International business MGCR 382 : combined textbook 9781323697542, 1323697543

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International Business MGCR 382 Combined Textbook Table of Contents 1. International Trade and Investment – Page 2 2. Trade Protectionism (Governmental Influence on Trade) – Page 34 3. The Instruments of Trade Policy – Page 58 4. Multinational Financial Management: Opportunities and Challenges – Page 89 5. The International Monetary System - Page 110 6. The Balance of Payments – Page 138 7. International Parity Conditions – Page 166 8. Foreign Exchange Rate Determination – Page 197 9. International Business and Globalization – Page 225 10. Forms and Ownership of Foreign Production (Direct Investment and Collaborative Strategies) – Page 249 11. Culture (The Cultural Environments Facing Business) – Page 278 12. Governmental and Legal Systems (The Political and Legal Environments Facing Business) – Page 310 13. Strategies for International Business – Page 346 14. The Organization and Governance of Foreign Operations (The Organization of International Business) – Page 380 15. Ethics and Social Responsibility (Globalization and Society) – Page 414 16. Wal-Mart Case – Page 437

Part 2 The International Environment

Chapter 6

John Warburton-Lee Photography/Alamy

International Trade and Investment

After studying this chapter, you should be able to: 1. Understand the motivation for international trade. 2. Summarize and discuss the differences among the classical country-based theories of international trade. 3. Use the modern firm-based theories of international trade to describe global strategies adopted by businesses. 4. Describe and categorize the different forms of international investment. 5. Explain the reasons for foreign direct investment. 6. Summarize how supply, demand, and political factors influence foreign direct investment.

MyManagementLab® Improve Your Grade! More than 10 million students improved their results using the Pearson MyLabs. Visit mymanagementlab.com for simulations, tutorials, and end-of-chapter problems.

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Trade Is Blossoming

D

id you ever wonder where those red roses you gave or ­received on Valentine’s Day came from? If you are a North American, they probably were grown on a mountainside in Colombia or Ecuador. If you are European, they might have come from Ethiopia or Kenya. And if you are Asian, their origin may be Kunming, a city in the rural province of Yunnan, China. Although most r­ecipients of floral bouquets give little thought to where their b­ eautiful blooms are grown, they are beneficiaries of the ­blossoming ­international trade in flowers and plants. Once the domain of small ­mom-and-pop growers focused on serving ­local markets, the globalization of the floriculture ­industry is driven by the forces we discussed in Chapter 1: ­technological change, trade liberalization, the desire to leverage core c­ompetencies, and the need to respond to new competitors. The supply chains and t­echnology needed to bring fresh cut roses or mums to a loved one are no less sophisticated than those used by ­high-tech manufacturers of smartphones, personal computers, and ­big-screen TVs. The Netherlands has long been the center of the international commercial flower industry. Dutch farmers began to use greenhouses to grow fruits, flowers, and vegetables during medieval times. Its universities, growers, and floral research c­ enters have been leaders for centuries in developing new breeds of plants. The Dutch remain the most important ­exporters of flowers and plants, with about 65 percent of the world e­ xport market. Much of the country’s prominence is attributable to FloraHolland, the most important flower auctioneer in the world. Structured as a cooperative owned by its 5,000 members (primarily growers), FloraHolland was created in 2008 through the merger of six of the country’s flower auction markets, the largest of which was Aalsmeer (near Schipol Airport), followed by Naaldwijk and Rijnsburg. In 2011, FloraHolland auctioned more than 12.5 billion plants and flowers worth €4.2 billion. Cut flowers accounted for about 57 percent of these revenues. Not surprisingly, roses were the most important flower, with auction sales valued at €761 m ­ illion, followed by chrysanthemums and tulips. Most of its cut flowers are destined for European Union (EU) m ­ arkets; potted plants and bulbs, being less fragile, have a wider ­market. For example, the U.S. market absorbs about a q­ uarter of Dutch bulb exports. Such statistics, however, do not tell the whole story of FloraHolland’s significance. Its large trading volumes have ­allowed it to create a futures market in tulips, roses, and other flowers. By purchasing a flower future, large flower wholesalers can advertise and market flowers for delivery to their clients

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over the coming months without fear that unexpected changes in flower prices might wipe out their profits when they actually take delivery and pay for the flowers. The availability of flower futures attracts more buyers and sellers to the FloraHolland exchanges, thus increasing their transaction volumes and the liquidity of the market. To expand its influence beyond the regional market, the flower exchange has integrated e-commerce into its auction system. Now buyers from Germany, France, and other European countries can monitor tulip, rose, and chrysanthemum a­ uctions from their home computers without having to travel to Aalsmeer. The auction’s website can also be used to place orders. By ­melding new technologies with its traditional auction methods, FloraHolland is ensuring that it will continue to play a critical role in the international flower market. These adaptations are important, because Dutch growers face high labor and land costs, which have created opportunities for growers in other countries. Colombian farmers have benefited from their lower costs, geographic location, and ­favorable climates to become the primary source of cut flowers to the North American market, accounting for more than half of the flowers imported by U.S. flower wholesalers and retailers. Neighboring Ecuador specializes in roses, which its climate favors. Kenya and Ethiopia are becoming important providers for the European market. China—particulary the city of Kunming in Yunnan province—is growing as a supplier to the Asian market. The Chinese government has encouraged the growth of the industry through low interest loans on greenhouses and refrigerated trucks. Dutch, Korean, and Japanese companies have started to invest in the area, believing it provides a lower cost source of flowers for the Asian market. The domestic Chinese market is also expanding rapidly, in line with the growth of the country’s middle class. The growing international trade in flowers and plants has impacted other industries. The airline industry has been quick to adapt to the changing needs of the floricultural industry. Flowers are perishable, so the reliability of scheduled air service is critical to the buyers’ needs. Moreover, most passenger carriers have unused cargo space after accommodating travelers’ baggage. Flowers also have a high value-to-weight ratio and are packed in small boxes that easily fit into the cargo hold of a modern jet airliner. And once the flowers arrive at their destination airport, specialized transporters are needed to ensure that flowers are kept refrigerated from the airport to the wholesaler or retailer, creating new opportunities for innovative trucking companies and providers of logistics services to prosper.1  n

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178    Part 2  • The INTERNATIONAL ENVIRONMENT

FloraHolland and its members are prime examples of the firms throughout the world who have used technology, knowledge, and the resources at their disposal to compete successfully in the global marketplace. In this chapter we analyze the underlying economic forces that shape and structure the international business transactions conducted by firms in the f­loriculture ­industry and in thousands of other industries. We discuss the major theories that explain and predict ­international trade and investment activity. These theories help firms sharpen their global ­business strategies, identify promising export and investment ­opportunities, and react to threats posed by foreign competitors. As they introduce you to the economic environment in which firms compete, the theories help you understand why Dutch floriculture firms, ­despite their high labor costs, have proved to be so successful in international markets.

International Trade and the World Economy Trade is the voluntary exchange of goods, services, assets, or money between one person or organization and another. Because it is voluntary, both parties to the transaction must believe they will gain from the exchange or else they would not complete it. International trade is trade between residents of two countries. The residents may be individuals, firms, not-for-profit ­organizations, or other forms of associations. Why does international trade occur? The answer follows directly from our definition of trade: Both parties to the transaction, who happen to reside in two different countries, believe they benefit from the voluntary exchange. Behind this simple truth lies much economic theory, business practice, government policy, and international conflict—topics we cover in this and the next four chapters. As Figure 6.1 indicates, world trade has grown dramatically in the more than h­ alf-century since the end of World War II. Total international merchandise trade in 2012 was $18.4 ­trillion, or approximately 26 percent of the world’s $71.7 trillion gross domestic product (GDP); trade in services that year amounted to $4.4 trillion. The EU, the United States, Canada, and Japan accounted for 46.8 percent of the world’s merchandise exports (see Figure 6.2); China, Figure 6.1 The Growth of World Exports since 1950





Source: Based on data from International Monetary Fund Supplement on Trade Statistics (International Monetary Fund, Washington, DC: 1990); World Trade Organization website (www.wto.org), June 2013.



Billions of U.S. dollars



Goods Services













19 5 19 0 50 19 5 19 2 54 19 5 19 6 58 19 6 19 0 6 19 2 6 19 4 6 19 6 6 19 8 7 19 0 7 19 2 7 19 4 7 19 6 7 19 8 8 19 0 8 19 2 8 19 4 8 19 6 8 19 8 9 19 0 9 19 2 9 19 4 9 19 6 98 20 0 20 0 0 20 2 0 20 4 2006 0 20 8 1 20 0 12



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Figure 6.2 Source of the World’s Merchandise Exports, 2012 Source: Based on data from World Trade Organization (www.wto.org), April 2013.

United States 8.4% Canada 2.5% European Union 31.5% Other countries 42.1%

China 11.1%

Japan 4.4%

11.1  ­percent; and other countries, 42.1 percent. Such international trade has important direct and ­indirect effects on national economies. On the one hand, exports spark additional economic ­activity in the domestic economy. Consider a leading exporter like Caterpillar. Its $22.8 ­billion in exports generates orders for its U.S. suppliers, wages for its U.S. workers, and dividend ­payments for its U.S. shareholders, all of which then create income for local automobile dealers, grocery stores, and others, which in turn add to their own payrolls. On the other hand, imports can pressure domestic suppliers to cut their prices and improve their competitiveness. Failure to respond to foreign competition may lead to closed factories and unemployed workers. Because of the obvious significance of international trade to businesses, consumers, and workers, scholars have attempted to develop theories to explain and predict the forces that ­motivate such trade. Governments use these theories when they design policies they hope will benefit their countries’ industries and citizens. Managers use them to identify promising markets and profitable internationalization strategies.

In Practice Trade benefits both parties to the transactions. If not, why would each agree to the deal? International trade in goods and services has grown rapidly in the past three decades. For further consideration: how does international trade affect your standard of living? ● ●

Classical Country-Based Trade Theories The first theories of international trade developed with the rise of the great European ­nation-states during the sixteenth century. Not surprisingly, these early theories focused on the individual ­country in examining patterns of exports and imports. As we discuss in more detail later in this chapter, these country-based theories are particularly useful for describing trade in ­commodities— standardized, undifferentiated goods such as oil, sugar, or lumber that are t­ypically bought on the basis of price rather than brand name. However, as multinational c­ orporations (MNCs) rose to power in the middle of the twentieth century, scholars shifted their attention to the firm’s role in promoting international trade. The firm-based theories developed after World War II are ­useful in describing patterns of trade in differentiated goods—those such as automobiles, consumer electronics, and personal care products, for which brand name is an important component of the customer’s purchase decision. In this section, we examine the classical country-based theories of international trade; in the next section, we explore the more modern firm-based theories.

Mercantilism Mercantilism is a sixteenth-century economic philosophy that maintains that a country’s wealth is measured by its holdings of gold and silver. According to mercantilists, a country’s goal should be to enlarge these holdings by promoting exports and discouraging imports. The logic was transparent to sixteenth-century policymakers: If foreigners buy more goods from you

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than you buy from them, then the foreigners have to pay you the difference in gold and silver, enabling you to amass more treasure. Mercantilist terminology is still used today, for e­ xample, when television commentators and newspaper headlines report that a country suffered an ­“unfavorable” balance of trade—that is, its exports were less than its imports. At the time mercantilism seemed to be sound economic policy. Large gold and silver ­holdings meant the reigning monarchs could afford to hire armies to fight other countries and thereby ­expand their realms. Politically, mercantilism was popular with many ­manufacturers and their workers. Export-oriented manufacturers favored mercantilist trade policies, such as those ­establishing subsidies or tax rebates, which stimulated sales to foreigners. Domestic ­manufacturers threatened by foreign imports endorsed mercantilist trade policies, such as those imposing tariffs or quotas, which protected the manufacturers from foreign competition. These businesses, their workers, their suppliers, and the local politicians representing the communities in which the manufacturers had production facilities all praised the wisdom of the monarchs’ mercantilist policies. Most members of society, however, are hurt by such policies. Governmental subsidies of the exports of certain industries are paid by taxpayers in the form of higher taxes. Governmental ­import restrictions are paid for by consumers in the form of higher prices because domestic firms face less competition from foreign producers. During the age of imperialism, ­governments often shifted the burden of mercantilist policies onto their colonies. For example, under the Navigation Act of 1660 all European goods imported by the American colonies had to be shipped from Great Britain. The British prohibited colonial firms from exporting certain goods that might compete with those from British factories, such as hats, finished iron goods, and woolens. To ensure adequate supplies of low-cost inputs for British merchants, the British ­required some colonial industries to sell their output only to British firms. This output included rice, tobacco, and naval stores (forest products used in shipbuilding).2 This particular ­mercantilist strategy ­ultimately backfired—it contributed to the grievances that led to the overthrow of the British Crown in the American colonies. Because mercantilism does benefit certain members of society, mercantilist policies are still politically attractive to some firms and their workers. Modern supporters of such policies, called neomercantilists or protectionists, include such diverse U.S. groups as the American Federation of Labor–Congress of Industrial Organizations, textile manufacturers, steel companies, sugar growers, and peanut farmers. Protectionist attitudes are not limited to the United States. North Americans and Europeans have long complained that Japan limits the access of foreign goods to its market. For instance, it took 40 years of negotiations before Japan grudgingly agreed in the 1990s to allow the ­importation of foreign rice, and even then it limited rice imports to less than 10 percent of its market. Asian and North American firms criticize the Europeans for imposing barriers against imported goods such as beef, bananas, and other agricultural products. Such finger-pointing is amply justified: Nearly every country has adopted some neomercantilist policies to protect key industries in its economy.

Absolute Advantage Neomercantilism has superficial appeal, particularly to patriots who want to strengthen their ­country’s economy. Why should a country not try to maximize its holdings of gold and silver? According to Adam Smith, the Scottish economist who is viewed as the father of free-market ­economics, mercantilism’s basic problem is that it confuses the acquisition of treasure with the ­acquisition of wealth. In An Inquiry into the Nature and Causes of the Wealth of Nations (1776), Smith attacked the intellectual basis of mercantilism and demonstrated that it actually weakens a country because it robs individuals of the ability to trade freely and to benefit from voluntary exchanges. Moreover, in the process of avoiding imports at all costs, a country must squander its resources producing goods it is not suited to produce. The inefficiencies caused by mercantilism ­reduce the wealth of the country as a whole, even though certain special interest groups may benefit. Smith advocated free trade among countries as a means of enlarging a country’s wealth. Free trade enables a country to expand the amount of goods and services available to it by ­specializing in the production of some goods and services and trading for others. But which goods and services should a country export and which should it import? To answer this question, Smith developed the theory of absolute advantage, which suggests that a country should export those goods and services for which it is more productive than other countries are and import those goods and services for which other countries are more productive than it is.

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Table 6.1  The Theory of Absolute Advantage: An Example Output Per Hour of Labor France

Japan

Wine

2

1

Clock radios

3

5

Absolute advantage can be demonstrated through a numerical example. Assume, for the sake of simplicity, that there are only two countries in the world, France and Japan; only two goods, wine and clock radios; and only one factor of production, labor. Table 6.1 shows the output of the two goods per hour of labor for the two countries. In France one hour of labor can produce either two bottles of wine or three clock radios. In Japan one hour of labor can produce either one bottle of wine or five clock radios. France has an absolute advantage in the p­ roduction of wine: One hour of labor produces two bottles in France but only one in Japan. Japan has an absolute advantage in the production of clock radios: One hour of labor produces five clock ­radios in Japan but only three in France. If France and Japan are able to trade with each other, both will be better off. Suppose France agrees to exchange two bottles of wine for four clock radios. Only 1 hour of French labor is needed to produce the two bottles of wine bound for Japan. In return, France will get four clock radios from Japan. These four clock radios would have required 1.33 hours of French labor had France produced them rather than buy them from Japan. By trading with Japan rather than ­producing the clock radios itself, France saves 0.33 hour of labor. France can use this freed-up labor to produce more wine, which in turn can be consumed by French citizens or traded to Japan for more clock radios. By allocating its scarce labor to produce goods for which it is more productive than Japan and then trading them to Japan, France can consume more goods than it could have done in the absence of trade. Japan is similarly better off. Japan uses 0.8 hour of labor to produce the four clock radios to exchange for the two bottles of French wine. Producing the two bottles of wine itself would have required 2 hours of labor. By producing clock radios and then trading them to France, Japan saves 1.2 hours of labor, which can be used to produce more clock radios that the Japanese can consume themselves or trade to France for more wine.

Comparative Advantage The theory of absolute advantage makes intuitive sense. Unfortunately, the theory is flawed. What happens to trade if one country has an absolute advantage in both products? The theory of absolute advantage incorrectly suggests that no trade would occur. David Ricardo, an ­early-nineteenth-century British economist, solved this problem by developing the theory of comparative advantage, which states that a country should produce and export those goods and services for which it is relatively more productive than other countries are and import those goods and services for which other countries are relatively more productive than it is.3 The difference between the two theories is subtle: Absolute advantage looks at absolute ­productivity differences; comparative advantage looks at relative productivity differences. The distinction occurs because comparative advantage incorporates the concept of opportunity cost in determining which good a country should produce. The opportunity cost of a good is the value of what is given up to get the good. Most of us apply the principles of comparative ­advantage and opportunity cost without realizing it. Consider a brain surgeon who is better at both brain surgery and lawn mowing than her neighbor’s teenaged son is. If the surgeon is ­comparatively better at surgery than at lawn mowing, she will spend most of her time at the ­operating table and pay the teenager to mow her lawn. The brain surgeon behaves this way ­because the opportunity cost of mowing the lawn is too high: Time spent mowing is time ­unavailable for surgery. Let us return to the example in Table 6.1 to contrast absolute and comparative advantage. Recall that France has an absolute advantage in wine and Japan has an absolute advantage in clock radios. The theory of absolute advantage says that France should export wine to Japan

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Table 6.2  The Theory of Comparative Advantage: An Example Output Per Hour of Labor France

Japan

Wine

4

1

Clock radios

6

5

and Japan should export clock radios to France. As Table 6.1 shows, France also has a comparative advantage in wine: With 1 hour of labor it produces 2 times as much wine as Japan does but only 0.6 times as many clock radios. Thus, France is relatively more productive in wine. Japan has a ­comparative advantage in clock radios: With 1 hour of labor it produces 1.67 times as many clock radios as France does but only 0.5 times as much wine. So Japan is relatively more ­productive in clock r­ adios. The theory of comparative advantage says that France should export wine to Japan and Japan should export clock radios to France. For the example in Table 6.1, the theory of absolute advantage and the theory of comparative advantage both yield the same outcome. Now let us change the facts. Suppose productivity stays the same in Japan but doubles in France as the result of new job training programs. Table 6.2 shows this new situation. France now can produce four bottles of wine or six clock radios per hour of labor. France now has an absolute advantage in both wine and clock radios: For each hour of labor, France can produce three more bottles of wine (four minus one) or one more clock radio (six minus five) than Japan can. According to the theory of absolute advantage, no trade should occur because France is more productive than Japan in producing both goods. The theory of comparative advantage, on the other hand, indicates that trade should still ­occur. France is 4 times better than Japan is in wine production but only 1.2 times better in clock radio production. (Alternatively, Japan is only 0.25 times as good as France in wine production but 0.83 times as good in clock radio production.) France is comparatively better than Japan in wine production, whereas Japan is comparatively better than France in clock radio production. By the theory of comparative advantage, France should export wine to Japan and Japan should export clock radios to France. If they do so, both will be better off. In the absence of trade, one bottle of wine will sell for 1.5 clock radios in France and for 5 clock radios in Japan. If Japan offers to trade 2 clock radios for one bottle of wine, France will be better off—even though France has an absolute advantage in clock radio production. Without trade, ­sacrificing one bottle of wine domestically would yield France only 1.5 clock radios in increased ­production. With trade, France could get 2 clock radios by giving up one bottle of wine to Japan. France gets more clock radios per bottle of wine given up by trading with Japan than by ­producing the clock radios domestically. Japan also gains. Without trade, Japan has to give up five clock radios to get one more bottle of wine. With trade, Japan has to give up only two clock radios to obtain one more bottle. Japan gets more wine per clock radio given up by trading with France than by producing the wine domestically. Even though France has an absolute advantage in both wine and clock r­ adio ­production, both countries gain from this trade. It is comparative advantage that motivates trade, not absolute advantage. For another insight into comparative advantage and the problems ­inherent in neomercantilism, see “Bringing the World into Focus.”

Comparative Advantage with Money The lesson of the theory of comparative advantage is simple but powerful: You are better off ­specializing in what you do relatively best. Produce (and export) those goods and services you are relatively best able to produce, and buy other goods and services from people who are ­relatively better at producing them than you are. Of course, Tables 6.1 and 6.2 are both simplistic and artificial. The world economy ­produces more than two goods and services and is made up of more than two countries. Barriers to trade may exist, someone must pay to transport goods between markets, and inputs other than labor are necessary to produce goods. Even more important, the world economy uses money as

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degist/Fotolia

Vietnam’s low labor costs, coupled with fertile soil and abundant ­rainfall, grant it a comparative ­advantage in growing rice. Vietnam is the second-largest exporter of rice, after Thailand.

a medium of exchange. Table 6.3 introduces money into our discussion of trade and incorporates the following assumptions: 1. The output per hour of labor in France and Japan for clock radios and wine is as shown in Table 6.2. 2. The hourly wage rate in France is 12 euros (€). 3. The hourly wage rate in Japan is 1,000 yen (¥). 4. One euro is worth 125 yen.

Bringing the World into Focus The Lincoln Fallacy Foreign trade policy has been debated by politicians, pundits, and professors for centuries. Proponents of free trade see little distinction between domestic trade and foreign trade: If the voluntary exchange of goods, services, and assets between two residents of the same country is to be encouraged because it benefits both parties to the transaction, the same logic should hold true for voluntary ­exchanges between a domestic resident and a foreigner. But other groups argue that government policy should favor domestic producers over foreign producers. In their view, foreign trade builds up the economies of foreign countries while weakening the domestic economy. Abraham Lincoln, for example, endorsed this position with his characteristic

c­larity: “I know this much. When we buy goods manufactured abroad, we get the goods and the foreigner gets the money. When we buy goods manufactured at home, we get both the goods and the money.” Although Lincoln’s statements may seem like c­ommon sense to patriots concerned about strengthening their n ­ ation’s economy and ­promoting job opportunities for their fellow c­ itizens, trade experts find his argument misleading and ­incomplete. Lincoln is correct in asserting that buying goods from ­foreign producers sends our money abroad, whereas buying goods from domestic producers keeps our money in our country. What his argument fails to consider is the resources—the factors of (Continued)

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184    Part 2  • The INTERNATIONAL ENVIRONMENT production—needed to create the goods. When we buy goods ­produced domestically, domestic f­actors of production, such as labor, land, and natural resources, must be ­consumed and thus are u ­ navailable for other uses. When we buy goods produced by f­oreigners, foreign ­resources are used, leaving the domestic ­factors of production available to be used for other purposes. That, of course, is the benefit of free trade in the eyes of proponents like Adam Smith and David Ricardo: it allows a country to allocate its domestic resources to produce goods for which the country has a comparative advantage. Thus, a more complete and appropriate analysis would be: “When we buy goods from domestic producers, we (or our countrymen) get the goods and the money, but to do so we have to consume some of our country’s resources that could have been used to make other goods. When we buy goods from foreign producers, we get the goods and we get to keep the resources that would otherwise be needed to produce those goods domestically; the foreigners get our money, but they have to consume their resources to make the goods they sold to us.” If we use those freed resources to specialize in the production of goods for which we have a comparative advantage—and so do our foreign trading partners—both we and our foreign trading partners will have more goods to consume after we engage in international trade.

The gains from specialization and trade are reflected in how most of us spend our daily lives. As producers, we spend our workweek ­specializing in providing a single service, whether it is unclogging a drain as a plumber or writing code as a computer programmer. As c­onsumers, we buy almost everything we consume from other specialists. To obtain food, we trade money for groceries from the ­supermarket; to obtain clothing, we trade money for jeans or shirts from the clothing retailer. It is certainly true that when we purchase our food from the grocer, we get the food and the grocer gets our money, but both of us benefit from this transaction. If we had to grow our own food, we would have to devote more of our time and ­energies to that task and less time to our own productive s­pecialty, be it computer programming or plumbing. Most of us quickly ­determine that our standard of living will be higher if we focus our energies on our productive specialty and then trade for goods and services produced by others. This concept applies to countries as well as i­ndividuals. By specializing in products for which they have a ­comparative advantage and trading freely, countries’ productivity increases and, therefore, their citizens have more to consume and a higher standard of living than they would if trade were restricted by tariffs, quotas, and other barriers.

Table 6.3  The Theory of Comparative Advantage with Money: An Example Cost of Goods in France French Made

Japanese Made

Cost of Goods in Japan French Made

Japanese Made

Wine

€3

€8

¥375

¥1,000

Clock radios

€2

€ 1.6

¥250

¥200

Note: For example, one hour’s worth of French labor can produce four bottles of wine at a total cost of €12 or an average cost of €3 per bottle. At an exchange rate of 125 yen per euro, a bottle of French-made wine will cost ¥375 (375 = 3 × 125).

Given these assumptions, in the absence of trade, a bottle of wine in France costs €3, the equivalent of ¥375, and clock radios cost €2, the equivalent of ¥250. In Japan a bottle of wine costs ¥1,000 (€8), and clock radios cost ¥200 (€1.60). In this case, trade will occur because of the self-interest of individual entrepreneurs (or the ­opportunity to make a profit) in France and Japan. Suppose buyers for Galeries Lafayette, a ­major Paris department store, observe that clock radios cost €2 in France and the equivalent of only €1.60 in Japan. To keep their cost of goods low, these buyers will acquire clock radios in Japan, where they are cheap, and sell them in France, where they are expensive. Accordingly, clock ­radios will be exported by Japan and imported by France, just as the law of ­comparative advantage ­predicts. Similarly, wine distributors in Japan observe that a bottle of wine costs ¥1,000 in Japan but the equivalent of only ¥375 in France. To keep their cost of goods as low as possible, buyers for Japanese wine distributors will buy wine in France, where it is cheap, and sell it in Japan, where it is expensive. Wine will be exported by France and imported by Japan, as predicted by the law of comparative advantage. Note that none of these businesspeople needed to know anything about the theory of ­comparative advantage. They merely looked at the price differences in the two markets and made their business decisions based on the desire to obtain supplies at the lowest possible cost. Yet they benefit from comparative advantage because prices set in a free market reflect a ­country’s comparative advantage.

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CHAPTER 6  •  International Trade and Investment    185

Zandra Pustay

The elegant Galeries Lafayette department store on Boulevard Haussmann, a Parisian fixture for over a century, is a magnet for international shoppers desiring the latest in fashion and design from around the world.

Relative Factor Endowments The theory of comparative advantage begs a broader question: What determines the p­ roducts for which a country will have a comparative advantage? To answer this question, two Swedish ­economists, Eli Heckscher and Bertil Ohlin, developed the theory of relative factor ­endowments, now often referred to as the Heckscher-Ohlin theory. These economists made two basic observations: 1. Factor endowments (or types of resources) vary among countries. For example, Argentina has much fertile land, Saudi Arabia has large crude oil reserves, and Bangladesh has a large pool of unskilled labor. 2. Goods differ according to the types of factors that are used to produce them. For ­example, wheat requires fertile land, oil production requires crude oil reserves, and apparel ­manufacturing requires unskilled labor. From these observations, Heckscher and Ohlin developed their theory: A country will have a comparative advantage in producing products that intensively use resources (factors of ­production) it has in abundance. Thus, Argentina has a comparative advantage in wheat ­growing because of its abundance of fertile land; Saudi Arabia has a comparative advantage in oil ­production because of its abundance of crude oil reserves; and Bangladesh has a comparative advantage in apparel manufacture because of its abundance of unskilled labor. The Heckscher-Ohlin theory suggests a country should export those goods that ­intensively use those factors of production that are relatively abundant in the country. The theory was tested ­ empirically after World War II by economist Wassily Leontief using input-output ­analysis, a m ­ athematical technique for measuring the interrelationships among the sectors of an ­economy. Leontief believed the United States was a capital-abundant and labor-scarce economy.

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Figure 6.3 U.S. Imports and Exports, 1947: The Leontief Paradox $3.093 million of capital + 170.0 person-years of labor produces . . .

A bundle of U.S. imports worth $1 million

$2.551 million of capital + 182.3 person-years of labor produces . . .

A bundle of U.S. exports worth $1 million

Therefore, according to the Heckscher-Ohlin theory, he reasoned that the United States should export capital-intensive goods, such as bulk chemicals and steel, and import labor-intensive goods, such as clothing and footwear. Leontief used his input-output model of the economy to estimate the quantities of labor and capital needed to produce “bundles” of U.S. exports and imports worth $1 million in 1947 (see Figure 6.3). (Each bundle was a weighted average of all U.S. exports or imports in 1947.) He determined that in 1947 U.S. factories used $2.551 million of capital and 182.3 person-years of labor, or $13,993 of capital per person-year of labor, to produce a bundle of exports worth $1 million. He also calculated that $3.093 million of capital and 170.0 person-years of labor, or $18,194 of capital per person-year of labor, were used to produce a bundle of U.S. imports worth $1 million in that year. Thus, U.S. imports were more capital-intensive than U.S. exports. Imports required $4,201 ($18,194 – $13,993) more in capital per person-year of labor to produce than exports did. These results were not consistent with the predictions of the Heckscher-Ohlin theory: U.S. imports were nearly 30 percent more capital-intensive than were U.S. exports. The economics profession was distraught. The Heckscher-Ohlin theory made such intuitive sense, yet Leontief’s findings were the reverse of what was expected. Thus was born the Leontief paradox. During the past 60 years numerous economists have repeated Leontief’s initial study in an attempt to resolve the paradox. The first such study was performed by Leontief himself. He thought trade flows might have been distorted in 1947 because much of the world economy was still recovering from World War II. Using 1951 data he found that U.S. imports were 6 ­percent more capital-intensive than U.S. exports were. Although this figure was less than that in his o­ riginal study, it still disagreed with the predictions of the Heckscher-Ohlin theory. Some scholars argue that measurement problems flaw Leontief’s work. Leontief assumed there are two homogeneous factors of production: labor and capital. Yet other factors of production exist, most notably land, human capital, and technology—none of which were included in Leontief’s analysis. Failure to include these factors might have caused him to mismeasure the labor intensity of U.S. exports and imports. Many U.S. exports are intensive in either land (such as agricultural goods) or human knowledge (such as computers, aircraft, and services). Consider the products sold by one of the leading U.S. exporters, Boeing. Leontief’s approach measures the physical capital (the plants, property, and equipment) and the physical labor used to ­construct Boeing aircraft but fails to gauge adequately the role of human capital and technology in the firm’s operations. Yet human capital (the well-educated engineers who design the aircraft and the highly skilled machinists who assemble it) and technology (the sophisticated management techniques that control the world’s largest assembly lines) are more important to Boeing’s ­success than mere physical capital and physical labor. Leontief’s failure to measure the role that these other factors of production play in determining international trade patterns may account for his paradoxical results.

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In Practice The country-based trade theories focus on the nation’s resource base to explain the ­nation’s competitiveness in international markets. ● The theory of comparative advantage predicts that countries will export goods for which they are relatively more productive than other countries. For further consideration: Do you use “comparative advantage” in your daily life or in ­allocating tasks when you are involved in a group project? ●

Modern Firm-Based Trade Theories Since World War II, international business research has focused on the role of the firm rather than the country in promoting international trade. Firm-based theories have developed for ­several ­reasons: (1) the growing importance of MNCs in the postwar international ­economy; (2) the inability of the country-based theories to explain and predict the existence and growth of ­intraindustry trade (defined in the next section); and (3) the failure of Leontief and other researchers to empirically validate the country-based Heckscher-Ohlin theory. Unlike ­country-based ­theories, firm-based theories incorporate factors such as quality, technology, brand names, and customer loyalty into explanations of trade flows. Because firms, not ­countries, are the agents for international trade, the newer theories explore the firm’s role in ­promoting exports and imports.

Product Life Cycle Theory Product life cycle theory, which originated in the marketing field to describe the ­evolution of marketing strategies as a product matures, was modified by Raymond Vernon of the Harvard Business School to create a firm-based theory of international trade (and, as we will see, of ­international investment). International product life cycle theory traces the roles of ­innovation, market expansion, comparative advantage, and strategic responses of global rivals in ­international production, trade, and investment decisions. According to Vernon’s theory, and as illustrated in Figure 6.4, the international product life cycle consists of three stages: new ­product, maturing product, and standardized product. In stage 1, the new product stage, a firm develops and introduces an innovative product, such as a photocopier or a personal computer, in response to a perceived need in the domestic market. Because the product is new, the innovating firm is uncertain whether a profitable market for the product exists. The firm’s marketing executives must closely monitor customer reactions to ensure that the new product satisfies consumer needs. Quick market feedback is important, so the product is likely to be initially produced in the country where its research and development occurred, typically a developed country such as Japan, Germany, or the United States. Further, because the market size also is uncertain, the firm usually will minimize its investment in manufacturing capacity for the product. Most output initially is sold in the domestic market, and export sales are limited. For example, during the early days of the personal computer industry the small producers that populated the industry had their hands full trying to meet the burgeoning demand for their product. Apple Computer typified this problem. Founded on April Fool’s Day in 1976, its ­initial assembly plant was located in the garage of cofounder Steve Jobs. The first large order for its homemade computers—50 units from a local computer hobbyist store—almost bankrupted the firm because it lacked the financing to buy the necessary parts.4 Apple survived because of the nurturing environment in which it was born, California’s Silicon Valley. Home to major ­electronics firms such as Hewlett-Packard, Intel, and National Semiconductor, Silicon Valley was full of electrical engineers who could design and build Apple’s products and venture ­capitalists who were seeking the “next Xerox.” It was the perfect locale for Apple’s sales to grow from zero in 1976 to $7.8 million in 1978 and $156 billion in 2012. In stage 2, the maturing product stage, demand for the product expands dramatically as ­consumers recognize its value. The innovating firm builds new factories to expand its capacity and satisfy domestic and foreign demand for the product. Domestic and foreign competitors begin

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Source: Raymond Vernon and Louis T. Wells, Jr., The Economic Environment of International Business, 5th ed. (©1991, p. 85. Adapted by ­permission of Prentice Hall, Upper Saddle River, NJ).

INNOVATING FIRM’S COUNTRY Units produced

Figure 6.4 The International Product Life Cycle

150

120 Exports

90

Imports

Production 60 Consumption 30

0

Units produced

OTHER INDUSTRIALIZED COUNTRIES 150 Exports 120

90

60 Imports

Consumption 30 Production 0

Units produced

LESS DEVELOPED COUNTRIES 150

120

90 Exports 60

30

Imports Consumption

0

STAGE 1 New product

STAGE 2 Maturing product

Production STAGE 3 Standardized product

to emerge, lured by the prospect of lucrative earnings. In the case of Apple, the firm ­introduced a hand-assembled version of its second model, the Apple II, at a San Francisco c­ omputer fair in the spring of 1977. Within three years Apple had sold 130,000 units and ­expanded its production facilities beyond Jobs’ garage. To serve domestic and foreign ­customers, Apple IIs were manufactured in California and Texas and distributed from ­warehouses in the United States and the Netherlands.

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In stage 3, the standardized product stage, the market for the product stabilizes. The ­product becomes more of a commodity, and firms are pressured to lower their manufacturing costs as much as possible by shifting production to facilities in countries with low labor costs. As a result, the product begins to be imported into the innovating firm’s home market (by either the firm or its competitors). In some cases, imports may result in the complete elimination of ­domestic production. The personal computer industry has entered the standardized product stage. Chinese ­computer companies like Lenovo and Taiwanese manufacturers such as Asustek, Hon Hai, Tatung, Mitac International, and First International—none of them household names in the United States—annually export to the United States and to other countries millions of personal computers, many of which are produced under contract for leading PC vendors like Apple, Dell, and Hewlett-Packard. Such an arrangement is typical in this stage of the product life cycle: the production of the good shifts to lower-cost manufacturing sites, but the branding and marketing functions remain in the innovating country.5 According to the international product life cycle theory, domestic production begins in stage 1, peaks in stage 2, and slumps in stage 3. Exports by the innovating firm’s country also begin in stage 1 and peak in stage 2. By stage 3, however, the innovating firm’s country becomes a net importer of the product. Foreign competition begins to emerge toward the end of stage 1, as firms in other industrialized countries recognize the product’s market potential. In stage 2, foreign competitors expand their productive capacity, thus servicing an increasing portion of their home markets and perhaps becoming net exporters. As competition intensifies in stage 2, however, the innovating firm and its domestic and foreign rivals seek to lower their production costs by shifting production to low-cost sites in less-developed countries. Eventually, in stage 3, the less-developed countries may become net exporters of the product.

Country Similarity Theory Country-based theories, such as the theory of comparative advantage, do a good job of explaining interindustry trade among countries. Interindustry trade is the exchange of goods produced by one industry in country A for goods produced by a different industry in country B, such as the exchange of French wines for Japanese clock radios. Yet much international trade consists of intraindustry trade, that is, trade between two countries of goods produced by the same ­industry. For example, Japan exports Toyotas to Germany, and Germany exports BMWs to Japan. Intraindustry trade accounts for approximately 40 percent of world trade, and it is not predicted by country-based theories. Swedish economist Steffan Linder sought to explain the phenomenon of intraindustry trade. Linder hypothesized that international trade in manufactured goods results from similarities of preferences among consumers in countries that are at the same stage of economic development. In his view, firms initially manufacture goods to serve the firms’ domestic market. As they e­xplore exporting opportunities, they discover that the most promising foreign markets are in countries where consumer preferences resemble those of their own domestic market. The Japanese market, for example, provides BMW with well-off, prestige- and performance-seeking automobile buyers similar to the ones who purchase its cars in Germany. The German market provides Toyota with quality-conscious and value-oriented customers similar to those found in its home market. As each company targets the other’s home market, intraindustry trade arises. Linder’s country similarity theory suggests that most trade in manufactured goods should be between countries with similar per capita incomes and that intraindustry trade in manufactured goods should be common. This theory is particularly useful in explaining trade in d ­ ifferentiated goods such as automobiles, expensive electronics equipment, and personal care products, for which brand names and product reputations play an important role in consumer decision ­making. (Undifferentiated goods, such as coal, petroleum products, and sugar, are those for which brand names and product reputations play a minor role at best in consumer purchase decisions.)

New Trade Theory The so-called new trade theory developed by Elhanen Helpman, Paul Krugman,6 and Kelvin Lancaster,7 in the 1970s and 1980s extends Linder’s analysis by incorporating the impact of economies of scale on trade in differentiated goods. Economies of scale occur if a firm’s

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a­verage costs of producing a good decrease as its output of that good increases. Suppose ­automobile manufacturing and marketing benefits from economies of scale. If both BMW and Toyota are able to expand their sales beyond their home market, each will benefit from lower average costs and each will improve its competitiveness vis-à-vis smaller firms. In industries in which economies of scale are important, we would expect firms to be particularly aggressive in expanding beyond their domestic markets. Like Linder’s approach, the new trade theory predicts that intraindustry trade will be ­commonplace. It also suggests MNCs within the same industry, such as Caterpillar and Komatsu, Unilever and Procter & Gamble, and Airbus and Boeing, will continually play c­ at-and-mouse games with one another on a global basis as they attempt to expand their sales to capture scale economies. Often they seek to harness some sustainable competitive advantage they enjoy as a means of leveraging their own strengths and neutralizing those of their rivals. Firms competing in the global marketplace have numerous ways of obtaining a sustainable competitive advantage. The more popular ones are owning intellectual property rights, investing in research and development (R&D), achieving economies of scope, and exploiting the ­experience curve. We discuss each of these options next. Owning Intellectual Property Rights A firm that owns an intellectual property right—

a trademark, brand name, patent, or copyright—often gains advantages over its competitors. For instance, owning prestigious brand names enables Ireland’s Waterford Wedgwood and France’s LVMH Moët Hennessy Louis Vuitton to charge premium prices for their upscale products. And Coca-Cola and PepsiCo compete for customers worldwide on the basis of their trademarks and brand names. Investing in R&D  R&D is a major component of the total cost of high-technology products. For example, Airbus has spent more than $12 billion developing its superjumbo jet, the A380. Firms in the computer, pharmaceutical, and semiconductor industries also spend large amounts on R&D to maintain their competitiveness. Because of such large “entry” costs, other firms often hesitate to compete against established firms. Thus, the firm that acts first often gains a first-mover advantage. However, knowledge does not have a nationality. Firms that invest up front and secure the first-mover advantage have the opportunity to dominate the world market for goods that are intensive in R&D. Thus, national competitiveness and trade flows may be determined by which firms make the necessary R&D expenditures. Why is the EU a large exporter of commercial ­aircraft? Because Airbus is one of the few firms willing to spend the large sums of money ­required to develop new aircraft and because it is headquartered in Europe. Firms with large domestic markets may have an advantage over their foreign rivals in high-technology markets because these firms often are able to obtain quicker and richer ­ ­feedback from customers. With this feedback the firms can fine-tune their R&D efforts, enabling the firms to better meet the needs of their domestic customers. This knowledge can then be used to serve foreign customers. For example, U.S. agricultural chemical producers such as Monsanto and Eli Lilly have an advantage over Japanese rivals in developing soybean pesticides because the U.S. market for such pesticides is large but the Japanese market is small. Knowledge gained in the U.S. pesticide market can be readily transferred to meet the needs of Japanese farmers. Achieving Economies of Scope Economies of scope offer firms another opportunity to o­ btain a sustainable competitive advantage in international markets. Economies of scope o­ ccur when a firm’s average costs decrease as the number of different products it sells increases. Firms that are able to achieve economies of scope enjoy low average costs, which give the firms a competitive advantage over their global rivals. Consider the e-retailer Amazon, which has benefited from both economies of scale and scope. It has spent enormous sums developing and maintaining its website and building its customer base. Because many of these costs are fixed, the company’s average costs per sale decline as the company expands its sales. In its quest to capture the volume-driven economies of scale, Amazon has been expanding its operations into the international marketplace. Moreover, the marginal cost of adding an additional product line

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to its website is relatively small. Accordingly, Amazon has expanded from books to compact discs to DVDs to myriad other goods to capture such economies of scope. Exploiting the Experience Curve  Another source of firm-specific advantages in international

trade is exploitation of the experience curve. For certain types of products production costs ­decline as the firm gains more experience in manufacturing the product. Experience curves may be so significant that they govern global competition within an industry. For instance, in semiconductor chip production, unit cost reductions of 25 to 30 percent with each doubling of a firm’s cumulative chip production are not uncommon.8 Any firm attempting to be a ­low-cost producer of so-called commodity chips—such as DRAM memory chips—can achieve that goal only if it moves further along the experience curve than its rivals do. Both U.S. and Asian chip manufacturers have often priced their new products below current production costs to capture the sales necessary to generate the production experience that will in turn enable the m ­ anufacturers to lower future production costs. Because of their technological leadership in manufacturing and their aggressive, price-­cutting strategies, Asian semiconductor manufacturers such as Samsung and Hynix dominate the production of low-cost, standardized semiconductor chips.9 Similarly, innovative U.S. semiconductor firms such as Intel and Advanced Micro Devices use the ­experience curve to maintain leadership in the production of high-priced, proprietary chips that form the brains of newer microcomputers.

Porter’s Theory of National Competitive Advantage Harvard Business School professor Michael Porter’s theory of national competitive advantage is the newest addition to international trade theory. Porter believes that success in international trade comes from the interaction of four country- and firm-specific elements: factor conditions; demand conditions; related and supporting industries; and firm strategy, structure, and rivalry. Factor Conditions A country’s endowment of factors of production affects its ­ ability to c­ ompete internationally. Although factor endowments were the centerpiece of the H ­ ecksher-Ohlin theory, Porter goes beyond the basic factors—land, labor, and capital—­considered by the classical trade theorists to include more advanced factors such as the ­educational level of the ­workforce and the quality of the country’s infrastructure. His work stresses the role of factor creation through training, research, and innovation. Demand Conditions The existence of a large, sophisticated domestic consumer base o ­ ften stimulates the development and distribution of innovative products as firms struggle for ­dominance in their domestic markets. In meeting their domestic customers’ needs, however, firms continually develop and fine-tune products that also can be marketed internationally. Thus, pioneering firms can stay ahead of their international competitors as well. For example, Japanese consumer electronics producers benefit internationally because of the willingness of Japan’s large, well-off middle class to buy the latest electronic creations of Sony, Toshiba, and Matsushita. After being fine-tuned in the domestic market, new models of Japanese digital ­cameras, ­big-screen TVs, and Blu-ray players are sold to eager European and North American consumers. A similar phenomenon is occurring in the telecommunications market, where the rapid adoption of the Internet, tablets, and smartphones by North American consumers and companies has created a fertile climate for companies such as Twitter, Facebook, eBay, and Amazon to develop and tailor new products to meet the needs of this market domestically and internationally. Related and Supporting Industries The emergence of an industry often stimulates the

development of local suppliers eager to meet that industry’s production, marketing, and ­distribution needs. An industry located close to its suppliers will enjoy better communication and the exchange of cost-saving ideas and inventions with those suppliers. Competition among these input suppliers leads to lower prices, higher-quality products, and technological innovations in the input market, in turn reinforcing the industry’s competitive advantage in world markets. For example, Hollywood’s dominance of the world film industry is based in part on the local ­availability of specialist input suppliers, such as casting directors, stunt coordinators, costume and set designers, demolition experts, animators, special-effects firms, and animal wranglers.

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Scott Pustay

The Netherlands’ rich ­farmland and favorable climate makes it the world’s largest ­producer of tulip and daffodil bulbs—an ­estimated 9 billion per year. Dutch producers in turn ­benefit from sophisticated supporting industries and trade associations, such as the Dutch Flower Council, the Association of Dutch Flower Growers Research Groups, and the FloraHolland flower ­auctions, which facilitate the ­competitiveness of Dutch flower growers.

Firm Strategy, Structure, and Rivalry  The domestic environment in which firms c ­ ompete

shapes their ability to compete in international markets. To survive, firms facing vigorous ­competition domestically must continuously strive to reduce costs, boost product quality, raise productivity, and develop innovative products. Firms that have been tested in this way often develop the skills needed to succeed internationally. Further, many of the ­investments they have made to succeed in the domestic market (for example, in R&D, quality control, brand image, and employee training) are transferable to international markets at low cost. Such firms have an edge as they expand abroad. Thus, according to Porter’s theory, the international success of Japanese automakers and consumer electronics manufacturers and of Hollywood film studios is aided by intense domestic competition in these firms’ home countries. Porter holds that national policies may also affect firms’ international strategies and ­opportunities in more subtle ways. Consider the German automobile market. German labor costs are high, so German automakers find it difficult to compete internationally on the basis of price. As most auto enthusiasts know, however, there are no speed limits on many stretches of Germany’s famed autobahns. So German automakers such as Daimler-Benz, Porsche, and BMW have chosen to compete on the basis of quality and high performance by engineering chassis, engines, brakes, and suspensions that can withstand the stresses of highspeed driving. Consequently, these firms dominate the world market for high-performance automobiles. Porter’s theory is a hybrid: It blends the traditional country-based theories that emphasize factor endowments with the firm-based theories that focus on the actions of individual firms. Countries (or their governments) play a critical role in creating an environment that can aid or harm the ability of firms to compete internationally, but firms are the actors that actually ­participate in international trade. Some firms succeed internationally; others do not. Porsche, Daimler-Benz, and BMW successfully grasped the opportunity presented by Germany’s ­decision to allow unlimited speeds on its highways and captured the high-performance niche of the worldwide automobile industry. Conversely, Opel chose to focus on the broader middle ­segment of the German automobile market, ultimately limiting its international options. In summary, no single theory of international trade explains all trade flows among ­countries. The classical country-based theories are useful in explaining interindustry trade of ­homogeneous, undifferentiated products, such as agricultural goods, raw materials, and p­ rocessed goods like

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Map 6.1 Key Industrial Clusters in Western Europe NORWAY Alesund NETHERLANDS Rotterdam

Specialized Ocean Vessels

Transportation Services

UNITED KINGDOM West Midlands

SWEDEN Lidkoping

Automotive

Aerospace

LITHUANIA

POLAND Lodz

Business Services

BELGIUM Flanders

Wine

SLOVAKIA Western Slovakia

Banking

LUXEMBOURG

Automotive

Financial Services

FRANCE Champagne & Burgundy

Software

HUNGARY Zala county

SWITZERLAND Basel

Wine

ROMANIA Bucharest

CZECH REPUBLIC

Wood Furniture

Pharmaceuticals

SWITZERLAND Zurich SPAIN Galacia

CROATIA

Financial Services

Tourism

ITALY Northern Italy

SERBIA Zagreb

ITALY Tuscany & Lombardy

Textile Machinery

Apparel

Ceramics

GERMANY Frankfurt

Financial Services

Fishing

PORTUGAL Norte

ROMANIA Alba

Automobiles

UNITED KINGDOM London

Aircraft Manufacturing

PORTUGAL Oporto

Building Fixtures

GERMANY Stuttgart

Diamonds

FRANCE Brittany

FRANCE Toulouse

POLAND Silesia

Semiconductors

Financial Services

Pharmaceuticals

Agriculture

Textiles

GERMANY Dresden

NETHERLANDS Amsterdam

BELGIUM Antwerp

Telecommunications

Information Technology

Furniture

Software

Semiconductors

FINLAND Helsinki

ESTONIA Tallinn

DENMARK Copenhagen

IRELAND Dublin

IRELAND County Kildare

Paper And Pulp

Furniture

Offshore Drilling Technology

Video Games

FINLAND Helsinki

LATVIA Riga

NORWAY Kristiansand

UNITED KINGDOM Dundee

Automotive

SWEDEN Gothenburg

Agricultural Machinery

Leather Fashion Goods

SPAIN Valencia Construction Materials

CROATIA

SPAIN Catalonia

ITALY Parma

AUSTRIA Styria

Ceramic Tiles

Food Machinery

Clean Technologies

CZECH REPUBLIC Carlsbad

AUSTRIA Salzburg

Musical Instruments

Tourism

CZECH REPUBLIC

SLOVENIA

Horice Stone Processing

Wood Processing

Leisure Boats

BULGARIA Northern Bulgaria Mining

BULGARIA Sofia Apparel

GREECE Pireaus Shipping

steel and aluminum. The firm-based theories are more helpful in ­understanding intraindustry trade of heterogeneous, differentiated goods, such as Samsung smartphones and Caterpillar bulldozers, many of which are sold on the basis of their brand names and reputations. Further, in many ways, Porter’s theory synthesizes the features of the existing country-based and ­firm-based theories. It also explains another important phenomenon of international competition, the regional clustering of firms within an industry, which is discussed in “Venturing Abroad.” Figure 6.5 summarizes the major theories of international trade.

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Venturing Abroad Birds of a Feather Flock Together Although important for the development of trade t­heory, Porter’s theory of national competitive advantage also ­ explains the ­existence of another phenomenon of international ­business activity, the regional clustering of firms within an industry r­esulting from agglomeration economies. Agglomeration ­economies ­occur when a firm’s costs of production decline as the number of firms in that industry increase within a given area. Such growth a­ ttracts ­additional input suppliers to the areas, which then increases price competition and innovation among those suppliers. As their customer base increases, suppliers can specialize, ­ developing unique abilities that benefit the cluster as a whole. Clusters also promote innovation and entrepreneurship. Competition is intense, and firms must continually improve their products and productivity to survive. Entrepreneurs can tap into sophisticated local ­knowledge networks. Moreover, local bankers and ­financiers understand the ­ins-and-outs of the local industry and thus are better able to ­recognize good ideas when entrepreneurs request loans or capital. Firms within the cluster thus enjoy significant a­dvantages when competing with a firm from outside the cluster. Map 6.1 depicts some key industrial clusters in Western Europe. Consider three California industries, filmed entertainment, centered in Los Angeles; premium wines, centered in Napa and ­ Sonoma counties; and personal computing, centered in the Silicon Valley. Each industry no doubt started and benefited from supportive factor endowments and demand conditions. But as area firms ­began to prosper, other firms within the same industry were attracted to the region seeking to replicate the pioneering firms’ success. The expanding number of customers then induced supplier firms to ­ ­relocate as well. Over time, the cluster becomes so strong that firms not in the cluster are at a significant disadvantage. Film studios ­requiring the best directors, cinematographers, screenwriters, ­casting agents, and such are likely to find them in Hollywood. Suppliers of specialized services like pyrotechnics, animal wrangling, special

PASSPORT

effects, and set design are readily available as well. Similarly, firms seeking the latest vineyard management techniques or viniculture science are likely to find them in Napa or Sonoma counties or at the nearby University of California at Davis. Firms specializing in making or supplying wine-making and grape-harvesting equipment, barrels, corks, bottles, and label design have proliferated there as well, benefiting and strengthening the area’s vineyards. Or consider the move of Facebook from Cambridge, Massachusetts, to the Silicon Valley as portrayed in the movie The Social Network. There are plenty of smart people in Cambridge. However, Facebook founder Mark Zuckerberg realized that Facebook needed to access the specialized resources and talent that the Silicon Valley could best provide if it were to dominate the social networking market. Porter argues that clusters play an important role in promoting international competitiveness. Such competition is being transformed from a firm-versus-firm basis to a cluster-versus-cluster basis. In wine, for example, we often think of competition as being between a French vineyard such as Chateau Lafite Rothschild or a California grower like Chateau Montelena. From a cluster perspective, however, the nature of competition changes: California’s Sonoma and Napa Valley vintners compete against vintners from France’s Burgundy and Champagne provinces and from growers in Australia’s Barossa Valley. In Porter’s view, a wise government institutes policies that allow the cluster to flourish, perhaps by funding research at local universities or providing infrastructure improvements that benefit the cluster as a whole. Sources: Based on Harvard Business School, “Global Wine War 2009: New World versus Old,” Case number 9-910-405 (2009); Harvard Business School, “Finland and Nokia: Creating the World’s Most Competitive Economy,” Case number 9-702-427 (2008); Michael Porter, “Clusters and the New Economics of Competition,” Harvard Business Review, November–December 1998, pp. 77–90; Michael Porter, “The Competitive Advantage of Nations,” Harvard Business Review, March–April 1990, pp. 73–93.

In Practice The firm-based trade theories highlight the importance of multinational corporations in international trade and international investment flows. ● Regional clustering of firms within an industry can be an important source of ­competitive advantage to firms and to countries. For further consideration: What percentage of your budget do you spend on ­undifferentiated goods? on differentiated goods? ●

Figure 6.5 Theories of International Trade

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Country-Based Theories Country is unit of analysis Emerged prior to World War II Developed by economists Explain interindustry trade Include: Mercantilism Absolute advantage Comparative advantage Relative factor endowments (Heckscher-Ohlin)

Firm-Based Theories Firm is unit of analysis Emerged after World War II Developed by business school professors Explain intraindustry trade Include: Country similarity theory Product life cycle New trade theory National competitive advantage

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An Overview of International Investment Trade is the most obvious but not the only form of international business. Another major form is international investment, whereby residents of one country supply capital to a second country.

Types of International Investments International investment, as discussed in Chapter 1, is divided into two categories: foreign ­portfolio investment (FPI) and foreign direct investment (FDI). The distinction between the two rests on the question of control: Does the investor seek an active management role in the firm or merely a return from a passive investment? Foreign portfolio investments (FPI) represent passive holdings of securities such as ­foreign stocks, bonds, or other financial assets, none of which entails active management or c­ ontrol of the securities’ issuer by the investor. Modern finance theory suggests that FPI will be motivated by attempts to seek an attractive rate of return as well as the risk r­ eduction that can come from geographically diversifying one’s investment portfolio. Sophisticated money ­managers in New York, London, Frankfurt, Tokyo, and other financial centers are well aware of the advantages of international diversification. In 2012, for example, private U.S. citizens ­purchased $145 ­billion worth of foreign securities, bringing their total holdings of such ­securities to $7.5 trillion. Foreign official and private investors purchased $764 billion worth of U.S. corporate, federal, state, and local securities, raising their total holdings of such securities to $12.5 trillion.10 Foreign direct investment (FDI) is acquisition of foreign assets for the purpose of controlling them. U.S. government statisticians define FDI as “ownership or control of ­ 10 ­percent or more of an enterprise’s voting securities or the equivalent interest in an unincorporated ­business.”11 FDI may take many forms, including purchase of existing assets in a foreign country, new investment in property, plant, and equipment, and participation in a joint venture with a local partner. Perhaps the most historically significant FDI in the United States was the $24 that Dutch explorer Peter Minuit paid local Native Americans for Manhattan Island.12 The ­result: New York City, one of the world’s leading financial and commercial centers. “Venturing Abroad” discusses the growing importance of sovereign wealth funds in global capital markets.

Venturing Abroad The New Player in Global Capital Markets: Sovereign Wealth Funds Sovereign wealth funds (SWFs) are one of the newest, and perhaps most controversial, sources of capital in the world ­economy. Sovereign wealth funds, which are government-controlled pools of capital, are estimated to possess $5 trillion in assets in 2012. Most of the SWFs are owned by oil-rich governments. The Abu Dhabi Investment Authority is currently the largest, with $627 billion in assets, followed by the Government Pension Fund of Norway with $611 billion. Other SWFs are owned by governments of countries enjoying large balance of payments surpluses, such as the China Investment Corporation ($440 billion), Temasek Holdings of Singapore ($157 billion), and the Government of Singapore Investment Corporation ($248 billion). China, for example, has accumulated foreign exchange reserves totaling $3.4 trillion as a result of its balance of payments surpluses. The government transferred $200 billion of these reserves to the China Investment Corporation (CIC) to manage in hopes of improving the government’s rate of return on its investments. One of the first investments made by the CIC was a $3 billion equity position in the Blackstone Group, a U.S. private equity firm. The rise of the SWFs reflects the growing role of emerging markets in the global economy. Their ownership of the world’s productive assets has grown in conjunction with their increasing share of the world’s GDP. SWFs have invested in a variety of industries. For example, Dubai

PASSPORT

International Capital, owned by the ruler of Dubai, owns stakes in European Aeronautic Defense & Space (the parent of Airbus), Sony, and HSBC Holdings. It has also purchased ownership stakes in the London Stock Exchange, the Nasdaq Stock Market, and OMX AB, which controls seven stock exchanges in Scandinavia and the Baltic region. The Qatar Investment Authority holds major positions in Volkswagen, Porsche, Total, Barclays, J Sainsbury, and Harrods. Similarly, Temasek purchased a controlling interest in Shin Corporation, the largest provider of mobile telephone service in Thailand. The SWFs were particularly important in shoring up the b ­ alance sheets of international banks, hedge funds, and private equity firms hurt by the chaos in the U.S. mortgage market during the global recession of 2008–2009. UBS, which lost $37 billion in the crisis, ­received $9.7 billion in new equity from the Government of Singapore Investment Corporation, and an additional $1.8 billion from an ­unidentified strategic investor from the Middle East. The Singapore SWF owns about 9 percent of the Swiss bank as a result of this ­investment. The China Investment Corporation invested $5 billion in Morgan Stanley, while the Abu Dhabi Investment Authority purchased a 4.9 percent stake in Citigroup for $7.5 billion and a 7.5 percent share of the Carlyle Group for $1.35 billion. Most of the investments made by SWFs to date have been passive in nature, seeking to earn financial returns rather than actively (Continued)

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196    Part 2  • The INTERNATIONAL ENVIRONMENT control assets. Many have purchased equity stakes in investment banks and private equity firms, allowing the SWFs to tap into the sophisticated knowledge of these concerns without having to develop the expertise themselves. They are also attractive to the firms because to date they have not concerned themselves with corporate governance issues or proven to be activist investors. Their investments typically do not entitle the SWF to a board seat, allowing them to avoid political problems and national investment control laws like the Exon-Florio Act. (This act allows the president of the United States to reject certain investments made by foreign nationals for national security reasons.) Nonetheless, the growth of SWFs has made politicians in many countries uneasy. As a result, the International Monetary Fund is ­trying to develop a voluntary code of conduct for SWFs. The primary objective of the code is to ensure that investments made by SWFs are solely for commercial purposes, rather than a backdoor means of promoting the political goals of the governmental owner of the SWF.

Sources: Based on “China’s forex reserves reach $3.4tn,” Financial Times, April 11, 2013; “Here, there and everywhere,” Financial Times, March 19, 2013, p. 7; “Norway’s national nest egg,” Financial Times, August 20, 2012, p. 5; “Wealth funds fight for reputation,” Wall Street Journal, May 10, 2011, p. C3; “Beijing to give wealth fund $200bn,” Financial Times, April 26, 2011, p. 4; “China’s wealth-fund chief warns on global growth,” Wall Street Journal, April 18, 2011, p. A7; www.swfinstitute.org; “IMF clears way for development of sovereign wealth fund codes,” Wall Street Journal, March 24, 2008, p. A12; “Code set for state-run funds,” Wall Street Journal, March 21, 2008, p. A4; “Temasek rising,” TheDeal.com, February 22, 2008 ­(online); “Dubai investment fund plans to spend in Asia,” International Herald Tribune, February 19, 2008 (online); “Ascent of sovereign-wealth funds ­illustrates new world order,” Wall Street Journal, January 28, 2008, p. A2; “Asset-backed insecurity,” The Economist, January 19, 2008, pp. 78ff.; “Gulf states seen raising foreign-asset holdings,” Wall Street Journal, January 17, 2008, p. A10; “$9.4 billion write-down at Morgan Stanley,” New York Times, December 20, 2007 (online); “UBS gains two new investors, writes down $10 billion,” Wall Street Journal, December 10, 2007 (online); “Abu Dhabi to bolster Citigroup with $7.5 ­billion capital infusion,” Wall Street Journal, November 27, 2007, p. A3.

The Growth of FDI The growth of FDI during the past 30 years has been phenomenal. As Figure 6.6 indicates, in 1980 the total stock (or cumulative value) of FDI received by countries worldwide was $689  ­billion. Worldwide FDI as of 2011 topped $20.4 trillion. This stunning growth in FDI—and its acceleration beginning in the 1990s—reflects the globalization of the world’s economy. As you might expect, most FDI comes from developed countries. Surprisingly, most FDI also goes to developed countries. We discuss later in this chapter reasons for this explosive growth in FDI.

Figure 6.6 Stock of Foreign Direct Investment, by Recipient (in trillions of dollars)

25.0

Source: Based on data from United Nations Conference on Trade and Development, World Investment Report (online at www.unctad.org/wir).

World Developed Countries Western Europe United States

Trillions of U.S. dollars

20.0

15.0

10.0

5.0

20 10 20 11

08 20

6 20 0

20 04

02 20

00 20

98 19

96 19

94 19

92 19

90 19

88 19

86 19

84 19

82 19

19

80

0.0

Year

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Table 6.4  Stock of FDI for the United States, end of 2012 (billions of dollars) a. Sources of FDI in the United States United Kingdom

488.8

Japan

308.3

Netherlands

274.9

Canada

225.3

France

209.1

Switzerland

204.0

Luxembourg

202.3

Germany

199.0

Belgium

88.7

Bermuda, The Bahamas, and other Caribbean Islands

68.6

Spain

47.4

Other European Union countries

137.4

All other countries

197.0

Total

2650.8

b. Destination of FDI from the United States Netherlands

645.1

United Kingdom

597.8

Bermuda, The Bahamas, and other Caribbean Islands

537.5

Luxembourg

383.6

Canada

351.5

Ireland

203.8

Singapore

138.6

Japan

134.0

Australia

132.8

Switzerland

130.3

Germany

121.2

Other European Union countries

288.1

All other countries

788.7

Total

4453.0

Source: Based on data from Survey of Current Business, July 2013, pp. 40 and 42.

FDI and the United States We can gain additional insights into FDI by looking at individual countries. Consider the stock of FDI in the United States, which totaled $2.7 trillion (measured at historical cost) at the end of 2012 (see Table 6.4[a]). The United Kingdom was the most important source of this FDI, accounting for $488.8 billion, or 18 percent, of the total. The countries listed by name in Table 6.4(a) account for 87 percent of total FDI in the United States. The stock of FDI by U.S. residents in foreign countries totaled $4.5 trillion at the end of 2012 (see Table 6.4[b]). Most of this FDI was in other developed countries, particularly the Netherlands ($645.1 billion) and the United Kingdom ($597.8 billion). The countries listed by name in Table 6.4(b) account for 76 percent of total FDI from the United States. Looking at Table 6.4, you may wonder why Bermuda, the Bahamas, and other small Caribbean islands are so important. They serve as offshore financial centers, which we will discuss in Chapter 8. Many U.S. companies set up finance and other subsidiaries in such centers to take advantage of low taxes and business-friendly regulations. Similarly, many

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financial ­services companies from other countries establish such subsidiaries as the legal owners of their U.S. operations. During the past decade outward FDI has remained larger than inward FDI for the United States (see Figure 6.7), but both categories have roughly doubled in size. Although inward and outward flows of FDI are not perfectly matched, the pattern is clear: Most FDI is made by and destined for the most prosperous countries. In the next section we discuss how this pattern ­suggests the crucial role MNCs play in FDI. Figure 6.7 Outward and Inward U.S. FDI, 1982–2012

4500

4,453

4400 4300

Source: Based on Survey of Current Business, July 2013, pp. 26.

4200 4100 4000

U.S. FDI abroad

3900

Foreign FDI in the U.S.

3800

3,742

3700 3600 3500 3400 3300 3200 3100 3000 2900 2800 2700

2,651

Billions of U.S. dollars

2600 2,477

2500 2400

2,280

2300 2200 2100 2000 1900

1,841

1800 1700

1,617

1600 1500 1400

1,327

1300 1200 1100 1,001

1000 900

778

800 700

613

600

481

500

431

400 300 200 100 0

M06_GRIF8218_08_SE_C06.indd 198

271 208

395

220

125

1982

1986

1990

1994

1998

2002

2006

2010

2012

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International Investment Theories Why does FDI occur? A sophomore taking his or her first finance course might answer with the obvious: Average rates of return are higher in foreign markets. Yet given the pattern of FDI between countries that we just discussed, this answer is not satisfactory. Canada and the United Kingdom are both major sources of FDI in the United States and important destinations for FDI from the United States. Average rates of return in Canada and the United Kingdom cannot be simultaneously below that of the United States (which would justify inward U.S. FDI) and above that of the United States (which would justify outward U.S. FDI). The same pattern of two-way investment occurs on an industry basis. By the end of 2012, for example, U.S. firms had invested $11.0 billion in the chemical industry in the Netherlands, whereas Dutch firms had invested $27.6 billion in the U.S. chemical industry. This pattern cannot be explained by national or ­industry differences in rates of return. We must search for another explanation for FDI.

Ownership Advantages More powerful explanations for FDI focus on the role of the firm. Initially researchers explored how firm ownership of competitive advantages affected FDI. The ownership ­ ­advantage theory suggests that a firm owning a valuable asset that creates a competitive advantage domestically can use that advantage to penetrate foreign markets through FDI. The asset could be, for e­ xample, a superior technology, a well-known brand name, or economies of scale. This theory is consistent with the observed patterns of international and intraindustry FDI discussed previously in this chapter. Caterpillar, for example, built factories in Asia, Europe, Australia, South America, and North America to exploit proprietary technologies and its brand name. Its chief rival, Komatsu, constructed plants in Asia, Europe, and the United States for the same reason.

Internalization Theory The ownership advantage theory only partly explains why FDI occurs. It does not explain why a firm would choose to enter a foreign market via FDI rather than exploit its ownership advantages internationally through other means, such as exporting its products, franchising a brand name, or licensing technology to foreign firms. For example, McDonald’s has successfully internationalized by franchising its fast-food operations outside the United States, whereas Boeing has relied on exporting to serve its foreign customers. Internalization theory addresses this question. In doing so, it relies heavily on the ­concept of transaction costs. Transaction costs are the costs of entering into a transaction, that is, those connected to negotiating, monitoring, and enforcing a contract. A firm must decide whether it is better to own and operate its own factory overseas or to contract with a foreign firm to do this through a franchise, licensing, or supply agreement. Internalization theory suggests that FDI is more likely to occur—that is, international production will be internalized within the firm—when the costs of negotiating, monitoring, and enforcing a contract with a second firm are high. For example, Toyota’s primary competitive advantages are its reputation for high quality and its sophisticated manufacturing techniques, neither of which is easily conveyed by contract. As a result, Toyota has chosen to maintain ownership of its overseas automobile assembly plants. Conversely, internalization theory holds that when transaction costs are low, firms are more likely to contract with outsiders and internationalize by licensing their brand names or ­franchising their business operations. For example, McDonald’s is a premier expert in the United States in devising easily enforceable franchising agreements. Because McDonald’s is so successful in reducing transaction costs between itself and its franchisees, it has continued to rely on franchising for its international operations.

Dunning’s Eclectic Theory Although internalization theory addresses why firms choose FDI as the mode for entering ­international markets, the theory ignores the question of why production, by either the c­ ompany or a ­contractor, should be located abroad. In other words, is there a location advantage to ­producing abroad? This issue was incorporated by John Dunning in his eclectic theory, which combines ­ ownership advantage, location advantage, and internalization advantage to form

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a ­unified theory of FDI. This theory recognizes that FDI reflects both international business ­activity and business ­activity internal to the firm. According to Dunning, FDI will occur when three conditions are satisfied: 1. Ownership advantage. The firm must own some unique competitive advantage that ­overcomes the disadvantages of competing with foreign firms on their home turfs. This advantage may be a brand name, ownership of proprietary technology, the benefits of ­economies of scale, and so on. Caterpillar, for example, enjoys all three of these advantages in competing in Brazil against local firms. 2. Location advantage. Undertaking the business activity must be more profitable in a foreign location than undertaking it in a domestic location. For example, Caterpillar produces bulldozers in Brazil to enjoy lower labor costs and avoid high tariff walls on goods exported from its U.S. factories. 3. Internalization advantage. The firm must benefit more from controlling the foreign business activity than from hiring an independent local company to provide the service. Control is advantageous, for example, when monitoring and enforcing the contractual performance of the local company is expensive, when the local company may misappropriate proprietary technology, or when the firm’s reputation and brand name could be jeopardized by poor behavior by the local company. All of these factors are important to Caterpillar.

In Practice International investments can take the form of portfolio investments or of direct ­investments. The distinction between the two forms rests on whether the investment is for ­purposes of control. ● Dunning’s eclectic theory argues that ownership, location, and internalization ­advantages determine whether firms will use FDI when entering a foreign market. For further consideration: Does foreign direct investment affect you or your community? If so, how? ●

Factors Influencing FDI Given the complexity of the global economy and the diversity of opportunities that firms face in different countries, it is not surprising that numerous factors may influence a firm’s decision to undertake FDI. These can be classified as supply factors, demand factors, and political factors (see Table 6.5).

Supply Factors A firm’s decision to undertake FDI may be influenced by supply factors, including production costs, logistics, availability of natural resources, and access to key technology.

Table 6.5  Factors Affecting the FDI Decision Supply Factors

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Demand Factors

Political Factors

Production costs

Customer access

Avoidance of trade barriers

Logistics

Marketing advantages

Economic development incentives

Resource availability

Exploitation of competitive advantages

Access to technology

Customer mobility

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Production Costs  Firms often undertake FDI to lower production costs. Foreign locations may be more attractive than domestic sites because of lower land prices, tax rates, commercial real estate rents, or because of better availability and lower cost of skilled or unskilled labor. For example, Intel built a new chip fabrication facility in Chengdu in China’s inland Sichuan province because labor and land costs were much lower than in Shanghai, where the company already operates three facilities.13 Similarly, Nokia built a $275-million mobile phone assembly plant in northern Vietnam to take advantage of the area’s low labor costs.14 Logistics If transportation costs are significant, a firm may choose to produce in the

f­ oreign market rather than export from domestic factories. For example, Heineken has used FDI ­extensively as part of its internationalization strategy because its products are primarily water. Brewing its beverages close to where its foreign consumers live is cheaper for Heineken than transporting the beverages long distances from the company’s Dutch breweries. International businesses also often make host-country investments to reduce distribution costs. For example, Citrovita, a Brazilian producer of orange juice concentrate, operates a storage and ­distribution terminal at the Port of Antwerp rather than ship to European grocery chains directly from Brazil. Citrovita can take advantage of low ocean-shipping rates to transport its goods in bulk from Brazil to the Belgian port. The company then uses the Antwerp facility to repackage and ­distribute concentrate to its customers in France, Germany, and the Benelux countries. Availability of Natural Resources  Firms may use FDI to access natural resources that are critical to their operations. For instance, because of the decrease in conventional onshore ­domestic oil production, many U.S.-based oil companies made significant investments worldwide to obtain new oil reserves. Often international businesses negotiate with host governments to obtain access to raw materials in return for FDI. For example, the China National Petroleum Company created a $10 billion joint venture with state-owned Petróleos de Venezuela to extract, refine, and transport 1 million barrels of oil a day from Venezuela’s Orinoco basin.15 Access to Key Technology  Another motive for FDI is to gain access to technology. Firms

may find it more advantageous to acquire ownership interests in an existing firm than to ­assemble an in-house group of research scientists to develop or reproduce an emerging ­technology. For instance, many Swiss pharmaceutical manufacturers have invested in small U.S. biogenetics companies as an inexpensive means of obtaining cutting-edge biotechnology. Similarly, Korea’s Doosan Infracore paid $4.9 billion for the Bobcat division of Ingersoll-Rand to benefit from Bobcat’s superior technology, outstanding distribution network, and skilled m ­ anagement team.16 Starbucks recently purchased a 600-acre plot in Costa Rica as an e­ xperiment station for ­developing new coffee varieties and new coffee-growing secrets.17

Demand Factors Firms also may engage in FDI to expand the market for their products. The demand factors that encourage FDI include customer access, marketing advantages, exploitation of competitive ­advantages, and customer mobility. Customer Access Many types of international business require firms to have a physical

p­ resence in the market. For example, fast-food restaurants and retailers must provide convenient access to their outlets for competitive reasons. KFC cannot supply its freshly prepared fried chicken to Japanese customers from its restaurants in the United States; it must locate outlets in Japan to do so. Similarly, IKEA’s success in broadening its customer base beyond its home ­market in Sweden is the result of its opening a number of new stores worldwide. Marketing Advantages FDI may generate several types of marketing advantages. The physical presence of a factory may enhance the visibility of a foreign firm’s products in the host market. The foreign firm also gains from “buy local” attitudes of host country consumers. For example, through ads in such magazines as Time and Sports Illustrated, Toyota has publicized the beneficial impact of its U.S. factories and input purchases on the U.S. economy. Firms may

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also engage in FDI to improve their customer service. Taiwan’s Delta Products, which makes battery packs for laptop computers, was concerned that it could not respond quickly and flexibly enough from its factories in China and Thailand to meet the changing needs of its U.S. customers. As one of its executives noted, if you “build in the Far East, you’re too far away. You can’t do a last-moment modification while the product is on the ocean.” Accordingly, Delta shifted some of its production to a Mexican factory just across the border from Nogales, Arizona, to better serve its U.S. customers.18 Exploitation of Competitive Advantages  FDI may be a firm’s best means to exploit a

competitive advantage that it already enjoys. An owner of a valuable trademark, brand name, or technology may choose to operate in foreign countries rather than export to them. Often this decision depends on the product’s nature. For instance, companies such as Procter and Gamble, Nestlé, and Unilever often choose to site factories in the countries in which they sell their ­products. By so doing, they enhance their ability to customize their products to meet local tastes while still benefitting from the power of their brand names and manufacturing prowess. Customer Mobility A firm’s FDI also may be motivated by the FDI of its customers or c­ lients. If one of a firm’s existing customers builds a foreign factory, the firm may decide to locate a new facility of its own nearby, thus enabling it to continue to supply its ­customers promptly and a­ ttentively. Equally important, establishing a new facility reduces the ­possibility that a ­competitor in the host country will step in and steal the customer. For example, Japanese parts suppliers to the major Japanese automakers have responded to the construction of Japanese-owned automobile assembly plants in the United States by building their own U.S. ­factories, warehouses, and research facilities. Their need to locate facilities in the United States is magnified by the automakers’ use of just-in-time (JIT) inventory management techniques; JIT minimizes the amount of parts inventory held at an assembly plant, putting a parts-supply ­facility located in Japan at a severe disadvantage. Likewise, after Samsung decided to construct and operate an electronics factory in northeast England, six of its Korean parts suppliers also established factories in the vicinity.19

Political Factors Political factors may also enter into a firm’s decision to undertake FDI. Firms may invest in a foreign country to avoid trade barriers by the host country or to take advantage of economic ­development incentives offered by the host government. Avoidance of Trade Barriers  Firms often build foreign facilities to avoid trade barriers.

For example, in 2011 Hon Hai Precision Industries, a leading Taiwanese contract manufacturing firm, announced it would build a new electronics manufacturing plant in Brazil to avoid that country’s high tariffs on imported consumer electronics goods. Other types of g­ overnment policies may also impact FDI. Microsoft, for example, located a software ­development center in Richmond, British Colombia, in part to avoid limitations placed by the U.S. g­ overnment on the number of highly skilled immigrant workers who can obtain H-1B work visas in any given year.20 Economic Development Incentives  Most democratically elected governments—local, state,

and national—are vitally concerned with promoting the economic welfare of their citizens, many of whom are, of course, voters. Many governments offer incentives to firms to induce them to locate new facilities in the governments’ jurisdictions. Governmental incentives that can be an important catalyst for FDI include reduced utility rates, employee training ­programs, ­infrastructure additions (such as new roads and railroad spurs), and tax reductions or tax ­holidays. Often MNCs benefit from bidding wars among communities eager to attract the ­companies and the jobs they bring. For instance, the Kentucky Economic Development Finance Authority agreed to provide Toyota $145 million in tax concessions in return for the company investing $531 million to expand the capacity of its Georgetown, Kentucky, assembly facility. The new investments will allow Toyota to build 60,000 new Lexus ES sedans starting in 2015, creating 750 new jobs at the site.21

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In Practice FDIs can be motivated by supply, demand, and political factors. Countries often provide economic development incentives to encourage FDI and the jobs that FDI creates. For further consideration: Do you think that providing economic development incentives is a wise use of government revenues? ● ●

MyManagementLab® Go to mymanagementlab.com to complete the problems marked with this icon

.

Chapter Review Summary International trade is an important form of international business—$22.8 trillion of goods and services were traded ­ among residents of different countries in 2012. International trade affects domestic economies both directly and indirectly. Exports stimulate additional demand for products, thus generating income and employment gains. Imports lower consumer prices and pressure domestic firms to become more efficient and productive. Because of the importance of trade to businesses and governments worldwide, scholars have offered numerous ­explanations for its existence. The earliest theories, such as absolute a­dvantage, comparative advantage, and relative factor endowments, relied on characteristics of countries to explain patterns of exports and imports. These country-based theories help explain trade in ­undifferentiated goods such as wheat, sugar, and steel. Coincident with the rise of MNCs, post–World War II ­research focused on firm-based explanations for international trade. Product life cycle, country similarity, and new trade theories focus on the firm as the agent for generating trade and investment decisions. These firm-based theories help explain intraindustry trade and trade in differentiated goods such as ­automobiles, ­personal care products, and consumer electronics goods. International investment is the second major way in which firms participate in international business. International ­investments fall into two categories: FPI and FDI. FDI has risen in importance as MNCs have increased in size and number. Dunning’s eclectic theory suggests that FDI will occur when three conditions are met: (1) the firm possesses a ­competitive advantage that allows it to overcome the disadvantage of competing on the foreign firm’s home turf; (2) the foreign location is superior to a domestic location; and (3) the firm finds it cheaper (because of high transaction costs) to produce the product itself rather than hire a foreign firm to do so.

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Numerous factors can influence a firm’s decision to undertake FDI. Some FDI may be undertaken to reduce the firm’s costs. Such supply factors include production costs, logistics, availability of natural resources, and access to key technology. The decision to engage in FDI may be affected by such demand factors as developing access to new c­ ustomers, obtaining marketing advantages through local production, exploiting competitive advantages, and maintaining nearness to customers as they internationalize their operations. Political considerations may also play a role in FDI. Often firms use FDI to avoid host country trade barriers or to capture economic development incentives offered by host country governments.

Review Questions 6 -1. What is international trade? Why does it occur? 6-2. Which kind of international trade is explained by the theory of comparative advantage? 6-3. What is intraindustry trade? 6-4. How useful are country-based theories in explaining ­international trade? 6-5. How do interindustry and intraindustry trade differ? 6-6. Explain the impact of the product life cycle on ­international trade and international investment. 6-7. What are the primary sources of the competitive advantages firms use to compete in international markets? 6-8. Illustrate the Porter’s Diamond of national competitive ­advantages by selecting a country or a sector of your choice. 6-9. Why has FDI become so important in international business? 6-10. What are the three parts of Dunning’s eclectic theory? 6-11. How do political factors influence international trade and investment?

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Questions for Discussion 6-12. In our example of France trading wine to Japan for clock radios, we arbitrarily assumed that the countries would trade at a price ratio of one bottle of wine for two clock radios. Over what range of prices can trade ­occur between the two countries? (Hint: In the absence of trade, what is the price of clock radios in terms of wine in France? In Japan?) Does your answer differ if you use Table 6.2 instead of Table 6.1? 6-13. In the public debate over ratification of the North American Free Trade Agreement, Ross Perot said he heard a “giant sucking sound” from U.S. jobs headed south because of low wage rates in Mexico. Using the theory of comparative ­advantage, discuss whether Perot’s fears were valid.

6-14. Why is intraindustry trade not predicted by countrybased theories of trade? 6-15. Hyundai decided to build a new automobile assembly plant in Alabama. a. What factors do you think Hyundai considered in ­selecting Alabama as the site for the factory? b. Who benefits and who loses from the new plant in Alabama? c. Is the firm’s decision to build the new plant consistent with Dunning’s eclectic theory? 6-16. Why are clusters established, and why are they important in international trade? Illustrate you answer with examples.

Building Global Skills The U.S. market for computers is dominated by domestic firms such as Dell, Hewlett-Packard, and Apple. The U.S. market for consumer electronics is dominated by Japanese firms and brands such as Sony, JVC, Panasonic, Mitsubishi, and Toshiba. However, the U.S. automobile market includes both domestic firms such as Ford and General Motors and formidable Japanese competitors such as Toyota and Honda. Your instructor will divide the class into groups of four or five and assign each group one of the three industries just noted. To begin, discuss within your group your individual views on why different patterns exist for these industries. Next, analyze the industry assigned to your group from the standpoint of each country-based and firm-based theory of international trade discussed in this chapter. Try to agree on which theory is the best predictor and which is the worst ­predictor of reality for your specific industry. Now reconvene as a class. Each group should select a spokesperson. Each spokesperson should indicate the industry

Closing Case

6-17. Do some theories work better than others for different industries? Why? 6-18. Discuss one of the patterns presented in the initial paragraph with reference to a specific industry. 6-19. Do the same theories work as well in making ­predictions for those industries? 6-20. Based on what you know about the Japanese market, decide whether the same pattern of competitiveness that exists in the United States for the computer, ­consumer electronics, and automobile industries also holds true for the Japanese market. Why or why not?

The Growing Trade in Growing Grapes

Wine is one of mankind’s oldest and most important ­industries. Archaeological evidence of wine production dates back to 6000 b.c.e. Hieroglyphics from 3000 b.c.e. depict Egyptians enjoying celebratory cups of wine. The Bible records Jesus’ first miracle, turning water into wine at the wedding feast at Cana. Today, some 18.5 million acres of land are devoted to vineyards, which yield 26 billion liters of wine annually.

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that the person’s group discussed and identify the best and worst theories selected. Note the points on which the groups who analyzed the same industries agree. Finally, separate again into your small groups and discuss the areas of common disagreements. Also discuss the following questions:

The EU produces about 60 percent of this output, with France, Italy, and Spain accounting for the bulk of the EU’s production. The United States, Argentina, and Australia are the largest non-European producers. Until the 1980s, French vineyards were the ­dominant force in the global wine trade, with Italy, Spain, and Germany trailing behind them. These Old World producers benefitted from centuries of tradition and their reputations

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for quality and sophistication. The mystique of French wine was in part attributable to the belief by oenophiles (a fancy word for wine experts) that terroir and the character of the grape itself contributed to the creation of unique characteristics for each vineyard’s wine. (Terroir means “a sense of place” and includes numerous factors that convey character to the wine, including soil chemistry, ­topography, and the microclimate of an individual plot of land.) So critical is terroir to the French wine industry that in the nineteenth century French officials assessed the quality of the wine produced in each French vineyard and established an elaborate schema for categorizing the wines according to their location and quality—Grand cru, Premier cru, etc. Known today as the Appellation d’origine contrôlée (AOC) (controlled designation of origin) system, effectively the French government provided a quality ­assurance and consumer protection program for lovers of French wine. Under the AOC system, for example, the only wines that can bear the label “Champagne” must be fermented from grapes grown in the Champagne region of northeastern France. Grand cru champagne must originate from lands specifically designated as such by the AOC system. The Italian and the German governments established similar programs. The Old World producers, although dominant, were not invulnerable to global competition, particularly ­ after the so-called “Judgment of Paris” in 1976, when a British wine merchant living in Paris organized a blind taste-testing ­competition between French and Californian wines. To the surprise of nearly everyone, the judges rated California wines as superior to those of French wines in the two ­contested categories. (Bottle Shock, a 2008 movie s­tarring Alan Rickman, dramatizes the events surrounding the Judgment of Paris.) Nonetheless, French wines command a price premium in the export market, averaging more than $6.00 a liter compared to only $3.00 for wines from Australia, Argentina, Chile, or the United States. The AOC system, although conferring some marketing advantages, does have some disadvantages. ­ It requires that consumers have a fair degree of knowledge to make wise wine purchases. Moreover, individual vineyards are ­vulnerable to the vagaries of the weather. If Mother Nature fails to cooperate, a vineyard might receive too much or too little rainfall or sunshine in a growing season; thus, the q­uality of its grapes could vary from year to year. This may raise the snob appeal of the Old World wines—you can impress your friends with your expertise by recommending one vintage over another. However, many ­ consumers, ­ particularly firsttime buyers, found that downright ­confusing. Because the AOC system tied the wine label to the land on which the grape was grown, Old World vintners were also limited in their ability to b­enefit from technological changes and economies of scale. If someone invented a machine to facilitate grape harvesting, you could not n­ ecessarily buy out your neighbor to capture economies of scale—his

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land might have a different terroir, and p­ erhaps a different government cru classification. As a result, the a­ verage size vineyard in France is only 7.4 acres and 1.3 acres in Italy, compared to 167 acres in Australia and 213 acres in the United States. Driven by the Judgment of Paris and changes in ­consumption patterns, wine production grew steadily during the 1970s, 1980s, 1990s, and into the new ­century in New World countries such as the United States, Chile, Argentina, Australia, and South Africa. The New World wine ­makers differentiated their wines primarily by grape variety—pinot noir, cabernet sauvignon, etc.—rather than by the ­ specific vineyard or chateau where the grapes were grown. Moreover, the New World wine makers ­relied on branding, rather than vineyard names, to market their products. This had several advantages. First, it simplified the purchase decision for unsophisticated buyers—­remembering a brand name like Columbia Crest or Yellowtail was often easier than recalling that of an ­obscure, small French vineyard. Second, New World vintners were able to blend grapes from various vineyards to create a wine with consistent taste from year to year, regardless of random changes in the weather. Third, they were able to market large volumes of wine under that brand name, allowing them to distribute their ­ products more easily through mass-market retailers like Tesco, Marks & Spencer, Kroger, and Walmart. As a result, New World vintners are much larger than their Old World rivals and are more able to capture economies of scale from use of the latest technological breakthroughs and labor-saving ­mechanization. The four largest firms in the United States, for example, control 56 percent of U.S. sales; for Australia, 62 percent; and Chile, 82 percent. In France, the four largest firms are responsible for only 16 percent of sales; Spain, 21 percent, and Italy, 10 percent. Export markets are vitally important to both Old World and New World vineyards. About 4 billion liters of wine are traded in a typical year. The EU accounts for 36 ­percent of the export market and the United States for 10 ­percent, ­primarily from California. Because both are major ­consumers of wine, the bulk of their production is ­consumed domestically. Such is not the case for Australia and Chile, each of which export 700 million liters of wine annually. Australia, for example, accounts for 5  ­percent of global production but 15 percent of global wine exports.

Case Questions 6-21. Both Old World vineyards and New World vineyards compete in the global market place. What are the competitive advantages and disadvantages of the Old World vineyards? Of the New World vineyards? 6-22. Why are French wines able to command a price ­premium in export markets?

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6-23. Should the French government relax its AOC system, allowing French vintners to expand the size of their chateâux to capture economies of scale? Why or why not? 6-24. Should the U.S. government adopt an AOC system to ensure the quality of U.S. wines destined for export markets? 6-25. “Bottle shops”—small retail outlets specializing in selling fine wines—might purchase a case or two of a specific wine when placing an order. (A case typically consists of a dozen 750-milliliter bottles.) Buyers for large multistore firms such as Tesco or Walmart often order thousands of cases at a time. Which type of retailer is likely to specialize in Old World wines? In New World Wines? Give a reason for your answer.

Sources: Based on “China as a Vast Wine Market,” Wall Street Journal, March 25, 2013; p. B6; “The Future of French Wine: Overcoming ‘Terroirisme’ and Stagnation,” Knowledge@Wharton, January 2, 2013; WWTG Vini-Viticultural Data, World Wine Trade Group, November 2012; Kym Anderson, “The Southern Hemisphere and Global Wine Markets to 2030: Case Study of Australia,” Giannini Foundation of Agricultural Economics, University of California; Kym Anderson and Glyn Wittwer, “Modelling the impact of exchange rate movements on the world’s wine markets, 2007–2011,” Wine Economics Research Centre Working Paper No. 0312, November 2012, University of Adelaide; James Simpson, Creating Wine (Princeton University Press: Princeton, 2011); Kym Anderson and S. Nelgen, Global Wine Markets, 1961 to 2009: A Statistical Compendium (Adelaide: University of Adelaide Press, 2011); “Wine: World Markets and Trade,” U.S. Department of Agriculture, Foreign Agricultural Service, April 2010.

MyManagementLab® Go to mymanagementlab.com for the following assisted-graded writing questions: 6-26.  Discuss the strengths and weaknesses of the country-based trade theories and the firm-based trade theories. 6-27.  What are the primary factors that affect FDI? 6-28.  Mymanagementlab only—comprehensive writing assignment for this chapter.

