MIE-ChapSummary

1998 POSTSCRIPT Outline

The Integration of the World Economy

Globalization

cross-border trade and investment
volume of world trade has grown faster than volume of world output since 1950

facilitated by declining barriers to cross-border investment
greater liberalization of regulatory regimes
firms invest in foreign countries to:

create physical presence in markets where they do a significant amount of business
take advantage of favorable factor costs, infrastructure and access to regional or global markets

1/3 of international trade volume was internal to multinational corporations. It was trade between different subsidiaries of the same corporation
Japan still has barriers to inward FDI
Latin America had the largest increase of FDI inflows due to:

shift toward a market-based economic system
resulting privatization of former state-owned enterprises

The World Trade Organization: The Early Experience

WTO established 1/1/95 as a result of the Uruguay Round of GATT

130 member states
role:

function as "policeman" of global trade
push further liberalization of international trade and investment

biggest achievements to date:

open national telecommunications markets to foreign competition
to liberalize the global financial industry

The WTO as Global Police

More trade disputes have been brought to WTO in three years than in the 50 years of GATT
WTO fear: the US would undermine the system by continuing to rely on unilateral measures when it suited or by refusing to accept WTO verdicts.
The US has been the biggest user of the WTO
WTO encouraged to extend its reach to encompass regulations governing FDI—something GATT had never done
The first real test of the procedures will arise when the WTO has to arbitrate a politically sensitive case especially one that involves the US or EU where vocal politicians argue that the WTO infringes on national sovereignty

WTO Telecommunications Agreement

Uruguay Round of GATT extended global trading rules to cover services
Global telecomm market worth $600B—only 20% open to competition
Goals of WTO:

Get countries to open their telecomm markets to competition
Allow foreign operators to purchase ownership in domestic telecomm providers
Establish a set of common rules for fair competition in the telecomm sector

Benefits:

Inward investment and increased competition would stimulate the modernization of telephone networks around the world and lead to higher quality service
The increased competition would benefit customers thorough lower prices
Better flow of communication would increase international trade volume and become less costly for traders.

A deal was reached on 2/15/97
All forms of basic telecommunications service are covered including voice, data and fax transmissions, and satellite and radio communications

WTO Global Financial Services Liberalization

Financial services industry includes banking, securities businesses, insurance, asset management services, etc.
The goal of the WTO is to create more competition in the sector to:

Allow firms greater opportunities abroad
Encourage greater efficiency

Must ensure system is sound and stable because:

Economic shocks can be caused if exchange rates, interest rates, or other market conditions fluctuate excessively
Economic crisis would ensue if banks failed

Shared objectives in agreement:

The right of financial service firms to establish and operate competitively in foreign markets
The granting of equal access for foreign and domestic investors to domestic markets
The reduction of barriers to the posting of personnel across borders
The removal of restrictions on the provision of cross-border financial services

Agreement reached on 12/14/97

NAFTA: The Early Experience

Established on 1/1/94
Three member states: Mexico, Canada and US
Effects on US:

Marginal impact on the level of trade between US and Mexico
Very slight, but positive, impact of NAFTA jobs in US
Too early to draw conclusions about the true impact of NAFTA on trade flows and employment due to the peso devaluation of ’95

Asian Contagion

Overview

Over the previous decade, the Southeast Asian states (Thailand, Malaysia, Singapore, Indonesia, Hong Kong and S. Korea) had recorded impressive growth rates
In 1997 local stock and currency markets imploded
In 1998 many of these stock markets lost 70%+ of their value and their currencies depreciated against the US dollar by a similar amount

Background

Export-led growth fueled an investment boom in real estate, industrial assets and infrastructure. Most financed by borrowed $$
As the volume of investments ballooned during the 90s, the quality of these investments declined. This resulted in excess capacity

The Debt Bomb

Much of the borrowing had been in US$ as opposed to local currency
Currency depreciation would raise borrowing costs and could result in companies defaulting on their debt payments
Due to growing imports in the mid-90s, SE Asian states had a strong shift in their BOP

Asian Meltdown

Thailand

Began on 2/5/97
Significant declines in the stock markets caused property and financial institutions to declare bankruptcy.
The Thai currency, the baht, fell dramatically
Currency traders began to sell the baht short in order to profit from a future decline in the value of the baht against the dollar
Government spent most reserves to save the currency
Government also raised interest rates to attract foreign investors. However, this raised corporate borrowing costs which exacerbated the debt crisis
Since neither approached worked, Thai government relented and let the currency float. This further reduced the currency and caused more businesses to default
Appeal to the IMF for funding
Strict IMF regulations led to worsening of crisis

Malaysia

The Malaysian currency, the ringgit, declined, but did not need an IMF bailout
Malaysian government took steps to manage fiscal policy

Indonesia

The Indonesian currency, the rupiah, was allowed to float on 7/14/97 following speculative selling
The rupiah immediately declined and so did the stock market
Government turned to IMF for assistance
The rupiah continued to decline and IMF renegotiated stricter agreement terms to eliminate President Suharto’s business privileges and accelerated financial reform.
Problems still plague the rupiah

Suharto decided to run for a 7^th term. This could lead to social breakdown and political violence
Hundreds of Indonesian businesses are insolvent and cannot payback the $65B in debts. The IMF has not addressed this issue.

South Korea

At first, as the world’s 11^th largest economy, the country seemed to be isolated.
However in late 1996, economic growth slowed, excess capacity was emerging, prices for critical industrial products were falling and imports were rising.
These events prompted international credits agencies to downgrade bank ratings. This raised the borrowing cost of banks and led them to tighten credit
This precipitated a sharp sell off of the Korean won.
Banks raised interest rates and the government sold most of their US$ depleting reserves
International lenders refused to roll over short-term loans which meant that Korea had $100B in debt obligations due within 12 months
The won was allowed to float and the currency dropped dramatically
The government request loans from the IMF.
Initial reaction was good. However, the S. Korean government tried to go around IMF regulations which made the international financial community skeptical and the won dropped.
A second agreement was reached with the IMF and a number of US and British banks
The economic situation improved and 13 banks rescheduled their short-term debt to Korea

Japan

As the Asian crisis unfolded, the Japanese felt it had little to do with them. The main issue was whether Japan should take a leadership role in handling the crisis
This was a myopic view given that Japanese banks had major exposure throughout Asia
Three financial institutions filed for bankruptcy due to events a decade earlier. In the late 1980s when Japan’s stock market and property frenzy was at its peak, Japan’s financial institutions went on a lending binge. The stock market and property prices fell leading people to default on their loans
To compound matters, security houses frequently guaranteed major customers a certain minimum rate of return on investments and would make up the difference from their own pockets if the investments failed to meet that minimum. After 8 years of recession, the three major institutions declared bankruptcy
Japan’s Ministry of Finance (MOF) was extremely powerful to guarantee support for the country’s shaky financial institutions for that period of time. The MOF changed direction to shock politicians and the public to use public funds to bail out the financial sector
With the use of public funds, Japan’s stock market stabilized
The credibility of Japan both as a source of stability within the region and as the de-facto economic leader of the Asian Pacific economies has been severely damaged by its inability to take a leadership role in solving the crisis.

Aftermath: Implications of the Crisis

The Asian Economic Model

State-directed capitalism seemed to combine a market economy with the advantages of centralized government planning
Close cooperation between government and business to formulate industrial policy for long-term planning and investment
Informal lending practices created flexibility vs. strict US standards
Encouragement of exports and protection of domestic producers from imports
Others argue it was not the Asian Economic model that promoted growth, but rather high savings rates, good education systems and rapid growth in the labor force
Now that the crash has occurred, there is a shift away from the Asian model and toward the Western economic model

The IMF

IMF policies toward Asian countries have come under tough criticisms from Western observers

Tight macroeconomic policies are inappropriate for countries that are suffering not from excessive government spending and inflation but from a private-sector debt crisis with deflationary tones (i.e S. Korea)
IMF rescue efforts are exacerbating a moral hazard
IMF has become too powerful for an institution that lacks any real mechanism for accountability

Implications for Exchange Rate Policy

Problem: Pegging Asian currencies to the US$ which leaves them vulnerable to speculative pressure
Possible solution: A currency board (i.e. Hong Kong). A country that introduces a currency board commits itself to converting its domestic currency on demand into another currency at a fixed exchange rate. The currency board then holds reserves of foreign currency equal at the fixed exchange rate to at least 100% of the domestic currency issued. The currency board can issue additional domestic notes and coins only when there are foreign exchange reserves to back it. This limits the ability of the government to print money and create inflationary pressures. Under this system, interest rates adjust automatically

Implications for Business

Many Asian companies will now be looking to export their way out of recessionary conditions in their home markets. This may lead to a flood of low-priced exports from troubled Asian economies
On the other hand, firms that source components from Asia have seen a drop in the price of those inputs, which boost profit margins
Furthermore, the financial situation in Asia has made it attractive for inward FDI

The Globalization Debate: Prosperity or Impoverishment?

Globalization, Jobs and Incomes

Positive: Lower prices for goods and services

Globalization will stimulate economic growth, raise the incomes of consumers, help to create jobs

Negative: Falling barriers to international trade destroy manufacturing jobs in wealthy advanced economies
Benefits outweigh costs

Specialization of production

Globalization, Labor Policies and the Environment

Negative: Move manufacturing facilities to less-developed countries to escape labor and environmental regulations
Positive: Tougher environmental regulations and stricter labor standards go hand in hand with economic progress

Globalization and National Sovereignty

A concern is that economic power is shifting away from national governments and toward supranational organizations such as the WTO, EU, IMF and UN
As perceived by critics, unelected bureaucrats are now sometimes able to impose policies on the democratically elected governments of nations, thereby undermining the sovereignty of those states

Vocabulary:

Chaebol—S. Korean giant diversified conglomerates

Tobashi—Japanese brokerages temporarily shift investment losses from one client to another to prevent a favored customer from having to report losses

Moral hazard—When people behave recklessly because they know they will be saved if things go wrong

MANAGER IN THE INTERNATIONAL ECONOMY

CHAPTER 1 – Introduction and Overview

Introduction

Managers today need to understand the economic, political, and cultural environment within which international business occurs. Perhaps the most important aspect of this is the mechanisms governing currency exchange rates between countries. Companies that once dominated their national markets because of barriers to trade and investment are now competing in a global marketplace. However, national differences still exist and have a profound effect on the way business is conducted in different nations.

International business – any firm that engages in international trade or investment

International trade – occurs when a firm exports goods or services to consumers in

another country

International Investment – occurs when a firm invests resources in business activities

outside it’s home country

The Globalization of the World Economy

"global shift" – term describing the globalization of markets and production

"globalization of markets" - it has been argued that national markets are merging into one huge global marketplace, e.g. Coca Cola, McDonald’s, and the standardization of products and services.

"globalization of production" – individual firms are dispersing parts of their production

process to various locations around the globe to take advantage of national differences in the cost and quality of production factors (ex. labor, land, energy, and capital)

No longer talk about "American products" or "German products, " for example, the components of the GM Pontiac Le Mans are made in several countries.

Two factors seem to underlie the trend toward globalization of markets and productions:

1 – decline in barriers to the free flow of goods, services, and capital

2 – dramatic development in communication, information, and transportation technologies

Declining Trade and Investment Barriers

GATT – General Agreement on Tariffs and Trade

the goal of removing barriers to the free flow of goods, services, and capital between nations

WTO – World Trade Organization – to police the international trading system

Over the last decade, the volume of world trade grew faster than the volume of world output: 1980-1994: world output grew by 40%, world trade grew by 70%. This demonstrates that the lowering of trade barriers has facilitated the globalization of production.

Foreign direct investment (FDI) is playing an increasing role in the global economy; increasing cross-boarder investments.

The growing integration of the world economy into a single, huge marketplace is increasing the intensity of competition in a wide range of manufacturing and service industries.

The Role of Technological Change

Technology is a driving force of globalization: major advances in communication, info processing, transportation technology and the WWW.

Microprocessors and telecommunications: cost decreased, while power increased (Moore’s Law: predicts that the power of microprocessor technology doubles and its cost of production fall in half every 18 months)

Internet and World Wide Web: will lower costs of global communications and facilitate the creation of a truly global electronic marketplace.

Transportation Technology:

development of commercial jet aircraft and superfreighters
containerization – simplifies transshipment from one mode of transport to another

Implications for the Globalization of Production: the real costs of info processing and communication have fallen dramatically.

While modern communications and transport technologies are ushering in the "global village," very significant differences remain among countries in culture, consumer preferences, and the way business is conducted.

Implications for Management: managers of today’s firm operate in an environment that offers more opportunities but one that is more complex and competitive.

The Changing Nature of International Business

1960’s:

1 – US dominance in world-trade

2 – US dominance in foreign direct investment

3 – dominance of large, multi-national US firms

4 – half of the globe (communists) was off-limits

The Changing World Output and World Trade Picture:

-US decrease in manufacturing world output; but not an absolute decline since US

economy grew ("relative decline")

-Japan increase in manufacturing output

Further "relative" decline in the share of world output and world exports for US seems likely.

The relative decline of US reflects the growing industrialized countries of the world economy, as opposed to any absolute decline in US economy health.

If World Bank’s prediction is true: by 2020, today’s developing nations may account for over 60% of world economic activity, while today’s rich nations may only account for 38%

The Changing Foreign Direct Investment Pictures: There is an increase tendency for cross-border investments to be directed at developing rather than rich industrialized nations.

Stock of foreign direct investment – refers to the cumulative value of foreign investments

Flow of foreign direct investment – refers to amounts invested across national

Borders each year

The Changing Nature of Multinational Enterprise, two trends:

1 – rise of non-US multinationals (Japan)

2 – growth of mini-multinationals

The Changing World Order:

-communism is falling

-new commitment to democratic politics and free markets

A risk in doing business with these companies is high, but so may be the returns.

How International Business Is Different

1 – countries are different

2 – the range of problems confronted by a manager in an international business is wider and the problems themselves more complex

3 – international business must find ways to work within the limits imposed by government intervention in the international intervention in the international trade and investment system

4 – international transactions involve converting money into different currencies

CHAPTER 2

National Differences In Political Economy

INTRODUCTION

Political economy – political, economic, and legal systems of a country are not

independent

Political economy and culture of a nation are not independent of each other.

POLICIAL SYSTEMS: the system of government in a nation

Two Related Dimensions:

1 – collectivism as opposed to individualism

2 – democratic or totalitarian

These dimensions are interrelated; systems that emphasize collectivism tend to be totalitarian while systems that place a high value on individualism tend to be democratic.

(but it is possible for them to be vice versa)

Collectivism and Individualism:

Collectivism – refers to a system that stresses the primacy of collective goals over

individual goals

When collectivism is emphasized, the needs of society as a whole are generally viewed as being more important than individual freedoms.

Socialism:

Socialists trace their intellectual roots back to Karl Marx.
Marx’s basic argument is that in a capitalist society where individual freedoms are not restricted, the few benefit at the expense of many.
Marx feels the pay of workers does not reflect the full value of their labor.
If the state owned the means of production, the state could ensure that workers were fully compensated for their labor.

SOCIALIST IDEOLOGY

Communists Social Democrats

-socialism could be achieved only through -committed themselves to achieving

violent revolution and totalitarian dictatorship. Socialism by democratic means.

1970 – the majority of the world’s population lived in communist states

1990 – communism was in retreat world wide

Social democracy also seems to have passed, although the ideology may prove to be more enduring than communism.
Experience demonstrates that state ownership of the means of production often runs counter to public interest.
State owned companies:

-poor performance

-monopolies

-inefficient

In the end, individuals found themselves having to pay for the luxury of state ownership through higher prices and higher taxes.

Privatization – selling state-owned interprises to private investors

Individualism

Individualism – refers to a philosophy that an individual should have freedom in his

economic and political pursuit

Individualism stresses that the interests of the individual should take precedence over the interests of the state.

INDIVIDUALISM:

Emphasis on the importance of guaranteeing individual freedom and self-expression
The welfare of society is best served by letting people pursue their own economic self-

interest "invisible hand"

The Cold War was essentially a war between collectivism championed by the now defunct Soviet Union, and individualism, championed by the U.S.
Individualism translates into an advocacy for democratic political systems and free market economics.
A wave of democratic ideals and free market economics is currently sweeping away socialism and communism worldwide.

Democracy and Totalitarianism:

Democracy and totalitarianism are at different ends of a political dimension.

Democracy – refers to a political system in which government is by the people, exercised

either directly or through elected representative

Totalitarianism – is a form of government in which one person or political party exercises absolute control over all spheres of human life and opposing political parties are prohibited.

