How do countries buy and sell goods from each other when they use different currencies?
Answers
Answer:
Generally speaking ‘countries’ do not buy and sell goods, people in those countries do. They are free to make whatever arrangements they like between one another.
Normally (but by no means universally) the vendor determines the currency in which the contract is written. There are also some goods (such as oil) that are traditionally prices and traded in dollars.
The trading of goods and services between countries using different countries is one of the reasons why a currency hedging market exists.
Say I am a retailer and want to sell the goods that are made in a foreign country. When I sell them I am going to price them in my country’s currency (Currency A). I order the goods that I want to sell and we agree a price (in currency B).
I’m not going to receive the goods for some months and don’t have to pay for them straight away. This means that I am exposed to a risk. If the value of currency A declines relative to currency B in the meantime I might end up paying more (in my currency) that I thought I would have to. I am then going to have to either lose money when I resell them or have to charge a higher price than I originally thought.
I could convert enough money right now into currency B so that when I finally pay for the goods the cost (in terms of my currency) is the same as I originally expected. However, this is bad for my cashflow.
An alternative is to take out a forward contract (to buy a certain amount of currency B at an agreed exchange rate) so that when I have to pay for the goods I can do so at a predictable amount in my currency (A).
Of course the exchange rate might have moved in the other direction and benefitted me, but generally businesses are not prepared to take on this sort of risk.