Endnotes 1. “Kenya flower farmers braced for poll threat,” Financial Times, February 5, 2013, p. 5; FloraHolland 2011 Annual report; “Flower Power,” China Daily, May 27, 2011; “The Secrets Behind your flowers,” Smithsonian, February, 2011; “With flights grounded, Kenya’s ­produce wilts, New York Times, April 19, 2010; “Houston to take on Miami for global flower market,” Houston Chronicle, October 9, 2009; www.floraholland.com; http:// en.kunming.cn; “Yunnan’s flower i­ndustry blooms,” China International Business, June 10, 2009; “Flower market has rosy outlook,” Boston Globe, February 6, 2008. 2. Arthur M. Schlesinger, The Colonial Merchants and the American Revolution 1763–1776 (New York: Facsimile Library, 1939), pp. 16–20. 3. David Ricardo, The Principles of Political Economy and Taxation (Homewood: Irwin, 1963). (Ricardo’s book was first published in 1817.) 4. Michael Moritz, The Little Kingdom: The Private Story of Apple Computer (New York: William Morrow, 1984). 5. “Taiwan eases rules for Chinese investors,” Financial Times, February 28, 2011, p. 20.

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6. P. Krugman, “Intraindustry specialization and the gains from trade,” Journal of Political Economy, vol. 89 (October 1981), pp. 959–973. 7. K. Lancaster, “Intra-industry trade under perfect ­monopolistic competition,” Journal of International Economics, vol. 10 (May 1980), pp. 151–175. 8. Andrew R. Dick, “Learning by doing and dumping in the semiconductor industry,” Journal of Law and Economics, vol. 34, no. 1 (April 1991), p. 134. 9. Fred Warshofsky, The Chip War (New York: Scribner’s, 1989), pp. 131–132. 10. The investment statistics for this section are taken from the Survey of Current Business, July 2013, pp. 14ff. 11. A. Quijana, “A guide to BEA statistics on foreign ­direct investment in the United States,” Survey of Current Business, February 1990, pp. 29–37. 12. Grant T. Hammond, Countertrade, Offsets and Barter in International Political Economy (St. Martin’s Press: New York, 1990), p. 3. 13. “Intel pushes chip production deep into China’s ­hinterland,” Wall Street Journal, May 23, 2006, p. B1.

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14. “Nokia to establish new manufacturing site in Vietnam,” Nokia press release dated March 1, 2011. 15. “China joins Venezuela in heavy-oil venture,” Houston Chronicle, September 11, 2007 (online). 16. “Korea finds a new way to exploit expertise,” Financial Times, August 16, 2007 (www.ft.com). 17. “Starbucks Buys Its First Coffee Farm,” Wall Street Journal, March 19, 2013, p. B3. 18. “Asian investment floods into Mexican border region,” Wall Street Journal, September 6, 1996, p. A10.

19. “Samsung attracts six Korean suppliers,” Financial Times, April 24, 1996, p. 9. 20. “Limit reached on Visas for skilled workers after one week,” Wall Street Journal, April 9, 2008, p. A12; “Firms get creative to work around Visa bottlenecks,” Wall Street Journal, August 27, 2007, p. B1; “Microsoft plans Canada software enter,” Wall Street Journal, July 6, 2007 (online). 21. “Toyota to build Lexus in U.S. for first time,” Chicago Tribune, April 17, 2013.

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CHAPTER 6 Trade Protectionism

OBJECTIVES After studying this chapter, you should be able to 6-1 Recognize the conflicting outcomes of trade protectionism 6-2 Assess governments’ economic rationales and outcome uncertainties with international trade intervention 6-3 Assess governments’ noneconomic rationales and outcome uncertainties with international trade intervention 6-4 Describe the major instruments of trade control 6-5 Classify how companies deal with governmental trade influences

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Mining work in Chile

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Source: FXEGS Javier Espuny. Shutterstock

Charity begins at home.

CASE

The Case of REEs: Trade Disputes and Protectionist Measures for Strategic Materials1 —Stefania Paladini

China’s rapid rise as a political and economic power has caught the attention of many countries across the world, especially with regard to natural resources. Rare earth elements (REEs), important strategic materials for many countries in terms of production of advanced technologies globally, are almost exclusively mined by Chinese firms due to the low costs of production there. As it has a large REE mining industry, both state-owned and private, the Chinese government has a massive political and economic influence in the REE market. The REEs are the 17 elements scandium, yttrium, and the 15 elements in the lanthanide series. The term REE comes from the fact that these elements have only been discovered quite recently, the first one at the end of 18th century in Sweden, the other blocks in the course of the 19th century. In addition, the extraction is usually complicated, expensive, and often environmentally taxing because of their low concentration in the minerals that contain them. The use and relative importance of REEs has been increasing due to the special properties that characterize them; they are essential components in magnets and indispensable for hybrid vehicles, computer screens, smart phones, and turbines for wind farms.

THE CHINESE MARKET DOMINANCE AND PROTECTIONISM The recent case of the REEs is in many ways emblematic of the way protectionist measures can lead to disputes (and in extreme cases may even result in trade wars), and offers an example of the recourses that states can expect from the World Trade Organization (WTO). Mostly unknown to a majority of the world, REEs suddenly came into the spotlight when, in 2009, the world industry realized that 97 percent of the production was primarily in China, creating a situation of virtual monopoly. From 2005, China had started imposing an export quota to maintain a substantial part of the product in the domestic market, causing a spike in the spot and future prices of the minerals. These economic policies imposed by the Chinese government, restricting trade between it and other countries to promote domestically produced goods, are indicators of China’s protectionism. The forms of protectionism include exchange rate controls, tariffs, direct subsidies, and administrative barriers of various kinds. The reasons for China’s quotas are generally two-fold. The first is linked to economic reasons. China’s industries require huge amounts of raw materials that generally they are forced to import, with the exceptions of a few, like rare earths, which, however, need to be secured for domestic producers, especially now that the extraction is concentrated in China. The second reason is the high environmental costs involved in the extraction of REEs, which China has become sensitive to in the last decade. The quotas have had the effect of a sharp rise in prices, which had previously fallen in the 1990s as a

result of the overproduction in China. Therefore, they represent an environmental tax that China imposes on the rest of the world.

TRADE DISPUTE SETTLEMENT: THE OPPOSITION China’s approach to the exports of REEs caused concern in the global market. It’s attempt to acquire the Mountain Pass mine in California, which had been at the center of REE world production before China, and the Australian Lynas Corporation, reflected a need for regulated trade at a global level. In 2012, Japan, the United States, and the European Union (EU) filed a complaint to the WTO Dispute Settlement Board (DSB), stating that free trade was being undermined by the imposition of such regulations. In 2015, after the DSB examined the issue, China lost the case and had to remove the export quotas. The procedure that had been followed for this REE case is an example of how trade disputes are often tackled. Various countries—like Brazil, Canada, India, Korea, Norway, and Australia—registered as co-complainants, while the United States, the EU, and Japan requested and obtained from the WTO the right to constitute an inquiring panel. It was found that tungsten and molybdenum—two other raw materials not listed as part of the REE 17—were also under the restriction. While China did lift the restrictions, the government did not lift similar export quotas and duties that applied to materials like tungsten and molybdenum. The WTO stated that China’s sovereign rights pertaining to its natural resources do not give it the right to control global markets or the distribution of raw materials. The investigating panel was given time to issue its final report by November 2013, in accordance with the timetable adopted after consultations with all the countries that had filed their interest in this case. In March 2014, the panel issued a report presenting its conclusions and recognizing the allegations as valid. Regarding the trade quotas and restrictions, the WTO decided that that China’s export quotas were not designed to preserve China’s natural resources and environment, but there were directed instead to meet precise industrial policy goals. As a result, the restrictive measures were removed. In a 2015 paper by Schlinkert and Boogaart, an economic model was proposed to explain China’s behavior as an REE supplier. According to the model, how the world REE market develops can be divided into four stages 1. Market penetration.  Due to lower costs of production, China enters the REE market. 2. Market exploitation.  China enjoys monopoly status and restricts the export of REEs in order to maximize profit and gain political influence.

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MAP 6.1 The People’s Republic of China (PRC) The People’s Republic of China has a large REE mining industry that incur low costs of production, the Chinese government has a massive political and economic influence in the REE market.

CHINA

3. Declining market. China begins to lose its monopoly as production costs increase and foreign mining operations restart. 4. Moving from monopoly to oligopoly. With external competitors increasing their share in the industry, Chinese producers and global producers reach a state of equilibrium.

GLOBAL REE SUPPLY AND OTHER ALTERNATIVES While many did state that China created a monopoly by increasing export prices, some experts felt that the bubble created by the high prices made it economically possible for global business like the Mountain Pass mine and Lynas Corporation to invest in the production of other rare earth mines. In 2011, Lynas commenced its production activities at its rare earth mine in Mount Weld. It also has a refining facility built in Malaysia where it processes REE products. In 2015, Mountain Pass began full production. China’s trade quotas also forced foreign companies and governments to consider other options to ease the supply tension. Alternative options, while they require a significant investment, do exist. Created as byproducts of various mining activities, REEs are often present in other countries, but are rarely used. Potential sources of REEs, while not very economical, include sifting through

the fly ash residue from the production of minerals like alumina and zirconium. Kazakhstan, the leader of global uranium production, is considering entering the REE market as both heavy and light elements are commonly found in uranium mines. In 2012, Japanese corporation Sumitomo invested in Kazatomprom, a state-owned nuclear company in Kazakhstan, and laid plans to create a factory with a production capacity of 1,500 tons of rare earth oxides per year. Another alternative has been found in recycling REEs from discarded consumer goods and hardware. Countries like Japan, Europe, and the United States are researching this area.

THE FUTURE The immediate concern for China was the environmental impact of REE mining in the country and that the alternatives created a declining global demand for China’s REE, which hurt job prospects in domestic markets. We should, however, understand that China’s behavior is not in isolation. Its market is not the first to have had a near monopoly on strategic materials and definitely not the first (or last) to have considered using it to its advantage. This economic outlook also indicates that protectionism may lead to trade retaliation, which in turn would raise prices, detrimentally affect living standards, leave

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business in a worsened fiscal position, and counteract the effects of any positive initiatives that may have been taken for domestic and global growth. There have also been concerns about non-Chinese rare earth investment projects. Non-Chinese players questioned whether China would reduce its export taxes and abolish its export quotas as this would impact the rare earth producers outside of China. While global prices are typically 20 percent higher than Chinese domestic prices, a fall in the prices in the global markets, due to changes in Chinese policies, would make investments outside of China non-competitive. Non-Chinese producers have to compete against China with higher capital costs and higher environmental standards. In 2014 and 2015, companies like Lynas and MolyCorp were almost bankrupt and looking at large-scale recapitalization to keep business active.

The technological importance of rare earth elements and China’s near monopoly makes the REE industry full of political and economic uncertainty. Whether the country’s monopoly on REEs will strengthen or weaken in the near future is unclear, with evidence being available to justify either side of the debate. ■ QUeStIONS 6-1. Using the data provided by the case (and by searching the Internet), identify which kind of raw materials have become sensitive resources. Why? 6-2.  Complaints procedures and dispute resolution mechanisms at the WTO are lengthy and complex, and this might explain why their adoption is not as common or frequent as it could be. In this specific case, what was the reason China was censured?

CONFLICTING OUTCOMES OF TRADE PROTECTIONISM

All countries seek to influence trade and respond to their economic, social, and political objectives.

CONCEPT CHECK Chapter 5 (pages 180–182) demonstrates how specialization and free trade can increase output, but here we point out that protectionist policies, although sometimes warranted, can lead to conflicting outcomes.

At some point, you may be an employee or shareholder in a company whose performance or survival depends on governmental trade practices. These may affect foreign producers’ ability to compete in your home market and your company’s ability to operate abroad. Collectively, governmental actions to influence international trade are known as protectionism. Restrictions, such as those illustrated in the opening case, are common inasmuch as all countries regulate the flow of goods and services across their borders. Figure 6.1 illustrates the institutions that pressure governments to regulate trade and the subsequent effect on business competitiveness. This chapter reviews the economic and noneconomic rationales for trade protectionism, the major forms of trade controls, and trade control’s effects on companies’ operating decisions. Despite free-trade benefits, governments intervene in trade to attain economic, social, or political objectives. Officials enact trade policies that they reason will have the best chance to benefit their nation and its citizens—and, in some cases, their personal political longevity. Their decisions are complicated because outcomes are uncertain and affect groups of their citizens differently. FIGURE 6.1

Institutional Factors Affecting the Flow of Goods and Service

In response to a variety of institutional factors (i.e., cultural, political/legal, and economic), governments enact measures designed to either enhance or restrict international trade flows. These measures invariably affect the competitive environment in which companies operate internationally. To an extent, of course, the converse is also true: Companies influence government trade policies that affect their institutions.

TRADE ENHANCEMENTS COUNTRY A • Cultural values, attitudes, and beliefs • Political policies and legal practices • Economic forces

COUNTRY B TRADE RESTRICTIONS

COMPANIES’ COMPETITIVE ENVIRONMENT

• Cultural values, attitudes, and beliefs • Political policies and legal practices • Economic forces

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THE ROLE OF STAKEHOLDERS Those stakeholders most affected by trade regulations push hardest for trade rules favorable to them.

Proposals on trade regulations often spark fierce debate among people who believe they will be affected—the so-called stakeholders. Of course, those most directly affected are most apt to speak out, such as workers, owners, suppliers, and local politicians whose livelihoods depend on the actions taken. Displaced workers may see themselves as unemployed for the long term or forced to take new jobs in new industries, perhaps even in new towns at lower wages. People threatened in this way tend to voice their views often and loudly. In contrast, consumer stakeholders typically buy the best product they can find for the lowest price, often without knowing or caring about its origin. They frequently don’t realize how much retail prices rise in aggregate because of import restrictions. Nor do they take much notice, since the retail price rises are typically spread out among many people over time and entail a small increase for individual purchases. For example, even if U.S. consumers realized that import restrictions cause them to pay more for catfish at restaurants and supermarkets, they would not likely band together to lobby for removal of the restrictions. In effect, their potential gains would be too low in comparison with their efforts.

ECONOMIC RATIONALES FOR GOVERNMENTAL TRADE INTERVENTION AND OUTCOME UNCERTAINTIES Governments intervene in international trade for either economic or noneconomic reasons, as shown in Table 6.1. Let’s begin by analyzing some leading economic rationales.

FIGHTING UNEMPLOYMENT The unemployed can form an effective pressure group for import restrictions.

Import restrictions to create domestic employment • may lead to retaliation by other countries, • affect large and small economies differently, • reduce import handling jobs, • may decrease jobs in another industry, • may decrease export jobs because of lower incomes abroad.

Probably no pressure group is more effective than the unemployed; no other group has more time and incentive to protest publicly and contact government representatives. Importdisplaced workers are often the least able to find alternative work, especially if large numbers are concentrated in small company towns where there are virtually few alternative employment opportunities.2 When they do, they generally earn less than before.3 Moreover, they often need to spend their unemployment benefits to survive in the short term, and they put off retraining because they hope to be recalled to their old jobs. Further, many workers, especially older ones, lack the needed educational background to gain required skills. Or they train for jobs that do not materialize. What’s Wrong with Full Employment as an Economic Objective? Nothing! However, gaining jobs by limiting imports may not fully work as expected. Even if jobs are gained, the costs may be high and must be borne by someone. The Prospect of Retaliation When imposing trade restrictions used to protect or promote domestic industries at the expense of foreign players, the foreign players will retaliate. The opening case addressed concerns about how China retaliated the WTO decision by lifting restrictions on REE trade, but retaining those on other strategic materials like tungsten. Thus, the restrictions would merely move from one industry to another. TABLE 6.1

Why Governments Intervene in Trade

Economic Rationales

Noneconomic Rationales

Fighting unemployment Protecting infant industries Promoting industrialization Improving comparative position

Maintaining essential industries Promoting acceptable practices abroad Maintaining or extending spheres of influence Preserving national culture

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Large trading countries are more important in the retaliation process. For instance, China would have more power to retaliate than, say, Mauritius, to U.S. limits on clothing imports. And the United States is less apt to retaliate against Mauritian than Chinese trade restrictions because of the lesser effect on the U.S. economy. Other Limits on Employment has the following limitations:

In addition to retaliation, gaining jobs by limiting imports

1. Fewer imports mean fewer import-handling jobs, such as those in the container-shipping

industry, the clearance of goods through customs, and the distribution of the imports. 2. Given the global complexity of production, import restrictions on one industry cause higher input costs for other industries, thus making them less competitive.4 For example, U.S. import restrictions on steel raise input costs in the U.S. automobile and farm equipment industries. 3. Imports stimulate exports, though less directly, by increasing foreign income, which foreign consumers then spend partially on new imports. Thus, restricting earnings abroad has some negative effect on domestic earnings and employment. Analyzing Trade-Offs Analysis of net changes in employment cannot capture the price of distress suffered by people who lose their jobs through import competition. Nor is it easy for working people to understand that their economic gains through lower prices from freer trade may exceed their higher taxes to support unemployment or welfare benefits for those who lose jobs. In summary, many groups call for protectionism to increase or protect employment. However, evidence suggests that employment is better dealt with through fiscal and monetary policies.

PROTECTING “INFANT INDUSTRIES” The infant-industry argument says that production becomes more competitive over time because of

The infant-industry argument holds that a government should shield an emerging industry from foreign competition by guaranteeing it a large share of the domestic market until it can compete on its own.

• increased economies of scale, • greater worker efficiency.

Underlying Assumptions The infant-industry argument presumes that early operating costs within a newly producing country may be too high to compete in world markets and that sufficient cost reductions will occur over time. Therefore, protection for fledgling companies enables them to gain economies of scale and higher productivity through worker experience.

CONCEPT CHECK In Chapter 5 (pages 192–193 in the Point-Counterpoint section), we discuss governmental problems to determine what industries to support in a strategic trade policy and the difficulty of removing the support if the industries do not become globally competitive.

Possible costs of import restrictions include higher prices and higher taxes. Such costs should be compared with those of unemployment.

Risks in Designating Industries However, production costs may never fall enough to create internationally competitive products. Inherently, there are problems. Determining Probability of Success First, governments must identify those industries that have a high probability of success, and this is hard. For example, governmental protection worked for the Brazilian automobile industry, but not for the Malaysian one. Second, the security of government import protection may deter managers from adopting the cost and quality measures needed to compete. Third, if a protected industry fails to become globally competitive, its affected stakeholders may successfully prevent the imports that benefit consumers. Who Should Bear the Cost? Even if policymakers choose the right industries, some economic segment must absorb the high early cost before domestic production becomes internationally viable. This burden may fall on consumers who pay higher prices for the protected products or on taxpayers who pay for subsidies. When taxes go for subsidies, governments may be less able to spend to improve overall competitiveness, such as on education and infrastructure. Finally, why rely on governmental assistance? Many entrepreneurs have endured early losses to achieve future competitiveness.

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DEVELOPING AN INDUSTRIAL BASE Countries seek protection to promote industrialization because that type of production • can use surplus agricultural workers more easily, • brings in investment funds, • diversifies the economy, • brings faster growth than primary products do.

Since the industrial revolution, countries increasing their industrial bases grew their employment and economies more rapidly. This observation led to protectionist arguments to spur local industrialization. These arguments have been based on the following assumptions:

1. Surplus workers can increase manufacturing output more easily than agricultural output. 2. Import restrictions lead to foreign investment inflows, which provide jobs in manufacturing.

3. Prices and sales of agricultural products and raw materials fluctuate widely, which is a detriment to economies that depend heavily on them, especially if the dependence is on just one or a few commodities. 4. Markets for industrial products grow faster than markets for both agricultural and raw material commodities. In the sections that follow, we review each of these assumptions. Surplus Workers Disguised unemployment is high in rural areas of many developing countries, where many people effectively contribute little, if anything, to the agricultural output. Consequently, they can move into the industrial sector without significantly reducing agricultural output. This industrialization argument presumes that, although a country may develop an inefficient and non-globally competitive industrial sector, it will achieve economic growth by enabling the unemployed and underemployed to work in industry.5 Shifting people out of agriculture, however, can create problems:

When a country shifts from agriculture to industry • output may increase if the agricultural workers produced little before, • demands on social and political services in cities may increase, • development possibilities in the agricultural sector may be overlooked, • industrial jobs may not be forthcoming.

1. The underemployed in rural areas may lose the safety net of their extended families, while many migrating to urban areas cannot find enough suitable jobs, housing, and social services. For example, although millions of Chinese have moved to cities to find jobs, many have not prospered through the move.6 2. Improved agricultural practices may be a better means of achieving economic success than a drastic shift to industry. Many developed countries continue to profit from exports of agricultural products and maintain high per capita income with a mix of industry and efficient agricultural production. 3. Most past manufacturing was performed by relatively unskilled workers and at a time when this output’s proportion of global output and growth exceeded those in other sectors (e.g., agriculture, raw materials, and services). Thus, there were ample opportunities in factories for the unskilled labor force who were “fresh off the farm.” However, this situation has changed and is known as premature industrialization. Manufacturing employment has been falling as a portion of total global employment because technology is replacing the need for as many workers, especially unskilled ones. Although there are growing employment opportunities in the service sector, people lacking much education are forced into low-paying service jobs.7

If import restrictions keep out foreign-made goods, foreign companies may invest to produce in the restricted area.

Investment Inflows Import restrictions, applied to spur industrialization, also may increase FDI, which provides capital, technology, and jobs. Barred from exporting to an attractive foreign market, foreign companies may transfer manufacturing to that country to avoid the loss of a lucrative or potential market.

Although demand and prices for commodities fluctuate markedly, a shift to production of manufactures creates competitive risk.

Diversification Export prices of many commodities, such as oil and coffee, fluctuate markedly because of weather and technology affecting supply or business cycles affecting demand, thus wreaking havoc on economies that depend on their export. Because many developing countries rely on only one or a few commodities, they are caught in a feastor-famine cycle, as it were: able to afford foreign luxuries one year but unable to find the funds for essential equipment’s replacement parts the next. However, a greater dependence on manufacturing does not guarantee diversification of export earnings. The population of many developing economies is small; a move to manufacturing may shift dependence from

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one or two agricultural commodities to one or two manufactured products, which face competitive risks and potential obsolescence. Terms of trade may deteriorate because • demand for primary products grows more slowly than manufactured ones, • production cost savings for primary products will be passed on to consumers.

Industrialization emphasizes either • products to sell domestically or • products to export.

Growth in Manufactured Goods The quantity of imports that a given quantity of a country’s exports can buy—say, how many bananas Country A must sell to Country B to purchase one refrigerator from Country B—is the terms of trade. Historically, except for short periods, the prices of commodities have not risen as fast as those of finished products.8 Over time, therefore, it takes more low-priced primary products to buy the same amount of high-priced manufactured goods. Why? First, the quantity of primary products demanded does not rise as rapidly as manufactured products and services, due partly to consumers’ spending a lower percentage of income on food as their incomes rise and partly to raw-material-saving technologies. Second, because commodities are hard to differentiate, they usually must compete on price, whereas the prices of manufactured products can stay high because competition is based more on differentiation. Import Substitution and Export-Led Development Traditionally, developing countries fostered industrialization by promoting import substitution—restricting imports to boost local production of products they would otherwise import. In contrast, some countries, such as Taiwan and South Korea, have achieved rapid economic growth by promoting the development of industries with export potential, an approach known as export-led development. In reality, it’s not easy to distinguish between import substitution and export-led development. Industrialization may result initially in import substitution, yet export development of the same products may be feasible later.

ECONOMIC RELATIONSHIPS WITH OTHER COUNTRIES Nations monitor their absolute economic situations and compare their performance to other countries. Among their many practices to improve their relative positions, four stand out: making balance-of-trade adjustments, gaining comparable access to foreign markets, using restrictions as a bargaining tool, and controlling prices. Balance-of-Trade Adjustments A trade deficit influences reductions in a nation’s exchange reserves—the funds that help purchase priority foreign goods and maintain the trustworthiness of its currency. So balance-of-trade deficits may cause a government to act to reduce imports or encourage exports. Two options that can affect its competitive position broadly are:

1. Depreciating or devaluing its currency, which makes basically all of its products cheaper

in relation to foreign products 2. Relying on fiscal and monetary policy to bring about lower price increases in general than those in other countries

If domestic producers have less access to foreign markets than foreign producers’ have to their market,

Both of these options take time. Furthermore, they aren’t selective; for instance, they make both foreign essentials and foreign luxury products more expensive. Thus, a country may use protection instead to affect only certain products. Doing so is really a stopgap measure to gain time to address the fundamental competitive situation—the perceived quality, quantity, characteristics, and prices of products—that is causing its residents to buy more abroad than they are selling.

• they may be disadvantaged, • restricting foreign entry may disadvantage domestic consumers, • negotiating equal market access for each product is impractical.

Comparable Access or “Fairness” The comparable access argument holds that industries are entitled to the same access to foreign markets as foreign industries have to theirs. Economic theory supports this idea when substantial production cost decreases result from economies of scale. Companies that lack equal access to a competitor’s market will be relatively disadvantaged in gaining enough sales to be cost-competitive.9

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Comparable access is also presented from a fairness perspective. For instance, the U.S. government permits foreign financial service firms to operate in the United States, but only if their home governments allow U.S. financial service firms equivalent market access. There are, however, at least two practical reasons for rejecting the idea of fairness:

1. Tit-for-tat market access can lead to restrictions that may deny one’s own consumers lower prices.

2. Governmental negotiation and monitoring of separate agreements for each of the thou-

sands of different products and services that might be traded would simply be impractical.

Successful countries’ threats to levy trade restrictions to coerce other countries to change their policies • must be believable, • involve products important to the other countries.

Import Restrictions as a Bargaining Tool The threat or imposition of import restrictions may persuade other countries to lower their import barriers or not raise them. The danger is that each country then escalates its restrictions instead, creating, in effect, a trade war that negatively impacts all their economies. Using restrictions successfully as a bargaining tool requires very careful product targeting by considering the following criteria: •

•

Export restrictions may • raise world prices, • require more controls to prevent smuggling, • be ineffective for digital products, • lead to product substitution or new ways to produce the product, • keep domestic prices down by increasing domestic supply, • give producers less incentive to increase output.

Believability: Either the country has access to alternative sources for the product or its consumers are willing to do without it. The EU successfully retaliated against U.S. import restrictions on clothing by threatening to impose trade restrictions on U.S.-grown soybeans when Brazil had a surplus. Importance: Exports of the restricted product must be significant to influential parties in the producer country. This consideration was emphasized when the United States placed restrictions on imported steel. The EU threatened to restrict apple and orange imports, which would hurt producers in Washington and Florida. Given the importance of these two states in a close presidential election, apple and orange stakeholders quickly convinced the United States to remove the steel import restrictions.

Export Restrictions Countries that hold a near-monopoly of certain resources sometimes limit their international sale in an effort to raise prices abroad. However, this policy often encourages smuggling (such as occurs with emeralds and diamonds), the development of technology (such as synthetic rubber in place of natural rubber), or different means to produce the same product (such as caviar from farm-grown rather than wild sturgeons).10 Export controls are especially ineffective for digital products because they are so easily copied abroad. A country may also limit exports of a product that is in short supply worldwide to favor domestic consumers. Typically, a greater supply drops domestic prices beneath foreign ones. Russia and Argentina have pursued this strategy by limiting exports of food products; India has limited cotton exports to increase supplies for its textile industry, and the United States has curtailed crude-oil exports.11 However, favoring domestic consumers disfavors domestic producers, so they have less incentive to maintain production when prices are low. Affecting Exporters’ Prices ers’ prices.

Import restrictions may aim either to raise or lower export-

Prevention of Foreign Monopolies There is fear that foreign producers will price their exports so artificially low that they will drive producers out of business in the importing country. If they succeed, there are two potential adverse consequences for the importing economy: CONCEPT CHECK Discussion of neomercantilism in Chapter 5 (page 178–179) explained that countries may attempt to shift their economic and social problems abroad.

1. The foreign country may be shifting its unemployment abroad by subsidizing the sales. 2. If there are high entry barriers, surviving foreign producers may be able to charge exorbitant

prices. However, for most products competition is so widespread that no country or company can reach such a dominant position. For example, low import prices have eliminated most U.S. production of consumer electronics; still, the United States has some of the world’s lowest consumer electronics prices because so many companies make them in so many countries.

Prevention of Dumping Exporting below cost or below home-country price is dumping. Most countries restrict imports of dumped products, but enforcement usually occurs only if

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Dumping • may be used to introduce a new product, • may cause higher prices or subsidies in the exporting country, • is hard to prove.

An optimum tariff’s success • shifts revenue to an importing country, • is difficult to predict, • may cause lower worker income in developing countries.

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the imported product disrupts domestic production; otherwise host-country consumers get the benefit of lower prices and don’t complain. While exporting countries may encourage dumping to improve employment, companies may dump products to introduce them and build a market abroad. Essentially, a low entry price encourages consumers to sample the foreign brand—after which they can charge a high enough price to make a profit. Companies can afford to dump products if they are subsidized or if they can charge high prices in their home market. Ironically, exporting-country consumers or taxpayers seldom realize that they are paying for foreign consumers’ lower prices. An industry that believes it’s competing against dumped products may appeal to its government to restrict the imports. However, determining a foreign company’s cost or even its domestic price to middlemen is difficult because of limited access to its accounting records, fluctuations in exchange rates, and the passage of products through layers of distribution before reaching the end consumer. Nevertheless, industries do manage to succeed, (e.g., U.S. steelmakers’ curtailment of Korean steel pipes).12 However, critics claim that governments allegedly limit imports arbitrarily through antidumping restrictions and are slow to dispose of the restrictions if pricing situations change. Companies caught by antidumping restrictions often lose the export market they labored to build. Invoking the Optimum-Tariff An optimum-tariff theory is one by which a foreign producer lowers its export prices when an importing country places a tax on its products. If this occurs, benefits shift to the importing country because the producer lowers its profits on the export sales. Let’s examine a hypothetical situation. Assume an exporter has costs of $500 per unit and is selling abroad for $700 per unit. With the imposition of a 10 percent tax on the imported price, the exporter may choose to lower its price to $636.36 per unit, which, with a 10 percent tax of $63.64, would keep the price at $700 in the foreign market. The exporter may feel that a foreign market price higher than $700 would result in lost sales and that a profit of $136.36 per unit instead of the previous $200 is better than no profit at all. Consequently, an amount of $63.64 per unit has shifted to the importing country. As long as the foreign producer lowers its price by any amount, some shift in revenue goes to the importing country and the tariff is deemed an optimum one. There are many examples of products whose prices did not rise as much as the amount of the imposed tariff. For instance, purveyors of luxury producers have narrowed profit margins in Brazil to help offset import levies and sales taxes.13 However, predicting when, where, and which exporters will voluntarily reduce their profit margins is imprecise. Further, a criticism of the optimum tariff is that developing country exporters reduce payment to their workers rather than absorbing the full impact through a lower profit margin, thus sometimes causing severe hardships.14

GOVERNMENTS’ NONECONOMIC RATIONALES AND OUTCOME FOR TRADE INTERVENTION Although noneconomic arguments are used to influence trade, many of these also have economic undertones and consequences. However, let’s look at the major noneconomic rationales: • • • • In protecting essential industries, countries must • determine which ones are essential, • consider costs and alternatives, • consider political and economic consequences.

Maintaining essential industries (especially defense) Promoting acceptable practices abroad Maintaining or extending spheres of influence Preserving national culture

MAINTAINING ESSENTIAL INDUSTRIES Under the essential-industry argument nations apply trade restrictions to protect crucial domestic industries so that they are not dependent on foreign supplies during hostile political periods. For example, the United States subsidizes domestic silicon production so that its computer-chip makers need not depend on foreign suppliers. (In some cases, countries also

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prevent foreign companies from acquiring domestic companies needed for national security; the United States does this through the Committee on Foreign Investment in the United States [CFIUS].) Because of nationalism, defense needs have much appeal in rallying support for import barriers. However, in times of real (or perceived) crisis or military emergency, almost any product could be deemed essential. The essential-industry argument should not be (but frequently is) accepted without a careful evaluation of costs, real needs, and alternatives. Once given, protection is hard to remove, even when the rationale for protection no longer exists. For instance, the United States subsidized mohair producers for more than 20 years after mohair was no longer essential for military uniforms.15 In addition, governments buy and stockpile supplies of essential raw materials that might be in future short supply. For example, the United States stockpiles rare-earth elements because China controls most output and because the military needs them for weapons, jet engines, high-powered magnets, and other gear.16

PROMOTING ACCEPTABLE PRACTICES ABROAD Trade limitations may be used to compel a foreign country to amend an objectionable practice.

Governments limit exports, even to friendly countries, of strategic goods that might fall into the hands of potential enemies. They also limit exports and imports to compel a foreign country to change some objectionable policy or capability. The rationale is to weaken the foreign country’s economy by decreasing its foreign sales and by limiting its access to needed products, thus coercing it to amend its practices on some issue such as human rights, environmental protection, military activities, and production of harmful products. Trade limitations are often combined with other economic pressures and incentives such as restricting access to bank accounts and cutting off or increasing foreign aid. The effectiveness of trade sanctions depends on the sanctioned country’s inability to retaliate effectively, secure alternative markets and supplies, and develop a production capability of its own. Our Point-Counterpoint section discusses the pros and cons of sanctions.

Point

Point

Yes Let’s face it: We’re now living in a global society where actions in one country can spill over and affect people all over the world. For instance, the development of a nuclear arsenal in one nation can escalate the damage that terrorists can do elsewhere. The failure of a country to protect endangered species can have long-term effects on the whole world’s environment. We simply can’t sit back and let things happen elsewhere that will come back to haunt us. At the same time, some pretty dastardly things occur in some countries that most of the world community would like to see stopped: human trafficking for forced prostitution, child slaves to harvest crops, political prisoners given near-starvation diets, to name a few. Even if we can’t stop such occurrences, we have a moral responsibility not to participate even if it costs us. I may get some economic benefits by buying from criminals, and I may not stop their activity by withholding my business; however, I refuse to deal with them because, in effect, that makes me a criminal’s associate. Although not all trade sanctions have been successful, many have at least been influential in achieving their objectives. These included UN sanctions against Rhodesia

Should Governments Impose Trade Sanctions? (now Zimbabwe), U.K. and U.S. sanctions against the Amin government of Uganda, and Indian sanctions against Nepal.17 Sanctions against Myanmar helped bring the country to such economic disaster that its military leaders decided democracy was a better route to take.18 Sanctions against Iran helped terminate Iran’s nuclear program, and pressure on Brazil led to greatly reduced cutting of Amazon forests.19 Further, even if sanctions do not completely change behavior, they may force countries not to escalate their unacceptable practices.20 Finally, when a nation breaks international agreements or acts in unpopular ways, what courses of action can other nations take? Between 1827 and World War I, nations mounted 21 blockades, but these are now considered too dangerous. Military force has also been used, for example, during the overthrow of the Saddam regime in Iraq, but such measures have little global support. Thus, nations may take such punitive actions as withholding diplomatic recognition, boycotting athletic and cultural events, seizing the other country’s foreign property, and eliminating foreign aid and loans. These may be ineffective in and of themselves without the addition of trade sanctions.

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Should Governments Impose Trade Sanctions?

Counterpoint

No

Every time I turn around, I see governments imposing a new sanction. Some of these cause law-abiding companies to lose revenue that took years to develop. For one, there is a chance of retaliation. Trade sanctions on Russia after its annexation of Crimea were costly to Norwegian fish exporters because Russia turned to Chile.21 Thus, the trade sanctions aimed at hurting the Russian government ended up hurting non-Russian companies even though they’d never engaged in any objectionable behavior. Besides, I really question whether these sanctions even work. When the United States was maintaining its 20-year trade embargo on Vietnam, Vietnamese consumers could still buy U.S. products such as Coca-Cola, Kodak film, and Apple computers through other countries that did not enforce the sanctions.22 The more than 50-year trade embargo with Cuba weakened over time and became ineffective as countries ceased their trade suppression. Oil embargoes against South Africa, because of its racial policies, merely spurred South African companies to become leaders in converting coal to oil.23 Even if trade sanctions succeed at weakening the targeted countries’ economies, who really suffers? You can bet that the political leaders will still get whatever they need, so innocent people bear the costs of sanctions. This occurred in Iran, where there were widespread reports of deaths because of sanction-induced shortages

Photo shows seized ivories and ivory products prior to their destruction in Belgium. Source: Gong Bing/Xinhua/Alamy Stock Photo

▶

Counterpoint of medicine.24 Moreover, the people adversely affected usually blame their suffering not on their internal regime but on the countries carrying on the sanctions. Despots are very good at manipulating public opinion.25 In addition, critics of sanctioning point to import restrictions that are not fully effective because they aim too much at curtailing supply rather than demand (e.g., U.S. actions aiming to curtail the production of opiates abroad rather than efforts to restrain U.S. demand). In another example, many countries restrict ivory imports so that countries (mainly African) will limit ivory supplies by protecting elephants.26 However, although restrictions may have slowed elephant slaughter, poaching still continues (in the five years between 2010 and 2015, Tanzania and Mozambique lost 60 and 48 percent of their elephants respectively) because of high demand for ivory.27 The below photo shows part of 1.5 tons of imported ivory products seized and destroyed by the Belgian government. Finally, governments sometimes seem to impose trade sanctions based on one issue rather than on a country’s overall record. For instance, some critics have suggested using trade policies to press Brazil to restrict the cutting of Amazon forests, even though its overall environmental record—particularly its limitation of adverse exhaust emissions by converting automobile engines to use methanol instead of gasoline—is quite good.

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MAINTAINING OR EXTENDING SPHERES OF INFLUENCE Governments use trade to support their spheres of influence—giving aid and credits to, and encouraging imports from, countries that join a political alliance or vote a preferred way within international bodies. For example, the EU and 78 states from Africa, the Caribbean, and the Pacific participate in the Cotonou Agreement that formalizes an array of economic and political ties and economic issues.

PRESERVING NATIONAL CULTURE CONCEPT CHECK We observe in Chapter 2 (pages 73–74) that a primary function of culture is that it supports a nation’s sense of its uniqueness and integrity.

To help sustain a collective identity that sets their citizens apart from other nationalities, governments prohibit exports of art and historical items deemed to be part of their national heritage. In addition, they limit imports that may either conflict with or replace their dominant values. The relevance of culture has been confirmed through several UNESCO conventions aimed at preserving cultural diversity, and the concern has been largely focused, but not entirely, on media (print, visual, and audio).28 For instance, many countries, such as Canada and Australia, require levels of national content in media.29 In addition to media, Japan, South Korea, and China maintained for many years an almost total ban on rice imports, largely because rice farming has been a historically cohesive force in each nation.30

MAJOR INSTRUMENTS OF TRADE CONTROL In seeking to influence exports or imports, governments’ choice of trade-control instrument is crucial because each may incite different responses from domestic and foreign groups. One way to understand these instruments is by distinguishing between those that directly influence export or import prices and those that directly limit the amount of a good that can be traded. Let’s review these instruments.

TARIFFS: DIRECT PRICE INFLUENCES Tariffs may be levied • on goods entering, leaving, or passing through a country; • for protection or revenue; • on a per-unit basis, a value basis, or both.

Tariff barriers directly affect prices, and nontariff barriers may directly affect either price or quantity. A tariff (also called a duty) is a tax levied on a good shipped internationally. That is, governments charge a tariff on a good when it crosses an official boundary— whether it be that of a nation or a group of nations that have agreed to impose a common tariff on goods crossing the boundary of their bloc. A tariff assessed on a per-unit basis is a specific duty, on a percentage of the item’s value an ad valorem duty, and on both a compound duty. Tariffs collected by the exporting country are called export tariffs; if they’re collected by a country through which the goods pass, they’re transit tariffs; if they’re collected by importing countries, they’re import tariffs. Because import tariffs are by far the most common, we discuss them in some detail. Import Tariffs Unless they’re optimum tariffs (discussed earlier in the chapter), import tariffs raise the price of imported goods by taxing them, thereby giving domestically produced goods a relative price advantage. Although consumers are often unaware of the cost increase from tariffs on imports, they learn very quickly when encountering duty-free shops in international airports and at cruise ship stopovers. (See the following photo.) Tariffs as Sources of Revenue Tariffs also generate governmental revenue, but revenue is of little importance to developed countries because collection costs usually exceed the yield.31 In many developing countries, though, they are a major source of revenue because they are often more easily collected than income taxes. Although revenue tariffs are most commonly

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Tourists shopping for ▶ duty-free items in St. John’s, Antigua and Barbuda. Source: M.Sobreira/Alamy Stock Photo

collected on imports, some countries charge export tariffs on raw materials. Transit tariffs were once a major source of countries’ revenue, but governmental agreements have nearly abolished them. Developing countries argue that their processed portion of commodities have higher tariffs than the published rates.

The Effective Tariff Controversy Raw materials (say, coffee beans) from developing countries frequently enter developed countries free of duty; however, if they are processed (say, instant coffee), developed countries then assign an import tariff. Because an ad valorem tariff is based on the total value of the product (say, 10 percent on a $5 jar of instant coffee), the raw materials and the processing combined (say, $2.50 for the coffee beans and $2.50 for the processing) pays $.50. Developing countries have argued that the effective tariff on the manufactured portion turns out to be higher than the published tariff rate because the manufactured portion is effectively charged 20 percent. This anomaly further challenges developing countries to find export markets for products that use their raw materials.

NONTARIFF BARRIERS: DIRECT PRICE INFLUENCES Governmental subsidies may help companies be competitive, • but there is little agreement on what a subsidy is, • but agricultural subsidies are difficult to dismantle, • especially to overcome market imperfections because they are least controversial.

Now that we’ve shown how tariffs raise prices, let’s discuss other ways that governments alter product prices to affect their trade. Subsidies Subsidies offer direct assistance to companies to boost their competitiveness. Although this definition is straightforward, disagreement on what constitutes a subsidy causes trade frictions. In essence, not everyone agrees that companies are being subsidized just because they lose money, nor that all types of government loans or grants are subsidies. One long-running controversy involves commercial aircraft. Airbus Industrie and the EU claim that the U.S. national and state governments subsidize Boeing through R&D contracts for military aircraft that also have commercial applications and through the granting of incentives to influence their location decisions. Further, because the U.S. Ex-Im Bank offers loan guarantees to foreign buyers, Delta Air Lines has argued that this gives non-U.S. airlines an advantage not available to U.S. airlines.32 Meanwhile, Boeing and the U.S. government claim that the EU subsidizes Airbus Industrie through low-interest government loans.33

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An area that may well raise future questions about subsidies is governmental support to shore up floundering companies and industries, especially during global recessions. For instance, governments have bailed out banks, granted generous consumer loans to support their auto companies, eliminated taxes on their companies’ export earnings, and invested in an ownership share of key companies. In turn, these actions alter international competitiveness.34 Agricultural Subsidies The one area in which everyone agrees that subsidies exist is agriculture, especially in developed countries. The official reason is that food supplies are too critical to be left to chance. Although subsidies lead to surplus production, they are argued to be preferable to the risk of food shortages. Further, to counter overproduction, the United States pays additional subsidies to farmers so that they do not produce as much.35 However, this official reason does not explain agricultural subsidies for nonfood products, such as U.S. cotton subsidies that Brazil claims to disadvantage its competitiveness.36 The strength of agricultural interests is also important. Within Japan, the United States, and the EU, rural areas have a disproportionately high representation in government decisionmaking. For instance, Japanese rural interests have been able to force a 778 percent tariff on rice.37 In the United States, there is one senator per 300,000 people in Vermont (a state with a 68 percent rural population) and one senator per 19 million in California (which is 93 percent urban). Agriculture accounts for 38 percent of the EU budget even though it composes only 7 percent of GDP.38 The result is that internal politics effectively prevent the dismantling of such instruments as price supports for farmers, government agencies to improve agricultural productivity, and low-interest loans to farmers. What is the effect? Although some developing countries, such as India, are also major agricultural subsidizers, many are deprived from fully serving the developed markets with competitive agricultural products. Further, much surplus production from developed countries is exported at very low prices, thus distorting trade and further disadvantaging developing countries’ production.39 Overcoming Market Imperfections Most countries offer potential exporters many business development services, such as market information, trade expositions, and foreign contacts. This type of subsidization is less contentious than tariffs because the actions seek to overcome, rather than create, market imperfections. Further, collecting and disseminating information widely is less costly than if each potential exporter were to work individually. Aid and Loans When governments require foreign aid and loan recipients to spend the funds in the donor country, a situation known as tied aid or tied loans, some otherwise noncompetitive output can compete abroad. For instance, tied aid helps win large contracts for infrastructure, such as telecommunications, railways, and electric power projects. However, tied aid and loans sometimes require the recipient to use output and suppliers that may not be the best. They may also slow the advancement of local suppliers in developing countries. These concerns led OECD members to untie financial aid to developing countries.40 However, China is using tied aid for nearly all its foreign infrastructure projects.41 Because it is difficult for customs officials to determine the honesty of import invoices, • valuation procedures have been developed, • they may restate the value, • they may question the origin of and product-classification of imports.

Customs Valuation Import tariff assessments depend on the product, price, and origin— which tempts exporters and importers to declare these wrongly to pay a lower duty and tempts governments to declare wrongly as a protectionist measure. What Is the Import Worth? Most countries have agreed to use import invoice information unless customs doubt its authenticity. Agents must then appraise on the basis of the value of identical or similar goods arriving at about the same time.42 Customs must appraise similarly when goods enter for lease rather than purchase because there is no invoice. Critics,

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especially companies and governmental authorities from exporting countries, complain that agents in importing countries too often use discretionary power to levy higher duties, such as on Philippine cigarettes imported into Thailand.43 What Is the Product? Misclassifying a product (by accident or intentionally) is an easy way to change its corresponding tariff. Administering more than 13,000 categories of products (with new products coming onto the market all the time) means a customs agent must use discretion to determine, say, if silicon chips should be considered “integrated circuits for computers” or “a form of chemical silicon.” In our opening case, we saw the controversy over whether China lifted restrictions over REEs and whether they lifted the restrictions on other strategic materials like Tungsten. The differences between the elements in terms of production use are also minute. For example, the U.S. tariffs on athletic footwear are different from those on sports footwear, and these are subcategorized by whether the sole overlaps the upper part of the shoe or not. Each type of accessory and reinforcement of the shoes’ uppers is a different category. Although classification differences may seem trivial, the disparity in duties may cost or save companies millions of dollars. Some contentious examples include whether the French company Agatec’s laser leveling device would be used primarily indoors or outdoors,44 whether Marvel’s X-Men Wolverines were toys or dolls, and whether sport utility vehicles— such as the Suzuki Samurai and the Land Rover—were cars or trucks. Where Does the Product Originate? Because of different trade agreements, customs must determine products’ origins. For example, red meat products may involve animals born in one country, raised in a second, and slaughtered in a third. U.S. Customs requires traders to provide details on these stages of production, thus adding documentation costs above those for meat products of a 100 percent U.S. origin.45 Officials have also uncovered many instances of product transshipment and document falsification to avoid or lessen restrictions. For instance, U.S. Customs fined Staples, OfficeMax, and Target for mislabeling the country of origin of pencils in order to avoid paying antidumping duties assessed on Chinese imports.46 Other Direct-Price Influences Countries use other practices to affect import prices, including special fees (such as for consular and customs clearance and documentation), requirements that customs deposits be placed in advance of shipment, and minimum price levels at which goods can be sold after they have cleared customs.

NONTARIFF BARRIERS: QUANTITY CONTROLS Governments’ regulations and practices affect the quantity of imports and exports directly. Let’s take a look at the various forms these typically take. A quota may • be on imports or exports, • set the total amount to be traded, • allocate amounts by country, • be negotiated as a voluntary export restraint (VER), • prohibit all trade when it is an embargo.

Quotas A quota limits the quantity of a product that can be imported or exported in a given time frame, typically per year. Import quotas normally raise prices because they (1) limit supplies and (2) provide little incentive to use price competition to increase sales. A notable difference between tariffs and quotas is their effect on revenues. Tariffs generate revenue for the government. Quotas generate revenue only for those companies that obtain and sell a portion of the intentionally limited supply of the product at prices higher than what competitive prices would be. (Sometimes governments allocate quotas among countries based on political or market conditions.) To circumvent quotas, companies sometimes convert the product into one for which there is no quota. For instance, the United States maintains sugar import quotas that result in its sugar prices averaging more than the world market price. As a result, some U.S. candy producers have moved plants to Mexico and Canada where they can buy lower-cost sugar and import the candy duty-free to the United States.47 A country may establish export quotas to provide domestic consumers a sufficient supply of goods at a low price, to prevent depletion of natural resources, or to attempt to raise prices abroad by restricting foreign supply.

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Voluntary Export Restraints A voluntary export restraint (VER) is a quota variation whereby, essentially, Country A asks Country B to voluntarily reduce its companies’ exports to Country A. For instance, the United States and Mexico agreed on a VER dealing with Mexican tomato exports.48 The term voluntarily is misleading; typically, either Country B agrees to reduce its exports or else Country A may impose tougher trade restrictions. Procedurally, VERs have unique advantages. They are much easier to switch off than an import quota, and the appearance of a “voluntary” choice by a particular country to constrain its shipments can do less damage to political relations than an import quota. Embargoes A specific type of quota that prohibits all trade is an embargo. As with quotas, a country or group of countries may place embargoes on either imports or exports, on particular products regardless of origin or destination, on specific products with certain countries, or on all products with given countries. Governments impose embargoes in an effort to use economic means to achieve political goals, thus they are a type of trade sanction which we discuss in our Point-Counterpoint section. Through “buy local” rules • government purchases give preference to domestically made goods, • governments sometimes legislate a percentage of domestic content.

Other types of trade barriers include • arbitrary standards; • importing, exporting, and currency licensing; • administrative delays; • reciprocal requirements; • service restrictions.

“Buy Local” Legislation Buy local legislation sets rules whereby governments give preference to domestic production in their purchases. Given the enormity of government sectors in most economies, this preference can be substantial. Sometimes governments, such as the U.S. government, specify a domestic content restriction—that is, a certain percentage of the product must be of domestic origin.49 Sometimes governments favor domestic producers through price mechanisms, such as permitting an agency to buy a foreign-made product only if the price is a predetermined margin below that of a domestic competitor. Sometimes governments favor domestic purchases indirectly, such as the U.S. prohibition of foreign Medicare payments for elderly Americans except in emergency situations—a regulation that limits U.S. foreign purchases in the fast-growing area of medical tourism. Standards and Labels Countries can devise classification, labeling, and testing standards to allow the sale of domestic products while obstructing foreign-made ones. Consider product labels. The requirement that companies indicate products’ origins informs consumers who may prefer buying domestic products. In our opening case, we saw that the U.S. catfish industry sought country-of-origin labeling on fish. Countries also may dictate that companies place content information on their packaging, which differs from what is required elsewhere. These technicalities may seem trivial, but they add to a firm’s costs, particularly if the labels must be translated for different export markets. In addition, raw materials, components, design, and labor increasingly come from many countries, so most products today are of such mixed origin that they are difficult to sort out. The professed purpose of standards is to protect safety or health, but some companies argue they are just a means to protect domestic producers. For example, some U.S. and Canadian producers have contended that EU regulations and labeling requirements on genetically engineered corn and canola oil are merely means to keep out the products until their own technology catches up.50 In another case, following U.S. publicity about contaminated Chinese foods, China retaliated by upping its rejection of foodstuffs from the United States, citing contamination with drugs and salmonella.51 In reality, there’s no way of knowing to what extent products are kept out of countries for legitimate safety and health reasons versus arbitrarily protecting domestic production. Rejecting shipments for health and safety reasons, particularly those from developing countries, may cause a negative image for the exporting countries’ other products, causing them to lose sales and lower their export prices.52 Specific Permission Requirements Countries may require that importers or exporters secure governmental permission (an import or export license) before transacting trade. A company may have to submit samples to government authorities to obtain such a license. The procedure can restrict imports or exports directly by denying permission or indirectly because of the cost, time, and uncertainty involved.

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A foreign exchange control requires an importer to apply to a government agency to secure the foreign currency to pay for the product. As with an import license, failure to grant the exchange, not to mention the time and expense of completing forms and awaiting replies, obstructs foreign trade. Administrative Delays Closely akin to specific permission requirements are administrative customs delays that may be caused by intention or inefficiency. In either case, they create uncertainty and raise the cost of carrying inventory. Intentional delays may occur not only to protect domestic producers, but also for political reasons. Japanese companies reported such delays in China after Japan and China clashed over ownership of islands in the East China Sea.53 Reciprocal Requirements Importing countries sometimes require that whole or partial payment be made to exporters in merchandise rather than fully in currency, a transaction known as barter trade. The World Trade Organization estimates that 15 percent of world trade involves some type of barter.54 Countertrade In countertrade or offsets, a government in the importing country requires the exporter to provide it with additional economic benefits such as jobs or technology as part of the transaction. Critics in exporting countries contend that large defense contractors, by participating in these arrangements, shift purchases from smaller domestic contractors to those in foreign countries, thus weakening these domestic suppliers and the exporting country’s future defense capabilities.55 Problems for Exporters Reciprocal requirements necessitate that exporters assess the value and find markets for goods outside their expertise, engage in complicated operating arrangements, and undertake activities outside their proficiency. Raytheon, which makes such products as missiles and radar systems, had to undertake shrimp farming to gain a Saudi Arabian contract.56 All things being equal, companies avoid these transactions. However, some have developed competencies in these types of arrangements in order to gain competitive advantages. Others rely on specialized companies that handle barter transactions. Four main reasons why trade in services is restricted are • essentiality, • preference for not-for-profit operations, • different professional standards, • immigration.

Restrictions on Services Service is the fastest-growing sector in international trade. In deciding whether to restrict service trade, countries typically consider four factors: essentiality, not-for-profit preference, standards, and immigration. Essentiality Governments sometimes prohibit private companies, foreign or domestic, from operating in some sectors because they feel the services are essential and provide social stability. In other cases, they set price controls or subsidize government-owned service organizations that create disincentives for foreign private participation. Some essential services in which foreign firms might be excluded are media, communications, banking, utilities, and domestic transport. Not-for-Profit Services Mail, education, and hospital health services are often not-forprofit sectors in which few foreign firms compete. When a government privatizes these industries, it customarily prefers local ownership and control. Standards Some services require face-to-face interaction between professionals and clients, and governments limit entry into many of them to ensure practice by qualified personnel. The licensing requirements include such professionals as accountants, actuaries, architects, electricians, engineers, gemologists, hairstylists, lawyers, medical personnel, real estate brokers, and teachers. At present, there is little reciprocal recognition in licensing because countries’ occupational standards and requirements differ substantially. Thus an accounting or legal firm from one country faces obstacles in another, even to serve its domestic clients’ needs. The firm

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must hire professionals within each foreign country or else have its domestic professionals earn certification abroad. The latter option is problematic because of having to take examinations and learn new materials, sometimes in a foreign language. There also may be lengthy prerequisites for taking an examination, such as internships, time in residency, and coursework at a local university. CONCEPT CHECK In discussing “Factor Mobility” in Chapter 5 (pages 194–195), we explain the increasing reliance on people as an internationally mobile production factor and that countries hand out immigration papers only sparingly. When facing import competition, companies can • move abroad or find foreign supplies, • seek other market niches, • make domestic output competitive, • try to get protection.

Immigration Satisfying the standards of a particular country is no guarantee that a foreigner can then work there. In addition, governmental regulations often require an organization— domestic or foreign—to search extensively for qualified personnel locally before it can even apply for work permits for personnel it would like to bring in from abroad.

HOW COMPANIES DEAL WITH GOVERNMENTAL TRADE INFLUENCES When companies are threatened by import competition, they have several options, four of which stand out:

1. 2. 3. 4.

Move operations to another country. Concentrate on market niches that attract less international competition. Adopt internal innovations, such as greater efficiency or superior products. Try to get governmental protection.

Each option entails costs and risks; therefore, different companies make different choices. For example, competition from Japanese imports spurred the U.S. automobile industry to move some production abroad (such as subcontracting with foreign suppliers for parts), develop niche markets through the sale of minivan and sport utility vehicles (SUVs) that initially had less international competition, and adopt innovations such as lean production techniques to improve efficiency and product quality. They also successfully sought VERs from Japan, and General Motors and Chrysler eventually received substantial government funding to survive.

TACTICS FOR DEALING WITH IMPORT COMPETITION Granted, these methods are not realistic for every industry or company. Companies may lack the resources to shift their own production or find suppliers abroad. They may not be able to identify more innovative or profitable product niches. Even if they do, foreign competitors may quickly emulate them. In such situations, companies often ask their governments to restrict imports or open export markets.

CONVINCING DECISION-MAKERS Governments cannot try to help every company that faces tough international competition. Likewise, helping one industry may hurt another. Thus, as a manager, you may propose or oppose a particular protectionist measure. Inevitably, the burden falls on you and your company to convince officials that your situation warrants particular policies. You must identify the key decision-makers and convince them by using the economic and noneconomic arguments presented in this chapter. You must also put forward the types of restrictive mechanisms most likely to help your situation and convey to public officials that voters and stakeholders support your position.57

INVOLVING THE INDUSTRY AND STAKEHOLDERS A company improves the odds of success if it can ally most, if not all, domestic companies in its industry. Otherwise, officials may feel that its problems are due to its specific inefficiencies

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rather than the general trade challenges. Similarly, involving stakeholders, such as taxpayers and local merchants, can help. Finally, it can lobby decision-makers and endorse the political candidates who are sympathetic to its situation.

PREPARING FOR CHANGES IN THE COMPETITIVE ENVIRONMENT Companies take different approaches to deal with changes in the international competitive environment. Frequently, their attitudes toward protectionism are a function of the investments they have made to implement their international strategy. Those that depend on freer trade and/or have integrated their production and supply chains among countries tend to oppose protectionism. In contrast, those with single or multi-domestic production facilities, such as a plant in Japan to serve the Japanese market and a plant in Taiwan to serve the Taiwanese market, tend to support protectionism. Companies also differ in their confidence to compete against imports. Thus when companies recommend protection for their industries, typically one or more companies in that industry oppose it. The opposition usually comes from companies with commanding competitive advantages in terms of scale economies, supplier relationships, or differentiated products. Thus, they reason that not only can they successfully battle international rivals, they also stand to gain even more as their weaker domestic competitors fail to do so.58

Looking to the Future

Dynamics and Complexity of Future World Trade When trade restrictions change, there are winners and losers among countries, companies, and workers. So it’s probably safe to say that we’ll see mixtures of pushes for freer trade and greater protection. In addition, consumers’ gains from freer trade may be at the expense of some companies and workers—people who see themselves as big losers. They are not apt to lose without a struggle; they’ll garner as much support for protection as they can, and they may win. The support may well come from alliances that cross national borders, such as clothing companies in various developing nations uniting to push importing countries to enact quota agreements to protect their export markets against

Chinese and Indian competition. Thus, if you are a manager in an industry that may be affected by changes in governmental protection, you must watch closely to predict how the evolving politics may affect your own situation. Finally, the international regulatory situation is becoming more, rather than less, complex—a situation that challenges companies to find the best locations in which to produce. These complexities include new products that challenge the task of tariff classification, Internet services that create new channels of foreign competition, and heightened concerns about terrorism and product safety that compound considerations of what can be traded and with whom. ■

CASE

Doing Business in Singapore59

The Government of Singapore offers a pro-business environment and Singapore is placed 1st in the World Bank’s global ranking index for “Ease of Doing Business” and “Trading Across Borders.” To achieve this, the Singapore government has created a robust ecosystem to promote international trade and investments through its various ministries and agencies or statutory boards. For instance, the mission of the Ministry Of Trade and Industry (MTI) of Singapore is to promote economic growth and create jobs, so as to achieve higher standards of living for its citizens, protecting Singapore’s international trade interests, in particular, with a view to enhance access to global markets for goods, services and investments; and providing a good understanding of the current state of and outlook, for policy formulation and refinement. These strategies are derived from Singapore’s general philosophy of economic management—strong adherence to a free market economic system, and active pursuit of outward-oriented economic policies. Its vision is to develop a globalized, entrepreneurial and diversified economy to turn Singapore into a leading global city. MTI oversees ten statutory boards including the Singapore Economic Development Board (EDB). The EDB is the lead government agency that plans and executes strategies to enhance Singapore’s position as a global business center and grow its economy. Its “Host to Home” strategy aims to move Singapore from being a host to companies to becoming a home where global business, innovation, and talent are nurtured. EDB’s consistently result-oriented initiatives are testament to Singapore’s governmental influence on trade. The following are examples of some global companies that leveraged good government policy to expand their Asia wide presence in Singapore.

Siemens Medical Instruments As one of the world’s leading manufacturers of digital hearing instruments utilizing the latest microelectronic technology, Siemens established the operations of Siemens Medical Instruments (SMI) in Singapore in 1974. Ever since, their research department has grown into a fullfledged R&D center taking advantage of the robust growth and market opportunities in Asia that now homes a fast rising ageing population (estimated to cross 850 million by 2050) and middle class. These factors prompted Siemens to boost its investments in research and development by 10 percent in 2013. Siemens’ long term investment in and dedication to the region is testament to the Singapore government’s growing role as a strategic partner with leading companies, to achieve visionary growth.

Trina Solar Similarly in 2011, Trina Solar, one of the world’s leading photovoltaic (PV) companies, established its Asia Pacific operating headquarters in Singapore to strengthen its growing presence and customer base in Asia after it sealed a research agreement with the Solar Energy Research Institute of Singapore to develop high efficiency solar cells using Trina Solar’s mono-crystalline wafers. The Singapore government through its energy agency Energy Innovation Programme Office (EIPO) created an investment environment that fostered the development of a skilled talent base and strong logistics infrastructures. These made it strategically advantageous for Trina Solar’s regional R&D center as it developed new solar technologies and applications to meet the demands for clean energy expected to be fueled by Asian markets.

Rolls-Royce Since its entry into the country in the 1950s, Rolls-Royce has become a major player in Singapore’s aerospace industry, accounting for over 15 percent of Singapore’s aerospace output. A world leader of power systems and services, Rolls-Royce is anticipating strong growth in its operations in Asia achieved through joint ventures with key local industry partners including Singapore Airlines Engineering, and activities in the energy and marine sector. The Singapore government has been a strong partner of growth for Rolls-Royce and the country is a leader in aerospace maintenance, repair and overhaul, aviation manufacturing and R&D in Asia. According to Jonathan Asherson, Regional Director, Rolls-Royce, the company has also benefited from the valuable business opportunities, excellent talent pool, and solid infrastructure that Singapore offers.

Procter & Gamble Procter & Gamble or P&G’s market capitalization is more than the GDP of many countries and it markets its products in over 180 countries. It is the largest household and personal care company in the world, and its brands include some of the world’s best-known names such as Gillette, Pampers, Pantene, Oral-B, and SK-II. The Asia Pacific headquarters for P&G’s operations in Singapore carries out brand and business management activities like manufacturing, marketing, supply chain management, research and development, finance and talent development across the region. Singapore is also home to P&G’s Asia Leadership Development Center

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P&G leveraged on the strong research capabilities in Singapore through an agreement with Singapore’s government Agency for Science, Technology and Research (A*STAR). In 2011, P&G invested US$192 million to build a mega innovation center in Singapore. Deborah Henretta, Group President, Asia, P&G remarked that Singapore embodies the essence of what successful companies look for: commitment to innovation, world-class infrastructure, business- friendly environment, excellent local talent and an ability to work as partners in progress.

Unilever Another leading global supplier of fast moving consumer goods (FMCG) with a presence in more than 150 countries is Unilever. Parent to the world’s best-known brands such as Lipton, Wall’s, and Dove, Unilever deals products in nutrition, hygiene and personal care reaching out to a wide range of consumers. Established in Singapore over 50 years ago, Unilever Singapore has since emerged as a strategic global hub for Unilever, and is home to several key members of its senior leadership team. Through Four Acres Singapore, its new global leadership development center, Unilever will access the Singapore EDB’s LINK (Leadership Initiatives, Networks and Knowledge) ecosystem to provide executive talent development and leadership programs with business schools and corporate partners. Paul Polman, CEO of Unilever, recognizes that Singapore’s evolved business infrastructure, excellent human capital, connectivity, and strong base for supporting industries combined with the support provided by the Singapore Government make it an ideal regional business hub.

Dell Since 1984, Dell has pioneered technologies and innovations as the front-runner in the computer industry that sells custom-built computers directly to customers. Dell currently operates its Asia Pacific headquarters in Singapore using this cosmopolitan market and strategic location as a test bed for its services and solutions in Asia. Dell opened its first design center in Singapore in 2005 to boost the company’s R&D capabilities in display and imaging products. It further added its Dell Singapore Solution Center (DSC) in 2011, tapping into the country’s large pool of infocomm industry professionals and highly proactive government agency, the Infocomm Development Authority of Singapore (IDA). Amit Midha, President of Dell Asia Pacific and Japan, points to the fact that Singapore’s robust ecosystem, pro-business environment, geo-political landscape and high-technology infrastructure enables Dell to bring the benefits of technology solutions to customers in the Asia Pacific region.

Mitsui Chemicals Mitsui Chemicals (MCI) is one of the largest chemical companies in Japan. In Singapore, its business includes manufacturing plants, R&D facilities, and sales offices. MCI subsidiaries in Singapore are Mitsui Chemicals Asia Pacific Ltd, Mitsui Phenols Singapore Pte Ltd, and Mitsui Elastomers Singapore Pte Ltd. The company has invested over US$600 million to expand its operations in Singapore since the 1980s including phenol, bisphenol and Tafmer plants. MCI’s Asia Pacific Headquarters in Singapore also provides support in sales and marketing, technical, logistics, and business planning functions. In 2011, it opened its R&D Center (MSR&D) working closely with its Singapore government agency partner A*STAR and research institutes. Mr Yasushi Nawa, Managing Director of Mitsui Chemicals Asia Pacific, commented that Singapore’s pro-business government policies, talented and hardworking workforce and top infrastructures have enabled Mitsui Chemicals to look to the country as a launch pad for its growth strategies in the Asia Pacific region.

China-Singapore Cooperation Initiatives As part of an ongoing effort by Singapore’s government to influence and facilitate international trade, the Monetary Authority of Singapore (MAS) has developed new initiatives to influence and support trade. Singapore and China have agreed on new initiatives to strengthen cooperation on financial sector development and regulation. The new initiatives will further promote the international use of the Renminbi (RMB) through Singapore. China will extend its Renminbi Qualified Foreign Institutional Investor (RQFII) program to Singapore, with an aggregate quota of RMB 50 billion. This will allow qualified Singapore-based institutional investors to channel offshore RMB from Singapore into China’s securities markets. RQFII license holders may also issue RMB investment products to the broad pool of investors in Singapore, using the RQFII quota. The RQFII program will help to diversify the base of investors in China’s capital markets and promote adoption of the RMB for investment. Singapore will be given consideration as one of the investment destinations under the new Renminbi Qualified Domestic Institutional Investor (RQDII) scheme. This will allow qualified Chinese institutional investors to use RMB to invest in Singapore’s capital markets. The measure will help to broaden the universe of assets available to Chinese investors as well as the investor base for Singapore’s capital markets. China and Singapore will introduce direct currency trading between the Chinese Yuan and Singapore Dollar. New measures will allow cross-border flows of RMB between Singapore and Suzhou Industrial Park (SIP) as well as Tianjin Eco-City (TEC). In addition, Singapore and China have agreed on and announced measures to strengthen regulatory cooperation. Relevant agencies are in discussions to facilitate

C h a pt e r 6

China-incorporated companies which have received regulatory approval to list directly in Singapore, instead of through entities incorporated outside China. Furthermore, the Singapore Exchange and Shanghai Futures Exchange have signed an MOU to strengthen collaboration in the joint development of commodity derivatives. The Singapore and Chinese governments have also agreed to strengthen cooperation in banking regulatory issues, through exchanges and dialogs on topics of shared interest, and enhanced coordination on international regulatory issues. These new initiatives build on agreements concluded earlier this year, including the signing of the MOU on RMB Business Cooperation between the Monetary Authority of Singapore (MAS) and the People’s Bank of China (PBC), and the enhancement of the bilateral swap agreement between the two central banks, which paved the way for the launch of RMB clearing functions in Singapore in May this year (2013).

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Ravi Menon, the Managing Director of MAS, already declared that 2013 had been the productive year with lots of cooperation initiatives between Singapore and China. The excellent relations between MAS and the central bank and their regulatory counterparts in China only cemented ties between the two countries, putting Singapore in a position to promote RMB for long-term trade and investment in the future.

QUeStIONS 6-3. Discuss why and how the Singapore government promotes the international trade process. 6-4. Why is free trade so vital to Singapore’s survival and growth? 6-5. Singapore has a highly developed trade-oriented market economy and its economy has been ranked as the most open in the world. What has been the government’s role in achieving this feat?

MyLab Management Go to mymanagementlab.com for the following Assisted-graded writing questions: 6-6 Why do multinational corporations (MNCs) find Singapore an attractive place to do business? 6-7 Discuss the advantages and disadvantages of protectionist policies to domestic industry.

Endnotes Scan for Endnotes or go to www.pearsonglobaleditions.com/Daniels

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9

CHAPTER

The Instruments of Trade Policy

After reading this chapter, you will be able to: ■■

■■

■■

Evaluate the costs and benefits of tariffs, their welfare effects, and winners and losers of tariff policies. Discuss what export subsidies and agricultural subsidies are, and explain how they affect trade in agriculture in the United States and the European Union. Recognize the effect of voluntary export restraints (VERs) on both importing and exporting countries, and describe how the welfare effects of these VERs compare with tariff and quota policies.

Basic Tariff Analysis A tariff, the simplest of trade policies, is a tax levied when a good is imported. Specific ­tariffs are levied as a fixed charge for each unit of goods imported (for example, $3 per barrel of oil). Ad valorem tariffs are taxes that are levied as a fraction of the value of the imported goods (for example, a 25 percent U.S. tariff on imported trucks—see the box on page 253). In either case, the effect of the tariff is to raise the cost of shipping goods to a country.

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LEARNING GOALS

PART TWO

P

revious chapters have answered the question, “Why do nations trade?” by describing the causes and effects of international trade and the functioning of a trading world economy. While this question is interesting in itself, its answer is even more interesting if it also helps answer the question, “What should a nation’s trade policy be?” For example, the grittiest part of the Brexit, Britain’s withdrawal from the European Union (EU) negotiations is over trade. Its tariff, quota, and subsidy rules are fixed by its EU membership. Thus, the EU, Britain, and certain third countries are faced with a dilemma of possibilities of trade. Outside the customs union of the EU, Britain would face tariffs and non-tariff barriers, which could add between 2 and 15 percent to the cost of exports, depending on the product? This chapter examines the policies that governments adopt toward international trade, policies that involve a number of different actions. These actions include taxes on some international transactions, subsidies for other transactions, legal limits on the value or volume of particular imports, and many other measures. The chapter thus provides a framework for understanding the effects of the most important instruments of trade policy.

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Tariffs are the oldest form of trade policy and have traditionally been used as a source of government income. Until the introduction of the income tax, for instance, the U.S. government raised most of its revenue from tariffs. Their true purpose, however, has usually been twofold: to provide revenue and to protect particular domestic sectors. In the early 19th century, for example, the United Kingdom used tariffs (the famous Corn Laws) to protect its agriculture from import competition. In the late 19th century, both Germany and the United States protected their new industrial sectors by imposing tariffs on imports of manufactured goods. In the late 19th century, protection was a trade policy instrument used in Europe’s development. In Europe tariffs had a positive impact on a country’s growth, specifically on infant industry grounds. For example, Sweden, Italy, and France adopted rather severe agricultural protection policies. Germany adopted protectionist policies in both agriculture and manufacturing and experiencing strong growth of its infant industries with set higher tariffs. Also countries of the New World, such as Canada, Australia, and the United States also chose to protect its manufacturing and infant industries from European competition. The importance of tariffs has declined in modern times because modern governments usually prefer to protect domestic industries through a variety of nontariff barriers, such as import quotas (limitations on the quantity of imports) and export restraints (limitations on the quantity of exports—usually imposed by the exporting country at the importing country’s request). Nonetheless, an understanding of the effects of a tariff remains vital for understanding other trade policies. In developing the theory of trade in Chapters 3 through 8, we adopted a general equilibrium perspective. That is, we were keenly aware that events in one part of the economy have repercussions elsewhere. However, in many (though not all) cases, trade policies toward one sector can be reasonably well understood without going into detail about those policies’ repercussions on the rest of the economy. For the most part, then, trade policy can be examined in a partial equilibrium framework. When the effects on the economy as a whole become crucial, we will refer back to general equilibrium analysis.

Supply, Demand, and Trade in a Single Industry Let’s suppose there are two countries, Home and Foreign, both of which consume and produce wheat, which can be costlessly transported between the countries. In each country, wheat is a simple competitive industry in which the supply and demand curves are functions of the market price. Normally, Home supply and demand will depend on the price in terms of Home currency, and Foreign supply and demand will depend on the price in terms of Foreign currency. However, we assume the exchange rate between the currencies is not affected by whatever trade policy is undertaken in this market. Thus, we quote prices in both markets in terms of Home currency. Trade will arise in such a market if prices are different in the absence of trade. Suppose that in the absence of trade, the price of wheat is higher in Home than it is in Foreign. Now let’s allow foreign trade. Since the price of wheat in Home exceeds the price in Foreign, shippers begin to move wheat from Foreign to Home. The export of wheat raises its price in Foreign and lowers its price in Home until the difference in prices has been eliminated. To determine the world price and the quantity traded, it is helpful to define two new curves: the Home import demand curve and the Foreign export supply curve, which are derived from the underlying domestic supply and demand curves. Home import demand is the excess of what Home consumers demand over what Home producers supply; Foreign export supply is the excess of what Foreign producers supply over what Foreign consumers demand. Figure 9-1 shows how the Home import demand curve is derived. At the price P1, Home consumers demand D1, while Home producers supply only S 1. As a result, Home import demand is D1 - S 1. If we raise the price to P2, Home consumers demand only D2, while Home producers raise the amount they supply to S 2, so import demand falls to D2 - S 2. These price-quantity combinations are plotted as



CHAPTER 9   ■   The Instruments of Trade Policy

Price, P

245

Price, P

S

A

PA

2

P2

1

P1

MD

D S1 S 2

D 2 – S 2 D1 – S1

Quantity, Q

D 2 D1

Quantity, Q

FIGURE 9-1

Deriving Home’s Import Demand Curve As the price of the good increases, Home consumers demand less, while Home producers supply more, so that the demand for imports declines.

points 1 and 2 in the right-hand panel of Figure 9-1. The import demand curve MD is downward sloping because as price increases, the quantity of imports demanded declines. At PA, Home supply and demand are equal in the absence of trade, so the Home import demand curve intercepts the price axis at PA (import demand = zero at PA). Figure 9-2 shows how the Foreign export supply curve XS is derived. At P1 Foreign producers supply S *1, while Foreign consumers demand only D*1, so the amount of the total supply available for export is S *1 - D*1. At P2 Foreign producers raise the quantity they supply to S *2 and Foreign consumers lower the amount they demand to D*2, so the quantity of the total supply available to export rises to S *2 - D*2.

Price, P

Price, P

S*

XS

P2 P1

PA* D* D * 2 D *1

S *1 S *2

Quantity, Q

S *1 – D *1 S *2 – D *2

Quantity, Q

FIGURE 9-2

Deriving Foreign’s Export Supply Curve As the price of the good rises, Foreign producers supply more while Foreign consumers demand less, so that the supply available for export rises.

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FIG U R E 9-3

Price, P

World Equilibrium The equilibrium world price is where Home import demand (MD curve) equals Foreign export supply (XS curve).

PA

PW

XS 1

MD

PA*

QW

Quantity, Q

Because the supply of goods available for export rises as the price rises, the Foreign export supply curve is upward sloping. At P*A, supply and demand would be equal in the absence of trade, so the Foreign export supply curve intersects the price axis at P*A 1 export supply = zero at P*A 2 . World equilibrium occurs when Home import demand equals Foreign export supply (Figure 9-3). At the price PW where the two curves cross, world supply equals world demand. At the equilibrium point 1 in Figure 9-3, Home demand - Home supply = Foreign supply - Foreign demand. By adding and subtracting from both sides, this equation can be rearranged to say that Home demand + Foreign demand = Home supply + Foreign supply or, in other words, World demand = World supply.

Effects of a Tariff From the point of view of someone shipping goods, a tariff is just like a cost of transportation. If Home imposes a tax of $2 on every bushel of wheat imported, shippers will be unwilling to move the wheat unless the price difference between the two markets is at least $2. Figure 9-4 illustrates the effects of a specific tariff of t per unit of wheat (shown as t in the figure). In the absence of a tariff, the price of wheat would be equalized at PW in both Home and Foreign, as seen at point 1 in the middle panel, which illustrates the world market. With the tariff in place, however, shippers are not willing to move wheat from Foreign to Home unless the Home price exceeds the Foreign price by at least t. If no wheat is being shipped, however, there will be an excess demand for wheat in Home and an excess supply in Foreign. Thus, the price in Home will rise and that in Foreign will fall until the price difference is t. Introducing a tariff, then, drives a wedge between the prices in the two markets. The tariff raises the price in Home to PT and lowers the price in Foreign to P*T = PT - t. In Home, producers supply more at the higher price, while consumers demand less, so that fewer imports are demanded (as you can see in the move from point 1 to point 2 on the MD curve). In Foreign, the lower price leads to reduced supply and increased



CHAPTER 9   ■   The Instruments of Trade Policy

Home market Price, P

World market Price, P

S

Foreign market Price, P

XS

2

PT

t

PW

S*

1

PT*

3

D Quantity, Q

247

MD QT QW

Quantity, Q

D* Quantity, Q

FIG U R E 9-4

Effects of a Tariff A tariff raises the price in Home while lowering the price in Foreign. The volume traded thus declines.

demand, and thus a smaller export supply (as seen in the move from point 1 to point 3 on the XS curve). Thus, the volume of wheat traded declines from QW, the free trade volume, to QT, the volume with a tariff. At the trade volume QT, Home import demand equals Foreign export supply when PT - P*T = t. The increase in the price in Home, from PW to PT, is less than the amount of the tariff because part of the tariff is reflected in a decline in Foreign’s export price and thus is not passed on to Home consumers. This is the normal result of a tariff and of any trade policy that limits imports. The size of this effect on the exporters’ price, however, is often very small in practice. When a small country imposes a tariff, its share of the world market for the goods it imports is usually minor to begin with, so that its import reduction has very little effect on the world (foreign export) price. The effects of a tariff in the “small country” case where a country cannot affect foreign export prices are illustrated in Figure 9-5. In this case, a tariff raises the price of the imported good in the country imposing the tariff by the full amount of the tariff, from PW to PW + t. Production of the imported good rises from S 1 to S 2, while consumption of the good falls from D1 to D2. As a result of the tariff, then, imports fall in the country imposing the tariff.

Measuring the Amount of Protection A tariff on an imported good raises the price received by domestic producers of that good. This effect is often the tariff’s principal objective—to protect domestic producers from the low prices that would result from import competition. In analyzing trade policy in practice, it is important to ask how much protection a tariff or other trade policy actually provides. The answer is usually expressed as a percentage of the price that would prevail under free trade. An import quota on sugar could, for example, raise the price received by U.S. sugar producers by 35 percent. Measuring protection would seem to be straightforward in the case of a tariff: If the tariff is an ad valorem tax proportional to the value of the imports, the tariff rate itself

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FIG U R E 9-5

A Tariff in a Small Country When a country is small, a tariff it imposes cannot lower the foreign price of the good it imports. As a result, the price of the import rises from PW to PW + t and the quantity of imports demanded falls from D1 - S1 to D2 - S2.

Price, P S

PW + t PW

D S1 S 2

D 2 D1

Quantity, Q

Imports after tariff Imports before tariff

should measure the amount of protection; if the tariff is specific, dividing the tariff by the price net of the tariff gives us the ad valorem equivalent. However, there are two problems with trying to calculate the rate of protection this simply. First, if the small-country assumption is not a good approximation, part of the effect of a tariff will be to lower foreign export prices rather than to raise domestic prices. This effect of trade policies on foreign export prices is sometimes significant. The second problem is that tariffs may have very different effects on different stages of production of a good. A simple example illustrates this point. Suppose an automobile sells on the world market for $8,000, and the parts out of which that automobile is made sell for $6,000. Let’s compare two countries: one that wants to develop an auto assembly industry and one that already has an assembly industry and wants to develop a parts industry. To encourage a domestic auto industry, the first country places a 25 percent tariff on imported autos, allowing domestic assemblers to charge $10,000 instead of $8,000. In this case, it would be wrong to say that the assemblers receive only 25 percent protection. Before the tariff, domestic assembly would take place only if it could be done for $2,000 (the difference between the $8,000 price of a completed automobile and the $6,000 cost of parts) or less; now it will take place even if it costs as much as $4,000 (the difference between the $10,000 price and the cost of parts). That is, the 25 percent tariff rate provides assemblers with an effective rate of protection of 100 percent. Now suppose the second country, to encourage domestic production of parts, imposes a 10 percent tariff on imported parts, raising the cost of parts of domestic assemblers from $6,000 to $6,600. Even though there is no change in the tariff on assembled automobiles, this policy makes it less advantageous to assemble domestically. Before the tariff, it would have been worth assembling a car locally if it could be done for +2,000 (+8,000 - +6,000); after the tariff, local assembly takes place only if it can be done for +1,400 (+8,000 - +6,600). The tariff on parts, then, while providing positive protection to parts manufacturers, provides negative effective protection to assembly at the rate of -30 percent (-600>2,000).



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Reasoning similar to that seen in this example has led economists to make elaborate calculations to measure the degree of effective protection actually provided to particular industries by tariffs and other trade policies. Trade policies aimed at promoting economic development, for example (Chapter 11), often lead to rates of effective protection much higher than the tariff rates themselves.1

Costs and Benefits of a Tariff A tariff raises the price of a good in the importing country and lowers it in the exporting country. As a result of these price changes, consumers lose in the importing country and gain in the exporting country. Producers gain in the importing country and lose in the exporting country. In addition, the government imposing the tariff gains revenue. To compare these costs and benefits, it is necessary to quantify them. The method for measuring costs and benefits of a tariff depends on two concepts common to much microeconomic analysis: consumer and producer surplus.

Consumer and Producer Surplus Consumer surplus measures the amount a consumer gains from a purchase by computing the difference between the price he actually pays and the price he would have been willing to pay. If, for example, a consumer would have been willing to pay $8 for a bushel of wheat but the price is only $3, the consumer surplus gained by the purchase is $5. Consumer surplus can be derived from the market demand curve (Figure 9-6). For example, suppose the maximum price at which consumers will buy 10 units of a good FIG U R E 9-6

Deriving Consumer Surplus from the Demand Curve

Price, P

Consumer surplus on each unit sold is the difference between the actual price and what consumers would have been willing to pay.

$12 $10 $9

D 8 9 10 11

1

Quantity, Q

The effective rate of protection for a sector is formally defined as (VT - VW)>VW, where VW is value added in the sector at world prices and VT is value added in the presence of trade policies. In terms of our example, let PA be the world price of an assembled automobile, PC the world price of its components, tA the ad valorem tariff rate on imported autos, and tC the ad valorem tariff rate on components. You can check that if the tariffs don’t affect world prices, they provide assemblers with an effective protection rate of VT - VW tA - tC tA + PC ¢ ≤. VW PA - PC

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is $10. Then, the 10th unit of the good purchased must be worth $10 to consumers. If it were worth less, they would not purchase it; if it were worth more, they would have been willing to purchase it even if the price were higher. Now suppose that in order to get consumers to buy 11 units, the price must be cut to $9. Then, the 11th unit must be worth only $9 to consumers. Suppose the price is $9. Then, consumers are willing to purchase only the 11th unit of the good and thus receive no consumer surplus from their purchase of that unit. They would have been willing to pay $10 for the 10th unit, however, and thus receive $1 in consumer surplus from that unit. They would also have been willing to pay $12 for the 9th unit; in that case, they would have received $3 of consumer surplus on that unit, and so on. Generalizing from this example, if P is the price of a good and Q the quantity demanded at that price, then consumer surplus is calculated by subtracting P times Q from the area under the demand curve up to Q (Figure 9-7). If the price is P1, the quantity demanded is D1 and the consumer surplus is measured by the areas labeled a plus b. If the price rises to P2, the quantity demanded falls to D2 and consumer surplus falls by b to equal just a. Producer surplus is an analogous concept. A producer willing to sell a good for $2 but receiving a price of $5 gains a producer surplus of $3. The same procedure used to derive consumer surplus from the demand curve can be used to derive producer surplus from the supply curve. If P is the price and Q the quantity supplied at that price, then producer surplus is P times Q minus the area under the supply curve up to Q (Figure 9-8). If the price is P1, the quantity supplied will be S 1, and producer surplus is measured by area c. If the price rises to P2, the quantity supplied rises to S 2, and producer surplus rises to equal c plus the additional area d. Some of the difficulties related to the concepts of consumer and producer surplus are technical issues of calculation that we can safely disregard. More important is the question of whether the direct gains to producers and consumers in a given market accurately measure the social gains. Additional benefits and costs not captured by

FIG U R E 9-7

Geometry of Consumer Surplus

Price, P

Consumer surplus is equal to the area under the demand curve and above the price.

a P2 b P1 D D2

D1

Quantity, Q



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FIG U R E 9-8

Geometry of Producer Surplus

Price, P S

Producer surplus is equal to the area above the supply curve and below the price. P2 d P1 c

S1

S2

Quantity, Q

consumer and producer surplus are at the core of the case for trade policy activism discussed in Chapter 10. For now, however, we will focus on costs and benefits as measured by consumer and producer surplus.

Measuring the Costs and Benefits Figure 9-9 illustrates the costs and benefits of a tariff for the importing country. The tariff raises the domestic price from PW to PT but lowers the foreign export price from PW to P*T (refer back to Figure 9-4). Domestic production rises from S 1 to S 2 while

FIG U R E 9-9

Costs and Benefits of a Tariff for the Importing Country

Price, P S

The costs and benefits to different groups can be represented as sums of the five areas a, b, c, d, and e. PT a PW

b

c

d

e

PT* D S1 S2

D2 D1

Quantity, Q

QT = consumer loss (a + b + c + d) = producer gain (a) = government revenue gain (c + e)

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domestic consumption falls from D1 to D2. The costs and benefits to different groups can be expressed as sums of the areas of five regions, labeled a, b, c, d, e. Consider first the gain to domestic producers. They receive a higher price and therefore have higher producer surplus. As we saw in Figure 9-8, producer surplus is equal to the area below the price but above the supply curve. Before the tariff, producer surplus was equal to the area below PW but above the supply curve; with the price rising to PT, this surplus rises by the area labeled a. That is, producers gain from the tariff. Domestic consumers also face a higher price, which makes them worse off. As we saw in Figure 9-7, consumer surplus is equal to the area above the price but below the demand curve. Since the price consumers face rises from PW to PT, the consumer surplus falls by the area indicated by a + b + c + d. So consumers are hurt by the tariff. There is a third player here as well: the government. The government gains by collecting tariff revenue. This is equal to the tariff rate t times the volume of imports QT = D2 - S 2. Since t = PT - PT*, the government’s revenue is equal to the sum of the two areas c and e. Since these gains and losses accrue to different people, the overall cost-benefit evaluation of a tariff depends on how much we value a dollar’s worth of benefit to each group. If, for example, the producer gain accrues mostly to wealthy owners of resources, while consumers are poorer than average, the tariff will be viewed differently than if the good is a luxury bought by the affluent but produced by low-wage workers. Further ambiguity is introduced by the role of the government: Will it use its revenue to finance vitally needed public services or waste that revenue on $1,000 toilet seats? Despite these problems, it is common for analysts of trade policy to attempt to compute the net effect of a tariff on national welfare by assuming that at the margin, a dollar’s worth of gain or loss to each group is of the same social worth. Let’s look, then, at the net effect of a tariff on welfare. The net cost of a tariff is

Consumer loss - producer gain - government revenue, (9-1)

or, replacing these concepts by the areas in Figure 9-9,

(a + b + c + d) - a - (c + e) = b + d - e. (9-2)

That is, there are two “triangles” whose area measures loss to the nation as a whole and a “rectangle” whose area measures an offsetting gain. A useful way to interpret these gains and losses is the following: The triangles represent the efficiency loss that arises because a tariff distorts incentives to consume and produce, while the rectangle represents the terms of trade gain that arise because a tariff lowers foreign export prices. The gain depends on the ability of the tariff-imposing country to drive down foreign export prices. If the country cannot affect world prices (the small-country case illustrated in Figure 9-5), region e, which represents the terms of trade gain, disappears, and it is clear that the tariff reduces welfare. A tariff distorts the incentives of both producers and consumers by inducing them to act as if imports were more expensive than they actually are. The cost of an additional unit of consumption to the economy is the price of an additional unit of imports, yet because the tariff raises the domestic price above the world price, consumers reduce their consumption to the point at which that marginal unit yields them welfare equal to the tariff-inclusive domestic price. This means that the value of an additional unit of production to the economy is the price of the unit of imports it saves, yet domestic producers expand production to the point at which the marginal cost is equal to the tariff-inclusive price. Thus, the economy produces at home additional units of the good that it could purchase more cheaply abroad.



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TARIFFS and Retaliation

W

e just saw how a tariff can be used to increase producer surplus at the expense of a loss in consumer surplus. However, there are many other indirect costs of tariffs. In an indefinite economic environment, it is usually quite challenging to spot whether the cause of import decline is due to improved efficiency of companies in the sector, or due to some “covered” government incentives.1 Nevertheless, imposed tariffs by one country in most cases would be followed by retaliation of another. If country A imposes a tariff, exporting producers of country B are hurt and the country loses out by the tariff burden. Thus, country B may retaliate with a tariff of its own and form a broader violation of the free trade’s philosophies. As a result of this tariff war, both countries are more likely to end up worse off by the reduced volume trade. In June 2013, a “solar dispute” occurred between the world’s biggest economies and the world’s biggest trading partners, the European Union (EU) and China. The EU is China’s biggest international trading partner, and China is the EU’s second biggest partner, after the United States. The trade dispute between Beijing and Brussels was one of the biggest in history. The European Commission, after a nine-month investigation, started a formal complaint from a group of more than 20 European producers, imposed provisional tariffs on solar panels imported from China, and accused subsidized exporters of flooding the EU at prices below production cost. China became the largest producer of solar panels due to a rise in the world’s economy, influencing global trade by lowering prices in the manufacturing sector. Nearly 80 percent of the produced solar panels in China are exported to the EU market. However, according 1

to EU trade commissioner Karel de Gucht, under a fair price the Chinese solar panels would be 88 percent higher than the current price. The inflow of Chinese solar panels became a big issue for local producers and competitors. There were opposing opinions between EU member states, because there were uncertainties about the impact of the tariff on the sector and the fact that the EU solar industry supports 265,000 jobs across Europe. Nevertheless, a tariff of 11.8 percent was set to be applied to Chinese solar imports to Europe from June 6, 2013, and was set to rise to an average of 47.6 percent within two months, imposing these duties for up to five years. Although the tariff was set to be applied to imports of solar panels, which value was €21 billion a year, this would have created a negative effect on the entire trading relationship worth about €480 billion and would have undermined the confidence of Chinese companies doing business in Europe. China, as opposed to the EU solar restraint, took steps to defend its interests and Beijing launched anti-dumping and anti-subsidy probes into imports of European wine, as of the received requests and allegations of unfair trade from domestic wine producers. At the same time, exporters of luxury cars were also threatened as China was about to conduct another probe in the EU luxury cars industry. The wine industry is not the EU’s core industry. However, some EU countries, such as France, Italy, and Spain, would definitely experience a negative and damaging impact. China’s total bottled wine imports from 2002 to 2012 skyrocketed to around 15,000 percent and China is the number one importer of French wine. China’s local wine suppliers are the ones who would have benefited the most out of this tariff war.