Democracy and individualism go hand in hand, as do the communist version of collectivism and totalitarianism. (gray areas do exist)

Democracy:

Based on a belief that citizens should be directly involved in decision making process

representative democracy – citizens periodically elect individuals to represent them

Totalitarianism:

A totalitarian country denies citizens all the constitutional guarantees on which representative democracies are built, such as individuals right to freedom of expression and organization, a free media, and regular elections.

There are four major forms of totalitarism in the world today:

1 – Communist Totalitarism:

-most widespread

-communism is a version of collectivism that advocates socialism can be achieved

only through totalitarian dictatorship

2 – Theocractic Totalitarinism:

-found in states where political power is monopolized by a party, group, or individual

that governs according to religious principles ex) Islam

-restricted freedom of political expression and religious expression

3 – Tribal Totalitarianism:

-found principally in African countries

-when a political party that represents the interest of a particular tribe monopolizes

power

4 – Right-wing Totalitarianism:

-generally permits individual economic freedom but restricts individual political freedom on

the grounds that it would lead to a rise of communism

-overt hostility to socialist or communists ideas

-backed by military ex) Latin America – now in retreat

Economic Systems:

In countries where individual goals are given primacy over collective goals, we are more likely to find free market economic systems.

-Market Economy

-:pure" – the goods and services a country produces, and the quantity in which they

are produced, is not planned by anyone.

Rather it is determined by the interaction of supply and demand and signaled to producers through the price system.

For a market system to work, there must be no monopolist.

Monopolist – no competition in the market

The net result of a monopolist is likely to become increasingly inefficient, producing high-priced, low quality goods, while society duffers as a consequence.

Given the dangers inherent in monopoly, the role of the government in a market economy is to encourage vigorous competition:

-outlawing monopolies

-antitrust laws in US

Private ownership (which allows them profit) encourages competition and economic efficiency.

Command Economy

The goods and services that a country produces, the quantity in which they are produced, and the prices at which they are sold, are all PLANNED BY THE GOVERNMENT.

-consistent with the collectivist ideology

-"pure" all businesses are state owned

-communist countries or socialist-inclined

Mixed Economy:

Certain sectors of the economy are left to private ownership and free market mechanisms, while in other sectors, there is significant state ownership and government planning.

Government intervenes in those sectors where it believes private ownership is not in the best interests of society. Ex) state-owned health systems or Renault (troubled companies)

Legal Systems

The LEGAL SYSTEM of a country refers to the system of rules, or laws, that regulate behavior, along with the processes by which the laws of a country are enforced and through which redress for grievances are given.

A countries laws regulate business practice, define the manner in which business transactions are to be executed, and set down the rights and obligations of those involved in business transactions.

Property Rights

-refer to the bundle of legal rights over-the use to which a resource is put and over the use made of any income that may be derived from that resource.

Although almost all countries have laws on their books that protect property rights, in many countries these laws are not well enforce by the authorities and property rights are routinely violated.

Property rights can be violated in two ways:

1 – Private Action: Ex) Russian Mafia

-refers to theft, piracy, blackmail, and the like by private individuals or groups

2 – Public Action:

-public action to violate property rights occurs when public officials such as politicians

and government bureaucrats, extort income or resources from property holders ex)

excessive taxation, requiring expensive licenses or permits from property holders, and

taking assets into state ownership without compensation or demanding bribes.

The Protection of Intellectual Property:

Intellectual property – refers to property, such as computer software, a screen play, a music

score, or the chemical formula for a new drug, that is the product of intellectual activity.

It is possible to establish ownership rights over intellectual property through patents, copyrights, and trademarks.

Patent – grants the inventor of a new product or process exclusive rights to the manufacture,

use, or sale of that invention

copyrights – legal rights of authors, composers, playwrights, artists, and publishers to publish

and dispose of their work as they see fit.

Trademarks – designs and names, often officially registered, by which merchants or

manufactures designate and differentiate their products ex) McDonalds

The philosophy behind intellectual property laws is to reward the originator.

Without the guarantees provided by patents, it is unlikely that companies would commit themselves to extensive basic research.

Weak enforcement encourages the piracy of intellectual property. Ex) China

GATT – extended to cover intellectual property ("General Agreement on Tariffs and Trade") à council à WTO "World Trade Organization"

In addition to lobbying their governments, firms may want to stay out of countries where intellectual property laws are lax.

Ex) Coca-Cola, IBM à India

Microsoft à piracy showing up in US

-Product Safety and Product Liability

Product safety laws set certain safety standards to which a product must adhere.

Product liability involves holding a firm and its officers responsible when their product causes injury, death or damage.

Civil (payment & money demands) and Criminal (fines & imprisonment) product liability laws.

In US à and increase in liability suits has resulted in dramatic increases in cost of liability insurance. (which may make US companies less competitive in global market)

Ethical Issue: which countries standards to conform to?

-Contract Law

A contract is a document that specifies the conditions under which an exchange is to occur and details the rights and obligations of the parties to a contract.

Two main legal traditions found in the world today are:

1 – Common Law System:

-evolved in England

-found in US

-common law is based on tradition, precedent, and custom

-when law courts interpret common law, they do so with regard to these

characteristics.

2 – Civil Law:

-is based on a very detailed set of laws that are organized into codes

-among other things, these codes define the laws that govern business transactions

Since common law tends to be relatively ill-specified, contracts drafted under a common law framework tent to be very detailed with all contingencies spelled out.

In civil law systems, however, contracts ten to be much shorter and less specific, since many of the issues typically covered in a common law contract are already covered in a civil code.

The Determinants of Economic Development

-Differences in Economic Development

One of the most common measures of economic development is a countries GNP per head of population. GNP (Gross National Product)

GNP – measures the total value of the goods and services produced annually "GNP per head"

GNP per capita figures can be misleading because they don’t consider differences in the cost of living.

To account for differences in the cost of living, the United Nations has calculated a purchasing power parity index (PPP)

This PPP adjusts GNP per capita for the cost of living (allows for "direct comparison)

100 = country in which PPP is highest (US)

Look at the economic growth rates.

A number of other indicators can also be used to assess the level of a countries economic development and its likely future growth rate.

-literacy rates; number of people/doctor; infant mortality rates; life expectancy;

food consumption; car ownership; education spending

In an attempt to assess the impact of such factors on the quality of life in a country, the United Nations has developed a human development index (1 through 100)

1 < Poor quality 50 < 80 adequate < 100 high quality

This index is based on 3 measures:

-life expectancy

-literacy rates

-whether average incomes are sufficient to meet basic needs (food, shelter, health care)

The disturbing fact revealed is that some of the world’s poorest countries, are not only heavily populated, but also have rapidly expanding populations.

The underdevelopment of the Third World may hold back the continuing economic growth of the world’s advanced industrialized nations.

-Political Economy and Economic Progress

Innovation is the engine of growth:

Innovation – new products, new process, new organization, new management practices and

new strategies ex) Toys ‘R’ Us

Innovation requires a market economy:

-market economy creates greater incentives for innovation than either a planned or

mixed economy

-rewards of "high profit"

Innovation requires strong property rights:

-both individuals and businesses must be given the opportunity to profit from

innovative ideas

-without strong property rights protection, businesses and individuals run the risk that

the profits from their innovative efforts will be expropriated, either by criminal

elements or the state itself.

The required political system:

-we in the west tent to associate a representative democracy with a market economic

system, strong property rights protection, and economic progress.

-we tend to argue that democracy is good for growth

-however, many totalitarian countries have been successful and some examples

include the fastest growing economics in the last 30 years à South Korea,

Singapore, and Hong Kong

-it seems likely that democratic regimes are far more conducive to long-term economic

growth than a dictatorship

-only in a well-functioning mature democracy are property rights truly secure

Economic progress begets democracy:

-it seems evident that subsequent economic growth leads to establishment of a

democratic regime.

Thus, while democracy may not always be the cause of initial economic progress, it seems to be one of the consequences of that progress.

Ex) China à western attitude is tolerating them in hopes of them becoming democratic

-States in Transition:

Two trends since 1980’s:

1 – a wave of democratic revolutions swept the world

2 – there has been a strong move away from centrally planned and mixed economies and toward a free market economic model

-Eastern Europe and the Former Soviet Union:

Mikhail Gorbachev – Soviet Communist Party "perestroika"

-with the support of Gorbachev, several of the Communist regimes of Eastern Europe

began to loosen their repressive economic and political systems in an attempt to

receive their stalled economies.

-"domino effect" of freedom

-Jan 1, 1992 the Union of Soviet Socialist Republics passed into history, to be replaced

with 15 independent republics (11 as Commonwealth of Independent States)

-dismantled decades of price controls, allowed widespread private ownership of

businesses and permitted much greater competition.

-in this new environment, many inefficient state-owned enterprises found that without

a guaranteed market, they could not survive

-subsidies continued leading to ballooning budget deficits that were typically finance

by printing money à hyperinflation

-Western Europe

-stable democratic government for some time, here too has been a major ideological

shift in recent years

-basic industries were state-owned while many other sectors faced heavy state

regulations

-gov’t have moved progressively away from this mixed economy

ex) Margaret Thatcher’s Conservative gov in Britain 1980s

ex) France, Germany, Italy

-Asia and Latin America:

shifted towards democracy & free market

Implications:

From shift towards democracy & free trade, the world’s "market" opened up with more potential,

Political Risk – the likelihood that political forces will cause drastic changes in a country’s business environment that adversely affect the profit and other goals of a particular business enterprise.

CHAPTER OUTLINE FOR MIE STUDY GROUP

BY

Todd Rich

Chapter 4 – International Trade Theory

Opening Case: Ghana & South Korea example

An Overview of Trade Theory

Mercantilism – advocated that countries should simultaneously encourage exports and

discourage imports.

Adam Smith 1776 – theory of absolute advantage; 1^st to explain why unrestricted free

trade in beneficial to a country "invisible hand"; laissez-faire stance toward trade

free trade – occurs when a government does not attempt to influence through quotas or

duties what its citizens can buy from another country, or what they can produce or

sell to another country

Benefits of Trade:

The theories of Smith, Ricardo, and Heckscher-Ohlin go beyond this commonsense notion of trade is good, to show why it is beneficial for a country to engage in international trade EVEN FOR PRODUCTS IT IS ABLE TO PRODUCE FOR ITSELF.

The gains arise because international trade allows a country to specialize in the manufacture and export of products that can be produced most efficiently in that country, while importing products that can be produced most efficiently in other countries.

Protection for a particular group ex) American textile business, hurts the entire economy

Pattern of International Trade:

-climate and natural resources

-factors of production (land, labor, capital)

-product life-cycle theory

-new trade theory (support for only a few firms)

-first mover advantage

-theory of national competitive advantage

-domestic demand

-domestic rivalry

Trade Theory and Government Policy:

All theories agree international trade is beneficial to a country, but they lack agreement in their recommendation for government policy.

-Mercantilism – makes a crude case for government involvement in promoting exports

and limiting imports

Smith, Ricardo & Heckscher-Ohlin – unrestricted free trade: both import controls & export incentives (such as subsidies) are self-defeating and result in wasted resources.

New Trade Theory & Porter’s Theory of National Competitive Advantage:

Justify some limited and selective government intervention to support the development of certain export-oriented industries.

MERCANTILISM

England mid 16^th century

It was in a country’s best interest to maintain a trade surplus, to export more than it imported. By doing so a country would accumulate gold and silver and increase its national wealth and prestige.

Mercantilist doctrine advocated government intervention to achieve a surplus in the balance of trade (MAX exports and MIN imports)

Imports were limited by tariffs and quotas, and exports were subsidized.

David Hume 1752:

If England had a balance-of-trade surplus with France (exporting more than importing), the resulting inflows of gold and silver would swell the domestic money supply and generate inflation in England.

In France – money supply would contract and its prices would fall.

This change in relative prices between France and England would encourage the French to buy fewer English goods (too expensive) and the English to buy more French goods (cheaper). The real result would be deterioration in the English balance of trade and an improvement in France’s trade balance, until the English surplus was eliminated.

According to Hume, in the long run, no country could sustain a surplus on the balance of trade.

Mercantilism viewed trade as a zero-sum game (one in which a gain by one country results in a loss by another)

Smith and Ricardo show trade as a positive sum game ( a situation that all countries could benefit, even if some benefit more than others do).

Mercantilism is not dead: ex) Japan is neo-mercantilist – publicly supports free trade, while seeks to protect certain segments of its economy

Absolute Advantage

Adam Smith 1776 "The Wealth of Nations"

Ex) ENGLISH had an "absolute advantage" in the production of textiles while the FRENCH had an "absolute advantage" in the production of wine

Thus a country has an ABSOLUTE ADVANTAGE in the production of a product when it is more efficient than any other country producing it.

Smith – you should never produce goods at home that you can buy at a lower cost from other countries (trade for them instead)

By specializing in the production of goods in which each has an absolute advantage, both countries benefit.

PPF – production possibility frontier

Ex) Ghana – cocoa South Korea – rice Absolute Advantage

If each country were to specialize in producing the good for which it had an absolute advantage and trade with the other for the good it lacks, the production of both goods could be increased.

Comparative Advantage

David Ricardo – when one country has an absolute advantage in the production of all goods (Smith suggests that such a country may derive no benefits from trade)

Ricardo: 1817 "Principles of Political Economy"

Comparative advantage: it makes sense for a country to specialize in the production of those goods that is produces most efficiently and to buy the goods that it produces less efficiently from other countries, even if it could produce them more efficiently itself.

Ex) Ghana & South Korea

In light of Ghana’s absolute advantage in the production of both goods, why should it trade with South Korea?

Although Ghana has an absolute advantage in the production of both cocoa and rice, it ahs a comparative advantage only in the production of cocoa, therefore, Ghana is COMPARATIVELY more efficient at producing cocoa than it is at producing rice.

By engaging in trade, the two countries can increase their combined production of rice and cocoa, and consumers in both nations can consume more of both goods.

-The Gains of Trade:

Consumption of cocoa and rice can increase in both countries as a result of specialization and trade.

The basic message of the theory of comparative advantage is that potential world production is greater with unrestricted free trade than it is with restricted trade.

Ricardo’s theory suggests that consumers in all nations can consume more if there are no restrictions on trade. (trade is a positive sum game in which all gain)

-Qualifications and Assumptions:

There are many unrealistic assumptions inherent in our simple model, including:

1 – assumed 2 countries and 2 goods

2 – assumed away transportation costs between countries

3 – assumed away differences in the prices of resources in different countries

(ex) exchange rates; assume one-to-one swap

4 – assumed resources can move freely from the production of one good to another

within a country, but they are not free to move internationally

5 – assumed constant returns to scale. In reality, both diminishing and increasing returns

to specialization exist. The amount of resources required to produce a good might

decrease or increase as a nation specializes.

6 – assumed each country has a fixed stock of resources and that free trade does not

change the efficiency with which a country uses its resources

7 – assumed away the effects of trade on income distribution within a country

Basic proposition of the Ricardian model: countries will export the goods they are most efficient at producing.

-Simple Extensions of the Ricardian Model

Relax two of the assumptions:

1 – constant returns to specialization

2 – static assumptions that trade does not change a country’s stock of resources or the

efficiency with which it utilizes those resources

Diminishing Returns:

Constant returns to specialization: we mean that the units of resources required to produce a goods are assumed to remain constant no matter where one is on a country’s production possibility frontier (PPF)

It is more realistic to assume diminishing returns to specialization.

Diminishing returns to specialization:

-occur when the more of a good a country produces, the greater the units of

resources required to produce each additional unit

Diminishing returns implies a convex PPF for Ghana, rather than the straight line depicted.

There are two reasons it is more realistic to assume diminishing returns:

1 – not all resources are of the same quality ex) land – some is more fertile than other

2 –different goods use resources in different proportions ex) land vs. labor intensive

The significance of diminishing returns is that it is not feasible for a country to specialize to the degree suggested by the simple Ricardian model. Diminishing returns to specialization suggest that the gains from specialization are likely to be exhausted before specialization is complete. (show graph)

In reality, most countries do not specialize, but instead, produce a large range of goods.

The theory predicts that it is worthwhile to specialize until that point where the resulting gains from trade are outweighed by diminishing returns.

The basic conclusion that unrestricted free trade is beneficial still holds, although due to diminishing returns, the gains may not be as great as suggested in the constant return case.

-Dynamic effects and economic growth

relax: assume that trade does not change a countries stock of resources or the efficiency with which it utilizes those resources.

If we relax this assumption, it becomes apparent that opening an economy to trade is likely to generate dynamic gains.

