution:

In the above example, e = 100.87. (Current exchange rate)

If the U.S. price is $100 and the Japanese price is ¥8000, then

(100.87) x (100) ÷ 8000 yields an RER of 1.3

Conclusion:

• The above calculation concludes that with the RER as 1.3 it would be cheaper for XYZ to purchase tractor from the Japanese Komatsu.
• If the RER=1 the cost of tractor would be the same at both Caterpillar and Komatsu
• If RER<1, then the cost of the tractor would be cheaper at US’s Caterpillar.

So, to answer the question, yes, the real exchange rate (RER) made a difference in who emerged as the victor between Caterpillar and Komatsu. Because it compares the cost of goods rather than the cost of currencies.

3. In 2011, Japanese policy makers were discussing possible sales of yen on the foreign exchange market. How would this affect the Caterpillar/Komatsu rivalry?

Due to the Japanese earthquakes and Tsunami crisis in 2011, the Yen was weakened and hit a record high of ¥76.52 against the dollar ($1).

Considering the situation of Caterpillar and Komatsu, buyers would be more invested in getting the product from Caterpillar due to the higher RER of Komatsu products.

This would mean that Caterpillar would see a spike in sales figures whereas Komatsu is pushed back.