WTO, “Trade and Public Policies: A Closer Look at Non-Tariff Measures in the 21st Century,” World trade report 2012, https://www.wto.org/english/res_e/booksp_e/anrep_e/wtr12-2e_e.pdf

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Nonetheless, China and the EU agreed to settle the dispute through negotiations rather than continuing to heat up the trade war. Trade between these two partners is estimated at €1 billion per day. As a result of this tariff war, the volume of trade between these two countries would be reduced, hurting the economies of both countries.

In July 2013, per the settlement on the solar panel dispute both parties reached an agreement— a minimum price of €0.56 per watt peak for the solar panels until the end of 2015 and a limitation on the export volume. Nearly 90 percent of China’s solar manufacturers agreed to the terms of this settlement.2.

2

Yu-Chen, “EU-China Solar Panels Trade Dispute: Settlement and challenges to the EU,” EU-Asia at a Glance, European Institute for Asian Studies, June 2015, http://www.eias.org

The net welfare effects of a tariff are summarized in Figure 9-10. The negative effects consist of the two triangles b and d. The first triangle is the production distortion loss resulting from the fact that the tariff leads domestic producers to produce too much of this good. The second triangle is the domestic consumption distortion loss resulting from the fact that a tariff leads consumers to consume too little of the good. Against these losses must be set the terms of trade gain measured by the rectangle e, which results from the decline in the foreign export price caused by a tariff. In the important case of a small country that cannot significantly affect foreign prices, this last effect drops out; thus, the costs of a tariff unambiguously exceed its benefits.

FIG U R E 9-10

Net Welfare Effects of a Tariff

Price, P S

The colored triangles represent efficiency losses, while the rectangle represents a terms of trade gain. PT PW

b

d e

PT* D

Imports = efficiency loss (b + d) = terms of trade gain (e)

Quantity, Q



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255

Other Instruments of Trade Policy Tariffs are the simplest trade policies, but in the modern world, most government intervention in international trade takes other forms, such as export subsidies, import quotas, voluntary export restraints, and local content requirements. Fortunately, once we have understood tariffs, it is not too difficult to understand these other trade instruments.

Export Subsidies: Theory An export subsidy is a payment to a firm or individual that ships a good abroad. Like a tariff, an export subsidy can be either specific (a fixed sum per unit) or ad valorem (a proportion of the value exported). When the government offers an export subsidy, shippers will export the good up to the point at which the domestic price exceeds the foreign price by the amount of the subsidy. The effects of an export subsidy on prices are exactly the reverse of those of a tariff (Figure 9-11). The price in the exporting country rises from PW to PS, but because the price in the importing country falls from PW to P*S , the price increase is less than the subsidy. In the exporting country, consumers are hurt, producers gain, and the government loses because it must expend money on the subsidy. The consumer loss is the area a + b; the producer gain is the area a + b + c; the government subsidy (the amount of exports times the amount of the subsidy) is the area b + c + d + e + f + g. The net welfare loss is therefore the sum of the areas b + d + e + f + g. Of these, b and d represent consumption and production distortion losses of the same kind that a tariff produces. In addition, and in contrast to a tariff, the export subsidy worsens the terms of trade because it lowers the price of the export in the foreign market from PW to P*S . This leads to the additional terms of trade loss e + f + g, which is equal to PW - P*S times the quantity exported with the subsidy. So an export subsidy unambiguously leads to costs that exceed its benefits.

FIG U R E 9-11

Effects of an Export Subsidy

Price, P

An export subsidy raises prices in the exporting country while lowering them in the importing country.

PS Subsidy

PW

S

a

c

b e

f

d g

PS*

D Exports = producer gain (a + b + c) = consumer loss (a + b) = cost of government subsidy (b + c + d + e + f + g)

Quantity, Q

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CASE STUDY

Europe’s Common Agricultural Policy

In 1957, six Western European nations—Germany, France, Italy, Belgium, the Netherlands, and Luxembourg—formed the European Economic Community, which has since grown to include most of Europe. Now called the European Union (EU), its two biggest effects are on trade policy. First, the members of the European Union have removed all tariffs with respect to each other, thus creating a customs union (discussed in Chapter 10). Second, the agricultural policy of the European Union has developed into a massive export subsidy program. The European Union’s Common Agricultural Policy (CAP) began not as an export subsidy but as an effort to guarantee high prices to European farmers by having the European Union buy agricultural products whenever the prices fell below specified support levels. To prevent this policy from drawing in large quantities of imports, it was initially backed by tariffs that offset the difference between European and world agricultural prices. Since the 1970s, however, the support prices set by the European Union have turned out to be so high that Europe—which, under free trade, would be an importer of most agricultural products—was producing more than consumers were willing to buy. As a result, the European Union found itself obliged to buy and store huge quantities of food. At the end of 1985, for example, European nations had stored 780,000 tons of beef, 1.2 million tons of butter, and 12 million tons of wheat. To avoid unlimited growth in these stockpiles, the European Union turned to a policy of subsidizing exports to dispose of surplus production. Figure 9-12 shows how the CAP works. It is, of course, exactly like the export subsidy shown in Figure 9-11, except that Europe would actually be an importer under free trade. The support price is set not only above the world price that would FIG U R E 9-12

Price, P

Europe’s Common Agricultural Policy Agricultural prices are fixed not only above world market levels but also above the price that would clear the European market. An export subsidy is used to dispose of the resulting surplus.

S

Support price EU price without imports World price

D

Exports

Quantity, Q

= cost of government subsidy



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prevail in its absence but also above the price that would equate demand and supply even without imports. To export the resulting surplus, an export subsidy is paid that offsets the difference between European and world prices. The subsidized exports themselves tend to depress the world price, increasing the required subsidy. A recent study estimated that the welfare cost to European consumers exceeded the benefits to farm producers by nearly $30 billion (21.5 billion euros) in 2007.3 Despite the considerable net costs of the CAP to European consumers and taxpayers, the political strength of farmers in the EU has been so strong that the program has been difficult to rein in. One source of pressure has come from the United States and other food-exporting nations, which complain that Europe’s export subsidies drive down the price of their own exports. The budgetary consequences of the CAP have also posed concerns: In 2013, the CAP cost European taxpayers $65 billion (59 billion euros)—and that figure doesn’t include the indirect costs to food consumers. Government subsidies to European farmers are equal to about 19 percent of the value of farm output, roughly twice the U.S. figure of 9.4 percent. (U.S. agriculture subsidies are more narrowly targeted on a subset of crops.) Recent reforms in Europe’s agricultural policy represent an effort to reduce the distortion of incentives caused by price support while continuing to provide aid to farmers. If politicians go through with their plans, farmers will increasingly receive direct payments that aren’t tied to how much they produce; this should lower agricultural prices and reduce production.

Import Quotas: Theory An import quota is a direct restriction on the quantity of some good that may be imported. The restriction is usually enforced by issuing licenses to some group of individuals or firms. For example, the United States has a quota on imports of foreign cheese. The only firms allowed to import cheese are certain trading companies, each of which is allocated the right to import a maximum number of pounds of cheese each year; the size of each firm’s quota is based on the amount of cheese it imported in the past. In some important cases, notably sugar and apparel, the right to sell in the United States is given directly to the governments of exporting countries. Another example is the European Union applying tariff quotas to imports of a specified origin.4 It is important to avoid having the misconception that import quotas somehow limit imports without raising domestic prices. The truth is that an import quota always raises the domestic price of the imported good. When imports are limited, the immediate result is that at the initial price, the demand for the good exceeds domestic supply plus imports. This causes the price to be bid up until the market clears. In the end, an import quota will raise domestic prices by the same amount as a tariff that limits imports to the 3

See Pierre Boulanger and Patrick Jomini, Of the Benefits to the EU of Removing the Common Agricultural Policy, Sciences Politique Policy Brief, 2010. 4 European Commission.

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same level (except in the case of domestic monopoly, in which the quota raises prices more than this; see the appendix to this chapter). The difference between a quota and a tariff is that with a quota, the government receives no revenue. When a quota instead of a tariff is used to restrict imports, the sum of money that would have appeared with a tariff as government revenue is collected by whoever receives the import licenses. License holders are thus able to buy imports and resell them at a higher price in the domestic market. The profits received by the holders of import licenses are known as quota rents. In assessing the costs and benefits of an import quota, it is crucial to determine who gets the rents. When the rights to sell in the domestic market are assigned to governments of exporting countries, as is often the case, the transfer of rents abroad makes the costs of a quota substantially higher than the equivalent tariff.

CASE STUDY

Tariff-Rate Quota Origin and its Application in Practice with Oilseeds

In international trade, oilseed products are one of the most highly traded agricultural products (others include grains and meat), making this trade one of crucial importance for many countries, either through production or utilization. Oilseeds are crops that have high oil content such as soybeans, rapeseed, sunflower, flax, and cottonseed. In 2001, about 80 percent of the world imports of oilseeds consisted of 11 percent soybeans, 9 percent rapeseed, and other types of oilseeds. Tariff quotas for these goods are more often applied than those for the traditionally protected products like dairy or sugar. In practice, in 1990s world trade in oilseeds generally was characterized by “low to moderate” applied tariffs and bound tariff rates. The bound tariff rate, which is the maximum allowable rate under a country’s WTO commitments, in most cases is quite high, particularly in developing countries. For instance, the highest tariffs were imposed by Colombia (and Venezuela) with a 15 percent duty to its imports of soybeans in 2001, but it had a bound tariff rate of 97 percent under the WTO commitment. India had a 40 percent applied tariff, but imposed a 100 percent bound tariff rate. In general, tariff rates on oilseed products (for example, vegetable oils and oilseed meal) were much higher than those on whole oilseeds. This situation is called tariff escalation and its practice was designed mainly for two main reasons: to protect both domestic oilseed crushing industry and vegetable oil refineries, and to discourage the development of processing activities in the countries of its origin. In Japan, for example, with limited domestic oilseed production, there was no tariff on whole oilseeds. However, a tariff of 12.9 yen/kg for soy oil/rape oil was imposed with intension to protect local crushers.5 The EU applied a tariff on

5

Mitchell D. A note on rising food prices, The world Banks Development prospects group, July 2008, Policy research working paper 4682; and Oils Crop Situation and Outlook Yearbook / OCS-2006/May 2006, Economic Research Service, USDA. 6 Ames Glenn C.W., Gunter L., Davis C.D. (1996) Analysis of USA-European Community oilseeds agreement, Agriculture Economics 15, p.97–112.



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soybean oil of 30 percent ad valorem, and had a bound tariff of 45 percent, for soybean meal a tariff was 5 percent (with a bound tariff of 10 percent). Although the duty on soybeans imports was bound duty-free under WTO commitment, all other oilseeds and oilseed meals imports also had free of duty import status under the Dillon round. An alternative measure in the form of non-tariff policies, specifically domestic price support and subsidies served producers as a substitute. These policies encouraged excess production and distorted trade flows as well as reduced world imports, increased export subsidies, encouraged low-price selling on world markets. EU oilseed production subsidies, real price supports, budgetary expenditures or oilseed crops increased dramatically (by 1985 the budgetary expenditure on oilseeds and protein crops exceeded 10percent of the EU’s total annual spending on agriculture) for domestic growers resulted in oilseeds production increase.6 The EU nearly tripled oilseed production between 1980 and 1990, which contributed to a 53 percent drop in the volume of US soybean and soybean meals export for the same period, displacing and impairing US exports to the EU. This led to an oilseeds dispute between the United States and the EU in the end of 1980s, which was later solved by the Blair House agreement on oilseeds.7 Uruguay’s Round Agreement on Agriculture (URAA) had greatly influenced the process of trade barriers reduction and the major achievement was cut in tariff levels on agricultural products, lowering the volume of and expenditures on subsidized export and reducing domestic programs for agriculture. Participating developed countries in URAA were required to reduce existing tariffs on agricultural products on average of 36 percent. Whereas developing countries had committed to smaller average tariff reductions of 24 percent and longer transition period compared to developed. Another important requirement was to convert existing non-tariff agricultural trade barriers to tariffs, establishing a tariff-rate quota (TRQ). The idea by TRQ was to impose a lower tariff rate to imports below a certain quantitative limit and higher tariffs to imports above that initial limit. As of URAA tariffs were to be reduced from the base levels to a bound level. According to URAA the size of quota was aimed to be equal or greater than actual import levels during a recent period and required that out-of-quota bound tariff rates be reduced from the based tariff rates. In 1997 40percent of 1,366 TRQs were supposed to increase their quotas, indicating easier market access.8 Of these TRQs, 124 (which is 9 percent) were applied to oilseeds and products. The 21 member states of the WTO notified having at least one TRQ on oilseeds or oilseed products. For instance, Iceland had 22 TRQs—Colombia, 20; Venezuela, 19; South Africa, 8;

7

Oilseed disputed narrowed During GATT Uruguay Round in 1992 a memorandum of Understanding on oilseeds (often referred to as the “Blair House Agreement”) was negotiated with the US, resolving a dispute over EU domestic support programs that weakened the US access to the EU oilseeds market. As of the agreement a number of restriction on production support of oilseeds was established. The EU oilseeds planting area of certain type was limited (specifically rapeseed, sunflower seed and soybeans), while certain support allowance of the production of some oilseeds to continue. The limitation included on area that should not have exceeded 5.482 million hectares. The agreement also allowed for modification of the supported area in regards to EU enlargement. While the original maximum base was set at 5.128 million hectares, it was modified to cover EU15 in 1995 with no amendments for subsequent EU enlargement. 8 Oils Crop Situation and Outlook Yearbook / OCS-2006/May 2006, Economic Research Service, USDA.

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FIG U R E 9-13

Base Tariff Rate

Bound Tariff Rate (Rate of Over Quota Tariff)

Applied Tariff (TRQ)

USA

  0.7

  0.45

 0.53

Mexico

 25

22.5

15

Columbia, Venezuela

108

97

15

Poland

10

5

3

India

100

100

40

Malaysia

13

10

0

World Oilseed Tariff Rates in cents per kg Source: Oil Crops Situation and Outlook Yearbook, May 2007, Economic Research Service, USDA.

Country

Guatemala, 7; and Thailand and Morocco had 6.9 The URAA fixed an upper bound on tariff levels for agricultural commodities, however these limits were often quite high, varying by country. The establishment of TRQ aimed to bring more transparency of non-tariff barriers to trade and though was a major achievement, the level of trade creation resulting from these TRQs were quite modest. For TRQ quotas to be more effective and for the trade to be more liberalized reduced tariffs (or elimination) on imports above the quota or increased the quota level would be far better options for overall trade. The modest result was mostly linked to high over-quotas tariff rates, which was a barrier to trade in oilseeds and products. Overall tariff-rate quota became a more often used form of domestic market protection and in a way a gradual alternative to international trade liberalization form. Perspective on EU oilseed market The EU is one of the top importers of oilseeds products, and oilseeds consumption is higher than the net production minus exports. In fact, the EU is highly dependent on imports of oilseed and its products (protein meals and vegetable oils). Oilseeds (rapeseed, sunflower seed, soybeans, linseed) are grown in the European Union for food, feed, fuel and industrial purposes. Nearly all oilseeds are crushed and processed to produce oil and meal.10 Vegetable oils are used in food industry, biodiesel and other industries. Oilseeds meals are also essential protein-rich animal fee ingredient. Some oilseeds have limited or no domestic production (such as soybeans, soybean products and palm oil). Around 54 percent of soybean meal, around 50 percent of sunflower meal and more that 80 percent of soybeans for

9

As of URRA requirement imports that meet a minimum of 5percent of domestic consumption by the end of the implementation period. Countries that already import over that amount are not required to raise their quota level. 10 OECD (2003) Agriculture, Trade and the Environment: the Arable Crop Sector.



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FIG U R E 9-14

Tariffs on oilseeds as well as oilseed meals are set at zero, some duties vegetable oils (except olive oil) range from 0 to 12.8 percent.

Description Oilseeds Vegetable oils, other than olive oil Oilseed meals

Duty percent 0 0 – 12.8 0

Oilseeds and protein crops in the EU, Directorate-General for Agriculture and Rural Development, Unit C5, European Commission, 201111.

crush are imported to meet the domestic demand. In the EU, cereal production represents the most important use of arable land, whereas 5.4 million ha are allocated to the production of oilseeds. Currently, about 2/3 of the oilseeds consumed within the European Union each year are produced in the EU and the rest is being imported. Since 2012 there are no specific domestic support measures for the production of oilseeds in the EU and no longer any restriction on the EU’s oilseed area. From January 2002 to June 2008, the world’s food prices saw a drastic growth due to several factors. The rapid increase in oilseed prices was mostly caused by a large increase in biofuels production from grains and oilseeds both in the US and EU. The growth in the EU poultry sector was mostly responsible for the growing demand for protein feed. With mandatory use of biofuels in the EU by 2020 (as stated by the 2009 Renewable Energy Directive12) the use of vegetable oils in the EU also increased, causing prices to rise as well as pushing the domestic oilseed production to grow.

11

For the olive oil market, the European Commission can provide private storage aid in case of disturbances in the olive oil market or the average price for the following products are recorded during a two weeks period: Eur 1,779/tonne for extra virgin olive oil, Eur 1,710/tonne for virgin olive oil, Eur 1,524/tonne for lampante olive oil; and the European Commission, Directorate-General for Agriculture and Rural Development, Unit C5, October, 2011. 12 Directive 2009/28/EC of the European Parliament and of the Council of 23 April 2009 on the promotion of the use of energy from renewable sources and amending and subsequently repealing Directives 2001/77/EC and 2003/30/EC.

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Voluntary Export Restraints A variant on the import quota is the voluntary export restraint (VER), also known as a voluntary restraint agreement (VRA). (Welcome to the bureaucratic world of trade policy, where everything has a three-letter symbol!) A VER is a quota on trade imposed from the exporting country’s side instead of the importer’s. The most famous example is the limitation on auto exports to the United States enforced by Japan after 1981. Voluntary export restraints are generally imposed at the request of the importer and are agreed to by the exporter to forestall other trade restrictions. As we will see in ­Chapter 10, certain political and legal advantages have made VERs preferred instruments of trade policy in some cases. From an economic point of view, however, a voluntary export restraint is exactly like an import quota where the licenses are assigned to foreign governments and is therefore very costly to the importing country. A VER is always more costly to the importing country than a tariff that limits imports by the same amount. The difference is that what would have been revenue under a tariff becomes rents earned by foreigners under the VER, so that the VER clearly produces a loss for the importing country. Numerical examples suggest that voluntary export restraints can be beneficial for the exporting country and damaging to the importing country. A study that examines the welfare effect of VERs on the world economy suggests that a government’s preference for VERs offers a short-term expansion effect on the exporting country. The effects of VERs can only bring positive results in the case of perfect competition for the goods market or when the exporting country is larger than the importing country. Overall, a VER not only damages the domestic economy in the long-run but also has a deteriorating effect on the overall welfare of the world economy.13 Some voluntary export agreements cover more than one country. The most famous multilateral agreement is the Multi-Fiber Arrangement, which limited textile exports from 22 countries until the beginning of 2005. Such multilateral voluntary restraint agreements are known by yet another three-letter abbreviation: OMA, for “orderly marketing agreement.”

CASE STUDY

A Voluntary Export Restraint in Practice

JAPANESE AUTOS For much of the 1960s and 1970s, the U.S. auto industry was largely insulated from import competition by the difference in the kinds of cars bought by U.S. and foreign consumers. U.S. buyers, living in a large country with low gasoline taxes, preferred much larger cars than Europeans and Japanese, and, by and large, foreign firms had chosen not to challenge the United States in the large-car market. In 1979, however, sharp oil price increases and temporary gasoline shortages caused the U.S. market to shift abruptly toward smaller cars. Japanese producers, whose costs had been falling relative to those of their U.S. competitors in any case, moved in to fill the new demand. As the Japanese market share soared and U.S. output fell, strong political forces in the United States demanded protection

13 Wang F. (2011) Who bears the burden of voluntary export restraints? Prague Economic Paper Vol. 3., p. 216–231. DOI: 10.18267/j.pep.397.



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for the U.S. industry. Rather than act unilaterally and risk creating a trade war, the U.S. government asked the Japanese government to limit its exports. The Japanese, fearing unilateral U.S. protectionist measures if they did not do so, agreed to limit their sales. The first agreement, in 1981, limited Japanese exports to the United States to 1.68 million automobiles. A revision raised that total to 1.85 million in 1984. In 1985, the agreement was allowed to lapse. The effects of this voluntary export restraint were complicated by several factors. First, Japanese and U.S. cars were clearly not perfect substitutes. Second, the Japanese industry to some extent responded to the quota by upgrading its quality and selling larger autos with more features. Third, the auto industry is clearly not perfectly competitive. Nonetheless, the basic results were what the discussion of voluntary export restraints earlier would have predicted: The price of Japanese cars in the United States rose, with the rent captured by Japanese firms. The U.S. government estimates the total costs to the United States to be $3.2 billion in 1984, primarily in transfers to Japan rather than efficiency losses. CHINESE SOLAR PANELS Although voluntary export restraints are no longer allowed under WTO rules, this only applies to an agreement negotiated by governments and imposed onto exporters. Recently, a European Union–China trade dispute over a surge in Chinese exports of solar panels was resolved by the Chinese producers “agreeing” to limit their exports to EU countries below 7 gigawatts-worth of solar panels per year—along with a minimum price floor for those units. EU solar panel makers were disappointed, as this agreement forestalled the imposition of 47 percent anti-dumping duties on all Chinese solar panel imports (the threat that generated those concessions by Chinese solar panel producers). However, the imposition of the anti-dumping duties would have triggered a significant retaliation from China, whose officials had already drawn up a list of European products—including luxury fashion goods and wines—that would be subjected to stiff import duties into China. Chinese producers were persuaded to agree to the export limit and price floor instead, since this would allow them to keep the higher prices charged in the European Union. The main losers are European consumers, who will pay substantially more for solar power (and the environment).

Local Content Requirements A local content requirement is a regulation that requires some specified fraction of a final good to be produced domestically. In some cases, this fraction is specified in physical units, like the U.S. oil import quota in the 1960s. In other cases, the requirement is stated in value terms by requiring that some minimum share of the price of a good represent domestic value added. Local content laws have been widely used by developing countries trying to shift their manufacturing base from assembly back into intermediate goods. In the United States, a local content bill for automobiles was proposed in 1982 but was never acted on. From the point of view of the domestic producers of parts, a local content regulation provides protection in the same way an import quota does. From the point of view of the firms that must buy locally, however, the effects are somewhat different. Local content

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Healthcare Protection with Local Content Requirements

L

ocal content requirements (LCR) are attracting more and more attention as a non-tariff form of protectionism providing domestic producers additional benefits over the foreign competitors. In fact, both developed and developing countries have turned their interest towards this policy. While LCR has been around for a long period of time, in recent years a substantial increase has been witnessed in the use of these restrictions, especially after the financial crisis of 2008. Using LCR, various governments have put in efforts to improve domestic employment and industrial performance. For example, the healthcare sector in Brazil is divided into three groups: medical services and hospitals, medical devices, and pharmaceuticals. While hospitals and other providers of medical services in Brazil cannot be owned by foreign companies, foreign companies are actively engaged in other healthcare sector groups: imported medical devices make around 60 percent and pharmaceuticals – 24 percent of Brazilian market. In 2011, the Brazilian pharmaceutical market was around $30 billion, whilst the medical devices sector was more than 10 times bigger and made it to roughly $4 billion. The Brazilian Ministry of Health controls the market of healthcare products and services through a licensing

system. In order to sell either pharmaceutical or healthcare products a producer (regardless the origin of the goods) must receive approval of the products registration as well as obtain a license. The idea of these requirements is to set a population’s sanitary control of production and marketing. As a result, it creates additional costs and requires additional time for foreign companies to register medical devices in the Brazilian market. Although registration requirements do not fall into the discriminative policy, it generates delays in business while waiting for approvals and permissions and additional costs. Around 70 percent of Brazilian pharmaceuticals are manufactured by foreign companies, thus, foreign companies tend to acquire Brazilian companies or construct green field production plants because of the local content requirements and other aspects. In addition, with the target to create demand for domestic products and positively influence economy and increase employment rate in 2012 the Brazilian government established a LCR policy—up to 25 percent preferences for Brazilian medical devices and medicine in government contracts. This local content requirement obviously has a discriminative nature for those devices and medication produced abroad.14.

14 Hufbauer G.C., Schott J.J., Cimino C., Vieiro M, Wada E. Local content requirements: Report on a global problem, Peterson Institute for International Economics (June 28, 2013).



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does not place a strict limit on imports. Instead, it allows firms to import more, provided that they also buy more domestically. This means that the effective price of inputs to the firm is an average of the price of imported and domestically produced inputs. Consider, for instance, the earlier automobile example in which the cost of imported parts is $6,000. Suppose purchasing the same parts domestically would cost $10,000, but assembly firms are required to use 50 percent domestic parts. Then, they will face an average cost of parts of +8,000 (0.5 * +6,000 + 0.5 * +10,000), which will be reflected in the final price of the car. The important point is that a local content requirement does not produce either government revenue or quota rents. Instead, the difference between the prices of imports and domestic goods in effect gets averaged in the final price and is passed on to consumers. An interesting innovation in local content regulations has been to allow firms to satisfy their local content requirement by exporting instead of using parts domestically. This is sometimes important. For example, U.S. auto firms operating in Mexico have chosen to export some components from Mexico to the United States, even though those components could be produced in the United States more cheaply because doing so allows them to use less Mexican content in producing cars in Mexico for Mexico’s market.

Other Trade Policy Instruments Governments influence trade in many other ways. We list some of them briefly. 1. Export credit subsidies. This is like an export subsidy except that it takes the form of a subsidized loan to the buyer. The United States, like most other countries, has a government institution, the Export-Import Bank, devoted to providing at least slightly subsidized loans to aid exports. 2. National procurement. Purchases by the government or strongly regulated firms can be directed toward domestically produced goods even when these goods are more expensive than imports. The classic example is the European telecommunications industry. The nations of the European Union in principle have free trade with each other. The main purchasers of telecommunications equipment, however, are phone companies—and in Europe, these companies have until recently all been government-owned. These government-owned telephone companies buy from domestic suppliers even when the suppliers charge higher prices than suppliers in other countries. The result is that there is very little trade in telecommunications equipment within Europe. 3. Red-tape barriers. Sometimes a government wants to restrict imports without doing so formally. Fortunately or unfortunately, it is easy to twist normal health, safety, and customs procedures in order to place substantial obstacles in the way of trade. The classic example is the French decree in 1982 that all Japanese videocassette recorders had to pass through the tiny customs house at Poitiers (an inland city nowhere near a major port)—effectively limiting the actual imports to a handful.

The Effects of Trade Policy: A Summary The effects of the major instruments of trade policy are usefully summarized by Table 9-1, which compares the effect of four major kinds of trade policy on the welfare of consumers. This table certainly does not look like an advertisement for interventionist trade policy. All four trade policies benefit producers and hurt consumers. The effects of the

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TABLE 9-1

Effects of Alternative Trade Policies

Policy Producer surplus Consumer surplus Government revenue

Tariff Increases Falls Increases

Overall national welfare

Ambiguous (falls for small country)

Export Subsidy Increases Falls Falls (government spending rises) Falls

Import Quota Increases Falls No change (rents to license holders) Ambiguous (falls for small country)

Voluntary Export Restraint Increases Falls No change (rents to foreigners) Falls

policies on economic welfare are at best ambiguous; two of the policies definitely hurt the nation as a whole, while tariffs and import quotas are potentially beneficial only for large countries that can drive down world prices. Why, then, do governments so often act to limit imports or promote exports? We turn to this question in Chapter 10.

SUMMARY 1. In contrast to our earlier analysis, which stressed the general equilibrium interaction of markets, for analysis of trade policy it is usually sufficient to use a partial equilibrium approach. 2. A tariff drives a wedge between foreign and domestic prices, raising the domestic price but by less than the tariff rate. An important and relevant special case, however, is that of a “small” country that cannot have any substantial influence on foreign prices. In the small-country case, a tariff is fully reflected in domestic prices. 3. The costs and benefits of a tariff or other trade policy may be measured using the concepts of consumer surplus and producer surplus. Using these concepts, we can show that the domestic producers of a good gain because a tariff raises the price they receive; the domestic consumers lose, for the same reason. There is also a gain in government revenue. 4. If we add together the gains and losses from a tariff, we find that the net effect on national welfare can be separated into two parts: On one hand is an efficiency loss, which results from the distortion in the incentives facing domestic producers and consumers. On the other hand is a terms of trade gain, reflecting the tendency of a tariff to drive down foreign export prices. In the case of a small country that cannot affect foreign prices, the second effect is zero, so that there is an unambiguous loss. 5. The analysis of a tariff can be readily adapted to analyze other trade policy measures, such as export subsidies, import quotas, and voluntary export restraints. An export subsidy causes efficiency losses similar to those of a tariff but compounds these losses by causing a deterioration of the terms of trade. Import quotas and voluntary export restraints differ from tariffs in that the government gets no revenue. Instead, what would have been government revenue accrues as rents to the recipients of import licenses (in the case of a quota) and to foreigners (in the case of a voluntary export restraint).



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KEY TERMS ad valorem tariff, p. 243 consumer surplus, p. 249 consumption distortion loss,  p. 254 effective rate of protection,  p. 248 efficiency loss, p. 252 export restraint, p. 244 export subsidy, p. 255

export supply curve, p. 244 import demand curve, p. 244 import quota, p. 244 local content requirement,  p. 263 nontariff barriers, p. 244 producer surplus, p. 250 production distortion loss,  p. 254

quota rent, p. 258 specific tariff, p. 243 terms of trade gain, p. 252 voluntary export restraint (VER), p. 262

Pearson MyLab Economics

PROBLEMS 1. Home’s demand curve for books is

D = 50 - 10P. Its supply curve is S = 10 + 10P. Derive and graph Home’s import demand schedule. What would the price of books be in the absence of trade? 2. Now add Foreign, which has a demand curve D* = 60 - 10P and a supply curve S* = 20 + 10P. a. Derive and graph Foreign’s export supply curve and find the price of books that would prevail in Foreign in the absence of trade. b. Now allow Foreign and Home to trade with each other, at zero transportation cost. Find and graph the equilibrium under free trade. What is the world price? What is the volume of trade? 3. Home imposes a specific tariff of 1.5 on books imports. a. Determine and graph the effects of the tariff on the following: (1) the price of books in each country; (2) the quantity of books supplied and demanded in each country; (3) the volume of trade. b. Determine the effect of the tariff on the welfare of each of the following groups: (1) Home import-competing producers; (2) Home consumers; (3) the Home government. c. Show graphically and calculate the terms of trade gain, the efficiency loss and the total effect on welfare of the tariff. 4. Suppose Foreign had been a much smaller country with domestic demand. D* = 8 - 2P, S* = 4 + 2P (Notice that this implies the Foreign price of books in the absence of trade would have been the same as in problem 2). Recalculate the free trade equilibrium and the effects of a 1.5 specific tariff by Home. Relate the difference in results to the discussion of the small-country case in the text.

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5. What would be the effective rate of protection on bicycles in China if China places a 50 percent tariff on bicycles, which have a world price of $200, and no tariff on bike components, which together have a world price of $100? 6. For a company that produces candy canes, sugar is 70 percent of its ingredient costs. The United States limits the imports of sugar to protect cane farmers, which has led to an increase in the price of sugar by about 25 percent relative to what it would be otherwise. Suppose your country, however, allows free trade in candy canes, which are made with sugar that accounts for approximately 65 percent of its cost. What is the effective rate of protection on the process of turning sugar into candy canes? 7. Return to the example of problem 2. Starting from free trade, assume that Foreign offers exporters a subsidy of 1.5 per unit. Calculate the effects on the price in each country and on welfare, both of individual groups and of the economy as a whole in both countries. 8. Use your knowledge about trade policy to evaluate each of the following statements: a. “Tariffs on imported goods will increase domestic price, leading to high unemployment.” b. “High tariffs and quotas can result in trade wars between nations.” c. “Smartphone manufacturing jobs are heading back to United States because wages started to rise in China. As a result, we should implement tariffs on smartphones equal to the difference between U.S. and China’s wage rates.” 9. The nation of Cologne is “large,” but unable to affect world prices. It imports chocolate at the price of $20 per box. The demand curve is: D = 700 - 10P. The supply curve is S = 200 + 5P. Determine the free trade equilibrium. Then calculate and graph the following effects on an import quota that limits imports to 50 boxes: a. The increase in the domestic price. b. The quota rents. c. The consumption distortion loss. d. The production distortion loss. 10. If tariffs are already in place as a trade policy, why might a country choose to apply also nontariff barriers as another way to control the amount of trade that they conduct with other countries? 11. Suppose workers involved in manufacturing are paid less than all other workers in the economy. What would be the effect on the real income distribution within the economy if there were a substantial tariff levied on manufactured goods?

FURTHER READINGS Jagdish Bhagwati. “On the Equivalence of Tariffs and Quotas,” in Robert E. Baldwin et al., eds. Trade, Growth, and the Balance of Payments. Chicago: Rand McNally, 1965. The classic comparison of tariffs and quotas under monopoly. W. M. Corden. The Theory of Protection. Oxford: Clarendon Press, 1971. A general survey of the effects of tariffs, quotas, and other trade policies. Robert W. Crandall. Regulating the Automobile. Washington, D.C.: Brookings Institution, 1986. Contains an analysis of the most famous of all voluntary export restraints.



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Robert C. Feenstra. “How Costly Is Protectionism?” Journal of Economic Perspectives 6 (1992), pp. 159–178. A survey article summarizing the empirical work measuring the costs associated with protectionist policies. Gary Clyde Hufbauer and Kimberly Ann Elliot. Measuring the Costs of Protection in the United States. Washington, D.C.: Institute for International Economics, 1994. An assessment of U.S. trade policies in 21 different sectors. Kala Krishna. “Trade Restrictions as Facilitating Practices.” Journal of International Economics 26 (May 1989), pp. 251–270. A pioneering analysis of the effects of import quotas when both foreign and domestic producers have monopoly power, showing that the usual result is an increase in the profits of both groups—at consumers’ expense. Patrick Messerlin. Measuring the Costs of Protection in Europe: European Commercial Policy in the 2000s. Washington, D.C.: Institute for International Economics, 2001. A survey of European trade policies and their effects, similar to Hufbauer and Elliot’s work for the United States. D. Rousslang and A. Suomela. “Calculating the Consumer and Net Welfare Costs of Import Relief.” U.S. International Trade Commission Staff Research Study 15. Washington, D.C.: International Trade Commission, 1985. An exposition of the framework used in this chapter, with a description of how the framework is applied in practice to real industries. U.S. International Trade Commission. The Economic Effects of Significant U.S. Import Restraints. Washington, D.C., 2009. A regularly updated economic analysis of the effects of protection on the U.S. economy.

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Pearson MyLab Economics

If your exam were tomorrow, would you be ready? For each chapter, Pearson MyLab Economics Practice Tests and Study Plans pinpoint sections you have mastered and those you need to study. That way, you are more efficient with your study time, and you are better prepared for your exams. To see how it works, turn to page 37 and then go to www.myeconlab.com

A PP ENDI X T O C HAP T E R

9

Tariffs and Import Quotas in the Presence of Monopoly The trade policy analysis in this chapter assumed that markets are perfectly competitive, so that all firms take prices as given. As we argued in Chapter 8, however, many markets for internationally traded goods are imperfectly competitive. The effects of international trade policies can be affected by the nature of the competition in a market. When we analyze the effects of trade policy in imperfectly competitive markets, a new consideration appears: International trade limits monopoly power, and policies that limit trade may therefore increase monopoly power. Even if a firm is the only producer of a good in a country, it will have little ability to raise prices if there are many foreign suppliers and free trade. If imports are limited by a quota, however, the same firm will be free to raise prices without fear of competition. The link between trade policy and monopoly power may be understood by examining a model in which a country imports a good and its import-competing production is controlled by only one firm. The country is small on world markets, so the price of the import is unaffected by its trade policy. For this model, we examine and compare the effects of free trade, a tariff, and an import quota.

The Model with Free Trade Figure 9A-1 shows free trade in a market where a domestic monopolist faces competition from imports. D is the domestic demand curve: demand for the product by domestic residents. PW is the world price of the good; imports are available in unlimited quantities at that price. The domestic industry is assumed to consist of only a single firm, whose marginal cost curve is MC.

FIG U R E 9A-1

A Monopolist under Free Trade The threat of import competition forces the monopolist to behave like a perfectly competitive industry.

Price, P MC PM

PW D MR Qf

QM

Df

Imports under free trade

270

Quantity, Q



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If there were no trade in this market, the domestic firm would behave as an ordinary profit-maximizing monopolist. Corresponding to D is a marginal revenue curve MR, and the firm would choose the monopoly profit-maximizing level of output QM and price PM. With free trade, however, this monopoly behavior is not possible. If the firm tried to charge PM, or indeed any price above PW, nobody would buy its product, because cheaper imports would be available. Thus international trade puts a lid on the monopolist’s price at PW. Given this limit on its price, the best the monopolist can do is produce up to the point where marginal cost is equal to the world price, at Qf. At the price PW, domestic consumers will demand Df units of the good, so imports will be Df - Qf. This outcome, however, is exactly what would have happened if the domestic industry had been perfectly competitive. With free trade, then, the fact that the domestic industry is a monopoly does not make any difference in the outcome.

The Model with a Tariff The effect of a tariff is to raise the maximum price the domestic industry can charge. If a specific tariff t is charged on imports, the domestic industry can now charge PW + t (Figure 9A-2). The industry still is not free to raise its price all the way to the monopoly price, however, because consumers will still turn to imports if the price rises above the world price plus the tariff. Thus the best the monopolist can do is to set price equal to marginal cost, at Qt. The tariff raises the domestic price as well as the output of the domestic industry, while demand falls to Dt and thus imports fall. However, the domestic industry still produces the same quantity as if it were perfectly competitive.8 FIG U R E 9A-2

A Monopolist Protected by a Tariff The tariff allows the monopolist to raise its price, but the price is still limited by the threat of imports.

Price, P MC PM

PW + t PW D MR Qf Qt QM

Dt Df

Quantity, Q

Imports under a tariff, t

8

There is one case in which a tariff will have different effects on a monopolistic industry than on a perfectly competitive one. This is the case where a tariff is so high that imports are completely eliminated (a prohibitive tariff). For a competitive industry, once imports have been eliminated, any further increase in the tariff has no effect. A monopolist, however, will be forced to limit its price by the threat of imports even if actual imports are zero. Thus, an increase in a prohibitive tariff will allow a monopolist to raise its price closer to the profit-maximizing price PM.

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FIG U R E 9A-3

A Monopolist Protected by an Import Quota The monopolist is now free to raise prices, knowing that the domestic price of imports will rise too.

Price, P MC Pq

PW D MRq Qq Qq + Q

Dq Quantity, Q

Imports = Q

The Model with an Import Quota Suppose the government imposes a limit on imports, restricting their quantity to a fixed level Q. Then the monopolist knows that when it charges a price above PW, it will not lose all its sales. Instead, it will sell whatever domestic demand is at that price, minus the allowed imports Q. Thus, the demand facing the monopolist will be domestic demand less allowed imports. We define the post-quota demand curve as Dq; it is parallel to the domestic demand curve D but shifted Q units to the left (so long as the quota is binding and the domestic price is above the world price PW; see Figure 9A-3). Corresponding to Dq is a new marginal revenue curve MRq. The firm protected by an import quota maximizes profit by setting marginal cost equal to this new marginal revenue, producing Qq and charging the price Pq. (The license to import one unit of the good will therefore yield a rent of Pq - PW.)

Comparing a Tariff and a Quota We now ask how the effects of a tariff and a quota compare. To do this, we compare a tariff and a quota that lead to the same level of imports (Figure 9A-4). The tariff level t leads to a level of imports Q; we therefore ask what would happen if instead of a tariff, the government simply limited imports to Q. We see from the figure that the results are not the same. The tariff leads to domestic production of Qt and a domestic price of PW + t. The quota leads to a lower level of domestic production, Qq, and a higher price, Pq. When protected by a tariff, the monopolistic domestic industry behaves as if it were perfectly competitive; when protected by a quota, it clearly does not. The reason for this difference is that an import quota creates more monopoly power than a tariff. When monopolistic industries are protected by tariffs, domestic firms know that if they raise their prices too high, they will still be undercut by imports. An import quota, on the other hand, provides absolute protection: No matter how high the domestic price, imports cannot exceed the quota level.



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FIG U R E 9A-4

Comparing a Tariff and a Quota A quota leads to lower domestic output and a higher price than a tariff that yields the same level of imports.

Price, P MC Pq PW + t

PW D MRq Qq

Dq

Qt Qt + Q

Quantity, Q

Imports = Q

This comparison seems to say that if governments are concerned about domestic monopoly power, they should prefer tariffs to quotas as instruments of trade policy. In fact, however, protection has increasingly drifted away from tariffs toward nontariff barriers, including import quotas. To explain this, we need to look at considerations other than economic efficiency that motivate governments.

CHAPTER

1

Multinational Financial Management: Opportunities and Challenges I define globalization as producing where it is most costeffective, selling where it is most profitable, and sourcing capital where it is cheapest, without worrying about national boundaries.  —Narayana Murthy, Founder and Executive Chairman of the Board, Infosys.

Learning Objectives ■

Examine the requirements for the creation of value

■

Consider the basic theory, comparative advantage, and its requirements for the explanation and justification for international trade and commerce

■

Discover what is different about international financial management

■

Detail which market imperfections give rise to the multinational enterprise

■

Consider how the globalization process moves a business from a purely domestic focus in its financial relationships and composition to one truly global in scope

■

Examine possible causes of the limitations to globalization in finance

The subject of this book is the financial management of multinational enterprises (MNEs)— multinational financial management. MNEs are firms—both for-profit companies and notfor-profit organizations—that have operations in more than one country, and conduct their business through branches, foreign subsidiaries, or joint ventures with host country firms. New MNEs are appearing all over the world today, while many of the older and established ones are struggling to survive. Businesses of all kinds are seeing a very different world than in the past. Today’s MNEs depend not only on the emerging markets for cheaper labor, raw materials, and outsourced manufacturing, but also increasingly on those same emerging markets for sales and profits. These markets—whether they are emerging, less developed, or developing, or are BRIC (Brazil, Russia, India, and China), BIITS (Brazil, India, Indonesia, Turkey, South Africa, which are also termed the Fragile Five), or MINTs (Mexico, Indonesia, Nigeria, Turkey)—represent the majority of the earth’s population and, therefore, potential 2

Chapter 1   Multinational Financial Management: Opportunities and Challenges

3

customers. And adding market complexity to this changing global landscape is the risky andchallenging international macroeconomic environment, both from a long-term and short-term perspective. The global financial crisis of 2008–2009 is already well into the business past, and capital is flowing again—although in and out of economies—at an ever-increasing pace. How to identify and navigate these risks is the focus of this book. These risks may all occur on the playing field of the global financial marketplace, but they are still a question of management—of navigating that complexity in pursuit of the goals of the firm.

Financial Globalization and Risk Back in the halcyon pre-crisis days of the late 20th and early 21st centuries, it was taken as self evident that financial globalisation was a good thing. But the subprime crisis and eurozone dramas are shaking that belief. . . . what is the bigger risk now—particularly in the eurozone—is that financial globalisation has created a system that is interconnected in some dangerous ways. —“Crisis Fears Fuel Debate on Capital Controls,” Gillian Tett, Financial Times, December 15, 2011.

The theme dominating global financial markets today is the complexity of risks associated with financial globalization—far beyond whether it is simply good or bad, but how to lead and manage multinational firms in the rapidly moving marketplace. ■

The international monetary system, an eclectic mix of floating and managed fixed exchange rates, is under constant scrutiny. The rise of the Chinese renminbi is changing much of the world’s outlook on currency exchange, reserve currencies, and the roles of the dollar and the euro (see Chapter 2).

■

Large fiscal deficits, including the current eurozone crisis, plague most of the major trading countries of the world, complicating fiscal and monetary policies, and ultimately, interest rates and exchange rates (see Chapter 3).

■

Many countries experience continuing balance of payments imbalances, and in some cases, dangerously large deficits and surpluses—whether it be the twin surpluses enjoyed by China, the current account surplus of Germany amidst a sea of eurozone deficits, or the continuing current account deficit of the United States, all will inevitably move exchange rates (see Chapter 3).

■

Ownership, control, and governance vary radically across the world. The publicly traded company is not the dominant global business organization—the privately held or familyowned business is the prevalent structure—and their goals and measures of performance vary dramatically (see Chapter 4).

■

Global capital markets that normally provide the means to lower a firm’s cost of capital, and even more critically, increase the availability of capital, have in many ways shrunk in size and have become less open and accessible to many of the world’s organizations (see Chapter 1).

■

Today’s emerging markets are confronted with a new dilemma: the problem of first being the recipients of capital inflows, and then of experiencing rapid and massive capital outflows. Financial globalization has resulted in the ebb and flow of capital in and out of both industrial and emerging markets, greatly complicating financial management (Chapter 5 and 8).

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PART 1  Global Financial Environment

These are but a sampling of the complexity of risks. This first chapter is meant only as an introduction and a taste. The Mini-Case at the end of this first chapter, Bitcoin—­ Cryptocurrency or Commodity?, is intended to push you in your thinking about how and why money moves across the globe today.

The Global Financial Marketplace Business—domestic, international, global—involves the interaction of individuals and individual organizations for the exchange of products, services, and capital through markets. The global capital markets are critical for the conduct of this exchange. The global financial crisis of 2008–2009 served as an illustration and a warning of how tightly integrated and fragile this marketplace can be.

Assets, Institutions, and Linkages Exhibit 1.1 provides a map of the global capital markets. One way to characterize the global financial marketplace is through its assets, institutions, and linkages. Assets.  The assets—financial assets—at the heart of the global capital markets are the debt securities issued by governments (e.g., U.S. Treasury Bonds). These low-risk or risk-free assets form the foundation for the creation, trading, and pricing of other financial assets like bank loans, corporate bonds, and equities (stock). In recent years, a number of additional securities have been created from existing securities—derivatives, whose value is based on market value changes of the underlying securities. The health and security of the global financial system relies on the quality of these assets. Exhibit 1.1 Global Capital Markets The global capital market is a collection of institutions (central banks, commercial banks, investment banks, not-forprofit financial institutions like the IMF and World Bank) and securities (bonds, mortgages, derivatives, loans, etc.), which are all linked via a global network—the Interbank Market. This interbank market, in which securities of all kinds are traded, is the critical pipeline system for the movement of capital.

Public Debt

Mortgage Loan Corporate Loan Corporate Bond

Bank

Interbank Market (LIBOR )

Bank

Currency Currency

Currency

Private Debt Private Equity

Bank

Central Banks

Institutions

The exchange of securities—the movement of capital in the global financial system—must all take place through a vehicle—currency. The exchange of currencies is itself the largest of the financial markets. The interbank market, which must pass-through and exchange securities using currencies, bases all of its pricing through the single most widely quoted interest rate in the world—LIBOR (the London Interbank Offered Rate).

Chapter 1   Multinational Financial Management: Opportunities and Challenges

5

Institutions.  The institutions of global finance are the central banks, which create and control each country’s money supply; the commercial banks, which take deposits and extend loans to businesses, both local and global; and the multitude of other financial institutions created to trade securities and derivatives. These institutions take many shapes and are subject to many different regulatory frameworks. The health and security of the global financial system relies on the stability of these financial institutions. Linkages.  The links between the financial institutions, the actual fluid or medium for exchange, are the interbank networks using currency. The ready exchange of currencies in the global marketplace is the first and foremost necessary element for the conduct of financial trading, and the global currency markets are the largest markets in the world. The exchange of currencies, and the subsequent exchange of all other securities globally via currency, is the international interbank network. This network, whose primary price is the London Interbank Offered Rate (LIBOR), is the core component of the global financial system. The movement of capital across currencies and continents for the conduct of business has existed in many different forms for thousands of years. Yet, it is only within the past 50 years that these capital movements have started to move at the pace of an electron in the digital marketplace. And it is only within the past 20 years that this market has been able to reach the most distant corners of the earth at any moment of the day. The result has been an explosion of innovative products and services—some for better, some for worse, and as described in Global Finance in Practice 1.1, not always without challenges.

Global Finance in Practice

1.1

The Trouble with LIBOR “The idea that my word is my Libor is dead.” — Mervyn King, Bank of England Governor.

No single interest rate is more fundamental to the operation of the global financial markets than the London Interbank Offered Rate (LIBOR). LIBOR is used in loan agreements, financial derivatives, swap agreements, in different maturities and different currencies, every day—globally. But beginning as early as 2007, a number of participants in the interbank market on both sides of the Atlantic suspected that there was trouble with LIBOR. LIBOR is published under the auspices of the British Bankers Association (BBA). Each day, a panel of 16 major multinational banks are requested to submit their estimated borrowing rates in the unsecured interbank market which are then collected, massaged, and published in three steps. Step 1. The banks on the LIBOR panels must submit their estimated borrowing rates by 11:10 a.m. London time. The submissions are directly to Thomson Reuters, which executes the process on behalf of the BBA. Step 2. Thomson Reuters discards the lowest 25% and highest 25% of interest rates submitted. It then calculates an average rate by maturity and currency using the remaining 50% of borrowing rate quotes.

Step 3. The BBA publishes the day’s LIBOR rates 20 minutes later, by 11:30 a.m. London time. This process is used to publish LIBOR for 10 different currencies across 15 different maturities. The three-month and six-month maturities are the most significant maturities due to their widespread use in various loan and derivative agreements, with the dollar and the euro being the most widely used currencies.

The Trouble One problem with LIBOR is the origin of the rates submitted by banks. First, rates are not limited to those at which actual borrowing occurred, meaning they are not market transaction rates. The logic behind including “estimated borrowing rates” was to avoid reporting only actual transactions, as many banks may not conduct actual transactions in all maturities and currencies each day. As a result, the origin of the rate submitted by each bank becomes, to some degree, discretionary. Secondly, banks—specifically money-market and derivative traders within the banks—have a number of interests that may be impacted by borrowing costs reported by the bank that day. One such example can be found in the concerns of banks in the interbank market in September 2008, when the credit crisis was in full-bloom. A bank reporting that other banks were demanding it pay a higher rate that day would, in effect, be self-reporting the market’s

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PART 1  Global Financial Environment

assessment that it was increasingly risky. In the words of one analyst, akin “to hanging a sign around one’s neck that I am carrying a contagious disease.” Market analysts are now estimating that many of the banks in the LIBOR panel were reporting borrowing rates which were anywhere from 30 to 40 basis points lower than actual rates throughout the financial crisis. As one financial reform advocate so sharply stated it, “the issue is Lie More, not Libor.” Court documents continue to shed light on the depth of the market’s manipulation, although it is not really known to what degree attempts at manipulation have been successful.

Hi Guys, We got a big position in 3m libor for the next 3 days. Can we please keep the libor fixing at 5.39 for the next few days. It would really help. —Barclays New York trader email, September 13, 2006, as reported in Barclays PLC, Barclays Bank PLC, and Barclays Capital Inc., CFTC Docket No. 12-25, CFTC, p.10.

In December 2013, a collection of banks in London and New York agreed to pay $2.3 billion in fines to the European Commission for LIBOR manipulation. And more lawsuits, accusations, and regulations are sure to come.

The Market for Currencies The price of any one country’s currency in terms of another country’s currency is called a foreign currency exchange rate. For example, the exchange rate between the U.S. dollar ($ or USD) and the European euro (€ or EUR) may be stated as “1.3654 dollar per euro” or simply abbreviated as $1.3654/€. This is the same exchange rate as when stated “EUR1.00 = USD1.3654.” Since most international business activities require at least one of the two parties in a business transaction to either pay or receive payment in a currency that is different from their own, an understanding of exchange rates is critical to the conduct of global business. Currency Symbols.  As noted, USD and EUR are often used as the symbols for the U.S. dollar and the European Union’s euro. These are the computer symbols (ISO-4217 codes) used today on the world’s digital networks. The field of international finance, however, has a rich history of using a variety of different symbols in the financial press, and a variety of different abbreviations are commonly used. For example, the British pound sterling may be £ (the pound symbol), GBP (Great Britain pound), STG (British pound sterling), ST£ (pound sterling), or UKL (United Kingdom pound). This book uses the simpler common symbols—the $ (dollar), the € (euro), the ¥ (yen), the £ (pound)—but be warned and watchful when reading the business press! Exchange Rate Quotations and Terminology.  Exhibit 1.2 lists currency exchange rates for January 13, 2014, as would be quoted in New York or London. The exchange rate listed is for a specific country’s currency—for example, the Argentina peso against the U.S. dollar is Peso 6.6580/$, against the European euro is Peso 9.0905/€, and against the British pound is Peso 10.9078/£. The rate listed is termed a “mid-rate” because it is the middle or average of the rates at which currency traders buy currency (bid rate) and sell currency (offer rate). The U.S. dollar has been the focal point of most currency trading since the 1940s. As a result, most of the world’s currencies have been quoted against the dollar—Mexican pesos per dollar, Brazilian real per dollar, Hong Kong dollars per dollar, etc. This quotation convention is also followed against the world’s major currencies, as listed in Exhibit 1.2. For example, the Japanese yen is commonly quoted as ¥103.365/$, ¥141.129/€, and 169.343/£. Quotation Conventions.  Several of the world’s major currency exchange rates, however, follow a specific quotation convention that is the result of tradition and history. The exchange rate between the U.S. dollar and the euro is always quoted as “dollars per euro” or $/€. For example, $1.3654 listed in Exhibit 1.2 under “United States.” Similarly, the exchange rate between the U.S. dollar and the British pound is always quoted as “dollars per pound” or $/£. For example, $1.6383 listed under “United States” in Exhibit 1.2. In addition, countries that were formerly members of the British Commonwealth will often be quoted against the U.S. dollar, as in U.S. dollars per Australian dollar or U.S. dollars per Canadian dollar.

Exhibit 1.2 January 13, 2014 Country

Selected Global Currency Exchange Rates Currency

Symbol

Code

Currency to Equal 1 U.S. Dollar

Currency to Equal 1 Euro

Currency to Equal 1 Pound 10.9078

Argentina

peso

Ps

ARS

6.6580

9.0905

Australia

dollar

A$

AUD

1.1043

1.5078

1.8092

Bahrain

dinar

—

BHD

0.3770

0.5148

0.6177

Bolivia

boliviano

Bs

BOB

6.9100

9.4346

11.3207

Brazil

real

R$

BRL

2.3446

3.2012

3.8411

Canada

dollar

C$

CAD

1.0866

1.4836

1.7801 863.351

Chile

peso

$

CLP

526.980

719.512

China

yuan

¥

CNY

6.0434

8.2514

9.9009

Colombia

peso

Col$

COP

1,924.70

2,627.89

3,153.24

colon

499.475

681.959

818.291

koruna

// C Kc

CRC

Czech Republic

Costa Rica

CZK

20.0425

27.3650

32.8356

Denmark

krone

Dkr

DKK

5.4656

7.4624

8.9542

Egypt

pound

£

EGP

6.9562

9.4977

11.3964 12.7045

Hong Kong

dollar

HK$

HKD

7.7547

10.5878

Hungary

forint

Ft

HUF

218.680

298.575

358.264

India

rupee

INR

61.5750

84.0715

100.8780

Indonesia

rupiah

Rp

IDR

12,050.0

16,452.5

19,741.5

rial

—

IRR

12,395.5

16,924.2

20,307.5

Israel

shekel

Shk

ILS

3.4882

4.7627

5.7148

Japan

yen

¥

JPY

103.365

141.129

169.343 141.303

Iran

Kenya

shilling

KSh

KES

86.250

117.761

Kuwait

dinar

—

KWD

0.2824

0.3856

0.4627

Malaysia

ringgit

RM

MYR

3.2635

4.4559

5.3466 21.2561

Mexico

new peso

$

MXN

12.9745

17.7148

New Zealand

dollar

NZD

1.1957

1.6326

1.9590

Nigeria

naira

NZ$ = N

NGN

159.750

218.115

261.718

Norway

krone

NKr

NOK

6.1216

8.3581

10.0290

Pakistan

rupee

Rs.

PKR

105.535

144.092

172.898

new sol

S/. = P

PEN

2.7965

3.8182

4.5816

peso

PHP

44.5950

60.8878

73.0600

zloty

—

PLN

3.0421

4.1535

4.9839

new leu

L

RON

3.3133

4.5238

5.4281 54.4997

Peru Phillippines Poland Romania Russia

ruble

RUB

33.2660

45.4198

Saudi Arabia

riyal

SR

SAR

3.7505

5.1207

6.1444

Singapore

dollar

S$

SGD

1.2650

1.7272

2.0725

South Africa

rand

R

ZAR

10.7750

14.7117

17.6527

South Korea

won

W

KRW

1,056.65

1,442.70

1,731.11

Sweden

krona

SKr

SEK

6.4986

8.8728

10.6466

Switzerland

franc

Fr.

CHF

0.9026

1.2324

1.4788

Taiwan

dollar

T$

TWD

30.0060

40.9687

49.1588

Thailand

baht

B

THB

32.9750

45.0224

54.0230

Tunisia

dinar

DT

TND

1.6548

2.2593

2.7110

Turkey

lira

TRY

2.1773

2.9728

3.5671

Ukraine

hrywnja

—

UAH

8.3125

11.3495

13.6184

United Arab Emirates

dirham

—

AED

3.6730

5.0149

6.0175

United Kingdom

pound

£

GBP

0.6104

0.8334

—

United States

dollar

$

USD

—

1.3654

1.6383

peso

$U

UYU

21.6050

29.4984

35.3955

bolivar fuerte

Bs d – €

VEB

6.2921

8.5910

10.3084

VND

21,090.0

28,795.2

34,551.8

EUR

0.7324

—

1.1999

—

SDR

0.6509

0.8887

1.0663

Uruguay Venezuela Vietnam

dong

Euro

euro

Special Drawing Right

—

Notes: A number of different currencies use the same symbol (for example both China and Japan have traditionally used the ¥ symbol, yen or yuan, meaning round or circle). That is one of the reasons why most of the world’s currency markets today use the three-digit currency code for clarity of quotation. All quotes are mid-rates, and are drawn from the Financial Times, January 14, 2014. The British pound and euro are quoted here in the identical terms — per dollar, per euro, per pound — as are all other country currencies. However, the Financial Times, which is the original source for these currency quotations, will quote the pound and euro in the reciprocal form as is industry practice for these currencies.

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8

PART 1  Global Financial Environment

Eurocurrencies and LIBOR One of the major linkages of global money and capital markets is the eurocurrency market and its interest rate, which is LIBOR. Eurocurrencies are domestic currencies of one country on deposit in a second country for a period ranging from overnight to more than a year or longer. Certificates of deposit are usually for three months or more and in million-dollar increments. A eurodollar deposit is not a demand deposit—it is not created on the bank’s books by writing loans against required fractional reserves, and it cannot be transferred by a check drawn on the bank having the deposit. Eurodollar deposits are transferred by wire or cable transfer of an underlying balance held in a correspondent bank located within the United States. In most countries, a domestic analogy would be the transfer of deposits held in nonbank savings associations. These are transferred when the association writes its own check on a commercial bank. Any convertible currency can exist in “euro-” form. Note that this use of “euro-” should not be confused with the new common European currency called the euro. The eurocurrency market includes eurosterling (British pounds deposited outside the United Kingdom); euroeuros (euros on deposit outside the eurozone); euroyen (Japanese yen deposited outside Japan) and eurodollars (U.S. dollars deposited outside the U.S.). Eurocurrency markets serve two valuable purposes: 1) eurocurrency deposits are an efficient and convenient money market device for holding excess corporate liquidity; and 2) the eurocurrency market is a major source of short-term bank loans to finance corporate working capital needs, including the financing of imports and exports. Banks in which eurocurrencies are deposited are called eurobanks. A eurobank is a financial intermediary that simultaneously bids for time deposits and makes loans in a currency other than that of its home currency. Eurobanks are major world banks that conduct a eurocurrency business in addition to all other banking functions. Thus, the eurocurrency operation that qualifies a bank for the name eurobank is, in fact, a department of a large commercial bank, and the name springs from the performance of this function. The modern eurocurrency market was born shortly after World War II. Eastern European holders of dollars, including the various state trading banks of the Soviet Union, were afraid to deposit their dollar holdings in the United States because those deposits might be attached by U.S. residents with claims against communist governments. Therefore, Eastern European holders deposited their dollars in Western Europe, particularly with two Soviet banks: the Moscow Narodny Bank in London, and the Banque Commerciale pour l’Europe du Nord in Paris. These banks redeposited the funds in other Western banks, especially in London. Additional dollar deposits were received from various central banks in Western Europe, which elected to hold part of their dollar reserves in this form to obtain a higher yield. Commercial banks also placed their dollar balances in the market because specific maturities could be negotiated in the eurodollar market. Such companies found it financially advantageous to keep their dollar reserves in the higher-yielding eurodollar market. Various holders of international refugee funds also supplied funds. Although the basic causes of the growth of the eurocurrency market are economic efficiencies, many unique institutional events during the 1950s and 1960s contributed to its growth. ■

■

In 1957, British monetary authorities responded to a weakening of the pound by imposing tight controls on U.K. bank lending in sterling to nonresidents of the United Kingdom. Encouraged by the Bank of England, U.K. banks turned to dollar lending as the only alternative that would allow them to maintain their leading position in world finance. For this they needed dollar deposits. Although New York was “home base” for the dollar and had a large domestic money and capital market, international trading in the dollar centered in London because of that city’s

Chapter 1   Multinational Financial Management: Opportunities and Challenges

■

9

expertise in international monetary matters and its proximity in time and distance to major customers. Additional support for a European-based dollar market came from the balance of payments difficulties of the U.S. during the 1960s, which temporarily segmented the U.S. domestic capital market.

Ultimately, however, the eurocurrency market continues to thrive because it is a large international money market relatively free from governmental regulation and interference. Eurocurrency Interest Rates.  The reference rate of interest in the eurocurrency market is the London Interbank Offered Rate, or LIBOR. LIBOR is the most widely accepted rate of interest used in standardized quotations, loan agreements or financial derivatives valuations. The use of interbank offered rates, however, is not confined to London. Most major domestic financial centers construct their own interbank offered rates for local loan agreements. Examples of such rates include PIBOR (Paris Interbank Offered Rate), MIBOR (Madrid Interbank Offered Rate), SIBOR (Singapore Interbank Offered Rate), and FIBOR (Frankfurt Interbank Offered Rate), to name but a few. The key factor attracting both depositors and borrowers to the eurocurrency loan market is the narrow interest rate spread within that market. The difference between deposit and loan rates is often less than 1%. Interest spreads in the eurocurrency market are small for many reasons. Low lending rates exist because the eurocurrency market is a wholesale market, where deposits and loans are made in amounts of $500,000 or more on an unsecured basis. Borrowers are usually large corporations or government entities that qualify for low rates because of their credit standing and because the transaction size is large. In addition, overhead assigned to the eurocurrency operation by participating banks is small. Deposit rates are higher in the eurocurrency markets than in most domestic currency markets because the financial institutions offering eurocurrency activities are not subject to many of the regulations and reserve requirements imposed on traditional domestic banks and banking activities. With these costs removed, rates are subject to more competitive pressures, deposit rates are higher, and loan rates are lower. A second major area of cost avoided in the eurocurrency markets is the payment of deposit insurance fees (such as the Federal Deposit Insurance Corporation, FDIC) and assessments paid on deposits in the United States.

The Theory of Comparative Advantage The theory of comparative advantage provides a basis for explaining and justifying international trade in a model world assumed to enjoy free trade, perfect competition, no uncertainty, costless information, and no government interference. The theory’s origins lie in the work of Adam Smith, and particularly with his seminal book, The Wealth of Nations, published in 1776. Smith sought to explain why the division of labor in productive activities, and subsequently international trade of those goods, increased the quality of life for all citizens. Smith based his work on the concept of absolute advantage, with every country specializing in the production of those goods for which it was uniquely suited. More would be produced for less. Thus, with each country specializing in products for which it possessed absolute advantage, countries could produce more in total and trade for goods that were cheaper in price than those produced at home. In his work, On the Principles of Political Economy and Taxation, published in 1817, David Ricardo sought to take the basic ideas set down by Adam Smith a few logical steps further. Ricardo noted that even if a country possessed absolute advantage in the production of two goods, it might still be relatively more efficient than the other country in one good’s

10

PART 1  Global Financial Environment

production than the production of the other good. Ricardo termed this comparative advantage. Each country would then possess comparative advantage in the production of one of the two products, and both countries would then benefit by specializing completely in one product and trading for the other. Although international trade might have approached the comparative advantage model during the nineteenth century, it certainly does not today, for a variety of reasons. Countries do not appear to specialize only in those products that could be most efficiently produced by that country’s particular factors of production. Instead, governments interfere with comparative advantage for a variety of economic and political reasons, such as to achieve full employment, economic development, national self-sufficiency in defense-related industries, and protection of an agricultural sector’s way of life. Government interference takes the form of tariffs, quotas, and other non-tariff restrictions. At least two of the factors of production—capital and technology—now flow directly and easily between countries, rather than only indirectly through traded goods and services. This direct flow occurs between related subsidiaries and affiliates of multinational firms, as well as between unrelated firms via loans and license and management contracts. Even labor flows between countries, such as immigrants into the United States (legal and illegal), immigrants within the European Union, and other unions. Modern factors of production are more numerous than in this simple model. Factors considered in the location of production facilities worldwide include local and managerial skills, a dependable legal structure for settling contract disputes, research and development competence, educational levels of available workers, energy resources, consumer demand for brand name goods, mineral and raw material availability, access to capital, tax differentials, supporting infrastructure (roads, ports, and communication facilities), and possibly others. Although the terms of trade are ultimately determined by supply and demand, the process by which the terms are set is different from that visualized in traditional trade theory. They are determined partly by administered pricing in oligopolistic markets. Comparative advantage shifts over time as less-developed countries become more developed and realize their latent opportunities. For example, over the past 150 years comparative advantage in producing cotton textiles has shifted from the United Kingdom to the United States, to Japan, to Hong Kong, to Taiwan, and to China. The classical model of comparative advantage also did not really address certain other issues such as the effect of uncertainty and information costs, the role of differentiated products in imperfectly competitive markets, and economies of scale. Nevertheless, although the world is a long way from the classical trade model, the general principle of comparative advantage is still valid. The closer the world gets to true international specialization, the more world production and consumption can be increased, provided that the problem of equitable distribution of the benefits can be solved to the satisfaction of consumers, producers, and political leaders. Complete specialization, however, remains an unrealistic limiting case, just as perfect competition is a limiting case in microeconomic theory.

Global Outsourcing of Comparative Advantage Comparative advantage is still a relevant theory to explain why particular countries are most suitable for exports of goods and services that support the global supply chain of both MNEs and domestic firms. The comparative advantage of the twenty-first century, however, is one that is based more on services, and their cross-border facilitation by telecommunications and the Internet. The source of a nation’s comparative advantage, however, still is created from the mixture of its own labor skills, access to capital, and technology.

Chapter 1   Multinational Financial Management: Opportunities and Challenges

11

For example, India has developed a highly efficient and low-cost software industry. This industry supplies not only the creation of custom software, but also call centers for customer support, and other information technology services. The Indian software industry is composed of subsidiaries of MNEs and independent companies. If you own a Hewlett-Packard computer and call the customer support center number for help, you are likely to reach a call center in India. Answering your call will be a knowledgeable Indian software engineer or programmer who will “walk you through” your problem. India has a large number of well-educated, English-speaking technical experts who are paid only a fraction of the salary and overhead earned by their U.S. counterparts. The overcapacity and low cost of international telecommunication networks today further enhances the comparative advantage of an Indian location. The extent of global outsourcing is already reaching out to every corner of the globe. From financial back-offices in Manila, to information technology engineers in Hungary, modern telecommunications now take business activities to labor rather than moving labor to the places of business.

What Is Different about International Financial Management? Exhibit 1.3 details some of the main differences between international and domestic financial management. These component differences include institutions, foreign exchange and political risks, and the modifications required of financial theory and financial instruments. Multinational financial management requires an understanding of cultural, historical, and institutional differences such as those affecting corporate governance. Although both domestic firms and MNEs are exposed to foreign exchange risks, MNEs alone face certain unique risks, such as political risks, that are not normally a threat to domestic operations. MNEs also face other risks that can be classified as extensions of domestic finance theory. For example, the normal domestic approach to the cost of capital, sourcing debt and equity,

Exhibit 1.3

What Is Different about International Financial Management?

Concept

International

Domestic

Culture, history, and institutions

Each foreign country is unique and not always understood by MNE management

Each country has a known base case

Corporate governance

Foreign countries’ regulations and institutional practices are all uniquely different

Regulations and institutions are well known

Foreign exchange risk

MNEs face foreign exchange risks due to their subsidiaries, as well as import/ export and foreign competitors

Foreign exchange risks from import/ export and foreign competition (no subsidiaries)

Political risk

MNEs face political risk because of their foreign subsidiaries and high profile

Negligible political risks

Modification of domestic finance theories

MNEs must modify finance theories like capital budgeting and the cost of capital because of foreign complexities

Traditional financial theory applies

Modification of domestic financial instruments

MNEs utilize modified financial instruments such as options, forwards, swaps, and letters of credit

Limited use of financial instruments and derivatives because of few foreign exchange and political risks

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PART 1  Global Financial Environment

Global Finance in Practice

1.2

Corporate Responsibility and Corporate Sustainability Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs. —Brundtland Report, 1987, p. 54.

What is the purpose of the corporation? It is accepted that the purpose of the corporation is to certainly create profits and value for its stakeholders, but the responsibility of the corporation is to do so in a way that inflicts no costs on society, including the environment. As a result of globalization, this growing responsibility and role of the corporation in society has added a level of complexity to the leadership challenges faced by the multinational firm.

This developing controversy has been somewhat hampered to date by conflicting terms and labels—corporate goodness, corporate responsibility, corporate social responsibility (CSR), corporate philanthropy, and corporate sustainability, to list but a few. Confusion can be reduced by using a guiding principle—that sustainability is a goal, while responsibility is an obligation. It follows that the obligation of leadership in the modern multinational is to pursue profit, social development, and the environment, all along sustainable principles. The term sustainability has evolved greatly within the context of global business in the past decade. A traditional primary objective of the family-owned business has been the “sustainability of the organization”—the long-term ability of the company to remain commercially viable and provide security and income for future generations. Although narrower in scope, the concept of environmental sustainability shares a common core thread—the ability of a company, a culture, or even the earth, to survive and renew over time.

capital budgeting, working capital management, taxation, and credit analysis needs to be modified to accommodate foreign complexities. Moreover, a number of financial instruments that are used in domestic financial management have been modified for use in international financial management. Examples are foreign currency options and futures, interest rate and currency swaps, and letters of credit. The main theme of this book is to analyze how an MNE’s financial management evolves as it pursues global strategic opportunities and new constraints emerge. In this chapter, we will take a brief look at the challenges and risks associated with Trident Corporation (Trident), a company evolving from domestic in scope to becoming truly multinational. The discussion will include constraints that a company will face in terms of managerial goals and governance as it becomes increasingly involved in multinational operations. But first we need to clarify the unique value proposition and advantages that the MNE was created to exploit. And as noted by Global Finance in Practice 1.2, the objectives and responsibilities of the modern multinational have grown significantly more complex in the twenty-first century.

Market Imperfections: A Rationale for the Existence of the Multinational Firm MNEs strive to take advantage of imperfections in national markets for products, factors of production, and financial assets. Imperfections in the market for products translate into market opportunities for MNEs. Large international firms are better able to exploit such competitive factors as economies of scale, managerial and technological expertise, product differentiation, and financial strength than are their local competitors. In fact, MNEs thrive best in markets characterized by international oligopolistic competition, where these factors are particularly critical. In addition, once MNEs have established a physical presence abroad, they are in a better position than purely domestic firms to identify and implement market opportunities through their own internal information network.

Chapter 1   Multinational Financial Management: Opportunities and Challenges

13

Why Do Firms Become Multinational? Strategic motives drive the decision to invest abroad and become an MNE. These motives can be summarized under the following categories: 1. Market seekers produce in foreign markets either to satisfy local demand or to export to markets other than their home market. U.S. automobile firms manufacturing in Europe for local consumption are an example of market-seeking motivation. 2. Raw material seekers extract raw materials wherever they can be found, either for export or for further processing and sale in the country in which they are found—the host country. Firms in the oil, mining, plantation, and forest industries fall into this category. 3. Production efficiency seekers produce in countries where one or more of the factors of production are underpriced relative to their productivity. Labor-intensive production of electronic components in Taiwan, Malaysia, and Mexico is an example of this motivation. 4. Knowledge seekers operate in foreign countries to gain access to technology or managerial expertise. For example, German, Dutch, and Japanese firms have purchased U.S.-located electronics firms for their technology. 5. Political safety seekers acquire or establish new operations in countries that are considered unlikely to expropriate or interfere with private enterprise. For example, Hong Kong firms invested heavily in the United States, United Kingdom, Canada, and Australia in anticipation of the consequences of China’s 1997 takeover of the British colony. These five types of strategic considerations are not mutually exclusive. Forest products firms seeking wood fiber in Brazil, for example, may also find a large Brazilian market for a portion of their output. In industries characterized by worldwide oligopolistic competition, each of the above strategic motives should be subdivided into proactive and defensive investments. Proactive investments are designed to enhance the growth and profitability of the firm itself. Defensive investments are designed to deny growth and profitability to the firm’s competitors. Examples of the latter are investments that try to preempt a market before competitors can get established in it, or capture raw material sources and deny them to competitors.

The Globalization Process Trident is a hypothetical U.S.-based firm that will be used as an illustrative example throughout the book to demonstrate the globalization process—the structural and managerial changes and challenges experienced by a firm as it moves its operations from domestic to global.

Global Transition I: Trident Moves from the Domestic Phase to the International Trade Phase Trident is a young firm that manufactures and distributes an array of telecommunication devices. Its initial strategy is to develop a sustainable competitive advantage in the U.S. market. Like many other young firms, it is constrained by its small size, competitors, and lack of access to cheap and plentiful sources of capital. The top half of Exhibit 1.4 shows Trident in its early domestic phase. Trident sells its products in U.S. dollars to U.S. customers and buys its manufacturing and service inputs from U.S. suppliers, paying U.S. dollars. The creditworth of all suppliers and buyers is established under domestic U.S. practices and procedures. A potential

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PART 1  Global Financial Environment

Exhibit 1.4

Trident Corp: Initiation of the Globalization Process Phase One: Domestic Operations U.S. Suppliers (domestic)

U.S. Buyers (domestic)

All payments in U.S. dollars. All credit risk under U.S. law. Trident Corporation (Los Angeles, USA)

Mexican Suppliers

Canadian Buyers

Are Mexican suppliers dependable? Will Trident pay US$ or Mexican pesos?

Are Canadian buyers creditworthy? Will payment be made in US$ or C$?

Phase Two: Expansion into International Trade

issue for Trident at this time is that although Trident is not international or global in its operations, some of its competitors, suppliers, or buyers may be. This is often the impetus to push a firm like Trident into the first phase of the globalization process—into international trade. Trident was founded by James Winston in Los Angeles in 1948 to make telecommunications equipment. The family-owned business expanded slowly but steadily over the following 40 years. The demands of continual technological investment in the 1980s, however, required that the firm raise additional equity capital in order to compete. This need led to its initial public offering (IPO) in 1988. As a U.S.-based publicly traded company on the New York Stock Exchange, Trident’s management sought to create value for its shareholders. As Trident became a visible and viable competitor in the U.S. market, strategic opportunities arose to expand the firm’s market reach by exporting product and services to one or more foreign markets. The North American Free Trade Area (NAFTA) made trade with Mexico and Canada attractive. This second phase of the globalization process is shown in the lower half of Exhibit 1.4. Trident responded to these globalization forces by importing inputs from Mexican suppliers and making export sales to Canadian buyers. We define this phase of the globalization process as the International Trade Phase. Exporting and importing products and services increases the demands of financial management over and above the traditional requirements of the domestic-only business in two ways. First, direct foreign exchange risks are now borne by the firm. Trident may now need to quote prices in foreign currencies, accept payment in foreign currencies, or pay suppliers in foreign currencies. As the values of currencies change from minute to minute in the global marketplace, Trident will increasingly experience significant risks from the changing values associated with these foreign currency payments and receipts. Second, the evaluation of the credit quality of foreign buyers and sellers is now more important than ever. Reducing the possibility of non-payment for exports and non-delivery of imports becomes a key financial management task during the international trade phase. This credit risk management task is much more difficult in international business, as buyers and suppliers are new, subject to differing business practices and legal systems, and generally more challenging to assess.

Chapter 1   Multinational Financial Management: Opportunities and Challenges

15

Global Transition II: The International Trade Phase to the Multinational Phase If Trident is successful in its international trade activities, the time will come when the globalization process will progress to the next phase. Trident will soon need to establish foreign sales and service affiliates. This step is often followed by establishing manufacturing operations abroad or by licensing foreign firms to produce and service Trident’s products. The multitude of issues and activities associated with this second larger global transition is the real focus of this book. Trident’s continued globalization will require it to identify the sources of its competitive advantage, and with that knowledge, expand its intellectual capital and physical presence globally. A variety of strategic alternatives are available to Trident—the foreign direct investment sequence—as shown in Exhibit 1.5. These alternatives include the creation of foreign sales offices, the licensing of the company name and everything associated with it, and the manufacturing and distribution of its products to other firms in foreign markets. As Trident moves farther down and to the right in Exhibit 1.5, the degree of its physical presence in foreign markets increases. It may now own its own distribution and production facilities, and ultimately, may want to acquire other companies. Once Trident owns assets and enterprises in foreign countries it has entered the multinational phase of its globalization.

The Limits to Financial Globalization The theories of international business and international finance introduced in this chapter have long argued that with an increasingly open and transparent global marketplace in which capital may flow freely, capital will increasingly flow and support countries and companies

Exhibit 1.5

Trident’s Foreign Direct Investment Sequence Trident and Its Competitive Advantage

Change Competitive Advantage

Greater Foreign Presence

Exploit Existing Competitive Advantage Abroad

Production at Home: Exporting

Production Abroad

Licensing Management Contract

Control Assets Abroad

Wholly Owned Subsidiary

Joint Venture Greater Foreign Investment

Greenfield Investment

Acquisition of of aa Acquisition Foreign Enterprise Enterprise Foreign

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PART 1  Global Financial Environment

based on the theory of comparative advantage. Since the mid-twentieth century, this has indeed been the case as more and more countries have pursued more open and competitive markets. But the past decade has seen the growth of a new kind of limit or impediment to financial globalization: the growth in the influence and self-enrichment of organizational insiders. One possible representation of this process can be seen in Exhibit 1.6. If influential insiders in corporations and sovereign states continue to pursue the increase in firm value, there will be a definite and continuing growth in financial globalization. But, if these same influential insiders pursue their own personal agendas, which may increase their personal power and influence or personal wealth, or both, then capital will not flow into these sovereign states and corporations. The result is the growth of financial inefficiency and the segmentation of globalization outcomes—creating winners and losers. As we will see throughout this book, this barrier to international finance may indeed be increasingly troublesome. This growing dilemma is also something of a composite of what this book is about. The three fundamental elements—financial theory, global business, and management beliefs and actions—combine to present either the problem or the solution to the growing debate over the benefits of globalization to countries and cultures worldwide. The Mini-Case sets the stage for our debate and discussion. Are the controlling family members of this company creating value for themselves or for their shareholders? We close this chapter—and open this book—with the simple words of one of our colleagues in a recent conference on the outlook for global finance and global financial management. Welcome to the future. This will be a constant struggle. We need leadership, citizenship, and dialogue. —Donald Lessard, in Global Risk, New Perspectives and Opportunities, 2011, p. 33.

Exhibit 1.6

The Limits of Financial Globalization

There is a growing debate over whether many of the insiders and rulers of organizations with enterprises globally are taking actions consistent with creating firm value or consistent with increasing their own personal stakes and power. Actions of Rulers of Sovereign States

Higher Firm Value (possibly lower insider value) The Twin Agency Problems Limiting Financial Globalization

Lower Firm Value (possibly higher insider value)

Actions of Corporate Insiders

If these influential insiders are building personal wealth over that of the firm, it will indeed result in preventing the flow of capital across borders, currencies, and institutions to create a more open and integrated global financial community. Source: Constructed by authors based on “The Limits of Financial Globalization,” Rene M. Stulz, Journal of Applied Corporate Finance, Vol. 19, No. 1, Winter 2007, pp. 8–15.

Chapter 1   Multinational Financial Management: Opportunities and Challenges

17

Summary Points ■

The creation of value requires combining three critical elements: 1) an open marketplace; 2) high-quality strategic management; and 3) access to capital.

■

The theory of comparative advantage provides a basis for explaining and justifying international trade in a model world assumed to enjoy free trade, perfect competition, no uncertainty, costless information, and no government interference.

■

■

■

International financial management requires an understanding of cultural, historical, and institutional differences, such as those affecting corporate governance. Although both domestic firms and MNEs are exposed to foreign exchange risks, MNEs alone face certain unique risks, such as political risks, that are not normally a threat to domestic operations. MNEs strive to take advantage of imperfections in national markets for products, factors of production, and financial assets.

Mini-Case

Bitcoin—Cryptocurrency or Commodity?1 The difference is that established fiat currencies—ones where the bills and coins, or their digital versions, get their value by dint of regulation or law—are underwritten by the state which is, in principle at least, answerable to its citizens. Bitcoin, on the other hand, is a community currency. It requires self-policing on the part of its users. To some, this is a feature, not a bug. But, in the grand scheme of things, the necessary open-source engagement remains a niche pursuit. Most people would rather devolve this sort of responsibility to the authorities. Until this mindset changes, Bitcoin will be no rival to real-world dosh. —“Bits and bob,” The Economist, June 13, 2011. Bitcoin is an open-source, peer-to-peer, digital currency. It is a cryptocurrency, a digital currency that is created and managed using advanced encryption techniques known as cryptography. And it may be the world’s first completely decentralized digital-payments system. The unofficial three letter currency code for Bitcoin is BTC, and its singular currency symbol is shown above.

■

Large international firms are better able to exploit such competitive factors as economies of scale, managerial and technological expertise, product differentiation, and financial strength than are their local competitors.

■

A firm may first enter into international trade transactions, then international contractual arrangements, such as sales offices and franchising, and ultimately the acquisition of foreign subsidiaries. At this final stage it truly becomes a multinational enterprise (MNE).

■

The decision whether or not to invest abroad is driven by strategic motives and may require the MNE to enter into global licensing agreements, joint ventures, crossborder acquisitions, or greenfield investments.

■

If influential insiders in corporations and sovereign states pursue their own personal agendas, which may increase their personal power, influence, or wealth, then capital will not flow into these sovereign states and corporations. This will, in turn, create limitations to globalization in finance.

But is Bitcoin a true currency? Is it, or can it become, money? In January 2014 a number of major regulatory bodies across the world—the U.S. Federal Reserve, the European Central Bank, the People’s Bank of China—were all trying to decide whether Bitcoin was something to be prohibited, regulated, or simply left alone. Perspectives on Bitcoin use varied dramatically, and in many cases, unexpectedly so. But the regulators were only one stakeholder interest; users and producers had their own perspectives on the potential of Bitcoin. Producing and Using Bitcoins Bitcoin was invented in 2009 by a man claiming to be Satoshi Nakamoto. Nakamoto published, via the Internet, a nine-page paper outlining how the Bitcoin system would work. He also provided the open-source code needed to both produce the digital coins (mine in Bitcoin terminology) and trade Bitcoins digitally as money. (Nakamoto is not thought to be a real person, likely being a nome de plume for some relatively small working group. Nakamoto disappeared from the Internet in 2012.) Mining. The actual mining of Bitcoins is a mathematical process. The miner must find a sequence of data (called a block) that produces a particular pattern when the Bitcoin

Copyright © 2014 Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Michael H. Moffett for the purpose of classroom discussion only and not to indicate either effective or ineffective management. 1

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PART 1  Global Financial Environment

hash algorithm is applied to it. When a match is found, the miner obtains a bounty—an allocation—of Bitcoins. This repetitive guessing, conducted by increasingly complex computers, is called hashing. The motivation for mining is clear: to make and earn money. The Bitcoin software system is designed to release a 25-coin reward to the miner in the worldwide network (anyone, anywhere, can theoretically be a part of the network) who succeeds in solving the mathematical problem. Once solved, the solution is broadcast network-wide, and competition for the next 25-coin reward begins. The system’s protocol is designed to release a new block of Bitcoins every 10 minutes until all 21 million are released, with the blocks getting smaller as time goes on. If the miners in the network take more than 10 minutes to find the correct code, the Bitcoin program adapts to make the mathematics easier. If the miners solve the problems in less than 10 minutes, the mathematical code becomes harder. The difficulty of the search continually increases over time with mining. This creates an ever-increasing scarcity over time, similar to what many believe about gold when gold was the basis of currency values. But ultimately the Bitcoin system is limited in both time (every 10 minutes) and total issuance (21 million). Theoretically the last of the 21 million Bitcoins would be mined in 2140. Within a few short years Bitcoin mining has become a big business of its own. Whereas in the early stages an individual could have theoretically mined Bitcoins on a laptop, or theoretically without a computer at all, that is no longer the case. By 2014, Bitcoin mining had become the object of multimillion dollar investments in computer systems by business startups from Iceland to Austin in what one journalist described as a “computational arms race.” Eleven ­million of the total potential 21 million coins had been mined. Users. Once mined, Bitcoins are considered a pseudonymous—nearly anonymous—cryptocurrency.2 Bitcoins are initially issued to the successful miners, who are then able to buy things with them or sell them to non-miners who wish to use digital currency for purchases or speculate on its future value. Ownership of each and every coin is verified and registered through a digital chain timestamp across the thousands of network nodes. Like cash, this prevents double spending, since every Bitcoin exchange is authenticated across the decentralized Bitcoin network (currently estimated at 20,000 nodes). Unlike cash, every transaction that has ever occurred in the Bitcoin system is recorded in terms of the two public keys (the transactors, the Bitcoin addresses) in the system. This record, called the block chain, includes the

time, amount, and the two near-anonymous IP addresses (public keys are not tied to any person’s identity). And unlike credit cards or PayPal, there is no third-party facilitator. It is true peer-to-peer. The Bitcoin Foundation, a nonprofit organization, runs the global system. The current Bitcoin Foundation chief scientist is Gavin Andresen, who is paid a salary. The Foundation is funded mainly through grants made by for-profit companies (like the Linux Foundation) who either mine or use the Bitcoin system. Value Drivers and Concerns Traditional currencies are issued by governments through central banks. They regulate the growth of the currency, its supply, and they also implicitly guarantee its value in some way. Bitcoin has no such guarantor, no insurer, no lenderof-last-resort. If a Bitcoin user were to lose or erase their records of ownership, there would be no support or insurer—no one to sue, no institution to apply to for recourse.3 The value of a Bitcoin is completely dependent on what users and investors are willing to pay for it at any point in time. This makes it similar in nature to both a currency and a commodity. Bitcoin is a rather complex composite of currency systems. A gold standard like that used in the first part of the twentieth century, is a system based on specie; it has some fixed link to a scarce metal of some intrinsic value. Bitcoin does have digital scarcity, and ultimately a fixed limit on its availability. But Bitcoins have no intrinsic value; they are not composed of a precious metal; they are nothing more than digital code. Their value reflects the supply and demand by those in the marketplace who believe in its value—a fiat currency—similar to the world’s major currencies today. As illustrated in Exhibit A, that value has been very volatile. After spending several years trading at less than $10 per Bitcoin (using U.S. dollar values, like an exchange rate), its price skyrocketed to $1238 per coin in December 2013—and then plummeted. The reasons behind Bitcoin’s price volatility in 2013 provide some insight into its potential uses. A bank crisis in November 2013 in Cyprus resulted in many Cypriot citizens putting their money into Bitcoins (bidding the price up) in an effort to keep their money out of the hands of government. Similarly, in late 2013 Bitcoins surged in interest and use in China. Chinese residents, in search of a way to invest their money outside of China despite Chinese capital controls (restrictions on taking money out of the country), purchased Bitcoins through a number of different Bitcoin exchanges in China, using Chinese renminbi, and then used the Bitcoins to invest abroad. Chinese authorities moved

Bitcoin is not the only cryptocurrency or altcoin. Competitors include Litecoin, Ripple, MintChip, Anoncoin, Peercoin, and Zerocoin. Physical bitcoins, called Casascius coins, can be purchased from casascius.com. These coins contain a private key on a card embedded in the coin and sealed with a tamper-evident hologram.

2

3

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Chapter 1   Multinational Financial Management: Opportunities and Challenges

Exhibit A

Bitcoin Price in U.S. Dollars

Daily close: January 1, 2013 – January 19, 2014 $1,400 $1,200 $1,000

Average price 2010: $0.14 2011: $5.44 2012: $8.29 2013: $200.16

Price peak of $1,237.96 on December 4, 2013

$800 $600 $400 $200

quickly to shut down the Bitcoin exchanges by prohibiting them from accepting deposits in Chinese renminbi, the local currency. This ability of Bitcoin to bypass authorities has led to concerns about the potential use of Bitcoin for illicit trade, the laundering of money associated with illegal drugs and other illegal business activity globally. Global government response to this concern has been varied. The German government has officially labeled Bitcoin a unit of account. India has raided a number of exchanges thought to be conducting illicit trade using Bitcoin. The United Kingdom has left it alone, as has the EU, to date. South Korea announced that it does not recognize Bitcoin as legal tender. Bitcoins are not illegal in the U.S., as the U.S. Constitution actually only prevents the states from coining money, but not private parties. The United States Federal Reserve Chairman, Ben Bernanke, when speaking to Congress in November 2013, noted that online currencies “may hold long-term promise, particularly if the innovations promote a faster, more secure, and more efficient payment system.” Examples of expanding acceptance continue to grow: The Pembury Tavern in London; the EVR bar in New York; Cups and Cakes Bakery in San Francisco all accept Bitcoin for purchases. The Sacramento Kings of the National Basketball Association in the U.S. have told their customers that they will start accepting Bitcoin for purchases of tickets and merchandise. Yet, these are still anecdotal examples and

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in no way constitute acceptance and use as common. Meanwhile many of the world’s established financial institutions, banks, have stayed away from digital currency involvement as legal issues over their use worldwide continue to evolve. Wells Fargo, a major U.S. bank, has asked for a ‘summit’ with Bitcoin activists to learn more. Bitcoin’s promise has had its highs and lows. One low was seen when Bitcoin became the primary currency for sales on Silk Road, an underground Web site for illegal drug trafficking. Although eventually shut down by the U.S. government, Bitcoin’s potential use for illegal activities has impacted the public’s perception of its potential. Others, however, see promise. For example many see the introduction of Bitcoin into Africa as a means of providing institution-free access to financial services for Africa’s poor (termed the “Impala Revolution”), removing one of the major barriers to economic development. So is Bitcoin a currency or a commodity? Is it money? Many, see it as a way to break the rules, others as an opening to a “tsunami of openness.” Traditionalists, including the Financial Times, do not believe it will work. Nonetheless, Nakamoto missed a crucial point. A good currency must hold its value over long periods. It must also be readily exchangeable for the goods and services that people actually want. Combining those two functions in a single instrument requires a delicate balance.