These gains are of two sorts:

1 – free trade might increase a country’s stock of resources as increase supplies of labor and capital from abroad become available for use within the country (ex. Outside investing)

2 – free trade might also increase the efficiency with which a country utilizes its resources

ex) -economies of large-scale production

-better technology from abroad to domestic firms, therefore increases labor

productivity or land productivity

-increased competition stimulates domestic producers to increase efficiency

Dynamic gains in both the stock of a country’s resources and the efficiency with which resources are utilized cause a country’s PPF to shift outward.

As a consequence of this outward shift, the country can produce more of both goods than it did before free trade.

Heckscher-Ohlin Theory

Ricardo’s theory stresses that comparative advantages arise from differences in productivity.

Ricardo himself stressed labor productivity and argues that differences in labor productivity between nations underlie the notion of comparative advantage.

Swedish economist Eli Heckscher (1919) and Bertil Ohlin (1933) put forward a different explanation of comparative advantage.

They argue that comparative advantages arises from differences in national factor endowments.

By factor endowments, they meant the extent to which a country is endowed with such resources as land, labor, and capital.

The more abundant a factor, the lower it’s cost.

The Heckscher – Ohlin theory predicts that countries will export those goods that make intensive use of those factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce.

Like Ricardo’s theory, the Heckscher Ohlin theory argues that free trade is beneficial.

Unlike Ricardo’s theory, however, the Heckscher-Ohlin theory argues that the pattern of international trade is determined by differences in factor endowments, rather than differences in productivity.

Note that it is relative, not absolute, endowments that are important; a country may have larger amounts of land and labor than another country, but be relatively abundant in one of them.

-The Leontief Paradox:

Most economists prefer the Heckscher-Ohlin theory to Ricardo’s theory because it makes fewer simplifying assumptions.

1953 Wassily Leontief:

Using the Heckscher-Ohlin theory, Leontief postulated that since the US was relatively abundant in capital compared to other nations, the US would be an exporter of capital-intensive goods and an importer of labor intensive goods.

To his surprise however, he found that US exports were less capital intensive than US imports. It has become known as the Leontief paradox.

One possible explanation is that the US has a special advantage in producing new products or goods made with innovative technologies. Such products may well be less capital intensive than products whose technology has had time to mature and to become suitable for mass production.

Thus the US may export goods that heavily use skilled labor and innovative entrepreneurship while importing heavy manufactures that use large amounts of capital.

This leaves economist with a difficult dilemma:

They prefer the Heckscher-Ohlin theory, but it is a relatively poor predictor of real-world international trade. On the other hand, Ricardo’s limited theory, actually predicts trade patterns with greater accuracy.

Thus the US exports commercial aircraft and imports automobiles not because its factor endowments are especially suited to aircraft manufacture and not suited to automobile manufacture, but because the US is more efficient at producing aircraft than automobiles.

-The Product-Life-Cycle Theory:

Raymond Vernon mid 1960

Vernon’s theory was based on the observation that for most of the 20^th century, a very large proportion of the world’s new products had been developed by US firms and sold first in US market (ex. Cars, cameras)

The wealth and size of US gave US firms a strong incentive to develop new consumer products.

Vernon argued that most new products were initially produced in American. Apparently, the pioneering firms thought it was better to keep production facilities close to home.

The demand for most new products tends to be based on nonprice factors. Consequently, firms can charge relatively high prices for new products, which decreases the need to look for low-cost production sites in other countries.

The limited initial demand in other advanced countries does not make it worthwhile for firms in those countries to start producing the new product, but it does necessitate some exports from the US to those countries.

Over-time, demand starts to grow in those advanced countries. Foreign producers begin producing or US firms might set up production facilities in those advanced countries (limiting US exports).

As the market matures, the product becomes more standardized, and price becomes the main competitive weapon.

-One result is that producers based in advanced countries where labor costs are

lower than in US might now export to US.

-If cost pressure persist, developing countries begin to acquire a production

advantage over advanced countries.

Thus the focus of global production initially switches from the US to other advanced nations, and then to developing countries.

Over time, the US goes from exporting to importing.

(See graphs pg 137)

-Evaluating the Product Life-Cycle Theory:

-explains international trade patterns quite accurately ex) photocopiers

Weakness: with increased globalization and integration of the world economy, a growing number of new products are now introduced simultaneously in the US, Japan, and others. This may be accompanied by globally dispersed production.

Ex) laptop computer’s (globally manufactured)

Although Vernon’s theory may be useful for explaining the pattern of international trade during the brief period of American global dominance, its relevance in the modern world is limited.

-The New Trade Theory

1970 – questioning the assumption of diminishing returns to specialization

They argued that in many industries, because of the presence of substantial economies of scale, there are increasing returns to specialization.

The new trade theorists argue that due to the presence of substantial scale economies, in many industries world demand will only support a few firms (ex. Jet aircraft)

In those industries where the existence of substantial economies of scale imply that the world market will profitably support only a few firms, countries may export certain products simply because they have a firm that was an early entrant "first mover advantage"

"firs-mover advantage"

-economies and strategic advantages that accrue to early entrants

-creates a barrier to entry

This theory has profound implications.

a country may predominate in the export just because it was first
this varies from Heckscher-Ohlin theory which suggests that a country will predominate in exports only if it is well endowed with those factors used intensively
the new trade theory is not at variance with the theory of comparative advantage

The New Trade Theory is so new that little empirical work has been done.

Consistent with the theory: Alfred Chandler - Harvard

Perhaps the most contentious implications of the New Trade Theory is the argument that it generates for government intervention and strategic trade policy.

New Trade theorists stress:

-role of luck

-entrepreneurship

-innovation in first-mover advantage

ex) Boeing’s 707 - government funded R&D, government intervention

-National Competitive Advantage: Porter’s Diamond

1990 Michael Porter of Harvard – attempted to show why some nations succeed and others fail in international competition; "The Competitive Advantage of Nations"

Porter’s task – was to explain why a nation achieves international success in a particular industry.

Porter’s thesis is that four broad attributes of a nation shape the environment in which local firms shape the environment in which local firms compete, and these attributes promote or impede the creation of competitive advantage.

"The Diamond"

Firm Strategy, Structure,

And Rivalry

Chance

Factor Endowments ß ------------------------------------à Demand Conditions

Related and Supporting Government

Industries

A mutually reinforcing system.

Porter maintains that two additional variables can influence the national diamond – chance (major innovations) and government (policies)

-Factor Endowments:

Porter recognizes hierarchies among factors, distinguishing between basic factors (natural, climate, location) and advanced factors (communication, skilled labor).

Porter argues that advanced factors are the most significant for competitive advantage

Ex) government investment in education

The relationship between advanced and basic factors is complex. Basic factors can provide an initial advantage that is subsequently reinforced and extended by investment in advanced factors.

Disadvantages in basic factors can create pressure to invest in advanced factors ex) Japan

-Demand Conditions:

Firms are typically most sensitive to the needs of their closet customers.

Porter argues that a nation’s firms gain competitive advantage if their domestic consumers are sophisticated and demanding ex) Japan and cameras

-Related and Support Industries:

The benefits of investments in advanced factors of production by related and supporting industries can spill over into an industry, thereby helping it achieve a strong competitive position internationally.

One consequence of this process is that successful industries within a country tend to be grouped into clusters of related industries.

Ex) German textile and apparel sector:

-high-quality cotton

-wool

-synthetic machine needles

-textile machinery

-Firm Strategy, Structure and Rivalry:

Two important points:

1 – different nations are characterized by different "management ideologies" which either help them or do not help them to build national competitive advantage

ex) Japan’s management teams à are engineers; so they put emphasis on improving manufacturing processes

US à management is finance – we lack attention in improving manufacturing processes

2 – There is a strong association between vigorous domestic rivalry and the creation and persistence of competitive advantage in and industry.

Evaluating Porter’s Theory: too new to tell if it works

Implications for Business:

-Location Implications:

It makes sense for a firm to disperse its various productive activities to those countries where they can be performed most efficiently.

Global Web of productive activities – ex) laptop computer

By dispersing production activities to different locations around the globe, US manufacturer is taking advantage of the differences between countries identified by the various theories of international trade.

-Firs-Mover Implications:

It pays to invest substantial financial resources in trying to build a first-mover, or early-mover, advantage.

-Policy Implications:

Business firms can and do exert a strong influence on government trade policy

Ex) tariff on Japan’s LCD screen – IBM and Apple protested

-"Voluntary" restrictions

-automobiles, machine tools, textiles, and steel

Firms should invest in upgrading advanced factors of production

-Employee training; R&D; "diamond" (lobbying)

Chapter Five: The Political Economy of International Trade

Jason Epstein

INSTRUMENTS OF TRADE POLICY

tariff: import tax

specific tariff: levied as a fixed charge for each unit of a good imported

ad valorem tariff: levied as a proportion of the value of the imported good

Tariffs raise the cost of imported products relative to domestic products. The government gains, because the tariff increases government revenues. Domestic producers gain, because the tariff gives them a measure of protection against foreign competitors by increasing the cost of imported foreign goods. Consumers lose since they must pay more for those affected imports.

Tariffs reduce the overall efficiency of the world economy, because they pressure domestic producers to manufacture products at home that could be produced more efficiently abroad.

subsidies: government payment to a domestic producer

Examples of subsidies include cash grants, low-interest loans, tax breaks, and government equity participation in domestic firms. By lowering costs, subsidies help domestic producers by helping them compete against low-cost foreign imports and gain export markets.

Subsidies principally assist domestic producers, whose international competitiveness is increased. Advocates of strategic trade policy argue that subsidies help domestic companies achieve a dominant position in those industries where economies of scale are important and the world market is not large enough to profitably support more than a few firms.

In contrast, taxpayers suffer. Additionally, in practice many subsidies do not lead to international competitiveness of domestic producers.

import quota: direct restriction on the quantity of a good that may be imported into a country

An import quota is typically enforced by issuing import licenses to a group of individuals or firms.

voluntary export restraint (VER): trade quota imposed by the exporting country, typically at the request of the importing country’s government

Typically, foreign producers agree to VERs because they fear that if they do not, far more damaging punitive tariffs or import quotas will soon be imposed.

Domestic producers tend to gain, while consumers get schtupped.

local content requirement (LER): demand that some specific fraction of a good be produced domestically

An LER can be expressed either in physical terms or in value terms. They are widely applied by developing countries to shift their manufacturing base form the simple assembly of products whose parts are manufactured elsewhere into the local manufacture of component parts. In recent years, many developed nations have done likewise.

As a result, foreign competition is limited, assisting domestic producers of component parts, but prices on the imported products rise. Guess what? Consumers suffer.

administrative trade policies (ATP): bureaucratic regulations that are designed to make it difficult for imports to enter a country

Americans tend to associate ATPs most with Japanese trade policies. For example, Japanese customs inspectors insist on opening a large portion of FedEx packages to check for pornography. These inspections frequently last for days.

Do you still need to know who shall benefit and who shall suffer?

THE CASE FOR GOVERNMENT INTERVENTION

political arguments: protecting jobs, national security, and retaliation

economic arguments: infant industry, strategic trade policy

The infant industry argument claims that manufacturing in developing countries cannot always compete with well-established industries in developed countries. Governments should temporarily support new industries until they grow strong enough to handle international competition on a level playing field.

Detractors argue that protection does not make the industry efficient. Additionally, firms are increasingly able to obtain capital on the international market.

THE REVISED CASE FOR FREE TRADE

Strategic trade policies seek to boost national income at the expense of other countries. This provokes retaliation. A resulting trade war will only hurt those involved. Some argue that the establishment of rules that minimize the use of trade-distorting subsidies stymies unfair subsidizations.

Domestic policies impact government decision making. Embracing strategic trade policy inevitably leads to special interest group economics. This is not necessarily in the government’s national interest.

DEVELOPMENT OF THE WORLD TRADING SYSTEM

Although the UK had established free trade as a national policy in 1846, few nations followed suit. The Smoot-Hawley tariff of 1930 erected an enormous wall of tariff barriers to US imports. Other countries responded by adopting similar tariffs. As a result, the world slid deeper into the Great Depression.

In 1947, the US helped established the General Agreement on Tariffs and Trade (GATT). GATT was a product of the post-war free trade movement. It was successful in lowering trade barriers on manufactured goods and commodities. For example, US tariffs plummeted by an average of 92% between 1947 and 1979. The move toward greater free trade under GATT appeared to economic stimulate growth.

An increase in protectionist trends stimulated the need to make progress on more ambitious goals. The completion of the Uruguay Round of GATT talks and the establishment of the World Trade Organization (WTO) has strengthened the world trading system by extending GATT rules to services, increasing protection for intellectual property, reducing agricultural subsidies, lowering textile quotas, and enhancing monitoring and enforcement mechanisms.

IMPLICATIONS FOR BUSINESS

Trade barriers constrain a firm’s ability to disperse its various production activities to optimal locations around the globe. One response to trade barriers is to establish more production activities in the protected country. Business may have more to gain from government efforts to open protected markets to imports and foreign direct investment, than from government efforts to protect domestic industries from foreign competition.

Chapter 6 – Foreign Direct Investment

Prepared by Hunaid Sulemanji

FDI (Foreign Direct Investment) occurs when a firm invests directly in facilities to produce and/or market a product in a foreign country. For example, a US entity takes an interest of 10 percent or more in a foreign business entity is considered an FDI by the Dept of Commerce.

Economic rationale that underlies FDI – overcome trade barriers, open access to local markets, cost considerations.

Horizontal FDI – is FDI in the same industry in which a firm operates at home. For examples, Honda’s investment in the US to produce cars is a horizontal FDI. Alternatives of exporting and licensing must be explored before choosing FDI. FDI is expensive (because of the costs of establishing production facilities and/or acquiring foreign enterprise) and risky investment (because of different "rules of the game" in different cultures) compared to exporting and licensing.

Why FDI over exporting or licensing? Numbers of factors alter the relative attractiveness of exporting, licensing, and FDI.

Transportation costs – when transportation costs are added to production costs, it may become unprofitable to ship some products over a large distance, especially products that have a low value-to-weight ratio and can be produced at any location.
Market Imperfections (internalization theory) – market imperfections are factors that inhibit markets from working perfectly. Market imperfection approach to FDI is referred to as internalization theory. Market imperfections in horizontal FDI arise in two circumstances – impediments to the free flow of products between nations, and impediments to the sale of know-how.

Following Competitors – this theory explains that FDI is based on the idea that firms follow their domestic competitors overseas. Also known as Knickerbocker theory developed with regard to oligopolistic industries. What one firms does can have an immediate impact on the major competitors, forcing a response in kind. For example, Toyota and Nissan responded to investments by Honda in the US and Europe by undertaking their own FDI.

The Product Life Cycle – Vernon’s product life cycle theory says that firms undertake FDI at particular stages in the life cycle of the product they have pioneered. They invest in other advance countries when local demand in those countries grows large enough to support local productions (For example, Xerox). Thus, the product life cycle theory argues that once a foreign market is large enough to support local production, FDI will occur.

Location-Specific FDI Advantages – these are advantages that arise from utilizing resource endowments or assets that are tied to a particular foreign location and the firm finds valuable to combine with its own unique assets (such as the firm’s technological, marketing, or management know-how). For example, natural resources, such as oil and other minerals, which are by their character specific to certain locations.

Vertical FDI – is FDI in an industry that provides inputs for a firm’s domestic operations. Vertical FDI takes two forms – backward vertical FDI into an industry that provides inputs for a firm’s domestic production processes (For example, oil extraction, bauxite mining, and tin and copper mining). The objective is to provide inputs into the firm’s downstream operations (For example, refining and smelting). It is an attempt to create barriers to entry by gaining control over the source of material inputs into the downstream stage of the production process.

The second form is forward vertical FDI, which is FDI into an industry abroad that sells the outputs of the firm’s domestic production processes. It is an attempt to circumvent entry barriers and gain access to a national market. For example, when Volkswagen first entered the US market, rather than sell its cars through independent dealers, it acquired a large number of dealers. There are two basic answers to these decisions – market power and market imperfection.

Market Power – Firms undertake vertical FDI to limit competition and strengthen their control over the market. The most common argument is that by vertically integrating backward to gain control over the source of raw material inputs, a firm can effectively shut new competitors out of an industry.

Market Imperfections – this approach offers two explanations for vertical FDI. First, there are impediments to the sale of know-how through the market mechanism. Second, investments in specialized assets expose the investing firm to the hazards that can be reduced only through vertical FDI.

FDI in the World Economy – difference between flow of FDI and stock of FDI. Flow refers to the amount of FDI undertaken over a given period of time. Stock refers to the total accumulated value of foreign-owned assets at a given time.

Some numbers (World numbers)

1981-1985 period outflow of FDI increased from $47b pa to 163b pa between 1986-1990 period. In 1990, outflow of FDI a record $222b.

