The Apparel Exporter's Exchange-Rate Squeeze
A mid-sized apparel exporter in a small open economy sells 60% of its output abroad, priced in US dollars, and imports 40% of its fabric, also priced in dollars. Last year the exchange rate was 100 units of local currency per dollar; this year it is 125. The firm's dollar revenue is unchanged at $10 million, and its dollar costs are $6 million, of which $3 million is imported fabric. Domestic wages and rent, paid in local currency, total the equivalent of $2.5 million at last year's rate. The government is debating whether to defend the old exchange rate or let it float, and the firm's owner is lobbying for a return to 100.
1. Calculate the firm's local-currency profit before and after the depreciation. Does the depreciation help or hurt this firm, and why?
Read the worked answer
Last year (100 per dollar):
- Revenue: $10m × 100 = 1,000m local units
- Imported fabric: $3m × 100 = 300m
- Other dollar costs (domestic content, $3m equivalent): 300m
- Total cost: 600m → Profit = 400m
This year (125 per dollar):
- Revenue: $10m × 125 = 1,250m
- Imported fabric: $3m × 125 = 375m
- Domestic costs (wages, rent) fixed in local currency at the old equivalent: 250m
- Total cost: 625m → Profit = 625m
Profit rises by 225m local units, about 56%. The depreciation helps this firm because it is a net exporter with a large domestic-cost base. Its revenue is in dollars and its domestic costs are in local currency, so a weaker currency raises the local-currency value of revenue faster than it raises the local-currency cost of imported inputs. The imported fabric (40% of dollar costs) partially offsets the gain, but the domestic wage and rent bill is the larger lever.
The owner's lobbying for a return to 100 is therefore against the firm's own interest - unless the firm has large dollar debts or relies on imported machinery whose cost would rise further. The arithmetic says the depreciation is a tailwind.
2. The government asks whether defending the old rate would be wise. Evaluate the trade-offs, including the effect on other exporters and importers.
Read the worked answer
Defending the rate at 100 means the central bank must buy local currency with foreign reserves, or raise interest rates to attract capital. Costs:
- Reserve depletion: sustained defense burns reserves and can end in a sudden, larger depreciation anyway.
- Higher interest rates slow domestic investment and hurt domestic-demand sectors.
- Credibility risk: a failed defense is more damaging than an orderly float.
Who gains and who loses:
- Exporters with domestic cost bases (like the apparel firm) gain from a weaker currency; defending at 100 would deny them that gain.
- Importers and consumers of imported goods lose from depreciation; defending at 100 protects them.
- Dollar borrowers face higher local-currency debt service under depreciation, which is a genuine financial-stability concern if such borrowing is widespread.
Judgment: a blanket defense is hard to justify when the currency move is helping the tradable sector the government says it wants to grow. A better approach is to let the rate adjust while using targeted tools - reserve buffers, macroprudential limits on dollar borrowing, and support for import-dependent households - to manage the transition. The government should distinguish between the level of the rate (a price) and the adjustment (which is doing useful work). Defending 100 would be defending a number, not an objective.