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If issuance is too tight, there is not enough money moving around to meet the payment needs of the economy. This can lead to deflation and recession. Yet if too much money is issued the result will be inflation, which erodes the currency’s value. This is the dilemma that “private money”, the creation of banks rather than government authorities, has never been able to solve. —“Beware the mania for Bitcoin, the tulip of the 21st century,” Financial Times, January 16, 2014. Proponents are quick to explain that it does not have to replace all currencies, globally, to be successful. Time will tell.

Questions 1. Globalization and the MNE. The term globalization has become widely used in recent years. How would you define it? 2. Assets, Institutions, and Linkages. Which assets play the most critical role in linking the major institutions that make up the global financial marketplace? 3. Eurocurrencies and LIBOR. Why have eurocurrencies and LIBOR remained the centerpiece of the global financial marketplace for so long? 4. Theory of Comparative Advantage. Define and explain the theory of comparative advantage. 5. Limitations of Comparative Advantage. Key to understanding most theories is what they say and what they don’t. Name four or five key limitations to the theory of comparative advantage. 6. Trident’s Globalization. After reading the chapter’s description of Trident’s globalization process, how would you explain the distinctions between international, multinational, and global companies? 7. Trident, the MNE. At what point in the globalization process did Trident become a multinational enterprise (MNE)? 8. Trident’s Advantages. What are the main advantages that Trident gains by developing a multinational presence? 9. Trident’s Phases. What are the main phases that Trident passed through as it evolved into a truly global firm? What are the advantages and disadvantages of each? 10. Financial Globalization. How do the motivations of individuals, both inside and outside the organization or business, define the limits of financial globalization?

Case Questions 1. What are the costs and benefits of using Bitcoins for transactions? 2. According to economic theory, a true currency must be capable of serving as a unit of account, a medium of exchange, and a store of value. Does Bitcoin fulfill these criteria? 3. Currencies have always been expected to grow, as money, with real economic output. If they were to grow too fast, they fuel inflation; too slow, deflation. What would be Bitcoin’s impact, if any, over time?

Problems Comparative Advantage Problems 1–5 illustrate an example of trade induced by comparative advantage. They assume that China and France each have 1,000 production units. With one unit of production (a mix of land, labor, capital, and technology), China can produce either 10 containers of toys or 7 cases of wine. France can produce either 2 cases of toys or 7 cases of wine. Thus, a production unit in China is five times as efficient compared to France when producing toys, but equally efficient when producing wine. Assume at first that no trade takes place. China allocates 800 production units to building toys and 200 production units to producing wine. France allocates 200 production units to building toys and 800 production units to producing wine. 1. Production and Consumption. What is the production and consumption of China and France without trade? 2. Specialization. Assume complete specialization, where China produces only toys and France produces only wine. What would be the effect on total production? 3. Trade at China’s Domestic Price. China’s domestic price is 10 containers of toys equals 7 cases of wine. Assume China produces 10,000 containers of toys and exports 2,000 to France. Assume France produces 7,000 cases of wine and exports 1,400 cases to China. What happens to total production and consumption? 4. Trade at France’s Domestic Price. France’s domestic price is 2 containers of toys equals 7 cases of wine. Assume China produces 10,000 containers of toys and exports 400 containers to France. Assume France in turn produces 7,000 cases of wine and exports 1,400 cases to China. What happens to total production and consumption?

Chapter 1   Multinational Financial Management: Opportunities and Challenges

5. Trade at Negotiated Mid-Price. The mid-price for exchange between France and China can be calculated as follows. What happens to total production and consumption? Toys (containers/unit)

Assumptions China—output per unit of production input

Wine (cases/unit)

10

7

2

France—output per unit of production input China—total production inputs

1,000

France—total production inputs

1,000

7

Problems 6–10 are based on Americo Industries. Americo is a U.S.-based multinational manufacturing firm with whollyowned subsidiaries in Brazil, Germany, and China, in addition to domestic operations in the United States. Americo is traded on the NASDAQ. Americo currently has 650,000 shares outstanding. The basic operating characteristics of the various business units is as follows: U.S. Parent Company (US$)

Brazilian Subsidiary (reais, R$)

Earnings before taxes (EBT)

$4,500

Corporate income tax rate Average exchange rate for the period

7. Americo’s EPS Sensitivity to Exchange Rates (A). Assume a major political crisis wracks Brazil, first affecting the value of the Brazilian reais and, subsequently, inducing an economic recession within the country. What would be the impact on Americo’s consolidated EPS if the Brazilian reais were to fall in value to R$3.00/$, with all other earnings and exchange rates remaining the same? 8. Americo’s EPS Sensitivity to Exchange Rates (B). Assume a major political crisis wracks Brazil, first affecting the value of the Brazilian reais and, subsequently, inducing an economic recession within the country. What would be the impact on Americo’s consolidated EPS if, in addition to the fall in the value of the reais to R$3.00/$, earnings before taxes in Brazil fell as a result of the recession to R$5,8000,000?

Americo Industries—2010

Business Performance (000s, local currency)

21

Chinese Subsidiary (yuan, ¥)

R$6,250

German Subsidiary (euros, €) €4,500

35%

25%

40%

30%

—

R$1.80/$

€0.7018/$

¥7.750/$

¥2,500

6. Americo Industries’ Consolidate Earnings. Americo must pay corporate income tax in each country in which it currently has operations. a. After deducting taxes in each country, what are Americo’s consolidated earnings and consolidated earnings per share in U.S. dollars? b. What proportion of Americo’s consolidated earnings arise from each individual country? c. What proportion of Americo’s consolidated earnings arise from outside the United States?

9. Americo’s Earnings and the Fall of the Dollar. The dollar has experienced significant swings in value against most of the world’s currencies in recent years. a. What would be the impact on Americo’s consolidated EPS if all foreign currencies were to appreciate 20% against the U.S. dollar? b. What would be the impact on Americo’s consolidated EPS if all foreign currencies were to depreciate 20% against the U.S. dollar? 10. Americo’s Earnings and Global Taxation. All MNEs attempt to minimize their global tax liabilities. Return to the original set of baseline assumptions and answer the following questions regarding Americo’s global tax liabilities: a. What is the total amount—in U.S. dollars—that Americo is paying across its global business in corporate income taxes? b. What is Americo’s effective tax rate (total taxes paid as a proportion of pre-tax profit)? c. What would be the impact on Americo’s EPS and global effective tax rate if Germany instituted a corporate tax reduction to 28%, and Americo’s earnings before tax in Germany rose to €5,000,000?

Internet Exercises 1. International Capital Flows: Public and Private. Major multinational organizations (some of which are listed next) attempt to track the relative movements and magnitudes of global capital investment. Using these Web pages and others you may find, prepare a twopage executive briefing on the question of whether capital generated in the industrialized countries is

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finding its way to the less-developed and emerging markets. Is there some critical distinction between “less-developed” and “emerging”? The World Bank

www.worldbank.org

OECD www.oecd.org European Bank for Reconstruction and Development

www.ebrd.org

2. External Debt. The World Bank regularly compiles and analyzes the external debt of all countries globally. As part of their annual publication on World Development Indicators (WDI), they provide summaries of the long-term and short-term external debt obligations of selected countries online like that of Poland shown here. Go to their Web site and find the decomposition of external debt for Brazil, Mexico, and the Russian Federation. The World Bank www.worldbank.org/data

3. World Economic Outlook. The International Monetary Fund (IMF) regularly publishes its assessment of the prospects for the world economy. Choose a country of interest and use the IMF’s current analysis to form your own expectations of its immediate economic prospects. IMF Economic Outlook www.imf.org/external/index​ .htm

4. Financial Times Currency Global Macromaps. The Financial Times provides a very helpful real-time global map of currency values and movements online. Use it to track the movements in currency. Financial Times http://markets.ft.com/ research/Markets/Currencies

The International Monetary System

CHAPTER

The price of every thing rises and falls from time to time and place to place; and with every such change the ­purchasing power of money changes so far as that thing goes.  —Alfred Marshall.

2

Learning Objectives ■

Learn how the international monetary system has evolved from the days of the gold standard to today’s eclectic currency arrangement

■

Analyze the characteristics of an ideal currency

■

Explain the currency regime choices faced by emerging market countries

■

Examine how the euro, a single currency for the European Union, was created

This chapter begins with a brief history of the international monetary system, from the days of the classical gold standard to the present time. The first section describes contemporary currency regimes and their construction and classification, fixed versus flexible exchange rate principles, and what we would consider the theoretical core of the chapter—the attributes of the ideal currency. The second section describes the introduction of the euro and the path toward monetary unification, including the continuing expansion of the European Union. The third section analyzes the regime choices of emerging markets. The fourth and final section analyzes the trade-offs between exchange rate regimes based on rules, discretion, cooperation, and independence. The chapter concludes with the Mini-Case, Russian Ruble Roulette, which examines the recent change in how one country manages its currency’s value.

History of the International Monetary System Over the centuries, currencies have been defined in terms of gold, silver, and other items of value, all within a variety of different agreements between nations to recognize these varying definitions. A review of the evolution of these systems—or eras as we refer to them in Exhibit 2.1—provides a useful perspective against which to understand today’s rather eclectic system of fixed rates, floating rates, crawling pegs, and others, and it helps us to evaluate weaknesses in and challenges for governments and business enterprises c­ onducting global business.

The Gold Standard, 1876–1913 Since the days of the pharaohs (about 3000 b.c.), gold has served as a medium of exchange and a store of value. The Greeks and Romans used gold coins, and they passed on this tradition through the mercantile era to the nineteenth century. The great increase in trade 23

24

PART 1  Global Financial Environment

Exhibit 2.1 The Evolution of Capital Mobility Exchange Rate Era

The Gold Standard

CrossBorder Political Economy

Growing openness in trade, with growing, but limited, capital mobility

Implication

Trade dominates capital in total influence on exchange rates

1860

The Inter-War Years

1914

The Bretton Woods Era

The Floating Era

The Emerging Era

Protectionism and isolationism

Growing belief in the benefits of open economies

Industrialized (primary) nations open; emerging states (secondary) restrict capital flows to maintain economic control

More and more emerging nations open their markets to capital at the expense of reduced economic independence

Rising barriers to the movement of both trade and capital

Trade increasingly dominated by capital; era ends as capital flows

Capital flows dominate trade; emerging nations suffer devaluations

Capital flows increasingly drive economic growth and health

1945

1971

1997

Present

The last 150 years has seen periods of increasing and decreasing political and economic openness between countries. Beginning with the Bretton Woods Era, global markets have moved toward increasing open exchange of goods and capital, making it increasingly difficult to maintain fixed or even stable rates of exchange between currencies. The most recent era, characterized by the growth and development of emerging economies is likely to be even more challenging.

during the free-trade period of the late nineteenth century led to a need for a more formalized system for settling international trade balances. One country after another set a par value for its currency in terms of gold and then tried to adhere to the so-called “rules of the game.” This later came to be known as the classical gold standard. The gold standard, as an international monetary system, gained acceptance in Western Europe in the 1870s. The United States was something of a latecomer to the system, not officially adopting the gold standard until 1879. Under the gold standard, the “rules of the game” were clear and simple: Each country set the rate at which its currency unit (paper or coin) could be converted to a given weight of gold. The United States, for example, declared the dollar to be convertible to gold at a rate of $20.67 per ounce (this rate was in effect until the beginning of World War I). The British pound was pegged at £4.2474 per ounce of gold. As long as both currencies were freely convertible into gold, the dollar/pound exchange rate was $20.67/Ounce of Gold = $4.8665/£ £4.2474/Ounce of Gold Because the government of each country on the gold standard agreed to buy or sell gold on demand at its own fixed parity rate, the value of each individual currency in terms of gold, and therefore exchange rates between currencies, was fixed. Maintaining reserves of gold that were sufficient to back its currency’s value was very important for a country under this system. The system also had the effect of implicitly limiting the rate at which any individual country could expand its money supply. Growth in the money supply was limited to

Chapter 2   The International Monetary System

25

the rate at which official authorities (government treasuries or central banks) could acquire additional gold. The gold standard worked adequately until the outbreak of World War I interrupted trade flows and the free movement of gold. This event caused the main trading nations to suspend operation of the gold standard.

The Interwar Years and World War II, 1914–1944 During World War I and through the early 1920s, currencies were allowed to fluctuate over fairly wide ranges in terms of gold and in relation to each other. Theoretically, supply and demand for a country’s exports and imports caused moderate changes in an exchange rate about a central equilibrium value. This was the same function that gold had performed under the previous gold standard. Unfortunately, such flexible exchange rates did not work in an equilibrating manner. On the contrary: international speculators sold the weak currencies short, causing them to fall further in value than warranted by real economic factors. Selling short is a speculation technique in which an individual speculator sells an asset, such as a currency, to another party for delivery at a future date. The speculator, however, does not yet own the asset and expects the price of the asset to fall before the date by which the speculator must purchase the asset in the open market for delivery. The reverse happened with strong currencies. Fluctuations in currency values could not be offset by the relatively illiquid forward exchange market, except at exorbitant cost. The net result was that the volume of world trade did not grow in the 1920s in proportion to world gross domestic product. Instead, it declined to a very low level with the advent of the Great Depression in the 1930s. The United States adopted a modified gold standard in 1934 when the U.S. dollar was devalued to $35 per ounce of gold from the $20.67 per ounce price in effect prior to World War I. Contrary to previous practice, the U.S. Treasury traded gold only with foreign central banks, not private citizens. From 1934 to the end of World War II, exchange rates were theoretically determined by each currency’s value in terms of gold. During World War II and its chaotic aftermath, however, many of the main trading currencies lost their convertibility into other currencies. The dollar was one of the few currencies that continued to be convertible.

Bretton Woods and the International Monetary Fund, 1944 As World War II drew to a close in 1944, the Allied Powers met at Bretton Woods, New Hampshire, to create a new postwar international monetary system. The Bretton Woods Agreement established a U.S. dollar-based international monetary system and provided for two new institutions: the International Monetary Fund and the World Bank. The International Monetary Fund (IMF) aids countries with balance of payments and exchange rate problems. The International Bank for Reconstruction and Development (World Bank) helped fund postwar reconstruction and has since supported general economic ­development. Global Finance in Practice 2.1 provides some insight into the debates at Bretton Woods. The IMF was the key institution in the new international monetary system, and it has remained so to the present day. The IMF was established to render temporary assistance to member countries trying to defend their currencies against cyclical, seasonal, or random occurrences. It also assists countries having structural trade problems if they promise to take adequate steps to correct their problems. If persistent deficits occur, however, the

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PART 1  Global Financial Environment

Global Finance in Practice

2.1

Hammering Out an Agreement at Bretton Woods The governments of the Allied powers knew that the devastating impacts of World War II would require swift and decisive policies. In the summer of 1944 (July 1–22), a full year before the end of the war, representatives of all 45 allied nations met at Bretton Woods, New Hampshire, for the United Nations Monetary and Financial Conference. Their purpose was to plan the postwar international monetary system. It was a difficult process, and the final synthesis was shaded by pragmatism. The leading policymakers at Bretton Woods were the British and the Americans. The British delegation was led by Lord John Maynard Keynes, known as “Britain’s economic heavyweight.” The British argued for a postwar system that would be more flexible than the various gold standards used before the war. Keynes argued, as he had after World War I, that attempts to tie currency values to gold would create pressures for deflation in many of the war-ravaged economies. The American delegation was led by the director of the U.S. Treasury’s monetary research department, Harry D. White, and the U.S. Secretary of the Treasury, Henry ­Morgenthau, Jr. The Americans argued for stability (fixed exchange rates) but not a return to the gold standard itself. In fact, although the U.S. at that time held most of the gold of the Allied powers, the U.S. delegates argued that

currencies should be fixed in parities,1 but that redemption of gold should occur only between official authorities like central banks. On the more pragmatic side, all parties agreed that a postwar system would be stable and sustainable only if there was sufficient credit available for countries to defend their currencies in the event of payment imbalances, which they knew to be inevitable in a reconstructing world order. The conference divided into three commissions for weeks of negotiation. One commission, led by U.S. Treasury Secretary Morgenthau, was charged with the organization of a fund of capital to be used for exchange rate stabilization. A second commission, chaired by Lord Keynes, was charged with the organization of a second “bank” whose purpose would be for long-term reconstruction and development. A third commission was to hammer out details such as what role silver would have in any new system. After weeks of meetings, the participants came to a three-part agreement—the Bretton Woods Agreement. The plan called for: 1) fixed exchange rates, termed an “adjustable peg,” among members; 2) a fund of gold and constituent currencies available to members for stabilization of their respective currencies, called the International Monetary Fund (IMF); and 3) a bank for financing longterm development projects (eventually known as the World Bank). One proposal resulting from the meetings, which was not ratified by the United States, was the establishment of an international trade organization to promote free trade.

Fixed in parities is an old expression in this field, which means that the value of currencies should be set or fixed at rates that equalize their value, typically purchasing power.

1

IMF cannot save a country from eventual devaluation. In recent years, it has attempted to help countries facing financial crises. It has provided massive loans as well as advice to Russia and other former Russian republics, Brazil, Indonesia, and South Korea, to name but a few. Under the original provisions of the Bretton Woods Agreement, all countries fixed the value of their currencies in terms of gold but were not required to exchange their ­currencies for gold. Only the dollar remained convertible into gold (at $35 per ounce). Therefore, each country established its exchange rate vis-à-vis the dollar, and then ­calculated the gold par value of its currency to create the desired dollar exchange rate. Participating countries agreed to try to maintain the value of their currencies within 1%  (later expanded to 2.25%) of par by buying or selling foreign exchange or gold as needed. Devaluation was not to be used as a competitive trade policy, but if a currency became too weak to defend, devaluation of up to 10% was allowed without formal

Chapter 2   The International Monetary System

27

approval by the IMF. Larger devaluations required IMF approval. This became known as the gold-exchange standard. An additional innovation introduced by the Bretton Woods Agreement was the creation of the Special Drawing Right or SDR. The SDR is an international reserve asset created by the IMF to supplement existing foreign exchange reserves. It serves as a unit of account for the IMF and other international and regional organizations. It is also the base against which some countries peg the exchange rate for their currencies. Initially defined in terms of a fixed quantity of gold, the SDR is currently the weighted average of four major currencies: the U.S. dollar, the euro, the Japanese yen, and the British pound. The weights assigned to each currency are updated every five years by the IMF. Individual countries hold SDRs in the form of deposits in the IMF. These holdings are part of each country’s international monetary reserves, along with its official holdings of gold, its foreign exchange, and its reserve position at the IMF. Member countries may settle transactions among themselves by transferring SDRs.

Fixed Exchange Rates, 1945–1973 The currency arrangement negotiated at Bretton Woods and monitored by the IMF worked fairly well during the post-World War II period of reconstruction and rapid growth in world trade. However, widely diverging national monetary and fiscal policies, differential rates of inflation, and various unexpected external shocks eventually resulted in the system’s demise. The U.S. dollar was the main reserve currency held by central banks and was the key to the web of exchange rate values. Unfortunately, the United States ran persistent and growing deficits in its balance of payments. A heavy capital outflow of dollars was required to finance these deficits and to meet the growing demand for dollars from investors and businesses. Eventually, the heavy overhang of dollars held by foreigners resulted in a lack of confidence in the ability of the United States to meet its commitment to convert dollars to gold. This lack of confidence came to a head in the first half of 1971. In a little less than seven months, the United States suffered the loss of nearly one-third of its official gold reserves as global confidence in the value of the dollar plummeted. Exchange rates between most major currencies and the U.S. dollar began to float, and thus indirectly, their values relative to gold. A year and a half later, the U.S. dollar once again came under attack, thereby forcing a second devaluation on February 12, 1973; this time by 10% to $42.22 per ounce of gold. By late February 1973, a fixed-rate system no longer appeared feasible given the speculative flows of currencies. The major foreign exchange markets were actually closed for several weeks in March 1973. When they reopened, most currencies were allowed to float to levels determined by market forces. Par values were left unchanged. The dollar floated downward an average of another 10% by June 1973.

The Floating Era, 1973–1997 Since March 1973, exchange rates have become much more volatile and less predictable than they were during the “fixed” exchange rate period, when changes occurred ­infrequently. Exhibit 2.2 illustrates the wide swings exhibited by the nominal exchange rate index of the U.S. dollar since 1964. Clearly, volatility has increased for this currency measure since 1973. Exhibit 2.3 summarizes the key events and external shocks that have affected currency values since August 1971. The most important shocks in recent years have been the European

28

PART 1  Global Financial Environment

Exhibit 2.2 The BIS Exchange Rate Index of the Dollar Index Value

2010 = 100

180

Dollar peaks on Feb 28, 1985 Euro, launched Jan 1999 Louvre Accords Feb 1987

Euro peaks at $1.60/ April 2008

130 US dollar devalued Feb 1973

14

08

20

06

20

04

20

98

20

96

19

94

19

92

19

90

19

88

19

86

19

84

19

82

19

80

19

78

19

76

19

74

19

72

19

70

19

68

19

66

19

19

19

64

90

02

Dollar reaches low on index basis Aug 2011

EMS Crisis of Sept 1992

20

EMS Created March 1979

100

00

110

20

120

12

140

Asian Crisis June 1997

20

Jamaica Agreement Jan 1976

150

10

Bretton Woods Period ends Aug 1971

160

20

170

Source: BIS.org. Nominal exchange rate index for the U.S. dollar.

Monetary System (EMS) restructuring in 1992 and 1993; the emerging market currency crises, including that of Mexico in 1994, Thailand (and a number of other Asian currencies) in 1997, Russia in 1998, and Brazil in 1999; the introduction of the euro in 1999; and the currency crises and changes in Argentina and Venezuela in 2002.

The Emerging Era, 1997–Present The period following the Asian Crisis of 1997 has seen growth in both breadth and depth of emerging market economies and currencies. We may end up being proven wrong on this count, but the final section of this chapter argues that the global monetary system has already begun embracing—for over a decade now—a number of major emerging market currencies, beginning with the Chinese renminbi. Feel free to disagree.

IMF Classification of Currency Regimes The global monetary system—if there is indeed a singular “system”—is an eclectic combination of exchange rate regimes and arrangements. Although there is no single governing body, the International Monetary Fund (IMF) has at least played the role of “town crier” since World War II. We present its current classification system of currency regimes here.

29

Chapter 2   The International Monetary System

Exhibit 2.3 World Currency Events, 1971–2014 Date

Event

Impact

August 1971

Dollar floated

Nixon closes the U.S. gold window, suspending purchases or sales of gold by U.S. Treasury; temporary imposition of 10% import surcharge

December 1971

Smithsonian Agreement

Group of Ten reaches compromise whereby the US$ is devalued to $38/oz. of gold; most other major currencies are appreciated versus US$

February 1973

U.S. dollar devalued

Devaluation pressure increases on US$, forcing further devaluation to $42.22/oz. of gold

February–March 1973

Currency markets in crisis

Fixed exchange rates no longer considered defensible; speculative ­pressures force closure of international foreign exchange markets for nearly two weeks; markets reopen on floating rates for major industrial currencies

June 1973

U.S. dollar depreciation

Floating rates continue to drive the now freely floating US$ down by about 10% by June

Fall 1973–1974

OPEC oil embargo

Organization of Petroleum Exporting Countries (OPEC) impose oil embargo, eventually quadrupling the world price of oil; because world oil prices are stated in US$, value of US$ recovers some former strength

January 1976

Jamaica Agreement

IMF meeting in Jamaica results in the “legalization” of the floating exchange rate system already in effect; gold is demonetized as a reserve asset

1977–1978

U.S. inflation rate rises

Carter administration reduces unemployment at the expense of inflation increases; rising U.S. inflation causes continued depreciation of the US$

March 1979

EMS created

The European Monetary System (EMS) is created, establishing a c ­ ooperative exchange rate system for participating members of the ­European Economic Community (EEC)

Summer 1979

OPEC raises prices

OPEC nations raise price of oil again

Spring 1980

U.S. dollar begins rise

Worldwide inflation and early signs of recession coupled with real ­interest differential advantages for dollar-denominated assets contribute to increased demand for dollars

August 1982

Latin American debt crisis

Mexico informs U.S. Treasury on Friday 13, 1982, that it will be unable to make debt service payments; Brazil and Argentina follow within months

February 1985

U.S. dollar peaks

The US$ peaks against most major industrial currencies, hitting record highs against the deutsche mark and other European currencies

September 1985

Plaza Agreement

Group of Ten members meet at the Plaza Hotel in New York City to sign an international cooperative agreement to control the volatility of world ­currency markets and to establish target zones

February 1987

Louvre Accords

Group of Six members state they will “intensify” economic policy ­coordination to promote growth and reduce external imbalances

December 1991

Maastricht Treaty

European Union concludes a treaty to replace all individual currencies with a single currency—the euro

September 1992

EMS crisis

High German interest rates induce massive capital flows into deutsche markdenominated assets, causing the withdrawal of the Italian lira and British pound from the EMS common float

July 1993

EMS realignment

EMS adjusts allowable deviation band for all member countries (except the Dutch guilder); US$ continues to weaken; Japanese yen reaches ¥ 100.25/$

1994

EMI founded

European Monetary Institute (EMI), the predecessor to the European ­Central Bank, is founded in Frankfurt, Germany

December 1994

Peso collapse

Mexican peso suffers major devaluation as a result of increasing pressure on the managed devaluation policy; peso falls from Ps3.46/$ to Ps5.50/$ within days; the peso’s collapse results in a fall in most major Latin ­American exchanges in a contagion process—the “tequila effect”

August 1995

Yen peaks

Japanese yen reaches an all-time high versus the US$ of ¥79/$; yen slowly depreciates over the following two-year period, rising to over ¥130/$ (continued)

30

PART 1  Global Financial Environment

Exhibit 2.3

World Currency Events, 1971–2014 (continued)

Date

Event

Impact

June 1997

Asian crisis

The Thai baht is devalued in July, followed soon after by the Indonesian rupiah, Korean won, Malaysian ringgit, and Philippine peso; following the initial exchange rate devaluations, the Asian economy plummets into recession

August 1998

Russian crisis

On Monday, August 17, the Russian Central Bank devalues the ruble by 34%; the ruble continues to deteriorate in the following days, sending the already weak ­Russian economy into recession

January 1999

Euro launched

Official launch date for the euro, the single European currency; 11 European Union member states elect to participate in the system, which irrevocably locks their individual currencies rates among them

January 1999

Brazilian reais crisis

The reais, initially devalued 8.3% by the Brazilian government on January 12, is allowed to float against the world’s currencies

January 2002

Euro coinage

Euro coins and notes are introduced in parallel with home currencies; national ­currencies are phased out during the six-month period beginning January 1

January 8, 2002

Argentine peso crisis

The Argentine peso, its value fixed to the US$ at 1:1 since 1991 through a currency board, is devalued to Ps1.4/$, then floated

February 13, 2002

Venezuelan bolivar floated

The Venezuelan bolivar, fixed to the US$ since 1996, is floated as a result of increasing economic crisis

Feburary 14, 2004

Venezuelan bolivar devalued

Venezuela devalues the bolivar by 17% versus the US$, to deal with its growing fiscal deficit

May 2004

EU enlargement

Ten more countries join the European Union, thereby enlarging it to 25 members; in the future, when they qualify, most of these countries are expected to adopt the euro

July 21, 2005

Yuan reform

April 2008

Euro peaks

The Chinese government and the People’s Bank of China abandon the peg of the Chinese yuan (renminbi) to the US$, announcing that it will be instantly revalued from Yuan8.28/$ to Yuan8.11/$, and reform the exchange rate regime to a managed float in the future; Malaysia announces a similar change to its exchange rate regime The euro peaks in strength against the US$ at $1.60/€. In the following months the euro falls substantially, hitting $1.25/€ by late 2008

Fall 2011

Greek/EU debt crisis

Rising fears over the future of the euro revolve around the mounting public debt levels of Greece, Portugal, and Ireland

January 2014

Emerging market downgrades

Multitude of emerging markets currencies (Argentina, Venezuela, India, and Libya) suffer significant capital flight as US$ interest rates rise and emerging market economies slow

Brief Classification History The IMF was for many years the central clearinghouse for exchange rate classifications. Member states submitted their exchange rate policies to the IMF, and those submissions were the basis for its categorization of exchange rate regimes. However, that all changed in 1997–1998 with the Asian Financial Crisis. During the Asian Financial Crisis, many countries began following very different exchange rate practices than those they had committed to with the IMF. Their actual practices—their de facto systems—were not what they had publicly and officially committed to—their de jure systems. Beginning in 1998 the IMF changed its practice and stopped collecting regime classification submissions from member states. Instead, it confined its regime classifications and reports to analysis performed in-house.1 As a global institution, which is in principle apolitical, the This included the cessation of publishing its Annual Report on Exchange Arrangements and Exchange Restrictions, a document on which much of the financial industry depended for decades. 1

31

Chapter 2   The International Monetary System

IMF’s analysis today is focused on classifying currencies on the basis of an ex post analysis of how the currency’s value was based in the recent past. This analysis focuses on observed behavior, not on official government policy pronouncements.

The IMF’s 2009 de facto System The IMF’s methodology of classifying exchange rate regimes today, in effect since January 2009, is presented in Exhibit 2.4. It is based on actual observed behavior, de facto results, and not on the official policy statements of the respective governments, de jure Exhibit 2.4 IMF Exchange Rate Classifications Rate Classification

2009 de facto System

Description and Requirements

Hard Pegs

Arrangement with no separate legal tender

The currency of another country circulates as the sole legal tender ­(formal dollarization), as well as members of a monetary or currency union in which the same legal tender is shared by the members.

10

Currency board arrangement

A monetary arrangement based on an explicit legislative commitment to exchange domestic currency for a specific foreign currency at a fixed exchange rate, combined with restrictions on the issuing ­authority. ­Restrictions imply that domestic currency will be issued only against ­foreign exchange and that it remains fully backed by foreign assets.

13

Conventional pegged arrangement

A country formally pegs its currency at a fixed rate to another currency or a basket of currencies of major financial or trading partners. Country authorities stand ready to maintain the fixed parity through direct or ­indirect intervention. The exchange rate may vary { 1% around a central rate, or may vary no more than 2% for a six-month period.

45

Stabilized arrangement

A spot market rate that remains within a margin of 2% for six months or more and is not floating. Margin stability can be met by either a single currency or basket of currencies (assuming statistical measurement). Exchange rate remains stable as a result of official action.

22

Crawling peg

Currency is adjusted in small amounts at a fixed rate or in response to changes in quantitative indicators (e.g., inflation differentials).

5

Crawl-like arrangement

Exchange rate must remain with a narrow margin of 2% relative to a statistically defined trend for six months or more. Exchange rate cannot be considered floating. Minimum rate of change is greater than allowed under a stabilized arrangement.

3

Pegged exchange rate within horizontal bands

The value of the currency is maintained within certain margins of fluctuation of at least ±1% around a fixed central rate, or the margin between the maximum and minimum value of the exchange rate exceeds 2%. This includes countries which are today members of the Exchange Rate Mechanism II (ERM II) system.

3

Floating

Exchange rate is largely market determined without an ascertainable or predictable path. Market intervention may be direct or indirect, and serves to moderate the rate of change (but not targeting). Rate may exhibit more or less volatility.

39

Free floating

A floating rate is freely floating if intervention occurs only exceptionally, and confirmation of intervention is limited to at most three instances in a six-month period, each lasting no more than three business days.

36

Other managed arrangements

This category is residual, and is used when the exchange rate does not meet the criteria for any other category. Arrangements characterized by frequent shifts in policies fall into this category.

12

Soft Pegs

Countries

Intermediate pegs:

Floating Arrangements

Residual

Source: “Revised System for the Classification of Exchange Rate Arrangements,” by Karl Habermeier, Anamaria Kokenyne, Romain Veyrune, and Harald Anderson, IMF Working Paper WP/09/211, International Monetary Fund, November 17, 2009. Classification includes 188 countries at the time of publication.

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PART 1  Global Financial Environment

­classification. 2 The classification process begins with the determination of whether the exchange rate of the c­ ountry’s currency is dominated by markets or by official action. Although the classification system is a bit challenging, there are four basic categories. Category 1: Hard Pegs.  These countries have given up their own sovereignty over monetary policy. This category includes countries that have adopted other country’s currencies (e.g., Zimbabwe’s adoption of the U.S. dollar, dollarization), and countries utilizing a currency board structure that limits monetary expansion to the accumulation of foreign exchange. Category 2: Soft Pegs.  This general category is colloquially referred to as fixed exchange rates. The five subcategories of soft peg regimes are differentiated on the basis of what the currency is fixed to, whether that fix is allowed to change—and if so under what conditions, what types, magnitudes, and frequencies of intervention are allowed/used, and the degree of variance about the fixed rate. Category 3: Floating Arrangements.  Currencies that are predominantly market-driven are further subdivided into free floating with values determined by open market forces without governmental influence or intervention, and simple floating or floating with intervention, where government occasionally does intervene in the market in pursuit of some rate goals or objectives. Category 4: Residual.  As one would suspect, this category includes all exchange rate arrangements that do not meet the criteria of the previous three categories. Country systems demonstrating frequent shifts in policy typically make up the bulk of this category. Exhibit 2.5 provides a glimpse as to what these major regime categories translate into in the global market—fixed or floating. (The IMF’s category 4 is truly residual, often ­characterized as ‘who knows?’, and is not explicitly shown in the exhibit.) The vertical dashed line, the crawling peg, is the zone some currencies move into and out of depending on their relative currency stability. Although the classification regimes appear clear and distinct, the distinctions are often more difficult to distinguish in practice in the market. For example, in January 2014, the Bank of Russia announced it would no longer conduct intervention ­activities with regard to the value of the ruble and that it planned to allow the ruble to trade freely, with no intervention, by 2015. Time will tell.

A Global Eclectic Despite the IMF’s attempt to lend rigor to regime classifications, the global monetary system today is indeed a global eclectic in every sense of the term. As Chapter 5 will describe in detail, the current global market in currency is dominated by two major currencies, the U.S. dollar and the European euro, and after that, a multitude of systems, arrangements, currency areas, and zones. The euro itself is an example of a rigidly fixed system, acting as a single currency for its member countries. However, the euro is also an independently floating currency against all other currencies. Other examples of rigidly fixed exchange regimes include Ecuador, Panama, and Zimbabwe, which use the U.S. dollar as their official currency; the Central African Franc (CFA) zone, in which countries such as Mali, Niger, Senegal, Cameroon, and Chad among others use a single common currency (the franc, which is tied to the euro); and the Eastern Caribbean Currency Union (ECCU), a set of countries that use the Eastern Caribbean dollar. “Revised System for the Classification of Exchange Rate Arrangements,” by Karl Habermeier, Annamaria ­ okenyne, Romain Veyrune, and Harald Anderson, Monetary and Capital Markets Department, IMF Working Paper K 09/211, November 17, 2009. The system presented is a revision of the IMF’s 1998 revision to a de facto system.

2

Chapter 2   The International Monetary System

33

Exhibit 2.5 Taxonomy of Exchange Rate Regimes Fixed (pegged) or Floating?

Fixed (pegged to something)

Floating (market driven) Intermediate or Crawling Peg

Hard Peg Extreme currency regime peg forms such as Currency Boards and Dollarization

Soft Peg

Managed Float

Fixed Exchange Rates where authorities maintain a set but variable band about some other currency

Market forces of supply and demand set the exchange rate, but with occasional government intervention

Free Floating Market forces of supply and demand are allowed to set the exchange rate with no government intervention

At the other extreme are countries with independently floating currencies. These include many of the most developed countries, such as Japan, the United States, the United K ­ ingdom, Canada, Australia, New Zealand, Sweden, and Switzerland. However, this category also includes a number of unwilling participants—emerging market countries that tried to maintain fixed rates but were forced by the marketplace to let them float. Among these are Korea, the Philippines, Brazil, Indonesia, Mexico, and Thailand. It is important to note that only the last two categories, managed floats and free floats (applying to only half of the 188 countries covered), are actually “floating” to any real degree. Although the contemporary international monetary system is typically referred to as a “floating regime,” it is clearly not the case for the majority of the world’s nations. And as illustrated by the press release in Global Finance in Practice 2.2 regarding the Swiss franc, even the world’s most stable currencies have to “manage” their values on occasion. Global Finance in Practice

2.2

Swiss National Bank Sets Minimum Exchange Rate for the Franc The current massive overvaluation of the Swiss franc ­(symbol CHF) poses an acute threat to the Swiss ­economy and carries the risk of a deflationary development. The Swiss National Bank (SNB) is therefore aiming for a ­substantial and sustained weakening of the Swiss franc. With immediate effect, it will no longer tolerate a EUR/CHF

exchange rate below the minimum rate of CHF 1.20. The SNB will enforce this minimum rate with the utmost ­determination and is p ­ repared to buy foreign currency in unlimited quantities. Even at a rate of CHF 1.20 per euro, the Swiss franc is still high and should continue to weaken over time. If the economic outlook and deflationary risks so require, the SNB will take further measures. Source: “Swiss National Bank sets minimum exchange rate at CHF 1.20 per euro,” Communications Press Release, Swiss National Bank, Zurich, 6 September 2011.

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Fixed versus Flexible Exchange Rates A nation’s choice as to which currency regime to follow reflects national priorities about all facets of the economy, including inflation, unemployment, interest rate levels, trade balances, and economic growth. The choice between fixed and flexible rates may change over time as priorities change. At the risk of overgeneralizing, the following points partly explain why countries pursue certain exchange rate regimes. They are based on the premise that, other things being equal, countries would prefer fixed exchange rates. ■

■

Fixed rates provide stability in international prices for the conduct of trade. Stable prices aid in the growth of international trade and lessen risks for all businesses. Fixed exchange rates are inherently anti-inflationary, requiring the country to follow restrictive monetary and fiscal policies. This restrictiveness, however, can often be a burden to a country wishing to pursue policies that alleviate continuing internal economic problems, such as high unemployment or slow economic growth.

Fixed exchange rate regimes necessitate that central banks maintain large quantities of international reserves (hard currencies and gold) for use in the occasional defense of the fixed rate. As international currency markets have grown rapidly in size and volume, increasing reserve holdings has become a significant burden to many nations. Fixed rates, once in place, may be maintained at levels that are inconsistent with economic fundamentals. As the structure of a nation’s economy changes, and as its trade relationships and balances evolve, the exchange rate itself should change. Flexible exchange rates allow this to happen gradually and efficiently, but fixed rates must be changed administratively—usually too late, with too much publicity, and at too large a one-time cost to the nation’s economic health. The terminology associated with changes in currency values is also technically specific. When a government officially declares its own currency to be worth less or more relative to other currencies, it is termed a devaluation or revaluation, respectively. This obviously applies to currencies whose value is controlled by government. When a currency’s value is changed in the open currency market—not directly by government—it is called a depreciation (with a fall in value) or appreciation (with an increase in value).

The Impossible Trinity If the ideal currency existed in today’s world, it would possess the following three attributes (illustrated in Exhibit 2.6), often referred to as the impossible trinity: 1. Exchange rate stability. The value of the currency would be fixed in relationship to other major currencies, so traders and investors could be relatively certain of the foreign exchange value of each currency in the present and into the near future. 2. Full financial integration. Complete freedom of monetary flows would be allowed, so traders and investors could easily move funds from one country and currency to another in response to perceived economic opportunities or risks. 3. Monetary independence. Domestic monetary and interest rate policies would be set by each individual country to pursue desired national economic policies, especially as they might relate to limiting inflation, combating recessions, and fostering prosperity and full employment. These qualities are termed the impossible trinity (also referred to as the trilemma of international finance) because the forces of economics do not allow a country to simultaneously achieve all three goals: monetary independence, exchange rate stability, and full financial integration.

Chapter 2   The International Monetary System

35

Exhibit 2.6 The Impossible Trinity All countries must implicitly decide which of the Trinity Elements they wish to pursue, and therefore which element they must give up (you can’t have all three). Trinity Element: The Ultimate Objective

Must Give Up Either: An independent monetary policy, or allowing the free movement of capital in and out of its country

Exchange Rate Stability (a managed or fixed exchange rate)

Monetary Independence (an independent monetary policy)

A stable exchange rate, or allowing the free movement of capital in and out of its country

Full Financial Integration (the free movement of capital)

A stable exchange rate, or an independent monetary policy

In recent years, with the increasing deregulation of capital markets and capital controls around the globe, more countries are opting to pursue Full Financial Integration. The results are as theory would predict: more currency volatility and less independence in the conduct of monetary policy.

As described in Exhibit 2.6, the consensus of many experts is that the force of increased capital mobility has been pushing more and more countries toward full financial integration in an attempt to stimulate their domestic economies and feed the capital appetites of their own MNEs. As a result, their currency regimes are being “cornered” into being either purely floating (like the United States) or integrated with other countries in monetary unions (like the European Union). Global Finance in Practice 2.3 drives this debate home. Global Finance in Practice

2.3

Who Is Choosing What in the Trinity/ Trilemma? The global financial crisis of 2008–2009 sparked much debate over the value of currencies—in some cases invoking what one academic termed “currency wars.” With most of the non-Chinese world suffering very slow economic growth, and under heavy pressure to stimulate their economies and alleviate high unemployment rates, there have been increasing arguments and efforts favoring a weak or undervalued currency. Although that may sound logical, the impossible trinity makes it very clear Choice #1

that each economy must choose its own medicine. The table shows what many argue are the choices of three of the main global economic powers. The choices facing the EU are clearly the more complex. As a combination of different sovereign states, the EU has pursued integration of a common currency, the euro, and free movement of labor and capital. The result, according to the impossible trinity, is that EU member states had to give up independent monetary policy, replacing individual central banks with the European Central Bank (ECB). The recent fiscal deficits and near-collapses of government debt issuances in Greece, Portugal, and Ireland have raised questions over the efficacy of the arrangement.

Choice #2

Implied Condition #3

United States

Independent monetary policy

Free movement of capital

Currency value floats

China

Independent monetary policy

Fixed rate of exchange

Restricted movement of capital

Europe (EU)

Free movement of capital

Fixed rate of exchange

Integrated monetary policy

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PART 1  Global Financial Environment

A Single Currency for Europe: The Euro Beginning with the Treaty of Rome in 1957 and continuing with the Single European Act of 1987, the Maastricht Treaty of 1991–1992, and the Treaty of Amsterdam of 1997, a core set of European countries worked steadily toward integrating their individual countries into one larger, more efficient, domestic market. However, even after the launch of the 1992 Single Europe program, a number of barriers to true openness remained, including the use of different currencies. The use of different currencies required both consumers and companies to treat the individual markets separately. Currency risk of cross-border commerce still persisted. The creation of a single currency was seen as the way to move beyond these last vestiges of separated markets. The original 15 members of the European Union (EU) were also members of the ­European Monetary System. The EMS formed a system of fixed exchange rates amongst the member currencies, with deviations managed through bilateral responsibility to maintain rates at {2.5% of an established central rate. This system of fixed rates, with adjustments along the way, remained in effect from 1979–1999. Its resiliency was seriously tested with exchange rate crises in 1992 and 1993, but it held and moved onward.

The Maastricht Treaty and Monetary Union In December 1991, the members of the EU met at Maastricht, the Netherlands, and concluded a treaty that changed Europe’s currency future. The Maastricht Treaty specified a timetable and a plan to replace all individual EMS member currencies with a single currency—eventually named the euro. Other aspects of the treaty were also adopted that would lead to a full European Economic and Monetary Union (EMU). According to the EU, the EMU is a single-currency area within the the singular EU market, now known informally as the eurozone, in which people, goods, services, and capital are allowed to move without restrictions. The integration of separate country monetary systems is not, however, a minor task. To prepare for the EMU, the Maastricht Treaty called for the integration and coordination of the member countries’ monetary and fiscal policies. The EMU would be implemented by a process called convergence. Before becoming a full member of the EMU, each member country was expected to meet the following convergence criteria in order to integrate systems that were at the same relative performance levels: 1) nominal inflation should be no more than 1.5% above the average for the three members of the EU that had the lowest inflation rates during the previous year; 2) long-term interest rates should be no more than 2% above the average of the three members with the lowest interest rates; 3) individual government budget deficits—fiscal deficits— should be no more than 3% of gross domestic product; and 4) government debt outstanding should be no more than 60% of gross domestic product. The convergence criteria were so tough that few, if any, of the members could satisfy them at that time, but 11 countries managed to do so just prior to 1999 (Greece was added two years later).

The European Central Bank (ECB) The cornerstone of any monetary system is a strong, disciplined, central bank. The Maastricht Treaty established this single institution for the EMU, the European Central Bank (ECB), which was established in 1998. (The EU created the European Monetary Institute (EMI) in 1994 as a transitional step in establishing the European Central Bank.) The ECB’s structure and functions were modeled after the German Bundesbank, which in turn had been modeled after the U.S.

Chapter 2   The International Monetary System

37

Federal Reserve System. The ECB is an independent central bank that dominates the activities of the individual countries’ central banks. The individual central banks continue to regulate banks resident within their borders, but all financial market intervention and the issuance of the single currency is the sole responsibility of the ECB. The single most important mandate of the ECB is its charge to promote price stability within the European Union.

The Launch of the Euro On January 4, 1999, 11 member states of the EU initiated the EMU. They established a single currency, the euro, which replaced the individual currencies of the participating member states. The 11 countries were Austria, Belgium, Finland, France, Germany, Ireland, Italy, ­Luxembourg, the Netherlands, Portugal, and Spain. Greece did not qualify for EMU participation at the time, but joined the euro group later, in 2001. On December 31, 1998, the final fixed rates between the 11 participating currencies and the euro were put into place. On January 4, 1999, the euro was officially launched. The United Kingdom, Sweden, and Denmark chose to maintain their individual currencies. The United Kingdom has been skeptical of increasing EU infringement on its sovereignty, and has opted not to participate. Sweden, which has failed to see significant benefits from EU membership (although it is one of the newest members), has also been skeptical of EMU participation. Denmark, like the United Kingdom, Sweden, and Norway has so far opted not to participate. (Denmark is, however, a member of ERM II, the Exchange Rate Mechanism II, which effectively allows Denmark to keep its own currency and monetary sovereignty, but fixes the value of its currency, the krone, to the euro.) The official currency symbol of the euro, EUR, was registered with the International Standards Organization. The official symbol of the euro is €. According to the EU, the € symbol was inspired by the Greek letter epsilon (є), simultaneously referring to Greece’s ancient role as the source of European civilization and recalling the first letter of the word Europe. The euro would generate a number of benefits for the participating states: 1) Countries within the eurozone enjoy cheaper transaction costs; 2) Currency risks and costs related to exchange rate uncertainty are reduced; and 3) All consumers and businesses both inside and outside the eurozone enjoy price transparency and increased price-based competition. The ­primary “cost” of adopting the euro, the loss of monetary independence, would be a ­continuing challenge for the members for years to come. Global Finance in Practice

2.4

The Euro and the Greek/EU Debt Crisis The European Monetary Union is a complex organism compared to the customary country structure of fiscal and monetary policy institutions and policies described in a typical Economics 101 course. The members of the EU do not have the ability to conduct independent monetary policy. When the EU moved to a single currency with the adoption of the euro, its member states agreed to use a single currency (exchange rate stability), allow the free movement of capital in and out of their economies (financial integration), but give up individual control of their own money supply (monetary independence). Once again, a choice was made among

the three competing dimensions of the impossible trinity; in this case, to form a single monetary policy body—the European Central Bank (ECB)—to conduct monetary policy on behalf of all EU members. But fiscal and monetary policies are still somewhat intertwined. Government deficits that are funded by issuing debt to the international financial markets still impact monetary policy. Proliferating sovereign debt—debt issued by Greece, Portugal, and Ireland, for example—may be eurodenominated, but it is the debt obligation of each individual government. However, if one or more of these governments flood the market with debt, this may result in increased cost and decreased availability of capital to other member states. In the end, if monetary independence is not preserved, then one or both of the other elements of the impossible trinity may fail—capital mobility or exchange rate stability.

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PART 1  Global Financial Environment

On January 4, 1999, the euro began trading on world currency markets. Its introduction was a smooth one. The euro’s value slid steadily following its introduction, however, primarily as a result of the robustness of the U.S. economy and U.S. dollar, and sluggish economic sectors in the EMU countries. Beginning in 2002, the euro appreciated versus the dollar. Since that time, as illustrated in Exhibit 2.7, it had remained in a range of roughly $1.20 to $1.50 per euro. It has, however, demonstrated significant volatility. The use of the euro has continued to expand since its introduction. As of January 2012, the euro was the official currency for 17 of the 27 member countries in the European Union, as well as five other countries (Montenegro, Andorra, Monaco, San Marino, and the Vatican) that may eventually join the EU. The 17 countries that currently use the euro—the so-called eurozone—are Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, ­Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. Although all ­members of the EU are expected eventually to replace their currencies with the euro, recent years have seen growing debates and continual postponements by new members in moving toward full euro adoption. The continuing issues with European sovereign debt, as discussed in Global Finance in Practice 2.4, also continue to pose serious challenges to further euro expansion.

Emerging Markets and Regime Choices The 1997–2005 period specifically saw increasing pressures on emerging market countries to choose among more extreme types of exchange rate regimes. The increased capital mobility pressures noted in the previous section have driven a number of countries to choose between a free-floating exchange rate (as in Turkey in 2002) or, at the opposite extreme, a fixed-rate regime—such as a currency board (as in Argentina throughout the 1990s and detailed in the

Exhibit 2.7 The U.S. Dollar/Euro Exchange Rate U.S. dollars to = 1 euro 1.60 1.50 1.40 1.30 1.20 1.10 1.00 0.90

Ja n Ju -99 n N -99 ov Ap -99 r Se -00 pFe 00 bJu 01 D l-01 e M c-0 ay 1 O -02 ct M -02 ar Au -03 g Ja -03 n Ju -04 n N -04 ov Ap -04 r Se -05 pFe 05 bJu 06 D l-06 e M c-0 ay 6 O -07 ct M -07 ar Au -08 g Ja -08 n Ju -09 n N -09 ov Ap -09 r Se -10 pFe 10 bJu 11 D l-11 e M c-1 ay 1 O -12 c M t-12 ar Au -13 g13

0.80

Chapter 2   The International Monetary System

39

following section) or even dollarization (as in Ecuador in 2000). These systems deserve a bit more time and depth in our discussions.

Currency Boards A currency board exists when a country’s central bank commits to back its monetary base—its money supply—entirely with foreign reserves at all times. This commitment means that a unit of domestic currency cannot be introduced into the economy without an additional unit of foreign exchange reserves being obtained first. Eight countries, including Hong Kong, utilize currency boards as a means of fixing their exchange rates. Argentina.  In 1991, Argentina moved from its previous managed exchange rate of the ­Argentine peso to a currency board structure. The currency board structure pegged the Argentine peso’s value to the U.S. dollar on a one-to-one basis. The Argentine government preserved the fixed rate of exchange by requiring that every peso issued through the Argentine banking system be backed by either gold or U.S. dollars held on account in banks in Argentina. This 100% reserve system made the monetary policy of Argentina dependent on the country’s ability to obtain U.S. dollars through trade or investment. Only after Argentina had earned these dollars through trade could its money supply be expanded. This requirement eliminated the possibility of the nation’s money supply growing too rapidly and causing inflation. Argentina’s system also allowed all Argentines and foreigners to hold dollar-denominated accounts in Argentine banks. These accounts were in actuality Eurodollar accounts, dollardenominated deposits in non-U.S. banks. These accounts provided savers with the ability to choose whether or not to hold pesos. From the very beginning there was substantial doubt in the market that the Argentine government could maintain the fixed exchange rate. Argentine banks regularly paid slightly higher interest rates on peso-denominated accounts than on dollar-denominated accounts. This interest differential represented the market’s assessment of the risk inherent in the Argentine financial system. Depositors were rewarded for accepting risk—for keeping their money in peso-denominated accounts. The market proved to be correct. In January 2002, after months of economic and political turmoil and nearly three years of economic recession, the Argentine currency board was ended. The peso was first devalued from Peso1.00/$ to Peso1.40/$, then it was floated completely. It fell in value dramatically within days. The Argentine decade-long experiment with a rigidly fixed exchange rate was over.

Dollarization Several countries have suffered currency devaluation for many years, primarily as a result of inflation, and have taken steps toward dollarization. Dollarization is the use of the U.S. dollar as the official currency of the country. Panama has used the dollar as its official currency since 1907. Ecuador, after suffering a severe banking and inflationary crisis in 1998 and 1999, adopted the U.S. dollar as its official currency in January 2000. One of the primary attributes of dollarization was summarized well by BusinessWeek in a December 11, 2000, article entitled “The Dollar Club”: One attraction of dollarization is that sound monetary and exchange-rate policies no longer depend on the intelligence and discipline of domestic policymakers. Their monetary policy becomes essentially the one followed by the U.S., and the exchange rate is fixed forever. The arguments for dollarization follow logically from the previous discussion of the impossible trinity.

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PART 1  Global Financial Environment

A country that dollarizes removes any currency volatility (against the dollar) and would theoretically eliminate the possibility of future currency crises. Additional benefits are expectations of greater economic integration with other dollar-based markets, both product and financial. This last point has led many to argue in favor of regional dollarization, in which several countries that are highly economically integrated may benefit significantly from dollarizing together. Three major arguments exist against dollarization. The first is the loss of sovereignty over monetary policy. This is, however, the point of dollarization. Second, the country loses the power of seigniorage, the ability to profit from its ability to print its own money. Third, the central bank of the country, because it no longer has the ability to create money within its economic and financial system, can no longer serve the role of lender of last resort. This role carries with it the ability to provide liquidity to save financial institutions that may be on the brink of failure during times of financial crisis. Ecuador.  Ecuador officially completed the replacement of the Ecuadorian sucre with the U.S. dollar as legal tender in September 2000. This step made Ecuador the largest national adopter of the U.S. dollar, and in many ways made Ecuador a test case of dollarization for other emerging market countries to watch closely. As shown in Exhibit 2.8, this was the last stage of a massive depreciation of the sucre in a brief two-year period. During 1999, Ecuador suffered a rising rate of inflation and a falling level of economic output. In March 1999, the Ecuadorian banking sector was hit with a series of devastating “bank runs,” financial panics in which all depositors attempted to withdraw all of their funds simultaneously. Although there were severe problems in the Ecuadorian banking system, the truth was that even the healthiest financial institution would fail under the strain of this financial drain. Ecuador’s president immediately froze all deposits (this was termed a bank holiday in the United States in the 1930s when banks closed their doors). The value of the Ecuadorian sucre plummeted in early March, inducing the country to default on more than $13 billion in foreign debt in 1999 alone. Ecuador’s president moved quickly to propose dollarization to save the failing Ecuadorian economy.

Exhibit 2.8 Ecuadorian Sucre/U.S. Dollar Exchange Rate Sucre  1.00 USD 26,000

Sucre fixed at 25,000 to 1.00 USD

22,000

18,000

14,000

10,000

-9 9 Ap r-9 9 M ay -9 9 Ju n99 Ju l-9 9 Au g99 Se p99 O ct -9 9 N ov -9 9 D ec -9 9 Ja n00 Fe b00 M ar -0 0 Ap r-0 0 M ay -0 0 Ju n00

ar

M

b99

99

Fe

8

Ja n-

ec -9

D

N

ov -

98

6,000

Chapter 2   The International Monetary System

41

By January 2000, when the next president took office (after a rather complicated military coup and subsequent withdrawal), the sucre had fallen in value to Sucre25,000/$. The new president continued the dollarization initiative. Although unsupported by the U.S. government and the IMF, Ecuador completed its replacement of its own currency with the dollar over the next nine months. The results of dollarization in Ecuador are still unknown. Today, many years later, Ecuador continues to struggle to find both economic and political balance with its new currency regime.

Currency Regime Choices for Emerging Markets There is no doubt that for many emerging markets the choice of a currency regime may lie somewhere between the extremes of a hard peg (a currency board or dollarization) or freefloating. However, many experts have argued for years that the global financial marketplace will drive more and more emerging market nations toward one of these extremes. As shown in Exhibit 2.9, there is a distinct lack of middle ground between rigidly fixed and free-floating extremes. But is the so-called “bi-polar choice” inevitable? There is general consensus that three common features of emerging market countries make any specific currency regime choice difficult: 1) weak fiscal, financial, and monetary institutions; 2) tendencies for commerce to allow currency substitution and the denomination of liabilities in dollars; and 3) the emerging market’s vulnerability to sudden stoppages of outside capital flows. Calvo and Mishkin may have said it best:3

Exhibit 2.9 Regime Choices for Emerging Markets Emerging Market Country High capital mobility is forcing emerging market nations to choose between two extremes

Free-Floating Regime Currency value is free to float up and down with international market forces Independent monetary policy and free movement of capital allowed, but at the loss of stability Increased volatility may be more than what a small country with a small financial market can withstand

Currency Board or Dollarization Currency board fixes the value of local currency to another currency or basket; dollarization replaces the currency with the U.S. dollar Independent monetary policy is lost; political influence on monetary policy is eliminated Seignorage, the benefits accruing to a government from the ability to print its own money, is lost

“The Mirage of Exchange Rate Regimes for Emerging Market Countries,” Guillermo A. Calvo and Frederic S. Mishkin, The Journal of Economic Perspectives, Vol. 17, No. 4, Autumn 2003, pp. 99–118. 3

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PART 1  Global Financial Environment

Indeed, we believe that the choice of exchange rate regime is likely to be one second order importance to the development of good fiscal, financial and monetary institutions in producing macroeconomic success in emerging market countries. Rather than treating the exchange rate regime as a primary choice, we would encourage a greater focus on institutional reforms like improved bank and financial sector regulation, fiscal restraint, building consensus for a sustainable and predictable monetary policy and increasing openness to trade. In anecdotal support of this argument, a poll of the general population in Mexico in 1999 indicated that 9 out of 10 people would prefer dollarization over a floating-rate peso. Clearly, many in the emerging markets have little faith in their leadership and institutions to implement an effective exchange rate policy.

Globalizing the Chinese Renminbi Logically, it would be reasonable to expect China to make the RMB fully convertible before embarking on the ultimate goal of internationalizing the currency. But China appears to have put “the horse before the cart” by creating an offshore market to promote the currency’s use in international trade and investments first. And this offshore trade has taken the lead over the onshore market. —“RMB to Be a Globally Traded Currency by 2015,” John McCormick, RBS, in the May 3, 2013 China Briefing.

The Chinese renminbi (RMB) or yuan (CNY) is going global.4 Although trading in the RMB is closely controlled by the People’s Republic of China (PRC)—with all trading inside China between the RMB and foreign currencies (primarily the U.S. dollar) being conducted only according to Chinese regulations—its reach is spreading. The RMB’s value, as illustrated in Exhibit 2.10, has been carefully controlled but allowed to gradually revalue against the dollar. It is now quickly moving toward what most think is an inevitable role as a true international currency.

Two-Market Currency Development The RMB continues to develop along a segmented onshore/offshore two-market structure regulated by the PRC, as seen in Exhibit 2.11. The onshore market (carrying the official ISO code for the Chinese RMB, CNY) is a two-tier market, with retail exchange and an interbank wholesale exchange. The currency has, since mid-2005, been a managed float regime. Internally, the currency is traded through the China Foreign Exchange Trade System (CFETS), in which the People’s Bank of China sets a daily central parity rate against the dollar (­ fixing). Actual trading is allowed to range within {1% of the parity rate on a daily basis. This internal market continues to be gradually deregulated, with banks now being allowed to exchange negotiable certificates of deposit amongst themselves, with fewer and fewer interest rate restrictions. Nine different currencies are traded daily in the market against the RMB and themselves. The offshore market for the RMB has grown out of a Hong Kong base (accounts labeled CNH, an unofficial symbol). This offshore market has enjoyed preferred access to the onshore market by government regulators, both in acquiring funds and re-injecting The People’s Republic of China officially recognizes the terms renminbi (RMB) and yuan (CNY) as names of its ­official currency. Yuan is used in reference to the unit of account, while the physical currency is termed the renminbi.

4

Chapter 2   The International Monetary System

Exhibit 2.10 The Gradual Revaluation of the RMB RMB = 1.00 USD 9.50 Value fixed at RMB8.28 = USD1.0

People’s Bank of China announces it is abandoning its peg to the U.S. dollar on July 21, 2005

8.50 Continuation of a “managed floating exchange rate regime” translating into a gradual revaluation of the RMB against the dollar

8.00 7.50 7.00 6.50 6.00 5.50

Ja n Au -94 g M -94 ar O -95 ct M -95 ay D -96 ec Ju -96 l Fe -97 bSe 98 p Ap -98 r N -99 ov Ju -99 n Ja -00 n Au -01 gM 01 ar O -02 ct M -02 ay D -03 ec Ju -03 l Fe -04 bSe 05 p Ap -05 r N -06 ov Ju -06 n Ja -07 n Au -08 gM 08 ar O -09 ct M -09 ay D -10 ec Ju -10 l Fe -11 bSe 12 p Ap -12 r N -13 ov -1 3

5.00

Exhibit 2.11 Structure of the Chinese Renminbi Market China Onshore Market (CNY) Restricted exchange of currency in and out of the onshore market Backflow to onshore Hong Kong Offshore Market (CNH)

Hong Kong-based banks have preferred access to RMB for trade financing (imports and exports).

Corporate bond issues in RMB growing, the Panda Bond or Dim Sum Market RMB Qualified Foreign Institutional Investors gaining greater access to onshore financial deposits Expansion of offshore market to Singapore, Macau, and Taiwan, with trading hubs in London, Sydney, and Seoul

Exchange of RMB in and out of the onshore market continues to be heavily controlled and restricted. But RMB-denominated trade has risen to more than 16% of all foreign trade settlement.

43

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PART 1  Global Financial Environment

funds (termed backflow). Growth in this market has been fueled by the issuance of RMB-­ denominated debt, so-called Panda Bonds, by McDonald’s Corporation, Caterpillar, and the World Bank, among others. Hong Kong-based institutional investors are now allowed access to onshore financial deposits (interest bearing), allowing a stronger use of these offshore deposits. The PRC also continues to promote the expansion of the offshore market to other major regional and global financial centers like Singapore and London.

Theoretical Principles and Practical Concerns As the world’s largest commercial trader and second-largest economy, it is inevitable that the currency of China become an international currency. But there is a variety of degrees of internationalization. First and foremost, an international currency must become readily accessible for trade (this is technically described as Current Account use, to be described in detail in the next chapter). As noted in Exhibit 2.11, it is estimated that more than 16% of all Chinese trade is now denominated in RMB, which although small, is a radical increase from just 1% a mere four years ago. A Chinese exporter was typically paid in U.S. dollars, and was not allowed to keep those dollar proceeds in any bank account. Exporters were required to exchange all foreign currencies for RMB at the official exchange rate set by the PRC, and to turn them over to the Chinese government (resulting in a gross accumulation of foreign currency reserves). Now, importers and exporters are encouraged to use the RMB for trade denomination and settlement purposes. A second degree of internationalization occurs with the use of the currency for international investment—capital account/market activity. This is an area of substantial concern and caution for the PRC at this time. The Chinese marketplace is the focus of many of the world’s businesses, and if they were allowed free and open access to the market and its currency there is fear that the value of the RMB could be driven up, decreasing Chinese export competitiveness. Simultaneously, as major capital markets like the dollar and euro head into stages of rising interest rates, there is a concern that large quantities of Chinese savings could flow out of the country in search of higher returns—capital flight. A third degree of internationalization occurs when a currency takes on a role as a reserve currency (also termed an anchor currency), a currency to be held in the foreign exchange reserves of the world’s central banks. The continued dilemma of fiscal deficits in the United States and the European Union has led to growing unease over the ability of the dollar and euro to maintain their value over time. Could, or should, the RMB serve as a reserve currency? Forecasts of the RMB’s share of global reserves vary between 15% and 50% by the year 2020. The Triffin Dilemma.  One theoretical concern about becoming a reserve currency is the Triffin Dilemma (or sometimes called the Triffin Paradox). The Triffin Dilemma is the potential conflict in objectives that may arise between domestic monetary and currency policy objectives and external or international policy objectives when a country’s currency is used as a reserve currency.5 Domestic monetary and economic policies may on occasion require both contraction and the creation of a current account surplus (balance on trade surplus). If a currency rises to the status of a global reserve currency, in which it is considered one of the two or three key stores of value on earth (possibly finding its way into the IMF’s Special Drawing Right [SDR] definition), other countries will require the country to run current account deficits, essentially dumping growing quantities of the currency on global markets. The theory is the namesake of its originator, Belgian-American economist Robert Triffin (1911–1963), who was an outspoken critic of the Bretton Woods Agreement, as well as a strong advocate and collaborated in the development of the European Monetary System (EMS). 5

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45

This means that the country needs to become internationally indebted as part of its role as a reserve currency country. In short, when the world adopts a currency as a reserve currency, demands are placed on the use and availability of that currency, which many countries would prefer not to deal with. In fact, both Japan and Switzerland both worked for decades to prevent their currencies from gaining wider international use, partially because of these complex issues. The Chinese RMB, however, may eventually find that it has no choice—the global market may choose.

Exchange Rate Regimes: What Lies Ahead? All exchange rate regimes must deal with the trade-off between rules and discretion, as well as between cooperation and independence. Exhibit 2.12 illustrates the trade-offs between exchange rate regimes based on rules, discretion, cooperation, and independence. 1. Vertically, different exchange rate arrangements may dictate whether a country’s government has strict intervention requirements (rules) or if it may choose whether, when, and to what degree to intervene in the foreign exchange markets (discretion). 2. Horizontally, the trade-off for countries participating in a specific system is between consulting and acting in unison with other countries (cooperation) or operating as a member of the system, but acting on their own (independence). Regime structures like the gold standard required no cooperative policies among countries, only the assurance that all would abide by the “rules of the game.” Under the gold standard, in effect prior to World War II, this assurance translated into the willingness of governments to buy or sell gold at parity rates on demand. The Bretton Woods Agreement, the system in place between 1944 and 1973, required more in the way of cooperation, in that

Exhibit 2.12 Exchange Rate Regime Trade-Offs Policy Rules Bretton Woods

Pre-WWII Gold Standard

European Monetary System 1979–1999 Cooperation between Countries

Non-Cooperation between Countries

The Future? U.S. Dollar, 1981–1985 Discretionary Policy

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PART 1  Global Financial Environment

gold was no longer the “rule,” and countries were required to cooperate to a higher degree to maintain the dollar-based system. Exchange rate systems, like the European Monetary System’s (EMS) fixed exchange rate band system used from 1979 to 1999, were hybrids of these cooperative and rule regimes. The present international monetary system is characterized by no rules, with varying degrees of cooperation. Although there is no present solution to the continuing debate over what form a new international monetary system should take, many believe that it will succeed only if it combines cooperation among nations with individual discretion to pursue domestic social, economic, and financial goals.

Summary Points ■

Under the gold standard (1876–1913), the “rules of the game” were that each country set the rate at which its currency unit could be converted to a weight of gold.

■

During the inter-war years (1914–1944), currencies were allowed to fluctuate over fairly wide ranges in terms of gold and each other. Supply and demand forces determined exchange rate values.

■

The Bretton Woods Agreement (1944) established a U.S. dollar-based international monetary system. Under the original provisions of the Bretton Woods Agreement, all countries fixed the value of their currencies in terms of gold but were not required to exchange their currencies for gold. Only the dollar remained convertible into gold (at $35 per ounce).

■

A variety of economic forces led to the suspension of the convertibility of the dollar into gold in August 1971. Exchange rates of most of the leading trading countries were then allowed to float in relation to the dollar and thus indirectly in relation to gold.

■

If the ideal currency existed in today’s world, it would possess three attributes: a fixed value, convertibility,

and independent monetary policy. However, in both theory and practice, it is impossible for all three attributes to be simultaneously maintained. ■

Emerging market countries must often choose between two extreme exchange rate regimes: a free-floating regime or an extremely fixed regime, such as a currency board or dollarization.

■

The members of the European Union are also members of the European Monetary System (EMS). This group has tried to form an island of fixed exchange rates among themselves in a sea of major floating currencies. Members of the EMS rely heavily on trade with each other, so the day-to-day benefits of fixed exchange rates between them are perceived to be great.

■

The euro affects markets in three ways: 1) Countries within the eurozone enjoy cheaper transaction costs; 2) Currency risks and costs related to exchange rate uncertainty are reduced; and 3) All consumers and businesses both inside and outside the eurozone enjoy price transparency and increased price-based competition.

Mini-Case

Mini-Case: Russian Ruble Roulette1 The Russian ruble has experienced a multitude of regime shifts since the opening of the Russian economy under ­Perestroika in 1991.2 After a number of years of a highly controlled official exchange rate accompanied by tight capital controls, the 1998 economic crisis prompted a movement to a heavily managed float. Using both direct intervention

and interest rate policy, the ruble held ­surprisingly steady until 2008. But all of that stopped in 2008 when the global credit crisis, which started in the United States, spread to Russia. As illustrated by Exhibit A, the impact on the value of the ruble proved disastrous. In an effort to protect the value of the ruble, the Bank of Russia spent $200 billion—a full one-third of its foreign exchange reserves—throughout 2008 and into 2009.

Copyright © 2014 Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Michael H. Moffett for the purpose of classroom discussion only and not to indicate either effective or ineffective management. 2 There is no established correct English spelling for the Russian currency—the ruble or the rouble. There is a ­journalistic tradition that most North American publications use ruble, while European organizations favor rouble, as does the Oxford English Dictionary. 1

Chapter 2   The International Monetary System

47

Exhibit A Russian Ruble/U.S. Dollar Exchange Rate Rubles = 1.00 USD (monthly average) 36 Feb 2009: Bank of Russia launches a dual-currency Floating-band for management of the ruble

34 32 30

Financial Crisis causes fall in the value of the ruble

28 26 24

Ja

n0 Ap 7 r-0 Ju 7 l-0 O 7 ct -0 Ja 7 n0 Ap 8 r-0 Ju 8 l-0 O 8 ct -0 Ja 8 n0 Ap 9 r-0 Ju 9 l-0 O 9 ct -0 Ja 9 n1 Ap 0 r-1 Ju 0 l-1 O 0 ct -1 Ja 0 n1 Ap 1 r-1 Ju 1 l-1 O 1 ct -1 Ja 1 n1 Ap 2 r-1 Ju 2 l-1 O 2 ct -1 Ja 2 n1 Ap 3 r-1 Ju 3 l-1 O 3 ct -1 3

22

Although the market began to calm in early 2009, the Bank decided to introduce a new more flexible exchange rate regime for the management of the ruble. The new system was a dual-currency floating rate band for the ruble. A dual-currency basket was formed from two currencies, the U.S. dollar (55%) and the euro (45%), for the calculation of the central ruble rate. Around this basket rate, a neutral zone was established in which no currency intervention would be undertaken. This initial neutral zone was 1.00 ruble versus the basket. Around the neutral zone, a set of operational band boundaries were established, an upper band and lower band, for intervention purposes. If the ruble remained in the neutral zone, no intervention would be made. If, however, the ruble’s value hit either operational band, the Bank of Russia would intervene by buying rubles (upper band) or selling rubles (lower band) to stabilize its value. The Bank was allowed a maximum of $700 million per day in purchases of rubles. Once hitting that limit, the Bank was to move the band(s) in increments of 5 kopecks (100 kopecks = 1.00 ruble).3 As illustrated in Exhibit  B, the ruble continued to slide (appreciating) against the basket throughout 2009 and into 2010. The dual-currency band was continually adjusted—downward—in an effort to put a

‘moving floor’ underneath the currency. Finally, in late-2010, the ruble stabilized. As part of a continual program to allow the ruble to grow as a global currency, the distance between the upper and lower bands has been repeatedly increased over time. Starting with a floating band (the spread between the upper band and lower band in Exhibit B) that was only 2 rubles per basket value, the band had been continually expanded to reach 7 rubles by early 2014. Unfortunately, and frustratingly for Russian authorities, after a number of years of growing strength the ruble was now growing weaker against the dollar and euro basket. The ruble’s new found relative stability was rewarded in October 2013 when the Bank of Russia announced that it was expanding the neutral ‘no-intervention’ zone from 1 ruble to 3.1 rubles. This was followed by an announcement in January 2014 that the Bank would begin moving to end daily intervention, eventually ending all intervention sometime in 2015. (Daily intervention in recent months had averaged about $60 million, a relatively small amount given history.) If, however, the ruble did hit either of its bands, the Bank acknowledged that it was prepared to reenter the market to preserve stability. The impetus for moving to a freely-floating ruble was to both allow the changes in the currency’s value to “absorb”

The daily foreign exchange intervention limit has been adjusted downwards a number of times since the dual-currency band was ­instituted. In January 2014 the limit had contracted to $350 million per day. 3

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PART 1  Global Financial Environment

Exhibit B Russian Ruble Floating Band Rubles versus dual-currency basket 42 Upper Band

40 38

DualCurrency Basket

36 34 32 Lower Band

Ja nM 09 ar M 09 ay Ju 09 l-0 Se 9 pN 09 ov Ja 09 nM 10 ar M 10 ay Ju 10 l-1 Se 0 pN 10 ov Ja 10 nM 11 ar M 11 ay Ju 11 l-1 Se 1 pN 11 ov Ja 11 nM 12 ar M 12 ay Ju 12 l-1 Se 2 pN 12 ov Ja 12 nM 13 ar M 13 ay Ju 13 l-1 Se 3 pN 13 ov Ja 13 n14

30

Dual-currency basket calculated by authors (monthly average exchange rates).

global economic changes, and allow the central bank to increase its focus on controlling inflationary forces. ­Russian inflation has been stubbornly high in recent years, and with the U.S. Federal Reserve announcing that it would be slowing/stopping its loose money policy in the wake of the financial crisis of 2008–2009, inflationary pressures were sure to continue. The Bank of Russia was clearly continuing to implement its long-term currency strategy, which had first been put inplace back in 2009. It obviously believed that if it increasingly targeted inflation rather the ruble’s exchange value, the long-term economic prospects for Russia and the ruble would be improved, and the ruble could move from being a

simple “emerging market currency” to a regional currency, and ultimately, someday, a reserve currency.

Questions

3. Fixed versus Flexible. What are the advantages and disadvantages of fixed exchange rates? 4. The Impossible Trinity. Explain what is meant by the term impossible trinity and why it is in fact “impossible.” 5. Currency Board or Dollarization. Fixed exchange rate regimes are sometimes implemented through a currency board (Hong Kong) or dollarization (Ecuador). What is the difference between the two approaches?

1. The Gold Standard and the Money Supply. Under the gold standard, all national governments promised to follow the “rules of the game.” This meant defending a fixed exchange rate. What did this promise imply about a country’s money supply? 2. Causes of Devaluation. If a country follows a fixed exchange rate regime, what macroeconomic variables could cause the fixed exchange rate to be devalued?

Case Questions 1. How would you classify the exchange rate regime used by Russia for the ruble over the 1991–2014 period? 2. What did the establishment of operational bands do to the expectations of ruble speculators? Would these expectations be stabilizing or destabilizing in your opinion? 3. What would a depreciating ruble mean for Russia’s commercial trade and its war on inflation?

Chapter 2   The International Monetary System

6. Emerging Market Regimes. High capital mobility is forcing emerging market nations to choose between free-floating regimes and currency board or dollarization regimes. What are the main outcomes of each of these regimes from the perspective of emerging market nations? 7. Argentine Currency Board. How did the Argentine currency board function from 1991 to January 2002 and why did it collapse? 8. The Euro. On January 4, 1999, 11 member states of the European Union initiated the European Monetary Union (EMU) and established a single currency, the euro, which replaced the individual currencies of participating member states. Describe three of the main ways that the euro affects the members of the EMU. 9. Mavericks. The United Kingdom, Denmark, and Sweden have chosen not to adopt the euro but rather to maintain their individual currencies. What are the motivations of each of these three European Union member countries? 10. International Monetary Fund (IMF). The IMF was established by the Bretton Woods Agreement (1944). What were the original objectives of the IMF? 11. Special Drawing Rights. What are Special Drawing Rights? 12. Exchange Rate Regime Classifications. The IMF classifies all exchange rate regimes into four specific categories that are summarized in this chapter. Under which exchange rate regime would you classify the following countries? a. France b. The United States c. Japan d. Thailand 13. The Ideal Currency. What are the attributes of the ideal currency? 14. Bretton Woods Failure. Why did the fixed exchange rate regime of 1945–1973 eventually fail?

Problems 1. DuBois and Keller. Chantal DuBois lives in Brussels. She can buy a U.S. dollar for €0.7600. Christopher Keller, living in New York City, can buy a euro for $1.3200. What is the foreign exchange rate between the dollar and the euro? 2. Amazing Incorporated. The spot rate for ­Mexican pesos is Ps12.42/$. If the U.S.-based company A ­ mazing Inc. buys Ps500,000 spot from its bank on Monday, how much must Amazing Inc. pay and on what date?

49

3. Gilded Question. Before World War I, $20.67 was needed to buy one ounce of gold. If, at the same time, one ounce of gold could be purchased in France for FF410.00, what was the exchange rate between French francs and U.S. dollars? 4. Worth Its Weight in Gold. Under the gold standard, the price of an ounce of gold in U.S. dollars was $20.67, while the price of that same ounce in British pounds was £3.7683. What would be the exchange rate between the dollar and the pound if the U.S. dollar price had been $42.00 per ounce of gold? 5. Toyota Exports to the United Kingdom. Toyota manufactures in Japan most of the vehicles it sells in the United Kingdom. The base platform for the Toyota Tundra truck line is ¥1,650,000. The spot rate of the Japanese yen against the British pound has recently moved from ¥197/£ to ¥190/£. How does this change the price of the Tundra to Toyota’s British subsidiary in British pounds? 6. Loonie Parity. If the price of former Chairman of the U.S. Federal Reserve Alan Greenspan’s memoir, The Age of Turbulence, is listed on Amazon.ca as C$26.33, but costs just US$23.10 on Amazon.com, what exchange rate does that imply between the two currencies? 7. Mexican Peso Changes. In December 1994, the government of Mexico officially changed the value of the Mexican peso from 3.2 pesos per dollar to 5.5 pesos per dollar. What was the percentage change in its value? Was this a depreciation, devaluation, appreciation, or revaluation? Explain. 8. Hong Kong Dollar and the Chinese Yuan. The Hong Kong dollar has long been pegged to the U.S. dollar at HK$7.80/$. When the Chinese yuan was revalued in July 2005 against the U.S. dollar from Yuan8.28/$ to Yuan8.11/$, how did the value of the Hong Kong dollar change against the yuan? 9. Chinese Yuan Revaluation. Many experts believe that the Chinese currency should not only be revalued against the U.S. dollar as it was in July 2005, but also be revalued by 20% or 30%. What would be the new exchange rate value if the yuan was revalued an additional 20% or 30% from its initial post-revaluation rate of Yuan8.11/$? 10. Ranbaxy (India) in Brazil. Ranbaxy, an India-based pharmaceutical firm, has continuing problems with its cholesterol reduction product’s price in one of its rapidly growing markets, Brazil. All product is produced in India, with costs and pricing initially stated in Indian rupees (Rps), but converted to Brazilian reais (R$) for distribution and sale in Brazil. In 2009, the unit volume was priced at Rps21,900, with a Brazilian reais price set at R$895. But in 2010, the reais appreciated in value

50

PART 1  Global Financial Environment

versus the rupee, averaging Rps26.15/R$. In order to preserve the reais price and product profit margin in rupees, what should the new rupee price be set at? 11. Vietnamese Coffee Coyote. Many people were ­surprised when Vietnam became the second ­largest coffee producing country in the world in recent years, second only to Brazil. The ­V ietnamese dong, VND or d, is managed against the U.S. ­dollar but is not widely traded. If you were a traveling ­coffee buyer for the wholesale market (a “coyote” by industry terminology), which of the ­f ollowing ­currency rates and exchange commission fees would be in your best interest if traveling to V ­ ietnam on a buying trip? 12. Chunnel Choices. The Channel Tunnel or ­“Chunnel” passes underneath the English Channel between Great Britain and France, a land-link between the Continent and the British Isles. One side is therefore an economy of British pounds, the other euros. If you were to check the Chunnel’s rail ticket Internet rates you would find that they would be denominated in U.S. dollars (USD). For example, a first class round trip fare for a single adult from London to Paris via the Chunnel through RailEurope may cost USD170.00. This currency neutrality, however, means that customers on both ends of the Chunnel pay differing rates in their home currencies from day to day. What is the British pound and euro denominated prices for the USD170.00 round trip fare in local currency if purchased on the following dates at the accompanying spot rates drawn from the Financial Times? British Pound Spot Rate (£/$)

Euro Spot Rate (€/$)

Monday

0.5702

0.8304

Tuesday

0.5712

0.8293

Wednesday

0.5756

0.8340

Date of Spot Rate

13. Middle East Exports. Oriol Díez Miguel S.R.L., a manufacturer of heavy duty machine tools near ­Barcelona, ships an order to a buyer in Jordan. The purchase price is €425,000. Jordan imposes a 13%

import duty on all products purchased from the European Union. The Jordanian importer then re-exports the product to a Saudi Arabian importer, but only after imposing its own resale fee of 28%. Given the following spot exchange rates on April 11, 2010, what is the total cost to the Saudi Arabian importer in Saudi Arabian riyal, and what is the U.S. dollar equivalent of that price?

Internet Exercises 1. International Monetary Fund’s Special Drawing Rights. Use the IMF’s Web site to find the current weights and valuation of the SDR. International Monetary Fund www.imf.org/external/np/ tre/sdr/sdrbasket.htm

2. Malaysian Currency Controls. The institution of currency controls by the Malaysian government in the aftermath of the Asian currency crisis is a classic response by government to unstable currency conditions. Use the following Web site to increase your knowledge of how currency controls work. International Monetary Fund www.imf.org/external/pubs/ ft/bl/rr08.htm

3. Personal Transfers. As anyone who has traveled internationally learns, the exchange rates available to private retail customers are not always as attractive as those accessed by companies. The OzForex Web site possesses a section on “customer rates” that illustrates the difference. Use the site to calculate what the percentage difference between Australian dollar/U.S. dollar spot exchange rates are for retail customers versus interbank rates. OzForex www.ozforex.com.au/ exchange-rate

4. Exchange Rate History. Use the Pacific Exchange Rate database and plot capability to track value changes of the British pound, the U.S. dollar, and the Japanese yen against each other over the past 15 years. Pacific Exchange Rate Service fx.sauder.ubc.ca

The Balance of Payments The sort of dependence that results from exchange, i.e., from commercial transactions, is a reciprocal dependence. We cannot be dependent upon a foreigner without his being dependent on us. Now, this is what constitutes the very essence of society. To sever natural interrelations is not to make oneself independent, but to isolate oneself completely.  —Frederic Bastiat.

CHAPTER

3

Learning Objectives ■

Learn how nations measure their own levels of international economic activity, and how that activity is measured by the balance of payments

■

Examine the economic relationships underlying the two basic subcomponents of the balance of payments—the current account and financial account balances

■

Consider the financial dimensions of international economic activity, and how they ­differ between merchandise and services trade

■

Identify balance of payment activities by nations in the pursuit of domestic economic and political policies

■

Examine how exchange rate changes and volatility influence trade balances over time

■

Evaluate the history of capital mobility, and the conditions that lead, in times of crisis, to capital flight

The measurement of all international economic transactions that take place between the residents of a country and foreign residents is called the balance of payments (BOP). This chapter provides a sort of navigational map to aid in understanding the balance of payments and the multitude of economic, political, and business issues that it involves. But our emphasis is far from descriptive, as a deep understanding of trade and capital flows is integral to the management of multinational enterprises. In fact, the second half of the chapter emphasizes a more detailed analysis of how elements of the balance of payments affect trade volumes and prices, as well as how capital flows, capital controls, and capital flight alter the cost and ability to do business internationally. The chapter concludes with a Mini-Case, Global Remittances, which is an area of the current account that has only recently been explored in depth by governments as they try to monitor and sometimes control capital flows. Home-country and host-country BOP data are important to business managers, investors, consumers, and government officials because the data simultaneously influences and is influenced by other key macroeconomic variables, such as gross domestic product (GDP), employment levels, price levels, exchange rates, and interest rates. Monetary and fiscal policy must take the BOP into account at the national level. Business managers and investors need 51

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PART 1  Global Financial Environment

BOP data to anticipate changes in host-country economic policies that might be driven by BOP events. BOP data is also important for the following reasons: ■

■

■

The BOP is an important indicator of pressure on a country’s foreign exchange rate, and thus of the potential for a firm trading with or investing in that country to experience foreign exchange gains or losses. Changes in the BOP may predict the imposition or removal of foreign exchange controls. Changes in a country’s BOP may signal the imposition or removal of controls over payment of dividends and interest, license fees, royalty fees, or other cash disbursements to foreign firms or investors. The BOP helps to forecast a country’s market potential, especially in the short run. A country experiencing a serious trade deficit is not as likely to expand imports as it would be if running a surplus. It may, however, welcome investments that increase its exports.

Typical Balance of Payments Transactions International transactions take many forms. Each of the following examples is an international economic transaction that is counted and captured in the U.S. balance of payments: ■

■

■ ■

■

A U.S.-based firm, Fluor Corporation, manages the construction of a major water treatment facility in Bangkok, Thailand. The U.S. subsidiary of a French firm, Saint Gobain, pays profits back to its parent firm in Paris. An American tourist purchases a small Lapponia necklace in Finland. The U.S. government finances the purchase of military equipment for its military ally, Norway. A Mexican lawyer purchases a U.S. corporate bond through an investment broker in Cleveland.

This is a small sample of the hundreds of thousands of international transactions that occur each year. The BOP provides a systematic method for classifying these transactions. This rule of thumb always aids the understanding of BOP accounting: Follow the cash flow. The BOP is composed of a number of subaccounts that are watched quite closely by groups as diverse as investment bankers, farmers, politicians, and corporate executives. These groups track and analyze the major subaccounts—the current account, the capital account, and the financial account—continually.

Fundamentals of BOP Accounting The BOP must balance. If it does not, something has not been counted or has been counted improperly. Therefore, it is incorrect to state that “the BOP is in disequilibrium.” It cannot be. The supply and demand for a country’s currency may be imbalanced, but that is not the same thing as the BOP. A subacccount of the BOP, such as the balance on goods and services (a subaccount of any country’s current account), may be imbalanced (in surplus or deficit), but the entire BOP of a single country is always balanced. Exhibit 3.1 illustrates that the BOP does indeed balance, in this case for the United States from 2005 through 2012. The five balances listed in Exhibit 3.1—current account, capital account, financial account, net errors and omissions, and reserves and related—do indeed sum to zero.

53

Chapter 3   The Balance of Payments

Exhibit 3.1 The U.S. Balance of Payments Accounts, Summary Balance

2005

2006

2007

2008

2009

2010

2011

2012

Current Account Balance

- 740

- 798

- 713

- 681

- 382

- 449

- 458

- 440

Capital Account Balance

13

-2

0

6

0

0

-1

7

687

807

617

735

283

440

568

444

Net Errors and Omissions

26

-9

96

- 55

151

11

- 93

-6

Official Reserves Account

14

2

0

-5

- 52

-2

- 16

-5

Financial Account Balance

Source: Balance of Payments Statistics Yearbook: 2013, International Monetary Fund, December 2013.

There are three main elements of the actual process of measuring international economic activity: 1) identifying what is and is not an international economic transaction; 2) understanding how the flow of goods, services, assets, and money creates debits and credits to the overall BOP; and 3) understanding the bookkeeping procedures for BOP accounting.

Defining International Economic Transactions Identifying international transactions is ordinarily not difficult. The export of merchandise— goods such as trucks, machinery, computers, telecommunications equipment, and so forth—is obviously an international transaction. Imports such as French wine, Japanese cameras, and German automobiles are also clearly international transactions. But this merchandise trade is only a portion of the thousands of different international transactions that occur in the United States and other countries each year. Many other international transactions are not so obvious. The purchase of a good, like a glass figure in Venice, Italy, by a U.S. tourist is classified as a U.S. merchandise import. In fact, all expenditures made by U.S. tourists around the globe for services provided by, for example, restaurants and hotels are recorded in the U.S. balance of payments as imports of travel services in the current account.

The BOP as a Flow Statement The BOP is often misunderstood because many people infer from its name that it is a balance sheet, whereas in fact it is a cash flow statement. By recording all international transactions over a period of time such as a year, the BOP tracks the continuing flows of purchases and payments between a country and all other countries. It does not add up the value of all assets and liabilities of a country on a specific date like a balance sheet does for an individual firm (that is, in fact, the Net International Investment position of a country, described in a later section). Two types of business transactions dominate the balance of payments: 1. Exchange of real assets. The exchange of goods (e.g., automobiles, computers, textiles) and services (e.g., banking, consulting, and travel services) for other goods and services (barter) or for money 2. Exchange of financial assets. The exchange of financial claims (e.g., stocks, bonds, loans, and purchases or sales of companies) for other financial claims or money Although assets can be identified as real or financial, it is often easier to think of all assets as goods that can be bought and sold. The purchase of a hand-woven area rug in a shop in Bangkok by a U.S. tourist is not all that different from a Wall Street banker buying a British government bond for investment purposes.

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PART 1  Global Financial Environment

BOP Accounting The measurement of all transactions in and out of a country is a daunting task. Mistakes, errors, and statistical discrepancies will occur. The primary problem is that double-entry bookkeeping is employed in theory, but not in practice. Individual purchase and sale transactions should—in theory—result in financing entries in the balance of payments that match. In reality, current, capital, and financial account entries are recorded independently of one another, not together as double-entry bookkeeping would prescribe. Thus, there will be discrepancies (to use a nice term for it) between debits and credits.

The Accounts of the Balance of Payments The balance of payments is composed of three major subaccounts: the current account, the capital account, and the financial account. In addition, the official reserves account tracks government currency transactions, and a fifth statistical subaccount, the net errors and omissions account, is produced to preserve the balance in the BOP.

