A fall in sterling's value caused a drop in the FCO's core purchasing power
The decision to stop protecting the Foreign Office (FCO) budget from exchange rate changes has risked its efficiency, MPs have said.
The Commons Foreign Affairs Committee found a fall in sterling's value led to cuts in embassies around the world.
The FCO's core purchasing power had fallen by 13% since the previous system was axed in 2007, MPs found.
Last month ministers said they had a package to "substantially offset the foreign exchange pressures on the FCO".
The agreement, negotiated by Foreign Secretary David Miliband and Chancellor Alistair Darling, included an additional £25m from asset sales to be recycled into the FCO budget, £35m from Treasury reserves and £15m in "end-of-year flexibility".
Earlier this month the FCO asked the Treasury for an "urgent" cash injection to help fill a nearly £135m budget shortfall.
However, it insisted that was a "routine" procedure and unrelated to currency fluctuations.
FCO cuts caused a political row earlier this year when the Conservatives accused the government of undermining the UK's global interests by scrapping the special fund that provided insulation from movements in the pound.
In its report, the cross-party committee of MPs said the constraints placed on the FCO were "unacceptably disrupting and curtailing" its work.
In its report, the committee said: "We cannot see that it remains credible to regard the costs of currency fluctuations as predictable ones which the FCO might reasonably be expected to absorb.
"The cuts that the FCO is making at its overseas posts represent a serious reputational risk to the department and the UK, and thus a threat to the FCO's effectiveness."
It also stressed that closures of FCO oversees posts "risk leaving potentially damaging gaps in UK information-gathering, provision of assistance and exercise of influence".
Committee chairman Mike Gapes said the FCO's financial situation has come to represent "an unacceptable risk to the department's ability to perform its functions", adding that "exchange rates should not drive UK foreign policy".
Shadow Foreign Secretary William Hague said the report should be "taken very seriously".
"Poor ministerial leadership in recent years has indeed left the Foreign Office struggling with unpredictable changes in budgets which have made it impossible for it to plan properly.
"It was extraordinarily incompetent of David Miliband to agree to the FCO budget taking the whole of the risk of exchange rate movements.
"No other major country increases and reduces its diplomatic presence according to whether its currency is up or down in any given year.
"The Foreign Office needs stronger leadership at the top and a more stable framework to plan efficiently for the future."