Reasons FDI is growing more rapidly than world trade and word output

Fear protectionist pressures. Business execs see FDI as a way of circumventing future trade barriers.
FDI driven by dramatic political and economic changes that have been occurring in many of the world’s developing nations.

What has encouraged FDI – shift in democratic political institutions and free market economies in emerging markets of Asia, Eastern Europe, and Latin America.

Is the growth of FDI into the US good or bad for the US economy (argument can be used for other countries too) – foreign know-how could help improve the US competitiveness as well as provide jobs and investments. But critics also argue that the country has a lot to lose and little to gain from the growth of FDI. For example, Japanese FDI into the US. Critics argue that in exchange for a few lower-skilled, lower paying jobs, US companies are sacrificing their competitiveness to a Japanese strategy that keeps higher-valued, higher-paying jobs in Japan.

Just for general knowledge – a decision framework

Chapter 7 – The Political Economy of Foreign Direct Investment

Political Ideology and Foreign Direct Investment

Hostile to FDI (dogmatic) ß à progmatic nationalism ß à noninterventionist principal

The Radical View

Marxist political and economic theory

Radical writers argue that the multinational enterprise (MNE) is an instrument of imperialist domain.

They argue that MNEs extract profits from the host country and take them to their home country, giving nothing of value to the host country in exchange.

FDI by the MNEs of advanced capitalist nations keeps the less developed countries of the world relatively backward and dependent on advanced capitalist nations for investments, jobs, and technology.

Never allow FDI and if it already exist they should be nationalized immediately.

1945-80 radical view was very influential

By the end of 1980, radical position was in retreat because:

1 – collapse of communism in Eastern Europe

2 – poor economic performance using the radical position

3 – strong economic performance of those developing countries that embraced capitalism

rather then radial ideology

The Free Market View

classical economist – Adam Smith and David Ricardo

This view strengthened by the market imperfections explanation of horizontal and vertical FDI.

The free market view argues that international production should be distributed among countries according to the theory of comparative advantage. MNE is seen as that instrument for dispersing production where it is most efficient.

FDI by MNE is a way to increase the overall efficiency of the world economy.

Contrary to the radical view, the free market view stresses that such resources transfers benefit the host country and stimulate economic growth. (US, Britain)

No country has adopted the free market view in it’s pure form à governments have a tendency to intervene.

Pragmatic Nationalism:

The progmatic nationalist view is that FDI has both benefits and costs.

FDI can benefit a host country by bringing capital, skills, technology, and jobs, but those benefits come at a cost.

COSTS:

-profits may go abroad or back to home country

-import many components; which has a negative impact on the host country’s

balance-of-payments position

Accordingly, the pragmatic stance is to allow FDI only if the benefits outweigh the costs .

(See Table 7.1 pg 204)

The Benefits of FDI to Host Countries

1 – Resource-Transfer Effects:

FDI can make a positive contribution to a host economy by supplying capital, technology, and management resources that would otherwise not be available.

Capital: easier for large firms to borrow or invest their money

Technology: is a catalyst that can stimulate economic development and industrialization

Two Forms:

1 – production process (refining oil)

2 – product (personal computer)

Many countries lack the research and development resources and skills required to develop their own indigenous product and process technology.

FDI is not the only way to access advanced technology. Another option is to license that tech from foreign MNE’s . ex) Japanese government

The advantage of licensing is that in return for royalty payments, host-country firms are given direct access to valuable technology.

By licensing its technology to foreign companies, and MNE risks creating a future competitor.

Management:

"spin-off" effects (arise when local personnel who are trained to occupy managerial, financial, and technical post in the subsidiary of a foreign MNE subsequently leave the firm and help establish indigenous firms.

The beneficial effects may be considerably reduced if most management positions or highly-skilled jobs are reserved for home-country nationals. (major negotiation point)

2 – Employment Effects:

The beneficial employment effect claimed for FDI is that FDI brings jobs to a host country that would otherwise not be created there. (direct and indirect (supplies))

Cynics note that not all the "NEW JOBS" created by FDI represent net additions in employment.

Ex) Japanese auto FDI – some argue that the jobs created by this investment have been

more than offset by the jobs lost in US-owned auto companies which have lost market share.

3 – Balance-of-Payment Effects:

Balance-of-payments accounts: keep track of both its payments to and its receipts from

other countries

Any transaction resulting in a PAYMENT TO other countries in entered in the balance-of-payments accounts as a DEBIT and given a negative (-) sign.

Any transaction resulting in a RECEIPT from other countries is entered as a CREDIT and given a positive (+) sign.

Balance-of-Payments accounts are divided into two main sections:

1 – Current Account:

-records transactions that pertain to 3 categories:

1 – merchandise trade (export or import of goods)

2 – services

3 – investment income

Current Account Deficit (trade deficit):

-occurs when a country imports more goods, services, and income than it exports.

Current Account Surplus (trade surplus):

-occurs when a country exports more goods, services, and income than it imports

2 – Capital Account:

-recorded transactions that involve the purchase or sale of assets

ex) Japan firm buys US stock (the transaction enters US balance of payments as

a credit)

capital flow in à credit

capital flow out à debit

A basic principle of balance-of-payments accounting is double entry bookkeeping. Every international transaction automatically enters the balance of payments twice (once as a credit and once as a debit).

Because of double transactions: therefore the current account balance and the capital account balance should always add up to zero (except statistical discrepancies).

Governments are concerned when running a deficit.

When a country runs a current-account deficit, the money that flows to other countries is typically then used by those countries to purchase assets in the deficit country.

A deficit on the current account is financed by selling assets to other countries; that is, by a surplus on the capital account.

Countries that run current-account deficits become net debtors. The main problem is that debtor nations owe people money.

As a result of financing its current-account deficit through asset sales, from now on the US will be obliged to deliver a stream of interest payments to foreign bondholders, rents to foreign landowners, and dividends to foreign stockholders.

Such payments to foreigners drain resources from a country and limit the amount of funds available for investment within the country. Since investment within a country is necessary to stimulate economic growth, a persistent current-account-deficit can choke off a country’s future economic growth.

FDI and the balance of payments:

HOST Government Consequences:

1 – MNE establishes subsidiary, the capital account of the host country benefits from the

initial capital inflow (outflow of earning to foreign parent country).

2 – If FDI is a substitute for imports of goods or services, the effect can be to improve the

current account of the host country. Ex) Japan auto companies in US

3 – If MNE uses a foreign subsidiary to export goods to other countries ex)Nissan in

Britain was exporting 80%.

The Costs of FDI to Host Countries

1 – Adverse Effects on Competition:

Subsidiaries of foreign MNEs may have greater economic power than indigenous competitors because they are part of a larger firm (may subsidize their market to kill off competition)

Infant industries may never get started if larger FDI comes into play.

2 – Adverse Effects on the Balance of Payments:

The initial capital inflow that comes with FDI must be the subsequent outflow of earnings from the foreign subsidiary to its parent company.

Foreign subsidiaries imports a large number of its inputs from abroad, which results in a debit.

3 – National Sovereignty and Autonomy

Many host governments worry that FDI is accompanied by some loss of economic independence.

The concern is that key decisions that can affect the host country’s economy will be made by a foreign parent that has no real commitment to the host, and over which the host country’s Gov. has no real control.

Economist dismiss because in a world where firms from all advanced nations are increasingly investing in each other’s markets, it is not possible for one country to hold another "economic ransom" without hurting itself.

The Benefits and Costs of FDI to Home Countries

Benefits:

1 – the capital account of the home country’s balance of payments benefits from the

inward flow of foreign earnings.

Also, FDI may increase demand for home-country exports.

2 – outward FDI arises from employment effects (create demand for home country

exports of capital equipment, intermediate goods, complementary products.)

3 – home-country MNE learns valuable skills from its exposure to foreign markets

(reverse resource-transfer effect)

Costs:

The home country’s balance-of-payments may suffer in three ways:

1 – initial capital outflow required to finance FDI

2 – if the purpose of foreign investment is to serve the home market from a low-cost

production location

3 – if FDI is a substitute for direct exports

The most serious concern arises when FDI is seen as a substitute for domestic production.

International Trade Theory and Offshore Production

offshore production – FDI undertaken to serve the home market

Far from reducing home-country employment, such FDI may actually stimulate economic growth and employment in the home country by freeing home-country resources to concentrate on activities where the home country has a comparative advantage (plus the price of the product may fall).

Government Policy Instruments and FDI

Home-Country Policies:

Encouragingà foreign risk insurance, capital assistance tax incentive, political pressure

Types of Risks Insurable:

-expropriation (nationalization)

-war losses

-inability to transfer profits back home

Loans

Eliminate Double taxation of foreign income

Political Influence

Restrictingà limit capital outflow

Manipulated tax rules to encourage home investment

Host-Country Policies:

Encouragingà offer incentives such as tax concessions, low-interest loans, grants or

subsidies (areas compete for FDI)

Restrictingà ownership restraints:

-exclusion from certain business fields

-significant proportions must be owned by local investors

Performance Requirements:

Controls behavior of local subsidiary ex) local content, export ratio, tech transfer, local participation in top management

Implications for Business

Nature of Negotiations: 4C’s

Common Interest Conflicting Interest

Negotiation Process

Compromise Criteria

MIE CHAPTER 8 REVIEW

LEVELS OF ECONOMIC INTEGRATON

Free Trade Zone- all barriers to the trade of goods and services among member countries are removed (NAFTA)

Customs Union- eliminates trade barriers between member countries and adopts a common external trade policy (Andean Pact)

Common Market- eliminates trade barriers between member countries and adopts a common external trade policy, and factors of production move freely between member countries. (EU 1998)

Economic Union- eliminates trade barriers between member countries and adopts a common external trade policy, and factors of production move freely between member countries and there is a common monetary and fiscal policy. (EU with the Euro)

Political Union- eliminates trade barriers between member countries and adopts a common external trade policy, and factors of production move freely between member countries and there is a common monetary and fiscal policy and a common political foreign policy. (European Council of Ministers may grow into this)

THE CASE FOR REGIONAL INTEGRATION

The Economic Case for Integration- Free trade and investment is a positive-sum game, in which all participating countries stand to gain. Starts with a limited number of countries for a greater level of implementation success.
The Political- Countries can enhance their political weight in the world. Chance of international violence is reduced. Strength for small nations against economic powers.
Impediments to Integration- Costs, some groups in the country will lose. National sovereignty and pride is a major hurdle.

THE CASE AGAINST REGIONAL INTEGRATION- Trade diversion can out weight Trade creation

REGIONAL ECONOMIC INTEGRATION IN EUROPE

Evolution of the European Union- Product of two political factors, first after WWII a desire for peace. Two to have a stage for the European economy. Treaty of Rome in 1957 established the EC. 1973 GB, Ireland and Denmark joined. 1981 Greece, 1986 Spain & Portugal, 1996 Austria, Finland and Sweden
Political Structure of the European Union- Five main institutions, European Council, council of Ministers, European Commission, European Parliament and Court of Justice
The Single European Act- 1980 members felt the EC was falling short and the US was restructuring under Regan and then took off.

PROBLEM

Different Technical standards
Different taxes created price differentials
Country by country barriers and prices
Volition of Article 3 had varying prices creating disparities

SOLUTION 12/31/92

Frontier Controls
Mutual recognition of standards
Public Procurement
Financial Services
Exchange Controls
Freight transport
Supply side effects

Treaty of Maastricht and its Aftermath- 12/91 committed all 12 countries to adopting a common EC currency by 1/99 also paved the way for a closer political cooperation and possible creation of a European superstate. Single Currency, common foreign and defense policy, common citizenship and an EU parliament with teeth.
Enlargement of the European Union- next possible members; Hungary, Poland, Czech, Malta, Cyprus and Turkey
Fortress Europe?- Will EU adopt a protective anti trade stance with quotas and tariffs, probably not.

REGIONAL ECONOMIC INTEGRATION IN THE AMERICAS

NAFTA- 1/94 US, Mex & Can.

10yrs abolition of 99% of tariffs
1/00 all barriers to service industries lifted
protects intellectual property rights
removes restrictions on foreign direct investment between member nations (culture is protected)
common environmental standards
teeth due to fines and removal of trade privileges

Positive after first year and continues to do so.

The Andean Pact- 1969 EU model, South American countries, tough economic conditions for a trade pact.
MERCOSUR- 1988 free trade pact between Brazil & Argentina 1990 Paraguay and Uruguay. Aims for SAFTA by 2005

REGIONAL ECONOMIC INTEGRATION ELSEWHERE

Assc. Of SE Asian Nations- 1967 still weak
Asia Pacific Economic Cooperation- 1990 target for free trade zone for developed nations 2010 developing 2020

IMPLICATIONS FOR BUSINESS

Opportunities- maximization of trade, free movement of goods, product standards, simplified taxes, removal of barriers of trade, investment into a larger single market
Threats- more competitive, arbitrage opportunities can erode it, rationalizing production, fortress Europe

CH 9 THE FOREIGN EXCHANGE MARKET

defined– is a market for converting the currency of one country into that of another.

FUNCTIONS OF THE EXCHANGE RATE MARKET

Currency Conversion

Exchange rate – is the rate at which the market converts one currency into another.

There are four main uses of the foreign exchange market to international business.

Payments received for exports or income from a foreign investment or licensing agreement
Payments sent to a foreign company for products and services.
Investment for short term money markets on the best interest rate
Currency speculation – profit from shifts in exchange rates.

Insuring Against Foreign Exchange Risk

Currency markets provide insurance against adverse consequences of unpredictable exchange rates.

Spot Exchange Rate – is the rate exchanged on a particular day.

Forward Exchange Rate a quoted rate for 30, 90, 180 in the future. This rate is normally part of a forward contract where two parties agree to exchange currency at a future date.

Discount – forward exchange rate is worth less than the spot rate.

Premium – forward exchange rate is worth more than the spot rate.

Currency Swap – is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.

*** A SWAP DEAL IS JUST LIKE A COVENTIONAL FORWARD EXCEPT IT ENABLES A COMPANY TO INSURE ITSELF AGAINS FOREIGN EXCHANGE RISK.

NATURE OF THE FOREIGN EXCHANGE MARKET

Notes:

London dominates the exchange rate market thanks to history (first) and geography (can trade in Tokyo and NY in the same window.
Exchange market relies heavily on a vast network of telephone lines, fax, and computer linkages between trading centers around the world.

Arbitrage – process of buying a currency low and selling it high.

The dollar is a vehicle currency as it is used as a medium to sell one currency and buy another.
Methods to determine foreign exchange markets are complex and there is no theoretical consensus.

ECONOMIC THEORIES OF EXCHANGE RATE DETERMINATION

Experts agree three factors pay a role in determining foreign exchange rates: price inflation, interest rates, and market psychology.

A. Prices and Exchange Rates

One Price Law states that in competitive markets free of transportation costs and barriers to trade (such as tariffs), identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency. Differences result in an arbitrage opportunity which are acted upon to keep the exchange in balance. (See pg 279 for more explanation)

Purchasing Power Parity – by comparing the prices of identical products in different countries, it is possible to determine the "real" or PPP exchange rate that would exist if markets were efficient.

Less extreme PPP – markets with few impediments to international trade and investment should have the same price for a basket of goods in each country.

Purchasing Power Parity suggests exchange rates will change relative to inflation rates in a given country. For example if the exchange is $1 = 600DM. US has no inflation and Germany has 20% inflation. At the end of the year, the exhange rate should be equal to $1 = 720DM. Due to the effects of price inflation, the value of the DM has depreciated against the $1.

PPP also suggests that we can predict the inflation rate through the growth rate of a country’s money supply. When the growth in a country’s money supply is faster than its output, price inflation is fueled. The higher the inflation rate, the greater the depreciation of a currency.

Government policy normally controls the supply of money.

PPP is a good theory for long time periods of 20 years or more, but does not seem to be a good indicator for 5 years or less (due to transportation costs and government intervention).

Interest Rates and Exchange Rates

In countries where inflation is high interest rates will also be high. Therefore investors want to be compensated for their decline in value of money.

International Fisher Effect – for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the nominal interest rates between two countries.

(S1 – S2)/S2 x 100 I$ - IDM

Investor Psychology and Bandwagon Effects

There is increasing evidence that various psychological factors, as opposed to macro economic fundamentals, play an important role in determining the expectations of market traders as to likely future exchange rates. Example George Soros short sold the British Pound which created a Bandwagon effect, as a result he made $1 billion dollars in four weeks.

D. Exchange Rate Forecasting

A company’s need to predict future exchange rate variations raises the issue of whether it is worthwhile to invest in exchange rate forecasting services.

Efficiency Market School – market in which all information is available. If the market is efficient, then forward exchange rates are an accurate measure of future spot rates. It is therefore not worth investing in forecasting services.