The Current Account The current account includes all international economic transactions with income or payment flows occurring within the year, the current period. The current account consists of four subcategories:







1. Goods trade.  The export and import of goods is known as the goods trade. Merchandise trade is the oldest and most traditional form of international economic activity. Although many countries depend on imports of goods (as they should, according to the theory of comparative advantage), they also normally work to preserve either a balance of goods trade or even a surplus. 2. Services trade.  The export and import of services is known as the services trade. Common international services are financial services provided by banks to foreign importers and exporters, travel services of airlines, and construction services of domestic firms in other countries. For the major industrial countries, this subaccount has shown the fastest growth in the past decade. 3. Income.  This is predominantly current income associated with investments that were made in previous periods. If a U.S. firm created a subsidiary in South Korea to produce metal parts in a previous year, the proportion of net income that is paid back to the parent company in the current year (the dividend) constitutes current investment income. Additionally, wages and salaries paid to nonresident workers are also included in this category. 4. Current transfers.  The financial settlements associated with the change in ownership of real resources or financial items are called current transfers. Any transfer between countries that is one-way—a gift or grant—is termed a current transfer. For example, funds provided by the U.S. government to aid in the development of a less-developed nation would be a current transfer. Transfer payments made by migrant or guest workers back to their home countries, the subject of this chapter’s Mini-Case, is another example of a current transfer. All countries possess some amount of trade, most of which is merchandise. Many lessdeveloped countries have little in the way of service trade, or items that fall under the income or transfers subaccounts. The current account is typically dominated by the first component described, the export and import of merchandise. For this reason, the balance of trade (BOT),

Chapter 3   The Balance of Payments

55

which is so widely quoted in the business press, refers to the balance of exports and imports of goods trade only. If the country is a larger industrialized country, however, the BOT is somewhat misleading, in that service trade is not included. Goods Trade.  Exhibit 3.2 presents the two major components of the U.S. current account for the 2000–2012 period: 1) goods trade and 2) services trade and investment income. The first and most striking message is the magnitude of the goods trade deficit. The balance on services and income, although not large in comparison to net goods trade, has run a small but consistent surplus over the past two decades. Merchandise trade is the original core of international trade. The manufacturing of goods was the basis of the industrial revolution and the focus of the theory of comparative advantage in international trade. Manufacturing is traditionally the sector of the economy that employs most of a country’s workers. Declines in the U.S. BOT attributed to specific sectors, such as steel, automobiles, automotive parts, textiles, and shoe manufacturing, caused massive economic and social disruption. Understanding merchandise import and export performance is much like understanding the market for any single product. The demand factors that drive both are income, the economic growth rate of the buyer, and price of the product in the eyes of the consumer after passing through an exchange rate. U.S. merchandise imports reflect the income level of U.S. consumers and growth of industry. As income rises, so does the demand for imports.

Exhibit 3.2 U.S. Trade Balances on Goods and Services Billions of U.S. dollars $300 $200 $100 $0 –$100 –$200 –$300 –$400 –$500 –$600 –$700 –$800

19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12

–$900

Balance on Goods

Balance on Services

Source: Balance of Payments Statistics Yearbook: 2013, International Monetary Fund, December 2013, p. 1032.

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PART 1  Global Financial Environment

Exports follow the same principles, but in the reverse. U.S. manufacturing exports depend not on the incomes of U.S. residents, but on the incomes of buyers of U.S. products in all other countries around the world. When these economies are growing, the demand for U.S. products is growing. As illustrated in Exhibit 3.2, the United States has consistently run a surplus in services trade income. The major categories of services include travel and passenger fares; transportation services; expenditures by U.S. students abroad, foreign students studying in the U.S.; telecommunications services; and financial services.

The Capital and Financial Accounts The capital and financial accounts of the balance of payments measure all international economic transactions of financial assets. The capital account is made up of transfers of financial assets and the acquisition and disposal of nonproduced/nonfinancial assets. This account has been introduced as a separate component in the IMF’s balance of payments only recently. The magnitude of capital transactions covered by the Capital Account is relatively minor, and we will include it in principle in all of the following discussions of the financial account. But as noted in Global Finance in Practice 3.1, some mysteries in global accounts remain!

Financial Account The financial account consists of four components: direct investment, portfolio investment, net financial derivatives, and other asset investment. Financial assets can be classified in a number of different ways, including by the length of the life of the asset (its maturity) and the nature of the ownership (public or private). The financial account, however, uses degree of control over assets or operations to classify financial assets. Direct investment is defined as investment that has a long-term life or maturity and in which the investor exerts some explicit degree of control over the assets. In contrast, portfolio investment is defined as both short-term in maturity and as an investment in which the investor has no control over the assets.

Global Finance in Practice

3.1

The Global Current Account Surplus There are three kinds of lies: lies, damned lies and statistics. —Author unknown, though frequently attributed to Lord Courtney, Sir Charles Dilke, or Mark Twain.

One country’s surplus is another country’s deficit. That is, individual countries may and do run current account deficits and surpluses, but it should be, theoretically, a zero sum game. But according to the IMF’s most recent World Economic Outlook, however, the world is running a current account surplus. At least that is what the statistics say.* The rational explanation is that the statistics, as reported to the IMF by its member countries, are in error. The errors are most likely both accidental and intentional. The IMF believed for many years that the most likely explanation was under-reporting of foreign investment income by

residents of the wealthier industrialized countries, as well as under-reporting of transportation and freight charges. Many alternative explanations focus on intentional misreporting of international current account activities. Over- or under-invoicing has long been a ploy used in international trade to avoid taxes, capital controls, or purchasing restrictions. Other arguments, like under-reporting of foreign income for tax avoidance and the complexity of intra-­ company transactions and transfer prices, are all potential partial explanations. But in the end, while the theory says it can’t be, the numbers say it is. As noted by the Economist, planet Earth appears to be running a current account surplus in its trade with extraterrestrials (“Are aliens buying Louis ­Vuitton handbags?”).** *World Economic Outlook: Slowing Growth, Rising Risks, International Monetary Fund, September 2011. **Economics Focus, Exports to Mars,“ The Economist, November 12, 2011, p. 90.

Chapter 3   The Balance of Payments

57

Direct Investment.  This investment measure is the net balance of capital dispersed from and into a country like the United States for the purpose of exerting control over assets. If a U.S. firm builds a new automotive parts facility in another country or purchases a company in another country, this is a direct investment in the U.S. balance of payments accounts. When the capital flows out of the U.S., it enters the balance of payments as a negative cash flow. If, however, a foreign firm purchases a firm in the U.S., it is a capital inflow and enters the balance of payments positively. Foreign resident purchases of assets in a country are always somewhat controversial. The focus of concern over foreign investment in any country, including the United States, is on two issues: control and profit. Some countries place restrictions on what foreigners may own in their country. This rule is based on the premise that domestic land, assets, and industry in general should be owned by residents of the country. The U.S., however, has traditionally had few restrictions on what foreign residents or firms can own or control in the country (with the exception of national security concerns). Unlike the case in the traditional debates over whether international trade should be free, there is no consensus on international investment. The second major focus of concern over foreign direct investment is who receives the profits from the enterprise. Foreign companies owning firms in the U.S. will ultimately profit from the activities of those firms—or to put it another way, foreign companies will profit from the efforts of U.S. workers. In spite of evidence that indicates foreign firms in the U.S. reinvest most of their profits in their U.S. businesses (in fact, at a higher rate than do domestic firms), the debate on possible profit drains has continued. Regardless of the actual choices made, workers of any nation feel that the profits of their work should remain in their own hands in their own country. The choice of words used to describe foreign investment can also influence public opinion. If these massive capital inflows are described as “capital investments from all over the world showing their faith in the future of U.S. industry,” the net capital surplus is represented as decidedly positive. If, however, the net capital surplus is described as resulting in “the United States being the world’s largest debtor nation,” the negative connotation is obvious. Both are essentially spins on the economic principles at work. Capital, whether short-term or long-term, flows to where the investor believes it can earn the greatest return for the level of risk. And although in an accounting sense this is “international debt,” when the majority of the capital inflow is in the form of direct investment, a long-term commitment to jobs, production, services, technological, and other ­competitive investments, the impact on the competitiveness of industry located within a country is increased. Net direct investment cash flows for the U.S. are shown in Exhibit 3.3. Portfolio Investment.  This is the net balance of capital that flows into and out of a country but that does not reach the 10% ownership threshold of direct investment. If a U.S. resident purchases shares in a Japanese firm but does not attain the 10% threshold, we define the purchase as a portfolio investment (and an outflow of capital). The purchase or sale of debt securities (like U.S. Treasury bills) across borders is also classified as portfolio investment, because debt securities by definition do not provide the buyer with ownership or control. Portfolio investment is capital invested in activities that are purely profit-motivated (return), rather than activities to control or manage the investment. Purchases of debt securities, bonds, interest-bearing bank accounts, and the like are intended only to earn a return. They provide no vote or control over the party issuing the debt. Purchases of debt issued by the U.S. government (U.S. Treasury bills, notes, and bonds) by foreign investors constitute net portfolio investment in the United States. It is worth noting that most U.S. debt purchased by foreigners is U.S. dollar-denominated in the currency of the issuing country (dollars). Much of the foreign debt issued by countries such as Russia, Brazil, and Southeast Asian countries

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Exhibit 3.3 The U.S. Financial Accounts Billions of U.S. dollars $800 $700 $600 $500 $400 $300 $200 $100 $0 –$100 –$200

12

11

20

10

20

09

20

08

20

07

20

06

20

05

20

04

20

03

20

02

20

01

20

00

20

99

20

98

Net Direct Investment

19

97

19

96

19

95

19

94

19

93

19

92

19

91

19

90

19

89

19

88

19

87

19

86

19

19

19

85

–$300

Net Portfolio Investment

Source: Balance of Payments Statistics Yearbook: 2013, International Monetary Fund, 2013.

is also U.S. dollar-denominated, and is therefore the currency of a foreign country. The foreign country must then earn dollars to repay its foreign-held debt, typically through exports. As illustrated in Exhibit 3.3, portfolio investment has shown much more volatile behavior than net foreign direct investment has over the past decade. Many U.S. debt securities, such as U.S. Treasury securities and corporate bonds, are consistently in high demand by foreign investors of all kinds. The motivating forces for portfolio investment flows are always the same: return and risk. These same debt securities have also been influential in a different measure of international investment activity, as described in Global Finance in Practice 3.2. Other Asset Investment.  This final component of the financial account consists of various short-term and long-term trade credits, cross-border loans from all types of financial institutions, currency deposits and bank deposits, and other accounts receivable and payable related to cross-border trade. Global Finance in Practice

3.2

A Country’s Net International Investment Position (NIIP) The net international investment position (NIIP) of a country is an annual measure of the assets owned abroad by its citizens, its companies, and its government, less the assets owned by foreigners, public and private, in their

country. Whereas a country’s balance of payments is often described as a country’s international cash flow statement, the NIIP may be interpreted as the country’s international balance sheet. NIIP is a country’s stock of foreign assets minus its stock of foreign liabilities. In the same way company cash flows are related to a company’s balance sheet, the NIIP is based upon and categorized by the same capital and financial accounts used in the balance of payments: direct investment, portfolio

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Chapter 3   The Balance of Payments

U.S. Net International Position (NIIP) Billions of U.S. dollars $30,000

The United States has been running a negative NIIP consistently since 1985.

$25,000

Foreign-Owned Assets in the United States

$20,000 $15,000 U.S.-Owned Assets Abroad

$10,000 $5,000

12 20

11 20

10 20

09 20

08 20

07 20

06 20

05 20

04 20

03 20

02 20

01 20

00 20

99 19

98 19

97 19

96 19

19

95

$0

Source: Congressional Research Service.

investment, other investment and reserve assets. As international capital has found it easier and easier to move between currencies and cross borders in recent years, ownership of assets and securities has clearly boomed. One common method of putting a country’s NIIP into perspective is to measure it as a percentage of the total economic size of the nation—the Gross Domestic Product (GDP) of the country. As illustrated here, the NIIP of the U.S. has clearly seen a dramatic increase since 2005, now averaging 25% of U.S. GDP.

Although some observers have seen this growing percentage as a risk to the U.S. economy (calling the U.S. the world’s largest debtor nation), these investments in assets of all kinds in many ways represent the faith foreign investors have in the future of the nation and its economy. A large part of this investment is the purchase of U.S. government securities, Treasury notes and bonds, issued in part to finance the U.S. government’s growing deficits. These foreign purchasers have therefore aided in the financing of the U.S. government’s budget deficit.

5% 10%

The U.S. NIIP as a percentage of GDP has been growing steadily and rapidly over the past 16 years.

15% 20% 25% 30%

A large part of this growth has resulted from foreign investors purchasing U.S. government notes and bonds—U.S. Treasuries. This has aided in the financing of the U.S. government budget deficit while keeping the cost of that financing from rising rapidly.

12 20

11 20

10 20

09 20

08 20

07 20

06 20

05 20

04 20

03 20

02 20

01 20

00 20

99 19

98 19

97

96

19

0%

19

19

95

U.S. NIIP as Percentage of Gross Domestic Product

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PART 1  Global Financial Environment

Net Errors and Omissions and Official Reserves Accounts Exhibit 3.4 illustrates the current account balance and the capital/financial account balances for the United States over recent years. The exhibit shows one of the basic economic and accounting relationships of the balance of payments: the inverse relation between the current and financial accounts. This inverse relationship is not accidental. The methodology of the balance of payments, double-entry bookkeeping requires that the current and financial accounts be offsetting unless the country’s exchange rate is being highly manipulated by governmental authorities. The next section on China describes one very high profile case in which government policy has thwarted economics—the twin surpluses of China. Countries experiencing large current account deficits fund these deficits through equally large surpluses in the financial account, and vice versa. Net Errors and Omissions Account.  As previously noted, because current and financial account entries are collected and recorded separately, errors or statistical discrepancies will occur. The net errors and omissions account ensures that the BOP actually balances. Official Reserves Account.  The Official Reserves Account is the total reserves held by official monetary authorities within a country. These reserves are normally composed of the major currencies used in international trade and financial transactions (so-called “hard currencies” like the U.S. dollar, European euro, and Japanese yen; gold; and special drawing rights, SDRs). The significance of official reserves depends generally on whether a country is operating under a fixed exchange rate regime or a floating exchange rate system. If a country’s currency is fixed, the government of the country officially declares that the currency is convertible into a fixed

Exhibit 3.4 Current and Combined Financial /Capital Account Balances for the United States Billions of U.S. dollars $1,000 $800 $600 $400 $200 $0 –$200 –$400 –$600

Current Account

Financial/Capital Account

Source: Balance of Payments Statistics Yearbook: 2013, International Monetary Fund, December 2013, p. 1032.

20 12

20 11

20 10

20 09

20 08

20 07

20 06

20 05

20 04

20 03

20 02

20 01

20 00

19 99

19 98

19 97

19 96

19 95

19 94

19 93

19 92

–$800

61

Chapter 3   The Balance of Payments

amount of some other currency. For example, the Chinese yuan was fixed to the U.S. dollar for many years. It was the Chinese government’s responsibility to maintain this fixed rate, also called parity rate. If for some reason there was an excess supply of yuan on the currency market, to prevent the value of the yuan from falling, the Chinese government would have to support the yuan’s value by purchasing yuan on the open market (by spending its hard currency reserves) until the excess supply was eliminated. Under a floating rate system, the Chinese government possesses no such responsibility and the role of official reserves is diminished. But as described in the following section, the Chinese government’s foreign exchange reserves are now the largest in the world, and if need be, it probably possesses sufficient reserves to manage the yuan’s value for years to come.

Breaking the Rules: China’s Twin Surpluses Exhibit 3.5 documents one of the more astounding BOP behaviors seen globally in many years—the twin surplus balances enjoyed by China in recent years. China’s surpluses in both the current and financial accounts—termed the twin surplus in the business press—is highly unusual. Ordinarily, for example, in the cases of the United States, Germany, and Great Britain, a country will demonstrate an inverse relationship between the two accounts. This inverse relationship is not accidental, and typically illustrates that most large, mature, industrial countries “finance” their current account deficits through equally large surpluses in the financial account. For some countries like Japan, it is the inverse; a current account surplus is matched against a financial account deficit. China, however, has experienced a massive current account surplus and a marginal financial account surplus simultaneously. This is highly unusual, and an indicator of just how Exhibit 3.5 China’s Twin Surplus Billions of U.S. dollars $450 $400 $350 $300 $250 $200 $150 $100 $50 $0 –$50

1998

1999

2000

2001

2002

2003

2004

Current Account

2005

2006

2007

2008

Financial/Capital Account

Source: Balance of Payments Statistics Yearbook: 2013, International Monetary Fund, December 2013.

2009

2010

2011

2012

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PART 1  Global Financial Environment

exceptional the growth of the Chinese economy has been. Although current account surpluses of this magnitude would ordinarily always create a financial account deficit, the positive prospects of the Chinese economy have drawn such massive capital inflows into China in recent years that the financial account too is in surplus. The rise of the Chinese economy has been accompanied by a rise in its current account surplus, and subsequently, its accumulation of foreign exchange reserves. China’s foreign exchange reserves increased by a factor of 16 from 2001 to 2011—from $200 billion to nearly $3,200 billion. There is no real precedent for this build-up in foreign exchange reserves in global financial history. These reserves allow the Chinese government to manage the value of the Chinese yuan and its impact on Chinese competitiveness in the world economy. The magnitude of these reserves will allow the Chinese government to maintain a relatively stable managed fixed rate of the yuan against other major currencies like the U.S. dollar as long as it chooses.

BOP Impacts on Key Macroeconomic Rates A country’s balance of payments both impacts and is impacted by the three macroeconomic rates of international finance: exchange rates, interest rates, and inflation rates.

The BOP and Exchange Rates A country’s BOP can have a significant impact on the level of its exchange rate and vice versa, depending on that country’s exchange rate regime. The relationship between the BOP and exchange rates can be illustrated by using a simplified equation that summarizes BOP data: Current Account Balance

Capital Financial Reserve Balance of Account Account Balance Payments Balance Balance

(X - M)  +

(CI - CO)  +

X M CI CO FI FO

= = = = = = FXB =

(FI - FO)   +

FXB    =

BOP

exports of goods and services imports of goods and services capital inflows capital outflows financial inflows financial outflows official monetary reserves such as foreign exchange and gold.

The effect of an imbalance in the BOP of a country works somewhat differently depending on whether that country has fixed exchange rates, floating exchange rates, or a managed exchange rate system. Fixed Exchange Rate Countries.  Under a fixed exchange rate system, the government bears the responsibility to ensure that the BOP is near zero. If the sum of the current and capital accounts do not approximate zero, the government is expected to intervene in the foreign exchange market by buying or selling official foreign exchange reserves. If the sum of the first two accounts is greater than zero, a surplus demand for the domestic currency exists in the world.

Chapter 3   The Balance of Payments

63

To preserve the fixed exchange rate, the government must then intervene in the foreign exchange market and sell domestic currency for foreign currencies or gold in order to bring the BOP back to near zero. If the sum of the current and capital accounts is negative, an excess supply of the domestic currency exists in world markets. Then the government must intervene by buying the domestic currency with its reserves of foreign currencies and gold. It is obviously important for a government to maintain significant foreign exchange reserve balances, sufficient to allow it to intervene effectively. If the country runs out of foreign exchange reserves, it will be unable to buy back its domestic currency and will be forced to devalue its currency. Floating Exchange Rate Countries.  Under a floating exchange rate system, the government of a country has no responsibility to peg its foreign exchange rate. The fact that the current and capital account balances do not sum to zero will automatically—in theory—alter the exchange rate in the direction necessary to obtain a BOP near zero. For example, a country running a sizable current account deficit and a capital and financial accounts balance of zero will have a net BOP deficit. An excess supply of the domestic currency will appear on world markets. Like all goods in excess supply, the market will rid itself of the imbalance by lowering the price. Thus, the domestic currency will fall in value, and the BOP will move back toward zero. Exchange rate markets do not always follow this theory, particularly in the short to intermediate term. This delay is known as the J-curve (detailed in an upcoming section). The deficit gets worse in the short run, but moves back toward equilibrium in the long run. Managed Floats.  Although still relying on market conditions for day-to-day exchange rate determination, countries operating with managed floats often find it necessary to take action to maintain their desired exchange rate values. They often seek to alter the market’s valuation of their currency by influencing the motivations of market activity, rather than through direct intervention in the foreign exchange markets. The primary action taken by such governments is to change relative interest rates, thus influencing the economic fundamentals of exchange rate determination. In the context of the equation presented earlier, a change in domestic interest rates is an attempt to alter the term (CI - CO), especially the short-term portfolio component of these capital flows, in order to restore an imbalance caused by the deficit in the current account. The power of interest rate changes on international capital and exchange rate movements can be substantial. A country with a managed float that wishes to defend its currency may choose to raise domestic interest rates to attract additional capital from abroad. This step will alter market forces and create additional market demand for the domestic currency. In this process, the government signals to the markets that it intends to take measures to preserve the currency’s value within certain ranges. The process also raises the cost of local borrowing for businesses, however, so the policy is seldom without domestic critics.

The BOP and Interest Rates Apart from the use of interest rates to intervene in the foreign exchange market, the overall level of a country’s interest rates compared to other countries has an impact on the financial account of the balance of payments. Relatively low real interest rates should normally stimulate an outflow of capital seeking higher interest rates in other country currencies. However, in the case of the United States, the opposite effect has occurred. Despite relatively low

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PART 1  Global Financial Environment

real interest rates and large BOP deficits on the current account, the U.S. BOP financial account has experienced offsetting financial inflows due to relatively attractive U.S. growth rate prospects, high levels of productive innovation, and perceived political safety. Thus, the financial account inflows have helped the United States to maintain its lower interest rates and to finance its exceptionally large fiscal deficit. However, it is beginning to appear that the favorable inflow on the financial account is diminishing while the U.S. balance on the current account is worsening.

The BOP and Inflation Rates Imports have the potential to lower a country’s inflation rate. In particular, imports of lowerpriced goods and services place a limit on what domestic competitors charge for comparable goods and services. Thus, foreign competition substitutes for domestic competition to maintain a lower rate of inflation than might have been the case without imports. On the other hand, to the extent that lower-priced imports substitute for domestic production and employment, gross domestic product will be lower and the balance on the current account will be more negative.

Trade Balances and Exchange Rates A country’s import and export of goods and services is affected by changes in exchange rates. The transmission mechanism is in principle quite simple: changes in exchange rates change relative prices of imports and exports, and changing prices in turn result in changes in quantities demanded through the price elasticity of demand. Although the theory seems straightforward, real global business is more complex.

Trade and Devaluation Countries occasionally devalue their own currencies as a result of persistent and sizable trade deficits. Many countries in the not-too-distant past have intentionally devalued their currencies in an effort to make their exports more price-competitive on world markets. These competitive devaluations are often considered self-destructive, however, as they also make imports relatively more expensive. So what is the logic and likely results of intentionally devaluing the domestic currency to improve the trade balance?

The J-Curve Adjustment Path International economic analysis characterizes the trade balance adjustment process as occurring in three stages: 1) the currency contract period; 2) the pass-through period; and 3) the quantity adjustment period. These three stages are illustrated in Exhibit 3.6. Assuming that the trade balance is already in deficit prior to the devaluation, a devaluation at time t1 results initially in a further deterioration in the trade balance before an eventual improvement. The path of adjustment, as shown, takes on the shape of a flattened “j.” In the first period, the currency contract period, a sudden unexpected devaluation of the domestic currency has a somewhat uncertain impact, simply because all of the contracts for exports and imports are already in effect. Firms operating under these agreements are required to fulfill their obligations, regardless of whether they profit or suffer losses. Assume that the United States experienced a sudden fall in the value of the U.S. dollar. Most exports were priced in U.S. dollars but most imports were contracts denominated in foreign currency. The result of a sudden depreciation would be an increase in the size of the trade deficit at

Chapter 3   The Balance of Payments

65

Exhibit 3.6 Trade Balance Adjustment to Exchange Rate Changes: The J-Curve Trade Balance (Domestic Currency) Trade Balance

Initial Trade Balance Position (Typically in Deficit)

t1

Currency Contract Period

t2

Exchange Rate Pass-Through Period

Time (Months)

Quantity Adjustment Period

If export products are predominantly priced and invoiced in domestic currency, and imports are predominantly priced and invoiced in foreign currency, a sudden devaluation of the domestic currency can possibly result—initially—in a deterioration of the balance on trade. After exchange rate changes are passed through to product prices, and markets have time to respond to price changes by altering market demands, the trade balance will improve. The currency contract period may last from three to six months, with pass-through and quality adjustment following for an additional three to six months.

time  t1 because the cost to U.S. importers of paying their import bills would rise as they spent more dollars to buy the foreign currency they needed, while the revenues earned by U.S. exporters would remain unchanged. There is little reason, however, to believe that most U.S. imports are denominated in foreign currency and most exports in dollars. The second period of the trade balance adjustment process is termed the pass-through period. As exchange rates change, importers and exporters eventually must pass these exchange rate changes through to their own product prices. For example, a foreign producer selling to the U.S. market after a major fall in the value of the U.S. dollar will have to cover its own domestic costs of production. This need will require that the firm charge higher dollar prices in order to earn its own local currency in large enough quantities. The firm must raise its prices in the U.S. market. U.S. import prices then rise, eventually passing the full exchange rate changes through to prices. Similarly, the U.S. export prices are now cheaper compared to foreign competitors’ because the dollar is cheaper. Unfortunately for U.S. exporters, many of the inputs for their final products may actually be imported, dampening the positive impact of the fall of the dollar. The third and final period, the quantity adjustment period, achieves the balance of trade adjustment that is expected from a domestic currency devaluation or depreciation. As the import and export prices change as a result of the pass-through period, consumers both in the United States and in the U.S. export markets adjust their demands to the new prices. Imports are relatively more expensive; therefore the quantity demanded decreases. Exports are relatively cheaper; therefore the quantity demanded increases. The balance of trade—the expenditures on exports less the expenditures on imports—improves.

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PART 1  Global Financial Environment

Unfortunately, these three adjustment periods do not occur overnight. Countries like the U.S. that have experienced major exchange rate changes, have also seen this adjustment take place over a prolonged period. Empirical studies have concluded that for industrial countries, the total time elapsing between time t1 and t2 can vary from 3 to 12 months. To complicate the process, new exchange rate changes often occur before the adjustment is completed.

Trade Balance Adjustment Path: The Equation A country’s trade balance is essentially the net of import and export revenues, where each is a multiple of price:P$x and Pfc m :the prices of exports and imports, respectively. Export prices are assumed to be denominated in U.S. dollars, and import prices are denominated in foreign currency. The quantity of exports and the quantity of imports are denoted as Qx and Qm, respectively. Import expenditures are then expressed in U.S. dollars by multiplying the foreign currency denominated expenditures by the spot exchange rate, S$/fc. The U.S. trade balance, expressed in U.S. dollars, is then expressed as follows: U.S. Trade Balance = (P$xQx) - (S$/fcPfc MQM) The immediate impact of a devaluation of the domestic currency is to increase the value of the spot exchange rate S$/fc, resulting in an immediate deterioration in the trade balance (currency contract period). Only after a period in which the current contracts have matured, and new prices reflecting partial to full pass-through have been instituted, would improvement in the trade balance been evident (pass-through period). In the final stage, in which the price elasticity of demand has time to take effect (quantity adjustment period), is the actual trade balance which is expected to rise above where it started in Exhibit 3.7. Exhibit 3.7 The Evolution of Capital Mobility Exchange Rate Era

The Gold Standard

CrossBorder Political Economy

Growing openness in trade, with growing, but limited, capital mobility

Implication

Trade dominates capital in total influence on exchange rates

1860

The Inter-War Years

1914

The Bretton Woods Era

The Floating Era

The Emerging Era

Protectionism & isolationism

Growing belief in the benefits of open economies

Industrialized (primary) nations open; emerging states (secondary) restrict capital flows to maintain economic control

More and more emerging nations open their markets to capital at the expense of reduced economic independence

Rising barriers to the movement of both trade & capital

Trade increasingly dominated by capital; era ends as capital flows

Capital flows dominate trade; emerging nations suffer devaluations

Capital flows increasingly drive economic growth and health

1945

1971

1997

Present

The last 150 years has seen periods of increasing and decreasing political and economic openness between countries. Beginning with the Bretton Woods Era, global markets have moved toward increasing open exchange of goods and capital, making it increasingly difficult to maintain fixed or even stable rates of exchange between currencies. The most recent era, characterized by the growth and development of emerging economies is likely to be even more challenging.

Chapter 3   The Balance of Payments

67

Capital Mobility The degree to which capital moves freely cross-border is critically important to a country’s balance of payments. We have already seen how the U.S. has suffered a deficit in its current account balance over the past 20 years while running a surplus in the financial account, and how China has enjoyed a surplus in both the current and financial accounts over the last decade. But these are only two country cases, and may not reflect the challenges that changing balances in trade and capital may mean for many countries, particularly smaller ones or emerging markets.

Current Account versus Financial Account Capital Flows Capital inflows can contribute significantly to an economy’s development. Capital inflows can increase the availability of capital for new projects, new infrastructure development, and productivity improvements. All of which may stimulate general economic growth and job creation. For domestic holders of capital, the ability to invest outside the domestic economy may reap greater investment returns, portfolio diversification, and extend the commercial development of domestic enterprises. That said, the free flow of capital in and out of an economy can potentially destabilize economic activity. Although the benefits of free capital flows have been known for centuries, so have the negatives. For this very reason, the creators of the Bretton Woods system were very careful to promote and require the free movement of capital for current account transactions—foreign exchange, bank deposits, money market instruments—but they did not require such free transit for capital account transactions—foreign direct investment and equity investments. Experience has shown that current account-related capital flows can be more volatile, with capital flowing in and out of an economy and a currency on the basis of short-term interest rate differentials and exchange rate expectations. This volatility is somewhat compartmentalized, not directly impacting real asset investments, employment, or long-term economic growth. Longer-term capital flows reflect more fundamental economic expectations, including growth prospects and perceptions of political stability. The complexity of issues, however, is apparent when you consider the plight of many emerging market countries. Recall the impossible trinity from Chapter 2—the theoretical structure which states that no country can maintain a fixed exchange rate, allow complete capital mobility (both in and out of the country), and conduct independent monetary policy simultaneously. Many emerging market countries have continued to develop by maintaining a near-fixed (soft peg) exchange rate regime—a strictly independent monetary policy—while restricting capital inflows and outflows. With the growth of current account business activity (exports and imports of goods and services), more current account-related capital flows are deregulated. If, however, the country experiences significant volatility in these short-term capital movements, capital flows potentially impacting either exchange rate pegs or monetary policy objectives, authorities are often quick to re-institute capital controls. The growth in capital openness in the 1970s, 1980s, and first half of the 1990s resulted in a significant increase in political pressures for more countries to open up more of their financial account sectors to international capital. But the devastation of the Asian Financial Crisis of 1997/1998 brought much of that to a halt. Smaller economies, no matter how successful their growth and development may have been under export-oriented trade strategies, found themselves still subject to sudden and destructive capital outflows in times of economic crisis and financial contagion.

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PART 1  Global Financial Environment

Historical Patterns of Capital Mobility Before leaving our discussion of the balance of payments, we need to gain additional insights into the history of capital mobility and the contribution of capital outflows—capital flight—to balance of payments crises. Has capital always been free to move in and out of a country? Definitely not. The ability of foreign investors to own property, buy businesses, or purchase stocks and bonds in other countries has been controversial. Exhibit 3.7, first presented in Chapter 2, is helpful once again in categorizing the last 150  years of economic history into five distinct exchange rate eras and their associated ­implications for capital mobility (or lack thereof). These exchange rate eras obviously reflect the exchange rate regimes we discussed and detailed in Chapter 2, but also reflect the evolution of political economy beliefs and policies of both industrialized and emerging market nations over this period. The Gold Standard (1860–1914).  Although an era of growing capital openness in which trade and capital began to flow more freely, it was an era dominated by industrialized nation economies that were dependent on gold convertibility to maintain confidence in the system. The Inter-War Years (1914–1945).  An era of retrenchment, in which major economic powers returned to policies of isolationism and protectionism, restricting trade and nearly eliminating capital mobility. The devastating results included financial crisis, a global depression, and rising international political and economic disputes that drove nations into a second world war. The Bretton Woods Era (1945–1971).  The dollar-based fixed exchange rate system under Bretton Woods gave rise to a long period of economic recovery and growing openness of both international trade and capital flows in and out of countries. Many researchers (for example Obstfeld and Taylor, 2001) believe it was the rapid growth in the speed and volume of capital flows that ultimately led to the failure of Bretton Woods—global capital could no longer be held in check. The Floating Era (1971–1997).  The Floating Era, saw the rise of a growing schism between the industrialized and emerging market nations. The industrialized nations (primary currencies) moved to—or were driven to—floating exchange rates by capital mobility. The emerging markets (secondary currencies), in an attempt to both promote economic development and maintain control over their economies and currencies, opened trade but maintained restrictions on capital flows. Despite these restrictions, the era ended with the onslaught of the Asian Financial Crisis in 1997. The Emerging Era (1997–Present).  The emerging economies, led by China and India, attempt to gradually open their markets to global capital. But, as the impossible trinity taught the industrial nations in previous years, the increasing mobility of capital now requires that they give up either the ability to manage their currency values or to conduct independent monetary policies. By 2011 and 2012 an increasing number of emerging market currencies “suffer” appreciation (or fight appreciation) as capital flows grow in magnitude and speed. The 2008–2014 period reinforced what some call the double-edged sword of global capital movements. The credit crisis of 2008–2009, beginning in the United States, quickly spread to the global economy, pulling and pushing down industrial and emerging market economies alike. But in the post credit crisis period, global capital now flowed toward the emerging markets. Although funding and fueling their rapid economic recoveries, it came—in the words of

Chapter 3   The Balance of Payments

69

Exhibit 3.8 Purposes of Capital Controls Capital Flow Controlled

Control Purpose

Method

General Revenue/Finance War Effort

Controls on capital outflows permit a country to run higher inflation with a given fixed-exchange rate and also hold down domestic interest rates.

Outflows

Example Most belligerents in WWI and WWII

Financial Repression/Credit Allocation

Governments that use the financial system to reward favored industries or to raise revenue, may use capital controls to prevent capital from going abroad to seek higher returns.

Outflows

Common in developing countries

Correct a Balance of Payments Deficit

Controls on outflows reduce demand for foreign assets without contractionary monetary policy or devaluation. This allows a higher rate of inflation than otherwise would be possible.

Outflows

US interest equalization tax 1963–1974

Correct a Balance of Payments Surplus

Controls on inflows reduce foreign demand for domestic assets without expansionary monetary policy or revaluation. This allows a lower rate of inflation than would otherwise be possible.

Inflows

German Bardepot Scheme 1972–1974

Prevent Potentially Volatile Inflows

Restricting inflows enhances macroeconomic stability by reducing the pool of capital that can leave a country during a crisis.

Inflows

Chilean encaje 1991–1998

Prevent Financial Destabilization

Capital controls can restrict or change the composition of international capital flows that can exacerbate distorted incentives in the domestic financial system.

Inflows

Chilean encaje 1991–1998

Prevent Real Appreciation

Restricting inflows prevents the necessity of monetary expansion and greater domestic inflation that would cause a real appreciation of the currency.

Inflows

Chilean encaje 1991–1998

Restrict Foreign Ownership of Domestic Assets

Foreign ownership of certain domestic assets —especially natural resources—can generate resentment.

Inflows

Article 27 of the ­Mexican Constitution

Preserve Savings for Domestic Use

The benefits of investing in the domestic economy may not fully accrue to savers so the economy as a whole can be made better off by restricting the outflow of capital.

Outflows

—

Protect Domestic Financial Firms

Controls that temporarily segregate domestic financial sectors from the rest of the world may permit domestic firms to attain economies of scale to compete in world markets.

Inflows and Outflows

—

Source: “An Introduction to Capital Controls,” Christopher J. Neely, Federal Reserve Bank of St. Louis Review, November/December 1999, p. 16.

one journalist—“with luggage.” The increasing pressure on emerging market currencies to appreciate is partially undermining their export competitiveness. But then, just as suddenly as the capital came, it went. In late 2013, the U.S. Federal Reserve announced that it would be slowing money supply growth and allowing U.S. interest rates to rise. Capital once again moved; this time out of the emerging markets into the more traditional industrial countries like the U.S. and Europe.

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PART 1  Global Financial Environment

Capital Controls A capital control is any restriction that limits or alters the rate or direction of capital movement into or out of a country. Capital controls may take many forms, sometimes dictating which parties may undertake which types of capital transactions for which purposes—the who, what, when, where, and why of investment. It is in many ways the bias of the journalistic and academic press that believes that capital has been able to move freely across boundaries. Free movement of capital in and out of a country is more the exception than the rule. The United States has been relatively open to capital inflows and outflows for many years, while China has been one of the most closed over that same period. When it comes to moving capital, the world is full of requirements, restrictions, taxes, and documentation approvals. There is a wide spectrum of motivations for capital controls, with most associated with either insulating the domestic monetary and financial economy from outside markets or political motivations over ownership and access interests. As illustrated in Exhibit 3.8, capital controls are just as likely to occur over capital inflows as they are over capital outflows. Although there is a tendency for a negative connotation to accompany capital controls (possibly the bias of the word “control” itself), the impossible trinity requires that capital flows be controlled if a country wishes to maintain a fixed exchange rate and an independent monetary policy. Capital controls may take a variety of forms that mirror restrictions on trade. They may simply be a tax on a specific transaction, they may limit the quantity or magnitude of specific capital transactions, or they may prohibit transactions altogether. The controls themselves have tended to follow the basic dichotomy of the balance of payments current account transactions versus financial account transactions. In some cases capital controls are intended to stop or thwart capital outflows and currency devaluation or depreciation. The case of Malaysia during the Asian Crisis of 1997–1998 is one example. As the Malaysian currency came under attack and capital started to exit the Malaysian economy, the government imposed a series of capital controls that were intended to stop short-term capital movements, in or out, but not hinder trade and not restrict long-term inward investment. All trade-related requests for access to foreign exchange were granted, allowing current account-related capital flows to continue. But access to foreign exchange for inward or outward money market or capital market investments were restricted. Foreign residents wishing to invest in Malaysian assets—real assets not financial assets—had open access. Capital controls can be implemented in the opposite case, in which the primary fear is that large rapid capital inflows will both cause currency appreciation (and therefore harm export competitiveness) and complicate monetary policy (capital inflows flooding money markets and bank deposits). Chile in the 1990s provides an example. Newfound political and economic soundness started attracting international capital. The Chilean government responded with its encaje program, which imposed taxes and restrictions on short-term (less than one year) capital inflows, as well as restrictions on the ability of domestic financial institutions to extend credits or loans in foreign currency. Although credited with achieving its goals of maintaining domestic monetary policy and preventing a rapid appreciation in the Chilean peso, this program came at substantial cost to Chilean firms, particularly smaller ones. A similar use of capital controls to prevent domestic currency appreciation is the so-called case of Dutch Disease. With the rapid growth of the natural gas industry in the Netherlands in the 1970s, there was growing fear that massive capital inflows would drive up the demand for the Dutch guilder and cause a substantial currency appreciation. A more expensive guilder would harm other Dutch manufacturing industries, causing them to decline relative to the natural resource industry. This is a challenge faced by a number of resource-rich economies

Chapter 3   The Balance of Payments

71

of relatively modest size and with relatively small export sectors in recent years, including oil and gas development in Azerbaijan, Kazakhstan, and Nigeria, to name but a few. Capital Flight.  An extreme problem that has raised its head a number of times in international financial history is capital flight, one of the problems that capital controls are designed to control. Although defining capital flight is a bit difficult, the most common definition is the rapid outflow of capital in opposition to or in fear of domestic political and economic conditions and policies. Although it is not limited to heavily indebted countries, the rapid and sometimes illegal transfer of convertible currencies out of a country poses significant economic and political problems. Many heavily indebted countries have suffered significant capital flight, compounding their problems of debt service. There are a number of mechanisms used for moving money from one country to another— some legal, some not. Transfers via the usual international payments mechanisms (regular bank transfers) are obviously the easiest and lowest cost, and are legal. Most economically healthy countries allow free exchange of their currencies, but of course for such countries “capital flight” is not a problem. The opposite, transfer of physical currency by bearer (the proverbial smuggling out of cash in the false bottom of a suitcase) is more costly and, for transfers out of many countries, illegal. Such transfers may be deemed illegal for balance of payments reasons or to make difficult the movement of money from the drug trade or other illegal activities. And there are other more creative solutions. One is to move cash via collectibles or precious metals, which are then transferred across borders. Money laundering is the cross-border purchase of assets that are then managed in a way that hides the movement of money and its ownership. And finally, false invoicing of international trade transactions occurs when capital is moved through the under-invoicing of exports or the over-invoicing of imports, where the difference between the invoiced amount and the actual agreed upon payment is deposited in banking institutions in a country of choice.

Globalization of Capital Flows Notwithstanding these benefits, many EMEs [emerging market economies] are concerned that the recent surge in capital inflows could cause problems for their economies. Many of the flows are perceived to be temporary, reflecting interest rate differentials, which may be at least partially reversed when policy interest rates in advanced economies return to more normal levels. Against this backdrop, capital controls are again in the news. A concern has been that massive inflows can lead to exchange rate overshooting (or merely strong appreciations that significantly complicate economic management) or inflate asset price bubbles, which can amplify financial fragility and crisis risk. More broadly, following the crisis, policymakers are again reconsidering the view that unfettered capital flows are a fundamentally benign phenomenon and that all financial flows are the result of rational investing/borrowing/lending decisions. Concerns that foreign investors may be subject to herd behavior, and suffer from excessive optimism, have grown stronger; and even when flows are fundamentally sound, it is recognized that they may contribute to collateral damage, including bubbles and asset booms and busts. —“Capital Inflows: The Role of Controls,” Jonathan D. Ostry, Atish R. Ghosh, Karl ­Habermeier, Marcos Chamon, Mahvash S. Qureshi, and Dennis B.S. Reinhardt, IMF Staff Position Note, SPN/10/04, February 19, 2010, p. 3.

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PART 1  Global Financial Environment

Traditionally, the primary concern over capital inflows is that they are short-term in duration, may flow out with short notice, and are characteristics of the politically and economically unstable emerging markets. But as described in the preceding quote, two of the largest capital flow crises in recent years have occurred within the largest, most highly developed, mature capital markets—the United States and Western Europe. The 2008 global credit crisis, which had the United States as its core, and the current 2011–2012 Greece/European Union sovereign debt crisis, both occurred within markets that have long been considered the most mature, the most sophisticated, and the “safest.”

Summary Points ■

The BOP is the summary statement—a cash flow ­statement—of all international transactions between one country and all other countries over a period of time, typically a year.

■

Although in theory the BOP must always balance, in practice there are substantial imbalances as a result of statistical errors and misreporting of current account and financial/capital account flows.

■

The two subaccounts of the BOP that receive the most attention are the current account and the f­inancial account. These accounts summarize the current trade and international capital flows of the country, respectively.

■

The current account and financial account are typically inverse on balance, one in surplus and the other in deficit.

■

Although most nations strive for current account surpluses, it is not clear that a balance on current or financial account, or a surplus on current account, is either sustainable or desirable.

■

Although merchandise trade is more easily observed (e.g., goods flowing through ports of entry), today, the growth of services trade is more significant to the balance of payments for many of the world’s largest industrialized countries.

Mini-Case

Global Remittances “Remittances are a vital source of financial support that directly increases the income of migrants’ families,” said Hans Timmer, director of development prospects at the World Bank. “Remittances lead to more investments in health, education, and small business. With better tracking of migration and remittance trends, policy makers can make informed decisions to protect and leverage this

■

Monitoring the various subaccounts of a country’s BOP activity is helpful to decision-makers and policymakers, on all levels of government and industry, in detecting the underlying trends and movements of fundamental economic forces driving a country’s international economic activity.

■

Changes in exchange rates affect relative prices of imports and exports, and changing prices in turn result in changes in quantities demanded through the price elasticity of demand.

■

A devaluation results initially in a further deterioration of the trade balance before an eventual improvement—the path of adjustment taking on the shape of a flattened “j.”

■

The ability of capital to move instantaneously and massively cross-border has been one of the major factors in the severity of recent currency crises. In cases such as Malaysia in 1997 and Argentina in 2001, the national governments concluded that they had no choice but to impose drastic restrictions on the ability of capital to flow.

■

Although not limited to heavily indebted countries, the rapid and sometimes illegal transfer of convertible currencies out of a country poses significant economic and political problems. Many heavily indebted countries have suffered significant capital flight, which has compounded their problems of debt service.

massive capital inflow which is triple the size of official aid flows,” Timmer said. —“Remittances to Developing Countries Resilient in the Recent Crisis,” Press Release No. 2011/168DEC, The World Bank, November 8, 2010. One area within the balance of payments that has received intense interest in the past decade is that of remittances. The term remittance is a bit tricky. According to the International Monetary Fund (IMF), remittances are international

73

Chapter 3   The Balance of Payments

transfers of funds sent by migrant workers from the country where they are working to people, typically family members, in the country from which they originated.1 According to the IMF, a migrant is a person who comes to a country and stays, or intends to stay, for a year or more. As shown in Exhibit A, a brief overview of global remittances would include the following: ■

The World Bank estimates that $414 billion was remitted in 2009, with $316 billion of that going to developing countries. These remittance transactions were made by more than 190 million people, roughly 3% of the world’s population.

■

The top remittance-sending countries in 2009 were the United States, Saudi Arabia, Switzerland, ­Russia, and Germany. Worldwide, the top recipient countries in 2009 were India, China, Mexico, the Philippines, and France.

■

Remittances make up a very small, often negligible cash outflow from sending countries like the United States. They do, however, represent a more significant volume, for example as a percent of GDP, for smaller developing recipient countries, sometimes more than 25%. In many cases, this is greater than all

development capital and aid flowing to these same countries. The historical record on global remittances is short. As illustrated in Exhibit A, remittances have shown dramatic growth in the post-2000 period, until suffering a first real decline with the global financial crisis 2008–2009. Remittances largely reflect the income that is earned by migrant or guest workers in one country (source country) and then transferred to families or related parties in the workers’ home countries (receiving countries). Therefore, it is not surprising that although there are more migrant worker flows between developing countries, the highincome developed economies remain the main source of remittances. The global economic recession of 2009 resulted in reduced economic activities like construction and manufacturing in the major source countries; as a result, remittance cash flows fell in 2009 but rebounded slightly in 2010. Most remittances are frequent small payments made through wire transfers or a variety of informal channels (some even carried by hand). The United States Bureau of Economic Analysis (BEA), which is responsible for the compilation and reporting of U.S. balance of payments statistics, classifies migrant remittances as “current transfers” in the current account. Wider definitions of remittances may

Exhibit A Global Remittances – World Inflows Billions of U.S. dollars 450 After peaking at $443 billion in 2008, 2009 showed the first decline since 1985.

400 350 300

Average annual growth of 15.6% from 1970 to 2010e.

250 200 150 100

Source: The World Bank.

“Remittances: International Payments by Migrants,” Congressional Budget Office, May 2005.

1

0e

20 1

20 08

20 06

20 04

20 02

20 00

19 98

19 96

19 94

19 92

19 90

19 88

19 86

19 84

19 82

19 80

19 78

19 76

19 74

19 72

19 70

50

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PART 1  Global Financial Environment

also include capital assets that migrants bring with them to host countries, and similar assets that they take back with them to their home countries. All these values, when compiled, are generally reported under the financial account of the balance of payments. However, the definition of a “migrant” is also an area of some debate. Transfers back to his or her home country made by an individual who may be working in another country (for example, an expat working for an MNE) but who is not considered a “resident,” may also be considered global remittances under current transfers in the current account. Growing Controversies With the growth in global remittances has come a growing debate as to what role they do or should play in a country’s balance of payments, and more importantly, its economic development. In some cases, like India, there is growing resistance from the central bank and other banking institutions to allow online payment services like PayPal to process remittances. In other countries, like Honduras, Guatemala, and Mexico, there is growing debate on whether the bulk of remittances flow to families or if they are mostly payments to a variety of Central American smugglers—human trafficking smugglers.

Questions 1. Balance of Payments Defined. The measurement of all international economic transactions between the residents of a country and foreign residents is called the balance of payments (BOP). What institution provides the primary source of similar statistics for balance of payments and economic performance worldwide? 2. Importance of BOP. Business managers and investors need BOP data to anticipate changes in host-country economic policies that might be driven by BOP events. From the perspective of business managers and investors, list three specific signals that a country’s BOP data can provide. 3. Economic Activity. What are the two main types of economic activity measured by a country’s BOP? 4. Balance. Why does the BOP always “balance”? 5. BOP Accounting. If the BOP were viewed as an accounting statement, would it be a balance sheet of the country’s wealth, an income statement of the country’s earnings, or a funds flow statement of money into and out of the country? 6. Current Account. What are the main component accounts of the current account? Give one debit and

In Mexico for example, remittances now make up the second largest source of foreign exchange earnings, second only to oil exports. The Mexican government has increasingly viewed remittances as an integral component of its balance of payments, and in some ways, a “plug” to replace declining export competition and dropping foreign direct investment. But there is also growing evidence that remittances flow to those who need it most, the lowest income component of the Mexican population, and therefore mitigate poverty and support consumer spending. Former President Vicente Fox was quoted as saying that Mexico’s workers in other countries remitting income home to Mexico are “heroes.”

Case Questions 1. Where are remittances across borders included within the balance of payments? Are they current or financial account components? 2. Under what conditions are remittances significant contributors to the economy and overall balance of payments? 3. What role do remittances play in the economy of a country like Mexico?

one credit example for each component account for the United States. 7. Real versus Financial Assets. What is the difference between a “real” asset and a “financial” asset? 8. Direct versus Portfolio Investments. What is the difference between a direct foreign investment and a portfolio foreign investment? Give an example of each. Which type of investment is a multinational industrial company more likely to make? 9. The Financial Account. What are the primary subcomponents of the financial account? Analyitically, what would cause net deficits or surpluses in these individual components? 10. Classifying Transactions. Classify each of the following as a transaction reported in a subcomponent of the current account or of the capital and financial accounts of the two countries involved: a. A U.S. food chain imports wine from Chile. b. A U.S. resident purchases a euro-denominated bond from a German company. c. Singaporean parents pay for their daughter to study at a U.S. university. d. A U.S. university gives a tuition grant to a foreign student from Singapore.

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Chapter 3   The Balance of Payments



e. A British Company imports Spanish oranges, paying with eurodollars on deposit in London. f. The Spanish orchard deposits half its proceeds in a eurodollar account in London. g. A London-based insurance company buys U.S. corporate bonds for its investment portfolio. h. An American multinational enterprise buys insurance from a London insurance broker. i. A London insurance firm pays for losses incurred in the United States because of an international terrorist attack. j. Cathay Pacific Airlines buys jet fuel at Los Angeles International Airport so it can fly the return segment of a flight back to Hong Kong. k. A California-based mutual fund buys shares of stock on the Tokyo and London stock exchanges. l. The U.S. army buys food for its troops in South Asia from local venders. m. A Yale graduate gets a job with the International Committee of the Red Cross in Bosnia and is paid in Swiss francs. n. The Russian government hires a Norwegian salvage firm to raise a sunken submarine. o. A Colombian drug cartel smuggles cocaine into the United States, receives a suitcase of cash, and flies back to Colombia with that cash. p. The U.S. government pays the salary of a foreign service officer working in the U.S. embassy in Beirut. q. A Norwegian shipping firm pays U.S. dollars to the Egyptian government for passage of a ship through the Suez Canal. r. A German automobile firm pays the salary of its executive working for a subsidiary in Detroit. s. An American tourist pays for a hotel in Paris with his American Express card. t. A French tourist from the provinces pays for a hotel in Paris with his American Express card.



u. A U.S. professor goes abroad for a year on a Fulbright grant.

11. The Balance. What are the main summary statements of the balance of payments accounts and what do they measure? 12. Drugs and Terrorists. Where in the balance of payments accounts do the flows of “laundered” money by drug dealers and international terrorist organizations occur? 13. Capital Mobility—United States. The U.S. dollar has maintained or increased its value over the past 20 years despite running a gradually increasing current account deficit. Why has this phenomenon occurred? 14. Capital Mobility—Brazil. Brazil has experienced periodic depreciation of its currency over the past 20 years despite occasionally running a current account s­ urplus. Why has this phenomenon occurred? 15. BOP Transactions. Identify the correct BOP account for each of the following transactions: a. A German-based pension fund buys U.S. government 30-year bonds for its investment portfolio. b. Scandinavian Airlines System (SAS) buys jet fuel at Newark Airport for its flight to Copenhagen. c. Hong Kong students pay tuition to the University of California, Berkeley. d. The U.S. Air Force buys food in South Korea to supply its air crews. e. A Japanese auto company pays the salaries of its executives working for its U.S. subsidiaries. f. A U.S. tourist pays for a restaurant meal in Bangkok. g. A Colombian citizen smuggles cocaine into the United States, receives cash, and smuggles the dollars back into Colombia. h. A U.K. corporation purchases a euro-denominated bond from an Italian MNE.

Problems Australia’s Current Account Use the following balance of payments data for Australia from the IMF to answer Problems 1–4. Assumptions (million US$) Goods, credit (exports) Goods, debit (imports) Services, credit (exports)

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

64,052

63,676

65,099

70,577

87,207

107,011

124,913

142,421

189,057

154,777

213,782

271,677

257,754

- 68,865 - 61,890 - 70,530 - 85,946 - 105,238 - 120,383 - 134,509 - 160,205 - 193,972 - 159,216 - 196,303 - 242,915 - 262,966 18,677

16,689

17,906

21,205

26,362

31,047

33,088

40,496

45,240

40,814

46,968

51,852

52,672

(continued)

76

Assumptions (million US$) Services, debit (imports) Primary income: credit Primary income: debit

PART 1  Global Financial Environment

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

- 18,388 - 16,948 - 18,107 - 21,638 - 27,040 - 30,505 - 32,219 - 39,908 - 48,338 - 42,165 - 51,313 - 60,994 - 64,389 8,984

8,063

8,194

9,457

13,969

16,445

21,748

32,655

37,320

27,402

35,711

42,965

42,097

- 19,516 - 18,332 - 19,884 - 24,245 - 35,057 - 44,166 - 54,131 - 73,202 - 76,719 - 65,809 - 84,646 - 94,689 - 80,778

Secondary income: credit

2,622

2,242

2,310

2,767

3,145

3,333

3,698

4,402

4,431

4,997

5,813

7,389

7,357

Secondary income: debit

- 2,669

- 2,221

- 2,373

- 2,851

- 3,414

- 3,813

- 4,092

- 4,690

- 4,805

- 5,799

- 7,189

- 8,920

- 8,783

Note: The IMF has recently adjusted their line item nomenclature. Exports are all now noted as credits, imports as debits.

1. What is Australia’s balance on goods?

3. What is Australia’s balance on goods and services?

2. What is Australia’s balance on services?

4. What is Australia’s current account balance?

India’s Current Account Use the following balance of payments data for India from the IMF to answer Problems 5–9. Assumptions (million US$) Goods, credit (exports) Goods, debit (imports) Services, credit (exports) Services, debit (imports)

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

43,247

44,793

51,141

60,893

77,939

102,175

123,768

153,530

199,065

167,958

230,967

307,847

298,321

- 53,887 - 51,212 - 54,702 - 68,081 - 95,539 - 134,692 - 166,572 - 208,611 - 291,740 - 247,908 - 324,320 - 428,021 - 450,249 16,684

17,337

19,478

23,902

38,281

52,527

69,730

86,552

106,054

92,889

117,068

138,528

145,525

- 19,187 - 20,099 - 21,039 - 24,878 - 35,641 - 47,287 - 58,696 - 70,175 - 87,739 - 80,349 - 114,739 - 125,041 - 129,659

Primary income: credit

2,521

3,524

3,188

3,491

4,690

5,646

8,199

12,650

15,593

13,733

9,961

10,147

9,899

Primary income: debit

- 7,414

- 7,666

- 7,097

- 8,386

Secondary income: credit

13,548

15,140

16,789

22,401

20,615

24,512

30,015

38,885

52,065

50,526

54,380

62,735

68,611

Secondary income: debit

- 114

- 407

- 698

- 570

- 822

- 869

- 1,299

- 1,742

- 3,313

- 1,764

- 2,270

- 2,523

- 3,176

- 8,742 - 12,296 - 14,445 - 19,166 - 20,958 - 21,272 - 25,563 - 26,191 - 30,742

5. What is India’s balance on goods? 6. What is India’s balance on services?

8. What is India’s balance on goods, services, and income?

7. What is India’s balance on goods and services?

9. What is India’s current account balance?

China’s (Mainland) Balance of Payments Use the following balance of payments data for China (Mainland) from the IMF to answer Problems 10–13. Assumptions (million US$)

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

A. Current account balance

20,518

17,401

35,422

45,875

68,659

134,082

232,746

353,183

420,569

243,257

237,810

B. Capital account balance

- 35

- 54

- 50

- 48

- 69

4,102

4,020

3,099

3,051

3,958

4,630

2011

2012

136,097 193,139 5,446

4,272

(continued)

77

Chapter 3   The Balance of Payments

Assumptions (million US$)

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

1,958

34,832

32,341

52,774

110,729

96,944

48,629

91,132

37,075

194,494

282,234

260,024

21,084

D. Net errors and omissions

- 11,748 - 4,732

7,504

17,985

10,531

15,847

- 745

13,237

18,859

E. Reserves and related items

- 10,693 - 47,447 - 75,217 - 116,586 - 189,849 - 250,975 - 284,651 - 460,651 - 479,553 - 400,508 - 471,659 - 387,799 - 96,555

C. Financial account balance

- 41,181 - 53,016 - 13,768 - 79,773

10. Is China experiencing a net capital inflow or outflow?

12. What is China’s total for Groups A through C?

11. What is China’s total for Groups A and B?

13. What is China’s total for Groups A through D?

Russia’s (Russian Federation’s) Balance of Payments Use the following balance of payments data for Russia (Russian Federation) from the IMF to answer Problems 14–17. Assumptions (million US$)

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

A. Current account balance

46,839

33,935

29,116

35,410

59,512

84,602

94,686

77,768

103,530

48,605

70,253

B. Capital account balance

10,676

- 9,378

- 12,396

- 993

- 1,624

- 12,764

191

- 10,224

496

- 11,869

73

C. Financial account balance

- 34,295

- 3,732

921

3,024

- 5,128

1,025

3,071

94,730

- 131,674

- 31,648

- 25,956

D. Net errors and omissions

- 9,297

- 9,558

- 6,078

- 9,179

- 5,870

- 7,895

9,518

- 13,347

- 11,271

- 1,724

- 7,621

E. Reserves and related items

- 13,923

- 11,266

- 11,563

- 28,262

- 46,890

- 64,968

- 107,466

- 148,928

38,919

- 3,363

- 36,749

14. Is Russia experiencing a net capital inflow?

16. What is Russia’s total for Groups A through C?

15. What is Russia’s total for Groups A and B?

17. What is Russia’s total for Groups A through D?

Euro Area Balance of Payments Use the following balance of payments data for the Euro Area from the IMF to answer Problems 18–21. Assumptions (billion US$)

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

A. Current account balance

- 81.8

- 19.7

44.5

24.9

81.2

19.2

- 0.3

24.9

- 198.2

- 31.3

- 53.6

B. Capital account balance

8.4

5.6

10.3

14.3

20.5

14.2

11.7

5.4

13.2

8.5

8.2

50.9

- 41.2

- 15.3

- 47.6

- 122.9

- 71.4

- 27.9

- 1.9

204.4

70.3

77.3

6.4

38.8

- 36.5

- 24.4

5.6

15.0

19.0

- 22.7

- 14.5

12.4

- 18.3

16.2

16.4

- 3.0

32.8

15.6

23.0

- 2.6

- 5.7

- 4.9

- 59.8

- 13.6

C. Financial account balance D. Net errors and omissions E. Reserves and related items

18. Is the Euro Area experiencing a net capital inflow?

20. What is the Euro Area’s total for Groups A through C?

19. What is the Euro Area’s total for Groups A and B?

21. What is the Euro Area’s total for Groups A through D?

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PART 1  Global Financial Environment

22. Trade Deficits and J-Curve Adjustment Paths. Assume the United States has the following import/ export volumes and prices. It undertakes a major “devaluation” of the dollar, say 18% on average against all major trading partner currencies. What is the pre-devaluation and post-devaluation trade balance? Initial spot exchange rate ($/fc)

2.00

Price of exports, dollars ($)

20.0000

Price of imports, foreign currency (fc)

12.0000

Quantity of exports, units

100

Quantity of imports, units

120

Percentage devaluation of the dollar

18.00%

Price elasticity of demand, imports

-0.90

The World Bank Group

www.worldbank.org/

Europa (EU) Homepage

europa.eu/

Bank for International Settlements

www.bis.org/

2. St. Louis Federal Reserve. The Federal Reserve Bank of St. Louis provides a large amount of recent openeconomy macroeconomic data online. Use the following addresses to track down recent BOP and GDP data. Recent international economic data research.stlouisfed.org/ publications/iet/ Balance of payments statistics research.stlouisfed.org/ fred2/categories/125

3. U.S. Bureau of Economic Analysis. Use the following Bureau of Economic Analysis (U.S. government) and the Ministry of Finance (Japanese government) Web sites to find the most recent balance of payments statistics for both countries. Bureau of Economic Analysis www.bea.gov/ international/

Internet Exercises 1. World Organizations and the Economic Outlook. The IMF, World Bank, and United Nations are only a few of the major world organizations that track, report, and aid international economic and financial development. Using these Web sites and others that may be linked, briefly summarize the economic outlook for the developed and emerging nations of the world. For example, Chapter 1 of the World Economic Outlook published annually by the World Bank is available through the IMF’s Web page. International Monetary Fund

www.imf.org/

United Nations

www.unsystem.org/

Ministry of Finance

www.mof.go.jp/

4. World Trade Organization and Doha. Visit the WTO’s Web site and find the most recent evidence presented by the WTO on the progress of talks on issues including international trade in services and international recognition of intellectual property at the WTO. World Trade Organization

www.wto.org

5. Global Remittances Worldwide. The World Bank’s Web site on global remittances is a valuable source for new and developing studies and statistics on crossborder remittance activity. World Bank

http://remittanceprices.worldbank.org/

International Parity Conditions

CHAPTER

… if capital freely flowed towards those countries where it could be most profitably employed, there could be no ­difference in the rate of profit, and no other difference in the real or labour price of commodities, than the additional quantity of labour required to convey them to the various markets where they were to be sold. 

6

—David Ricardo, On the Principles of Political Economy and Taxation, 1817, Chapter 7.

Learning Objectives ■

Examine how price levels and price level changes (inflation) in countries determine the exchange rates at which their currencies are traded

■

Show how interest rates reflect inflationary forces within each country and currency

■

Explain how forward markets for currencies reflect expectations held by market ­participants about the future spot exchange rate

■

Analyze how, in equilibrium, the spot and forward currency markets are aligned with interest differentials and differentials in expected inflation

What are the determinants of exchange rates? Are changes in exchange rates predictable? Managers of MNEs, international portfolio investors, importers and exporters, and government officials must deal with these fundamental questions every day. This chapter describes the core financial theories surrounding the determination of exchange rates. Chapter 8 will introduce two other major theoretical schools of thought regarding currency valuation and combine the three different theories in a variety of real-world applications. The economic theories that link exchange rates, price levels, and interest rates are called international parity conditions. In the eyes of many, these international parity conditions form the core of the financial theory that is considered unique to the field of international finance. These theories do not always work out to be “true” when compared to what students and practitioners observe in the real world, but they are central to any understanding of how multinational business is conducted and funded in the world today. And, as is often the case, the mistake is not always in the theory itself, but in the way it is interpreted or applied in practice. This chapter concludes with a Mini-Case, Mrs. Watanabe and the Japanese Yen Carry Trade, that demonstrates how both the theory and practice of international parity conditions sometimes combine to form unusual opportunities for profit—for those who are willing to bear the risk!

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Prices and Exchange Rates If identical products or services can be sold in two different markets, and no restrictions exist on the sale or transportation of product between markets, the product’s price should be the same in both markets. This is called the law of one price. A primary principle of competitive markets is that prices will equalize across markets if frictions or costs of moving the products or services between markets do not exist. If the two markets are in two different countries, the product’s price may be stated in different currency terms, but the price of the product should still be the same. Comparing prices would require only a conversion from one currency to the other. For example, P$ * S = P¥ where the price of the product in U.S. dollars (P$), multiplied by the spot exchange rate (S, yen per U.S. dollar), equals the price of the product in Japanese yen (P¥). Conversely, if the prices of the two products were stated in local currencies, and markets were efficient at competing away a higher price in one market relative to the other, the exchange rate could be deduced from the relative local product prices: S =

P¥ P$

Purchasing Power Parity and the Law of One Price If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. By comparing the prices of identical products denominated in different currencies, one could determine the “real” or PPP exchange rate that should exist if markets were efficient. This is the absolute version of purchasing power parity. Absolute purchasing power parity states that the spot exchange rate is determined by the relative prices of similar baskets of goods. The “Big Mac Index,” as it has been christened by The Economist (see Exhibit 6.1) and calculated regularly since 1986, is a prime example of the law of one price. Assuming that the Big Mac is indeed identical in all countries listed, it serves as one form of comparison of whether currencies are currently trading at market rates that are close to the exchange rate implied by Big Macs in local currencies. For example, using Exhibit 6.1, in China a Big Mac costs Yuan 16.0 (local currency), while in the United States the same Big Mac costs $4.56. The actual spot exchange rate was Yuan6.1341/$ at this time. The price of a Big Mac in China in U.S. dollar terms was therefore Price of Big Mac in China in Yuan Yuan16.0 = = $2.61 Yuan/$ Spot Rate Yuan6.1341/$ This is the value in column 3 of Exhibit  6.1 for China. We then calculate the implied ­ urchasing power parity rate of exchange using the actual price of the Big Mac in China (Yuan16.0) p over the price of the Big Mac in the United States in U.S. dollars ($4.56): Price of Big Mac in China in Yuan Yuan16.0 = = Yuan3.509/$ Price of Big Mac in the U.S. in $ $4.56 This is the value in column 4 of Exhibit 6.1 for China. In principle, this is what the Big Mac Index is saying the exchange rate between the Yuan and the dollar should be according to the theory.

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Chapter 6   International Parity Conditions

Exhibit 6.1 Selected Rates from the Big Mac Index (1) Big Mac Price in Local Currency

(2) Actual Dollar Exchange Rate July 2013

(3) Big Mac Price in Dollars

$

4.56

—

4.56

Country and Currency United States Britain Canada China

(4) Implied PPP of the Dollar —

(5) Under/Overvaluation Against Dollar** —

£

2.69

1.4945*

4.02

1.695*

C$

5.53

1.0513

5.26

1.213

15.4%

- 11.8%

Yuan

16.0

6.1341

2.61

3.509

- 42.8%

Denmark

DK

28.5

5.8006

4.91

6.250

7.7%

Euro area

€

3.62

1.2858*

4.66

India

1.258*

2.2%

90.0

59.9800

1.50

19.737

- 67.1% - 29.9%

Japan

¥

320

100.11

3.20

70.175

Norway

kr

46.00

6.1281

7.51

10.088

64.6%

Peru

Sol

10.0

2.7830

3.59

2.193

- 21.2%

87.0

32.9389

2.64

19.079

- 42.1%

Switzerland

SFr

6.50

0.9674

6.72

1.425

47.3%

Thailand

Baht

89.0

31.2750

2.85

19.518

- 37.6%

Russia

* These exchange rates are stated in US$ per unit of local currency, $/£ and $/€. ** Percentage under/overvaluation against the dollar is calculated as (Implied-Actual)/(Actual), except for the Britain and Euro area c ­ alculations, which are (Actual-Implied)/(Implied). Source: Data for columns (1) and (2) drawn from “The Big Mac Index,” The Economist, July 2013.

Now comparing this implied PPP rate of exchange, Yuan 3.509/$, with the actual market rate of exchange at that time, Yuan 6.1341/$, the degree to which the yuan is either undervalued ( -%) or overvalued ( +%) versus the U.S. dollar is calculated as follows: Implied Rate - Actual Rate Yuan3.509/$ - Yuan6.1341/$ = ≈ -42.8% Actual Rate Yuan6.1341/$ In this case, the Big Mac Index indicates that the Chinese yuan is undervalued by 42.8% versus the U.S. dollar as indicated in column 5 for China in Exhibit 6.1. The Economist is also quick to note that although this indicates a sizable undervaluation of the managed value of the Chinese yuan versus the dollar, the theory of purchasing power parity is supposed to indicate where the value of currencies should go over the long-term, and not necessarily its value today. It is important to understand why the Big Mac may be a good candidate for the application of the law of one price and measurement of under or overvaluation. First, the product itself is nearly identical in each market. This is the result of product consistency, process excellence, and McDonald’s brand image and pride. Second, and just as important, the product is a result of predominantly local materials and input costs. This means that its price in each country is representative of domestic costs and prices and not imported ones, which would be influenced by exchange rates themselves. The index, however, still possesses limitations. Big Macs cannot be traded across borders, and costs and prices are influenced by a variety of other factors in each country market, such as real estate rental rates and taxes.

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PART 2  Foreign Exchange Theory and Markets

A less extreme form of this principle would be that in relatively efficient markets the price of a basket of goods would be the same in each market. Replacing the price of a single product with a price index allows the PPP exchange rate between two countries to be stated as S =

PI ¥ PI $

where PI ¥ and PI $ are price indices expressed in local currency for Japan and the United States, respectively. For example, if the identical basket of goods cost ¥1,000 in Japan and $10 in the United States, the PPP exchange rate would be ¥1000 = ¥100/$ $10 Just in case you are starting to believe that PPP is just about numbers, Global Finance in Practice 6.1 reminds you of the human side of the equation.

Relative Purchasing Power Parity If the assumptions of the absolute version of PPP theory are relaxed a bit, we observe what is termed relative purchasing power parity. Relative PPP holds that PPP is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between two countries over a period of time determines the change in the exchange rate over that period. More specifically, if the spot exchange rate between two countries starts in equilibrium,

Global Finance in Practice

6.1

The Immiseration of the North Korean People—The “Revaluation” of the North Korean Won The principles of purchasing power are not just theoretical, they can also capture the problems, poverty, and misery of a people. The devaluation of the North Korean won (KPW) in November 2009 was one such case. The North Korean government has been trying to stop the growth and activity in the street markets of its country for decades. For many years the street markets have been the sole opportunity for most of the Korean people to earn a living. Under the communist state’s stewardship, the quality of life for its 24 million people has continued to deteriorate. Between 1990 and 2008, the country’s infant mortality rate had increased 30%, and life expectancy had fallen by three years. The United Nations estimated that one in three children under the age of five suffered malnutrition. Although most of the working population worked officially for the government, many were underpaid (or in many cases not paid at all). They often bribed their bosses to allow them to leave work early to try to scrape out a living in the street markets of the underground economy.

But it was this very basic market economy that ­President Kim Jong-il (now deceased) and the governing regime wished to stamp out. On November 30, 2009, the Korean government made a surprise announcement to its people: a new, more valuable Korean won would replace the old one. “You have until the end of the day to exchange your old won for new won.” All old 1,000 won notes would be replaced with 10 won notes, knocking off two zeros from the officially recognized value of the currency. This meant that everyone holding old won, their cash and savings, would now officially be worth 1/100th of what it was previously. Exchange was limited to 100,000 old won. People who had worked and saved for decades to accumulate what was roughly $200 or $300 in savings outside of North Korea were wiped out; their total life savings were essentially worthless. By officially denouncing the old currency, the North Korean people would be forced to exchange their holdings for new won. The government would indeed undermine the underground economy. The results were devastating. After days of street protests, the government raised the 100,000 ceiling to 150,000. By late January 2010, inflation was rising so rapidly that Kim Jong-il apologized to the people for the revaluation’s impact on their lives. The government administrator who had led the revaluation was arrested, and in February 2010, executed “for his treason.”

Chapter 6   International Parity Conditions

141

any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate. Exhibit 6.2 shows a general case of relative PPP. The vertical axis shows the percentage change in the spot exchange rate for foreign currency, and the horizontal axis shows the percentage difference in expected rates of inflation (foreign relative to home country). The diagonal parity line shows the equilibrium position between a change in the exchange rate and relative inflation rates. For instance, point P represents an equilibrium point at which inflation in the foreign country, Japan, is 4% lower than in the home country, the United States. Therefore, relative PPP predicts that the yen will appreciate by 4% per annum with respect to the U.S. dollar. If current market expectations led to either point W or S in Exhibit 6.2, the home currency would be considered either weak (point W) or strong (point S), and the market would not be in equilibrium. The logic behind the application of PPP to changes in the spot exchange rate is that if a country experiences inflation rates higher than those of its main trading partners, and its exchange rate does not change, its exports of goods and services become less competitive with comparable products produced elsewhere. Imports from abroad become more ­price-­competitive with higher-priced domestic products. These price changes lead to a deficit on the current account in the balance of payments unless offset by capital and financial flows.

Empirical Tests of Purchasing Power Parity There has been extensive testing of both the absolute and relative versions of purchasing power parity and the law of one price.1 These tests have, for the most part, not proved PPP to be accurate in predicting future exchange rates. Goods and services do not in reality move at zero cost between countries, and in fact many services are not “tradable,” for example, Exhibit 6.2 Relative Purchasing Power Parity W (weak) P

4

Percentage change in the spot exchange rate for foreign currency

P

PP

3 ne

Li

S (strong)

2 1

–6

–5

–4

–3

–2

–1

1 –1

If the market was at point W, the expected change in the spot exchange rate would be 4% although the percentage difference in expected inflation was only –2 –2%; the home currency would be weak. –3 If the market was at point S, the expected change in the spot exchange rate would be 2% although the –4 percentage difference in expected inflation was -4%; the home currency would be strong.

2 3 4 5 6 Percentage difference in expected rates of inflation (foreign relative to home country)

See for example, Kenneth Rogoff, “The Purchasing Power Parity Puzzle,” Journal of Economic Literature, ­Vol. 34, No. 2, June 1996, 647–668; and Barry K. Goodwin, Thomas Greenes, and Michael K. Wohlgenant, “Testing the Law of One Price When Trade Takes Time,” Journal of International Money and Finance, March 1990, pp. 21–40.

1

PART 2  Foreign Exchange Theory and Markets

for haircuts. Many goods and services are not of the same quality across countries, reflecting differences in the tastes and resources of the countries of their manufacture and consumption. Two general conclusions can be made from these tests: 1) PPP holds up well over the very long run but poorly for shorter time periods; and 2) The theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets.

Exchange Rate Indices: Real and Nominal Because any single country trades with numerous partners, we need to track and evaluate its individual currency value against all other currency values in order to determine relative purchasing power. The objective is to discover whether its exchange rate is “overvalued” or “undervalued” in terms of PPP. One of the primary methods of dealing with this problem is the calculation of exchange rate indices. These indices are formed by trade-weighting the bilateral exchange rates between the home country and its trading partners. The nominal effective exchange rate index uses actual exchange rates to create an index, on a weighted average basis, of the value of the subject currency over time. It does not really indicate anything about the “true value” of the currency or anything related to PPP. The nominal index simply calculates how the currency value relates to some arbitrarily chosen base period, but it is used in the formation of the real effective exchange rate index. The real effective exchange rate index indicates how the weighted average purchasing power of the currency has changed relative to some arbitrarily selected base period. Exhibit 6.3 plots the real effective exchange rate indexes for Japan, the euro area, and the U.S. for the 1980–2012 period.

Exhibit 6.3 R  eal Effective Exchange Rate Indexes for the U.S., Japan, and the Euro Area Index Value (2005 = 100) 140 U.S. dollar

Japanese yen

130 120 110 100 90 80

Euro Area euro

70

19 8 19 0 8 19 1 8 19 2 8 19 3 8 19 4 8 19 5 8 19 6 8 19 7 8 19 8 8 19 9 9 19 0 9 19 1 9 19 2 9 19 3 9 19 4 9 19 5 9 19 6 9 19 7 9 19 8 9 20 9 0 20 0 0 20 1 0 20 2 0 20 3 0 20 4 0 20 5 0 20 6 0 20 7 0 20 8 0 20 9 1 20 0 1 20 1 12

142

Source: International Financial Statistics, IMF, annual, CPI-weighted real effective exchange rates, series RECZF.

Chapter 6   International Parity Conditions

143

The real effective exchange rate index for the U.S. dollar, E $R, is found by multiplying the nominal effective exchange rate index, E $N, by the ratio of U.S. dollar costs, C $ over foreign currency costs, C FC, both in index form: E $R = E $N *

C$ C FC

If changes in exchange rates just offset differential inflation rates—if purchasing power parity holds—all the real effective exchange rate indices would stay at 100. If an exchange rate strengthened more than was justified by differential inflation, its index would rise above 100. If the real effective exchange rate index were above 100, the currency would be considered “overvalued” from a competitive perspective. An index value below 100 would suggest an “undervalued” currency. Exhibit 6.3 shows how the real effective exchange rate of the U.S. dollar, Japanese yen, and the European euro have changed over the past three decades. The dollar’s index value was substantially above 100 in the early 1980s (overvalued), falling below 100 during the 1988–1997 period (undervalued), then rising above 100 again. According to this index, the dollar has consistently been undervalued since 2006. In this same post-2006 period, the euro has consistently been above 100, while the Japanese yen has bounced upwards from being significantly undervalued to slightly overvalued in recent years. Apart from measuring deviations from PPP, a country’s real effective exchange rate is an important tool for management when predicting upward or downward pressure on a country’s balance of payments and exchange rate, as well as an indicator of whether producing for export in that country could be highly competitive.

Exchange Rate Pass-Through Incomplete exchange rate pass-through is one reason that a country’s real effective exchange rate index can deviate for lengthy periods from its PPP-equilibrium level of 100. The degree to which the prices of imported and exported goods change as a result of exchange rate changes is termed exchange rate pass-through. Although PPP implies that all exchange rate changes are passed through by equivalent changes in prices to trading partners, empirical research in the 1980s questioned this long-held assumption. For example, sizable current account deficits of the United States in the 1980s and 1990s did not respond to changes in the value of the dollar. To illustrate exchange rate pass-through, assume that BMW produces an automobile in Germany and pays all production expenses in euros. When the firm exports the auto to the United States, the price of the BMW in the U.S. market should simply be the euro value ­converted to dollars at the spot exchange rate: P$BMW = P;BMW * S$/; where P$BMW is the BMW price in dollars, P ;BMW is the BMW price in euros, and S$/; is the spot exchange rate in number of dollars per euro. If the euro appreciated 10% versus the U.S. dollar, the new spot exchange rate should result in the price of the BMW in the United States rising a proportional 10%. If the price in dollars increases by the same percentage change as the exchange rate, the pass-through of exchange rate changes is complete (or 100%). However, if the price in dollars rises by less than the percentage change in exchange rates (as is often the case in international trade), the pass-through is partial, as illustrated in Exhibit 6.4. The 71% pass-through (U.S. dollar prices rose only 14.29% when the euro

144

PART 2  Foreign Exchange Theory and Markets

Exhibit 6.4 Exchange Rate Pass-Through Exchange rate pass-through is the measure of response of imported and exported product prices to exchange rate changes. Assume that the price in U.S. dollars and Euros of a BMW automobile produced in Germany and sold in the United States at the spot exchange rate is calculated as follows: $/: P $BMW = P : = :35,000 * $1.00/: = $35,000 BMW * S

If the euro were to appreciate 20% versus the U.S. dollar, from $1.00/€ to $1.20/€, the price of the BMW in the U.S. market should theoretically rise to $42,000. But if the price of the BMW in the U.S. does not rise by 20%, for example rising to only $40,000, then the degree of exchange rate pass-through is only partial. P $BMW,2 P $BMW,1

-

$40,000 = 1.1429, or a 14.29% increase $35,000

The degree of exchange rate pass-through is measured by the proportion of the exchange rate change reflected in the final price, in this case, the final U.S. dollar price of the BMW. In this example, the dollar price of the BMW rose only 14.29%, not 20% ([$42,000 , $35,000] - 1), resulting in a pass-through of 71% (14.29% , 20.00%). This means that only 71% of the exchange rate change was passed-through to the U.S. dollar price. The remaining 29% of the exchange rate change was absorbed in a reduced margin by BMW.

appreciated 20%) implies that BMW is absorbing a portion of the adverse exchange rate change. This absorption could result from smaller profit margins, cost reductions, or both. For example, components and raw materials imported to Germany cost less in euros when the euro appreciates. It is also likely that some time may pass before all exchange rate changes are finally reflected in the prices of traded goods, including the period over which previously signed contracts are delivered upon. It is obviously in the interest of BMW to keep the appreciation of the euro from raising the price of its automobiles in major export markets. The concept of price elasticity of demand is useful when determining the desired level of pass-through. Recall that the price elasticity of demand for any good is the percentage change in quantity of the good demanded as a result of the percentage change in the good’s price: Price elasticity of demand = ep =

%∆Qd %∆P

where Qd is quantity demanded and P is product price. If the absolute value of ep is less than 1.0, then the good is relatively “inelastic.” If it is greater than 1.0, the good is relatively “elastic.” A German product that is relatively price-inelastic, meaning that the quantity demanded is relatively unresponsive to price changes, may often demonstrate a high degree of passthrough. This is because a higher dollar price in the United States market would have little noticeable effect on the quantity of the product demanded by consumers. Dollar revenue would increase, but euro revenue would remain the same. However, products that are relatively price-elastic would respond in the opposite way. If the 20% euro appreciation resulted in 20% higher dollar prices, U.S. consumers would decrease the number of BMWs purchased. If the price elasticity of demand for BMWs in the United States were greater than one, total dollar sales revenue of BMWs would decline.

Chapter 6   International Parity Conditions

145

Interest Rates and Exchange Rates We have already seen how prices of goods in different countries should be related through exchange rates. We now consider how interest rates are linked to exchange rates.

The Fisher Effect The Fisher effect, named after economist Irving Fisher, states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation. More formally, this is derived from (1 + r)(1 + p) - 1 as: i = r + p + rp where i is the nominal rate of interest, r is the real rate of interest, and p is the expected rate of inflation over the period of time for which funds are to be lent. The final compound term, rp, is frequently dropped from consideration due to its relatively minor value. The Fisher effect then reduces to (approximate form): i = r + p The Fisher effect applied to the United States and Japan would be as follows: i $ = r $ + p $; i ¥ = r ¥ + p ¥ where the superscripts $ and ¥ pertain to the respective nominal (i), real (r), and expected inflation (p) components of financial instruments denominated in dollars and yen, respectively. We need to forecast the future rate of inflation, not what inflation has been. Predicting the future is, well, difficult. Empirical tests using ex-post national inflation rates have shown that the Fisher effect usually exists for short-maturity government securities such as Treasury bills and notes. Comparisons based on longer maturities suffer from the increased financial risk inherent in fluctuations of the market value of the bonds prior to maturity. Comparisons of private sector securities are influenced by unequal creditworthiness of the issuers. All the tests are inconclusive to the extent that recent past rates of inflation are not a correct measure of future expected inflation.

The International Fisher Effect The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as the international Fisher effect. “Fisher-open,” as it is often termed, states that the spot exchange rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries. More formally, S1 - S2 = i$ - i¥ S2 where i$ and i¥ are the respective national interest rates, and S is the spot exchange rate using indirect quotes (an indirect quote on the dollar is, for example, ¥/$) at the beginning of the period (S1) and the end of the period (S2). This is the approximation form commonly used in industry. The precise formulation is as follows: S1 - S2 i$ - i¥ = S2 1 + i¥ Justification for the international Fisher effect is that investors must be rewarded or penalized to offset the expected change in exchange rates. For example, if a dollar-based

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investor buys a 10-year yen bond earning 4% interest, instead of a 10-year dollar bond ­earning 6% interest, the investor must be expecting the yen to appreciate vis-à-vis the dollar by at least 2% per year during the 10 years. If not, the dollar-based investor would be better off remaining in dollars. If the yen appreciates 3% during the 10-year period, the dollar-based investor would earn a bonus of 1% higher return. However, the international Fisher effect predicts that, with unrestricted capital flows, an investor should be indifferent to whether his bond is in dollars or yen—because investors worldwide would see the same opportunity and compete it away. Empirical tests lend some support to the relationship postulated by the international Fisher effect, although considerable short-run deviations occur. A more serious criticism has been posed, however, by recent studies that suggest the existence of a foreign exchange risk premium for most major currencies. Also, speculation in uncovered interest arbitrage creates distortions in currency markets. Thus, the expected change in exchange rates might consistently be greater than the difference in interest rates.

The Forward Rate A forward rate (or outright forward as described in Chapter 5) is an exchange rate quoted today for settlement at some future date. A forward exchange agreement between currencies states the rate of exchange at which a foreign currency will be “bought forward” or “sold ­forward” at a specific date in the future (typically after 30, 60, 90, 180, 270, or 360 days). The forward rate is calculated for any specific maturity by adjusting the current spot exchange rate by the ratio of euro currency interest rates of the same maturity for the two subject currencies. For example, the 90-day forward rate for the Swiss franc/U.S. dollar exchange rate (F SF/$) is found by multiplying the current spot rate (SSF/$) by the ratio of the 90-day euro-Swiss franc deposit rate (iSF) over the 90-day eurodollar deposit rate (i$): J1 + ¢ iSF *

90 ≤R 360

J1 + ¢ i$ *

90 ≤R 360

= SSF/$ * F SF/$ 90

Assuming a spot rate of SF1.4800/$, a 90-day euro Swiss franc deposit rate of 4.00% per annum, and a 90-day eurodollar deposit rate of 8.00% per annum, the 90-day forward rate is SF1.4655/$: J1 + ¢ 0.0400 * = SF1.4800/$ * F SF/$ 90 J1 + ¢ 0.0800 *

90 ≤R 360 90 ≤R 360

= SF1.4800/$ *

1.01 = SF1.4655/$ 1.02

The forward premium or discount is the percentage difference between the spot and forward exchange rate, stated in annual percentage terms. When the foreign currency price of the home currency is used, as in this case of SF/$, the formula for the percent-per-annum premium or discount becomes: f SF =

Spot - Forward 360 * * 100 Forward Days

Chapter 6   International Parity Conditions

147

Exhibit 6.5 Currency Yield Curves and the Forward Premium Eurodollar yield curve

10.0% 9.0%

Interest Yield

8.0% 7.0%

Forward premium is the percentage difference of 3.96%

6.0% 5.0%

Euro-Swiss franc yield curve

4.0% 3.0% 2.0% 1.0% 30

60

90

120

150

180

Days Forward

Substituting the SF/$ spot and forward rates, as well as the number of days forward (90), f SF =

SF1.4800/$ - SF1.4655/$ 360 * * 100 = +3.96% per annum SF1.4655/$ 90

The sign is positive, indicating that the Swiss franc is selling forward at a 3.96% per annum premium over the dollar (it takes 3.96% more dollars to get a franc at the 90-day forward rate). As illustrated in Exhibit 6.5, the forward premium on the eurodollar forward arises from the differential between eurodollar interest rates and Swiss franc interest rates. Because the forward rate for any particular maturity utilizes the specific interest rates for that term, the forward premium or discount on a currency is visually obvious—the currency with the higher interest rate (in this case the U.S. dollar) will sell forward at a discount, and the currency with the lower interest rate (here the Swiss franc) will sell forward at a premium. The forward rate is calculated from three observable data items—the spot rate, the foreign currency deposit rate, and the home currency deposit rate—and is not a forecast of the future spot exchange. It is, however, frequently used by managers as a forecast, with mixed results, as the following section describes.

Interest Rate Parity (IRP) The theory of interest rate parity (IRP) provides the link between the foreign exchange markets and the international money markets. The theory states: The difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs. Exhibit 6.6 shows how the theory of interest rate parity works. Assume that an investor has $1,000,000 and several alternative but comparable Swiss franc (SF) monetary investments. If the investor chooses to invest in a dollar money market instrument, the investor would earn

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Exhibit 6.6 Interest Rate Parity (IRP)

Start $1,000,000

i $ = 8.00% per annum (2.00% per 90 days)

End $1,020,000

 1.02

$1,019,993*

Dollar Money Market

S = SF1.4800/$

F90 = SF1.4655/$

90 Days

Swiss Franc Money Market SF1,480,000

SF1,494,800

 1.01 i SF= 4.0% per annum (1.00% per 90 days)

the dollar rate of interest. This results in (1 + i$) at the end of the period, where i$ is the dollar rate of interest in decimal form. The investor may, however, choose to invest in a Swiss franc money market instrument of identical risk and maturity for the same period. This action would require that the investor exchange the dollars for francs at the spot rate, invest the francs in a money market instrument, sell the francs forward (in order to avoid any risk that the exchange rate would change), and at the end of the period convert the resulting proceeds back to dollars. A dollar-based investor would evaluate the relative returns of starting in the top-left corner and investing in the dollar market (straight across the top of the box) compared to investing in the Swiss franc market (going down and then around the box to the top-right corner). The comparison of returns would be as follows: (1 + i$) = SSF/$ * (1 + iSF) *

1 F

SF/$

where S = spot rate of exchange and F = the forward rate of exchange. Substituting in the spot rate (SF1.4800/$) and forward rate (SF1.4655/$) and respective interest rates from Exhibit 6.6, the interest rate parity condition is as follows: (1 + 0.02) = 1.4800 * (1 + 0.01) *

1 1.4655

The left-hand side of the equation is the gross return the investor would earn by investing in dollars. The right-hand side is the gross return the investor would earn by exchanging dollars for Swiss francs at the spot rate, investing the franc proceeds in the Swiss franc money market, and simultaneously selling the principal plus interest in Swiss francs forward for dollars at the current 90-day forward rate. Ignoring transaction costs, if the returns in dollars are equal between the two alternative money market investments, the spot and forward rates are considered to be at IRP.

