How devaluation affects a manufacturing business Devaluation of the local currency affects a manufacturing business in four different specific ways:

1. It reduces the dollar value of the local currency earnings. Thus for example, if a company earns 100,000 pesos and the exchange rate is 1 to 1, it earns $100,000; if the exchange rate goes to 2 to 1, it earns only $50,000.

2. It reduces the dollar value of the investment in net working capital. For example, if a company has 100,000 pesos in net working capital and the exchange rate is 1 to 1, it has net working capital equivalent to $100,000; if the exchange rate increases to 2 to 1 there is a loss in value of the net working capital of $50,000. Accepted accounting practices require that such losses be taken currently against profit and loss if certification of financial statements presented to stockholders and government agencies, such as the SEC, is to be obtained. Notwithstanding this requirement, no tax deduction either locally or in the United States is allowed for such losses.

3. It reduces and makes inadequate the dollar value of the local currency provision for depreciation. For example, if a company has $100,000 or 100,000 pesos, at the exchange rate of 1 to 1, invested in fixed assets, with a useful life of 10 years, the annual provision for depreciation should be $10,000 to maintain the integrity of the investment. Since the local currency depreciation allowable for tax purposes is based on the original local currency value of the fixed assets of 100,000 pesos, the annual provision for depreciation is 10,000 pesos. At a rate of exchange of 1 to 1, this is equivalent to the required $10,000.

If the rate of exchange increases to 2 to 1, this 10,000 pesos is only equivalent to $5,000, and it becomes necessary to reserve another $5,000, to provide full dollar depreciation on fixed assets. Here again this is required to be provided currently against profit and loss under accepted accounting practices and as in the case of the exchange loss on working capital no deduction for tax purposes, either locally or in the United States, is allowed.

4. If the company manages to raise prices (almost always inadequately as will be shown later) to compensate for the effects of devaluation, in an effort to maintain the basic dollar rate of return and the integrity of the investment, the company's local tax bill increases. This is so because no recognition for tax purposes is granted by the local government for the erosion of the investment in working capital resulting from exchange devaluation, or for the deficiency in the provision for depreciation.

Examples of the effects of exchange devaluation

There follows in the statement examples showing the adverse effects of exchange devaluation on U.S. owned manufacturing enterprises in Latin America, assuming:

1. Capital invested 50 percent in fixed assets and 50 percent in working capital-roughly the average in the United States for U.S. business. This is also the ratio indicated by U.S. Department of Commerce data for U.S. private investments in manufacturing in Latin America, in the 4 years 1958-61, i.e., 50 percent in fixed assets, and 50 percent in working capital (inventories, receivables, and other assets, such as cash and securities).

2. Fixed assets are depreciated at the rate of 10 percent a year.

3. Local tax rate of 35 percent.

4. Return on investment-15 percent after local taxes but before U.S. taxes, and 12.5 percent after U.S. and local taxes.

5. In the first year of operation the exchange rate for the local currency is 1 to 1 to the dollar. In the second year the exchange rate increases to:

(i) 1.15 to 1, an increase in the rate of exchange of 15 percent, or a devaluation of 13 percent; and

(ii) 1.30 to 1, an increase in the rate of exchange of 30 percent, or a devaluation of 23.1 percent.

(It will be noted that the maximum rate of devaluation assumed in the examples of 23.1 percent is far below the rate of devaluation this year in Argentina, Brazil, and Chile.)

6. Since the effects of exchange devaluation vary depending on the turnover ratio of sales to capital invested, the hypothetical examples are developed on two alternative bases:

(i) A sales to capital invested turnover ratio of 2 to 1; and
(ii) A sales to capital invested turnover ratio of 1 to 1.

CASE I.-Illustration based on a 2-to-1 turnover ratio ($2,000 sales to $1,000 investment) 1

Ratio of price increase, needed to maintain original dollar return, to increase in rate ofexchange.

CASE II.-Illustration based on a 1-to-1 turnover ratio ($1,000 sales to $1,000 investment) 1

1 Investment $1,000, of which: fixed assets, $500; working capital, $500. No increase assumed in this example.

3 Times.