Inefficiency Market School – prices do not reflect all available information. Forward exchange rates are not the best possible predictor of future spot rates.
Approaches to Forecasting

Fundamental analysis – draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements. They include money supply growth rate, interest rates, inflation rates, and balance of payments positions.

Technical analysis – uses price and volume data to determine past trends, which are expected to continue into the future.

IV. CURRENCY CONVERTIBILITY

Convertibility and Government Policy

Freely Convertible – allows both residents and non residents to purchase an unlimited amounts of foreign currency with it.

Externally Convertible – when only non residents may convert it into a foreign currency without any limitations.

Non Convertible – when neither residents or non residents are not allowed to convert currency into foreign currency.

Countertrade – refers to a range of barter-like agreements by which goods and services can be traded for other goods and services. Countertrade can make sense when a country’s currency is nonconvertible.

Chapter 10

Gold Standard: the practice of pegging currencies to gold and guaranteeing convertibility to gold

Gold coins were used as a medium of exchange, store of value and unit of account.

Shipping large quantities of gold around the world: impractical. So, payment began in paper currency and governments agreed to convert paper currency into gold at a fixed rate.

From 1870 – 1914: Given a common gold standard, the value of any currency in units of other currency (exchange rate) was very easy to determine. The gold standard worked well.

Strength of Gold Standard: It contained a powerful mechanism that contributed to the simultaneous achievement of a balance-of-payments equilibrium by all countries.

1918 – 1939 Because of World War I, governments financed part of their massive military expenditures by printing money. This resulted in inflation. The Gold Standard Collapsed. Reason for collapse: during the 1930s countries engaged in competitive devaluations.

Bretton Woods System (1944- 1973): in 1944, representatives from 44 countries met at BW, New Hampshire to design a new International Monetary System.

Agreement at BW established IMF and the World Bank.

It called for a system of fixed exchange rates to be policed by the IMF.

Only the dollar remained convertible to gold. All other countries pegged their currency to the dollar.

Values of currency had to stay within 1% of the par value (intervention band)

All countries agreed not to use devaluation as a competitive trade policy. (responsibility of signatories)

If a currency is too weak to defend itself, up to a 10% devaluation was allowed with out the approval of the IMF.

Roles of IMF and World Bank:

IMF:

*maintain order in the international monetary system; to control price inflation by imposing monetary discipline.

*avoid repetition of the chaos that occurred between the wars through a combination of discipline and flexibility.

Fixed exchange rate regime would impose discipline: eliminate competitive devaluation and impose monetary discipline: thereby curtailing inflation.

World Bank (actual name is the International Bank for Reconstruction and Development): promote general economic development (originally established to reconstruct War torn Europe, but was overshadowed by the Marshall plan) So, the World Bank began lending to less developed nations of the third World.

Both World Bank and IMF have evolved into lending to 3^rd world countries with BOP problems, debt or developmental problems. They serve as the macroeconomic police of the world.

COLLAPSE OF THE FIXED EXCHANGE RATE SYSTEM

The Fixed rate system collapsed in 1973 - went to a managed floating exchange rate. In 1973, the US was running a balance of trade deficit and there was high inflation.

Floating exchange rate regime: rates are much more volatile and less predictable.

Case for floating: gives countries autonomy regarding their monetary policy and that floating exchange rates facilitate smooth adjustment of trade imbalance. No reserves needed. Gradual adjustment needed.

(See page 301 for more details.)

Case for fixed exchange rate regime claims: the need to maintain a fixed exchange rate imposes monetary discipline on a country, floating exchange rate regimes are vulnerable. The uncertainty that accompanies floating exchange rates hinders the growth of international trade and investment and far from correcting trade imbalances, depreciating a currency on the foreign exchange market tends to cause price inflation.

Fixed has lower uncertainty, easier to plan, and imposes fiscal and monetary discipline.

Plaza accord: 1985, the US posted a trade deficit of over $160 Million. Ministers from UK, France , Japan and Germany met at the Plaza hotel in NY. They announced that it would be desirable for most major currency to appreciate vis-à-vis the US dollar and pledged to intervene in foreign exchange markets, selling dollars to encourage the objective.

European Monetary Union:

Consists of 15 countries

The objective of the European Monetary System (EMS) is to create a zone of monetary stability in Europe, control inflation, and coordinate exchange rate policies with non EU- currencies.

These three objectives have paved the way for a single common currency: the Euro.

2 instruments used to achieve these objectives:

the Ecu and the exchange rate mechanism.(ERM)

The ECU is a "basket" of currencies that serves as the unit of account for the EMS. Each national currency in the EMS is given a central rate vis-à-vis the ECU. The EMU established the ECU, which was based on a currency (made of all the EU members currencies) basket. The currencies were allowed to float. It differed from Bretton Woods in this way.

The ERM is based on fixed rates and all EU members impose monetary discipline, limit speculation and promote international trade.

Currency Management: speculative buying and selling of currencies can create very volatile movements in exchange rates.

If the EU is going to have a common currency - it must first achieve a convergence between the inflation rates and interest rates of its 15 member states.

Convergence Criteria:

Total government debt: <= 60% of GDP

Gov't budget deficit <=3% of GDP

Chapter 11 – The Global Capital Market (International Capital Market Section)

Opening Case: Biomedex

Intro:

Nature of the International Capital Market

Functions of a generic capital market

-a capital market brings together those who want to invest and those who want to

borrow

market makers – the financial service companies that connect investors and borrowers,

directly or indirectly (including commercial banks & investment banks)

Commercial banks perform an indirect connection function (making profit from the differences in interest rates).

Investment banks perform a direct connection function. They bring investors and borrowers together and charge commissions for doing so.

-The distinction between debt and equity:

An equity loan is made when a corporation sells stock to investors. A share of stock gives its holder a claim to a firm’s profit stream. The corporation honors this claim by paying dividends to the stockholder. The amount of the dividend is determined by management on the basis of how much profit the corporation is making.

A debt loan requires the corporation to repay a predetermined portion of the loan amount (principal plus interest) at regular intervals regardless of profit.

-Attractions of the International Capital Market:

The borrower’s perspective : a lower cost of capital

Most important drawback of the limited liquidity of a purely domestic capital market is that the cost of capital tends to be higher than it is in an international market.

The cost of capital is the rate of return borrowers must pay investors. (interest rates)

The lower the cost of capital, the more it will borrow. Developed and less developed nations have problems with limited liquidity.

-The Investor’s perspective: portfolio diversification

By using the international market, the investor has a much wider range of investment opportunities.

Diversification à lowering risk

An investor increases the number of stocks in their portfolio, so the risk will decline. Soon the rate of decline falls off and asymptotically approaches the systematic risk of the market.

Systematic risk – refers to movements in a stock portfolio’s value that are attributable to

macro effects to all firms rather than factors specifically to an individual firm.

The systematic risk is the level of nondiversifiable risk in a economy.

Movement in stock market prices across countries is not strongly correlated.

A fully diversified portfolio of international stocks is only about 12% as risky as a typical individual stock.

The risk-reducing effects of international portfolio diversification would be even greater were it not for the volatile exchange rates associated with the current floating exchange rate regime. The uncertainty engendered by volatile exchange rates may be slowing the otherwise fairly rapid growth of the international capital market.

Growth of the International Capital Market

What changed to allow the international capital market to bloom in the 1980’s.

1 – Information Technology:

Financial services is an info-intensive industry as a consequence, the financial services industry has been revolutionized more than any by advances in information.

Technology since the 1960’s:

-instantaneous communication

-advances in data processing absorbs and processes more

-cost has fallen by 95%

Such developments have facilitated the emergence of an integrated international capital market. (24 hour-a-day trading)

Dark side – "shock" that occur in one financial center now spread around the globe very

Quickly (benefits outweigh the costs)

-Deregulation:

-restrictions have been crumbling since the late 1970’s

-may be in response to Eurocurrency market

-pressure from financial services companies

-increasing acceptance of free market ideology

-Impediments to Globalization:

-some claim we do not yet have a truly global capital market

Feldstein argues that most capital moves internationally to pursue temporary gains and shifts in and out of countries as quickly as conditions change.

Short term – "hot money"

Long term – "patient money"

A major reason for the continuing segmentation of national capital markets from each other may be lack of information about investment opportunities (different accounting conventions make comparison difficult).

The Eurocurrency Market

Eurocurrency – is any currency banked outside its country of origin

Eurodollars – 2/3 are dollars banked outside of the US

-Genesis and Growth of the Market:

1950’s – fear of US government seizing foreign deposits

1960’s – US government discouraged US banks from lending to non-US residents

1973 – Collapse of Bretton Woods

OPEC

-Attractions of Eurocurrency Market:

-lack of government regulations (higher interest rates for lenders while lower

interest rates for borrowers)

Domestic currency deposits are regulated in all industrialized countries.

-banks are given more freedom in dealing with foreign currencies

Drawbacks:

1 – when depositors use a regulated banking system, they know the probability of a bank

failure is very low. In an unregulated system such as Eurocurrency market,

probability of loss is greater

2 – borrowing funds internationally can expose a company to foreign exchange risk.

Chapter 13 - The Organization of International Business

Hunaid Sulemanji

The chapter identifies the organizational structures and the internal control mechanisms businesses use to manage and direct their global operations. There are four main dimensions of organizational structures:

VERTICAL DIFFERENTIATION

Vertical differentiation - is the distribution of decision-making authority within a hierarchy (i.e. centralize vs. decentralize).

Arguments for centralization are as follows:

Centralization can facilitate coordination
Centralization can help ensure that decisions are consistent with organizational objectives
Centralization can give top-level managers the means to bring about needed major organizational changes
Centralization of R&D functions ensures that work is not duplicated

Arguments for decentralization:

Top-level management can become overburdened with decision making, and this can result in poor decisions
Motivational factors
Decentralization permits greater flexibility - more rapid response to changes
Decentralization results in better decisions because decisions are made by individuals who have more knowledge of the job
Decentralization can increase control by establishing relatively autonomous , self-contained subunits within an organization.

HORIZONTAL DIFFERENTIATION

Horizontal differentiation - is a division of an organization into subunits (i.e. functions, divisions or subsidiaries). Undiversified domestic firms are typically divided into subunits on the basis of functions.

Diversified domestic firms typically adopt a product divisional structure.

When firms expand abroad they often begin with an international division. However, this structure rarely serves satisfactorily very long due to its inherent potential for conflict and coordination problems between domestic and foreign operations.

Firms then switch to one of the two structures as follows:

A worldwide area structure - tends to be favored by firms with low degree of diversification and a domestic structure based on function. Each area tends to be self-contained and largely autonomous entity. Strategic decisions are typically decentralized. The strength of this structure is that it facilitates local responsiveness. The weakness is that it encourages fragmentation of the organization into highly autonomous entities.

A worldwide product division structure tends to be adopted by firms that are reasonably diversified. Each division is self contained and largely autonomous. This structure facilitates the transfer of core competencies within a division's worldwide operations. The weakness is the limited voice it gives to the area or country managers (seen as subservient to product division managers).

Since neither of the above structures achieves a balance between local responsiveness and achievement of location and experience curve economies, many multinational adopt matrix-type structures. However, global matrix structures have typically failed to work well because of bureaucratic problems.

INTEGRATING MECHANISMS

Firms use integrating mechanisms to help achieve coordination between subunits. The need for integrating mechanisms and coordination varies systematically with the firm strategy. This need is lowest in Multidomestic companies, higher in international companies, higher still in global companies, and highest in transnational. Integration is inhibited by a number of impediments to coordination, particularly by different subunit orientations such as differences of opinion between production group and the marketing group.

There are two ways integration can be achieved - formal and informal integrating mechanisms. Formal integrating mechanisms vary in complexity from direct contact to liaison roles, to teams, to a matrix structure. The drawback is these mechanisms can often be very bureaucratic.

Formal Integrating Mechanisms

To overcome bureaucracy, firms often use informal mechanisms, which include management networks and organization culture. For a network to function effectively, it must embrace as many managers within the organization as possible. Information systems and management development policies (such as job rotations and management education programs) can be used to establish firmwide networks. For a network to function properly, subunit managers must be committed to the same goals. One way of achieving this is to foster the development of a common organization culture such as leadership by example, management development programs, and human relations policies.

CONTROL SYSTEMS

A major task of the headquarters or firm's leadership is to control the various subunits to ensure their actions are consistent with the firm's overall strategic and financial objectives. Firms achieve this with various control systems. Four main types of control systems are used in multinational firms:

Personal controls: control by personal contact with subordinates such as direct supervision of subordinate's actions.
Bureaucratic controls: control through a system of rules and procedures that direct the actions of subunits such as budgets and capital spending rules.
Output controls: setting goals for subunits to achieve in terms of profitability, productivity, growth, market share, and quality, and then judging the performance of subunit management by their ability to achieve the goals.
Cultural controls: exists when employees "buy into" the norms and value systems of the firm. A firm with a strong culture, self-control can reduce the need for other control systems.

The key to understanding the relationship between international strategy and control systems is the concept of performance ambiguity, which is a function of the degree of interdependence of subunits and it raises the costs of control. The degree of subunit interdependence, and hence performance ambiguity and costs of control, is a function of firm's strategy.

Strategy	Interdependence	Performance Ambiguity	Costs of Control
Multidomestic	Low	Low	Low
International	Moderate	Moderate	Moderate
Global	High	High	High
Transnational	Very High	Very High	Very High

Synthesis - Strategy and Structure

Structure and Controls	Multidomestic	International	Global	Transnational
Vertical Differentiation	Decentralized	Core competency centralized; rest decentralized	Some centralized	Mixed - centralization & decentralization
Horizontal Differentiation	Worldwide area structure	Worldwide product division	Worldwide product division	Informal matrix
Need for coordination	Low	Moderate	High	Very High
Integrating mechanisms	None	Few	Many	Very many
Performance Ambiguity	Low	Moderate	High	Very High
Need for cultural controls	Low	Moderate	High	Very High

Ch. 14 Modes of Entry

Advantages Disadvantages

Exporting	1. Avoids setup costs 2. Location / experience curve economies	1. High transport costs 2. Trade barriers & NTBs 3. Problems w/ local agents 4. No arbitrage
Turnkey Projects	1. Greater returns from process technology in FDI restricted countries 2. Avoids exposure to political / economic risks abroad	1. Gives up competitive advantage of proprietary technology 2. May create efficient competitors 3. Lack of long-term presence in foreign market
Licensing	1. Low development costs & risks 2. Able to participate in foreign market otherwise closed to FDI 3. Allow others to develop business applications of intellectual property	1. Lack of control over technology 2. Unable to realize location / experience curve economies 3. Unable to exploit leverage from global strategic coordination
Franchising	1. Low development costs & risks 2. Fast global entry	1. Lack of quality control may jeopardize trademark 2. Unable to exploit leverage from global strategic coordination
Joint Ventures	1. Lower costs & risks from sharing 2. Access to local partner’s knowledge 3. Politically more acceptable	1. Lack of control over technology 2. Unable to exploit leverage from global strategic coordination 3. Unable to realize location / experience curve economies
Wholly Owned Subsidiaries	1. Protection of technology 2. Able to engage in global strategic coordination 3. Able to realize location / experience curve economies	1. High costs & risks 2. Harder to manage

Selecting Entry Mode

Technology vs. Management Know-How

If tech know-how is key competitive advantage, don’t license or joint venture

If advantage expected to be only temporary, license for quicker profit-taking

If management know-how is key, use franchise or subsidiary – wholly owned or joint

Pressures for Cost Reduction

If this is main concern, export or wholly owned subsidiary to realize location / experience curve economies. Tighter control over marketing for coordinated global value chain.

Strategic Alliances

- Cooperative agreements between potential or actual competitors

e.g. Boeing & Japan, Eastman Kodak & Canon of Japan, Motorola & Toshiba

Wholly Owned Subsidiaries vs. Strategic Alliances

PRO: 1. Protect strategic advantages

2. Leverage from strategic coordination

3. Realize location / experience curve economies

PRO: 1. Facilitate entry into foreign market

2. Share development costs w/ competitor

3. Bring together complementary skills & assets

4. Help steer industry standards

CON: 1. More costly

2. More risk

3. Harder to manage

CON: 1. Danger of losing technology advantage

2. Risk of "hollowing out" domestic firms

Chapter 15: Exporting, Importing, and Countertrade

Jason Epstein

IMPORTING EXPORT PERFORMANCE

How to export? Many exporters become discouraged or frustrated with the exporting process because they encounter many problems, delays, and pitfalls. It is a difficult challenge. Whereas large multinational enterprises have long been conversant with the steps that must be taken to export successfully, smaller enterprises can find the process intimidating. Among other things, the firm wishing to export must identify foreign market opportunities, avoid a host of unanticipated problems that are often associated with doing business in a foreign market, familiarize itself with the mechanics of export and import financing, learn where it can get financing and export credit insurance, and learn how it should deal with foreign exchange risk.