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The transaction is “covered,” because the exchange rate back to dollars is guaranteed at the end of the 90-day period. Therefore, as shown in Exhibit 6.6, in order for the two alternatives to be equal, any differences in interest rates must be offset by the difference between the spot and forward exchange rates (in approximate form): (1 + iSF) SF1.4655/$ F 1.01 , or = = = 0.9902 ≈ 1% $ S SF1.4800/$ 1.02 (1 + i )

Covered Interest Arbitrage (CIA) The spot and forward exchange markets are not constantly in the state of equilibrium described by interest rate parity. When the market is not in equilibrium, the potential for “riskless” or arbitrage profit exists. The arbitrager who recognizes such an imbalance will move to take advantage of the disequilibrium by investing in whichever currency offers the higher return on a covered basis. This is called covered interest arbitrage (CIA). Exhibit 6.7 describes the steps that a currency trader, most likely working in the arbitrage division of a large international bank, would implement to perform a CIA transaction. The currency trader, Fye Hong, may utilize any of a number of major Eurocurrencies that his bank holds to conduct arbitrage investments. The morning conditions indicate to Fye Hong that a CIA transaction that exchanges 1 million U.S. dollars for Japanese yen, invested in a six month euroyen account and sold forward back to dollars, will yield a profit of $4,638 ($1,044,638-$1,040,000) over and above the profit available from a eurodollar investment. Conditions in the exchange markets and euromarkets change rapidly however, so if Fye Hong waits even a few minutes, the profit opportunity may disappear. Fye Hong now executes the following transaction: Step 1:  Convert $1,000,000 at the spot rate of ¥106.00/$ to ¥106,000,000 (see “Start” in

Exhibit 6.7). Step 2: Invest the proceeds, ¥106,000,000, in a euroyen account for six months, earning 4.00% per annum, or 2% for 180 days. Exhibit 6.7 Covered Interest Arbitrage (CIA) Eurodollar rate = 8.00% per annum Start $1,000,000

End  1.04 Dollar Money Market

S = ¥106.00/$

180 Days

$1,040,000 $1,044,638

F180 = ¥103.50/$

Yen Money Market ¥106,000,000

 1.02 Euroyen Rate = 4.00% per annum

¥108,120,000

Arbitrage potential

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Step 3: Simultaneously sell the future yen proceeds (¥108,120,000) forward for dollars at

the 180-day forward rate of ¥103.50/$. This action “locks in” gross dollar revenues of $1,044,638 (see “End” in Exhibit 6.7). Step 4: Calculate the cost (opportunity cost) of funds used at the eurodollar rate of 8.00% per annum, or 4% for 180 days, with principal and interest then totaling $1,040,000. Profit on CIA (“End”) is $4,638 ($1,044,638-$1,040,000). Note that all profits are stated in terms of the currency in which the transaction was initialized, but that a trader may conduct investments denominated in U.S. dollars, Japanese yen, or any other major currency. Rule of Thumb.  All that is required to make a covered interest arbitrage profit is for interest rate parity not to hold. Depending on the relative interest rates and forward premium, Fye Hong would have started in Japanese yen, invested in U.S. dollars, and sold the dollars forward for yen. The profit would then end up denominated in yen. But how would Fye Hong decide in which direction to go around the box in Exhibit 6.7? The key to determining whether to start in dollars or yen is to compare the differences in interest rates to the forward premium on the yen (the cost of cover). For example, in Exhibit 6.7, the difference in 180-day interest rates is 2.00% (dollar interest rates are higher by 2.00%). The premium on the yen for 180 days forward is as follows: f¥ =

Spot - Forward 360 ¥106.00/$ - ¥103.50/$ * * 100 = * 200 = 4.8309% Forward 180 ¥103.50/$

In other words, by investing in yen and selling the yen proceeds forward at the forward rate, Fye Hong earns more on the combined interest rate arbitrage and forward premium than if he continues to invest in dollars. Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward ­premium (or expected change in the spot rate), invest in the higher interest yielding currency. If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower interest yielding currency. Using this rule of thumb should enable Fye Hong to choose in which direction to go around the box in Exhibit 6.7. It also guarantees that he will always make a profit if he goes in the right direction. This rule assumes that the profit is greater than any transaction costs incurred. This process of CIA drives the international currency and money markets toward the equilibrium described by interest rate parity. Slight deviations from equilibrium provide opportunities for arbitragers to make small riskless profits. Such deviations provide the supply and demand forces that will move the market back toward parity (equilibrium). Covered interest arbitrage opportunities continue until interest rate parity is reestablished, because the arbitragers are able to earn risk-free profits by repeating the cycle as often as possible. Their actions, however, nudge the foreign exchange and money markets back toward equilibrium for the following reasons: 1. The purchase of yen in the spot market and the sale of yen in the forward market narrows the premium on the forward yen. This is because the spot yen strengthens from the extra demand and the forward yen weakens because of the extra sales. A narrower premium on the forward yen reduces the foreign exchange gain previously captured by investing in yen.

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151

2. The demand for yen-denominated securities causes yen interest rates to fall, and the higher level of borrowing in the United States causes dollar interest rates to rise. The net result is a wider interest differential in favor of investing in the dollar.

Uncovered Interest Arbitrage (UIA) A deviation from covered interest arbitrage is uncovered interest arbitrage (UIA), wherein investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceeds into currencies that offer much higher interest rates. The transaction is “uncovered,” because the investor does not sell the higher yielding currency proceeds forward, choosing to remain uncovered and accept the currency risk of exchanging the higher yield currency into the lower yielding currency at the end of the period. Exhibit 6.8 demonstrates the steps an uncovered interest arbitrager takes when undertaking what is termed the “yen carry-trade.” The “yen carry-trade” is an age-old application of UIA. Investors, from both inside and outside Japan, take advantage of extremely low interest rates in Japanese yen (0.40% per annum) to raise capital. Investors exchange the capital they raise for other currencies like U.S. dollars or euros. Then they reinvest these dollar or euro proceeds in dollar or euro money markets where the funds earn substantially higher rates of return (5.00% per annum in Exhibit 6.8). At the end of the period—a year, in this case—they convert the dollar proceeds back into Japanese yen in the spot market. The result is a tidy profit over what it costs to repay the initial loan. The trick, however, is that the spot exchange rate at the end of the year must not change significantly from what it was at the beginning of the year. If the yen were to appreciate significantly against the dollar, as it did in late 1999, moving from ¥120/$ to ¥105/$, these “uncovered” investors would suffer sizable losses when they convert their dollars into yen to repay the yen they borrowed. Higher return at higher risk. The Mini-Case at the end of this chapter details one of the most frequent carry trade structures, the Australian dollar/Japanese yen cross rate. Global Finance in Practice 6.2 also demonstrates how foreign-currency home mortgages can turn an innocent homeowner into a foreign currency speculator.

Exhibit 6.8 Uncovered Interest Arbitrage (UIA): The Yen Carry Trade Investors borrow yen at 0.40% per annum Start ¥10,000,000

End  1.004 Japanese Yen Money Market

S = ¥120.00/$

360 Days

¥10,040,000 Repay ¥10,500,000 Earn ¥ 460,000 Profit

S360= ¥120.00/$

U.S. Dollar Money Market $83,333.33

 1.05 Invest dollars at 5.00% per annum

$87,500.00

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Global Finance in Practice

6.2

Hungarian Mortgages No one has learned the linkage between interest rates and currencies better than Hungarian homeowners. Given the choice of taking mortgages in local currency (Hungarian forint) or foreign currency (Swiss francs for

example), many chose francs because the interest rates were lower. But regardless of the actual interest rate itself, the fall in the value of the forint against the franc by more than 40% has resulted in radically increasing mortgage debt service payments. These borrowers are now trying to have their own mortgages declared “unconstitutional” in order to get out from under their rising debt burdens.

Hungarian forint = 1.00 Swiss franc (monthly, January 2000–January 2014) 260 Rising to HUN 240  1.00 CHF

240

220  40% 200 Averaging about HUN 170  1.00 CHF

180

160

140

00

Ju n N -00 ov Ap -00 r Se -01 pFe 01 b Ju -02 l D -02 ec M -0 ay 2 O -03 ct M -03 ar Au -04 g Ja -04 n Ju -05 n N -05 ov Ap -05 r Se -06 pFe 06 b Ju -07 l D -07 ec M -07 ay O -08 c M t-08 ar Au -09 g Ja -09 nJu 10 n N -10 ov Ap -10 r Se -11 pFe 11 b Ju -12 l D -12 ec M -12 ay -1 3

n-

Ja

3 -1 ct

O

Equilibrium between Interest Rates and Exchange Rates Exhibit 6.9 illustrates the conditions necessary for equilibrium between interest rates and exchange rates. The vertical axis shows the difference in interest rates in favor of the foreign currency, and the horizontal axis shows the forward premium or discount on that currency. The interest rate parity line shows the equilibrium state, but transaction costs cause the line to be a band rather than a thin line. Transaction costs arise from foreign exchange and investment brokerage costs on buying and selling securities. Typical transaction costs in recent years have been in the range of 0.18% to 0.25% on an annual basis. For individual transactions, like Fye Hong’s covered interest arbitrage (CIA) activities illustrated in Exhibit 6.7, there is no explicit transaction cost per trade; rather, the costs of the bank in supporting Fye Hong’s activities are the transaction costs. Point X in Exhibit 6.9 shows one possible equilibrium position, where a 4% lower rate of interest on yen securities would be offset by a 4% premium on the forward yen. The disequilibrium situation, which encouraged the interest rate arbitrage in the previous CIA example of Exhibit 6.7, is illustrated in Exhibit 6.9 by point U. Point U is located off the

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Chapter 6   International Parity Conditions

Exhibit 6.9 Interest Rate Parity and Equilibrium

4 3 2

Percentage premium on foreign currency (¥)

1 –6

–5

–4

–3

–2

–1

4.83 1

2

3

4

5

6

–1 –2 –3 Percentage difference between foreign (¥) and domestic ($) interest rates

–4

X Y

U Z

interest rate parity line because the lower interest on the yen is 4% (annual basis), whereas the premium on the forward yen is slightly over 4.8% (annual basis). Using the formula for forward premium presented earlier, we can find the premium on the yen as follows: 360 Days ¥106.00/$ - 103.50/$ * * 100 = 4.83% ¥103.50/$ 180 Days The situation depicted by point U is unstable, because all investors have an incentive to execute the same covered interest arbitrage. Except for a bank failure, the arbitrage gain is virtually risk-free. Some observers have suggested that political risk does exist, because one of the governments might apply capital controls that would prevent execution of the forward contract. This risk is fairly remote for covered interest arbitrage between major financial centers of the world, especially because a large portion of funds used for covered interest arbitrage is in eurodollars. The concern may be valid for pairings with countries not noted for political and fiscal stability. The net result of the disequilibrium is that fund flows will narrow the gap in interest rates and/or decrease the premium on the forward yen. In other words, market pressures will cause point U in Exhibit 6.9 to move toward the interest rate parity band. Equilibrium might be reached at point Y, or at any other locus between X and Z, depending on whether forward market premiums are more or less easily shifted than interest rate differentials.

Forward Rate as an Unbiased Predictor of the Future Spot Rate Some forecasters believe that foreign exchange markets for the major floating currencies are “efficient” and forward exchange rates are unbiased predictors of future spot exchange rates. Exhibit 6.10 demonstrates the meaning of “unbiased prediction” in terms of how the forward rate performs in estimating future spot exchange rates. If the forward rate is an unbiased

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Exhibit 6.10 Forward Rate as an Unbiased Predictor for Future Spot Rate Exchange Rate t1

t2

t3

t4

F2

S2 S1

Error

Error

F3 Error

S3

F1

S4

t1

t2

t3

t4

Time

The forward rate available today (Ft, t + 1), time t, for delivery at future time t + 1, is used as a “predictor” of the spot rate that will exist at that day in the future. Therefore, the forecast spot rate for time St2 is F1 ; the actual spot rate turns out to be S2. The vertical distance between the prediction and the actual spot rate is the forecast error. When the forward rate is termed an “unbiased predictor of the future spot rate,” it means that the forward rate overestimates or underestimates the future spot rate with relatively equal frequency and amount. It therefore “misses the mark” in a regular and orderly manner. The sum of the errors equals zero.

predictor of the future spot rate, the expected value of the future spot rate at time 2 equals the present forward rate for time 2 delivery, available now, E1 (S2) = F1,2. Intuitively, this means that the distribution of possible actual spot rates in the future is centered on the forward rate. The fact that it is an unbiased predictor, however, does not mean that the future spot rate will actually be equal to what the forward rate predicts. Unbiased prediction simply means that the forward rate will, on average, overestimate and underestimate the actual future spot rate in equal frequency and degree. The forward rate may, in fact, never actually equal the future spot rate. The rationale for this relationship is based on the hypothesis that the foreign exchange market is reasonably efficient. Market efficiency assumes that 1) All relevant information is quickly reflected in both the spot and forward exchange markets; 2) Transaction costs are low; and 3) Instruments denominated in different currencies are perfect substitutes for one another. Empirical studies of the efficient foreign exchange market hypothesis have yielded conflicting results. Nevertheless, a consensus is developing that rejects the efficient market hypothesis. It appears that the forward rate is not an unbiased predictor of the future spot rate and that it does pay to use resources to attempt to forecast exchange rates. If the efficient market hypothesis is correct, a financial executive cannot expect to profit in any consistent manner from forecasting future exchange rates, because current quotations in the forward market reflect all that is presently known about likely future rates. Although future exchange rates may well differ from the expectation implicit in the present forward market quotation, we cannot know today which way actual future quotations will differ from today’s forward rate. The expected mean value of deviations is zero. The forward rate is therefore an “unbiased” estimator of the future spot rate. Tests of foreign exchange market efficiency, using longer time periods of analysis, conclude that either exchange market efficiency is untestable or, if it is testable, that the market is not efficient. Furthermore, the existence and success of foreign exchange forecasting services suggest that managers are willing to pay a price for forecast information even though they

Chapter 6   International Parity Conditions

155

can use the forward rate as a forecast at no cost. The “cost” of buying this information is, in many circumstances, an “insurance premium” for financial managers who might get fired for using their own forecast, including forward rates, when that forecast proves incorrect. If they “bought” professional advice that turned out wrong, the fault was not in their forecast! If the exchange market is not efficient, it is sensible for a firm to spend resources on forecasting exchange rates. This is the opposite conclusion to the one in which exchange markets are deemed efficient.

Prices, Interest Rates, and Exchange Rates in Equilibrium Exhibit 6.11 illustrates all of the fundamental parity relations simultaneously, in equilibrium, using the U.S. dollar and the Japanese yen. The forecasted inflation rates for Japan and the United States are 1% and 5%, respectively—a 4% differential. The nominal interest rate in the U.S. dollar market (1-year government security) is 8%—a differential of 4% over the Japanese nominal interest rate of 4%. The spot rate is ¥104/$, and the 1-year forward rate is ¥100/$. Relation A: Purchasing Power Parity (PPP).  According to the relative version of purchasing power parity, the spot exchange rate one year from now, S2, is expected to be ¥100/$: S2 = S1 *

1 + p¥ 1 + p

$

= ¥104/$ *

1.01 = ¥100/$ 1.05

This is a 4% change and equal, but opposite in sign, to the difference in expected rates of inflation (1% - 5%, or -4%). Relation B: The Fisher Effect.  The real rate of return is the nominal rate of interest less the expected rate of inflation. Assuming efficient and open markets, the real rates of return should be equal across currencies. Here, the real rate is 3% in U.S. dollar markets (r = i - p = 8% - 5%) and in Japanese yen markets (4% - 1%). Note that the 3% real rate of return is not in Exhibit 6.11, but rather the Fisher effect’s relationship—that nominal interest rate differentials equal the difference in expected rates of inflation, -4%. Relation C: International Fisher Effect.  The forecast change in the spot exchange rate, in this case 4%, is equal to, but opposite in sign to, the differential between nominal interest rates: S1 - S2 * 100 = i¥ - i$ = -4% S2 Relation D: Interest Rate Parity (IRP).  According to the theory of interest rate parity, the difference in nominal interest rates is equal to, but opposite in sign to, the forward premium. For this numerical example, the nominal yen interest rate (4%) is 4% less than the nominal dollar interest rate (8%): i¥ - i$ = 1% - 5% = -4% and the forward premium, f ¥, is a positive 4%: S1 - F ¥104/$ - ¥100/$ * 100 = * 100 = 4% F ¥100/$ Relation E: Forward Rate as an Unbiased Predictor.  Finally, the 1-year forward rate on the Japanese yen, F, if assumed to be an unbiased predictor of the future spot rate, also forecasts ¥100/$. f¥ =

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Exhibit 6.11 International Parity Conditions in Equilibrium (Approximate Form) Forecast Change in Spot Exchange Rate + 4% (Yen Strengthens) Purchasing Power Parity (A)

Forward Rate as an Unbiased Predictor (E)

Forward Premium on Foreign Currency + 4% (Yen Strengthens)

International Fisher Effect (C)

Forecast Difference in Rates of Inflation – 4% (Less in Japan)

Fisher Effect (B)

Interest Rate Parity (D) Difference in Nominal Interest Rates – 4% (Less in Japan)

Summary Points ■

Parity conditions have traditionally been used by economists to help explain the long-run trend in an exchange rate.

■

Under conditions of freely floating rates, the expected rate of change in the spot exchange rate, differential rates of national inflation and interest, and the forward discount or premium are all directly proportional to each other and mutually determined. A change in one of these variables has a tendency to change all of them with a feedback on the variable that changes first.

■

If the identical product or service can be sold in two different markets, and there are no restrictions on its sale or transportation costs of moving the product between markets, the product’s price should be the same in both markets. This is called the law of one price.

■

The absolute version of purchasing power parity states that the spot exchange rate is determined by the relative prices of similar baskets of goods.

■

The relative version of purchasing power parity states that if the spot exchange rate between two countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate.

■

The Fisher effect, named after economist Irving Fisher, states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation.

■

The international Fisher effect, “Fisher-open” as it is often termed, states that the spot exchange rate should change in an equal amount, but in the opposite direction, to the difference in interest rates between two countries.

■

The theory of interest rate parity (IRP) states that the difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs.

■

When the spot and forward exchange markets are not in equilibrium as described by interest rate parity, the potential for “riskless” or arbitrage profit exists. This is called covered interest arbitrage (CIA).

■

Some forecasters believe that for the major floating currencies, foreign exchange markets are “efficient” and forward exchange rates are unbiased predictors of future spot exchange rates.

Chapter 6   International Parity Conditions

Mini-Case

Mrs. Watanabe and the Japanese Yen Carry Trade1 At more than ¥ 1,500,000bn (some $16,800bn), these savings are considered the world’s biggest pool of investable wealth. Most of it is stashed in ordinary Japanese bank accounts; a surprisingly large amount is kept at home in cash, in tansu savings, named for the traditional wooden cupboards in which people store their possessions. But from the early 2000s, the housewives—often referred to collectively as “Mrs. Watanabe”, a common Japanese ­surname—began to hunt for higher returns. —“Shopping, Cooking, Cleaning… Playing The Yen Carry Trade,” Financial Times, February 21, 2009. Over the past 20 years, Japanese yen interest rates have remained extremely low by global standards. For years the monetary authorities at the Bank of Japan have worked tirelessly fighting equity market collapses, deflationary pressures, liquidity traps, and economic recession, all by keeping yen-denominated interests rates hovering at around 1% per annum or lower. Combined with a sophisticated financial industry of size and need, these low interest rates have spawned an international financial speculation termed the yen carry trade. In the textbooks, this trading strategy is categorized more formally, as uncovered interest arbitrage (UIA). It is a fairly simple speculative position: borrow money where it is cheap and invest it in a different currency market with higher interest returns. The only real trick is to time the market ­correctly so that when the currency in the high-yield market is ­converted back to the original currency, the exchange rate has either stayed the same or moved in favor of the speculator. “In favor of” means that the high-yielding ­currency has strengthened against the borrowed currency. And as ­Shakespeare stated, “ay, there’s the rub.” Yen Availability But why the focus on Japan? Aren’t there other major currency markets in which interest rates are periodically low? Japan and the Japanese yen turn out to have a number of uniquely attractive characteristics to investors and speculators pursuing carry trade activities. First, Japan has consistently demonstrated one of the world’s highest savings rates for decades. This means that an enormous pool of funds has accumulated in the hands of private savers, savers who are traditionally very conservative. Those funds, whether stuffed in the mattress or placed

in savings accounts, earn little in return. (In fact, given the extremely low interest rates offered, there is little effective difference between the mattress and the bank.) A second factor facilitating the yen carry trade is the sheer size and sophistication of the Japanese financial sector. Not only is the Japanese economy one of the largest industrial economies in the world, it is one that has grown and developed with a strong international component. One only has to consider the size and global reach of Toyota or Sony to understand the established and developed infrastructure surrounding business and international finance in Japan. The Japanese banking sector, however, has been continuously in search of new and diverse investments with which to balance the often despondent domestic economy. It has therefore sought out foreign investors and foreign borrowers who are attractive customers. Multinational companies have found ready access to yen-denominated debt for years—debt which is, once again, available at extremely low interest. A third expeditor of the yen carry trade is the value of the Japanese yen itself. The yen has long been considered the most international of Asian currencies, and is widely traded. It has, however, also been exceedingly volatile over time. But it is not volatility alone, as volatility itself could undermine interest arbitrage overnight. The key has been in the relatively long trends in value change of the yen against other major currencies like the U.S. dollar, or as in the ­following example, the Australian dollar. The Australian Dollar/Japanese Yen Exchange Rate Exhibit A illustrates the movement of the Japanese yen/ Australian dollar exchange rate over a 13-year period, from 2000 through 2013. This spot rate movement and long-running periodic trends have offered a number of extended periods in which interest arbitrage was highly profitable. The two periods of Aussie dollar appreciation are clear. During those periods, an investor who was short yen and long Aussie dollars (and enjoying relatively higher Aussie dollar interest) could and did enjoy substantial returns. At least it is obvious after-the-fact! But what about shorter holding periods, say a year, in which the speculator does not have a crystal ball over the long-term trend of the spot rate—but only a guess? Consider the one-year speculation detailed in Exhibit B. An investor looking at the exchange rate in January 2009 (Exhibit A) would see a yen that had reached a recent historical “low”—a strong position against the Aussie dollar. Betting that the yen would likely bounce, weakening once again against the Aussie dollar, she could borrow

Copyright 2014 © Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Michael ­Moffett for the purpose of classroom discussion only, and not to indicate either effective or ineffective management. 1

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Exhibit A The Trending JPY and AUD Spot Rate Japanese yen  1.00 Australian dollar (monthly) 110

100

90

80

70

60

Ja

n0 Ju 0 l-0 Ja 0 n0 Ju 1 l-0 Ja 1 n0 Ju 2 l-0 Ja 2 n0 Ju 3 l-0 Ja 3 n0 Ju 4 l-0 Ja 4 n0 Ju 5 l-0 Ja 5 n0 Ju 6 l-0 Ja 6 n0 Ju 7 l-0 Ja 7 n0 Ju 8 l-0 Ja 8 n0 Ju 9 l-0 Ja 9 n1 Ju 0 l-1 Ja 0 n1 Ju 1 l-1 Ja 1 n1 Ju 2 l-1 Ja 2 n1 Ju 3 l-1 3

50

¥50 million at 1.00% interest per annum for one year. She could then exchange the ¥50 million yen for Australian dollars at ¥60.91/A$, and then deposit the A$820,883 proceeds for one year at the Australian interest rate of 4.50% per annum. The investor could even have rationalized that

even if the exchange rate did not change, she would earn a 3.50% per annum interest differential. As it turned out, the spot exchange rate one year later, in January 2010, saw a much weaker Japanese yen against the Aussie dollar, ¥83.19/A$. The one-year Aussie-Yen carry

Exhibit B The Aussie-Yen Carry Trade Start

End JPY50,500,000 71,362,297 JPY20,862,297

JPY50,000,000

1.0100

JPY to = 1 AUD 60.91

360 Days

JPY to = 1 AUD 83.19

AUS820,883

1.0450

AUS857,823

Chapter 6   International Parity Conditions

trade position would then have earned a very healthy profit of ¥20,862,296.83 on a one-year investment of ¥50,000,000, a 41.7% rate of return. Post 2009 Financial Crisis The global financial crisis of 2008–2009 has left a marketplace in which the U.S. Federal Reserve and the European Central Bank have pursued easy money policies. Both central banks, in an effort to maintain high levels of liquidity and to support fragile commercial banking systems, have kept interest rates at near-zero levels. Now global investors who see opportunities for profit in an anemic global economy are using those same low-cost funds in the U.S. and Europe to fund uncovered interest arbitrage activities. But what is making this “emerging market carry trade” so unique is not the interest rates, but the fact that investors are shorting two of the world’s core currencies: the dollar and the euro. Consider the strategy outlined in Exhibit B. An investor borrows EUR 20 million at an incredibly low rate, say 1.00% per annum or 0.50% for 180 days. The EUR 20 million are

Questions 1. Purchasing Power Parity. Define the following terms: a. The law of one price b. Absolute purchasing power parity c. Relative purchasing power parity 2. Nominal Effective Exchange Rate Index. Explain how a nominal effective exchange rate index is constructed. 3. Real Effective Exchange Rate Index. What formula is used to convert a nominal effective exchange rate index into a real effective exchange rate index? 4. Real Effective Exchange Rates: Japan and the United States. Exhibit 6.3 compares the real effective exchange rates for the United States and Japan. If the comparative real effective exchange rate was the main determinant, does the United States or Japan have a competitive advantage in exporting? Which of the two has an advantage in importing? Explain why. 5. Exchange Rate Pass-Through. Incomplete exchange rate pass-through is one reason that a country’s real effective exchange rate can deviate for lengthy periods from its purchasing power equilibrium level of 100. What is meant by the term exchange rate pass-through? 6. The Fisher Effect. Define the Fisher effect. To what extent do empirical tests confirm that the Fisher effect exists in practice? 7. The International Fisher Effect. Define the international Fisher effect. To what extent do empirical tests confirm that the international Fisher effect exists in practice?

159

then exchanged for Indian rupees (INR), the current spot rate being INR 60.4672 = EUR 1.00. The resulting INR 1,209,344,000 are put into an interest-bearing deposit with any of a number of Indian banks attempting to attract capital. The rate of interest offered, 2.50%, is not particularly high, but is greater than that available in the dollar, euro, or even yen markets. But the critical component of the strategy is not to earn the higher rupee interest (although that does help), it is the expectations of the investor regarding the direction of the INR per EUR exchange rate.

Case Questions 1. Why are interest rates so low in the traditional core markets of USD and EUR? 2. What makes this “emerging market carry trade” so different from traditional forms of uncovered interest arbitrage? 3. Why are many investors shorting the dollar and the euro?

8. Interest Rate Parity. Define interest rate parity. What is the relationship between interest rate parity and forward rates? 9. Covered Interest Arbitrage. Define the terms covered interest arbitrage and uncovered interest arbitrage. What is the difference between these two transactions? 10. Forward Rate as an Unbiased Predictor of the Future Spot Rate. Some forecasters believe that foreign exchange markets for the major floating currencies are “efficient” and forward exchange rates are unbiased predictors of future spot exchange rates. What is meant by “unbiased predictor” in terms of how the forward rate performs in estimating future spot exchange rates?

Problems 1. Pulau Penang Island Resort. Theresa Nunn is planning a 30-day vacation on Pulau Penang, Malaysia, one year from now. The present charge for a luxury suite plus meals in Malaysian ringgit (RM) is RM1,045/day. The Malaysian ringgit presently trades at RM3.1350/$. She determines that the dollar cost today for a 30-day stay would be $10,000. The hotel informs her that any increase in its room charges will be limited to any increase in the Malaysian cost of living. Malaysian inflation is expected to be 2.75% per annum, while U.S. inflation is expected to be 1.25%. a. How many dollars might Theresa expect to need one year hence to pay for her 30-day vacation? b. By what percent will the dollar cost have gone up? Why?

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PART 2   Foreign Exchange Theory and Markets

2. Crisis at the Heart of Carnaval. The Argentine peso was fixed through a currency board at Ps1.00/$ throughout the 1990s. In January 2002, the Argentine peso was floated. On January 29, 2003, it was trading at Ps3.20/$. During that one-year period, Argentina’s inflation rate was 20% on an annualized basis. Inflation in the United States during that same period was 2.2% annualized. a. What should have been the exchange rate in January 2003 if PPP held? b. By what percentage was the Argentine peso undervalued on an annualized basis? c. What were the probable causes of undervaluation? 3. Japanese/United States Parity Conditions. Derek Tosh is attempting to determine whether U.S./­ Japanese financial conditions are at parity. The current spot rate is a flat ¥89.00/$, while the 360-day forward rate is ¥84.90/$. Forecast inflation is 1.100% for Japan, and 5.900% for the United States. The 360day euroyen deposit rate is 4.700%, and the 360-day eurodollar deposit rate is 9.500%. a. Diagram and calculate whether international ­parity conditions hold between Japan and the United States. b. Find the forecasted change in the Japanese yen/ U.S. dollar (¥/$) exchange rate one year from now. 4. Traveling Down Under. Terry Lamoreaux owns homes in Sydney, Australia, and Phoenix, Arizona. He travels between the two cities at least twice a year. Because of his frequent trips, he wants to buy some new high-quality luggage. He has done his research and has decided to purchase a Briggs and Riley threepiece luggage set. There are retail stores in Phoenix and Sydney. Terry was a finance major and wants to use purchasing power parity to determine if he is paying the same price regardless of where he makes his purchase. a. If the price of the three-piece luggage set in Phoenix is $850 and the price of the same three-piece set in Sydney is A$930, using purchasing power parity, is the price of the luggage truly equal if the spot rate is A$1.0941/$? b. If the price of the luggage remains the same in Phoenix one year from now, determine the price of the luggage in Sydney in one year’s time if PPP holds true. The U.S. inflation rate is 1.15% and the Australian inflation rate is 3.13%. 5. Starbucks in Croatia. Starbucks opened its first store in Zagreb, Croatia in October 2010. In Zagreb, the price of a tall vanilla latte is 25.70kn. In New York City, the price of a tall vanilla latte is $2.65. The exchange rate between Croatian kunas (kn) and U.S. dollars is kn5.6288/$. According to purchasing power parity, is the Croatian kuna overvalued or undervalued?

6. Corolla Exports and Pass-Through. Assume that the export price of a Toyota Corolla from Osaka, Japan is ¥2,150,000. The exchange rate is ¥87.60/$. The forecast rate of inflation in the United States is 2.2% per year and in Japan it is 0.0% per year. Use this data to answer the following questions on exchange rate pass-through. a. What was the export price for the Corolla at the beginning of the year expressed in U.S. dollars? b. Assuming purchasing power parity holds, what should be the exchange rate at the end of the year? c. Assuming 100% exchange rate pass-through, what will be the dollar price of a Corolla at the end of the year? d. Assuming 75% exchange rate pass-through, what will be the dollar price of a Corolla at the end of the year? 7. Takeshi Kamada—CIA Japan (A). Takeshi Kamada, a foreign exchange trader at Credit Suisse (Tokyo), is exploring covered interest arbitrage possibilities. He wants to invest $5,000,000 or its yen equivalent, in a covered interest arbitrage between U.S. dollars and Japanese yen. He faced the following exchange rate and interest rate quotes. Is CIA profit possible? If so, how?   Arbitrage funds available

$5,000,000

  Spot rate (¥/$)

118.60

  180-day forward rate (¥/$)

117.80

  180-day U.S. dollar interest rate

4.800%

  180-day Japanese yen interest rate

3.400%

8. Takeshi Kamada—UIA Japan (B). Takeshi Kamada, Credit Suisse (Tokyo), observes that the ¥/$ spot rate has been holding steady, and that both dollar and yen interest rates have remained relatively fixed over the past week. Takeshi wonders if he should try an uncovered interest arbitrage (UIA) and thereby save the cost of forward cover. Many of Takeshi’s research associates—and their computer models—are predicting the spot rate to remain close to ¥118.00/$ for the coming 180 days. Using the same data as in Problem 7, analyze the UIA potential. 9. Copenhagen Covered (A). Heidi Høi Jensen, a foreign exchange trader at JPMorgan Chase, can invest $5 million, or the foreign currency equivalent of the bank’s short-term funds, in a covered interest arbitrage with Denmark. Using the following quotes, can Heidi make a covered interest arbitrage (CIA) profit?   Arbitrage funds available

$5,000,000

  Spot exchange rate (kr/$)

6.1720

  3-month forward rate (kr/$)

6.1980

  U.S. dollar 3-month interest rate

3.000%

  Danish kroner 3-month interest rate

5.000%

161

Chapter 6   International Parity Conditions

10. Copenhagen Covered (B). Heidi Høi Jensen is now evaluating the arbitrage profit potential in the same market after interest rates change. (Note that any time the difference in interest rates does not exactly equal the forward premium, it must be possible to make a CIA profit one way or another.)

  Arbitrage funds available

  Arbitrage funds available

$5,000,000

  Spot exchange rate (kr/$)

6.1720

15. Statoil of Norway’s Arbitrage. Statoil, the national oil company of Norway, is a large, sophisticated, and active participant in both the currency and petrochemical markets. Although it is a Norwegian company, because it operates within the global oil market, it considers the U.S. dollar, rather than the Norwegian krone, as its functional currency. Ari Karlsen is a currency trader for Statoil and has immediate use of either $3 million (or the Norwegian krone equivalent). He is faced with the following market rates and wonders whether he can make some arbitrage profits in the coming 90 days.

  3-month forward rate (kr/$)

6.1980

  U.S. dollar 3-month interest rate

4.000%

  Danish kroner 3-month interest rate

5.000%

11. Copenhagen Covered (C). Heidi Høi Jensen is again evaluating the arbitrage profit potential in the same market after another change in interest rates. (Remember that any time the difference in interest rates does not exactly equal the forward premium, it must be possible to make a CIA profit one way or another.)   Arbitrage funds available

$5,000,000

  Spot exchange rate (kr/$)

6.1720

  3-month forward rate (kr/$)

6.1980

  U.S. dollar 3-month interest rate

3.000%

  Danish kroner 3-month interest rate

6.000%

12. Casper Landsten—CIA (A). Casper Landsten is a foreign exchange trader for a bank in New York. He has $1 million (or its Swiss franc equivalent) for a shortterm money market investment and wonders whether he should invest in U.S. dollars for three months or make a CIA investment in the Swiss franc. He faces the following quotes:   Arbitrage funds available   Spot exchange rate (SFr/$)   3-month forward rate (SFr/$)

1.2740

  Swiss franc 3-month interest rate

3.200%

13. Casper Landsten—UIA (B). Casper Landsten, using the same values and assumptions as in Problem 12, decides to seek the full 4.800% return available in U.S. dollars by not covering his forward dollar receipts— an uncovered interest arbitrage (UIA) transaction. Assess this decision. 14. Casper Landsten—Thirty Days Later. One month after the events described in Problems 12 and 13, Casper Landsten once again has $1 million (or its Swiss franc equivalent) to invest for three months. He now faces the following rates. Should he again enter into a covered interest arbitrage (CIA) investment?

1.3286

  U.S. dollar 3-month interest rate

4.750%

  Swiss franc 3-month interest rate

3.625%

Arbitrage funds available

$3,000,000

Spot exchange rate (Nok/$)

6.0312

3-month forward rate (Nok/$)

6.0186

U.S. dollar 3-month interest rate

5.000%

Norwegian krone 3-month interest rate

4.450%

16. Separated by the Atlantic. Separated by more than 3,000 nautical miles and five time zones, money and foreign exchange markets in both London and New York are very efficient. The following information has been collected from the respective areas:

1.2810 4.800%

1.3392

  3-month forward rate (SFr/$)

$1,000,000

  U.S. dollar 3-month interest rate

$1,000,000

  Spot exchange rate (SFr/$)



Assumptions

London

New York

Spot exchange rate ($/€)

1.3264

1.3264

1-year Treasury bill rate

3.900%

4.500%

Expected inflation rate

Unknown

1.250%

a. What do the financial markets suggest for inflation in Europe next year? b. Estimate today’s 1-year forward exchange rate between the dollar and the euro?

17. Chamonix Chateau Rentals. You are planning a ski vacation to Mt. Blanc in Chamonix, France, one year from now. You are negotiating the rental of a chateau. The chateau’s owner wishes to preserve his real income against both inflation and exchange rate changes, and so the present weekly rent of €9,800 (Christmas season) will be adjusted upward or downward for any change in the French cost of living between now and then. You are basing your budgeting on purchasing power parity (PPP). French inflation is expected to average 3.5% for the coming year, while U.S. dollar inflation is expected to be 2.5%.

162

PART 2   Foreign Exchange Theory and Markets

The current spot rate is $1.3620/€. What should you budget as the U.S. dollar cost of the 1-week rental?

U.S. dollar, would he be better off receiving Maltese lira in one year (assuming purchasing power parity) or receiving a guaranteed dollar payment (assuming a   Spot exchange rate ($/€) $1.3620 gold price of $420 per ounce one year from now).   Expected U.S. inflation for coming year

2.500%

  Expected French inflation for coming year

3.500%

20. Malaysian Risk. Clayton Moore is the manager of an international money market fund managed out of ­London. Unlike many money funds that guarantee their   Current chateau nominal weekly rent (€) 9,800.00 investors a near risk-free investment with variable interest earnings, Clayton Moore’s fund is a very aggressive 18. East Asiatic Company—Thailand. The East Asiatic fund that searches out relatively high interest earnings Company (EAC), a Danish company with subsidiararound the globe, but at some risk. The fund is poundies throughout Asia, has been funding its Bangkok denominated. Clayton is currently evaluating a rather subsidiary primarily with U.S. dollar debt because of interesting opportunity in Malaysia. Since the Asian the cost and availability of dollar capital as opposed Crisis of 1997, the Malaysian government enforced a to Thai baht-denominated (B) debt. The treasurer of number of currency and capital restrictions to protect EAC-Thailand is considering a 1-year bank loan for and preserve the value of the Malaysian ringgit. The $250,000. The current spot rate is B32.06/$, and the ringgit was fixed to the U.S. dollar at RM3.80/$ for seven dollar-based interest is 6.75% for the 1-year period. years. In 2005, the Malaysian government allowed the 1-year loans are 12.00% in baht. currency to float against several major currencies. The a. Assuming expected inflation rates for the comcurrent spot rate today is RM3.13485/$. Local currency ing year of 4.3% and 1.25% in Thailand and the time deposits of 180-day maturities are earning 8.900% United States, respectively, according to purchase per annum. The London eurocurrency market for power parity, what would be the effective cost of pounds is yielding 4.200% per annum on similar 180-day funds in Thai baht terms? maturities. The current spot rate on the British pound is b. If EAC’s foreign exchange advisers believe $1.5820/£, and the 180-day forward rate is $1.5561/£. strongly that the Thai government wants to push



the value of the baht down against the dollar by 5% over the coming year (to promote its export competitiveness in dollar markets), what might be the effective cost of funds in baht terms? c. If EAC could borrow Thai baht at 13% per annum, would this be cheaper than either part (a) or part (b)?

19. Maltese Falcon. Imagine that the mythical solid gold falcon, initially intended as a tribute by the Knights of Malta to the King of Spain in appreciation for his gift of the island of Malta to the order in 1530, has recently been recovered. The falcon is 14 inches high and solid gold, weighing approximately 48 pounds. Assume that gold prices have risen to $440/ounce, primarily as a result of increasing political tensions. The falcon is currently held by a private investor in Istanbul, who is actively negotiating with the Maltese government on its purchase and prospective return to its island home. The sale and payment are to take place one year from now, and the parties are negotiating over the price and currency of payment. The investor has decided, in a show of goodwill, to base the sales price only on the falcon’s specie value—its gold value. The current spot exchange rate is 0.39 Maltese lira (ML) per 1.00 U.S. dollar. Maltese inflation is expected to be about 8.5% for the coming year, while U.S. inflation, on the heels of a double-dip recession, is expected to come in at only 1.5%. If the investor bases value in the

21. The Beer Standard. In 1999, The Economist reported the creation of an index, or standard, for the evaluation of African currency values using the local prices of beer. Beer, instead of Big Macs, was chosen as the product for comparison because McDonald’s had not penetrated the African continent beyond South Africa, and beer met most of the same product and market characteristics required for the construction of a proper currency index. Investec, a South African investment banking firm, has replicated the process of creating a measure of purchasing power parity (PPP) like that of the Big Mac Index of The Economist, for Africa.

The index compares the cost of a 375 milliliter bottle of clear lager beer across Sub-Saharan Africa. As a measure of PPP, the beer needs to be relatively homogeneous in quality across countries, and must possess substantial elements of local manufacturing, inputs, distribution, and service in order to actually provide a measure of relative purchasing power. The beer is first priced in local currency (purchased in the taverns of the locals, and not in the high-priced tourist centers). The price is then converted to South African rand and the rand-price compared to the local currency price as one measure of whether the local currency is undervalued or overvalued versus the South African rand. Use the data in the table and complete the calculation of whether the individual currencies are undervalued or overvalued.

Chapter 6   International Parity Conditions

163

Beer Prices Country

Beer

Local Currency

Price in Currency

Price in Rand

Implied PPP Rate

Spot Rate

South Africa

Castle

Rand

2.30

—

—

—

Botswana

Castle

Pula

2.20

2.94

0.96

0.75

Ghana

Star

Cedi

1,200.00

3.17

521.74

379.10

Kenya

Tusker

Malawi

Carlsberg

Mauritius

Phoenix

Namibia

Windhoek

Zambia Zimbabwe

Shilling

41.25

4.02

17.93

10.27

Kwacha

18.50

2.66

8.04

6.96

Rupee

15.00

3.72

6.52

4.03

N$

2.50

2.50

1.09

1.00

Castle

Kwacha

1,200.00

3.52

521.74

340.68

Castle

Z$

9.00

1.46

3.91

6.15

Internet Exercises

Data Listed by the Financial Times:

■

International money rates (bank call rates for major currency deposits)



■

Money rates (LIBOR and CD rates, etc.)



■

10-year spreads (individual country spreads versus the euro and U.S. 10-year treasuries). Note: Which countries actually have lower 10-year government bond rates than the United States and the euro? Probably Switzerland and Japan. Check.

The Economistwww.economist.com/markets-data



■

2. Purchasing Power Parity Statistics. The Organization for Economic Cooperation and Development (OECD) publishes detailed measures of prices and purchasing power for its member countries. Go to the OECD’s Web site and download the spreadsheet file with the historical data for purchasing power for the member countries.

Benchmark government bonds (sampling of representative government issuances by major countries and recent price movements). Note which countries are showing longer maturity benchmark rates.



■

Emerging market bonds (government issuances, Brady bonds, etc.)



■

Eurozone rates (miscellaneous bond rates for assorted European-based companies; includes debt ratings by Moodys and S&P)

1. Big Mac Index Updated. Use The Economist’s Web site to find the latest edition of the Big Mac Index of currency overvaluation and undervaluation. (You will need to do a search for “Big Mac Currencies.”) Create a worksheet to compare how the British pound, the euro, the Swiss franc, and the Canadian dollar have changed from the version presented in this chapter.

OECD www.oecd.org/std/prices-ppp/

3. International Interest Rates. A number of Web sites publish current interest rates by currency and maturity. Use the Financial Times Web site listed here to isolate the interest rate differentials between the U.S. dollar, the British pound, and the euro for all maturities up to and including one year. Financial Times markets.ft.com/RESEARCH/ Markets/Interest-Rates

4. World Bank’s International Comparison Program. The World Bank has an ongoing research program that focuses on the relative purchasing power of 107 different economies globally, specifically in terms of household consumption. Download the latest data tables and highlight which economies seem to be showing the greatest growth in recent years in relative purchasing power. Search the Internet for the World Bank’s ICP program site.

CHAPTER 6 APPENDIX

An Algebraic Primer to International Parity Conditions

The following is a purely algebraic presentation of the parity conditions explained in this chapter. It is offered to provide those students who desire additional theoretical detail and definition ready access to the step-by-step derivation of the various conditions.

The Law of One Price The law of one price refers to the state in which—in the presence of free trade, perfect substitutability of goods, and costless transactions—the equilibrium exchange rate between two currencies is determined by the ratio of the price of any commodity i denominated in two different currencies. For example, St =

P$i,t PSF i,t

where P$i and PSF i refer to the prices of the same commodity i, at time t, denominated in U.S. dollars and Swiss francs, respectively. The spot exchange rate, St, is simply the ratio of the two currency prices.

Purchasing Power Parity The more general form in which the exchange rate is determined by the ratio of two price indexes is termed the absolute version of purchasing power parity (PPP). Each price index reflects the currency cost of the identical “basket” of goods across countries. The exchange rate that equates purchasing power for the identical collection of goods is then stated as follows: St =

P$t PSF t

where P$t and PSF t are the price index values in U.S. dollars and Swiss francs at time t, respectively. If p$ and pSF represent the rates of inflation in each currency respectively, then the spot exchange rate at time t + 1 would be St + 1 =

164

P$t (1 + p$) SF PSF t (1 + p )

= St J

(1 + p$) (1 + pSF)

R

APPENDIX   An Algebraic Primer to International Parity Conditions

165

The change from period t to t + 1 is then P$t (1 + p$)

St J

SF PSF St + 1 t (1 + p ) = = St P$t

(1 + p$) (1 + pSF) St

R =

(1 + p$) (1 + pSF)

PSF t Isolating the percentage change in the spot exchange rate between periods t and t + 1 is then St + 1 - St = St

St J

(1 + p$) (1 + pSF) St

R - St =

(1 + p$) - (1 + pSF) (1 + pSF)

This equation is often approximated by dropping the denominator of the right-hand side if it is considered to be relatively small. It is then stated as St + 1 - St = (1 + p$) - (1 + pSF) = p$ - pSF St

Forward Rates The forward exchange rate is the contractual rate that is available to private agents through banking institutions and other financial intermediaries who deal in foreign currencies and debt instruments. The annualized percentage difference between the forward rate and the spot rate is termed the forward premium, f SF = J

Ft, t + 1 - St St

R * J

360 R nt,t + 1

where f SF is the forward premium on the Swiss franc, Ft, t + 1 is the forward rate contracted at time t for delivery at time t + 1, St is the current spot rate, and nt, t + 1 is the number of days between the contract date (t) and the delivery date (t + 1).

Covered Interest Arbitrage (CIA) and Interest Rate Parity (IRP) The process of covered interest arbitrage is when an investor exchanges domestic currency for foreign currency in the spot market, invests that currency in an interest-bearing instrument, and signs a forward contract to “lock in” a future exchange rate at which to convert the foreign currency proceeds (gross) back to domestic currency. The net return on CIA is Net Return = J

(1 + iSF)Ft,t + 1 St

R - (1 + i$)

where St and Ft, t + 1 are the spot and forward rates ($/SF), iSF is the nominal interest rate (or yield) on a Swiss franc-denominated monetary instrument, and i$ is the nominal return on a similar dollar-denominated instrument.

166

APPENDIX   An Algebraic Primer to International Parity Conditions

If they possess exactly equal rates of return—that is, if CIA results in zero riskless profit— interest rate parity (IRP) holds, and appears as $

(1 + i ) = J

(1 + iSF)Ft,t + 1 St

R

or alternatively as (1 + i$) SF

(1 + i )

=

Ft,t + 1 St

If the percent difference of both sides of this equation is found (the percentage difference between the spot and forward rate is the forward premium), then the relationship between the forward premium and relative interest rate differentials is Ft, t + 1 - St St

= f SF =

i$ - iSF 1 + iSF

If these values are not equal (thus, the markets are not in equilibrium), there exists a potential for riskless profit. The market will then be driven back to equilibrium through CIA by agents attempting to exploit such arbitrage potential—until CIA yields no positive return.

Fisher Effect The Fisher effect states that all nominal interest rates can be decomposed into an implied real rate of interest (return) and an expected rate of inflation: i$ = [(1 + r $)(1 + p$)] - 1 where r $ is the real rate of return and p$ is the expected rate of inflation for dollar-denominated assets. The subcomponents are then identifiable: i $ = r $ + p $ + r $p $ As with PPP, there is an approximation of this function that has gained wide acceptance. The cross-product term of r $p$ is often very small and therefore dropped altogether: i $ = r $ + p$

International Fisher Effect The international Fisher effect is the extension of this domestic interest rate relationship to the international currency markets. If capital, by way of covered interest arbitrage (CIA), attempts to find higher rates of return internationally resulting from current interest rate ­differentials, the real rates of return between currencies are equalized (e.g., r $ = r SF): (1 + i$) - (1 + iSF) St + 1 - St i$ - iSF = = St (1 + iSF) (1 + iSF)

APPENDIX   An Algebraic Primer to International Parity Conditions

167

If the nominal interest rates are then decomposed into their respective real and expected inflation components, the percentage change in the spot exchange rate is (r $ + p$ + r $p$) - (r SF + pSF + r SFpSF) St + 1 - St = St 1 + r SF + pSF + r SFpSF The international Fisher effect has a number of additional implications if the following requirements are met: (1) capital markets can be freely entered and exited; (2) capital markets possess investment opportunities that are acceptable substitutes; and (3) market agents have complete and equal information regarding these possibilities. Given these conditions, international arbitragers are capable of exploiting all potential riskless profit opportunities until real rates of return between markets are equalized (r $ = r SF). Thus, the expected rate of change in the spot exchange rate reduces to the differential in the expected rates of inflation: St + 1 - St p$ + r $p$ - pSF - r SFpSF = St 1 + r SF + pSF + r SFpSF If the approximation forms are combined (through the elimination of the denominator and the elimination of the interactive terms of r and p), the change in the spot rate is simply St + 1 - St = p$ - pSF St Note the similarity (identical in equation form) of the approximate form of the international Fisher effect to purchasing power parity discussed previously—the only potential ­difference is that between ex post and ex ante (expected) inflation.

Foreign Exchange Rate Determination The herd instinct among forecasters makes sheep look like independent thinkers.  —Edgar R. Fiedler.

CHAPTER

8

Learning Objectives ■

Examine how the supply and demand for any currency can be viewed as an asset choice issue within the portfolio of investors

■

Explore how the three major approaches to exchange rate determination—parity ­conditions, the balance of payments, and the asset approach—combine to explain, in part, numerous emerging market currency crises

■

Detail how direct and indirect foreign exchange market intervention is conducted by central banks

■

Observe how forecasters combine technical analysis with the three major theoretical approaches to forecasting exchange rates

What determines the exchange rate between currencies? This has proven to be a very difficult question to answer. Companies and agents need foreign currency for buying imports, or they may earn foreign currency by exporting. Investors need foreign currency to invest in interestbearing instruments in foreign countries and currencies, fixed-income securities like bonds, shares in publicly traded companies, or other new types of hybrid instruments in foreign markets. Tourists, migrant workers, speculators on currency movements—all of these economic agents buy and sell and supply and demand currencies every day. This chapter offers a basic theoretical framework with which to organize these elements, forces, and principles. Chapter 6 described the international parity conditions that integrate exchange rates with inflation and interest rates and provided a theoretical framework for both the global financial markets and the management of international financial business. Chapter 3 ­provided a detailed analysis of how an individual country’s international economic activity, its balance of payments, can impact exchange rates. This chapter builds on those discussions of exchange rate determination schools of thought and looks at a third school of thought—the asset m ­ arket approach. The chapter then turns to government intervention in the foreign exchange ­market. In the third and final section, we discuss a number of approaches to ­foreign exchange forecasting in practice. The chapter concludes with the Mini-Case entitled The ­Japanese Yen I­ ntervention of 2010—a study in how the Japanese government has repeatedly tried to ­intervene in the foreign exchange market. Exhibit 8.1 provides an overview of the many determinants of exchange rates. This ­roadmap is first organized by the three major schools of thought (parity conditions, balance of payments approach, asset market approach) and second by the individual drivers within those approaches. At first glance, the idea that there are three theories may appear daunting, but it is important to remember that these are not competing theories, but rather complementary theories. Without the depth and breadth of the various approaches combined, our ability to capture the complexity of the global market for currencies is lost. 195

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Exhibit 8.1 The Determinants of Foreign Exchange Rates Parity Conditions 1. 2. 3. 4.

Relative inflation rates Relative interest rates Forward exchange rates Interest rate parity

Is there a well-developed and liquid money and capital market in that currency?

Is there a sound and secure banking system in place to support currency trading activities?

Spot Exchange Rate

Asset Approach 1. 2. 3. 4. 5. 6.

Relative real interest rates Prospects for economic growth Supply and demand for assets Outlook for political stability Speculation and liquidity Political risks and controls

Balance of Payments 1. 2. 3. 4. 5.

Current account balances Portfolio investment Foreign direct investment Exchange rate regimes Official monetary reserves

Finally, note that most determinants of the spot exchange rate are also affected by changes in the spot rate. In other words, they are not only linked but also mutually determined.

Exchange Rate Determination: The Theoretical Thread There are basically three views of the exchange rate. The first takes the exchange rate as the relative price of monies (the monetary approach); the second, as the relative price of goods (the purchasing-power-parity approach); and the third, the relative price of bonds. —Rudiger Dornbusch, “Exchange Rate Economics: Where Do We Stand?,” Brookings Papers on Economic Activity 1, 1980, pp. 143–194.

Professor Dornbusch’s tripartite categorization of exchange rate theory is a good starting point, but in some ways not robust enough—in our humble opinion—to capture the multitude of theories and approaches. So, in the spirit of both tradition and completeness, we have amended Dornbusch’s three categories with several additional streams of thought in the following discussion. The next section will provide a brief overview of the many different, but related, theories of exchange rate determination, and their relative usefulness in forecasting for business purposes.

Purchasing Power Parity Approaches Under the skin of an international economist lies a deep-seated belief in some variant of the PPP theory of the exchange rate. —Paul Krugman, 1976.

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The most widely accepted of all exchange rate determination theories, the theory of purchasing power parity (PPP) states that the long-run equilibrium exchange rate is determined by the ratio of domestic prices relative to foreign prices, as explained in Chapter 6. PPP is both the oldest and most widely followed of the exchange rate theories, and most theories of exchange rate determination have PPP elements embedded within their frameworks. There are a number of different versions of PPP: the Law of One Price, Absolute ­Purchasing Power Parity, and Relative Purchasing Power Parity (discussed in detail in ­Chapter 6). The latter of the three theories, Relative Purchasing Power Parity, is thought to be the most relevant to possibly explaining what drives exchange rate values. In essence, it states that changes in relative prices between countries drive the change in exchange rates over time. If, for example, the current spot exchange rate between the Japanese yen and U.S. dollar was ¥90.00 = $1.00, and Japanese and U.S. prices were to change at 2% and 1% over the coming period, respectively, the spot exchange rate next period would be ¥90.89/$. St + 1 = St *

1 + ∆ in Japanese Prices 1.02 = ¥90.00/$ * = ¥90.89/$ 1 + ∆ in U.S. Prices 1.01

Although PPP seems to possess a core element of common sense, it has proven to be quite poor at forecasting exchange rates. The problems are both theoretical and empirical. The theoretical problems lie primarily with its basic assumption that the only thing that matters is relative price changes. Yet many currency supply and demand forces are driven by other forces, including investment incentives and economic growth. The empirical issues are primarily in deciding which measures or indexes of prices to use across countries, in addition to the ability to provide a “predicted change in prices” with the chosen indexes.

Balance of Payments (Flows) Approaches After PPP, the most frequently used theoretical approach to exchange rate determination is probably that involving the supply and demand for currencies in the foreign exchange market. These exchange rate flows reflect current account and financial account transactions recorded in a nation’s balance of payments, as described in Chapter 3. The basic balance of payments approach argues that the equilibrium exchange rate is found when the net inflow (outflow) of foreign exchange arising from current account activities matches the net outflow (inflow) of foreign exchange arising from financial account activities. The balance of payments approach continues to enjoy widespread appeal, as balance of payments transactions are among the most frequently captured and reported of international economic activity. Trade surpluses and deficits, current account growth in service activity, and, recently, the growth and significance of international capital flows continue to fuel this theoretical fire. Criticisms of the balance of payments approach arise from the theory’s emphasis on flows of currency and capital rather than on stocks of money or financial assets. Relative stocks of money or financial assets play no role in exchange rate determination in this theory, a weakness explored in the following discussion of monetary and asset market approaches. Curiously, while the balance of payments approach is largely dismissed by the academic community today, the practitioner public—market participants including currency traders themselves— still rely on different variations of this theory for much of their decision making.

Monetary Approaches The monetary approach in its simplest form states that the exchange rate is determined by the supply and demand for national monetary stocks, as well as the expected future levels and rates of growth of monetary stocks. Other financial assets, such as bonds, are not considered

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relevant for exchange rate determination as both domestic and foreign bonds are viewed as perfect substitutes. It is all about money stocks. The monetary approach focuses on changes in the supply and demand for money as the primary determinant of inflation. Changes in relative inflation rates in turn are expected to alter exchange rates through a purchasing power parity effect. The monetary approach then assumes that prices are flexible in the short run as well as the long run, so that the transmission mechanism of inflationary pressure is immediate in impact. A weakness of monetary models of exchange rate determination is that real economic activity is relegated to a role in which it only influences exchange rates through changes in the demand for money. The monetary approach is also criticized for its omission of a number of factors that are generally agreed upon by area experts as important to exchange rate determination, including 1) the failure of PPP to hold in the short- to medium-term; 2) money demand appears to be relatively unstable over time; and 3) the level of economic activity and the money supply appear to be interdependent, not independent.

Asset Market Approach (Relative Price of Bonds) The asset market approach, sometimes called the relative price of bonds or portfolio balance approach, argues that exchange rates are determined by the supply and demand for financial assets of a wide variety. Shifts in the supply and demand for financial assets alter exchange rates. Changes in monetary and fiscal policy alter expected returns and perceived relative risks of financial assets, which in turn alter rates. Many of the macroeconomic theoretical developments in recent years focused on how monetary and fiscal policy changes altered the relative perceptions of return and risk to the stocks of financial assets driving exchange rate changes. The frequently cited works of ­Mundell-Fleming are in this genre. Theories of currency substitution, the ability of individual and commercial investors to alter the composition of their portfolios, follow the same basic premises of the portfolio balance and re-balance framework. Unfortunately, for all of the good work and research over the past 50 years, the ­ability to forecast exchange rate values in the short term to long term is—in the words of the authors below—sorry. Although academics and practitioners alike agree that in the ­long run fundamental principles such as purchasing power and external balances drive currency values, none of the fundamental theories have proven to be very useful in the short- to medium-term. . . . the case for macroeconomic determinants of exchange rates is in a sorry state [The] results indicate that no model based on such standard fundamentals like money supplies, real income, interest rates, inflation rates and current account balances will ever succeed in explaining or predicting a high percentage of the variation in the exchange rate, at least at short- or medium-term frequencies. —Jeffrey A. Frankel and Andrew K. Rose, “A Survey of Empirical Research on Nominal Exchange Rates,” NBER Working Paper No. 4865, 1994.

Technical Analysis The forecasting inadequacies of fundamental theories has led to the growth and popularity of technical analysis, the belief that the study of past price behavior provides insights into future price movements. The primary feature of technical analysis is the assumption that exchange rates, or for that matter all market-driven prices, follow trends. And those trends may be analyzed and projected to provide insights into short-term and medium-term price movements in the future.

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Most theories of technical analysis differentiate fair value from market value. Fair value is the true long-term value that the price will eventually retain. The market value is subject to a multitude of changes and behaviors arising from widespread market participant perceptions and beliefs—at the time.

The Asset Market Approach to Forecasting The asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers. These drivers, as previously depicted in Exhibit 8.1, include the following elements: ■

■

■

■

■

■

■

■

Relative real interest rates are a major consideration for investors in foreign bonds and short-term money market instruments. Prospects for economic growth and profitability are an important determinant of crossborder equity investment in both securities and foreign direct investment. Capital market liquidity is particularly important to foreign institutional investors. Crossborder investors are not only interested in the ease of buying assets, but also in the ease of selling those assets quickly for fair market value if desired. A country’s economic and social infrastructure is an important indicator of its ability to survive unexpected external shocks and to prosper in a rapidly changing world economic environment. Political safety is exceptionally important to both foreign portfolio and direct investors. The outlook for political safety is usually reflected in political risk premiums for a country’s securities and for purposes of evaluating foreign direct investment in that country. The credibility of corporate governance practices is important to cross-border portfolio investors. A firm’s poor corporate governance practices can reduce foreign investors’ influence and cause subsequent loss of the firm’s focus on shareholder wealth objectives. Contagion is defined as the spread of a crisis in one country to its neighboring countries and other countries with similar characteristics—at least in the eyes of cross-border investors. Contagion can cause an “innocent” country to experience capital flight with a resulting depreciation of its currency. Speculation can either cause a foreign exchange crisis or make an existing crisis worse. We will observe this effect through the three illustrative cases—the Asian crisis, Russian crisis, and Argentine crisis—discussed later in this chapter.

Foreign investors are willing to hold securities and undertake foreign direct investment in highly developed countries based primarily on relative real interest rates and the outlook for economic growth and profitability. All the other drivers described in Exhibit 8.1 are assumed to be satisfied. For example, during the 1981–1985 period, the U.S. dollar strengthened despite growing current account deficits. This strength was due partly to relatively high real interest rates in the United States. Another factor, however, was the heavy inflow of foreign capital into the U.S. stock market and real estate, motivated by good long-run prospects for growth and profitability in the United States. The same cycle was repeated in the United States in the period between 1990 and 2000. Despite continued worsening balances on the current account, the U.S. dollar strengthened in both nominal and real terms due to foreign capital inflow motivated by rising stock and real estate prices, a low rate of inflation, high real interest returns, and a seemingly ­endless ­“irrational exuberance” about future economic prospects. This time the “bubble” burst

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following the September 11, 2001, terrorist attacks on the United States. The attacks and their aftermath caused a negative reassessment of long-term growth and profitability prospects in the United States (as well as a newly formed level of political risk for the United States itself). This negative outlook was reinforced by a very sharp drop in the U.S. stock markets based on lower expected earnings. Further damage to the economy was caused by a series of revelations about failures in corporate governance by several large corporations (including overstatement of earnings, insider trading, and self-serving executives). Loss of confidence in the U.S. economy led to a large withdrawal of foreign capital from U.S. security markets. As would be predicted by both the balance of payments and asset market approaches, the U.S. dollar depreciated. Indeed, its nominal rate depreciated by 18% between mid-January and mid-July 2002 relative to the euro alone. The experience of the United States, as well as other highly developed countries, illustrates why some forecasters believe that exchange rates are more heavily influenced by economic prospects than by the current account. One scholar summarizes this belief using an interesting anecdote. Many economists reject the view that the short-term behavior of exchange rates is determined in flow markets. Exchange rates are asset prices traded in an efficient financial market. Indeed, an exchange rate is the relative price of two currencies and therefore is determined by the willingness to hold each currency. Like other asset prices, the exchange rate is determined by expectations about the future, not current trade flows. A parallel with other asset prices may illustrate the approach. Let’s consider the stock price of a winery traded on the Bordeaux stock exchange. A frost in late spring results in a poor harvest, in terms of both quantity and quality. After the harvest the wine is finally sold, and the income is much less than the previous year. On the day of the final sale there is no reason for the stock price to be influenced by this flow. First, the poor income has already been discounted for several months in the winery stock price. Second, the stock price is affected by future, in addition to current, prospects. The stock price is based on expectations of future earnings, and the major cause for a change in stock price is a revision of these expectations. A similar reasoning applies to exchange rates: Contemporaneous international flows should have little effect on exchange rates to the extent they have already been expected. Only news about future economic prospects will affect exchange rates. Since economic expectations are potentially volatile and influenced by many variables, especially variables of a political nature, the short-run behavior of exchange rates is volatile. —Bruno Solnik, International Investments, 3rd Edition, Reading, MA: Addison Wesley, 1996, p. 58. Reprinted with permission of Pearson Education, Inc.

The asset market approach to forecasting is also applicable to emerging markets. In this case, however, a number of additional variables contribute to exchange rate determination. These variables are, as described previously, illiquid capital markets, weak economic and social infrastructure, political instability, corporate governance, contagion effects, and speculation. These variables will be illustrated in the section detailing major currency crises later in this chapter.

Currency Market Intervention A fundamental problem with exchange rates is that no commonly accepted method exists to estimate the effectiveness of official intervention into foreign exchange markets. Many interrelated factors affect the exchange rate at any given time, and no quantitative

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model exists that is able to provide the magnitude of any causal relationship between intervention and an exchange rate when so many interdependent variables are acting simultaneously. —“Japan’s Currency Intervention: Policy Issues,” Dick K. Nanto, CRS Report to Congress, July 13, 2007, CRS-7.

The value of a country’s currency is of significant interest to an individual government’s economic and political policies and objectives. Those interests sometimes extend beyond the individual country, but may actually reflect some form of collective country interest. Although many countries have moved from fixed exchange rate values long ago, the governments and central bank authorities of the multitude of floating rate currencies still privately and publicly profess what value their currency “should hold” in their eyes, regardless of whether the market for that currency agrees at that time. Foreign currency intervention­—the active management, manipulation, or intervention in the market’s valuation of a country’s currency—is a component of currency valuation and forecast that cannot be overlooked.

Motivations for Intervention There is a long-standing saying that “what worries bankers is inflation, but what worries elected officials is unemployment.” The principle is actually quite useful in understanding the various motives for currency market intervention. Depending upon whether a country’s central bank is an independent institution (e.g., the U.S. Federal Reserve), or a subsidiary of its elected government (as the Bank of England was for many years), the bank’s policies may either fight inflation or fight slow economic growth, but rarely can do both. Historically, a primary motive for a government to pursue currency value change was to keep the country’s currency cheap so that foreign buyers would find its exports cheap. This policy, long referred to as “beggar-thy-neighbor,” gave rise to many competitive devaluations over the years. It has not, however, fallen out of fashion. The slow economic growth and continuing employment problems in many countries in 2012 and 2013 led to some governments, the United States and the European Union being prime examples, working to hold their ­currency values down. Alternatively, the fall in the value of the domestic currency will sharply reduce the purchasing power of its people. If the economy is forced, for a variety of reasons, to continue to purchase imported products (e.g., petroleum imports because of no domestic substitute), a currency devaluation or depreciation may prove highly inflationary—and in the extreme, impoverish the country’s people (as in the case of Venezuela). It is frequently noted that most countries would like to see stable exchange rates and to avoid the entanglements associated with manipulating currency values. Unfortunately, that would also imply that they are also happy with the current exchange rate’s impact on ­country-level competitiveness. One must look no further than the continuing highly public debate between the United States and China over the value of the yuan. The U.S. believes the yuan is undervalued, making Chinese exports to the United States overly cheap, which in turn, results in a growing current account deficit for the United States and current account surplus for China. The International Monetary Fund, as one of its basic principles (Article IV), encourages members to avoid pursuing “currency manipulation” to gain competitive advantages over other members. The IMF defines manipulation as “protracted large-scale intervention in one direction in the exchange market.” It seems that many governments often choose to ignore the IMF’s advice.

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Intervention Methods There are many ways in which an individual or collective set of governments and central banks can alter the value of their currencies. It should be noted, however, that the methods of market intervention used are very much determined by the size of the country’s economy, the magnitude of global trading in its currency, and the depth and breadth of development in its domestic financial markets. A short list of the intervention methods would include direct intervention, indirect intervention, and capital controls. Direct Intervention.  This is the active buying and selling of the domestic currency against foreign currencies. This traditionally required a central bank to act like any other trader in the currency market—albeit a big one. If the goal were to increase the value of the domestic currency, the central bank would purchase its own currency using its foreign exchange reserves, at least to the acceptable limits that it could endure depleting its reserves. If the goal were to decrease the value of its currency—to fight an appreciation of its currency’s value on the foreign exchange market—it would sell its own currency in exchange for foreign currency, typically a major hard currency like the dollar and euro. Although there are no physical limits to its ability to sell its own currency (it could theoretically continue to “print money” endlessly), central banks are cautious in the degree to which they may potentially change their monetary supplies through intervention. Direct intervention was the primary method used for many years, but beginning in the 1970s, the world’s currency markets grew enough that any individual player, even a central bank, could find itself with insufficient resources to move the market. As one trader stated a number of years ago, “We at the bank found ourselves little more than a grain of sand on the beach of the market.” One solution to the market size challenge has been the occasional use of coordinated intervention, in which several major countries, or a collective such as the G8 of industrialized countries, agree that a specific currency’s value is out of alignment with their collective interests. In that situation, the countries may work collectively to intervene and push a currency’s value in a desired direction. The September 1985 Plaza Agreement, an agreement signed at the Plaza Hotel in New York City by the members of the Group of Ten, was one such coordinated intervention agreement. The members, collectively, had concluded that currency values had become too volatile or too extreme in movement for sound economic policy management. The problem with coordinated intervention is, of course, achieving agreement between nations. This has proven to be a major sticking point in the principle’s use. Indirect Intervention.  This is the alteration of economic or financial fundamentals that are thought to be drivers of capital to flow in and out of specific currencies. This was a logical development for market manipulation given the growth in size of the global currency markets relative to the financial resources of central banks. The most obvious and widely used factor here is interest rates. Following the financial principles outlined in the previous discussion of parity conditions, higher real rates of interest attract capital. If a central bank wishes to “defend its currency” for example, it might follow a restrictive monetary policy, which would drive real rates of interest up. The method is therefore no longer limited to the quantity of foreign exchange reserves held by the country. Instead, it is limited only by the country’s willingness to suffer the domestic impacts of higher real interest rates in order to attract capital inflows and therefore drive up the demand for its currency. Alternatively, in a country wishing for its currency to fall in value, particularly when confronted with a continual appreciation of its value against major trading partner currencies, the central bank may work to lower real interest rates, reducing the returns to capital.

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Because indirect intervention uses tools of monetary policy, a fundamental dimension of economic policy, the magnitude and extent of impacts may reach far beyond currency value. Overly stimulating economic activity, or increasing money supply growth beyond real economic activity, may prove inflationary. The use of such broad-based tools like interest rates to manipulate currency values requires a determination of importance, which in some cases may involve a choice to pursue international economic goals at the expense of domestic economic policy goals. Turkish Crisis of 2014.  It is also important to remember that intervention may—and often does—fail. The Turkish currency crisis of 2014 is a classic example of a drastic indirect intervention that ultimately only slowed the rate of capital flight and currency collapse. Turkey had enjoyed some degree of currency stability throughout 2012 and 2013. But the Turkish economy (one of the so-called “Fragile Five” countries, along with South Africa, India, Indonesia, and Brazil) was suffering a widening current account deficit and rising inflation. With the increasing anxieties in emerging markets in the fourth quarter of 2013 over the U.S. Federal Reserve’s announcement that it would be slowing its bond purchasing (the Taper Program, essentially a tighter monetary policy), capital began exiting Turkey. The Turkish lira came under increasing downward pressure as illustrated in Exhibit 8.2. Turkey, however, was also under a great deal of domestic political strife, as the president of Turkey believed that the central bank should be stimulating the Turkish economy by lowering interest rates. Lower rates provided additional incentive for short-term capital flight. Pressures intensified in early January 2014, resulting in a sudden increase in the Turkish one-week

Exhibit 8.2 The Turkish Lira Crisis of 2014 Turkish lira = 1.00 USD 2.50

Turkish lira exchange rate

2.40 2.30 2.20 2.10

10.0% 2.00 1.90 1.80 1.70 1.60

Turkish bank repo interest rate 5.8%

5.6%

4.5%

Ja n1 Fe 2 b1 M 2 ar -1 Ap 2 r-1 M 2 ay -1 Ju 2 n1 Ju 2 l-1 Au 2 g1 Se 2 p1 O 2 ct -1 N 2 ov -1 D 2 ec -1 Ja 2 n1 Fe 3 b1 M 3 ar -1 Ap 3 r-1 M 3 ay -1 Ju 3 n1 Ju 3 l-1 Au 3 g1 Se 3 p1 O 3 ct -1 N 3 ov -1 D 3 ec -1 Ja 3 n14

1.50

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bank repurchase interest rate (or “repo rate”) from 4.5% to 10.0%. Although the first few hours indicated some relief with the lira returning to a slightly stronger value versus the dollar (and euro), within days it was trading weaker once again. Indirect intervention in this case had not only proven a failure, but the attempted cure may in the end have worsened both political and economic instability for Turkey in the near-term.1 Capital Controls.  This is the restriction of access to foreign currency by government. This involves limiting the ability to exchange domestic currency for foreign currency. When access and exchange is permitted, trading often takes place only with official designees of the government or central bank, and only at dictated exchange rates. Often, governments will limit access to foreign currencies to commercial trade: for example, allowing access to hard currency for the purchase of imports only. Access for investment purposes—particularly for short-term portfolios in which investors are moving in and out of interest-bearing accounts, purchasing or selling securities or other funds—is often prohibited or limited. The Chinese regulation of access and trading of the Chinese yuan is a prime example of the use of capital controls over currency value. In addition to the government’s setting the daily rate of exchange, access to the exchange is limited by a difficult and timely bureaucratic process for approval, and limited to commercial trade transactions. Understanding the motivations and methods for currency market intervention is critical to any analysis of the determination of future exchange rates. And although it is often impossible to determine, in the end, whether subtle intervention was successful, it appears to be an area of growing market activity, particularly for countries trying to “emerge” to higher levels of economic income and wealth. Global Finance in Practice 8.1 provides a short list of possible best practices for effective intervention. Global Finance in Practice

8.1

centers, possibly other central banks, if possible. The markets are much more likely to be influenced if they believe the intervention activity is reflecting a grassroots movement, and not the singular activity of a ­single trading entity or bank.

Rules of Thumb for Effective Intervention There are a number of factors, features, and tactics, according to many currency traders that determine the effectiveness of an intervention effort. ■

■

Don’t Lean into the Wind. Markets that are moving significantly in one direction, like the strengthening of the Japanese yen in the fall of 2010, are very tough to turn. Termed “leaning into the wind,” intervention during a strong market movement will most likely result in a very expensive failure. Currency traders argue that central banks should time their intervention very carefully, choosing moments when trading volumes are light and direction nearly flat. Don’t lean into the wind, read it. Coordinate Timing and Activity. Use traders or associates in a variety of geographic markets and trading

■

Use Good News. Particularly when trying to quell a currency fall, time the intervention to coincide with positive economic, financial, or bu siness news closely associated with a country’s currency market. Traders often argue that “markets wish to celebrate good news,” and currencies may be no different.

■

Don’t Be Cheap. Overwhelm Them. Traders fear missing the moment, and a large, coordinated, welltimed intervention can make them fear they are leaning in the wrong direction. A successful intervention is in many ways a battle of psychology; play on insecurities. If it appears the intervention is gradually having the desired impact, throw ever-increasing assets into the battle. Don’t get cheap.

1 One of the most famous failures occurred in 1992 when the United Kingdom attempted to defend the value of the British pound. The Bank of England, in an attempt to defend the value of the pound within the ­European Monetary System, increased key interest rates three times in six hours, eventually exiting the EMS. The United Kingdom was said to have suffered a “humiliating defeat,” although it was a currency war, not a military one.

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Disequilibrium: Exchange Rates in Emerging Markets Although the three different schools of thought on exchange rate determination (parity conditions, balance of payments approach, and asset approach) described earlier make understanding exchange rates appear to be straightforward, that is rarely the case. The large and liquid capital and currency markets follow many of the principles outlined so far relatively well in the medium to long term. The smaller and less liquid markets, however, frequently demonstrate behaviors that seemingly contradict theory. The problem lies not in the theory, but in the relevance of the assumptions underlying the theory. An analysis of the emerging market crises illustrates a number of these seeming contradictions. After a number of years of relative global economic tranquility, the second half of the 1990s was racked by a series of currency crises that shook all emerging markets. The Asian crisis of July 1997, the Russian ruble’s collapse in August 1998, and the fall of the Argentine peso in 2002 provide a spectrum of emerging market economic failures, each with its own complex causes and unknown outlooks. These crises also illustrated the growing problem of capital flight and short-run international speculation in currency and securities markets. We will use each of the individual crises to focus on a specific dimension of the causes and consequences.

The Asian Crisis of 1997 At a 1998 conference sponsored by the Milken Institute, a speaker noted that the world’s preoccupation with the economic problems of Indonesia was incomprehensible because “the total gross domestic product of Indonesia is roughly the size of North Carolina.” The following speaker observed, however, that the last time he had checked, “North Carolina did not have a population of 220 million people.” The roots of the Asian currency crisis extended from a fundamental change in the economics of the region, the transition of many Asian nations from being net exporters to net ­importers. Starting as early as 1990 in Thailand, the rapidly expanding economies of the Far East began importing more than they exported, requiring major net capital inflows to ­support their ­currencies. As long as the capital continued to flow in—capital for manufacturing plants, dam projects, infrastructure development, and even real estate speculation—the pegged exchange rates of the region could be maintained. When the investment capital inflows stopped, ­however, crisis was inevitable. The most visible roots of the crisis were in the excesses of capital inflows into Thailand. With rapid economic growth and rising profits forming the backdrop, Thai firms, banks, and finance companies had ready access to capital on the international markets, finding U.S. dollar debt cheap offshore. Thai banks continued to raise capital internationally, extending credit to a variety of domestic investments and enterprises beyond what the Thai economy could support. As capital flows into the Thai market hit record rates, financial flows poured into investments of all kinds. As the investment “bubble” expanded, some participants raised questions about the economy’s ability to repay the rising debt. The baht came under attack. Currency Collapse.  In May and June 1997, more and more rumors circulated throughout the globe’s currency traders that the Thai baht was weak and that a number of major investors were now speculating on its fall. The Thai government and central bank quickly intervened in the foreign exchange markets directly (using up hard currency reserves) and indirectly (by raising interest rates in an attempt to stop the outflow). Foreign capital, which had flowed into Thailand freely in the months and years previous, stopped.

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Exhibit 8.3 The Thai Baht and the Asian Crisis Thai baht = 1.00 USD 38 36

As more Asian currencies fall in July and August the baht continues to fall under market pressure

34 32 30 Thai govt. intervenes heavily in May and June to thwart rumors of the baht’s potential fall

28 26

Thai baht officially floated on July 2, falling from THB25 to THB29 = USD1 in hours

The Asian crisis and fall of the Thai baht demonstrate how myopic the international markets can become, having ignored serious current account deficits in Thailand for years.

24 22

5/ 7 6/ 9 5/ 7 13 /9 5/ 7 20 /9 5/ 7 27 /9 6/ 7 3/ 9 6/ 7 10 /9 6/ 7 17 /9 6/ 7 24 /9 7/ 7 1/ 97 7/ 8/ 9 7/ 7 15 /9 7/ 7 22 /9 7/ 7 29 /9 8/ 7 5/ 9 8/ 7 12 /9 8/ 7 19 /9 8/ 7 26 /9 9/ 7 2/ 97 9/ 9/ 9 9/ 7 16 /9 9/ 7 23 /9 7

7

/9

4/

29

7

/9

/9

4/

22

97

15

4/

8/

4/

4/

1/

97

20

A second round of speculative attacks in late June and early July proved too much for the Thai authorities. On July 2, 1997, the Thai central bank finally allowed the baht to float (or sink in this case). The baht fell 17% against the U.S. dollar and more than 12% against the Japanese yen in a matter of hours. By November, the baht had fallen from 25 to 40 baht per dollar, a fall of about 38%, as illustrated in Exhibit 8.3. Within days, in Asia’s own version of what is called the tequila effect 2 , a number of neighboring Asian nations, some with and some without similar characteristics to Thailand, came under speculative attack by currency traders and capital markets. The Philippine peso, the Malaysian ringgit, and the Indonesian rupiah all fell in the months following the July baht devaluation. In late October 1997, Taiwan caught the markets off balance with a surprise competitive devaluation of 15%. The Taiwanese devaluation seemed only to renew the momentum of the crisis. Although the Hong Kong dollar survived (at great expense to its foreign exchange reserves), the Korean won (KRW) was not so lucky. In November 1997, the historically stable won also fell victim, falling from 900 Korean won per dollar to more than 1100. The only currency that had not fallen besides the Hong Kong dollar was the Chinese renminbi, which was not freely convertible. Causal Complexities.  The Asian economic crisis—for it was more than just a currency ­collapse—had many roots besides traditional balance of payments difficulties. The causes were different in each country, yet there were specific underlying similarities, which allow comparison: corporate socialism, corporate governance, and banking stability. ■

The rapidly growing export-led countries of Asia had known only stability. Because of the influence of government and politics in the business arena, even in the event of failure, it was believed that government would not allow firms to fail, workers to lose their jobs, or

“Tequila effect” is the term used to describe how the Mexican peso crisis of December 1994 quickly spread to other Latin American currency and equity markets, a form of financial panic termed contagion. 2

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■

■

207

banks to close. Practices that had persisted for decades without challenge, such as lifetime employment, were now no longer sustainable. Many firms operating within the Far Eastern business environments were often largely controlled either by families or by groups related to the governing party or body of the country. This tendency has been labeled cronyism. Cronyism means that the interests of minority stockholders and creditors are often secondary at best to the primary motivations of corporate management. The banking sector had fallen behind. Bank regulatory structures and markets had been deregulated nearly without exception across the globe. The central role played by banks in the conduct of business had largely been ignored. As firms across Asia collapsed, government coffers were emptied and banks failed. Without banks, the “plumbing” of business conduct was shut down.

The Asian economic crisis had global impacts. What started as a currency crisis quickly became a region-wide depression. The slowed economies of the region quickly caused major reductions in world demands for many products, especially commodities. World oil, metal, and agricultural products markets fell. Commodity export earnings fell, as did growth prospects for other emerging economies. In the aftermath, the international speculator and philanthropist George Soros was the object of much criticism for being the cause of the crisis because of massive speculation by his and other hedge funds. Soros, however, was likely only the messenger. Global Finance in Practice 8.2 details the Soros debate. Global Finance in Practice

8.2

Was George Soros to Blame for the Asian Crisis? For Thailand to blame Mr. Soros for its plight is rather like condemning an undertaker for burying a suicide. —The Economist, August 2, 1997, p. 57.

In the weeks following the start of the Asian Crisis in July 1997, officials from a number of countries including Thailand and Malaysia blamed the international financier George Soros for causing the crisis. Particularly vocal was the Prime Minister of Malaysia, Dr. Mahathir Mohamad, who repeatedly implied that Soros had a political agenda associated with Burma’s prospect of joining the Association of Southeast Asian Nations (ASEAN). Mahathir noted in a number of public speeches that Soros might have been making a political statement, and not just speculating against currency values. Mahathir argued that the poor people of Malaysia, Thailand, the Phillippines, and Indonesia would pay a great price for Soros’ attacks on Asian currencies. George Soros is probably the most famous currency speculator—and possibly the most successful—in global history. Admittedly responsible for much of the European financial crisis of 1992 and the fall of the French franc in 1993, he once again was the recipient of critical attention in 1997 following the fall of the Thai baht and Malaysian ringgit.

Nine years later, in 2006, Mahathir and Soros met for the first time. Mahathir apologized and withdrew his previous accusations. In Soros’ book published in 1998, The Crisis of Global Capitalism: Open Society Endangered (pp. 208–209), Soros explained his role in the crisis as follows: The financial crisis that originated in Thailand in 1997 was particularly unnerving because of its scope and severity. .  .  . By the beginning of 1997, it was clear to Soros Fund Management that the discrepancy between the trade account and the capital account was becoming untenable. We sold short the Thai baht and the Malaysian ringgit early in 1997 with maturities ranging from six months to a year. (That is, we entered into contracts to deliver at future dates Thai Baht and Malaysian ringgit that we did not currently hold.) Subsequently Prime Minister Mahathir of Malaysia accused me of causing the crisis, a wholly unfounded accusation. We were not sellers of the currency during or several months before the crisis; on the contrary, we were buyers when the currencies began to decline—we were purchasing ringgit to realize the profits on our earlier speculation. (Much too soon, as it turned out. We left most of the potential gain on the table because we were afraid that Mahathir would impose capital controls. He did so, but much later.) —From The Crisis of Global Capitalism by George Soros, copyright © 1998. Reprinted by permission of Public Affairs, a member of The Perseus Books Group.

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The Russian Crisis of 1998 The crisis of August 1998 was the culmination of a continuing deterioration in general economic conditions in Russia. During the period from 1995 to 1998, Russian borrowers—both governmental and non-governmental—had borrowed heavily on the international capital markets. Servicing this debt soon became a growing problem, as servicing dollar debt requires earning dollars. The Russian current account, a surprisingly healthy surplus, was not finding its way into internal investment and external debt service. Capital flight accelerated as hard-currency earnings flowed out as fast as they found their way in. Finally, in the spring of 1998, even Russian export earnings began to decline. Russian exports were predominantly commodity-based, and global commodity prices had been falling since the start of the Asian crisis in 1997. The Russian currency, the ruble (RUB), operated under a managed float. This meant that the Russian Central Bank set a trading band, and then adjusted it continually. Theoretically, the exchange rate was allowed to slide daily at a 1.5% per month rate. A ­ utomatically, the Central Bank announced an official exchange rate each day at which it was willing to buy and sell rubles, always within the official band. In the event that the ruble’s rate came under pressure at the limits of the band, the Central Bank intervened in the market by buying and selling rubles, usually buying, using up the country’s foreign exchange reserves. The August Collapse.  On August 7, 1998, the Russian Central Bank announced that its currency reserves had fallen by $800 million in the last week of July. Prime M ­ inister ­Kiriyenko said that Russia would issue an additional $3 billion in foreign bonds to help pay its rising debt, a full $1 billion more than scheduled. On August 10, Russian stocks fell more than 5% as investors feared a Chinese currency (renminbi) devaluation. The ­Chinese currency was the only Asian currency of size not devalued in 1997 and 1998. Analysts worldwide speculated that international markets were waiting to see if the ­Russian government would increase its tax revenues as it had promised the IMF throughout the year. Russian tax collections averaged $1 billion per month in 1998, less than those of New York City. The following days saw a continuing series of press releases assuring the world that the government had everything under control. The government stated that the “panic” was ­psychological, not fiscal. President Boris Yeltsin promised, “There will be no devaluation— that’s firm and definite. That would signify that there was a disaster and that everything was collapsing. On the contrary, everything is going as it should.” “As it should” turned out to mean devaluation. On Monday, August 17, the ­Russian Central Bank announced that the ruble would be allowed to fall by 34%, from 6.30 rubles per dollar to 9.50. The government then announced a 90-day moratorium on all repayment of foreign debt, debt owed by Russian banks and all private borrowers, in order to avert a banking collapse. The currency’s fall continued, as illustrated in Exhibit 8.4. The Central Bank of Russia, in an attempt to defray criticism of its management of the ruble’s devaluation, disclosed that it had expended $8.8 billion in the preceding eight weeks defending the ruble’s value. On August 28, the Moscow currency exchange closed after 10 minutes of trading as the ruble continued to fall. The Aftermath.  It is hard to say when a crisis begins or ends, but for the Russian people and the Russian economy, the deterioration of the economic conditions continued. What is of more substantial concern is the toll taken on Russian society. For many, the collapse of the ruble and the loss of Russia’s access to the international capital markets brought into question the benefits of a free-market economy, long championed by the advocates of Western-style democracy.

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Exhibit 8.4 The Fall of the Russian Ruble Russian rubles = 1.00 USD 30 Govt. announces the ruble will be allowed to fall marginally, but then cannot stop its continual decline throughout Aug. and early Sept. 25

Ruble’s value continues to deteriorate for months until settling at roughly RUB25 = USD1.00

20

15 After only eight years of a market economy, Russia’s accumulation of extreme levels of international debt and rapid rates of inflation combine to undermine the ruble and the Russian people’s purchasing power.

10

5

Russia spends $8.8 billion defending the ruble the previous two months

/9 9/ 8 1/ 9 9/ 8 15 /9 9/ 8 29 / 10 98 /1 3 10 /98 /2 7 11 /98 /1 0 11 /98 /2 4/ 12 98 /8 / 12 98 /2 2/ 9 1/ 8 5/ 9 1/ 9 19 /9 2/ 9 2/ 9 2/ 9 16 /9 3/ 9 2/ 9 3/ 9 16 /9 3/ 9 30 /9 4/ 9 13 /9 4/ 9 27 /9 5/ 9 11 /9 5/ 9 25 /9 6/ 9 8/ 9 6/ 9 22 /9 7/ 9 6/ 9 7/ 9 20 /9 9

18

8/

8/

4/

98

0

The Argentine Crisis of 2002 Now, most Argentines are blaming corrupt politicians and foreign devils for their ills. But few are looking inward, at mainstream societal concepts such as viveza criolla, an Argentine cultural quirk that applauds anyone sly enough to get away with a fast one. It is one reason behind massive tax evasion here: One of every three Argentines does so—and many like to brag about it. —“Once-Haughty Nation’s Swagger Loses Its Currency,” Anthony Faiola, The Washington Post, March 13, 2002.

Argentina’s economic ups and downs have historically been tied to the health of the Argentine peso. South America’s southernmost resident—which oftentimes considered itself more European than Latin American—had been wracked by hyperinflation, international indebtedness, and economic collapse in the 1980s. By 1991, the people of Argentina had had enough. Economic reform was a common goal of the Argentine people. They were not interested in quick fixes, but lasting change and a stable future. They nearly got it. The Currency Board.  In 1991, the Argentine peso had been pegged to the U.S. dollar at a one-to-one rate of exchange. The policy was a radical departure from traditional methods of fixing the rate of a currency’s value. Argentina adopted a currency board, a structure— rather than merely a commitment—to limit the growth of money in the economy. Under a currency board, the central bank may increase the money supply in the banking system only with increases in its holdings of hard currency reserves. The reserves were, in this case, U.S. dollars. By removing the ability of government to expand the rate of growth of the money supply, Argentina believed it was eliminating the source of inflation that had devastated its standard of living.

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The idea was simple: limit the rate of growth in the country’s money supply to the rate at which the country receives net inflows of U.S. dollars as a result of trade growth. It was both a recipe for conservative and prudent financial management, and a decision to eliminate the power of politicians, elected and unelected, to exercise judgment both good and bad. It was an automatic and unbendable rule. Although hyperinflation had been the problem, the “cure” was a restrictive monetary policy that slowed economic growth. The first and foremost cost of the slower economic growth was in unemployment. The country’s unemployment rate rose to double-digit levels in 1994 and stayed there. The real GDP growth rate settled into recession in late 1998, and the economy continued to shrink through 2000. Argentine banks allowed depositors to hold their money in either pesos or dollars. This was intended to provide a market-based discipline to the banking and political systems, and to demonstrate the government’s unwavering commitment to maintaining the peso’s value parity with the dollar. Although intended to build confidence in the system, in the end it proved disastrous to the Argentine banking system. Economic Crisis of 2001.  The 1998 recession proved to be unending. Three-and-a-half years later, Argentina was still in recession. By 2001, crisis conditions had revealed three very important underlying problems with Argentina’s economy: 1) The Argentine peso was overvalued; 2) The currency board regime had eliminated monetary policy alternatives for macroeconomic policy; and 3) The Argentine government budget deficit was out of control. Inflation had not been eliminated, and the world’s markets were watching. Most of the major economies of South America now slid into recession. With slowing economic activity, imports fell. Most South American currencies now fell against the U.S. dollar, but because the Argentine peso remained pegged to the dollar, Argentine exports grew increasingly overpriced. The Currency Board and Monetary Policy.  The increasingly sluggish economic growth in Argentina warranted expansionary economic policies, argued many policymakers. But the currency board’s basic premise was that the money supply to the financial system could not be expanded any further or faster than the ability of the economy to capture dollar reserves— eliminating monetary policy. Government spending was not slowing, however. As the unemployment rate grew higher, as poverty and social unrest grew—both in Buenos Aires, the civil center of Argentina, and in the outer provinces—government was faced with growing expansionary spending needs to close the economic and social gaps. Government spending continued to increase, but tax receipts did not. Argentina turned to the international markets to aid in the financing of its government’s deficit spending. The total foreign debt of the country began rising dramatically. Only a number of IMF capital injections prevented the total foreign debt of the country from skyrocketing. By the end of the 1990s, however, total foreign debt had doubled, and the economy’s earning power had not. As economic conditions continued to deteriorate, banks suffered increasing runs. ­Depositors, fearing that the peso would be devalued, lined up to withdraw their money— both Argentine peso and U.S. dollar cash balances. Pesos were converted to dollars, once again adding fuel to the growing fire of currency crisis. The government, fearing that the increasing financial drain on banks would cause their collapse, closed the banks. Consumers, unable to withdraw more than $250 per week, were instructed to use debit cards and credit cards to make p ­ urchases and to conduct the everyday transactions required by society.

