Caterpillar Tractor has long been one of America’s major exporters. The company sells its construction equipment, mining equipment, and engines to some 200 countries worldwide. As a leading exporter, Caterpillar’s fate has often been tied to the value of the U.S. dollar. In the 1980s, the U.S. dollar was strong against the Japanese yen. This gave Komatsu, Japan’s premier manufacturer of heavy construction equipment, a pricing advantage against Caterpillar. Undercutting Caterpillar’s prices by as much as 30 percent, Komatsu grabbed market share in the United States and other markets. For Caterpillar, it was a difficult time. At one point the company was losing a million dollars a day and battling a hostile labor union that was opposed to job restructuring designed to make the company more competitive. The company seemed to be yet another example of a declining business in America’s rust belt.

Fast forward to the mid-2000s, and Caterpillar was thriving. Much had changed over the previous two decades. Caterpillar had reached deals with its unions and invested in state-of-the-art manufacturing facilities. It’s productivity, once abysmal, was now among the best in the industry. Sales, exports, and profits were all rising. There was a worldwide boom in spending on infrastructure, and Caterpillar was reaping the gains, producing record amounts of equipment. Moreover, the U.S. dollar, which for years had been strong, weakened significantly during the mid-2000s. This reduced the price of Caterpillar’s exports, when translated into many foreign currencies, and helped the company to keep its prices down in foreign markets. At this point, Caterpillar was exporting over half of the output of its key U.S. factories in Peoria, Illinois.

Then in 2008, the dollar started to strengthen again. Even though the American economy was stumbling deep into a financial crisis that would usher in a steep economic recession, foreigners invested strongly in U.S. assets, particularly Treasury bills. Their demand for dollars to purchase these assets pushed up the value of the dollar on the foreign exchange markets. The hunger of foreigners for dollars was based on a belief that even though things were bad in America, they were probably going to be even worse in many other developed economies, and the U.S. government at least would not default on its bonds, making U.S. Treasury bills a safe haven in an economic storm.

Analysts fretted that the stronger dollar would impact negatively on Caterpillar’s financial performance, since the prices of its exports were now rising when converted into many foreign currencies. The reality, however, was somewhat different. As 2008 progressed, the strong dollar started to negatively impact Caterpillar’s revenues, but it had a favorable effect on Caterpillar’s costs! What had changed over the past two decades is that Caterpillar had dramatically expanded its network of foreign manufacturing operations. While still a major exporter, some 102 of its 237 manufacturing facilities were now located outside of North America, many in countries such as China, India, and Brazil that were expanding their infrastructure spending. Although the revenues generated by these operations in local currency, when translated back into dollars , declined as the dollar strengthened, the costs of these operations also fell, since their costs were also priced in local currencies, which reduced the impact on profit margins. Although Caterpillar’s export revenues from the United States started to fall, as one would expect, because the company now sourced many of its inputs from foreign producers, the price it paid for those inputs also fell, which again moderated the impact of the strong dollar on earnings. This is not to say that a strong dollar does not have an effect, it does, but through its globalization strategy Caterpillar has been able to reduce the impact of fluctuations in the value of the dollar on its profits.

Questions

1. In the 1980s a stronger dollar hurt Caterpillar’s competitive position, but in 2008 a stronger dollar did not seem to have the same effect. What had changed?
2. How did Caterpillar use strategy as a “real hedge” to reduce its exposure to foreign exchange risk? What is the downside of its approach?
3. Explain the difference between transaction exposure and translation exposure using the material in the Caterpillar case to illustrate your answer.