How does one overcome ignorance?

Collect information! Agencies within the US Department of Commerce provide important documentation, such as the names and addresses of potential foreign market distributors, market surveys, and the sponsoring of international trade events in cities across the country.

Through its network of contacts in potential markets, multilingual employees, and a good knowledge of different business mores and regulations, an export management company (EMC) can help the neophyte exporter to identify opportunities and avoid common pitfalls. Caveat emptor: there is a large variation in the quality of EMCs.

Carefully plan its exporting strategy! For example, focus on one market at a time, initially enter the market on a small scale, recognize the time and managerial commitment involved in building export sales, build relationships with local distributors and/or customers, hire local yokels to help the firm establish itself, and keeping open the option of local production.

EXPORTING AND IMPORTING FINANCING

Firms engaged in international trade have to trust someone they may have never seen, who lives in a different country, who speaks a different language, who abides by, or does not abide by, a different legal system, and who could be very difficult to track down if he or she defaults on an obligation.

What to do? Use a third party, trusted by both, to act as an intermediary.

letter of credit: Issued by a bank at the request of an importer, the letter of credit states the bank will pay a specified sum of money to a beneficiary, normally the exporter, on presentation of particular, specified documents.

e.g. FRG importer W wants to do business with US exporter X. W applies to her local bank, Bank Y, for the issuance of a letter of credit. Y then undertakes a credit check of W. If Y is satisfied with W’s creditworthiness, it will issue a letter of credit (However, Y will charge W a fee, ranging between 0.5 to 2 percent, for the service and may also require a cash deposit.). A financial contract is now in place between X and Y. Y then sends the letter of credit to X’s local bank, Z. Once Z receives the document, it tells X that the merchandise can now be sent. After X ships the goods, she draws a draft against Y in accordance with the terms of the letter of credit, attaches the required documents, and presents the draft to Z for payment. Z then forwards the letter of credit and associated documents to Y. If all the terms and conditions have been met, Y will honor the draft and forward payment to Z. When Z receives the money, it will pay X. Got that?

draft: Also known as a bill of exchange, it is the instrument normally used in international commerce to effect payment. It is simply an order written by an exporter instructing an importer or her agent to pay a specified amount of money at a specified time. Due to the lack of trust in many international transactions, payment or a formal promise to pay is required before the buyer can obtain the merchandise.

bill of lading: Issued to the exporter by the common carrier transporting the merchandise, it acts as a receipt, a contract, and a document of title. As a receipt, it indicates that the carrier has received the goods. As a contract, it specifies that the carrier is obligated to provide a transportation serve in return for a certain charge. As a document of title, it can be used to obtain payment or a written promise of payment before the merchandise is released to the importer. The bill of lading can also function as collateral against which funds may be advanced to the exporter by its local bank before or during shipment and before final payment by the importer.

EXPORT ASSISTANCE

Export-Import Bank: Also referred to as Eximbank, it is an independent US government agency. It provides financing aid that facilitates exports, imports, and the exchange of commodities between the US and other countries.

The Export-Import Bank guarantees repayment of medium- and long-term loans US commercial banks make to foreign borrowers for purchasing US exports. Its guarantee makes the commercial banks more willing to lend cash to foreign enterprises. It also has a direct lending operation under which it lends dollars to foreign borrowers for use in purchasing US exports. In some cases, the Export-Import Bank grants loans that commercial banks would not if it sees a potential benefit to the US in doing so. The foreign borrowers use the loans to pay US suppliers and repay the loan with interest.

export credit insurance: This can be an effective substitute for a letter of credit. Export credit insurance is provided in the US by the Foreign Credit Insurance Association (FCIA), an association of private commercial institutions operating under the guidance of the Export-Import Bank.
COUNTERTRADE

Noncovertibility implies the exporter may not be able to be paid in his or her home currency, and few exporters would desire payment in a currency that is not convertible. Countertrade is increasingly the solution of choice for problems posed by nonconvertibility. One example of modern era countertrade arose when Pepsico agreed to sell cola in the Soviet Union in exchange for Stolichnaya vodka.

barter: This is the direct exchange of goods and/or services between two parties without a cash transaction.

counterpurchase: A reciprocal buying agreement, it occurs when a firm agrees to purchase a certain amount of materials back from a country to which a sale is made.

offset: Having one party agree to purchase goods or services with a specified percentage from the original sale, this party can fulfill the obligation with any firm in the country to which the sale is being made.

switch trading: It occurs when a third-party trading house buys the firm’s counterpurchase credits and sells them to another firm that can make better use of them.

compensation or buybacks: They occur when a firm builds a plant or provides services in a country and agrees to take a certain percentage of the plant’s output as partial payment for the contract.

The principal attraction of countertrade is that it gives a firm a way to finance an export deal when other means are not available. A firm that insists on being paid in hard currency may be at a competitive disadvantage vis-a-vis one that is willing to engage in countertrade.

In contrast, countertrade’s main disadvantage is that the firm may receive unusable or poor quality goods that cannot be disposed of profitably.

Chapter 16

Global Manufacturing and Material Management

Opening Case : Timberland

Intro:

Where in the world should productive activities be located?

How much production should be performed in-house and how much should be out-sourced to foreign supplies?

How best to coordinate a globally dispersed supply chain?

Strategy, Manufacturing, and Material Management

Logistics – refers to the procurement and physical transmission of material through the

supply chain (included in materials management)

Manufacturing & materials management have two important strategic objectives:

1 – lower costs

2 – to simultaneously increase product quality (by eliminated defects)

The firm that improves its quality control will also reduce its costs of value creation:

1 – productivity increase à because time isn’t wasted; manufacturing poor-quality

products they can’t be sold

2 – increase product quality à decrease rework & scrap costs

3 – increase product quality à decrease warranty & rework costs

TQM – Total Quality Management

-main management technique that companies are utilizing to boost product quality

-it’s central focus is the need to improve quality (no defects)

-more supervision/work time; workers feel free to report problems

-training

The growth of international standards has in some cases focused greater attention on the importance of product quality. Ex) Europe & ISO9000

Two other objectives:

1 – manufacturing & materials management must be able to accommodate

demands for local responsiveness (decentralizing manufacturing activities)

2 – respond quickly to shifts in customer demand (time-based competition)

Where to Manufacture

-to achieve twin goals: decrease costs & increase quality

For International Production:

1 – Country Factors:

-political economy, culture, and relative factor costs differ from country to

country

-other country factors that impinge on location decisions include formal &

informal trade barriers, rules, and regulations regarding FDI

-expected future movements in it’s currency’s exchange rate

2 – Technological Factors:

-manufacturing technology

The type of technology a firm uses in its manufacturing can be pivotal in location decisions. Ex) due to technological constraints, it is sometime feasible to perform certain mfg. Activities in only one location to serve the world market.

Three characteristics oaf mfg. Technology:

1 – Fixed Costs: high fixed costs à serve the world from single location

low fixed costs à set up several locations to accommodate demands

for local responsiveness; avoid dependency on any one location

2 – Minimum efficient scale:

-economies of scale à increase output; decrease unit cost

-however, it is well know that beyond a certain level of output, few additional

scale economies are available

Large minimum efficient scale à centralize production

Low minimum efficient scales à produce at several locations (local responsiveness or to

hedge against currency risk)

3 – Flexible manufacturing (lean production ):

-best way to achieve high efficiency, and low unit costs, is through mass

production of a standardized output (the trade off is unit costs vs. product variety)

The term flexible manufacturing technology or lean production as it is often called – covers a range of manufacturing technology that are designed to:

1 – reduce set-up times for equipment

2 – increase utilization of individuals machine through scheduling

3 – increase quality at all stages

Flex manufacturing allows the company to produce a wider variety of end products at a decreased unit cost (may increase efficiency too)

Ex) Toyota

Flexible machine cells: groups of various types of machinery, a common materials

handler, and a centralized cell controller (computer)

contains 4-6 machines of varieties of operations

Improved capacity utilization and reductions in work in progress and waste are major efficiency benefits of flexible machine cells. Ex) GE locomotive operations

-also allows customization of products; increased customer responsiveness

Summary

Few choice locations or single location:

-fixed costs are substantial

-minimum efficient scale of production is high

-flexible manufacturing technologies are available

Many locations:

-fixed costs are low

-minimum efficient scales of production low

-flexible manufacturing technology not available

3 – Product Factors:

Two product features affect locations decisions:

1 – value-to-weight ratio because of transportation costs

ex) electronics à high value-to-weight; shipping is cheap so manufacturing in optimal location to serve the world

-low value-to-weight manufacturing these products in multiple locations

The other product feature that can influence location decisions is universal needs.

Universal needs – same need all over the world ex) electronics, steel

-reduces need for local responsiveness

-concentrate manufacturing at optimal location

-Locating Manufacturing Facilities

-concentration or decentralization

See Table 16.1

The appropriate strategic choice is determined by the various country, technology, and product factors.

Concentration:

1 – differences in factor costs, political economy, and culture have an impact

2 – low trade barriers

3 – stable exchange rates

4 – high fixed costs, high minimum efficiency scale, or flexible manufacturing

technology exists

5 – value-to-weight ratio is high

6 – product serves universal needs

Decentralization:

1 – differences in factor costs, political economy and culture DO NOT have an impact

2 – high trade barriers

3 – volatile exchange rates

4 – low fixed costs, low minimum efficient scales, flexible manufacturing is NOT

available

5 – low value-to-weight

6 – product does not serve universal needs

Make or Buy Decision

Sourcing decisions – whether they should make or buy the component parts that go into

their final product vertically integrate vs. outsourcing

-The Advantages of Make: (vertical integration)

1 – lower Costs: stay in-house if firm is more efficient ex) Boeing wings

2 – Facilitating specialized investments:

The argument is that when one firm must invest in specialized assets to supply another, mutual dependency is created. In such circumstances each party fears the other will abuse the relationship (lack of trust)

In general we can predict that when substantial investments in specialized assets are required to manufacture a component, the firm will prefer to make the component internally.

3 – Proprietary product technology protection:

-a technology unique to a firm which can give them competitive advantage

If the firm contracts out the manufacturing of components containing proprietary technology, it runs the risk that those suppliers will expropriate the technology for their own use or they will sell it to the firm’s competitors

4 – Improved scheduling:

-Weakest argument

That production costs savings result from it because it makes planning, coordination, and scheduling of adjacent processes easier.. Particularly important in firms with just-in-time inventory systems.

-The Advantages of Buy:

Buying component parts from independent suppliers gives the firm greater flexibility, it can help drive down the firm’s cost structure and it may help the firm to capture orders from international customers.

1 – Strategic flexibility:

-switch orders between suppliers as circumstances indicate (ex. Exchange rates or

trade barriers)

-optimal locations

DISADV:

If a supplier perceives the firm will change suppliers in response to changes in

exchange rates and etc., that supplier might not be willing to make specialized

investments in plant and equipment.

2 – Lower Costs:

-outsourcing may lower the firm’s cost structure because vertical integration increases an organization’s scope and organizational complexity can raise a firm’s cost structure:

1 – more subunits for coordinating and controlling (more management)

2 – internal suppliers have a captive customer in the firm, they will lack incentive to reduce costs

3 – integrated firms have to determine appropriate prices for goods transferred to subunits within the firm.

3 – Offsets:

-outsource in other countries to help the firm capture more orders from that country

Tradeoffs:

The benefits of manufacturing components in-house seem to be greatest when highly specialized assets are involved, when vertical integration is necessary for protecting proprietary technology, or when the firm is more efficient

-Strategic Alliances with Suppliers

International businesses have tried to reap some benefits of vertical integration without the associated organizational problems by entering into strategic alliances with key suppliers.

Companies commit themselves to long-term relationships with these suppliers, encouraging the suppliers to undertake specialized investments. (builds trust)

Ex) Toyota in Japan

The trends toward just-in-time systems (JIT), computer-aided design (CAD), and computer-aided manufacturing (CAM) seem to have increased pressures for firms to establish long-term relationships with their suppliers.

Alliances are not all good. A firm may limit its strategic flexibility by the commitments it makes to its alliance partners.

Coordinating a Global Manufacturing System

Materials management – encompasses logistics, embraces the activities necessary to get

materials to a manufacturing facility, through the manufacturing facility, through the manufacturing process, and out through a distribution system to an end user.

-reduce costs and fit customer needs

-The Power of Just-in Time:

-pioneered by Japan ‘50’s & ‘60’s

-economize on inventory holding costs by having materials arrive at a

manufacturing plant just-in-time to enter into production

-saves warehousing & storage costs

-JIT also improves product quality because defects are found instantly instead of

being warehoused for awhile

Drawbacks: leaves a firm without a buffer stock of inventory; should use many suppliers

to avoid shortages

-The Role of Organizations:

-number and complexity of organizational linkages

-legitimize materials management by separating it out as a function and giving it

equal weight in organizational terms.

-centralized solution à material management decisions are made at the corporate

level (but get too complex in large companies)

-advantages of decentralizing is that it allows plant-level material management

groups to develop for interacting with foreign suppliers

-The Role of Information Technology:

-tracking component parts

-EDI electronic data interchange (eliminates paperwork)
Chapter 17 – Global Marketing and R&D

Matt Sullivan

Opening Case: MTV and the Globalization of Teen Culture

Intro:

A global marketing strategy, which reviews the world’s consumers as similar in their tastes and preferences, is consistent with the mass production of a standardized output. By mass production of a standardized output, the firm can realize substantial unit cost reductions from experience curve and other scale economies. On the other hand, ignoring country differences in consumer tastes and preferences can lead to failure.

Marketing and R&D are considered together in this chapter.

A major factor of success for new-product introductions is the closeness of the relationship between marketing and R&D.

The Globalization of Markets?

Theodore Levitt à globalization of world markets à Harvard Business Review

-multinational corporations operate in a number of countries and adjusts its products and practices to each at high cost (Levitt says they are on their way out)

Against Levitt à globalization seems to be the exception rather than the rule (works for basic industrial products)

The continuing persistence of cultural and economic differences between nations acts as a major brake on any trend toward global consumer tastes and preferences.

Product Attributes

A product can be viewed as a bundle of attributes. Products sell well when their attributes match consumer needs.

1 – Cultural Differences:

-social structure, language, religion and education

The most important aspect of a countries’ cultural differences is probably the impact of tradition. Ex) Islamic’s won’t eat hamburger; scent preferences

Tastes and preferences are becoming more cosmopolitan.

2 – Economic Differences:

Firms based in highly developed countries such as the US tend to build a lot of extra performance attributes in their products.

At the same time, for most consumers durable, product reliability may be a more important attribute in less developed nations, where such a purchase may account for a major proportion of a consumer’s income.

Consumers in the most developed countries are often not willing to sacrifice their preferred attributes for lower prices.

3 – Product and Technical Standards:

-national preferences are strong

Differing product standards mandated by governments can rule out mass production and marketing of a standardized product. Ex) Caterpillar

The European Union (EU) is trying to harmonize such divergent product standards among its member nations.

Differences in technical standards also constrain the globalization of markets. Some of these differences result from idiosyncratic decisions made at particular points in history, rather than government actions. Ex) video equipment & VCRs

Distribution Strategy

Typical Distribution System

Manufacturer Manufacturer

Inside country Outside Country

Import Agent

Wholesale Distributor

Retail Distributor

Final Customer

If the firm manufactures its product in the particular country, it can sell directly to the consumer, retailer, or wholesaler. The same options are available a firm outside the country. Alternatively, this firm may decide to sell to an import-agent first.

-Differences between Countries:

1 – Retail Concentration:

In a concentrated system, a few retailers supply most of the market. A fragmented system is one in which there are many retailers, no one of which has a major share of the market.

Differences in concentration are rooted in history and tradition. Ex) US vs. Japan

There is a tendency for greater retail concentration in developed countries due to

1 – increase in car ownership

2 – number of households with refrigerators and freezers

3 – number of two income households

2 – Channel Length:

-refers to the number of intermediaries between the producer and the consumer

The most important determinant of channel length is the degree to which the retail system is fragmented. Fragmented retail systems tend to promote the growth of wholesalers to serve retailers, which lengthens channels.

The more fragmented the retail system, the more expensive it is for a firm to make contact with each individual retailer.

When a retail sector is very concentrated it makes sense for the firm to deal directly with retailers, cutting out wholesalers.