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Exhibit 8.5 The Collapse of the Argentine Peso Argentine pesos = 1.00 USD 4.00

Roughly six months pass before stabilization

3.50 Feb. 3 the government officially announces the flotation of the peso

3.00 2.50 2.00 1.50 1.00 0.50

Jan. 6 devaluation from 1.00/$ to 1.40/$ but banks closed, so no trading

Argentina’s Currency Board was an extreme system designed to eliminate the ability of government to conduct independent monetary policy. It was the result of years of disastrous inflationary suffering from poor policy control.

Currency Board fix ARS1.00 = USD1.00

11 /2 11 /01 / 11 9/01 /16 11 /0 /2 1 11 3/0 /30 1 12 /01 / 12 7/01 /14 12 /0 /2 1 12 1/0 /28 1 1/4 /01 1/1 /02 1 1/1 /02 8/0 1/2 2 5 2/1 /02 / 2/8 02 2/1 /02 5 2/2 /02 2/0 3/1 2 / 3/8 02 / 3/1 02 5 3/2 /02 2/0 3/2 2 9 4/5 /02 4/1 /02 2 4/1 /02 9/0 4/2 2 6 5/3 /02 5/1 /02 0 5/1 /02 7/0 5/2 2 4 5/3 /02 1/0 6/7 2 6/1 /02 4 6/2 /02 1/0 6/2 2 8 7/5 /02 7/1 /02 2 7/1 /02 9/0 7/2 2 6/0 2

0.00

Devaluation.  On Sunday, January 6, 2002, in the first act of his presidency, President E ­ duardo Duhalde devalued the peso from 1.00 Argentine peso per U.S. dollar to 1.40. But the economic pain continued. Two weeks after the devaluation, the banks were still closed. On February 3, 2002, the Argentine government announced that the peso would be floated, as shown in Exhibit 8.5. The government would no longer attempt to fix or manage its value to any specific level, allowing the market to find or set the exchange rate.3 Martin Feldstein, a former Harvard professor and member of the U.S. President’s Council of Economic Advisors, summed up the hard lessons of the Argentine story in the following way:4 In reality, the Argentines understood the risk that they were taking at least as well as the IMF staff did. Theirs was a calculated risk that might have produced good results. It is true, however, that the IMF staff did encourage Argentina to continue with the fixed exchange rate and currency board. Although the IMF and virtually all outside economists believe that a floating exchange rate is preferable to a “fixed but adjustable” system, in which the government recognizes that it will have to devalue occasionally, the IMF (as well as some outside economists) came to believe that the currency board system of a firmly fixed exchange rate (a “hard peg” in the jargon of international finance) is a viable long-term policy for an economy. Argentina’s experience has proved that wrong.

Unfortunately, this was not the last currency crisis for Argentina. Argentina once again suffered capital flight and a rapid deterioration in the recognized value of its currency in 2013–2014. This crisis, highlighted by capital controls and black market (“blue market”) trading, was described in Chapter 2. 3

“Argentina’s Fall,” Martin Feldstein, Foreign Affairs, March/April 2002. Reprinted by permission of FOREIGN AFFAIRS, (81, 2002). Copyright 2002 by the Council of Foreign Relations, Inc. www.ForeignAffairs.com 4

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Forecasting in Practice Numerous foreign exchange forecasting services exist, many of which are provided by banks and independent consultants. In addition, some multinational firms have their own in-house forecasting capabilities. Predictions can be based on econometric models, technical analysis, intuition, and a certain measure of gall. Exhibit 8.6 summarizes the various forecasting periods, regimes, and most widely followed methodologies. (Remember, if we authors could predict the movement of exchange rates with regularity, we surely wouldn’t write books.) Whether any of the forecasting services are worth their cost depends both on the motive for forecasting as well as the required accuracy. For ­example, long-run forecasts may be motivated by a multinational firm’s desire to initiate a foreign investment in Japan, or perhaps to raise long-term funds in Japanese yen. Or a portfolio manager may be considering diversifying for the long term in Japanese securities. The longer the time horizon of the forecast, the more inaccurate, but also the less critical the forecast is likely to be. Short-term forecasts are typically motivated by a desire to hedge a receivable, payable, or dividend for a period of perhaps three months. In this case, the long-run economic fundamentals may not be as important as technical factors in the marketplace, government intervention, news, and passing whims of traders and investors. Accuracy of the forecast is critical, since most of the exchange rate changes are relatively small even though the day-to-day volatility may be high. Forecasting services normally undertake fundamental economic analysis for long-term ­forecasts, and some base their short-term forecasts on the same basic model. Others base their short-term forecasts on technical analysis similar to that conducted in security analysis. They attempt to correlate exchange rate changes with various other variables, regardless of whether there is any economic rationale for the correlation. The chances of these forecasts

Exhibit 8.6 Exchange Rate Forecasting in Practice Forecast Period

Regime

Recommended Forecast Methods

SHORT-RUN

Fixed-Rate

1. Assume the fixed rate is maintained 2. Indications of stress on fixed rate? 3. Capital controls; black market rates 4. Indicators of government’s capability to maintain fixed-rate? 5. Changes in official foreign currency reserves

Floating-Rate

1. Technical methods that capture trend 2. Forward rates as forecasts  (a) 630 days, assume a random walk   (b) 30–90 days, forward rates   (c) 90–360 days, combine trend with fundamental analysis 3. Fundamental analysis of inflationary concerns 4. Government declarations and agreements regarding exchange rate goals 5. Cooperative agreements with other countries

Fixed-Rate

1. Fundamental analysis 2. BOP management 3. Ability to control domestic inflation 4. Ability to generate hard currency reserves to use for intervention 5. Ability to run trade surpluses

Floating-Rate

1. Focus on inflationary fundamentals and PPP 2. Indicators of general economic health such as economic growth and stability 3. Technical analysis of long-term trends; new research indicates possibility of long-term technical “waves”

LONG-RUN

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213

being consistently useful or profitable depend on whether one believes the foreign exchange market is efficient. The more efficient the market is, the more likely it is that exchange rates are “random walks,” with past price behavior providing no clues to the future. The less efficient the foreign exchange market is, the better the chance that forecasters may get lucky and find a key relationship that holds, at least for the short run. If the relationship is consistent, however, others will soon discover it and the market will become efficient again with respect to that piece of information.

Technical Analysis Technical analysts, traditionally referred to as chartists, focus on price and volume data to determine past trends that are expected to continue into the future. The single most important element of technical analysis is that future exchange rates are based on the current exchange rate. Exchange rate movements, similar to equity price movements, can be subdivided into three periods: 1) day-to-day movement, which is seemingly random; 2) short-term movements, ranging from several days to trends lasting several months; and 3) long-term movements, characterized by up and down long-term trends. Long-term technical analysis has gained new popularity as a result of recent research into the possibility that long-term “waves” in currency movements exist under floating exchange rates. The longer the time horizon of the forecast, the more inaccurate the forecast is likely to be. Whereas forecasting for the long run must depend on economic fundamentals of exchange rate determination, many of the forecast needs of the firm are short- to medium-term in their time horizon and can be addressed with less theoretical approaches. Time series techniques infer no theory or causality but simply predict future values from the recent past. Forecasters freely mix fundamental and technical analysis, presumably because forecasting is like playing horseshoes—getting close counts. Global Finance in Practice 8.3 provides a short analysis of how accurate one prestigious currency forecaster, JPMorgan Chase, was over a three-year period.

Cross-Rate Consistency in Forecasting International financial managers must often forecast their home currency exchange rates for the set of countries in which the firm operates, not only to decide whether to hedge or to make an investment, but also as part of preparing multi-country operating budgets in the home country’s currency. These are the operating budgets against which the performance of foreign subsidiary managers will be judged. Checking cross-rate consistency—the reasonableness of the cross rates implicit in individual forecasts—acts as a reality check.

Forecasting: What to Think? Obviously, with the variety of theories and practices, forecasting exchange rates into the future is a daunting task. Here is a synthesis of our thoughts and experience: ■

■

It appears, from decades of theoretical and empirical studies, that exchange rates do adhere to the fundamental principles and theories outlined in the previous sections. Fundamentals do apply in the long term. There is, therefore, something of a fundamental equilibrium path for a currency’s value. It also seems that in the short term, a variety of random events, institutional frictions, and technical factors may cause currency values to deviate significantly from their long-term fundamental path. This is sometimes referred to as noise. Clearly, therefore, we might expect deviations from the long-term path not only to occur, but also to occur with some regularity and relative longevity.

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Global Finance in Practice

8.3

JPMorgan Chase Forecast of the Dollar/Euro There are many different foreign exchange forecasting services and service providers. JPMorgan Chase (JPMC) is one of the most prestigious and widely used. A review of JPMC’s forecasting accuracy for the U.S. dollar/euro spot exchange rate ($/€) for the 2002 to 2005 period, in 90-day increments, is presented in the exhibit.* The graph shows the actual spot exchange rate for the period and JPMC’s forecast for the spot exchange rate for the same period. There is good news and there is bad news. The good news is that JPMC hit the actual spot rate dead-on in both May and November 2002. The bad news is that after that,

they missed. Somewhat worrisome is when the forecast got the direction wrong. For example, in February 2004, JPMC had forecast the spot rate to move from the current rate of $1.27/€ to $1.32/€, but in fact, the dollar had appreciated dramatically in the following three-month period to close at $1.19/€. This was in fact a massive ­difference. Again, in November 2004, JPMC had forecast the spot rate to move from the current spot rate of $1.30/€ to $1.23/€, but in fact, the actual spot rate proved to be $1.32/€. The lesson learned is probably that regardless of how professional and prestigious a forecaster may be, and how accurate they may have been in the past, forecasting the future—by ­a nyone about anything—is ­challenging to say the least. *This analysis uses exchange rate data as published in the print edition of The Economist, appearing quarterly. The source of the exchange rate forecasts, as noted in The Economist, is JPMorgan Chase.

U.S. dollars = 1 euro $1.40

1.38 1.32

$1.30

1.27

$1.20

1.23

1.19

1.19

1.16

1.15

1.26 1.23

1.22

1.17

1.30 1.23

1.21

Actual spot rate

1.32

1.13

$1.10 1.07 $1.00

0.98

$0.90 0.87

JPMC’s forecast of the spot rate 90 days into the future

0.91

0.90

1.02

1.01

1.00

5/

24

/0

5

5 /0 01 3/

04 0/ /2 11

19

/0

4

4 8/

/0 13 5/

12

/0

4

3 2/

3

/0 13 11 /

/0 14 8/

15

/0

3

3 5/

/0 13 2/

02 7/ /0 11

8/

08

/0

2

2 /0 16 5/

2/

14

/0

2

$0.80

Exhibit 8.7 illustrates this synthesis of forecasting thought. The long-term equilibrium path of the currency—although relatively well-defined in retrospect—is not always apparent in the short term. The exchange rate itself may deviate in something of a cycle or wave about the long-term path. If market participants agree on the general long-term path and possess stabilizing expectations, the currency’s value will periodically return to the long-term path. It is critical, however, that when the currency’s value rises above the long-term path, most market participants see it as being overvalued and respond by selling the currency—causing its price to fall. Similarly, when the currency’s value falls below the long-term path, market participants respond by buying the currency—driving its value up. This is what is meant by stabilizing expectations:

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Exhibit 8.7 Short-Term Noise versus Long-Term Trends Foreign currency per unit of domestic Technical or random currency events may drive the exchange rate from the long-term path

Fundamental equilibrium path

Short-term forces may induce noise — short-term volatility around the long-term path

Time

Market participants continually respond to deviations from the long-term path by buying or selling to drive the currency back to the long-term path. If, for some reason, the market becomes unstable, as illustrated by the dotted deviation path in Exhibit 8.7, the exchange rate may move significantly away from the long-term path for longer periods of time. Causes of these destabilizing markets—weak infrastructure (such as the banking system) and political or social events that dictate economic behaviors—are often the actions of speculators and inefficient markets.

Exchange Rate Dynamics: Making Sense of Market Movements Although the various theories surrounding exchange rate determination are clear and sound, it may appear on a day-to-day basis that the currency markets do not pay much attention to the theories—they don’t read the books! The difficulty is in understanding which fundamentals are driving markets at which points in time. One example of this relative confusion over exchange rate dynamics is the phenomenon known as overshooting. Assume that the current spot rate between the dollar and the euro, as illustrated in Exhibit 8.8, is S0. The U.S. Federal Reserve announces an expansionary monetary policy that cuts U.S. dollar interest rates. If euro-denominated interest rates remain unchanged, the new spot rate expected by the exchange markets based on interest differentials is S1. This immediate change in the exchange rate is typical of how the markets react to news, distinct economic and political events that are observable. The immediate change in the value of the dollar/euro is therefore based on interest differentials. As time passes, however, the price impacts of the monetary policy change start working their way through the economy. As price changes occur over the medium to long term, purchasing power parity forces drive the market dynamics, and the spot rate moves from S1 toward S2. Although both S1 and S2 were rates determined by the market, they reflected the dominance of different theoretical principles. As a result, the initial lower value of the dollar of S1 is described as overshooting the longer-term equilibrium value of S2.

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Exhibit 8.8 Exchange Rate Dynamics: Overshooting If the U.S. Federal Reserve were to announce a change in monetary policy, an expansion in money supply growth, it could potentially result in an “overshooting” exchange rate change. Spot Exchange Rate, $/€ S1 Overshooting S2 S0

t1

t2

Time

The Fed announces a monetary expansion at a time t1. This results immediately in lower dollar interest rates. The foreign exchange markets immediately respond to the lower dollar interest rates by driving the value of the dollar down from S0 to S1. This new rate is based on interest differentials. However, in the coming days and weeks, as the fundamental price effects of the monetary policy actions work their way through the economy, purchasing power parity takes hold and the market moves toward a longer term valuation of the dollar—by time t2—of S2, a weaker dollar than S0, but not as weak as initially set at S1.

This is, of course, only one possible series of events and market reactions. Currency markets are subject to new news every hour of every day, making it very difficult to forecast exchange rate movements in short periods of time. In the longer term, as shown in Exhibit 8.8, the markets do customarily return to fundamentals of exchange rate determination.

Summary Points ■

There are three major schools of thought to explaining the economic determinants of exchange rates: parity conditions, the balance of payments approach, and the asset market approach.

■

The asset market approach to exchange rate determination suggests that whether foreigners are willing to hold claims in monetary form depends partly on relative real interest rates and partly on a country’s outlook for economic growth and profitability.

■

The recurrence of exchange rate crises demonstrates not only how sensitive currency values continue to be to economic fundamentals like inflation and economic growth, but also how vulnerable many emerging market currencies continue to be in an ever-expanding global financial network.

■

Exchange rate forecasting is part of global business. All businesses of all kinds must form some expectation

of what the future holds. Short-term forecasting of exchange rates in practice tends to focus on time series trends and current spot rates. Longer-term forecasting, over one year, requires a return to the basic analysis of exchange rate fundamentals such as BOP, relative inflation rates, relative interest rates, and the long-run properties of purchasing power parity. ■

In the short term, a variety of random events, institutional frictions, and technical factors may cause currency values to deviate significantly from their longterm fundamental path. In the long term, it does appear that exchange rates follow a fundamental equilibrium path, one consistent with the fundamental theories of exchange rate determination.

Chapter 8   Foreign Exchange Rate Determination

Mini-Case

The Japanese Yen Intervention of 20101 We will take decisive steps if necessary, including intervention, while continuing to closely watch currency ­market moves from now on. —Yoshihiko Noda, Finance Minister of Japan, September 13, 2010. Japan has been the subject of continued criticism for nearly two decades over its frequent intervention in the foreign exchange markets. Trading partners have accused it of market manipulation, while Japan has argued that it is a country and economy that is inherently global in its economic structure, relying on its international competitiveness for its livelihood, and currency stability is its only desire. The debate was renewed in September 2010 when Japan intervened in the foreign exchange markets for the first time in nearly six years. Japan reportedly bought nearly 20 billion

217

U.S. dollars in exchange for Japanese yen in an attempt to stop the continuing appreciation of the yen. Finance ­Ministry officials had stated publicly that 82 yen per dollar was ­probably the limit of their tolerance for yen appreciation. As illustrated in Exhibit A, the Bank of Japan intervened on September 13 as the yen approached 82 yen per dollar. (The Bank of Japan is independent in its ability to conduct Japanese monetary policy, but as the organizational subsidiary of the Japanese Ministry of Finance, it must conduct foreign exchange operations on behalf of the Japanese government.) Japanese officials reportedly notified authorities in both the United States and the European Union of their activity, but noted that they had not asked for permission or support. The intervention resulted in public outcry from Beijing to Washington to London over the “new era of currency intervention.” Although market intervention is always looked down upon by free market proponents, the move by Japan was seen as particularly frustrating as it came at a time when the United States was continuing to pressure China to

Exhibit A Intervention and the Japanese Yen 2010 Japanese yen = 1.00 USD 96

¥94.71/$

94 92 90 88

Bank of Japan intervention Sept. 13 as yen hits 15-year high

86 84 82 ¥80.67/$

1/

4/ 1 1/ 0 18 /1 2/ 0 1/ 1 2/ 0 15 /1 3/ 0 1/ 1 3/ 0 15 /1 3/ 0 29 /1 4/ 0 12 /1 4/ 0 26 /1 5/ 0 10 /1 5/ 0 24 /1 6/ 0 7/ 1 6/ 0 21 /1 7/ 0 5/ 1 7/ 0 19 /1 8/ 0 2/ 1 8/ 0 16 /1 8/ 0 30 /1 9/ 0 13 /1 9/ 0 27 / 10 10 /1 1 10 /10 /2 5/ 11 10 /8 / 11 10 /2 2/ 12 10 /6 / 12 10 /2 0/ 10

80

Copyright © 2011 Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Michael Moffett for the purpose of classroom discussion only, and not to indicate effective or ineffective management. This Mini-Case draws from a number of sources including “Japan’s Currency Intervention: Policy Issues,” Dick K. Nanto, CRS Report for Congress, July 13, 2007; IMF Country Report No. 05/273, Japan: 2005 Article IV Consultation Staff Report, August 2005; “Interventions and the Japanese Economic Recovery,” Takatoshi Ito, paper presented at the University of Michigan Conference on Policy Options for Japan and the United States, October 2004; “Towards a New Era of Currency Intervention,” Mansoor Mohi-Uddin, Financial Times, September 22, 2010; “Currency Intervention’s Mixed Record of Success,” Russell Hotten, BBC News, September 16, 2010. 1

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PART 2  Foreign Exchange Theory and Markets

revalue its currency, the renminbi. As noted by economist Nouriel Roubini, “We are in a world where everyone wants a weak currency,” a marketplace in which all countries are looking to stimulate their domestic economies through exceptionally low interest rates and corresponding weak currency values—“a global race to the bottom.” Ironically, as illustrated in Exhibit A, it appears that the intervention was largely unsuccessful. When the Bank of Japan started buying dollars in an appreciating yen ­market—the so-called “leaning into the wind” strategy— it was hoping to either stop the appreciation, change the direction of the spot rate movement, or both. In either pursuit, it appears to have failed. As one analyst commented, it turned out to be a “short-term fix to a long-term problem.” Although the yen spiked downward (more yen per dollar) for a few days, it returned once again to an appreciating path within a week. Japan’s frequent interventions, described in Exhibit B, have been the subject of much study. In an August 2005 study by the IMF, it was noted that between 1991 and 2005, the Bank of Japan had intervened on 340 days, while the U.S. Federal Reserve intervened on 22 days, and the ­European Central Bank intervened only on 4 days (since its inception in 1998). Although the IMF has never found ­Japanese intervention to be officially “currency manipulation,” an analysis by Takatoshi Ito in 2004 concluded that there was on average a one-yen per dollar change in market rates, roughly 1%, as a result of Japanese intervention over time.

It is not clear at this time whether or not Japan will “sterilize” the intervention, meaning neutralize the impact of the additional yen on the money supply by buying bonds domestically. Although this has been the tendency historically, given the current deflation forces in Japan, it may not be necessary. Japan’s interventions are not, however, a lone example of attempted market manipulation. The Swiss National Bank repeatedly intervened in 2009 to stop the appreciation of the Swiss franc against both the dollar and the euro, and recently, in January 2011, Chile aggressively sold Chilean pesos against the U.S. dollar to stop its continued appreciation. There is no historical case in which [yen] selling intervention succeeded in immediately stopping the pre-existing long-term uptrend in the Japanese yen. —Tohru Sasaki, Currency Strategist, JPMorgan.

Case Questions 1. Could the Bank of Japan continually intervene to try to stop the appreciation of the yen? Is there any limit to its ability to intervene? 2. Why is a stronger yen such a bad thing for Japan? Isn’t a stronger currency value an indication of confidence by the global markets in the economy and policies of a country? 3. If currency intervention has such a poor record, why do you think countries like Japan or Switzerland or Chile continue to intervene in the foreign exchange market?

Exhibit B The History of Japanese Intervention Japanese yen = 1.00 USD 280

It is not clear that Japanese intervention over the past two decades has had the desired impact on preventing yen appreciation.

240

200

160

120

80 Intervention

9

10 p-

-0

Se

ay

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5

06

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p-

-0

ay

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04 M

02

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1 -0

p-

Se

00

ay

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M

7

98

Ja

p-

-9

Se

96

ay

M

3

94

n-

Ja

p-

-9

Se

92

ay

n-

M

9

90

Ja

p-

-8

Se

88

ay

M

5

86

n-

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p-

-8

Se

84

ay

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1

82

n-

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p-

-8

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80

ay

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08

Intervention

40

Chapter 8   Foreign Exchange Rate Determination

Questions 1. Term Forecasting. What are the major differences between short-term and long-term forecasts for a fixed exchange rate versus a floating exchange rate? 2. Exchange Rate Dynamics. What is meant by the term “overshooting”? What causes it and how is it corrected? 3. Fundamental Equilibrium. What is meant by the term “fundamental equilibrium path” for a currency value? What is “noise”? 4. Asset Market Approach to Forecasting. Explain how the asset market approach can be used to forecast spot exchange rates. How does the asset market approach differ from the BOP approach to forecasting? 5. Technical Analysis. Explain how technical analysis can be used to forecast future spot exchange rates. How does technical analysis differ from the BOP and asset market approaches to forecasting? 6. Forecasting Services. Numerous exchange rate forecasting services exist. Trident’s CFO Maria Gonzalez is considering whether to subscribe to one of these services at a cost of $20,000 per year. The price includes online access to the forecasting services’ computerized econometric exchange rate prediction model. What factors should Maria consider when deciding whether or not to subscribe? 7. Cross-Rate Consistency in Forecasting. Explain the meaning of “cross-rate consistency” as used by MNEs. How do MNEs use a check of cross-rate consistency in practice? 8. Financial Infrastructure Weakness. Infrastructure weakness was one of the causes of the emerging market crisis in Thailand in 1997. Define infrastructure weakness and explain how it could affect a country’s exchange rate. 9. Speculation. The emerging market crises of 1997–2002 were worsened because of rampant speculation. Do speculators cause such crisis or do they simply respond to market signals of weakness? How can a government manage foreign exchange speculation? 10. Foreign Direct Investment. Swings in foreign direct investment flows into and out of emerging markets contribute to exchange rate volatility. Describe one

219

concrete historical example of this phenomenon ­during the last 10 years. 11. Thailand’s Crisis of 1997. What were the main causes of Thailand’s crisis of 1997? What lessons were learned and what steps were eventually taken to ­normalize Thailand’s economy? 12. Russia’s Crisis of 1998. What were the main causes of Russia’s crisis of 1998? What lessons were learned and what steps were taken to normalize Russia’s economy? 13. Argentina’s Crisis of 2001–2002. What were the main causes of Argentina’s crisis of 2001–2002? What ­lessons were learned and what steps were taken to normalize Argentina’s economy?

Problems 1. Trepak (The Russian Dance). The Russian ruble (RUB) traded at RUB29.00/USD on January 2, 2009. On December 11, 2010, its value had fallen to RUB31.45/USD. What was the percentage change in its value? 2. Center of the World. The Ecuadorian sucre (S) suffered from hyper-inflationary forces throughout 1999. Its value moved from S5,000/$ to S25,000/$. What was the percentage change in its value? 3. Reais Reality. The Brazilian reais (R$) value was R$1.80/$ on Thursday, January 24, 2008. Its value fell to R$2.39/$ on Monday, January 26, 2009. What was the percentage change in its value? 4. That’s Loonie. The Canadian dollar’s value against the U.S. dollar has seen some significant changes over recent history. Use the following graph of the C$/US$ exchange rate for the 30-year period between 1980 and end-of-year 2010 to estimate the ­percentage change in the Canadian dollar’s value ­(affectionately known as the “loonie”) versus the dollar for the ­following periods. a. January 1980–December 1985 b. January 1986–December 1991 c. January 1992–December 2001 d. January 2002–December 2006 e. January 2007–December 2008 f. January 2009–December 2010

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PART 2  Foreign Exchange Theory and Markets

Monthly Average Exchange Rates: Canadian dollars = 1.00 USD   1.7 1.6 1.5 1.4 1.3 1.2 1.1 1.0 0.9

80

85

90

95

00

05

10

Source: PACIFIC Exchange Rates © 2010 by Prof. Werner Antweiler, University of British Columbia, Vancouver BC, Canada.

5. Paris to Tokyo. The Japanese yen-euro cross rate is one of the more significant currency values for global trade and commerce. The graph below shows this cross rate from when the euro was launched in ­January 1999 through the end-of-year 2010. Estimate the change in



the value of the yen over the following three periods of change. a. January 1999–August 2001 b. September 2001–June 2008 c. July 2008–December 2010

Monthly Average Exchange Rates: Japanese yen = 1.00 euro   170 160 150 140 130 120 110 100 90

00

02

04

06

08

10

Source: PACIFIC Exchange Rates © 2010 by Prof. Werner Antweiler, University of British Columbia, Vancouver BC, Canada.

6. Lowering the Lira. The Turkish lira (TL) was officially devalued by the Turkish government in February 2001 during a severe political and economic crisis. The Turkish government announced on February 21 that the lira would be devalued by 20%. The spot exchange rate on February 20 was TL68,000/$.



a. What was the exchange rate after devaluation? b. What was percentage change after falling to TL100,000/$?

7. Cada Seis Años. Mexico was famous—or infamous— for many years for having two things every six years (cada seis años in Spanish): a presidential election and

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Chapter 8   Foreign Exchange Rate Determination

a currency devaluation. This was the case in 1976, 1982, 1988, and 1994. In its last devaluation on ­December 20, 1994, the value of the Mexican peso (Ps) was ­officially changed from Ps3.30/$ to Ps5.50/$. What was the ­percentage devaluation? 8. Brokedown Palace. The Thai baht (THB) was devalued by the Thai government from THB25/$ to THB29/$ on July 2, 1997. What was the percentage devaluation of the baht?

9. Forecasting the Argentine Peso. As illustrated in the graph, the Argentine peso moved from its fixed exchange rate of Ps1.00/$ to over Ps2.00/$ in a matter of days in early January 2002. After a brief period of high volatility, the peso’s value appeared to settle down to a range varying between 2.0 and 2.5 pesos per dollar. If you were forecasting the Argentine peso further into the future, how would you use the information in the graph—the value of the peso freely floating in the weeks following devaluation—to forecast its future value?

Daily Exchange Rates: Argentine pesos = 1.00 USD 2.25   2.00 1.75 1.50 1.25 1.00 0.75

26

2

9

16

23

30

6

13

Jan 2002

20

27

Feb 2002

Forecasting the Pan-Pacific Pyramid Use the table, which contains economic, financial, and business indicators from the October 20, 2007, issue of The Economist (print edition), to answer Problems 10–15. Forecasting the Pan-Pacific Pyramid: Australia, Japan and The United States Gross Domestic Product Country

Latest Qtr

Qtr*

Forecast 2007e

Forecast 2008e

Industrial Production

Unemployment Rate

Recent Qtr

Latest

Australia

4.3%

3.8%

4.1%

3.5%

4.6%

4.2%

Japan

1.6%

- 1.2%

2.0%

1.9%

4.3%

3.8%

United States

1.9%

3.8%

2.0%

2.2%

1.9%

4.7%

Consumer Prices Country Australia

Year Ago

Latest

Interest Rates Forecast 2007e

3-Month Latest

1-Yr Govt Latest

4.0%

2.1%

2.4%

6.90%

6.23%

Japan

0.9%

- 0.2%

0.0%

0.73%

1.65%

United States

2.1%

2.8%

2.8%

4.72%

4.54%

Trade Balance Country Australia Japan United States

Last 12 Mos (billion $) - 13.0

Curent Account

Current Units (per U.S.$)

Last 12 Mos (billion $)

Forecast 07 (% of GDP)

Oct 17th

Year Ago

- $47.0

- 5.7%

1.12

1.33

98.1

$197.5

4.6%

117

119

- 810.7

- $793.2

- 5.6%

1.00

1.00

Source: Data abstracted from The Economist, October 20, 2007, print edition. Unless otherwise noted, percentages are percentage changes over one year. Recent Qtr = recent quarter. Values for 2007e are estimates or forecasts.

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PART 2  Foreign Exchange Theory and Markets

10. Current Spot Rates. What are the current spot exchange rates for the following cross rates? a. Japanese yen/U.S. dollar exchange rate b. Japanese yen/Australian dollar exchange rate c. Australian dollar/U.S. dollar exchange rate 11. Purchasing Power Parity Forecasts. Assuming purchasing power parity, and assuming that the forecasted change in consumer prices is a good proxy of predicted inflation, forecast the following cross rates: a. Japanese yen/U.S. dollar in one year b. Japanese yen/Australian dollar in one year c. Australian dollar/U.S. dollar in one year 12. International Fischer Forecasts. Assuming International Fischer applies to the coming year, forecast the following future spot exchange rates using the government bond rates for the respective country currencies: a. Japanese yen/U.S. dollar in one year b. Japanese yen/Australian dollar in one year c. Australian dollar/U.S. dollar in one year 13. Implied Real Interest Rates. If the nominal interest rate is the government bond rate, and the current change in consumer prices is used as expected ­inflation, calculate the “implied real rate of interest” (the nominal rate corrected for expected inflation) by currency. a. Australian dollar “real” rate b. Japanese yen “real” rate c. U.S. dollar “real” rate 14. Forward Rates. Using the spot rates and 3-month interest rates, calculate the 90-day forward rates for: a. Japanese yen/U.S. dollar exchange rate b. Japanese yen/Australian dollar exchange rate c. Australian dollar/U.S. dollar exchange rate 15. Real Economic Activity and Misery. Calculate the country’s Misery Index (unemployment + inflation) and then use it like an interest differential to forecast the future spot exchange rate, one year into the future.



a. Japanese yen/U.S. dollar exchange rate in one year b. Japanese yen/Australian dollar exchange rate in one year c. Australian dollar/U.S. dollar exchange rate in one year

Internet Exercises 1. Recent Economic and Financial Data. Use the following Web sites to obtain recent economic and financial data used for all approaches to forecasting presented in this chapter. Economist.com www.economist.com/ markets-data FT.com www.ft.com EconEdLink www.econedlink.org/ economic-resources/focuson-economic-data.php

2. OzForex Weekly Comment. The OzForex Foreign Exchange Services Web site provides a weekly commentary on major political and economic factors and events that move current markets. Using their Web site, see what they expect to happen in the coming week on the three major global currencies—the dollar, yen, and euro. OzForex www.ozforex.com.au/ news-commentary/weekly

3. Exchange Rates, Interest Rates, and Global Markets. The magnitude of market data can seem overwhelming on occasion. Use the following Bloomberg m ­ arkets page to organize your mind and your global data. Bloomberg Financial News

www.bloomberg.com/markets

4. Banque Canada and the Canadian Dollar Forward Market. Use the following Web site to find the ­latest spot and forward quotes of the Canadian dollar against the Bahamian dollar and the Brazilian real. Banque Canada www.bankofcanada.ca/rates/ exchange/

introduction

PARt One

chAPteR 1 international business and Globalization Objectives After studying this chapter, you should be able to 1-1 Relate globalization and international business (ib) to each other and explain why their study is important 1-2 Grasp the forces driving globalization and ib 1-3 Discuss the major criticisms of globalization 1-4 Assess the major reasons companies seek to create value by engaging in ib 1-5 Define and illustrate the different operating modes for companies to accomplish their international objectives 1-6 Recognize why national differences in companies’ external environments affect how they may best improve their ib performance

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The world’s a stage; each plays his part, and takes his share. —Dutch proverb

A group of cyclists in action during a cycling tour

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Case Sports may be the world’s most globalized business.1 Fans demand to see the best, and “best” has become a global standard of competition. (The opening photo shows a marathon in Berlin, Germany that had runners from over 130 nations and more than a million spectators.) Satellite TV brings live events from just about anywhere in the world to fans just about anywhere else. This gives the key sports-business participants—athletes, team owners, league representatives, and sports associations—broadened audience exposure, expanded fan bases, and augmented revenues. National sports federations’ sponsorship of international competitions are common, most notably the longstanding World Cup in football (soccer) and the Olympics. More national organizations participate in these events than there are United Nations (UN) members, and probably more people follow them than follow most of the UN’s activities. How do these international competitions relate to business? Cities and countries compete to host events to attract tourists and publicize their business opportunities. In turn, companies pay for marketing rights as sponsors. Finally, individual athletes, such as Michael Phelps in swimming, compete not only for medals, but also for lucrative contracts to endorse products. While the Olympics and the World Cup participations have long been global, the competitive location has been less so. This has recently changed with the 2010 World Cup in South Africa, the 2016 Olympics in Brazil, and the 2022 World Cup in Qatar.

The INTerNaTIoNal Job MarkeT The search for talent has become worldwide. Professional basketball scouts search remote areas of Nigeria for tall high-potential youngsters. Baseball agents provide live-in training camps for Dominican Republic teenagers in exchange for a percentage of their future professional signing bonuses. However, assembling talent is necessary but insufficient for making a sports business successful. Shrewd marketing and financial management are crucial too. For instance, Fútbol Barcelona, one of recent years’ best professional soccer teams, turned to young business graduates to help reduce its financial problems. Most of today’s top-notch athletes are willing to follow the money anywhere. About two-thirds of the players in England’s professional soccer league (Premiership) are from other countries, which helps improve the caliber of play and increase the TV fan base outside England.

how the aTP Courts Worldwide Support You’ve probably noticed that individual sports professionals are globe hoppers. Take tennis. No country boasts enough fans to keep players at home for year-round competition, yet today’s top-flight

The Globalized Business of sports tennis pros come from every inhabited continent. For 2017 the Association of Tennis Professionals (ATP) sanctioned 68 tournaments in 33 countries. It also requires pros to compete in a certain number of events—and thus play in a number of countries—to maintain international rankings. Because no tennis pro can possibly play in every tournament, organizers compete for top draws to fill stadium seats and land lucrative TV contracts. Prizes can be extremely generous (about US $2.7  million for each of the 2016 Australian Open singles champions). Tournaments earn money through ticket sales, corporate sponsorship agreements, television contracts, and leasing of advertising space. The larger the stadium and TV audiences, the more backers and advertisers will pay to get their attention. Moreover, international broadcasts attract sponsorship from companies in various industries and countries.

From National to International Sports Pastimes Some countries have legally designated a national sport as a means of preserving traditions; others effectively have one. Map 1.1 shows a sample of these. However, other sports have sometimes replaced national sports in popularity, such as cricket replacing field hockey as India’s most popular sport. Baseball was popular only in its North American birthplace for most of its history, but the International Baseball Federation now has over 100 member countries. As TV revenues flattened in North America, Major League Baseball (MLB) broadened its fan base by broadcasting games to international audiences, which also showed youngsters all over the world how the game was played. The average MLB clubhouse is now a bastion of multilingual camaraderie, with players and coaches talking baseball in Spanish, Japanese, Mandarin, and Korean as well as English.

The WIde World oF TelevISed SPorTS Not surprisingly, other professional sports have expanded their global TV coverage (and marketing programs). Most viewers of Stanley Cup hockey watch from outside North America. Fans can watch NASCAR races (National Association for Stock Car Auto Racing) and NBA games in most countries. TV isn’t the only means by which sports organizations are seeking foreign fan bases and players. The National Football League (NFL) of the United States underwrites football programs in Chinese schools and plays some regular games in Europe. The NBA is helping to build basketball youth leagues in India.

C h a pt e r 1

MaP 1.1

47

International Business and Globalization

examples of National Sports

Some 63 countries have either defined a national sport by law or de facto have a national sport. Some national sports are shared by more than one country, such as cricket by England and seven of its former colonies. Some others have been established to protect an historical heritage, such as tejo in Colombia and pato in Argentina. Note also that Canada has two designations, one for winter and one for summer. Source: The information on sports was taken from Wikipedia, http://en.wikipedia.org/wiki/National_sport (accessed March 18, 2016).

CANADA lacrosse (summer) hockey (winter)

NORWAY cross-country skiing SCOTLAND golf

RUSSIA bandy

JAPAN sumo

DOMINICAN REPUBLIC baseball COLOMBIA tejo

PAKISTAN field hockey GUYANA cricket

SRI LANKA volleyball

BANGLADESH kabaddi (hadudu)

NEW ZEALAND rugby

The Top-Notch Pro as Upscale brand Many top players are effectively global brands, such as U.S. tennis pro Serena Williams and Portuguese soccer forward Cristiano Ronaldo. Because of their sports success and charisma, companies within and outside the sports industry pay them handsomely for endorsing clothing, equipment, and other products.

Promotion as Teamwork A few teams, such as the New York Yankees in baseball, the New Zealand All Blacks in rugby, and Manchester United (Man U) in soccer also have enough brand-name cachet to be global brands for selling clothing and other items. Just about every team can get something for the rights to use its logo, while some have enough name recognition to support global chains of retail outlets. Similarly, companies both sponsor and seek endorsements from wellknown teams, such as the placement of “Fly Emirates” on Real Madrid’s soccer jerseys. Still others pay for naming rights to arenas and other venues. Of course, teams themselves can be attractive international investments. For instance, U.S. investors bought the Liverpool Football Club of the United Kingdom.

The Upsides and downsides of Globalized Sports What does all this mean to a sports fan? Now that pro sports have become a global phenomenon, fans can enjoy a greater variety— and a higher level of competition—than any former generation. That’s the upside, but people don’t always take easily to another country’s sport. Despite many efforts, cricket, although popular in countries that were British colonies for centuries, is not popular elsewhere. Nor has American football gained much popularity outside the United States. One possible reason is that rules for cricket and American football are so complicated. However, basketball and soccer have traveled to new markets more readily because they are easier to understand and require little specialized equipment. Further, there is disagreement about the economic effect of successfully winning a bid to host big international competitions such as the World Cup and Olympics. On the one hand, they help spur tourism, foreign investment, infrastructure construction, and improvement of blighted areas that will speed future economic growth. On the other hand, in light of threats from global terrorism, the cost of security has skyrocketed, while hosts may have to spend on stadiums and facilities that have no use afterward. Many competitions

48

p art 1

Introduction

have ended with substantially increased local and national debt. Critics, therefore, often believe the funds would have been better spent on social services. Nor is everyone happy with the unbridled globalization of sports—or at least with some of the effects. Brazilian soccer fans lament the loss of their best players, and French fans protested the purchase of the Paris Saint-Germain (PSG) football club by the Qatar Investment Authority. Some factions within England have contended that the large influx of foreign players has disadvantaged the development of native players. Finally, the high stakes within professional sports has tempted the commitment of corruption. Although this corruption has hit sports

as obscure as handball, the most notable recent instances have involved bribes to officials of FIFA (the soccer governing body) and the fixing of cricket matches in India. ■ Questions 1-1. Professional athlete A is a star, and professional athlete B is an average player. How has the globalization of professional sports affected each of these both positively and negatively? 1-2. As you read the chapter, identify and show an example of each international mode of operations that is illustrated in the globalization of professional sports.

INTrodUCTIoN The case shows how global contact allows the world’s best sports talent to compete, and their fans to watch them, just about anywhere. It also shows why sports bodies and players have moved internationally as well as inconsistencies in the global popularity of different sports, some forms by which organizations participate, and criticism of sports’ globalization. We will expand on these points, applying them to the growth of IB in general. As you read through the chapter, keep referring back to Figure 1.1, which outlines the set of relationships between international environments and operations.

Figure 1.1

Factors in iB Operations

The conduct of a company’s international operations depends on two factors: its objectives and the means by which it intends to achieve them. Likewise, its operations affect, and are affected by, two sets of factors: physical/social and competitive.

OPERATING ENVIRONMENT INSTITUTIONAL AND PHYSICAL FACTORS • Geographic influences • Cultural factors • Political policies and legal practices • Economic forces

OPERATIONS OBJECTIVES • Sales expansion • Resource acquisition • Risk reduction

STRATEGY

COMPETITIVE FACTORS • Competitive product strategy • Company resources and experience • Competitors in each market

MEANS Modes Functions Overlying Alternatives • Merchandise exports • Marketing • Choice of countries and imports • Manufacturing • Organization and • Service exports and imports and supply-chain control mechanisms • Investments management • Accounting and finance • Human resources

C h a pt e r 1

International Business and Globalization

49

Why STUdy aboUT GlobalIzaTIoN, Ib, aNd TheIr relaTIoNShIP? Globalization is the widening and deepening of interdependent relationships among people from different nations. The term sometimes refers to the elimination of barriers to international movements of goods, services, capital, technology, and people that influence the integration of world economies.2 Throughout history, expanded human connections have extended people’s access to more varied resources, products, services, and markets. We’ve altered the way we want and expect to live, and we’ve become more deeply affected (positively and negatively) by conditions outside our immediate domains. Industries have expanded to distant places to gain supplies and markets. As consumers we know from “Made in” labels that we commonly buy products from all over the world, but these labels do not tell us everything. For instance, a Belgian Neuhaus bonbon and an American Ford automobile contain so many different components, ingredients, and specialized business activities from diverse countries that pinpointing where they were made is challenging.3 Although Apple ships its iPhones from China and they appear to be Chinese products, less than 4 percent of their value is created in China.4 Globalization enables us to get more variety, better quality, or lower prices. Our meals contain spices that aren’t grown domestically and fresh produce that may be out of season in the local climate. Our cars cost less than they would if all the parts were made and the labor performed in one place.

hoW doeS IB FIT IN? IB consists of all commercial transactions between two or more countries. • The IB goal of private business is to make profits. • Government IB may or may not be motivated by profit.

The relation to Globalization The global connections between supplies and markets result from the activities of IB, which are all commercial transactions (including sales, investments, and transportation) that take place among countries. Private companies undertake such transactions for profit; governments may undertake them either for profit or for other reasons.

The STUdy oF Ib Studying IB is important because • most companies are either international or compete with international companies, • modes of operations may differ from those used domestically, • it helps managers to decide where to find resources and to sell, • the best way of conducting business may differ by country, • an understanding helps you make better career decisions, • an understanding helps you decide what governmental policies to support.

Why should you study IB? Simply, it makes up a large and growing portion of the world’s business. Global events and competition affect almost all industries and companies, large and small. Not only do companies sell output and secure supplies and resources abroad, they compete against products, services, and companies from foreign countries. Thus, most managers need to take into account IB when setting their operating strategies and practices. As a manager in almost any company you’ll need to consider (1) where you can obtain the best inputs at the best possible price for your production and (2) where you can best sell the product or service you’ve put together from those inputs. Understanding the environment/operations relationship The best way to do business abroad may not be the same as the best way within your domestic market. Why? First, when your company operates internationally, it will engage in modes of business, such as exporting and importing, which differ from those it uses domestically. Second, physical, institutional, and competitive conditions differ among countries and affect the optimum ways to conduct business. Thus, international companies have more diverse and complex operating environments than purely domestic ones. Making Nonbusiness decisions Even if you never have direct IB responsibilities, understanding some of the complexities may be useful to you. Companies’ international operations and their governmental regulations affect overall national conditions—economic growth,

50

Introduction

p art 1

employment, consumer prices, national security—as well as the success of individual industries and firms. A better understanding of IB will help you make more informed decisions, such as where to work and what governmental policies to support.

The ForCeS drIvING GlobalIzaTIoN aNd Ib Although hard to measure, globalization • has been growing, • is less pervasive than generally thought, • has economic and noneconomic dimensions, • is stimulated by several factors.

This solar-powered Internet café within a shipping container in a rural area of Kenya enables people in an impoverished village to have access to the rest of the world. Source: Tony Karumba/Stringer/Getty Images

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Measuring globalization is problematic, especially for historical comparisons. First, a country’s interdependence must be measured indirectly.5 Second, when national boundaries shift, such as in the breakup of Ukraine, domestic business transactions can become international ones and vice versa. Nevertheless, various reliable indicators assure us that economic interdependence has been increasing, although sporadically, at least since the mid-twentieth century. Currently, about a quarter of world production is sold outside its country of origin, compared to about 7 percent in 1950. Restrictions on imports have generally been decreasing, and output from foreign-owned investments as a percentage of world production has increased. In periods of rapid economic growth, such as most years since World War II, world trade grows more rapidly than world production. However, in recessionary periods, global trade and investment shrink even more than the global economy. At the same time, however, globalization is less pervasive than you might suppose. In fact, many Americans are surprised to learn that only about 15 percent of the value of U.S. consumption comes from other countries. In much of the world (especially in poor rural areas), people lack the resources to connect much beyond their isolated domains. Such isolation is changing quickly, though, especially since the advent of mobile phones.6 (The below photo shows a solar-powered Internet café in Kenya, thus illustrating how innovation is enabling people in remote areas to access the rest of the world.) Only a few countries—mainly very small ones—either sell over half their production abroad or depend on foreign output for more than half their consumption. This means that most of the world’s goods and services are still sold in the countries where they’re produced. Moreover, the principal source of capital in most countries is domestic rather than international.

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Granted, these measurements address only economic aspects of globalization. Various studies have made more comprehensive comparisons by including, say, people-to-people contacts through travel and communications, technological interchanges, government-togovernment relationships, and acceptance and adaptation of attributes from foreign cultures such as words from other languages.7 The studies’ results have several commonalities: • Size of countries—Smaller countries tend to be more globalized than larger ones, mainly because their smaller land masses and populations permit a lower variety of production. • Per capita incomes—Countries with higher per capita incomes tend to be more globalized than those with lower ones because their citizens can better afford foreign products, travel, and communications. • Variance among globalization aspects—Although a country may rank as highly globalized on one dimension, it may be low on another, such as the United States being high on technological scales but low on economic ones.

FaCTorS IN INCreaSed GlobalIzaTIoN What factors have contributed to the growth of globalization in recent decades? Most analysts cite the following interrelated factors:

1. 2. 3. 4. 5. 6. 7.

Rise in and application of technology Liberalization of cross-border trade and resource movements Development of services that support IB Growth of consumer pressures Increase in global competition Changes in political situations and government policies Expansion of cross-national cooperation

rise in and application of Technology Many of the proverbial “modern marvels” and efficient means of production have come about fairly recently. These include new products, such as handheld mobile communications devices, as well as new applications of old products, such as Indian guar beans in oil and natural gas mining.8 Thus, much of what we trade today either did not exist or was unimportant in trade a decade or two ago. Why have technical developments increased so much? More than half the scientists who have ever lived are alive today. One reason, of course, is population growth. But another is rising productivity— taking less time to produce the same thing—which frees up more people to develop new products because fewer people are necessary to produce them. This rising productivity also means that on average people can buy more, including the new products, by working the same number of hours. The entry of new products into the market creates a need for other complementary products (such as cases and apps for smartphones), thus accelerating the need for scientists and engineers. Construction of many new products cannot successfully take place in a single country. Much new technical innovation takes so many financial and intellectual resources that companies from different countries must cooperate to take on portions of development. Further, when new products are developed, the optimum scale size of production seldom corresponds with the market demand in a single country. Consequently, companies may need to sell both domestically and internationally in order to spread the fixed developmental and production costs over more units of production. Advances in Communications and Transportation Strides in communications and transportation now allow us to discover, desire, and demand goods and services from abroad. Meanwhile, the costs of these strides have risen more slowly in most years than costs in general, thus increasing affordability. A three-minute phone call from New York to London that

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cost $10.80 in 1970 costs less than $0.20 today, while a call using Voice over Internet Protocol (VoIP) is virtually free. Innovations in transportation mean that more countries can compete for sales to a given market. U.S. purchases of foreign-grown flowers used to be largely impractical and aimed only at high-income consumers; today, however, flower producers from as far away as Ecuador, Israel, the Netherlands, and New Zealand compete with each other for the U.S. market because growers can ship flowers quickly and economically. Improved communications and transportation also enhance a manager’s ability to oversee foreign operations, such as more easily visiting foreign facilities and communicating with managers therein. Thanks to the Internet, companies can instantly exchange pictures of samples. Even small companies can reach global customers and suppliers. However, you may ponder the following question: Has the Internet been a bigger force in globalization than the laying of the first transoceanic cable across the Atlantic in 1858 that reduced communication time from 10 days to a matter of a few minutes? liberalization of Cross-border Trade and resource Movements To protect its own industries, every country restricts the entry and exit of not only goods and services but also the resources—workers, capital, tools, and so on—needed to produce them. Such restrictions, of course, set limits on IB activities and, because regulations can change at any time, contribute to uncertainty. Over time, however, most governments have reduced such restrictions, primarily for three reasons:

1. Their citizens want a greater variety of goods and services at lower prices. 2. Competition spurs domestic producers to become more efficient. 3. They hope to induce other countries to lower their barriers in turn. Services that Support Ib Companies and governments have developed services that facilitate global commerce. For example, because of bank credit agreements—clearing arrangements that convert one currency into another and insurance that covers such risks as nonpayment and damage en route—most producers can be paid relatively easily for their sales abroad. When Nike sells sportswear to a French soccer team, a bank in France collects payment in euros from the soccer team when the shipment arrives at French customs and pays Nike in U.S. dollars through a U.S. bank. Growth in Consumer Pressures More consumers know more today about products and services available in other countries, can afford to buy them, and want the greater variety, better quality, and lower prices offered by access to them. However, this demand is spread unevenly because of uneven affluence, both among and within countries as well as from year to year. Consumer pressure has also spurred companies to spend more on research and development (R&D) and to search worldwide for innovations and products they can sell to evermore-demanding consumers. By the same token, consumers are more proficient today at scouring the globe for better deals, such as searching the Internet for lower-priced prescription drugs abroad. Increase in Global Competition Increased competitive pressures can persuade companies to buy or sell abroad. For example, a firm might introduce products into markets where competitors are already gaining sales, or seek supplies where competitors are getting cheaper or more attractive products. Once a few companies respond to foreign opportunities, others inevitably follow suit. And they learn from each other’s foreign experiences. As the opening case suggests, the early success of foreign-born baseball players in U.S. leagues undoubtedly spurred U.S. basketball and football organizations to look for and develop talent abroad.9 So-called born-global companies start out with a global focus because of their founders’ international experience10 and because advances in communications give them a good idea

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of the location for global markets and supplies. Take SoundCloud, a Swedish audio-sharing web service. Its cofounders—one born in England and one in Sweden—were previously knowledgeable enough about the German and U.S. markets to move into both within months of starting up.11 Regardless of industry, most firms and individuals have to become more global; in today’s competitive business environment, failure to do so can be disastrous. Changes in Political Situations and Government Policies For nearly half a century after World War II, business between Communist countries and the rest of the world was minimal. Today, only a few countries are heavily isolated economically or do business almost entirely within a political bloc. In fact, political changes sometimes open new frontiers, such as diplomatic relations between the United States and Cuba. Nevertheless, governments still deny business with others for political reasons, such as many countries’ sanctions against doing business with North Korea. Governments support programs, such as improving airport and seaport facilities, to foster efficiencies for delivering goods internationally. They also now provide an array of services to help domestic companies sell more abroad, such as collecting information about foreign markets, furnishing contacts with potential buyers, and offering insurance against nonpayment in the home-country currency. expansion of Cross-National Cooperation Governments have come to realize that their own interests can be addressed through international cooperation by means of treaties, agreements, and consultation. The willingness to pursue such policies is due largely to these three needs:

1. To gain reciprocal advantages 2. To attack problems jointly that one country acting alone cannot solve 3. To deal with areas of concern that lie outside the territory of any nation Gain Reciprocal Advantages Essentially, companies don’t want to be disadvantaged when operating internationally, so they lobby their governments to act on their behalf. Thus, governments join international organizations and sign treaties and agreements with other governments for a variety of commercial activities. For instance, some treaties and agreements allow countries’ commercial ships and planes to use each other’s seaports and airports; some cover commercial-aircraft safety standards and flyover rights; and some protect property, such as foreign-owned investments, patents, trademarks, and copyrights. Countries also enact treaties for reciprocal reductions of import restrictions. Multinational Problem Solving Governments often act to coordinate activities along their mutual borders by building highways, railroads, and hydroelectric dams that serve the interests of all parties. (However, there are still border inefficiencies. For instance, trains between Italy and Sweden must change locomotives three or four times because of different national systems.)12 They also cooperate to solve problems that they either can’t or won’t solve alone. First, the needed resources may be too great for one country to manage. Further, sometimes no single country is willing to pay all the cost for a project that will also benefit another country. In any case, many problems are inherently global—think of countering global climate change or terrorism. Second, one country’s policies may affect those of others. Higher real-interest rates in one country, for example, can attract funds very quickly from individuals and firms in countries with lower rates, thus creating a shortage of investment funds in the latter. This movement is particularly disruptive to small developing economies.13 Similarly, a country may weaken the value of its currency so that its products are cheaper in foreign markets. Thus buyers may switch to the newly cheaper country, hence contributing to unemployment in the country they forsook. To coordinate economic policies in these and other areas, the most economically important countries meet regularly to share information and pool ideas. The most

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notable coordination, known as the G20 countries, consists of 19 of the world’s most economically important countries plus representation from the European Union of its members not included in the 19. These countries account for over 85 percent of the world’s production, 80 percent of world trade, and about two-thirds of the world’s population. Areas Outside National Territories Three global areas belong to no single country: the noncoastal areas of the oceans, outer space, and Antarctica. Until their commercial viability was demonstrated, they excited little interest for either exploitation or multinational cooperation. The oceans, however, contain food and mineral resources and constitute the surface over which much international commerce passes. Today, we need agreements to specify the amounts and methods of fishing, to address questions of oceanic mineral rights (such as on oil resources below the Arctic Ocean), and to deal with the piracy of ships.14 Likewise, there is disagreement on the commercial benefits to be reaped from outer space. Commercial satellites, for example, pass over countries that receive no direct benefit from them but argue that they should. If that sounds a little far-fetched, remember that countries do charge foreign airlines for flying over their territories.15 Antarctica, with minerals and abundant sea life along its coast, attracts thousands of tourists each year, has a highway leading to the South Pole and a Russian Orthodox church. Thus, it has been the subject of agreements to limit commercial exploitation. However, there is still disagreement about the continent’s development—how much there should be and who does it.

The CrITICISMS oF GlobalIzaTIoN Critics of globalization claim • countries’ sovereignty is diminished, • the resultant growth hurts the environment, • some people lose both relatively and absolutely, • greater insecurity increases personal stress.

Although we’ve discussed interrelated reasons for and the benefits from the rise in IB and globalization, the consequences of the rise are controversial. Antiglobalization forces regularly protest international conferences and governmental policies—sometimes violently. We focus here on three issues: threats to national sovereignty, environmental stress, and growing income inequality and personal stress.

ThreaTS To NaTIoNal SovereIGNTy You’ve probably heard the slogan “Think globally, act locally,” which means to accommodate local interests before global ones. Some observers worry that the proliferation of international agreements, particularly those that undermine local regulations on how goods are produced and sold, will diminish a nation’s sovereignty—its freedom to “act locally” and without externally imposed restrictions. The Question of local objectives and Policies Countries seek to fulfill their citizens’ objectives by setting policies reflecting national priorities, such as those governing worker protection and environmental practices. However, critics argue that these priorities are undermined by opening borders to trade. For example, if a country has stringent regulations on labor conditions and requires clean production methods, it may not be able to compete with countries that have less rigorous rules. By opening its borders to trade, it may either have to forgo its labor and environmental priorities to be competitive or face the downside of fewer jobs and economic output. The Question of Small economies’ overdependence Critics complain that economically small countries depend too much on larger ones for supplies and sales. Thus, they are vulnerable to foreign mandates, including everything from defending certain UN positions to supporting a large economy’s foreign military or economic actions. Nobel economist George Akerlof has noted that this dependence is intensified by poor countries’ inadequate administrative capacity to deal with globalization.16 Similarly, critics complain that large international corporations are powerful enough to dictate their operating terms (say, by

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threatening to relocate), exploit legal loopholes to avoid political oversight and taxes, and counter the small economies’ best interests by favoring their home countries’ political and economic interests. The Question of Cultural homogeneity Finally, critics charge that globalization homogenizes merchandise, production methods, social structures, and even language, thus undermining the cultural foundation of sovereignty. In essence, they argue that countries have difficulty maintaining the traditional ways of life that unify and differentiate them. Fundamentally, they claim helplessness in stopping the incursion of foreign influences by such means as satellite television, print media, and Internet sites.17

eNvIroNMeNTal STreSS Much critique of globalization revolves around the economic growth it brings. One argument is that growth in both production and international travel consumes more nonrenewable natural resources and increases environmental damage—despoliation through toxic runoff into rivers and oceans, air pollution from factory and vehicle emissions, and deforestation that can affect weather and climate. In addition, critics contend that buying from more distant locations increases transportation, hence increasing the carbon footprint, which refers to the total set of greenhouse gases emitted.18 They point further to the more than 1000 container ships plying the seas and relying on heavy oil as a fuel; each pollutes as much as 50 million cars do.19 The argument for Global Growth and Global Cooperation However, other factions assert that globalization is positive for conserving natural resources and maintaining an environmentally sound planet—the former by fostering superior and uniform environmental standards and the latter by promoting global competition that encourages companies to seek resource-saving and eco-friendly technologies. A case in point is the automobile industry that has progressively produced cars that use less gas and emit fewer pollutants. The positive effects of pursuing global interests may, nevertheless, conflict with national interests. Consider the effect of global pressure on Brazil to help protect the world’s climate by curtailing logging activity in the Amazon region. Unemployed Brazilian workers have felt that job creation in the logging industry is more important than climate protection outside Brazil.

GroWING INCoMe INeQUalITy aNd PerSoNal STreSS In terms of economic well-being, we look not only at our absolute situations but also compare ourselves to others. We generally don’t find our economic status satisfactory unless we’re doing better and keeping up with others.20 Income Inequality By various measurements, income inequality, with some notable exceptions, has been growing both among and within many countries. Critics claim that globalization has affected this disparity by helping to develop a global superstar system, creating access to a greater supply of low-cost labor, and developing competition that leads to winners and losers. The superstar system is especially apparent in sports, where today’s global stars (as compared to past years) earn far more than the average professional player or professionals in less popular sports. The system carries over to other professions, such as in business, where charismatic leaders can command many times what others can. Although globalization has brought unprecedented opportunities for firms to profit by gaining more sales and cheaper or better supplies, critics argue that profits have gone disproportionately to the top executives rather than to the rank and file. Nobel economist Robert Solow has supported this criticism by arguing that greater access to low-cost labor in poor countries has reduced the real wage growth of labor in rich countries.21 And even if

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overall worldwide gains from globalization are positive, there are bound to be some absolute or relative losers (who will probably oppose globalization). The speed of global technological and competitive expansion creates more winners and losers along with changing the relative positions of individuals, companies, and countries. As an example, manufacturing and foreign sales growth in China and India have helped them to grow more rapidly than the United States, thus lessening the relative economic leadership of the United States over those countries.22 Likewise, some workers have lost economic and social standing as manufacturing jobs have shifted to other countries. The challenge, therefore, is to maximize the gains from globalization while simultaneously minimizing the costs borne by the losers. Personal Stress Some repercussions of globalization can’t be measured in strictly economic terms, such as people’s stress from real and potential loss of relative economic and social positions.23 Further, stress, if widespread, goes hand in hand with costly social unrest.24 Although few of the world’s problems are brand new, we may worry about them more now because globalized communications bring exotic sagas of misery into living rooms everywhere.25

Point

Point

Yes Offshoring is the dependence on production in a foreign country, usually by shifting from a domestic source. If offshoring succeeds in reducing costs, it’s good. This is happening with many companies. Most branded clothing companies locate offshore to have work done by cheaper sewing machine operators. Many investment companies, such as Fidelity in India, are hiring back-office workers in lower-wage countries to cut the cost of industry research. What good are cost savings? It’s basic. If you can cut your costs, you can cut your prices or improve your product. Thus, by offshoring work to India, Claimpower, a small U.S. medical-insurance billing company, cut costs, lowered the prices it charges doctors, quadrupled its business in two years, and hired more U.S. employees because of the growth.26 What’s the main complaint about offshoring? Too many domestic jobs end up abroad. As we discuss this, keep in mind that employment results from offshoring are difficult to isolate from other employment changes. Sure, many workers in high-income countries have lost jobs, but this has probably been due mainly to improvements in production technology. Let’s try to pinpoint direct results of offshoring. Samsung is a good example. By offshoring mobile phone assembly from Korea to Brazil, China, India, and Vietnam, the company was able to lower costs and sell more units, thereby maintaining the same number of low-paying domestic jobs while increasing high-paying jobs at home in R&D, engineering, design, and marketing.27 If Samsung failed to enact such cost savings, its competitors in low-wage countries could underprice it with competitive products and services. In summary, cost savings generate growth, and growth creates more jobs.

Is Offshoring of Production a Good Strategy? Not just any jobs, either: This process lets companies create more high-value jobs at home—the ones performed by people like managers and researchers, who draw high salaries. When that happens, demand for qualified people goes up. In the United States, that process has already resulted in a higher percentage of white-collar and professional employees in the workforce. These are high-income people, and more of them are employed as a result of sending low-income jobs to countries with lower labor costs.28 Further, offshoring is a natural extension of outsourcing, the process of companies’ contracting work to other companies so that they can concentrate on what they do best.29 This contributes to making a company more efficient. What is the difference, then, of outsourcing to a domestic versus a foreign location? Admittedly, workers do get displaced from offshoring, but aggregate employment figures show that these workers find other jobs, just like workers who get displaced for other reasons. In a dynamic economy, people are constantly shifting jobs, partly due to technology. The prevailing employment for U.S. women was once as telephone operators; direct dialing technology changed that. Attendants used to pump all the gas, but most is now self-service. Passenger aircraft used to carry five cockpit crew members; technology eliminated the need for the navigator, flight engineer, and radio operator. On the near-future horizon, pilotless passenger aircraft and package-carrying drone helicopters will reduce the cockpit crew to one or even zero,30 while driverless cars will reduce demand for traffic policemen, auto insurers, emergency room personnel, and makers of such products as road signals and guard rails.31 In fact, a study of 702 U.S. occupations showed that about 47 percent of employment is at risk from computerization.32

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What all this means is that the shifting of jobs is commonplace, and shifting because of outsourcing is no different from doing so for any other reason. In any case, because there are bound to be upper limits on the amount of outsourcing work a country can do, the direst predictions about job loss are exaggerated: There simply aren’t enough unemployed people abroad who have the needed skills and who will work at a sufficiently low cost. Further, as production increases in outsourced facilities abroad, wage rates go up there.

Is Offshoring of Production a Good Strategy?

Counterpoint

no Some things are good for some of the people some of the time, and that’s almost the case with offshoring. Unfortunately, it is good for only a few people but not for most. I keep hearing about the cost savings, but when I buy goods or services I rarely find anything that’s cheaper than it used to be. Whether buying a Ralph Lauren shirt, getting medical services from a doctor who is saving money through Claimpower, or having Fidelity manage my assets, I have seen no lower prices for me. Instead, the lower production costs have resulted in higher compensation for already high-paid managers and for shareholders. Further, Claimpower’s growth had to be at the expense of other companies in the business, not because of growth in the number of people getting medical services. In fact, studies show that in aggregate, the percentage of national income going to labor has gone down while the percentage of national income going to profits and upper-level employees has been going up.34 Here’s a key problem: When you replace jobs by offshoring, you’re exchanging good jobs for bad ones. Most of the workers who wind up with the short end of the offshoring stick struggled for decades to get reasonable work hours and a few basic benefits, such as health-care and retirement plans. More important, their incomes allowed them to send their kids to college, and the result was an upwardly mobile—and productive—generation. Now many of these employees have worked long and loyally for their employers and have little to show for it in the offshoring era. Yes, I know governments give them unemployment benefits but these never equal what the employees had before, and they run out.35 On top of everything else, they may have no other usable skills, and at their ages, who’s going to foot the bill for retraining them? The increase in what you call “high-value jobs” doesn’t do them any good. Further, when reshoring occurs (usually because managers didn’t think through the offshoring decision adequately in the first place), you can bet they rehire domestic

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Offshoring isn’t for all companies or all types of operations. Some firms are bringing many operations back from abroad, a situation known as reshoring or rightshoring, because of miscalculating offshoring advantages to begin with as well as poor quality, consumer pressure, concerns about competitive security, and advantages of locating production near technical development.33 That brings us back to what we said explicitly at the outset: Offshoring works when you cut operating costs effectively.

Counterpoint workers at less cost than before they offshored those jobs. Offshoring may lead to short-term cost savings, but many studies indicate that it merely diverts companies’ attention from taking steps to find innovative means of more efficient production, such as productivity-enhancing technologies.36 Concentrating on these innovative means may cut costs, increase production, maintain the jobs that are going abroad, and permit incomes of workers to rise. While we’re on the subject of job “value,” what kinds of jobs are we creating in poor countries? Because countries are competing with lower wages, it encourages them to keep wages from rising, a sort of race to the bottom. However, multinational enterprises (MNEs) no doubt pay workers in low-wage countries more than they could get otherwise, and I’ll grant that some of these jobs—the white-collar and technical jobs—are pretty good. But for most people, the hours are long, the working conditions are barbaric, and the pay is barely enough to survive. When you use such suppliers, your reputation can suffer. In Bangladesh, workers were killed when locked doors prevented their escape from a fire, and others were killed when their ramshackle workplace building collapsed. There is also little job security. If salaries creep up where companies are offshoring, the companies merely move to even cheaper places to get the job done. Admittedly, in a dynamic economy, people have to change jobs more often than they would in a stagnant economy— but not to the extent caused by offshoring. There’s still some disagreement about the effects of offshoring on a country’s employment rate. Researchers are looking into the issue, but what they’re finding is that more of the so-called better jobs are also being outsourced, such as in finance and IT. So are we really creating higher-level jobs at home? Here’s the bottom line: In countries like the United States, workers simply aren’t equipped to handle the pace of change when it means that jobs can be exported faster than the average worker can retrain for different skills.

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Why CoMPaNIeS eNGaGe IN Ib Let’s now focus on some of the specific ways firms can create value through IB. Take another look at Figure 1.1, where you’ll see three major IB operating objectives: • Sales expansion • Resource acquisition • Risk reduction Normally, these three objectives guide all decisions about whether, where, and how to engage in IB. Let’s examine each in more detail.

SaleS exPaNSIoN Pursuing international sales usually increases the potential sales and potential profits.

A company’s sales depend on consumers’ demand. Obviously, there are more potential consumers in the world than in any single country. Now, higher sales ordinarily create value, but only if the costs of making the additional sales don’t increase disproportionately. Recall, for instance, the opening case. Televising sports competitions to multiple countries generates advertising revenue in excess of the increased transmission costs. In fact, additional sales from abroad may enable a company to reduce its per-unit costs by covering its fixed costs—say, up-front research costs—over a larger number of consumers. Because of lower unit costs, it can boost sales even more. So increased sales are a major motive for expanding into international markets, and many of the world’s largest companies derive more than half their sales outside their home countries. Bear in mind, though, that IB is not the purview only of large companies. In the  United States, 97 percent of exporters are small firms. Further, many sell products to large companies, which install them in finished products slated for sale abroad.37

reSoUrCe aCQUISITIoN Foreign locations may give companies • lower costs, • new or better products, • additional operating knowledge.

Producers and distributors seek out products, services, resources, and components from foreign countries—sometimes because domestic supplies are inadequate (such as industrial diamonds in the United States). They’re also looking for anything that will create a competitive advantage. This may mean acquiring any resource that cuts costs. For instance, Rawlings’s relies on labor in Costa Rica—a country that hardly plays baseball—to produce baseballs. Sometimes firms gain competitive advantage by improving product quality or differentiating their products from those of competitors; in both cases, they’re potentially increasing market share and profits. Most automobile manufacturers, for example, hire design companies in northern Italy to help with styling. Many companies establish foreign R&D facilities to tap additional scientific resources.38 Indian firms have recently followed foreign acquisition strategies to gain knowledge needed to compete globally.39 Further, by operating abroad, companies gain diversity among their employees that can bring them new perspectives.

rISk redUCTIoN International operations may reduce operating risk by • smoothing sales and profits, • preventing competitors from gaining advantages.

Selling in countries with different timing of business cycles can decrease swings in sales and profits (e.g., increasing sales stability through operations in countries that enter and recover from recessions at even slightly different times). Moreover, by obtaining supplies of products or components both domestically and internationally, companies may be able to soften the impact of price swings or shortages in any one country. Finally, companies often go international for defensive reasons. Perhaps they want to counter competitors’ advantages in foreign markets that might hurt them elsewhere. By operating in Japan, for instance, Procter & Gamble (P&G) delayed potential Japanese rivals’ foreign expansion by slowing their amassment of the resources needed to enter into other

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international markets where P&G was active. Similarly, Tredegar Industries followed its main U.S. customer into the Chinese market so as to prevent its customer from finding an alternative supplier who might then threaten Tredegar’s U.S. position.

Ib oPeraTING ModeS When pursuing IB, an organization must decide on suitable modes of operations included in Figure 1.1. In the following sections, we define and introduce each of these modes.

MerChaNdISe exPorTS aNd IMPorTS Merchandise exports and imports are the most popular IB modes.

Exporting and importing are the most popular IB modes, especially among smaller companies. Merchandise exports and imports are tangible products—goods—that are respectively sent out of and brought into a country. Because we can actually see these goods, they are sometimes called visible exports and imports. For most countries, the export and import of goods are the major sources of international revenues and expenditures.

ServICe exPorTS aNd IMPorTS Service exports and imports are international nonproduct sales and purchases. • They include travel, transportation, banking, insurance, and the use of assets such as trademarks, patents, and copyrights. • They are very important for some countries. • They include many specialized IB operating modes.

The terms export and import often apply only to merchandise. For non-merchandise international earnings, the terms are service exports and imports and are referred to as invisibles. The provider and receiver of payment makes a service export; the recipient and payer makes a service import. Services constitute the fastest growth sector in international trade and take many forms. In this section we discuss the following: • Tourism and transportation • Service performance • Asset use Tourism and Transportation Let’s say that some U.S. fans take Korean Air to attend the 2018 Winter Olympics. Their tickets on Korean Air and travel expenses in Korea are service exports for Korea and service imports for the United States. Obviously, then, tourism and transportation are important sources of revenue for airlines, shipping companies, travel agencies, and hotels. The economies of some countries depend heavily on revenue from these sectors, such as Greece and Norway from foreign cargo carried on their shipping lines and for the Bahamas from foreign tourists. Service Performance Some services, including banking, insurance, rental, engineering, and management services, net companies earnings in the form of fees: payments for the performance of those services. On an international level, for example, companies receive fees for engineering services rendered in turnkey operations, which are construction projects performed under contract and transferred to owners when they’re operational. For instance, the Spanish turnkey operator, Sacyr Vallehermosa, constructed the Panama Canal expansion that opened in 2016. Companies also receive fees from management contracts—arrangements in which they provide personnel to perform management functions for another, such as Disney’s management of theme parks in France and Japan. asset Use Companies receive royalties from licensing agreements, whereby they allow others to use some assets—such as trademarks, patents, copyrights, or expertise. For example, the Real Madrid football team receives a royalty from Adidas’ use of its logo on merchandise. Companies also receive royalties from franchising, a contract in which a company assists another on a continuous basis and allows use of its trademark. For instance, McDonald’s assists individually owned McDonald’s’ trademarked restaurants by providing supplies, management services, technology, and joint advertising programs.

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INveSTMeNTS Dividends and interest from foreign investments are also service exports and imports because they represent the use of assets (capital). The investments themselves, however, are treated separately in national statistics. Note that foreign investment means ownership of foreign property in exchange for a financial return, such as interest and dividends, and it may take two forms: direct and portfolio. direct Investment In foreign direct investment (FDI), sometimes referred to simply as direct investment, the investor takes a controlling interest in a foreign company. When, for example, U.S. investors bought the Liverpool Football Club, it became a U.S. FDI in the United Kingdom. Control need not be a 100 percent or even a 50 percent interest; if a foreign investor holds a minority stake and the remaining ownership is widely dispersed, no other owner may effectively counter the investor’s decisions. When two or more companies share ownership of an FDI, the operation is a joint venture. (There are also non-equity joint ventures.) Key components of portfolio investment are • noncontrolling interest of a foreign operation, • extension of loans.

Portfolio Investment A portfolio investment is a noncontrolling financial interest in another entity. It consists of shares in or loans to a company (or country) in the form of bonds, bills, or notes purchased by the investor. They’re important for most international companies, which routinely move funds from country to country for short-term financial gain.

TyPeS oF INTerNaTIoNal orGaNIzaTIoNS Basically, an “international company” is any company operating in more than one country, but a variety of terms designate different ways of operating. The term collaborative arrangements denotes companies’ working together—in joint ventures, licensing agreements, management contracts, minority ownership, and long-term contractual arrangements. The term strategic alliance is sometimes used to mean the same, but it usually refers either to an agreement that is of critical importance to a partner or one that does not involve joint ownership. A multinational enterprise or MNE (sometimes called MNC or TNC) is a company with foreign direct investments.

Multinational enterprise A multinational enterprise (MNE) usually signifies any company with foreign direct investments. This is the definition we use in this text. However, some writers use the term only for a company that has direct investments in some minimum number of countries. The term multinational corporation or multinational company (MNC) is often used as a synonym for MNE, while the United Nations uses the term transnational company (TNC). Does Size Matter? Some definitions require a certain size—usually giant. However, a small company can have foreign direct investments and adopt any of the operating modes we’ve discussed. Note though that, if successful, small companies become medium or large ones.40 Vistaprint (now Cimpress) is a good example. Founded in 1995, its sales grew to $6.1 million in 2000 and to over $1 billion by 2012 with operations mainly in North America and Europe.

Although foreign external environmental differences are problematic

Why do CoMPaNIeS’ exTerNal eNvIroNMeNTS aFFeCT hoW They May beST oPeraTe abroad?

• some anecdotes of failures are merely myths, • they must be weighed against domestic opportunities and risks, • understanding institutional factors and how they affect all business functions helps assure success abroad.

Let’s now turn to the conditions in a company’s external environment that may affect its international operations. Although there are many anecdotes illustrating operational problems when companies have failed to consider foreign environmental differences, these differences are not so daunting that they prevent success. First, some of the anecdotes are merely myths that have been repeated so often their validity is seldom challenged. Second, gaining start-up success domestically is also problematic almost anywhere in the world; thus, when companies look objectively at their domestic opportunities and risks, foreign entries may

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seem less formidable. Third, a good understanding of what one will encounter helps reduce operating risks, and smart companies develop the means to implement international strategies by examining the following conditions abroad that can affect their success: • Physical factors (such as geography or demography) • Institutional factors (such as culture, politics, law, and economy) • Competitive factors (such as the number and strength of suppliers, customers, and rival firms) In examining these categories, we delve into external conditions that affect patterns of companies’ behavior in different parts of the world and that influence companies to alter what they do domestically to fit foreign needs.

PhySICal FaCTorS Physical factors can affect how companies produce and market products, employ personnel, and even maintain accounts. Remember that any of these factors may require a company to alter its operation abroad (compared to domestically) for the sake of performance. Physical factors affect • where different goods and services can be best produced, • operating risks.

Geographic Influences Managers who are knowledgeable about geography are in a position to better determine the location, quantity, quality, and availability of the world’s natural resources and conditions. Their uneven global distribution helps explain why different products and services are produced in different places. Again, take sports. Norway fares better in the Winter Olympics than in the Summer Olympics because of its climate, and except for the well-publicized Jamaican bobsled team (whose members actually lived in Canada), you seldom hear of tropical countries competing in the Winter Olympics. East Africans’ domination in distance races is due in part to their ability to train at higher altitudes than most other runners. Geographic barriers—mountains, deserts, jungles, and land-locked areas—often affect communications and distribution channels. And the chance of natural disasters and adverse climatic conditions can make business riskier in some areas than in others while affecting supplies, prices, and operating conditions in far-off countries. Keep in mind also that climatic conditions may have short- or long-term cycles. For instance, recent melting of Arctic ice floes along with new ship technologies have allowed more ships to use a Northwest Passage to cut transport costs by saving as many as 15 days at sea.41 demographic Influences Finally, countries’ populations differ in many ways, such as density, education, age distribution, and life expectancy. These differences impact IB operations, such as market demand and workforce availability.

INSTITUTIoNal FaCTorS Institutions refer to“systems of established and prevalent social rules that structure social interactions. Language, money, law, systems of weights and measures, table manners and firms (and other organizations) are thus all institutions.”42 We will now examine a sample of these. Politics often determines where and how IB can take place.

Political Policies Not surprisingly, a nation’s political policies influence how and if IB takes place. For instance, before Cuba and the United States severed diplomatic relations in the 1960s, Havana had a minor league baseball franchise. Not only did that disappear, but also the facility by which Cuban baseball players could join U.S. professional teams. Many of them did so, although most had to defect from Cuba to play abroad. That changed again with the beginning of political normalizations in 2014.43 Obviously, political disputes—particularly military confrontations—can disrupt trade and investment. Even conflicts that directly affect only small areas can have far-reaching effects since these areas may produce important components needed for production elsewhere and because tourists’ fear prevents their travel to the entire region.

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Each country has its own laws regulating business. Agreements among countries set international law.

legal Policies Domestic and international laws play a big role in determining how a company can operate abroad. Domestic law includes both home- and host-country regulations on such matters as taxation, employment, and foreign-exchange transactions. British law, for example, determines how the U.S.-investor-owned Liverpool Football Club is taxed and which nationalities of people it employs in the U.K. Meanwhile, U.S. law determines how and when the earnings from the operation are taxed in the United States. International law—in the form of legal agreements between countries—determines how earnings are taxed by all jurisdictions. As we point out in our closing case, international agreements permit ships’ crews to move about virtually anywhere. When transactions between countries involve disputes, such as whether a French football team must pay Nike for imported uniforms when it questions the quality, the contract usually specifies the country’s law that will make the determination. Finally, the ways in which laws are enforced also affect a firm’s foreign operations. In the realm of trademarks, patented knowledge, and copyrights, most countries have joined in international treaties and enacted domestic laws dealing with violations. Many, however, do very little to enforce either the agreements or their own laws. This is why companies must determine how fastidiously different countries implement their laws.

Countries’ behavioral norms influence how companies should operate there.

behavioral Factors The related disciplines of anthropology, psychology, and sociology can help managers better understand different values, attitudes, and beliefs to help them make operational decisions abroad. Let’s return once again to the opening case. Although professional sports are spreading internationally, the popularity of specific sports differs among countries, while rules and the customary way of play for the same sport sometimes differ as well. Because of tradition, tennis’s grand slam tournaments are played on hard courts in Australia and the United States, on clay in France, and on grass in England. A baseball game in the United States continues until there is a winner, while Japanese games end with a tie if neither team is ahead after 12 innings. Presumably the reason for the baseball difference is that the Japanese value harmony more than Americans do, whereas Americans value competitiveness more than the Japanese do.

Economics explains country differences in costs, currency values, and market size.

economic Forces Economics helps explain why countries exchange goods and services, why capital and people travel among countries in the course of business, and why one country’s currency has a certain value compared to another’s. Recall the internationalization of sports. Non-U.S.-born players make up an increasing portion of major league baseball rosters, and players from the Dominican Republic form the largest share. Obviously, higher incomes in the United States and Canada enable major league teams to offer salaries that attract Dominican players. Further, putting a major league baseball team in the Dominican Republic isn’t practical because too few Dominicans can afford the ticket prices necessary to support a team. Economics also helps explain why some countries can produce goods or services for less. And it provides the analytical tools to determine the impact of an international company’s operations on the economies of both host and home countries, as well as the impact of the host country’s economic environment on a foreign firm.

The CoMPeTITIve eNvIroNMeNT Companies’ competitive situations may differ by • their relative size in different countries, • the competitors they face by country, • the resources they can commit internationally.

In addition to its physical and social environments, every globally active company operates within a competitive environment. Figure 1.1 highlights the key competitive factors in the external environment of IB: product strategy, resource base and experience, and competitor capability. Competitive Product Strategy egies, the latter usually by

Products compete by means of cost or differentiation strat-

• developing a favorable brand image, usually through advertising or from long-term consumer experience with the brand; or • developing unique characteristics, such as through R&D efforts or different means of distribution.

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Using either approach, a firm may mass-market a product or sell to a niche market (the latter approach is called a focus strategy). Different strategies can be used for different products or for different countries, but a firm’s choice of strategy plays a big part in determining how and where it will operate. Take Fiat Chrysler Automobiles (FCA) that competes with its best-selling models by using a cost strategy aimed at mass-market sales. This strategy has influenced FCA to shift some fabrication of engine plants to China, where production costs are low, and to sell in India and Argentina, which are cost-sensitive markets. At the same time, FCA has centered its production of its Alfa Romeo and Maserati vehicles in Italy because these compete with a high-priced focus strategy that requires access to both the expertise and image of high technical competence. And it has targeted most sales of these high-priced vehicles in high-income countries. Company resources and experience Other competitive factors are a company’s size and resources compared to those of its competitors. A market leader, for example—say, CocaCola—has resources for much more ambitious international operations than a smaller competitor like Royal Crown. Royal Crown sells in about 60 countries, Coca-Cola in more than 200. In large markets (such as the United States), companies have to invest much more to secure national distribution than in small markets (such as Ireland). Further, they’ll probably face more competitors in large markets than in small ones. Conversely, national market share and brand recognition have a bearing on operating in a given country. A company with a long-standing dominant national market position uses operating tactics that are quite different from those employed by a newcomer. Such a company, for example, has much more clout with suppliers and distributors. Remember, too, that being a leader in one country doesn’t guarantee being a leader anywhere else. For example, in terms of global market share, Toyota and General Motors see-saw in the number one and two positions, but in many countries they hold neither of these top two positions. Competitors Faced in each Market Finally, market success, whether domestic or foreign, often depends on the strength of competition and whether it is international or local. Large commercial aircraft makers Boeing and Airbus, for example, compete almost only with each other in every market they serve. What they learn about each other in one country is useful in predicting the other’s strategies elsewhere. In contrast, Walmart faces different local competition with customized local strategies in almost every foreign market it enters.

Looking to the Future

Three Major Scenarios on Globalization’s Future At this juncture, opinions differ on the future of IB and globalization. Basically, there are three major scenarios: • Further globalization is inevitable. • IB will grow primarily along regional rather than global lines. • Forces working against further globalization and IB will slow down the growth of both.

Globalization is inevitable The view that globalization is inevitable reflects the premise that advances in human connectivity are so pervasive that consumers everywhere will know

about and demand the best products for the best prices regardless of their origins. This view, known as connectography, premises that internationally connecting infrastructure will accelerate.44 Those who hold this view also argue that because MNEs have built so many international production and distribution networks, they’ll pressure their governments to place fewer restrictions on international movements of goods and means to produce them. Even if we accept this view, we must still meet at least one challenge to riding the wave of the future: Because the future is what we make of it, we must figure out how to spread the benefits of globalization equitably while minimizing the hardships placed on those parties—both people and companies— who suffer from increased international competition.

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The Wall Street Journal posed a question to Nobel Prize winners in economics: “What is the greatest economic challenge for the future?” Several responses addressed globalization and IB. Robert Fogel said it’s the problem of getting available technology and food to people who are needlessly dying. Both Vernon Smith and Harry Markowitz specified the need to bring down global trade barriers. Lawrence Klein called for “the reduction of poverty and disease in a peaceful political environment.” John Nash felt we must address the problem of increasing the worldwide standard of living while the amount of the earth’s surface per person is shrinking.45 Clearly, each of these responses projects both managerial challenges and opportunities.

More regional than Global Growth The second view—that growth will be largely regional rather than global—is based on studies showing that almost all of the companies we think of as “global” conduct most of their business in home and neighboring countries.46 Most world trade is regional, and many treaties to remove trade barriers are regional. Transport costs favor regional over global business. And regional sales may be sufficient for companies to gain scale economies to cover their fixed costs adequately. Nevertheless, regionalization of business may be merely a transition stage. In other words, companies may first promote international business in nearby countries and then expand their activities once they’ve reached certain regional goals.

Globalization and iB Will slow The third view argues that the pace of globalization will slow, or may already have begun collapsing.47 In light of the antiglobalization sentiments mentioned earlier, it’s easy to see that some people are adamant and earnest in voicing their reservations. The crux of the antiglobalization movement is the perceived schism between parties (including MNEs) who are thriving in a globalized environment and those who aren’t. For example, in 2015, about 14 percent of the developing countries’ population was living in extreme poverty. However, the figure was 47 percent in 1990. Most of the improvement came in China.48 Antiglobalists pressure governments to promote nationalism by raising trade barriers and rejecting international organizations and treaties. Historically, they have often succeeded (at least temporarily) in obstructing either technological or commercial

advances that threatened their well-being. Recently, antiglobalization sentiments have grown in many countries, such as law changes in some U.S. states that hinder activities of undocumented aliens, the deportation by France of ethnic Roma (gypsies), the evacuation in Italy of immigrants to protect them against local residents, and the backlash against accepting refugees in a number of countries. In Brazil and South Africa, the governments have authorized domestic companies to copy pharmaceuticals under global patent protection. Bolivia and Venezuela have nationalized some foreign investments, and Canada prevented the Malaysian state energy firm, Petronas, from buying Progress Energy, a natural gas producer. The sparring between pro- and anti-globalists is one reason why the globalization process has progressed in fits and starts. Other uncertainties may hamper globalization. First is the question of oil prices, which affect international transportation because they can constitute more than 75 percent of operating costs on large ships.49 Not only have global oil prices fluctuated widely, but technology for fracking and shale oil conversion have altered production locations when prices are high. Many U.S. companies, such as furniture manufacturers, have responded by reshoring rather than facing transport cost uncertainty. Second, safety concerns—property confiscation, terrorism, piracy of ships, and outright lawlessness—may inhibit companies from venturing abroad as much. Finally, one view holds that for globalization to succeed, efficient organizations with clear-cut mandates are necessary; however, there is concern that neither the organizations nor the people working in them can adequately handle the complexities of an interconnected world.50

Going Forward Only time will tell, but one thing seems certain: If a company wants to capitalize on international opportunities, it can’t wait too long to see what happens on political and economic fronts. Investments in research, equipment, plants, and personnel training can take years to pan out. Forecasting foreign opportunities and risks is always challenging. Yet, by examining different ways in which the future may evolve, a company’s management has a better chance of avoiding unpleasant surprises. That’s why each chapter of this book includes a feature that shows how certain chapter topics can become subjects for looking into the future of IB. ■

Case

Transportation and Logistics: Dubai Ports World —Hamed Shamma

The world economy and global trade has been gradually growing since the recession of 2008–2009. Growth is coming from Europe and Japan where trade is stronger than expected, from China and India where high growth rates continue to be recorded, and from less developed countries where trade is primarily based on petroleum and basic commodities. The global transportation and logistics industry is one of the most important contributors to the expansion of trade and logistics, making it important to understand how this industry operates and know more about its trends. Several factors have led to the growth in the transportation and logistics industry: the separation of raw materials, labor and production, decline in tariffs, import restrictions, and exchange rate controls are some of the main factors that led to this growth. These factors have resulted in an increased demand for transporting raw materials, unfinished goods, and finished goods in the global economy. These trends have increased the demand for global transportation and logistics services. According to the World Shipping Council, in 2014, containers handled by ports around the world are estimated at more than 680 million TEU (twenty-foot equivalent units). In 2016, DP World alone handled around 64 million TEU across their portfolio. In 2015, Dubai Ports ranked among the top 10 global ports in container traffic, with Shanghai leading the list.

Trends in the Transportation and Logistics Industry The “geographic fragmentation of production” has been an important driver of global trade volumes. There has also been a gradual decline in tariffs, import restrictions, and exchange rate controls. The rise in global logistics and supply chain means that governments today have less of an incentive to impose trade barriers than in the past. While many countries thought that putting trade restrictions helps the companies in the domestic market, yet this hinders their growth in the global markets. These trends have increased the demand for global transportation and logistics services. Competition and rivalry brings constant need for change and improvement. In response to the growing world trade volume, the number of container ships that can accommodate a large capacity has increased over the past few years. This increase in vessel size of containers requires new port infrastructure. Ports play an important role in the international logistics chain, which includes providing quality services and

efficient productivity. In order to be competitive, ports need to use advanced technologies and skilled labor. The World Bank has for some years developed a logistics performance indicator (LPI 2016) that allows for comparisons across 160 countries. The LPI measures the different dimensions of supply chain performance in the different countries such as customs clearance procedures, quality of trade-related infrastructure, quality of transport services, timeliness of delivery, ability to track and trace consignments. The World Bank has also highlighted the importance that government policies have on logistics performance. Countries that attempt to develop policies to improve supply chain activities find themselves scoring higher on the LPI than countries that do not pay attention to such policies.

Transportation and Logistics Industry Logistics has in the past focused on reducing barriers to trade, and procedures to be followed by governments for getting clearance for goods at customs. While these are important aspects to consider, it is important to develop policies that integrate all the elements of the supply chain so that all the different players can easily manage all the different steps of their business. This aspect has been lacking lately and needs to be given more attention. An approach that centers on all of the policies will have a major impact on productivity and efficiency of logistics business. This requires bringing all the integrators together in the logistics chain: cargo handling, storage, warehousing, freight services, and courier. This should result in improving the global supply chain business.

Developing Logistics Clusters Governments around the world are investing significant resources in developing logistics clusters. This requires investment in seaports, airports, railroads, and highways. Examples of leading logistics clusters include Singapore, the Netherlands, Los Angeles, Dubai, and Sao Paulo. Other terms that are sometimes used to refer to logistics clusters include logistics parks, transport centers, logistics platform, and logistics centers. The advantages of logistics clusters include economies of scope, economies of scale, economies of density, better service, and price stability. These benefits create a positive feedback loop that attract more companies to the cluster, which results in further cost reduction and improved efficiency.

