Blades Inc
Case Study: Blades, Inc – Assessment of Purchasing Power Parity Summary: Blades Inc, a US based company that manufactures roller blades, is currently importing from and exporting to Thailand. The decision to work with Thailand resulted from the realization that there were little to no foreign or Thai competitors and Thailand’s potential growth as a country was on the rise. As a result Blades entered into an agreement with Entertainment Product, a Thai retailer, for an annual purchase contract lasting 3years.
This agreement stated Entertainment Product would buy 180,000 pair of Blades’ top product, Speedos, annually at a fixed baht-denominated price; which would ultimately result in 10% of Blades’ revenue. Additionally, the decision was made to import certain rubber and plastic components from Thailand. Due to the country’s ability to produce these items at a cheaper rate Blades believed they would be able to keep their cost low.
However, Blades failed to enter into an agreement on the price of the plastic and rubber components making them susceptible to the varying price changes. These fluctuations were caused by the country’s rise in inflation. As Blades made all purchases of these components in baht the higher the currency the more money spent on these items; raising their cost. With the purchase of these components Blades currently incurs approximately 4% of their cost of goods sold in Thailand alone. In this case Blades CFO, Ben Holt, is concerned about Thailand’s inflation levels.
Although Blades has an agreement with Entertainment Products for an annual purchase amount Holt has begun to question whether it was a good idea to agree to a fixed price with no inflation considerations in the contract. Also, he is concerned about the company’s cost of goods sold as Blades did not enter into a fixed price for the imported plastic and rubber components invoiced in baht making them subject to increases in the price due to inflation in their free floating currency.
Holt also wonders if the theories of purchase power parity will affect Blades in anyway. 1. What is the relationship between the exchange rates and relative inflation levels of the two countries? How will this relationship affect Blades’ Thai revenue and costs given that the baht is freely floating? What is the net effect of this relationship on Blades? The relationship between the exchange rates and relative inflation rates can be understood by reviewing the purchasing power parity (PPP) theory.
This theory has two forms; absolute and relative. Absolute states that should there be no international barriers on demand which would shift demand to wherever the price is cheapest for consumers. Therefore, based on this theory prices for the same basket of products in two different countries should be equal when measured in a common currency. This theory would even the “playing field”. Relative purchase power parity takes into consideration the imperfect market and how prices are affected due to transportation costs, tariffs, and quotas.
As these things are considered; relative PPP believes that products of the same basket could not be the same price when measured in a common currency. However, it does acknowledge that should two countries transportation cost, tariffs, and quotas be the same then the price of products in the same basket should be the same when compared in a common currency. Additionally, one should always be mindful that should one country’s inflation rate increase relative to that of another’s, the demand for country a’s currency will decline as their exports decline because of increased prices.
In considering both absolute and relative PPP the theories put forth the idea that a country with a higher level of inflation on their currency should chose to depreciate its value as a way to offset the difference between the two so that the prices when compared in a common currency will be “the same”. The relationship between the exchange rate and inflation levels will negatively affect Blades’ revenue generated in Thailand because of PPP. Due to high levels of inflation in Thailand the baht as a free floating currency will see great depreciation in its value.
Thanks to the agreement made between Blades and Entertainment Products Blades is unable to increase the fixed price to fall in line with the increase in inflation. Additionally, because Blades’ receives payment for their exported goods in baht once the conversion of baht to dollars is complete Blades will receive fewer dollars than originally calculated when the agreement was made. Yet, Blades will see an increase in their cost of goods sold since Thai exporters (of the plastic and rubber components imported by Blades) will have to adjust their pricing due to the increased inflation.
Considering that Blades generates some of their net cash inflows in baht from its Thai agreements they will be negatively affected by PPP in addition to the fact that some of the increase in inflation will be offset by the depreciation of the baht. 2. What are some of the factors that prevent PPP form occurring in the short run? Would you expect PPP to hold better if countries negotiate trade arrangements under which they commit themselves to the purchase or sale of a fixed number of goods over a specified time period? Why or why not?
Factors that prevent PPP from occurring in the short run are changes in; inflation, exchange rates, interest rates, national income levels, various government controls, and any changes predicted in future exchange rates. PPP may not affect some goods as there may not be any substitutes for that particular product that can be added to a basket of product available in the home country. Should a suitable substitute for a product in a particular category not be available the trade relationships between the two countries could potentially be affected by the differences in inflation rates as outlined by PPP.
In the short run however, should a company make an agreement to purchase a fixed number of goods over a specified time frame; PPP will not hold because of the differing inflation rates between the two firms in their home countries. Adding to this is the fact that contracts cannot be terminated without delay which will impact inflation rates on trade relationships and the exchange rates. 3. How do you reconcile the high level of interest rate in Thailand with the expected change of the baht dollar exchange rate according to PPP? An increase in a particular country’s interest rates could increase the demand for their currency.
Given that foreign investors invest based on a country’s interest rate which affects their potential return on their investment; having a high interest rate can bode well for a country whose economy depends greatly on exports and foreign investment such as; Thailand. This increase would give way to an upward pressure on the baht while increasing their interest rate and appreciating the value of the baht. As the baht increases with relation to the dollar this would show foreign investors that the country’s economy is on the rise causing an increase in investment.
The level of a Thailand’s nominal interest rate resulted from the expected increased levels of inflation for the baht. As PPP and international Fisher effect are closely related one must examine its theory when considering the effects of real and expected interest rates with relation to the PPP. The international Fisher effect is the application of the Fisher effect used to derive the expected change in the exchange rate. The Fisher effect states that the real interest rate is the nominal interest rate minus the expected inflation rate.
Accordingly, in considering the IFE when it comes to Thailand and their interest rate and inflation rate the value of the baht should be depreciated sufficiently as a way to offset the difference between the US and Thailand’s nominal interest rate. 4. Given Blades’ future plans in Thailand, should the company be concerned with PPP? Why or why not? Yes, Blades should be concerned with PPP as its affects will be seen in the long run. Although the effects are in the long run firm’s should always being mindful of anything that can affect their organization today or tomorrow.
In the short run PPP will not hold, however, in the long run with Blades 3 year contract with Entertainment Products and its possible expansion into Thailand; PPP should hold well. Additionally, Blades should watch for high levels of inflation in Thailand which may cause a depreciation in the value of the baht significant enough to offset the difference in inflation between them and the US. What Blades will need to consider is if renegotiation is a smart idea with Entertainment Products at the end of the contract period of 3 years.
They should be mindful this time of what their stipulations will be in regards to setting a fixed price considering inflation, increase rates, and depreciation value of Thailand’s currency is important. Considering various economic changes in both the short and long-term are very important for the next contract negotiations. 5. PPP may hold better for some countries than for others. The Thai baht has been freely floating for more than a decade. How do you think Blades can gain insight into whether PPP holds for Thailand?
Offer some logic to explain why the PPP relationship may not hold here. There are various ways to determine if PPP will hold for Thailand. One could go back and review historical exchange rates on inflation for Thailand and the US checking to see what the differences where between the two. However, because the baht has only been free floating for approximately a decade there is not enough data to review the relationship to see why PPP may not hold in this case. Remember prior to the baht being free floating it was pegged to the dollar and was not affect by the inflation rates.
Therefore, one would need to research the information for another country similar to Thailand in terms of inflation rate and various other economic characteristics, such as their income level. Once this data has been collected you could then use the same comparison method you would between Thailand and the US to see if PPP holds in this case. The results could then be used to forecast how the exchange rate between the baht and the dollar could be affected by the inflation difference between the US and Thailand going forward and therefore, if PPP would hold.