3 – Channel Exclusivity:

-one that is difficult for outsiders to access

ex) getting shelf-space in US supermarket

-Choosing a Distribution Strategy:

Since each intermediary in a channel adds its won markup to the products, there is generally a critical linkage between channel length, the final selling price, and the firm’s profit margin.

To ensure that prices do no get too high due to markup by multiple intermediaries, a firm might be forces to operate with lower profit margins.

The benefits of a longer chain often outweigh the drawbacks of a shorter one.

1 – it economizes on selling costs when the retail sector is fragmented

ex) use longer channels where retail sectors are fragmented and shorter

channels where retail is concentrated.

2 – market access

-the ability to enter an exclusive channel

ex) utilizing import agents because they have better relationships

ex) Apple Computer in Japan

ex) direct mail, catalogs

Communication Strategy

-communicating the attributes of the product to prospective customers

Communication Channels:

-direct selling

-sales promotion

-direct marketing

-advertising

-Barriers to International Communication:

-occurs whenever a firm uses a marketing message to sell its products in another

country

1 – Cultural Barrier:

A message that means one thing in one country man mean something quite different in another ex) Benetton

A firm needs to develop cross-cultural literacy; employ some local input.

Ex) local advertising agency or local sales force

2 – Source Effects:

-occur when the receiver of the message evaluates the message based on the status or image of the sender.

Many international businesses try to counter negative source effects by de-emphasizing their foreign origins. Source effects are not always negative; they may be positive.

3 – Noise Levels:

-noise refers to the amount of other messages competing for a potential

consumer’s attention ex) US, lots of noise

-Push vs. Pull Strategies

push à emphasizes personal selling rather than mass media advertising in the

promotional mix

personal selling requires: intensive use of sales force; costly

pull à depends more on mass media advertising to communicate the marketing message

to consumers

1 – Product type and consumer sophistication:

-pull strategy favored by firms in consumer goods industries that are trying to sell to a large segment of the market

-push strategy is favored by firms that sell industrial products or other complex products

One of the great strengths of direct selling is that it allows the firm to educate potential consumers. (not necessary when product has been used for awhile or where consumers are sophisticated) (used for less sophistication or in developing nations)

2 – Channel Length:

The longer the distribution channel, the more intermediaries there are that must be persuaded to carry the product. (expensive to "push" a product through, so firms "pull" by mass advertising) ex) US channels short

3 – Media availability:

A pull strategy relies on access to advertising media.

Ex) print media (newspaper)

Electronic (radio, TV)

Many developing countries don’t have these media’s. In such cases, a push strategy is more attractive. Media availability is limited by law in some cases. Ex) tobacco & alcohol.

-Push-Pull Mix:

Push strategies tend to be emphasized:

1 – for industrial products/complex new products

2 – short distribution channels

3 – when few print or electronic media are available

Pull Strategies emphasized:

1 – consumer goods

2 – long distribution channels

3 – sufficient print & electronic media are available

-Global Advertising:

-Theodore Levitt

-standardizing advertising worldwide ex) Phillip Morris’ promotion of Marlboro

cigarettes

PROS:

1 – economic advantages

2 – creative talent is scare

3 – many brand names are global (prevent confusion)

CONS:

1 – cultural differences

2 – advertising regulations

Dealing with country differences:

-capture some benefits of global standardization while recognizing differences in

countries’ cultural & legal environments

ex) Pepsi & Tina Turner with rock stars from every country

Polaroid "learn to Speak Polaroid"

-Pricing Strategy:

1 – Price Discrimination:

-exists whenever consumers in different countries are charged different prices for

the same product

-charging whatever the market will bear

Two conditions necessary for profitable price discrimination:

1 – the firm must be able to keep its national markets separate (to avoid arbitrage)

(arbitrage occurs when an individual or business capitalizes on a price

differential for a firm’s product between two countries by purchasing the

products in the country where prices are lower and reselling it in the country

where prices are higher – e.g. car market in Europe)

2 – different price elasticity’s of demand in different countries is required.

The price elasticity of demand is a measure of the responsiveness of demand for a product to changes in price.

Demand is said to be elastic when a small change in price produces a large change in demand.

$

Output

Ex) a firm can charge a higher price in a country where demand is inelastic

-The determinants of demand elasticity:

The elasticity of demand for a product is determined by a number of factors:

1 – Income Level:

-price elasticity tends to be greater (more elastic) in countries with low income

levels because consumers are more price conscious.

2 – Competitive Conditions:

-the more competitors there are, the greater consumer’s bargaining power will be

-a large number of competitors causes high elasticity of demand

-with few competitors, the consumer’s bargaining power is weaker and price is

less important as a competitive weapon

-Profit maximizing under price discrimination:

MR=MC (to max profits) see page 503

-Strategic Pricing:

-these two can result in problems with antidumping regulations

1 – Predatory pricing:

-use of price as a competitive weapon to drive weaker competitors out of a

national market (once the competitors have left the market, firms can raise prices

and enjoy high profits)

-for this to work, a firm must normally have a profitable position in another

national market, which it can use to subsidize aggressive pricing in the market it

is trying to monopolize ex) Japanese markets

2 – Experience curve pricing:

Price comes into the picture, since aggressive pricing is a way to build up accumulated sales volume rapidly and thus move down the experience curve.

-many firms are willing to suffer an initial loss to gain global sales volume.

-Regulatory Influence on Prices:

Firm’s abilities to engage in either price discrimination or strategic pricing may be limited by national or international regulations.

A firm’s freedom to set its own prices is constrained by antidumping regulations and competition policy.

-Antidumping:

Dumping occurs when a firm sells a product for a price that is less than the cost of producing it. Ex) Japanese light trucks in US, 25% duty placed on them

-Competition Policy:

-regulations designed

-promote competition and to restrict monopoly practices

-these regulations can be used to limit the prices a firm can charge in a given

country.

-Configuring the Marketing Mix:

It is rare to find a firm operating in an industry where it can adopt the same marketing mix worldwide ex) McDonalds, Castro Oil

The decision about what to customize and what to standardize, should be driven by a detailed examination of the costs and benefits of doing so for each element.

-New Product Development:

-competition is about technological innovation which shortens the product life

cycles.

An innovation can make established products obsolete or at the same time can make a host of new products possible. "creative destruction"

(requires firms to invest in R&D)

-Location of R&D

The rate of new-product development seems to be greater in countries where:

-more money is spent on R&D

-demand is strong

-consumers are affluent

-competition is intense

R&D discovers new technologies and then commercializes them. Strong demand & affluent consumers create a potential market. Intense competition stimulates innovation.

R&D and marketing need to be closely linked to make a product survive.

Chapter 19 – Accounting In The International Business

Opening Case: Adoption of ‘international Accounting Standards in Germany

Intro: accounting – "the language of business"

International business – faces the lack of consistency in the accounting standards of

Different countries

Country Differences in Accounting Standards

Accounting is shaped by the environment in which it operates. It has evolved in response to the demands for accounting information in that country.

Examples of differences: employee disclosure, goodwill (any advantage) ex) takeovers

Differences make it difficult to compare the financial performance of firms based in different nations.

Although many factors can influence the development of a country’s accounting system, there appear to be five main variables:

1 – relationship between business and the providers of capital

2 – political and economic ties with other countries

3 – level of inflation

4 – level of a country’s economic development

5 – prevailing culture in a country

#1: relationship between business and the providers of capital

There are 3 main external sources of capital for business enterprises:

1 – individual investors

2 – banks

3 – government ex) defense related R&D

The importance of each source varies from country to country. A country’s accounting system tends to reflect the relative importance of these three constituencies as providers of capital.

Ex) US financial accounting system is oriented toward providing individual investors with information they need for making decisions about purchasing/selling corporate stocks and bonds.

In contrast, Japan has a few large banks that satisfy most capital needs so information is transferred through contacts, visits or meetings. Accounting practices are oriented toward protecting a bank’s investment (assets valued conservatively, etc.).

#2: political and economic ties with other countries

ex) US influence on Canada & Mexico à NAFTA

British influence on former colonies

EU à need to conform to each other

#3: level of inflation:

Accounting is based on the historic cost principle. This principle assumes the currency unit used to report financial results is not losing its value due to inflation.

Asset valuation: If inflation is high, the historic cost principle yields an under-estimate of a firm’s assets. One result of this is that depreciation charges based on these underestimates can be inadequate for replacing assets when they wear out or become obsolete.

This principle varies inversely with the level of inflation in a country.

Great Britain’s current cost adjusts all items in a financial statement – assets, liabilities, costs and revenues – to factor out effects of inflation.

#4: level of a country’s economic development:

Accounting in developed countries tends to be far more sophisticated than it is in less developed countries.

#5: prevailing culture in a country:

Using Hofstede cultural typologies, researchers have found that the extent to which a culture is characterized by uncertainty avoidance seems to have a discernible impact upon accounting systems.

Uncertainty avoidance refers to the extent to which different cultures socialized their members into accepting ambiguous situations and tolerating uncertainty.

Countries with low uncertainty avoidance ex) US, Great Britain, cultures tend to have strong independent auditing professions.

-Accounting Clusters:

British – American Dutch group

-large, well developed stock markets

-accounting system tailored to providing information to individuals investors

Europe – Japan group:

-very close ties to banks

-needs gear to banks

South America

-experience persistent, rapid inflation

-adopted inflation accounting principles

National & International Standards

Accounting standards are rules for preparing financial statements; they define what is useful accounting information.

Auditing standards specify the rules for performing an audit - the technical process by which an independent person (the auditor) gathers evidence for determining if a set of financial accounts conforms to required accounting standards and if it is reliable.

-Consequences of the Lack of Comparability:

Growth of global capital markets

-also transnational financing and investment

Transnational financing occurs when a firm based in one country enters another country’s capital market to raise capital from the sale of stocks or bonds. Ex) opening case

Transnational investment occurs when an investor based in one country enters the capital market of another nation to invest in the stocks or bonds of a firm based in that country.

The rapid expansion of transnational financing and investment in recent years has been accompanied by a corresponding growth in transnational financial reporting.

Ex) issue two sets of report to satisfy both investor

The lack of comparability can lead to confusion. (financial position can look significantly different in the two reports) and explain that to investors.

-International Standards:

Substantial efforts have been made in recent years to harmonize accounting standards across countries.

International Accounting Standards Committee (IASC)

-composed of representatives of 106 professional accounting groups in 79 countries

-governed by a 14-member board of representatives from 13 countries plus a rep from

the International Federation of Financial Analysts.

-responsible for formulating international accounting standards

International Federation of Accountants (IFA)

-handles auditing, ethical, educational and public-sector standards

IASC à 1973 for Canada, US, GB

IFA à 1977 for broader issues

The two organizations work closely, but they operate and are funded separately

IASC: To issue a new standard, 75% of the 14 member board must agree (most new

statements provide two acceptable alternatives & compliance is voluntary)

FASB – US Financial Accounting Standards board

-principles for US firms

Some IASC standards have had a significant impact on practices in many other countries because they eliminated a commonly used alternative.

European Union influence:

-harmonize accounting principles of its 15 member countries.

Multinational Consolidation and Currency Translation

-Consolidated Financial Statements:

Many firms find it advantageous to organize themselves as a set of separate legal entities (companies). Multinationals are often required by the countries in which they do business to set up a separate company in each country.

Although the subsidiaries may be separate legal entities, they are not separate economic entities. Economically, all the companies in a corporate group are interdependent.

The purpose of consolidated financial statements is to provide accounting information about a group of companies that recognize their economic interdependence.

Transactions among the members of a corporate family are not included in consolidated financial statements; only assets, liabilities, revenues, and expenses with external third parties.

The process involves adding up the individual assets, liabilities, revenues, and expenses reported on the separate financial statements and then eliminating the intragroup ones.

Preparing consolidated financial statements is becoming the norm for multinational firms. Investors realize that without consolidated financial statement, a multinational firm could conceal losses in an unconsolidated subsidiary, thereby hiding the economic status of the entire group.

-Currency Translation:

-keep records in the currency of the country in which they are located

When a multinational prepares consolidated accounts, it must convert all these financial statements into the currency of its home country. (what exchange rate should be used?)

There are two main methods:

1 – The Current Rate Method:

-the exchange rate at the balance sheet date is used to translate the financial

statements

Although this may seem a logical choice, it is incompatible with the historic cost principle that is generally accepted accounting principle in many countries.

Ex) US company in France à purchase of land à hyper increase in value

2 – The Temporal Method:

-translate assets valued in a foreign currency into the home-country currency using

the exchange rate that exists when the assets are purchased.

Problem: Since various assets are acquired at different times, and since exchange rates seldom remain stable for long, different exchange rates will probably have to be used to translate those foreign assets. Consequently, the balance sheet may not balance.

-Current US practice for dealing with exchange rate gaps

-Statement 52 FASB

Under 52, a foreign subsidiary is classified either as a self-sustaining, autonomous subsidiary or as integral to the activities of the parent company.

(firms pursuing multidomestic and international strategies are most likely to have self-sustaining subsidiaries, whereas firms pursuing global and transnational strategies are most likely to have integral subsidiaries)

The local currency of a self-sustaining foreign subsidiary is to be its functional currency. The balance sheet for such subsidiaries is translated into the home currency using the exchange rate in effect at the end of the firm’s financial year.

The functional currency of an integral subsidiary is to be US$. The financial statements of such subsidiaries are translated at various historic rates using the temporal method.

Accounting Aspects of Control Systems

In the typical firm, the control process is annual and involves three main steps:

1 – head office and subunits management jointly determine subunits goals for the coming year

2 – throughout the year, the head office monitors subunits performance against agreed goals

3 – if a subunits fails to achieve its goals, the head office intervenes in the subunits to learn

Why the shortfall occurred, taking corrective action.

The budget is the main instrument of financial control. Once a budget is agreed to, accounting information systems are then used to collect data throughout the year so a subunits performance can be evaluated against the goals contained in its budget.

Two factors that can complicate the control process in an international business: exchange rate changes and transfer pricing practices.

-Exchange Rate Changes and Control Systems:

Most international businesses require all budgets and performance data within the firm to be expressed in the "corporate currency" which is normally the home currency. This practice facilitates comparisons between subsidiaries in different countries, and it makes things easier for headquarter management. It also allows exchange rate changes during the year to introduce substantial distortions.

Ex) The French subsidiary may fail to achieve profit goals in its budget merely due to the decline in the value of a franc against the dollar.

1 – The Lessard-Lorange Model:

They point out three exchange rates that can be used in the budget-setting process and in the subsequent tracking of performance to translate foreign currencies into corporate currency.

1 – initial rate – the spot exchange rate when the budget is adopted

2 – projected rate – the spot exchange rate forecasted for the end of the budget periods (ex)

the forward rate

3 – ending rate – the spot exchange rate when the budget and performance are being

compared

These three exchange rates imply nine possible combinations. Figure 19.3 pg 556

4 out of the 9 are illogical and unreasonable

With 3 of the 5 combinations – II, PP, and EE, the same exchange rate is used for translating both budget figures and performance figures.

ADV à a change in the exchange rate during the year does not distort the control process

With IE & PE, distortion does exist.

The potential for distortion is greater with IE; the ending spot exchange rate used to evaluate may be different from the initial spot rate used to translate the budget.

The distortion is less serious in the case of PE, since the projected exchange rate takes into account future exchange rate movements.

Of the 5 combos, L&L recommend firms use the projected spot exchange rate to translate both the budget and performance figures into the corporate currency. (may use the foreign exchange market or some company – generated forcast "internal forward rate")

The internal forward rate may differ from the FWD rate quote by the foreign exchange market if the firm wishes to bias its business in favor of, or against, the particular foreign currency.

-Transfer Pricing and Control Systems:

The volume of intrafirm transactions is high. Firms continually ship component parts and finished goods between subsidiaries in different countries.

Transfer price – the price at which goods & services are transferred

When setting budgets and reviewing a subsidiary’s performance, corporate headquarters must keep in mind the distorting effects of transfer prices.

-Separation of Subsidiary and Manager Performance:

Should not compare managers; may compare ROI (return on investment)

The managers evaluation should involve a degree of subjectivity that considers how hostile or beneign the country’s environment is for that business.

Managers should be evaluated in local currency terms after making allowances for those items over which they have no control (ex) interest rates, tax, inflation, transfer prices, exchange rates.

20 – Financial Management in the International Business

Todd Rich

Opening Case: Global Treasury Management at Procter & Gamble

Intro: Included within the scope of financial management are three sets of related decisions:

1 – investment decision – about what activities to finance

2 – financing decision – how to finance those activities

3 – money management – how to manage the firm’s financial resources most efficiently

In an international business investment, financing, and money management decisions are complicated by the fact that countries have different currencies, tax regimes, regulations concerning flow of capital across their borders, norms regarding financing, levels of economic & political risk, etc.

Good financial management can be an important source of competitive advantage.

Value Creation:

P&G and FMC show how good financial management can help the firm both to reduce the costs of creating value and to add value by improving customer service.

Investment Decision

A decision to invest in activities in a given country must consider a large number of economic, political, cultural, and strategic variables.

One role of the financial manager in an international business is to try to quantify the various benefits, costs, & risks that are likely to flow from an investment in a given location.

-Capital Budgeting: the purpose of capital budgeting is to quantify the benefits, costs,

and risks of an investment.

This enables managers to compare different investment alternatives within and across countries so they know where to invest its financial resources.

The firm must fist estimate the cash flows associated with the project over time. Then they must be discounted to determine their net present value using an appropriate discount rate.

So long as the net present value of the discounted cash flow is greater than zero, the firm should go ahead with the project.

Factors complicating the process:

1 – distinction must be made between cash flows to the project or to the parent company

2 – political & economic risk

3 – connection between cash flows to the parent and the source of financing

-Project and Parent Cashflows:

Cash flows to the project are not necessarily the same as cash flows to the parent.

The project may NOT be able to remit all cash flows to the parent company because:

-may be blocked by repatriation by host-country government

-taxed at an unfavorable rate

-host country may require reinvestment with host nation

The parent should be interested in what it can receive and not the cash flow from the project.

A move to free market economies ease this some.

-Adjusting for Political and Economic Risk:

Political Risk: likelihood that political forces will cause drastic change in a country’s

business environment

-political changes may result in expropriation of the assets of foreign firms

-social unrest may also result in economic collapse

-increased taxes

-exchange controls

Forecasting political risk is difficult.

Economic Risk:

-likelihood that economic mismanagement will cause drastic changes in a

country’s business environment

-inflation (biggest problem)

-depreciation on the foreign exchange market

In the long-run, there is a relationship between a country’s relative inflation rates and changes in its currency’s exchange rates.

Rick and Capital Budgeting:

The additional risk that stems from its location can be handled by:

1 – treat all risk as a single problem by increasing the discount rate applicable

(the higher the discount rate, the higher the projected net cash flows must be)

widely used; but critics argue it penalized early cash flows too heavily

2 – revise future cash flows from the project downward to reflect possible adverse

changes in distant future.

future cash flows several years out should be revised downward to reflect higher risk

(popular also)

Financing Decisions

1 – Source of Financing:

-if seeking external financing for a project, it will want to borrow funds from the

lowest-cost source of capital available (host country vs. elsewhere)

By size & liquidity, the global capital markets costs of capital is typically lower than in many domestic capital markets. However, host-country restrictions may rule out that option.

In countries where liquidity is limited, this raises the cost of capital. A discount rate would be adjusted upwards to reflect this. Some governments offer low-interest loans so the discount rate should be revised downward.

May consider local debt financing when local currency is expected to depreciate on the foreign exchange market. If foreign debt obligations must be served, the amount of local currency required will increase as the currency depreciates.

Although the initial cost may be greater with local borrowing, it may be better to borrow locally if the currency is expected to depreciate.

2 – Financial Structure:

-mix and debt and equity used to finance a business

-table of debt ratios ex) Japan relies highly on debt

One possible explanation is that different tax regimes determine the relative attractiveness of debt or equity (recent study show this is not true)

May be reflecting deep-seated cultural norms. (not yet explained)

The interesting question for international businesses is whether is should conform to local norms.

Good arguments for conforming:

-management can more easily compare to local competitors

-can improve the image of foreign affiliates and appear sensitive to local

monetary policy

The best recommendation is that an international business should adopt a financial structure that minimizes its costs of capital.

Global Money Management: The Efficiency Objective

Money management – decisions attempt to manage the firm’s global cash resources –its working capital – most efficiently

Essentially this involves:

Minimizing Cash Balances:

For any given period a firm must hold certain cash balances for serving any accounts and notes payable or unexpected demands for cash. If is invests its cash balance in money market accounts, it will have unlimited liquidity but earn a relatively low rate of interest. If is invests in long-term, interest rate increase, but liquidity will be limited. The firm will want to minimalize liquid cash balances.

2 – Reducing Transaction Costs:

-the cost of exchange

transfer fee – moving cash from one location to another

-cost of intrafirm transactions can be substantial

-should use multilateral netting to reduce the number of transactions

Global Money Management: The Tax Objective

Different countries have different tax regimes.

Many nations follow the worldwide principle that they have the right to tax income earned outside their boundaries by entities based in their country. Resulting in double taxation. However, double taxation is to some extent mitigated by tax credits, tax treaties, and the deferral principle.

Tax credit – allows an entity to reduce the taxes paid to the home government by the

amount of taxes paid to a foreign government

Tax treaty – between two countries is an agreement specifying what items of income will

be taxed by the authorities of the country where the income is earned.

Deferral principle – specifies that parent companies are not taxed on foreign source

income until they actually receive a dividend

The form in which income is remitted from a foreign subsidiary to the parent company can be structured to minimize the firm’s global tax liability.

Tax haven – minimize tax liability ex) Bahamas, Bermuda

a country with exceptionally low, or even no income tax and can be use to avoid or defer income taxes.

They do this by establishing a 100% owned, nonoperating subsidiary in the tax haven

US regulations won’t allow this

Moving Money across Borders: Attaining Efficiencies and Reducing Taxes

Unbundling – relying on more than one technique to transfer funds across borders

A firm’s ability to select a particular policy is severely limited when a foreign subsidiary is partly owned either by a local joint-venture partner or by local stockholders.

Various means for moving liquid funds from location to location:

1 – Dividend Remittance:

-Payments of dividend most common

-Depends on such factors as tax regulations, foreign exchange risk, age of

Subsidiary, local equity participation

2 – Royalty Payment and Fees:

royalties – represent the renumeration paid to the owners of technical , patents, or trade

names

common for a parent to charge subsidiaries for this (fixed amount/unit)

fee – compensation for professional services or expertise supplied to a subsidiary

(fixed charges)

Royalties and fees have certain tax advantages; often tax deductible locally. Local income taxes must be paid before dividend distribution.

3 – Transfer Prices:

-particularly likely in firms pursuing global and transnational strategies

-price at which goods & services are transferred

Transfer prices can be used to position funds within an international business.

ex) by setting high or low transfer prices

-transfers may occur between different subsidiaries or between the parent and subsidiary

Benefits of manipulating transfer prices:

1 – reduce tax liability by shifting to a low-tax area

2 – move funds out before a devaluation; reducing foreign exchange risk

3 – to avoid restriction by host countries

4 – to reduce import duties

Problems with transfer pricing:

-Few governments favorably dispose to is

-Restrictive legislation has been passed on this

-Management incentive and performance evaluation of comparing subsidiaries

Opportunity for price manipulation is much greater with cost-based transfer pricing methods.

Ethical Dilema:

Although a firm may be able to manipulate transfer prices to avoid taxes or to circumvent government restrictions, this does not mean it should do so.

4 – Fronting Loans:

-a loan between a parent and its subsidiary channeled through financial intermediary, usually a large international bank

In a direct intrafirm loan, the parent lends cash directly to the subsidiary. In a fronting loan, the parent deposits funds in a bank and the bank lends the same amount to the subsidiary.

From the bank perspective, the loan is risk-free and they make money by paying the parent lower interest rates than it collects from the subsidiary.

Firms use fronting loans for two reasons:

1 – can circumvent host-country government restrictions on the remittance of funds

form a subsidiary to the parent (high political turmoil)

2 – can provide tax advantages (by utilizing a safe haven)

Techniques for Global Money Management

Money management techniques firms use to manage global cash resources efficiently:

Centralized Depositories:

Every business needs to hold some cash. The critical issue for an international business is whether each of its foreign subsidiaries should hold its own cash or whether balances should be held at a centralized depository.

Firms prefer to hold cash balances at a centralized depository for three reasons.

1 – able to deposit larger amount to earn a higher interest rate

2 – more access to information about good short-term investments if located at a major

financial center (better investment decisions)

3 – by pooling cash reserves, the firm can reduce the total size of the cash pool it must

hold (which allows firms to invest more long-term)

The firm’s ability to establish a centralized depository can be limited by government-imposed restrictions on capital flow across borders.

Also the transaction costs of moving money into and out of different countries can limit the advantage of such a system.

Despite this, many firms hold at least their subsidiary’s precautionary cash reserves at a centralized depository while subsidiaries hold day-to-day needs cash.

2 – Multilateral Netting

-allows a multinational firm to reduce the transaction costs that arise when a large number of transactions occur between subsidiaries in the normal course of business.

Netting reduces transaction costs by reducing the number of transactions that occur.

Bilateral netting: Mexico owes France $6M

France owes Mexico $4M

One transaction of $2 M would then be made

Multilateral netting: payment schedule set up at the end of each month to minimize

transactions and value of payments

Managing Foreign Exchange Risk

Various strategies international businesses use to manage their foreign exchange risk.

Types of Foreign Exchange Exposure:

-the risk that future changes in a country’s exchange rate will hurt them

1 – Transaction Exposure:

-the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values (short term)

Such exposure includes obligations for purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies.

2 – Translation Exposure:

-The impact of currency exchange rate changes on the reported consolidated results and balance sheet of a company.

Translation exposure is basically concerned with the present measurement of past events. The resulting accounting gains or losses are said to be unrealized – "paper" gains or losses, but not to say it is not important.

3 – Economic Exposure:

-the extent to which a firm’s future international business earning power is affected by changes in the exchange rate; concerned with long-run effect of changes in exchange rates on future prices, sales, and costs.

Tactics and Strategies for Reducing Foreign Exchange Risk:

-Reducing transaction and translation exposure:

-primarily to protect short-term cash flows from adverse changes in exchange

rates ex) buying forward and currency swaps

1 – Leading and lagging payable and receivables, that is, collecting and paying early or late depending on expected exchange rate movements

lead strategy – attempting to collect foreign currency receivables early if depreciation is

expected on paying before they are due when appreciation is expected.

Lag strategy – delaying collection or delaying payables

Leading and lagging involve accelerating payments from weak-currency to strong-currency countries and delaying inflows from strong currency to weak currency countries. Firms do not always have bargaining power to implement these strategies. The government may also impose limits.

Several other factors:

1 – transfer prices can be manipulated to move funds out of a country where

Depreciation is expected

2 – local debt financing can help hedging

3 – accelerate dividend payment from weak currencies

4 – capital budgeting technique

-Reducing economic exposure:

The key to reducing economic exposure is to distribute the firm’s productive assets to various locations around the globe so the firm’s long-term financial well-being is not severely affected by adverse changes in exchange rates. Ex) Japanese auto firms

Reducing economic exposure requires firm’s to ensure its assets are not too concentrated

-Developing Policies for Managing Foreign Exchange Exposure:

1 – central control of exposure is needed to protect resources efficiently and ensure that

each subunit adopts the correct mix of tactics and strategies (in-house foreign

exchange centers)

2 – A need to distinguish between transaction and translation exposure and economic exposure. Many don’t focus on economic exposure.

3 – the need to forecast future exchange rate movements cannot be overstated, this is

tricky business

4 – need to establish good reporting systems so the central finance function can monitor

the firm’s exposure position on a regular basis.

5 – firms should produce monthly foreign exchange exposure reports

Absolute advantage/Comparative advantage problem (Fastbacks and Igloos)

Production Units

Used

Goods Produced –

US

Goods Produced – Greenland

Igloos

Fastbacks

Igloos

Fastbacks

Igloos

Fastbacks

5

0

30

0

10

0

4

1

24

4

8

0.5

3

2

18

8

6

1.0

2

3

12

12

4

1.5

1

4

6

16

2

2.0

0

5

0

20

0

2.5

US Productivity – Igloos = Number of Igloos Produced = 30 = 6 Igloos per Unit

Number of Units Used 5

Greenland Productivity – Igloos = 10 = 2 Igloos per Unit

5

US has absolute advantage in Igloos - 6 Igloos per Unit : 2 Igloos per Unit or 3 : 1

US Productivity – Fastbacks = Number of Fastbacks Produced = 20 = 4 Fastbacks per

Number of Units Used 5 Unit

Greenland Productivity –Fastbacks = 2.5 = 0.5 Fastbacks per Unit

5

US has absolute advantage in Fastbacks - 4 Fastbacks per Unit : 0.5 Fastbacks per

Unit

Or 8 : 1

US has greatest comparative advantage in Fastbacks (8 : 1 vs. 3 : 1)

Pricing

In US

In Greenland

Cost of a Fastback
6 igloos = 1.5 igloos

4 FBs FB
2 igloos = 4 igloos

0.5 FBs FB

Cost of an igloo
4 FBs = 0.67 FBs

6 igloos igloo
0.5 FBs = 0.25 FBs

2 igloos igloo

Therefore, the price range of a Fastback traded between the US and Greenland would have to be between 1.5 and 4 igloos and the price of an igloo traded between the US and Greenland would have to be between 0.25 and 0.67 FBs.

Interest Rate Parity
Important Equation : F – S x 12 x 100 = Difference in inflation rates

S n

(Always use direct rate with this equation)

Direct Exchange Rate (in US) = $ / Foreign Currency = Indirect Exchange Rate (in Foreign country)

Indirect Exchange Rate (in US) = Foreign Currency / $ = Direct Exchange Rate (in Foreign country)

Where F = Forward rate of exchange

S = Spot rate of exchange

n = number of months

Def.: Difference in national interest rates should be equal to, but with opposite sign, the currency forward rate discount or premium.

Usefulness: If forward rate does not equal difference in interest rates you have an arbitrage opportunity.

Problem 9-1
Germany United States

Interest rates : 4% 7%

Inflation rates : 2% 5%

Spot exchange rate : DM1.4 / $1

NOTE: Because of higher interest (and inflation) rates, US currency should devalue with respect to mark (i.e. fewer DMs per $) [International Fisher Effect]

Find : Forward exchange rate (F) in one year

F – S x 12 x 100 = Diff in inflation rates

S n

F – 1.4 x 12 x 100 = - 3% ; F – 1.4 = 3% x 1.4 ; F = 1.4 + (3% x 1.4 )

12 100 100

F = 1.4 - .042 = DM1.358 / $1

Three Way Arbitrage
You need to exploit cross rates

You hold DM1,000,000

Spot rate in Germany: 3.09FFr/DM

Spot rates in NY: 2.1336DM/$ and 6.6525FFr/$

Calculate cross rate in NY: 6.6525FFr/$ = 3.118FFr/DM

2.1336DM/$

There is a difference between the NY cross rate and the German spot rate

Therefore you buy 3,118,000FFr in NY for 1,000,000DM and

sell 3,090,000FFr in Germany for 1,000,000DM

Profit = 3,118,000FFr - 3,090,000FFr = 28,000FFr or $4,209

Covered Interest Arbitrage

Problem from notes
Spot rate = $2.20 / £1

91 day Forward rate = $2.178 / £1

UK 91 day int rate = 4.25%

US 91 day int rate = 3.00%

You are due to roll over a $2,200,000 T-Bill

Alternatives :

Roll it over Attempt Arbitrage

Have $2,200,000 Have $2,200,000

Roll over at 3% Use to buy £1,000,000

Gain $66,000 Sell forward 1.0425 x £1,000,000

End with $2,266,000 (£1,042,500)

Invest £1,000,000 in UK at 4.25%

Gain £ 42,500

Receive from forward sale

$2.178 x £1,042,500

$2,270,565

Net gain $2,270,565 – 2,266,000 =

$4,565

NOTE: Be very careful to be aware of the currency you’re dealing with at each step

Kogut Model
Why MNEs dominate domestic enterprises: They develop operational flexibility

Operational flexibility includes both arbitrage and leverage opportunities

Arbitrage opportunities:

Financial Market arbitrage

Production shifting arbitrage

Tax minimization arbitrage

Information arbitrage (knowledge)

Regulatory system arbitrage (not originally part of Kogut’s model)

Leverage opportunities

Political leverage

Global coordination leverage (to support competitive pushes into other markets)

Production Units Used		Goods Produced – US		Goods Produced – Greenland
Igloos	Fastbacks	Igloos	Fastbacks	Igloos	Fastbacks
5	0	30	0	10	0
4	1	24	4	8	0.5
3	2	18	8	6	1.0
2	3	12	12	4	1.5
1	4	6	16	2	2.0
0	5	0	20	0	2.5

	In US	In Greenland
Cost of a Fastback	6 igloos = 1.5 igloos 4 FBs FB	2 igloos = 4 igloos 0.5 FBs FB
Cost of an igloo	4 FBs = 0.67 FBs 6 igloos igloo	0.5 FBs = 0.25 FBs 2 igloos igloo