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dubai Ports World

Dubai Ports World operates in more than 70 terminals across 40 countries, some of which have been indicated in the following map. Source: The map has been created based on information from the DP World Web site at http://web.dpworld.com/our-business/marine-terminals/ (accessed October 2016)

Doing Business in Different Countries Local or domestic policies may affect the logistics operations in the various markets. Some of these policies may increase costs, reduce efficiency, preferential treatment for local or public owned corporations, a dominating supplier and limitations on investment in certain activities. These policies can significantly impact the supply chain which may add costs to a firm and also affect the business activity. Foreign countries may introduce restrictive policies such as importing raw material as opposed to processed products where the processing might be more efficient. Other restrictions include bilateral agreements that distort competition, embargoes, business visa restrictions, and security requirements.

About Dubai Ports (DP) World Headquartered in Dubai, United Arab Emirates, Dubai Ports (DP) World is among the top 3 Global Terminal Operators. It is considered to be one of the new players in the global market, yet has an aggressive growth and acquisition strategy. Founded in 2005 as a result of the merger between Dubai Ports Authority and Dubai Ports International, DP

World’s first project was in Jeddah, Saudi Arabia, and has expanded its operations to many other countries like Djibouti, India, and Romania. A large portion of its business is from the emerging markets in South America and Africa. With a team of over 36,000 employees from 103 countries, DP World operates in 77 terminals, marine and inland, across 40 countries. As DP World’s capacity is expected to rise to more than 100 million TEU’s by 2020, it continues to invest in its people and technology to provide the better customer service quality to its customers everywhere across the world. This customer-oriented approach has resulted in strong relationships with customers and superior customer service levels. DP World’s Jebel Ali facility has been voted as the “Best Seaport in the Middle East” for 19 consecutive years. In 2006, DP World acquired the Peninsular & Oriental (P&O) Steam Navigation company and expanded its global network and market position in Asia, Africa, Australia, Europe, and the Americas. In the same year, it faced some controversy after purchasing several ports in the United States, but had sold them shortly afterwards. The organization’s mission and vision include leading the future of global trade by adding value, thinking ahead, and building its legacy.

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The Overseas Environment

Technology in Business

Operating in various markets offer opportunities as well as challenges. The opportunities include access to new markets, larger business, access to resources, and technology leading to innovation. The industry remains to be dynamic and profitable, where emerging markets experience significant growth in business. Governments are usually aspiring to open their ports to logistics companies. Logistics brings with it economic growth and jobs. They offer blue collar, white collar, and no collar jobs. Logistics companies also provide opportunities to open new businesses. Logistics companies also offer value added services on products, and many manufacturers like to locate close of logistics companies. They offer support to a variety of industries. The challenges include the complexity of operating in certain countries such as Africa, where the supply chain is an expensive and time-consuming activity. Transportation cost comprise up to 75 percent of the retail price in markets such as Malawi, Rwanda, and Uganda. For example, transporting a car from China to Tanzania can cost around $5,000 while transporting the same car from China to Uganda can cost $9,000.

DP World has been keen to use advanced information technology tools to facilitate its business. It has been using mobile technology to make life easier for customers by saving time and money. They also use mobile technology for their employees. Issues such as labor deployment, vessel arrival, gate appointments are available on mobile devices. This is linked to the human resources department that assigns labor to points of work, which results in more efficient work. Recently, this technology enabled container shipping lines to access bay and stowage which helped reduce port call time.

Findings the Right Skills Although in many cases may be overlooked, the logistics industry is primarily a people business. Around 25 percent of the costs of logistics are labor costs. Thus, it becomes essential to attract, train, and motivate qualified people at all levels. Most companies find it difficult to recruit the right people, especially when they operate in foreign countries and finding the appropriate skills becomes a challenge. There is usually low supply of qualified candidates, in addition to low wages, low profile regarding the industry for many people, and poor working conditions.

Risk Issues In 2012, President Obama had stated that securing the global supply chain, while ensuring its smooth functioning is essential to our national security and economic prosperity. Addressing risk in supply chain is becoming a priority for business. Supply chain risk can be caused by various disruptions—environmental risk such as natural disasters; geopolitical risk such as threat of attacks and terrorism; economic risk such as currency fluctuations, demand shocks, and supplier failings; and technological risk such as outage in IT and telecommunication systems. Risk can be controlled by conducting scenario analysis, collaborating with the different players by sharing information, identifying vulnerabilities, and synchronizing back up plans.

Environmental Considerations Presence of logistics companies may result in a deterioration of air quality, and air pollution. This increases the health hazards around those clusters. Thus, there is always a tradeoff between the economic benefits of logistics operations and the hazards of its effect on the environment and health of the surrounding community. There are “green innovations” in logistics operations and processes that are ultimately minimizing the negative effects of logistics operations on the environment.

Future of Logistics The logistics industry is a very promising industry that has high prospects for growth as the global economy grows. There are several matters that need attention to support this growth. There is a need for more comprehensive logistics policies that bring the various components of logistics together—land transportation, railway, shipping, commerce, and finance—along with more coordination between these institutions. More investment is required in logistics infrastructure such as roads, rail, and shipping to ease traffic congestion and reduce costs and air pollution. People issues are also becoming essential to ensure the appropriate skills are available to offer the high-quality services.

Questions 1-3. What factors have contributed to the growth of the transportation and logistics industry and how? 1-4. What steps has DP World taken to benefit from global economic changes? 1-5. What economic factors influence the success of the international transportation and logistics industry?

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MyLab Management

Go to mymanagementlab.com for the following Assisted-graded writing questions: 1-6

What threats exist for DP World? Explain how you would overcome these threats if you were in charge of DP World.

1-7

How can a logistics company increase its business with countries in Europe, Asia, or Africa?

Endnotes Scan for Endnotes or go to www.pearsonglobaleditions.com/Daniels

CHAPTER 15 Forms and Ownership of Foreign Production OBJECTIVES After studying this chapter, you should be able to 15-1 Comprehend why export and import may not suffice for companies’ achievement of IB objectives 15-2 Explain why and how companies make wholly owned foreign direct investments 15-3 Ascertain why companies collaborate in international markets 15-4 Compare and contrast forms of and considerations for selecting an international collaborative arrangement 15-5 Grasp why IB collaborative arrangements fail or succeed

MyLab Management® Improve Your Performance! When you see this icon , visit www.mymanagementlab.com for activities that are applied, personalized, and offer immediate feedback. If you can’t beat them, join them.

ME By Meliá Hotel in Madrid, Spain.

▶

Source: StockOption/Shutterstock

—American proverb

CASE

Meliá Hotels International1 —Fidel León-Darder and Cristina Villar2

God bless the inventor of sleep. (Miguel de Cervantes Saavedra, Don Quijote de la Mancha)

Li Feng arrived in London after a 13-hour flight from Beijing, her first company trip since completing her MBA and her first time outside China. Upon entering her room at the Meliá White House, she felt too exhausted to do much more than shower and enjoy the comfort and amenities in her room. (The quote from Don Quijote was certainly applicable.) However, her excitement kept her from sleeping right away. So she perused the attractive hotel directory on her bedside table and was surprised to read that her hotel belonged to a Spanish company with more than 300 hotels all over the world. The photos showed an array of attractive hotels, ranging from those in big cities (primarily to serve businesspeople) to others on pristine beaches (primarily to serve vacationers). She was also intrigued by a small picture of Gabriel Escarré, who founded the chain in 1956. At only 21, he leased his first hotel in Majorca (Mallorca), Spain, with only his savings and the expertise gained from his job at a travel agency. Li Feng fell asleep and dreamt of holidaying in a Meliá beach resort, but she awoke curious as to how Mr. Escarré had built Meliá’s position in the global hospitality industry. For the next five days, she worked long hours, squeezed in a little sightseeing, and then returned to Beijing. Despite jet-lag, she worked the next day and began catching up with the accumulated papers on her desk. In her spare time she did some research on Meliá. What she learned is described below. (The chapter’s opening photo shows the tower of a Meliá Hotel in Madrid.)

GROWTH IN SPAIN That Gabriel Escarré’s first hotel was in Majorca is not surprising because most entrepreneurs begin in familiar surroundings. His timing was good—European incomes were rising and package tours for sun-loving tourists were gaining popularity. Most important, Escarré exhibited both a knack for hotel management and a motivation to expand. He grew by acquiring other properties in Spain’s Balearic and Canary Islands, branding them first as Hoteles Mallorquines, later as Hoteles Sol, still later to Sol-Meliá, which many people still call it, and finally to Meliá Hotels International in 2011. The early hotels aimed sales at beach-seeking tourists. In 1982, three years before its first foreign entry, the company began diversifying with urban hotels targeted to business travelers. In 1984, the company rebranded hotels as Sol and bought 32 hotel properties of a Spanish chain, Hotasa, which expanded the company into more Spanish cities. Three years later, Sol acquired

Meliá from Paretti, an Italian group, which led to further client-based diversification—most Sol Hotels were three- and four-star beach properties, whereas most Meliá’s were four- or five-star urban hotels. In 2000, Meliá merged with another Spanish hotel chain, TRYP, thus adding 45 hotels in Spain. Meliá is now the largest hotel operator in Spain, and Spain is the largest location for Meliá.

INTERNATIONAL EXPANSION Despite the importance of Spain to Meliá, where it still concentrates 49 percent of its hotels, 75 percent of its current income is from international operations. Some international expansion came from the acquisitions. The TRYP agreement included eight leased arrangements in Tunisia and three management contracts in Cuba. Meliá has used its 1999 purchase of the White House in London and the 2007 acquisition of the Innside Inns in Germany to bolster its European urban presence. (Map 15.1 shows the regional breakdown of Meliá’s hotels.) Having acquired experience and expertise within Spain, the firm’s first start-up abroad was a joint venture for the Meliá Bali in Indonesia. This start-up was long and complicated, involving difficulty in finding local suppliers. There were also logistics and import problems in sending materials from Majorca. Soon after, the company focused on Latin America and eventually on other areas. Let’s examine some major international forays that demonstrate different modes of operations. Cuba In terms of the number of hotels, Cuba’s 28 composed Meliá’s largest foreign presence until its recent growth in Germany. Yet the company has no ownership in hotels there because Cuba’s centralized economy disallows full ownership by foreign hotel groups. Thus, Meliá had to establish an agreement with a public agency, which usually owns the properties. Meliá has a contract to manage properties owned by Cubanacán. Operating in Cuba slowed Meliá’s access to the U.S. market because the U.S. government maintained restrictions on companies doing business with Cuba, such as on those managing expropriated assets once owned by U.S. citizens. Meliá had to prove that the hotels it managed were not expropriated from U.S. citizens before it could enter the U.S. market, where it currently operates. China Despite more than 25 years of international expansion, Meliá’s Asian expansion has been slow. In 2009, Meliá signed a 10-year contract renewable for 10 more to manage The Gran Meliá Shanghai. This became the first Spanish-branded hotel in China,

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Regional Breakdown of Meliá Hotels

The numbers refer to the number of hotels within each region at the end of 2014. Source: The regional breakdown is taken from Meliá Hotels International Annual Report 2014, page 6, http://www.meliahotelsinternational.com/sites/default/files/informes-financieros/ Informe_anual_RSC_14_completa_en.pdf, (accessed December 4, 2015).

even though the country had long been an important growth market for many international hotel chains, such as Hyatt, Marriott, Radisson, and China’s largest hotel chain, Jin Jiang. This anomaly is not due to Spanish hotel chains’ unawareness of the Chinese market potential; indeed, many projects were developed to conquer the market as much as 10 years earlier. However, the unsuccessful experience of Spain’s Barceló Hotels discouraged other Spanish hotel chains from carrying out Chinese operations. Barceló, one of Meliá’s main competitors, reached an agreement in 2000 with a Chinese state-owned company to manage the Shanghai International Convention Center & Hotel. Surprisingly, after operating eight months and bringing the hotel back into the black within six, the owners unilaterally terminated the contract by stating that the results were inadequate. Although Barceló won a two-year court battle on breach of contract and received some compensation, the affair left Spanish hoteliers with a bitter aftertaste and the suspicion that Chinese government partners would break agreements once they learned enough from their foreign partners. Meliá’s entry into China was facilitated by its favorable 20-year relationship with Cubanacán, which shares the Shanghai hotel ownership with the Chinese company Xintian (Suntime). Still, getting the deal was not easy; it took more than five years from the time talks began to the hotel’s opening. Further, from almost the beginning, there was friction between Meliá and the hotel’s owners, which led to cancellation of the agreement in 2013. The hotel is now operated by the Swiss chain, Kempinski.

During the period of friction, Meliá began seeking other means of growth in China. In 2011 it opened a representative office in Shanghai in order to boost its brand image and broaden its alliances within China. Subsequently, Meliá announced comanagement plans with Jin Jiang and Greenland, a Chinese real estate company. The plans provide for management sharing in six hotels, of which each partner had previously managed three. This allows the Chinese partners to extend their operations into three hotels—one each in Germany, Spain, and France—in exchange for Meliá’s comanagement of hotels in three Chinese cities. The partners share knowledge and best practices as well as integrate and develop training, information, and booking systems. Relationship with Wyndham Meliá’s motivation for a 2010 agreement with Wyndham was largely to facilitate North American expansion by using Wyndham’s knowledge of that market and reputation with developers who are potential hotel investors. (Wyndham is one of the world’s largest hospitality companies and hotel franchisors, with 7700 hotels and 15 brands in 75 countries.) Through the agreement, Meliá sold its TRYP brand to Wyndham, but sold no real estate. The hotels in the transaction were re-branded as TRYP by Wyndham. Meliá became the franchisee for all the hotels using the TRYP by Wyndham brand for a 20-year period. Wyndham gained by increasing its reservations offerings for a mid-market brand in Europe and Latin America, even though the same hotels are also included in Meliá’s reservation system. Of the hotels in the 2010 agreement,

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Meliá maintains ownership of 6, leases 49, has management contracts in 24, and re-franchises 12 to other parties. Subsequently, TRYP by Wyndham has opened hotels in 21 countries.

INTERNATIONAL HOTEL OPERATING MODES The hotel industry is included in the so-called “soft services” sector because production and consumption cannot be separated. There is usually a need to adapt operations locally—tourist clientele usually want an ambiance that resembles their perceptions of the foreign country, but at the same time, they expect a similar threshold level of service and amenities wherever a hotel brand operates. The industry presents some unique characteristics, such as high investment costs and the possibility of separating ownership and management through contractual operating modes. Thus, firms have a wide range of feasible operating modes, especially management by third parties for all or a part of necessary hotel services. To classify hotel operating modes, it is necessary to look at a chain’s degree of exercised control over the foreign operation. This control involves four non-mutually exclusive dimensions: 1. The daily operation of the hotel (e.g., the hiring and scheduling of personnel and the securement of supplies). 2. Physical assets (primarily property ownership and the maintenance thereof). 3. Organizational routines and tacit elements of the company, such as the culture and systems to gain both efficiency and effectiveness. 4. Codified assets, such as the brand and reservations system.

The responsibility for controlling these elements may lie with the international hotel chain or with contractual parties, depending on the operation mode used. The capital contribution for each of the above four dimensions may be categorized as controlling ownership (usually direct investment), shared ownership (usually equity joint ventures, though non-equity joint ventures also exist, such as the one between Meliá and Jin Jiang to comanage hotels in Europe and China), and no ownership (licensing, management contracts, turnkey operations, franchising, and leasing). Operating modes can be combined. For instance, for the TRYP by Wyndham brand, Meliá owns some hotels, pays a franchise fee to Wyndham for using the brand name, and depends both on its own and Wyndham’s reservation systems. In some other cases, it has no property ownership and is paid for managing the operation. The former Gran Meliá Shanghai is a joint venture between Chinese and Cuban organizations that, in turn, granted a management contract to Meliá (and subsequently to Kempinski) for day-to-day operations and signed a franchise contract to use its name and reservations services. In partnering with other companies, regardless of operating mode, one increases the chance of developing competitors because

partners may gain access to critical and core resources, especially knowledge. Thus, Meliá, like other companies, seeks ways to prevent partners’ opportunistic behavior. Meliá’s main control is over its codified resources, especially brands and reservations system, which are protected legally and which Meliá does not cede to other companies. Meliá has developed the recognition and reputation of its brands over decades, so new brands cannot easily overcome its advantage. The codified resources are tied closely as well to Meliá’s tacit resources because the value of the brands is dependent on clients’ hotel experience, and both physical resources and human behavior influence their opinions. Competitors can easily copy the physical resources if they have enough money. However, the human behavior is harder to emulate because learning must take place on a person-to-person basis (tacitly). Such learning in hotel operations is substantial—everything from greeting guests to making beds to assuring the flow of supplies—and affects efficiency and reputation. Over time, the actions become the essence of the company’s culture.

MELIÁ’S EVOLVING OPERATING MODES As we have seen, Meliá has made and continues to make use of various operating modes. However, it has not always had discretion in choosing a mode. When Gabriel Escarré established his first hotels, he had no track record to entice other hotel owners to pay him to manage their facilities or use his brand name and reservations system. He developed a positive reputation through his successful expansion over nearly 30 years in Spain before moving internationally. Nevertheless, most of Meliá’s early international growth resulted from acquisitions, such as its purchase of the Spanish chain TRYP that already had foreign operations and of Innside Inns in Germany. The success of these ventures built Meliá’s reputation as a quality hotel operator, allowing it to keep expanding its hotel portfolio with shared or no capital investment, including growth in countries that place restrictions on foreign ownership. Why grow? There are economies in handling larger hotel portfolios because of the clout and logistics in dealing with suppliers and the spreading of reservation and training system costs over more properties. There are also marketing advantages because potential customers are more familiar with the larger chains.

MELIÁ NOW AND IN THE FUTURE Currently, Meliá Hotels International comprises strong brands such as Meliá, Gran Meliá, ME by Meliá, Paradisus, Innside by Meliá, TRYP by Wyndham, Sol Hotels, and Club Meliá. The maintenance of different brands is important because of existing brand recognition and value when Meliá made acquisitions. Nevertheless, Meliá is linking that recognition with its name (hence Innside by Meliá and Meliá White House). In fact, the company includes “Meliá” in almost all

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its brands because the name has long been associated with luxury hotels and thus brings a certain cachet to its hotels. Additional brand linkage comes from handling all of them in the same reservations system (currently 37 percent of its beds are sold directly to customers through the corporate website). Further, the different brands are aimed at different market niches. Meliá suffered the effects of the global crisis of 2007. Growth based on acquisitions had increased Meliá’s debt to more than €1 billion. In turn, it sold some of its flagship hotels, such as the Meliá Mexico Reforma to help reduce the debt. The company resumed its growth with 120 new hotels from 2012 to 2015. In recent expansion, such as in Africa and the Middle East, Meliá has used alliances with local or international partners. Typically, the partners develop and own the properties while Meliá participates in the design and the subsequent management of the new hotels. In the United States, Meliá has signed long-term lease agreements with property owners that guarantee a source of income to the owners. In these agreements the developer assumes the risk associated with the ownership while Meliá assumes the operational risks. In Venezuela, where Meliá has owned the Gran Meliá Caracas since 1997, the company announced a management contract agreement for five new hotels starting from 2016. Foreign companies in Venezuela face high inflation rates and frequent currency depreciations and devaluations (e.g., a devaluation of 88 percent in 2014). Currency conversion and repatriation is sometimes authorized only after strong devaluations. However, Meliá’s international reservation system allows it to receive payments in hard currency. Meliá expects more international growth by entering additional countries and adding hotels in those where it now operates. It has also indicated an interest in linking with brands held by other companies, such as the Hard Rock Café and Flintstones. Its ambitions seem too great to do everything alone. And it might not want to, even if it

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has the capital resources. For instance, it has so far been reluctant to make big commitments in countries, such as those in Southeast Asia, where it perceives the operating environment to be too different from its European (especially Spanish) experience. Thus, the use of non-equity operations is the crux of Meliá’s future. As part of its growth strategy in high-potential markets, Meliá has recently entered several African and Middle Eastern countries and has indicated an interest in others by focusing on both the leisure and business traveler. In Asia, it has doubled its presence in recent years and has announced agreements in new countries such as Mongolia and Myanmar. In Latin America, recent growth has been carried out through the TRYP by Wyndham brand in Brazil, which has wide experience in that market. Its strategic plan for 2015–2017 calls for 99 percent of new projects outside Spain, 65 percent of which will be in emerging countries. However, so far, Meliá has no presence in Russia and India, nor do any other Spanish chains. Fast-forwarding to nearly a year since Li Feng returned to Beijing, we find that she has worked almost nonstop and has taken no more trips. Contractually, physically, and emotionally she is ready for a vacation. She looks back at the hotel directory she brought from London and focuses on a picture showing a hotel half hidden among the foliage in front of a white sand beach and turquoise waters. “Who knows,” she thought, “maybe I should forget my laptop and spend some time in such a beautiful place.” ■ QUeStIONS 15-1. After reading the chapter, explain the advantages for Meliá to own its hotels versus managing them for other organizations. 15-2. After reading the chapter, discuss the advantages and risks for Meliá in its non-equity joint venture with Jin Jiang.

INTRODUCTION To tap foreign market opportunities, firms may • not be able to depend entirely on home-country production, • rely on most types of operating modes, • combine different operating modes for their foreign production.

As Figure 15.1 shows, companies must choose an international operating mode/form to fulfill their objectives and carry out their strategies. These are sometimes referred to as entry strategies, however, we prefer to refer to them as operating modes because companies frequently enter with one and change to another later on.3 The preceding chapter examined exporting and importing—the preferred and most common modes of IB. Nevertheless, compelling factors can make these choices impractical. When companies depend, instead, on foreign production, they may own it in whole or in part, develop or acquire it, and/or use some type of collaborative agreement with another company. Figure 15.2 shows the types of operating modes associated with each of these options, categorized by whether the company’s IB activity involves foreign production and, if so, whether the company owns equity in the foreign production or depends on a collaborating company to own the equity. Experienced MNEs with a global orientation commonly use most of the operational modes, selecting them according to company capabilities, specific product, and foreign operating characteristics. The modes may also be combined, as with

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FIGURE 15.1 Factors Affecting Operating Modes in IB Companies may conduct IB operations independently or in collaboration with other companies. The choice will be determined both by external factors in the firm’s operating environment and by internal factors that include its objectives, strategies, and means of operation (e.g., such modes of IB as exporting, franchising, etc.).

OPERATING ENVIRONMENT

OPERATIONS

PHYSICAL AND SOCIAL FACTORS

OBJECTIVES

STRATEGY COMPETITIVE FACTORS Modes

Functions

MEANS Overlying Alternatives

* Self-conducted operations * Collaborative operations

Meliá’s contract to manage the Shanghai hotel owned by a joint venture between Chinese and Cuban organizations. This chapter first examines why exporting/importing may not suffice, thus leading to foreign production.

WHY EXPORT AND IMPORT MAY NOT SUFFICE Companies may find more advantages to locate production in foreign countries than export to them. The advantages occur under six conditions:

1. 2. 3. 4.

When production abroad is cheaper than at home When transportation costs are too high for moving goods or services internationally When companies lack domestic capacity When products and services need to be altered substantially to gain sufficient consumer demand abroad 5. When governments inhibit the import of foreign products 6. When buyers prefer products originating from a particular country

FIGURE 15.2 Foreign Expansions: Alternative Operating Modes A firm may choose to operate globally either through equity arrangements (e.g., joint venture) or through non-equity arrangements (e.g., licensing). Exporting operations are conducted in the home country, while all other modes entail production in foreign locations. The modes listed in the shaded area are collaborative arrangements. Note that, in any given location, a firm can conduct operations in multiple modes. *Joint ventures may also be non-equity, but equity joint ventures are by far the more common.

PRODUCTION OWNERSHIP

Equity arrangements

Non-equity arrangements

PRODUCTION LOCATION Home country Foreign country

a. Exporting

a. Wholly owned operations b. Partially owned with remainder widely held c. Joint ventures* d. Equity alliances a. Licensing b. Franchising c. Management contracts d. Turnkey operations

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WHEN IT’S CHEAPER TO PRODUCE ABROAD Although companies may offer products or services desired by consumers abroad, producing them in their home markets may be too expensive. For example, Turkey has been a growing market for automobiles. However, it is generally less expensive to produce the vehicles in Turkey than to export them there because the country’s skilled laborers and sophisticated engineers cost less and are willing to work more days per year and longer hours per day than workers in the home countries. Thus, automakers (e.g., Toyota, Renault, Fiat Chrysler, Ford) and many of their parts suppliers have established Turkish production to serve that market.4

WHEN TRANSPORTATION COSTS TOO MUCH CONCEPT CHECK In Chapter 5 (page 184), we explain the concept of nontradable goods—products and services that are seldom practical to export because of high transportation costs.

The cost of transportation added to production costs makes some products and services impractical to export. Generally, the more distant the market, the higher the transportation costs; the higher those are relative to production costs, the harder it is for companies to develop viable export markets. For instance, the international transportation cost for a soft drink is a high percentage of the manufacturing cost, so a sales price that includes both would be so high due to exporting that soft-drink companies would sell very little of the product. However, products such as watches have low transportation costs relative to production costs, so watch manufacturers lose few sales through exporting. The result is that companies such as Universal Genève and Seiko export watches from Switzerland and Japan, respectively, into the markets where they sell them.

WHEN DOMESTIC CAPACITY ISN’T ENOUGH Excess home-country capacity • usually leads to exporting rather than direct investment, • may lead to competitive exports because of declining unit costs.

A company with excess capacity may export effectively as long as the excess exists. In fact, its average cost of production per unit usually falls as it uses more of its capacity, such as by selling abroad, because of spreading fixed costs over more sales units. But this decrease continues only as long as there is unused capacity. Volkswagen, for instance, located its first plant to build the new Beetle at its Mexican facilities, which served global markets. When demand pushed that plant toward capacity, Volkswagen built a second plant in Europe to serve the markets there, thus freeing Mexican capacity to serve nearby markets while reducing transport costs for European sales.5

WHEN PRODUCTS AND SERVICES NEED ALTERING Product alterations for foreign markets • require additional investment, • may lead to foreign production of the products.

Altering products to gain sufficient sales in a foreign market affects production costs by requiring firms to make an additional investment, such as adding an assembly line to put automobile steering wheels on the right as well as on the left. As long as they must make an investment to run an added assembly line, they may place it near the market they wish to serve. The more a product must be altered for foreign markets, the more likely some production will shift abroad. Whirlpool finds that most U.S. washing machine demand is for top-loading, large-capacity washing machines using 110 electrical voltage, whereas most European demand is for front-loaders with less capacity using 220 volts.6 Given the differences in preference, Whirlpool produces in both the United States and Europe.

CONCEPT CHECK In Chapter 7 (pages 232–233), we explain why governments are reciprocally reducing trade restrictions. Nevertheless, exporters still face regulatory restrictions, of which some encourage them to produce abroad.

WHEN TRADE RESTRICTIONS HINDER IMPORTS Despite worldwide reduction in overall import barriers, there are still many import restrictions. As a result, companies may find that they must produce in a foreign country if they are to sell there. This has been the case with many auto companies, which manufacture, or at least assemble, in India because it charges a high duty on fully built imported cars.7 Managers must view import barriers along with other factors, such as the market size of the country imposing the barriers and the scale of production technology. For example,

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import trade restrictions have been highly influential in enticing automobile producers to locate in Brazil’s large market. Similar restrictions by Central American countries have been ineffective because of their small markets. However, Central American import barriers on products requiring lower amounts of capital investment for production, such as pharmaceuticals, have successfully enticed direct investment because these industries can be efficient with smaller-scale technologies and markets. Regional or bilateral trade agreements may also attract direct investment because they create expanded markets that may justify scale economies.

WHEN COUNTRY OF ORIGIN BECOMES AN ISSUE Consumers sometimes prefer goods produced in certain countries because of • nationalism, • a belief that these products are better, • a fear that foreign-made goods may not be delivered on time.

Exporting to countries where consumers prefer to buy goods from certain countries (perhaps preferring domestic products because of nationalism) is difficult.8 These consumers may push for country-of-origin labels, such as those for many Australian- and U.S.-made products.9 Consumers may also believe goods from certain countries are superior, like German cars and Italian fashion.10 They may also fear that service and replacement parts for imported products will be more difficult to obtain. Finally, companies using just-in-time manufacturing systems favor nearby suppliers who can deliver quickly and reliably. In any of these cases, companies may find advantages in placing production where their output will best be accepted.

WHY AND HOW DO COMPANIES MAKE WHOLLY OWNED FDI In situations where exporting is not feasible, a company may choose to “go it alone” or contract another company to produce or provide services on its behalf. In this section, we discuss the reasons and methods for making FDI for the two arrangements in Figure 15.2 that do not require collaboration: wholly owned operations and partially owned with the remainder widely held.

REASONS FOR WHOLLY OWNED FOREIGN DIRECT INVESTMENT Generally, the more ownership a company has, the greater its control over decisions. However, if equity shares are widely held, a company may be able to effectively control with even a minority interest. Nevertheless, governments often protect minority owners so that majority owners do not act against their interests; thus, companies may opt for 100 percent ownership if they want control. There are four primary explanations for companies to make a wholly owned FDI: market failure, internalization theory, appropriability theory, and freedom to pursue global objectives. Market Failure Collaboration is appealing as an entry strategy because it is a means whereby a firm may reduce its liability of foreignness. But this works only if management can find an associate knowledgeable about the host country at acceptable terms, which may be impossible since such companies may be inadequately equipped to deal efficiently with the entry company’s technology.11 Or, they may know too little about the entering company to entice them to consign sufficient resources to a collaboration. In these instances, companies must control foreign activities within their own management structures (internal hierarchies) rather than depending on the external market to do it for them.12 Of course, the failure of the market to connect firms as collaborators will entice a company to enter with wholly owned operations only if it perceives having operating advantages to overcome its liability of foreignness.

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Internalization Internalization is control through self-handling of operations.13 The concept comes from transactions cost theory, which holds that companies should seek the lower cost between self-handling of operations and contracting another party to do so for them. Self-handling may reduce costs for the following four reasons:

1. Different operating units within the same company are likely to share a common corporate

culture, which expedites communications. Executives have concluded that a lack of trust, common terminology, and knowledge are major obstacles to successful collaboration.14 2. The company can use its own managers, who understand and are committed to carrying out its objectives. When GE acquired a controlling interest in the Hungarian company Tungsram, it was able to expedite control and changes because it put GE managers in key positions.15 3. The company can avoid protracted negotiations with another company on such matters as partner responsibilities and how each will be compensated for contributions. Negotiations for establishing a collaboration may go on for years, with no guarantee that an agreement will be reached.16 4. The company can avoid possible enforcement problems. Such companies as L’Occitane and Burberry’s have had to fight licensed manufacturers from selling production overruns to non-prestige distributors, which cheapens their brand image.17 Companies may want control through FDI to lessen the chance of improving competitors’ capabilities.

CONCEPT CHECK In Chapter 12 (pages 365–367), we explain the difference between a global and a local responsiveness strategy.

Appropriability The idea of denying rivals access to resources is called the appropriability theory.18 Companies are reluctant to transfer vital resources—capital, patents, trademarks, and management know-how—to another organization for fear of their competitive position being undermined. In fact, Chinese automakers that have collaborative arrangements with major global auto competitors make no secret of their desire to learn from their partners so as to become global competitors.19 The fear of turning over know-how has led Germany’s Faber-Castell to manufacture abroad only where it can own its factories.20 This does not imply that the transfer of know-how to firms abroad is unnecessary. In fact, such transfer improves suppliers’ efficiency, and companies use formal and informal mechanisms to speed and improve the comprehension of transferred knowledge.21 Nevertheless, companies are less concerned about appropriability of non-strategic than of strategic resources. For instance, Coca-Cola collaborates with partners all over the world, but it steadfastly refuses to collaborate in concentrate production because its formula is too critical to the company’s competitive viability. Freedom to Pursue a Global Strategy A wholly owned foreign operation permits a company to more easily participate in a global strategy. For instance, a U.S. company owning 100 percent of its Brazilian operation might be able to take actions that, although suboptimizing Brazilian performance, could deal more effectively with competitors and customers globally, such as by decreasing prices to an industrial customer in Brazil to gain that customer’s business in Germany. Or it might standardize its product to gain global cost savings even though this loses some sales in Brazil. But if the company shared ownership in Brazil, its partners would balk at such practices.

ACQUISITION VERSUS GREENFIELD The advantages of acquiring an existing operation include

Companies acquire FDI by transferring abroad financial and/or other tangible or intangible assets. They can either acquire an interest in an existing operation or make a greenfield (start-up) investment. The reasons for each are discussed below.

• gaining vital resources that are otherwise hard to develop, • making financing easier at times, • adding no further capacity to the market, • avoiding start-up problems.

Acquisition One reason for a company to invest abroad via acquisition is to obtain some vital resource that may otherwise be slow or difficult to secure.22 Let’s say a company acquires knowledgeable personnel that it cannot easily hire at a good price on its own23—or perhaps it could hire them, but lacks experience in managing them effectively. For instance, many Russian companies with good scientific inventions and innovative products have recently expanded internationally to acquire management with experience in transforming innovation to successful

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product sales.24 Acquisitions allow a company to get not only labor and management, but also an existing organization with experience in coordinating functions such as product development and the subsequent marketing of the developed products. In addition, a company may gain goodwill, brand identification, and access to distribution. Recently, much Chinese investment in the United States has been by acquisition, seemingly because of Chinese companies’ desire to secure well-known brand names that will help them sell.25 There are also financial considerations. First, a company depending substantially on local financing rather than on transferring capital may find local capital suppliers more willing to put money into a known ongoing operation than to invest in a new facility owned by a less familiar foreign enterprise. Second, a company may be able to buy facilities, particularly those of a poorly performing operation, for less than the cost of new operations. For example, Brazil’s José Batista Sobrinho (JBS), the world’s largest meat company, bought U.S. companies Swift and Pilgrim’s Pride at opportunistically low prices because they were in financial trouble.26 Third, if a market does not justify added capacity, acquisition enables a firm to avoid the risk of depressed prices through overcapacity. Finally, by buying a company, an investor avoids start-up inefficiencies and gets an immediate cash flow rather than tying up funds during construction. Companies may choose greenfield expansion if • host governments discourage acquisitions, • it is easier to finance, • available acquisitions are performing poorly, • personnel in acquiring and acquired firms may not work well together.

Making Greenfield Investments Foreign companies may face local roadblocks to acquisitions. For example, local governments may want more competitors in the market because of fearing market dominance. In addition, a foreign company may find that development banks prefer to finance new operations because they create new jobs. Acquisitions often don’t succeed.27 First, turning around a poorly performing operation is difficult because of potential personnel and labor relations problems, ill will toward its products and brands, and inefficient or poorly located facilities. Second, managers in the acquiring and acquired companies may not work well together because of different management styles and organizational cultures or because of conflicts over decision-making authority.28 For instance, after acquiring IBM’s PC division, Lenovo had to overcome cultural differences between its Chinese and U.S. managers (e.g., the former thought the Americans talked even when having nothing to say, and the latter disapproved of publicly shaming latecomers to meetings).29 Intuition tells us that acquisitions in more culturally distant countries, such as in the Lenovo example, would perform less well than those in more culturally similar countries; however, some evidence shows the contrary. Evidently, there are performance gains from added diversity. In addition, acquiring companies take greater care in culturally distant countries to get a better match between organizational cultures, thus easing their integration into the corporate culture.30 Leasing We saw in our opening case that Meliá operates extensively by leasing hotels. This mode is much like an acquisition, but one that forgoes the need to invest. While common in the hospitality industry, it is not common in others. Although companies in other industries might lease certain assets abroad—computers, vehicles, buildings—such arrangements are quite different from leasing an entire operating facility.

WHY COMPANIES COLLABORATE Companies collaborate (use alliances that are often called strategic alliances) abroad for much of the same reasons they do so domestically. However, there are some reasons specific to international operations. Figure 15.3 shows both the general and internationally specific reasons for collaborative arrangements.

GENERAL MOTIVES FOR COLLABORATIVE ARRANGEMENTS Both domestically and internationally, companies collaborate to spread and reduce costs, enable them to specialize in their competencies, avoid competition, secure vertical and horizontal links, and gain knowledge.

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Collaborative Arrangements and International Objectives

A company may enter into an international collaborative arrangement for the same reasons that it does so domestically (e.g., to spread costs). In other cases, it may enter into a collaborative arrangement to meet objectives that are specific to its foreign-expansion strategies (e.g., to diversify geographically).

OBJECTIVES OF INTERNATIONAL BUSINESS • Sales expansion • Resource acquisition • Risk reduction

MOTIVES FOR COLLABORATIVE ARRANGEMENTS

MOTIVES FOR COLLABORATIVE ARRANGEMENTS

General • Spread and reduce costs • Specialize in competencies • Avoid or counter competition • Secure vertical and horizontal links • Learn from other companies

Specific to International Business • Gain location-specific assets • Overcome legal constraints • Diversify geographically • Minimize exposure in risky environments

Sometimes it’s cheaper to get another company to handle work, especially • at small volume, • when the other company has excess capacity.

To Spread and Reduce Costs Producing and selling incur fixed costs. At a small volume of business, contracting to a specialist rather than self-handling may be cheaper because a specialist can spread the fixed costs to more than one company. If business increases enough, the contracting company may then be able to handle the business more cheaply itself. A company can use excess production or sales capacity to handle the activities for a client company. This may lower average costs by covering fixed costs more fully, and it can prevent the client from having to incur fixed costs and longer delays for start-up and receipt of cash flows. Companies may lack resources to “go it alone”—especially small and young ones.31 By pooling efforts, they may be able to undertake activities that otherwise would be beyond their means. But large companies may also benefit when the cost of development and/or investment is very high. Disney’s theme park in Hong Kong cost so much to develop that Disney and the Hong Kong government share ownership and expenses.32 One of the fastest collaborative growth areas has been for projects too large, both in capital and technical-resource needs, for any single firm to handle, such as new aircraft and communication systems. From such an arrangement’s inception, different firms (sometimes from different countries) take on the cost and risk of developing different components. Then a lead company buys the components from the companies. A good example is the Boeing 787 aircraft, which involves companies from around the globe.

Granting asset rights to another company can yield income when the asset does not fit the yielding company’s strategic priority based on its competencies.

To Specialize in Competencies The resource-based view of the firm holds that each company has a unique combination of competencies. A company may improve its performance by concentrating on those activities that best fit its competencies, depending on other firms to supply it with products, services, or support activities in which it is less competent. However, a collaborative arrangement has a limited time frame, which may allow a company to exploit a particular product, asset, or technology at a later date if its core competencies change.

By banding together, companies may move faster, raise profits, and fight larger competitors.

To Avoid or Counter Competition When markets are too small to accommodate many competitors, companies may band together so as not to compete. Companies may also combine resources to combat competitors (e.g., Sony and Samsung combined resources to move faster in the development of LCD technology).33 Or they may simply

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collude to raise everyone’s profits. For example, Canpotex, a group of Canadian companies accounting for more than a quarter of the world’s potash market, joined together so as not to compete on export sales.34 Only a few countries take substantial actions against the collusion of competitors.35 Allying to gain vertical and horizontal links may enable companies to fill competency gaps, reduce costs, and deal more effectively with customers and suppliers.

To Secure Vertical and Horizontal Links Vertical integration provides potential cost savings and supply assurances. However, companies may lack competences or resources necessary to own and manage the full value chain of activities, thus they ally themselves closely with other companies to handle their gaps. Horizontal links may provide economies of scope in distribution, such as by offering a full line of products, thereby increasing the sales per fixed cost of customer visits. For example, in many parts of the world Avon representatives market such products as books and crayons in addition to the company’s cosmetics fare. An example of gains from both vertical and horizontal links involves a group of small and medium-sized Argentine furniture manufacturers. By allying horizontally, they pool resources to gain manufacturing efficiencies. In turn, their vertical alliance enables them to deal more effectively to sell abroad and to gain supplies.36

A company can improve its competence by learning from partners.

To Gain Knowledge Many companies pursue collaborative arrangements to learn about a partner’s technology, operating methods, or home market so as to improve their competitiveness.37 Sometimes each partner can learn from the other, a motive driving joint ventures between U.S. and European winemakers—such as the Opus One Winery owned by Constellation Brands’ Robert Mondavi from the United States and Baron Philippe de Rothschild from France.38

INTERNATIONAL MOTIVES FOR COLLABORATIVE ARRANGEMENTS In this section, we continue discussing why companies enter into collaborative arrangements, covering those reasons that apply only to international operations. Reasons include gaining location-specific assets, overcoming legal constraints, diversifying geographically, and minimizing risk exposure. Local companies may more easily access competitively important country-specific knowledge than foreign companies can.

To Gain Location-Specific Assets Cultural, political, competitive, and economic differences among countries create barriers for firms operating abroad. Those ill-equipped to handle the differences may seek help through collaboration with local firms. When Walmart first entered the Japanese market on its own, it gave up after having disappointing sales. It has since returned with a Japanese partner, Seiyu, which is more familiar with Japanese tastes and rules for opening new stores.39 In fact, most foreign companies in Japan need to collaborate with Japanese firms that can help in securing distribution and a competent workforce—two assets that are difficult for MNEs to gain on their own there. Collaborations may also facilitate companies’ learning about markets they enter. However, there is some danger that they assume wrongly that they can apply this learning effectively when entering subsequent countries—even those that appear to be similar to their previous entries.40

Legal factors may

To Overcome Governmental Constraints Recall that in centrally planned economies (e.g., China and Cuba) Meliá cannot own its hotels, so it must collaborate with local organizations. In addition, virtually all countries limit foreign ownership in some sectors. India, for example, sets maximum foreign percentage ownership in an array of industries.41 Government procurement policies also sometimes lead to collaboration because they favor bids that include national companies. Taiwan does this with purchases by the state enterprise monopoly, Taiwan Power (Tai Power).42

• prohibit certain operating forms, such as wholly owned foreign facilities, • favor locally owned firms.

Collaboration may hinder nonassociated companies from pirating an asset.

Protecting Assets Many countries provide little protection for intellectual property rights such as trademarks, patents, and copyrights unless authorities are prodded consistently.

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To prevent pirating of these proprietary assets, companies sometimes collaborate with local companies, which can more effectively monitor the local market and deal with authorities. In addition, some countries provide protection only if the internationally registered asset is exploited locally within a specified period. If not, then whatever entity first does so gains the right to it. In some cases, local citizens, known as trademark squatters, register rights to the not-yet-exploited trademarks, then negotiate sales to the original owners when they do try to enter the market. One Russian company registered over 300 foreign trademarks, including Starbucks’s trademark. Foreign companies then have to pay to regain their rights or go through lengthy and expensive court proceedings.43 Or they enter under a different name. Burger King sells under the Hungry Jack brand in Australia for this reason.44 CONCEPT CHECK In Chapter 13 (pages 398–399), we explained the differences between and reasons for pursuit of a geographic diversification versus concentration strategy. Collaborative arrangements reduce risk by allowing for greater asset-spreading among countries.

To Diversify Geographically For a company wishing to pursue a geographic diversification strategy, collaborative arrangements offer a faster initial means of entering multiple markets because other companies contribute resources. Arrangements will be less appealing for companies that have ample resources for such extension. To Minimize Risk Exposure One way to lessen a company’s international political and economic risk is to minimize its assets located abroad, which may be possible through collaboration. Further, if the company’s foreign assets are spread among countries, there is less chance that they will all encounter political adversity or economic downturns at the same time. Local partners may also be effective at thwarting governmental takeover of assets. Further, partnerships with other foreign companies, especially from different countries, may inhibit host governments’ takeovers because each can elicit support from its home government.

FORMS OF AND CHOICE OF COLLABORATIVE ARRANGEMENTS CONCEPT CHECK In Chapter 1 (page 60), we defined the different forms of collaborative arrangements.

Now that we have discussed reasons for collaborating in IB, we shall first discuss some factors to consider when choosing among collaborative forms, also known as alliances. Then we shall describe each of the forms.

SOME CONSIDERATIONS IN CHOOSING A FORM Each operating mode brings both advantages and disadvantages.

Companies have a wider choice of operating mode when they hold unique and needed capabilities. Terms differ for alliances depending on their purposes, whether they extend cooperation vertically or horizontally, and whether they involve competitors.

Trade-offs and Limitations Recall from Figure 15.2 that operating modes for foreign operations differ in the amount of resources a company commits and the proportion of the resources it locates abroad. In this respect, keep in mind that there are trade-offs. A decision, let’s say, to take no ownership abroad, such as by licensing another company to handle foreign production, may reduce exposure to political risk. However, learning about that environment will be slow, delaying (perhaps permanently) the ability to reap the full profits from producing and selling the product abroad. Furthermore, a company may be limited in entering a market with its preferred operating mode. Governmental actions and potential partners have a great deal to say. However, if a company has a desired, unique, difficult-to-duplicate resource, it is in a much better position to choose its preferred operating form and to increase its compensation therein. What’s the Purpose?: Alliance Types Alliances vary by objective and by place in the value chain. These variances have led to terms that describe different types. Scale alliances aim to provide efficiency for partners by pooling similar operations, such as airlines have done by combining their lounges. In a link alliance, firms use their partners’ complementary resources to expand into a new business.45 Nokia did this to develop and market cellular phones.46 A vertical alliance connects firms in different links of their value chains, such as a food franchiser with a franchisee. A horizontal alliance, such as the Mexican joint venture between Mercedes and Infiniti, enables each partner to extend its product offerings (in this

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case, a new compact car) on the same level of the value chain.47 Coopetition, such as the Mercedes-Infiniti example, refers to collaboration while competing (i.e., although these partners closely collaborate at every development stage, their end products are different and competitive with each other).48 Companies’ experience and assets in a foreign country influence their choices of operating mode when introducing new products or businesses.

Prior Company Expansion Each time a company adds products or businesses that it wishes to internationalize, it must decide on an operating form. If it already has operations (especially wholly owned ones) in a foreign country, some of the advantages of collaboration are no longer as important. It knows how to operate within that country and may have excess plant or human resource capacity it can use for new production or sales. However, much depends on the compatibility between existing foreign operations and the new ones the company is planning abroad. The less similarity between them, the more that collaboration may be advantageous.

Collaboration in foreign operations implies less control and a sharing of profits.

Compensation Collaboration also implies sharing revenues and knowledge—an important consideration when profit potentials are high. How to divide revenue is not clear-cut because many variables influence the outcome. Certainly, the bargaining power of the collaborative partners is important in any agreement, but such factors as government mandates, partners’ perception of risk, and competitive constraints are all important.49 Further, the mode of collaboration guides normal practices. As we discuss the different modes, we will introduce some of these practices.

Point

Point

Yes I believe they should, because a key industry affects a very large segment of the economy by virtue of its size or influence on other sectors. I’m not talking about either foreign control of small investments or noncontrolling interest in large investments. If countries need foreign firms’ resources— technology, capital, export markets, branded products, and so on—they can get them by requiring collaborations without ceding control to foreigners. In turn, the foreign companies can still achieve their objectives, such as gaining access to markets. Of course each country should and does define key industries. For instance, the United States prohibits foreign control of television and radio stations and domestic transportation because of security concerns. Canada limits foreign control of sectors that are sensitive to maintenance of its culture. Chile prohibits foreign investment in its economically dominant copper industry because of negative experiences with past foreign control therein. The rationale for protecting key industries is supported by history, which shows that home governments have used powerful companies to influence policies in the foreign countries where they operate. During colonial periods, firms such as Levant and the British East India Company often acted as the political arm of their home governments. More recently, governments, especially the United States, have pressured their companies to leave certain

Should Countries Limit Foreign Control of Key Industries? areas and to prohibit their subsidiaries from doing business with certain countries, even though the prohibition is counter to the interests of the countries where the subsidiaries were located.50 At the same time, some companies are so powerful that they can influence their home-country governments to intercede on their behalf. Probably the most notorious example was United Fruit Company (UFC) in so-called banana republics, which persuaded the United States to overthrow governments to protect its investments. Miguel Angel Asturias, a Nobel laureate in literature, referred to UFC’s head as the “Green Pope” who “lifts a finger and a ship starts or stops. He says a word and a republic is bought. He sneezes and a president . . . falls. . . . He rubs his behind on a chair and a revolution breaks out.”51 Whenever a company is controlled from abroad, its decisions can be made there. Such control means that corporate management abroad can decide such factors as personnel staffing, export prices, and the retention and payout of profits. These decisions might cause different rates of expansion in different countries as well as possible plant closings, sometimes with subsequent employment disruption. Finally, by withholding resources or allowing strikes, MNEs may affect other local industries adversely. In essence, the MNE looks after its global interests, which may not coincide with what is best for an operation in a given country.

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Should Countries Limit Foreign Control of Key Industries?

Counterpoint

No The passionate arguments against foreign control of key industries don’t convince me that such control leads to corporate decisions that are any different from those local companies would make. Nor do they convince me that limits on foreign ownership are in the best interests of people in host countries. Certainly, companies make strategic global decisions at headquarters, but typically they depend on a good deal of local advice beforehand. Further, MNEs staff their foreign subsidiaries mainly with nationals of the countries where they operate, and these nationals make most routine decisions. Regardless of the decision-makers’ or companies’ nationalities, managers decide based on what they think is best for their firms’ business, rather than based on some home-country or local socioeconomic agenda. At the same time, their decisions have to adhere to local laws and consider the views of their local stakeholders. Of course, MNEs sometimes make locally unpopular decisions, but so do local companies. In the meantime, governments can and do enact laws that apply to both local and international companies, and these laws can ensure that companies act in the so-called local interest. Although preventing foreign control of key industries may be well intentioned, the resultant local control may lead to the protection of inefficient performance. Further, the key-industry argument appeals to emotions rather than reason. That’s why arguments in the United States for security make little sense on close examination. Although foreign propaganda through foreign ownership of radio and television stations is the rationale

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Counterpoint for ownership restrictions, there are no such restrictions on foreign ownership of U.S. newspapers or on material appearing on the Internet. (Is this because people who read the news are presumed to be less swayed by propaganda?) The protection of U.S. domestic transportation for security reasons is a sham, just to protect the shipbuilding industry and maritime employees. For instance, U.S. merchant flagships must employ only U.S. citizens as crews because of ships’ vulnerability to bombs in U.S. waters, but foreign flag carriers regularly use U.S. ports, while foreigners can join the U.S. Navy. The banana-republic arguments are outdated and go back to dependencia theory, which holds that emerging economies have practically no power in their dealings with MNEs.52 More recent bargaining school theory states that the terms of a foreign investor’s operations depend on how much the investor and host country need each other.53 In effect, companies need countries because of their markets and resources, while countries need MNEs because of their technology, capital, access to foreign markets, and expertise. Through a bargaining process, they come to an agreement or contract that stipulates what the MNE can and cannot do. I completely disagree that either countries or companies can necessarily gain the same through collaborative agreements as through FDI. Although collaborative agreements are often preferable, there are company and country advantages from foreign-controlled operations. For example, with wholly owned operations, companies are less concerned about developing competitors, so they are more willing to transfer essential and valuable technology abroad.

LICENSING Licensing agreements may be • exclusive or nonexclusive, • used for patents, copyrights, trademarks, and other intangible property.

Licensing often has an economic motive, such as to gain faster start-up, lower costs, or access to additional resources.

The rights for use of intangible property may be for an exclusive license (the licensor can give rights to no other company for the specified geographic area for a specified period of time) or a nonexclusive one. The U.S. Internal Revenue Service classifies intangible property into five categories:

1. 2. 3. 4. 5.

Patents, inventions, formulas, processes, designs, patterns Copyrights for literary, musical, or artistic compositions Trademarks, trade names, brand names Franchises, licenses, contracts Methods, programs, procedures, systems

Usually, the licensor is obliged to furnish sufficient information and assistance, and the licensee is obliged to exploit the rights effectively and pay compensation to the licensor. Major Motives for Licensing A product or process may affect only part of a company’s total business, and then only for a limited time. In such a situation, the company may foresee

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insufficient sales to warrant establishing or continuing its own manufacturing and sales facilities. Meanwhile, a licensee may be able to produce and sell at a low cost and within a short start-up time. In turn, the licensee’s cost may be less than if it developed the product or process on its own. For industries in which technological changes are frequent and affect many products, companies in various countries often exchange technology or other intangible property rather than compete with each other on every product in every market—an arrangement known as cross-licensing. An example is Google (U.S.) and Samsung (Korea) entering a cross-licensing agreement for access to each other’s current and future patents.54 Payment Considerations The amount and type of payment for licensing arrangements vary, as each contract is negotiated on its own merits. For instance, the value to the licensee will be greater if potential sales are high. Potential sales depend, in turn, on such factors as the size of the sales territory and the longevity of the asset’s market value. Putting a Price on Intangible Assets Valuing partners’ contributions and rewards is complex and negotiable. Companies commonly agree on a “front-end” payment to cover technology transfer costs. Licensors of technology do this because there is usually more involved than simply transferring explicit knowledge, such as through publications and reports. The move requires the transfer of tacit knowledge, such as through engineering, consultation, and adaptation. To understand the difference between the two, think of giving a novice cook only a recipe for a chicken pot pie (explicit knowledge) versus going with the novice cook to choose a chicken, feel and smell produce in the market, and work together on the manual chores, such as chopping ingredients and rolling out dough (tacit knowledge). Of course, the license of some assets, such as copyrights or brand names, has much lower transfer costs. Intangible assets may be old or new, obsolete or still in use in the home market when a company licenses them. Many companies transfer rights to assets at an early or even a developmental stage so products hit different markets simultaneously. This is important when selling to the same industrial customers in different countries and when global advertising campaigns can be effective. On one hand, a licensee may be willing to pay more for a new intangible asset because it may have a longer useful life. On the other hand, a licensee may be willing to pay less for a newer one because of its untested market value. Licensing to subsidiaries is common because of parent and subsidiary legal separation and the potential effect on taxes.

Licensing to Subsidiaries Although we think of licensing among unassociated companies, it is also common between parents and their foreign-owned companies. One reason is that operations in a foreign country, even if 100 percent owned by the parent, are usually subsidiaries, which are legally separate companies. As such, taxes may differ depending on whether funds transferred to the parent are in the form of dividends or royalties. When a company owns less than 100 percent, a separate licensing arrangement also helps compensate the licensor for contributions beyond the mere investment in capital and managerial resources.

FRANCHISING Franchising includes providing an intangible asset (usually a trademark) and a continual infusion of necessary assets. Many types of products, companies, and countries participate in franchising.

In franchising, a specialized form of licensing, the parties act almost as a vertically integrated company because they are interdependent and each creates part of the product or service that ultimately reaches the consumer. Today, franchising is mostly associated with U.S. fast-food operations, although many international franchisors are from other countries and in many other sectors, such as Meliá’s hotel franchises discussed in the opening case. To illustrate how diverse franchising can be, consider the Danish company Cryos International, which franchises sperm banks in about 40 countries.55 Franchisors once depended on trade shows and costly visits to foreign countries to promote their expansion. While such trade shows are still important, especially for young franchising operations that are not well-known, the Internet has given companies another channel to exchange information.

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Franchise Organization A franchisor may deal directly with individual franchisees abroad or set up a master franchise that has rights to open outlets on its own or to develop subfranchisees in the country or region. Subfranchisees pay royalties to the master franchisee, which then remits some predetermined percentage to the franchisor. Companies are most apt to use a master franchise system when they are not confident about evaluating potential individual franchisees and when overseeing and controlling them directly would be too expensive.56 Picking good franchisees is, of course, essential for success.57 Franchisors face a dilemma: • Inadequacy of local supplies may hamper global product uniformity. • The more global standardization, the less acceptance in the foreign country. • The more adjustment to the foreign country, the less the franchisor is needed.

Operational Modifications Franchising success generally depends as well on product and service standardization, high identification through promotion, and effective cost controls. The latter two are pretty straightforward, but transferring the home country’s product and service, especially for food franchising, is often difficult, first, because of local supplies. McDonald’s, for instance, had to build a plant to make hamburger buns in the United Kingdom, while in Thailand it had to help farmers develop potato production.58 Second, foreign country taste preferences may differ from those in the home country—even within regions of large countries. In China, for example, Yum! Brands offers regionally different food in its KFC and Pizza Hut outlets.59 However, the more adjustments made for the host consumers’ different tastes, the less a franchisor has to offer a potential franchisee.

MANAGEMENT CONTRACTS Foreign management contracts are used primarily when the foreign company can manage better than the owners.

An organization may pay for managerial assistance under a management contract when it believes another can manage its operation more efficiently than it can, usually because the contractor has industry-specific capabilities. British Airport Authority (BAA) has these for airport administration, and it manages some airports in the United States, Italy, and Australia.60 Such contracts are common when host governments want foreign expertise, but do not want foreign ownership. In turn, the management company receives income without having to make a capital investment. Contracts are also popular in the hotel industry. (Recall the Meliá case.) In essence, host-country real estate owners may have good hotel locations, but know little about running a hotel. At the same time, many hotel chains have been shying away from property ownership abroad because of the perceived risk.61

TURNKEY OPERATIONS Turnkey operations are • most commonly performed by industrial-equipment, construction, and consulting companies, • often performed for a governmental agency. Turnkey operations generally differ from other IB collaborations because they • may be so large, • depend on top-level governmental contacts, • are often in very remote areas.

Companies handling turnkey operations are usually industrial-equipment manufacturers, construction companies, or consulting firms. Manufacturers also sometimes provide turnkey services when they are disallowed to invest. The customer for a turnkey operation is often a governmental agency. Recently, most large projects have been in those developing countries that are moving rapidly toward infrastructure development and industrialization. Contracting to Scale One characteristic setting turnkey business apart from most other IB operations is the size of most contracts, frequently for billions of dollars. This means that a few very large companies—such as Vinci (France), Bechtel (U.S.), and Hochtief (Germany)—account for a significant market share. Recently, several Chinese firms have become major players62 Some projects are so large that they are handled by a consortium of turnkey operators, such as the additional wider channel for the Panama Canal, led by Spain’s Sacyr Vallehermoso. (The following photo shows that channel’s construction.) Often, smaller firms serve either as subcontractors for primary turnkey suppliers or specialize in a particular sector, such as the handling of hazardous waste. Making Contacts The nature of these contracts places importance on hiring executives with top-level governmental contacts abroad, as well as on ceremony and building goodwill, such as opening a facility on a country’s national holiday or getting a head of state to inaugurate a facility. Although public relations is important to gain contracts, other factors—price,

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Construction on Panama’s wider canal channel.

▶

Source: Alejandro Bolivar/EPA/Newscom

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export financing, managerial and technological quality, experience, reputation, and so on— are necessary to sell contracts of such magnitude. Marshaling Resources Many turnkey contracts are in remote areas, necessitating massive housing construction and importation of personnel. Projects may involve building an entire infrastructure under the most adverse conditions, such as Bechtel’s complex for Minera Escondida high in the Andes, so turnkey operators must have expertise in hiring people willing to work in remote areas for extended periods and in transporting and using supplies under very difficult conditions. If a company has a unique capability, such as the latest refining technology, it will have little competition. As the production process becomes known, however, competition increases. Companies from developed countries have moved largely toward projects involving high technology, whereas those from such countries as China, India, Korea, and Turkey can compete better for conventional projects requiring low labor costs. The Chinese companies, China State Construction Engineering and Shanghai Construction Group, have worked on subway systems in Iran and Saudi Arabia, a railway line in Nigeria, a tourist complex in the Bahamas, an oil pipeline in Sudan, and office buildings in the United States.

JOINT VENTURES (JVs) Joint venture ownership may vary by type of participants and the portion of ownership they hold.

Although usually thought of as 50/50 companies, JVs may nonetheless involve more than two companies and ones in which a partner owns more than 50 percent. For example, Flagship Ventures (U.S.), AstraZeneca (U.K.-Sweden), Nestlé Health Science (Switzerland), and Bayer CropScience (Germany) have joined together to develop health-care innovations.63 When more than two organizations participate, the venture is sometimes called a consortium. JVs may also involve a partner owning over 50 percent, such as ANA’s ownership of 67 percent in AirAsia Japan.64 Possible Combinations • • •

Examples of the many combinations of JV partnerships include:

Two companies from the same country joining together in a foreign market (e.g., NEC and Mitsubishi [Japan] in the United Kingdom) A foreign company joining with a local company (e.g., Barrick [Canada] and Zijin Mining Group in China) Companies from two or more countries establishing a joint venture in a third country (e.g., Mercedes-Benz [Germany] and Nissan [Japan] in Mexico)

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FIGURE 15.4 Collaborative Strategy and Complexity of Control

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Forms and Ownership of Foreign Production

Many

Consortium

NUMBER OF PARTNERS

The more equity a firm puts into a collaborative arrangement, coupled with the fewer partners it takes on, the more control it will have over the foreign operations conducted under the arrangement. Note that non-equity arrangements typically entail at least one and often several partners. Source: Based on Shaker Zahra and Galal Elhagrasey,“Strategic Management of International Joint Ventures,” European Management Journal 12:1 (March 1994): 83–93. Reprinted with permission of Elsevier.

Management contract

Tight control

Turnkey

Medium control

Franchise Joint venture

License

Equity alliance

Little control

Sales contract

Wholly owned None OWNERSHIP CONTINUUM Equity Sharing (Greater degree of ownership)

• •

Nonequity (Lesser degree of ownership)

A private company and a local government forming a joint venture, or mixed venture (e.g., Mitsubishi [Japan] with the government-owned Exportadora de Sal in Mexico) A private company joining a government-owned company in a third country (e.g., BP Amoco [private British-U.S.] and Eni [government-owned Italian] in Egypt)

The more companies in the JV or any alliance, the more complex its management becomes. Development of the Boeing 787 (the Dreamliner) and the Airbus A380 were joint efforts among numerous companies from several countries.65 The projects were difficult to control, and a delay or performance hitch by any participating company delayed the others and caused project problems. Figure 15.4 shows that as a company increases the number of partners and decreases its portion of equity in a foreign operation, its ability to control that operation decreases.

EQUITY ALLIANCES Equity alliances help solidify collaboration.

An equity alliance is a collaborative arrangement in which at least one of the companies takes an ownership position (almost always minority) in the other(s). For instance, the Port of Antwerp (Belgium) took a minority position in Essar Ports (India) when the two signed a long-term alliance to mutually improve quality and productivity.66 In some cases, each party takes an ownership in the other, such as occurred with Panama-based Copa and Colombiabased AeroRepublic (airlines).67 The purpose of the equity ownership is to solidify a collaborating contract, such as a supplier–buyer contract, so that it is more difficult to break—particularly if the ownership is large enough for the investing company to secure a board membership.

WHY COLLABORATIVE ARRANGEMENTS FAIL OR SUCCEED All collaborative arrangement parties must be satisfied with performance; otherwise, the arrangement may fail.

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REASONS FOR FAILURE Problems can develop that lead partners to renegotiate in terms of objectives, responsibilities, ownership, performance criteria, or management structure. Despite renegotiation to restructure, many agreements break down because at least one partner becomes dissatisfied with the endeavor. Frequently, a partner buys out the other’s interest and the operation continues as a wholly owned foreign subsidiary. In other breakups, companies agree to dissolve the arrangement. The major strains on the arrangements are due to five factors: • • • • •

Relative importance to partners Divergent objectives Control problems Comparative contributions and appropriations Differences in culture

Partners’ uneven attention to a collaborative arrangement is often due to their disparate sizes.

Relative Importance Partners may give uneven management attention to a collaborative arrangement. If things go wrong, the more active partner blames the less active partner for its lack of attention, while the latter blames the former for making poor decisions. Difference in attention may be due to disparity in the partners’ sizes. For example, a smaller partner may take more interest in the venture because it is using a larger portion of its resources therein. Further, the smaller firm may be disadvantaged in fighting its bigger partner legally. For example, Igen, a small U.S. firm, licensed its technology to Boehringer Mannheim of Germany, whose sales were more than 100 times greater. When the two companies disagreed over royalty payments, Igen fought four years and spent the equivalent of one year’s sales on legal fees before winning a settlement.68 This example is unusual, however, because few small firms can or will fight a much larger company so effectively.

As partners’ capabilities and strategies evolve, their collaborative objectives may change.

Divergent Objectives Partners’ initial complementary objectives may evolve differently as a result of competitive forces and product dynamics. Thus, a partner may no longer perceive collaboration to be in its best interest. For instance, IBM partnered with Toshiba, but later it shifted its product line. At that point, it required a type of monitor with which Toshiba lacked expertise.69 Further, one partner may want to reinvest earnings for growth while the other wants to receive dividends. Or one partner may want to expand the product line and sales territory while the other may see this as competition with its wholly owned operations (a point of disagreement between BP and its Russian partner, TNK.)70 If one partner wants to sell or buy from the venture, the other may disagree with the price.

“Who’s in charge?” plagues collaboration despite all parties being held responsible.

Questions of Control Sharing assets with another company may generate confusion over control. Such confusion is rife with gray areas and may cause anxiety among employees. In a proposed JV between Merrill Lynch and UFJ, a Japanese senior manager queried, “Who is going to be in charge—a Japanese, an American, or both?”71 Moreover, when companies license their logos and trademarks for use on products they do not make, they may lack the ability to discern and control quality. Pierre Cardin’s licensing of its label for hundreds of products—from clothing to clocks to toilets—led to some poor-quality goods that hurt the image of the high-quality ones.72 In collaborative arrangements, even though control is ceded to one of the partners, both may be held responsible for problems. In a joint venture to make baby formula between the Israeli company Remedia and the German firm Humana Milchunion, Humana Milchunion’s removal of Vitamin B1 from the formula concentrate led to the deaths of three infants.73 Remedia was jointly responsible even though it had not been notified of the removal.

If one partner perceives that the other is contributing too little or taking out too much, the collaboration may weaken.

Comparative Contributions and Appropriations Partners’ relative capabilities may change, thus one partner may no longer contribute as much as the other or as much as was expected initially. In addition, one partner may suspect that the other is taking more from the operation than it is (particularly knowledge-based assets or key JV personnel).

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To counteract this appropriability, the suspicious firm may withhold information, eventually weakening the operation. In fact, there are many examples of companies “going it alone” after they no longer needed their partners—particularly if the purpose of the collaboration was to gain knowledge. Differences in country and company cultures may cause one partner to be satisfied and the other dissatisfied.

CONCEPT CHECK In Chapter 2 (page 85), we discussed differences in trust among cultures and explained that in high trust cultures, the cost of doing business tends to be lower.

Culture Clashes Both national and company cultural differences can affect the relationship between partners. Differences in Country Cultures Managers and companies are affected by their national cultures, and collaborative arrangements bring them directly together. For instance, preferences may vary in the method, timing, and frequency with which they report on performance and whether they evaluate primarily on the operations’ effect on shareholders or on stakeholders in general.74 These differences may mean that one partner is satisfied while the other is not. Such a clash led to the dissolution of a joint venture between Danone and its Chinese government-owned partner because the latter put employment maximization ahead of efficiencies and profits.75 Trust is another factor. There are national differences that influence interactions with foreign partners. In fact, some companies don’t like to collaborate with those of very different cultures.76 Nevertheless, JVs from culturally distant countries can thrive when partners learn to deal with each other’s differences.77 Differences in Company Cultures Similar company cultures aid companies’ ability to communicate and transfer knowledge to each other, whereas collaborations can experience problems when these cultures differ.78 For example, the joint venture between Japan’s ANA and Malaysia’s AirAsia broke up as the former wished to emphasize its culture of “meticulous service,” whereas the latter had a culture of cutting costs.79 One partner may be accustomed to internal managerial promotions while the other opens its searches to outsiders. One may use a participatory management style and the other an authoritarian style. One may be entrepreneurial, the other risk-averse. This is why many companies delay JV collaboration until they have had long-term positive experiences with each other, such as through distributorship or licensing arrangements which involve lower levels of commitment. In fact, there is evidence that a gradual increase in commitment, such as developing an alliance with a company before acquiring it, is a means of improving performance.80 Of course, as with marriage, a good prior relationship between two companies does not guarantee a good match in a joint venture.81

HELPING COLLABORATIVE OPERATIONS SUCCEED Despite our discussion on problems and failures of collaborative operations, we do not mean to imply that there are no success stories. There are. The JV between Xerox (U.S.) and Rank (U.K.) is a case in point: not only has it performed well for a long period, it even has a JV in Japan with Fuji Photo, which has also performed well. Aside from awareness of and adjustment to the pitfalls we have discussed, the following considerations help assure success when choosing among and managing operating forms:

Companies should make their highest commitments in terms of operating modes where markets are most attractive and best fit their competences and strategies.

• • • • • •

Fitting modes to country differences Finding and evaluating partners Negotiating agreements: The question of secrecy Controlling through contracts and trust Evaluating continually Adjusting the internal organization

Fitting Modes to Country Differences Country conditions influence the operating forms that best suit companies’ IB operations. To begin with, regulations (such as prohibitions on 100 percent foreign-owned FDI) and national conditions (such as political risk)

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CONCEPT CHECK In Chapter 13 (pages 392–394), we discussed how risk and opportunity differ among countries and how (pages 397–398) the choice of operating mode may reduce a company’s risk.

Partner pairing should depend on mutual assessment of each other’s resources, motivation, and compatibility.

Corporate Policy and Strategy

influence what companies can’t and won’t do in a foreign country. Concomitantly, countries offer different opportunities that mesh differently with companies’ capabilities and strategies. Thus, choosing the best operating form for each country helps companies succeed. A company should ordinarily commit more of its IB resources to those markets that are most attractive and fit best with its strategies and competence. The choice of operating mode directly affects this resource allocation inasmuch as different modes commit different levels of resources and different portions of those resources abroad. Figure 15.5 illustrates a matrix relating country attractiveness, a company’s competitive strength per country, and operating forms. Step one for a company is to evaluate countries’ general attractiveness (high, medium, or low) irrespective of the company’s fit with that country. Step 2 is to assess the company’s competitive strength to fulfill its objectives (high, medium, or low) for each of the countries. By using results from the two steps to plot each country within the six sectors of the matrix, one has a visual description of preferred mode per country. Although such a matrix may serve to guide decision-making, managers must use it with caution. First, separating the attractiveness of a country from a company’s position is often difficult; the country may seem attractive because it fits with the company. Second, some of the recommended actions take a defeatist attitude toward competitive capability. Many companies have built competitive strength in markets where they initially were weak competitively. Finding and Evaluating Potential Partners Contracting with a satisfactory partner is significant for success in collaborative agreements. Managers can identify potential partners by monitoring journals, attending technical conferences, developing links with academic institutions—even through social acquaintances.82 Whether seeking a partner or reacting to a partnership request, a company must evaluate the potential partner’s resources, motivation, and compatibility. The potential partner’s proven ability to handle similar types of collaboration is a key professional qualification. A good track record may indicate trustworthiness that could negate the need for expensive control mechanisms to carry out interests.

FIGURE 15.5

Country Attractiveness/Company Strength Matrix

In a given scenario, a country in the upper left-hand corner may be the most attractive place for a company to locate operations. Why? Because its market is well suited to the company’s greatest competitive strength and thus to its highest level of commitment (e.g., establishing a wholly owned subsidiary). A country in the upper right-hand corner also boasts an attractive market but poses a problem for a company whose competitive strengths don’t quite match the opportunity (perhaps it has no experience in this particular market). It needn’t forgo the opportunity, but it will probably prefer a joint venture or some other form of collaborative operation. Finally, note that because everything is subject to change—both a company’s capabilities and the features of a country’s market—firms try to be dynamic in their approach to potential operating modes.

Country attractiveness

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Maximize commitment, High such as wholly owned operations Individualized strategies

Medium

Low

Collaborations/ joint ventures to dominate

Minimize commitment, such as through nonequity arrangement

Individualized strategies High

Medium Competitive strength

Low

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At the same time that you are looking for and evaluating potential partners, those potential partners are doing the same. You can boost your visibility and partnership potential through trade fair attendance, brochures, websites, and contacts in the potential collaboration locale. If you are new to foreign operations and to collaboration, you have no track record and you may have to negotiate harder and make more concessions. In technology agreements, • sellers do not want to give information before assuring an agreement can be reached, • buyers want to evaluate information before committing to an agreement, • the contract terms may be considered proprietary.

Although both trust and contracts have control limitations, there are provisions that should be included in any collaborative agreement.

When collaborating with another company, managers must • continue to monitor performance, • assess whether to change the form of operations, • develop competency in managing a portfolio of collaborations.

Negotiating the Arrangement: The Question of Secrecy Numerous collaborative arrangements involve technology transfers. Because the value of many technologies would diminish if they were widely used or understood, technology owners have historically insisted on including contract provisions whereby recipients will not divulge such information. Some have also held onto the ownership and production of specific components so recipients would not have full knowledge of the product or the capability to produce an exact copy. Often companies want to sell techniques they have not yet completed, much less commercialized. A buyer is reluctant to buy what it has not seen, but a seller that shows the work in process to the potential buyer risks divulging the technology. For these and other reasons, it is common to set up pre-arrangement agreements that protect all parties. A controversial negotiation area is the secrecy surrounding the financial terms of arrangements. In some countries, for example, licensing contracts must be approved by governmental agencies, which consult their counterparts in other countries about similar agreements in order to improve their negotiating position. Many MNEs object, believing that contract terms between two companies are proprietary information with competitive importance, and market conditions usually dictate the need for very different terms in different countries. Controlling Through Contracts and Trust Contracts with other companies entail some loss of control over the asset transferred. This creates two concerns—the partner’s performance competency and the partner’s integrity so as not to act opportunistically.83 A host of potential problems must be settled as well as possible by setting mutual goals and spelling out all expectations in the contract, but not everything can be included in a contract. The parties need to develop sufficient rapport so that common sense also plays a part in running the operation.84 Once operating, partners can also build trust through actions.85 At the same time, national culture influences how much a partner wants to cover in a contract. Thus, if parties from cultures with similar levels of trust come together, they can more likely agree on what must be incorporated in detailed contractual arrangements and what must be left to trust.86 Partnering with a firm that highly values its reputation is probably a plus as well, inasmuch as it may prefer to settle differences quietly rather than having them exposed in the press. Frank communications may help determine potential partners’ underlying expectations, which may otherwise come as a surprise. One study of local firms in China and Russia discovered that they had expected their foreign partners to deal much more with the Chinese and Russian governments (such as to alleviate bribery payments) than the foreign partners realized or actually did.87 Although contracts cannot cover everything, their provisions should at least address the following issues: • • • • • • •

Will the agreement be terminated if the parties don’t adhere to the directives? What methods will be used to test for quality? What geographic limitations should be placed on an asset’s use? Which company will manage which parts of the operation outlined in the agreement? What will be each company’s future commitments? How will each company buy from, sell to, or otherwise use assets that result from the collaborative arrangement? How will revenues be divided?

Evaluating Continually Contracting with a capable and compatible partner is necessary but insufficient to ensure success. An agreement, once operational, must be run effectively. Management should estimate potential sales and costs, determine whether the arrangement

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is meeting quality standards, and assess servicing requirements to check whether goals are being met and whether one’s partners are doing an adequate job. In this respect, the relationship among partners may evolve positively or negatively, thus necessitating operational changes or even the termination of an agreement. In addition to continually assessing partners’ performance, a company must periodically assess the need for change in the type of collaboration, such as whether to replace a licensing agreement with a joint venture. Such modifications may be warranted because of companies’ changes in resources and strategies and because of external conditions such as host-country political and economic conditions. The evolution to a different operating mode may • be the result of experience, • create organizational tensions.

Adjusting Within the Internal Organization As companies enter into and grow their international collaborative arrangements, they gain competencies. As they change operating modes, they encounter pressures necessitating organizational adjustments. These include organizational application of what they have learned and the need to alter group and individual evaluations as operating forms change. Learning and Its Applications Evidence suggests that companies’ collaborative performance improves with experience. However, improvement is most associated with similar types of collaborations, such as applying what a firm has learned from JV operations in one country to JVs in another country.88 With experience, companies learn to choose partners better and to improve synergies with them. Thus, as a company’s number of collaborations grows, it should work toward developing competency in managing the portfolio of arrangements so that it applies what it learns in one situation to others.89 Nevertheless, companies should take into consideration that effective alliance management has been undergoing significant changes, thus they may not necessarily replicate their past successes.90 Pressures from Switching Collaborative Modes Changes in operating mode, such as from exporting to foreign production to serve a market, cause some individuals to gain and others to lose responsibilities. For example, the size of domestic marketing and manufacturing divisions may contract, thus disadvantaging people who lost responsibilities if bonuses and promotions are based largely on their sales or profits. Given that lower performance is due to decisions outside their control, companies will need to revise performance evaluations.

Looking to the Future

Growth in Project Size and Complexity More than a half century ago, John Kenneth Galbraith wrote that the era of cheap invention was over “because development is costly, it follows that it can be carried out only by a firm that has the resources associated with considerable size.”91 The statement seems prophetic in terms of the estimated dollars needed to bring a new commercial aircraft to market, eliminate death from diseases, develop defenses against unfriendly countries and terrorists, guard against cyberspace intrusions, and develop means to counteract adverse effects of climate change. However, Galbraith’s conclusion overlooks several factors. First, can firms reach the “considerable size” to solve the problems just mentioned? This is doubtful. Some of the largest companies in the world are in the

auto industry, but they are finding that they have to work with each other (e.g., Toyota with BMW, to meet ever-stricter rules on carbon-dioxide emissions).92 Further, governments constrain mergers and acquisitions because of antitrust concerns, thus inhibiting companies’ growth. Second, can companies internalize the breadth of technology necessary to solve these big problems? This is also doubtful. The recent mantra in strategy is to do what you do best and outsource the rest. Thus large companies’ breadth of technology has been receding rather than growing. Consequently, we are apt to see more horizontal and vertical linkages among firms from many industries in many countries. On the downside, some evidence indicates

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that collaborations slow the speed of innovation because firms consider internalization and appropriation factors.93 If we see greater horizontal and vertical linkages, will these linkages be traditional? Some will probably not be. For instance, in recent years, some of the fastest-growing start-ups, such as Uber and Airbnb, have been companies that link with outsiders who provide most of the investment. Thus, collaboration will probably increase, but it will involve new forms and may not attack the big developments that Galbraith envisioned. At the same time, most product development is much more modest than required to unravel the gigantic projects. Concomitantly, although business strategists have advised companies for some time to specialize on what they do best (which fosters collaboration), there is growing evidence that many customers prefer to deal with one rather than multiple suppliers. The result, especially in emerging economies, may be the return in popularity of conglomerates.94 Thus smaller companies may be able to handle much development for their domestic markets alone, even if they are conglomerates. Nevertheless, they lack all the product- and market-specific resources to go it alone everywhere

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outside their home markets, especially if national differences dictate operating changes on a countryto-country basis. Thus we may see them embracing more collaboration as they move internationally. Collaborative arrangements will bring both opportunities and problems as MNEs move simultaneously to new countries and to contractual arrangements with new companies. Differences must be overcome in a number of areas: • •

•

•

•

Country cultures that may cause partners to obtain and evaluate information differently National disparities in governmental policies, institutions, and industry structures that constrain companies from using operating forms they would prefer Distinct underlying ideologies and values affecting corporate cultures and practices that strain relationships Different strategic directions resulting from partners’ interests that cause disagreement over objectives and contributions Diverse management styles and organizational structures that cause partners to interact ineffectively95 ■

The oneworld Airline Alliance96

The airline industry is almost unique in that its need to form collaborative arrangements has been important almost from the start of international air travel because of cost, regulatory, and competitive factors. In recent years, this need has accelerated because of airlines’ difficult profit performance. In effect, the airlines have been squeezed. First, costs have become uncertain, particularly due to fluctuations in oil prices. Second, there is a need for greater security. In addition to airport passenger-security checks, airlines must provide advanced passenger information to governmental agencies and work with freight forwarders and supplychain operators to ensure the safety of cargo shipments on passenger aircraft. Third, a long-term trend toward greater

price competition has hindered airlines’ ability to pass on increased costs to passengers—a situation exacerbated by discount airlines and customers’ ability to search for lower fares on the Internet. Although growth in international passenger travel has largely spurred globalization, no airline has sufficient finances or aircraft to serve the whole world. Yet passengers are traveling the whole world and want airline connections that will minimize both distances and connecting times at airports while offering reasonable assurance of reaching destinations with checked luggage more or less on schedule. Thus, airlines have increasingly worked together to provide more seamless experiences for passengers and to cut costs.

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This discussion, however, should not imply that all cost cuts necessitate collaboration. Airlines have implemented cost-saving changes that cover the gamut from ticket purchase to arrival at destination. Online purchases of electronic tickets have largely replaced airlines’ need to pay travel agency commissions and to issue and maintain costly inventories of paper tickets. Self-service check-in at airports reduces the need for agents. On board, especially on short flights, less is included in the price of a basic ticket, such as generous leg space between rows of seats, food, pillows, and headphones.

A Bit of History: Changing Government Regulations Historically, governments played a major role in airline ownership. Many government-owned airlines were monopolies within their domestic markets, money losers, and recipients of government subsidies. However, although some airlines remain subsidized, there has been a subsequent move toward privatization.

What Governments Can Regulate Despite the move toward privatization, governments still regulate airlines and agree on restrictions and rights largely through reciprocal agreements. Specifically, they control: • • • •

Which foreign carriers have landing rights Which airports and aircraft the carriers can use The frequency of flights Whether foreign carriers can fly beyond the country (for instance, whether Iberia, after flying from Spain to the United States, can then fly from the United States to Panama) • Overflight privileges • Fares airlines can charge Several notable regulatory changes have occurred in recent years. First, the U.S. domestic market has been deregulated, which means that any approved U.S. carrier can fly any U.S. domestic route in any frequency while charging what the market will bear. Once deregulation was instituted, many U.S. airlines were competitively forced out of business. Second, similar deregulation within Europe influenced the demise of some airlines. Third, several open-skies agreements permit any airline from countries in an agreement to fly from any city in one signatory area to any city in the other signatory area. Further, these flights have no restrictions on capacity, frequency, or type of aircraft. For instance, an open-skies agreement between the United States and Japan spurred American Airlines (AA) to begin previously unapproved service between New York and Haneda International Airport. Fourth, European countries have permitted cross-national acquisitions, such as German Lufthansa’s acquisition of Swissair.

Why Governments Protect Airlines Three factors influence governments’ protection of their airlines: 1. Countries believe they can save money by maintaining small air forces and relying on domestic airlines in times of unusual air transport needs (e.g., the U.S. government using U.S. commercial carriers to help carry troops to and from Iraq and Afghanistan). 2. Public opinion favors spending at home. The public sees, for example, the requirement that government employees fly on national airlines as foreign-exchange savings. 3. Airlines are a source of national pride, and aircraft (sporting their national flags) symbolize a country’s sovereignty and technical competence. This national identification has become less important, but it still persuades some developing countries.

Regulatory Obstacles to Expansion Even if airlines had the financial capacity to expand everywhere in the world, national regulations would limit this expansion. With few exceptions, airlines cannot fly on lucrative domestic routes in foreign countries. For example, Japan Airlines (JAL) cannot compete on the New York to Los Angeles route, nor can AA fly between Tokyo and Nagoya. These restrictions prevent airlines from developing domestic routes abroad to feed into their international routes (e.g., JAL has no U.S. flights into Chicago to connect to its Chicago–Tokyo flights, but AA does). Further, the U.S. government limits foreign ownership in a U.S. airline to 25 percent of voting stock. Finally, airlines usually cannot service pairs of foreign countries. AA cannot fly between Brazil and South Africa because those governments give landing rights on such routes only to Brazilian and South African airlines. To avoid these restrictions, airlines must ally themselves with carriers from other countries.

Collaboration Examples Related to Motives Cost Factors Certain airlines have always dominated certain international airports, thereby amassing critical capabilities in them, such as baggage handlers and aircraft-handling equipment. Sharing these capabilities with other airlines may spread costs. For example, British Airways (BA) has long handled passenger check-in, baggage loading, and maintenance for a number of other airlines at London’s Heathrow Airport. The high cost of maintenance and reservations systems has led to JVs involving multiple airlines from multiple countries, such as ownership in the Apollo and Galileo reservation systems. Actually, the reservations systems are motivated by

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Forms and Ownership of Foreign Production

more than cost savings, inasmuch as the pooling of resources provides customers with better service.

Connecting Flights Given that governments restrict routes, airlines have long had agreements whereby passengers can transfer from one to another with a through ticket. However, people tend to select from among the first routings that show up on computer screens, and routings from one airline to another often appear on screens after those involving only one airline. Further, when passengers see that they must change airlines, they worry more about making those connections across great distances within ever-larger airports. To help avoid this worry, airlines have agreed to code sharing—a procedure whereby the same flight may have a designation for more than one carrier. For instance, the same flight operated by Iberia from Miami to Madrid is listed as AA 8636, Finnair 5642, and Iberia 6118. Hence, AA passengers originating in, say, Tampa and connecting at Miami may worry less about the connection because they see themselves on the same airline all the way. However, they may still need to go from one departure section to another to make the plane-change. In such a situation, airlines must adhere to a longer minimum connecting time when showing a through/connecting flight.

The oneworld Alliance

Antitrust Immunity AA has received antitrust immunity that allows it to cooperate more in both a joint venture across the Atlantic and one across the Pacific. In both cases, the agreements allow representatives from each airline to jointly manage capacity, sell and promote space on flights operated by each other, divide revenues, and schedule connecting flights. The major thrusts for these ventures are to cut operating costs by better controlling capacity, to avoid disruptive price competition, and to improve scheduling so that there are more and better departure times and connections for passengers.

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The oneworld Alliance comprises 15 airlines: airberlin, American Airlines, British Airways, Cathay Pacific, Finnair,

Iberia, Japan Airlines, LAN Airlines, Malaysia Airlines, Qantas, Qatar, Royal Jordanian, S7 Airlines, SriLankan Airlines, and TAM. At this writing, Aer Lingus is negotiating to become the 16th member, and Qatar has indicated it may leave the alliance. oneworld competes largely with two other alliances: Star and SkyTeam. Airlines in these alliances cooperate on various programs, such as allowing passengers to earn credits for free or upgraded travel on any one of them. In the case of oneworld, all members flying into Narita Airport in Tokyo have moved into terminal 2, which shortens legal connecting times among them. They also advertise their affiliation; you may have seen aircraft painted with the airline’s name and logo along with the oneworld name. These alliances allow for considerable cooperation, such as code-sharing; however, antitrust regulations (unless given immunity) prohibit their members from coordinating routes, schedules, and prices.

The adjacent photo shows an aircraft bearing both the oneworld and British Airways identifications.

Source: TRISTAR PHOTOS / Alamy Stock Photo

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The Transatlantic Joint Venture Three airlines—AA, BA, and Iberia—have a combined network of over 400 destinations in over 100 countries and account for more than 6,000 daily departures. When their JV and antitrust immunity were approved, they collectively had 48 different routes between Europe and North America that included 22 North American and 13 European cities. Of these 48 routes, they competed directly on only 9. Since these airlines entered this JV, they have been able to coordinate schedules better for the convenience of passengers. For instance, whereas AA and BA used to have flights leaving between New York-JKF and LondonHeathrow within minutes of each other, they now operate 16 flights per day between those two airports and have been able to coordinate departure times so that the flights leave approximately one hour apart. This gives passengers more options in finding a departure time convenient to them and allows for more connecting flight alternatives in either direction. Further, the participating airlines can now designate their own flight numbers on domestic connections when they connect to transatlantic destinations. For instance, Iberia shows one of its routes as San Diego to Madrid, even though both the San Diego–Chicago and Chicago–Madrid flights are operated by AA. Because of dual or multiple designations and the sharing of revenue, more than one airline’s sales force is trying to fill seats on the same route. The result is boosted sales,

which allows the JV members to offer new routes—nonstop service between Chicago and Helsinki and between New York and Budapest have come about since the JV’s formation.

The AA–JAL Joint Venture JAL is also a large airline, serving 85 cities in 20 countries and territories. Its joint venture with AA has the same advantages and objectives as the JV across the Atlantic. Some changes since inaugurating the JV are notable. By altering each company’s flight times between Chicago O’Hare and Tokyo Narita and tweaking schedules of connecting flights in both cities, many more passengers can make connections within two hours. For instance, 22 more flights from 20 more departure cities can make such connections for travel from O’Hare to Narita. Map 15.2 shows the joint AA–JAL routes and illustrates that flights between Honolulu and Japan are not included in the agreement. JAL moved its O’Hare flights from the international terminal to be adjacent to AA. Meanwhile, AA moved its Japanese offices to JAL’s headquarters building, a move that eases communications between the two airlines. Both are helping each other with cultural questions, such as JAL aiding AA with public address announcements in Japanese to make them more meaningful to Japanese passengers. Meanwhile, the airlines have greatly increased code sharing between

MAP 15.2 American Airlines and Japan Airlines: Transpacific Routes Note that the joint activity involves only flights from mainland North America into East Asia.

Vancouver Tokyo/ Nagoya Narita Osaka Tokyo/ Shanghai Haneda

San Francisco

Beijing

Honolulu

Boston Chicago New York

Los Angeles Dallas/ Fort Worth

Joint Business Routes Non-joint Business Routes Operated by JAL

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them, especially to points beyond gateway cities, such as showing a JAL flight as Tokyo–Salt Lake City and as an AA flight beyond Tokyo to JAL-served cities such as Hanoi.

Why Not a Merger or an Acquisition? To begin with, government regulations such as ownership requirements would prevent a merger or acquisition between U.S. and non-U.S. carriers. Even if they didn’t, fusing companies together creates daunting problems, even for domestic mergers and acquisitions. To complete the merger between AA and US Airways, the companies had to merge different operating and compensation systems between their respective pilots’ unions. US Airways transatlantic routes had to interface with AA’s agreements with BA and Iberia. US Airways had to sever its membership in the Star Alliance, and AA and US Airways had to combine their accrued frequent flyer passenger points.

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are possible by strengthening collaboration, such as having check-in counters worldwide that handle all oneworld passengers and combining more airport lounges as a cost-saving measure. It is probably safe to say that future cooperation will strengthen rather than weaken among oneworld members.

QUeStIONS 15-3. Companies within the oneworld, Star, and Sky Team alliances have also engaged in major mergers and acquisitions (M&A): American and US Air (oneworld), Delta and Northwest (Sky Team), and Continental and United (Star). What are the advantages and disadvantages of M&A versus non-equity alliances in this industry? 15-4. Some airlines, such as Southwest, have survived as niche players without extensive international connections. Can they continue this strategy? 15-5. Why should an airline not be able to establish service anywhere in the world simply by demonstrating that it can and

The Advantages of JVs In the JVs, each company keeps its own identity and operates independently except for the coordination of the transoceanic routes. In addition, each airline in the JVs and within oneworld has developed its own culture and brand to appeal to its own nationality. BA is still strongest with British passengers, JAL with Japanese passengers, etc. By keeping separate identities, despite sharing flights, the member airlines can capitalize on the differences. Nevertheless, natural extensions

will comply with the local labor and business laws of the host country? 15-6. The U.S. law limiting foreign ownership of U.S. airlines to no more than 25 percent of voting shares was enacted in 1938. Is this law an anachronism, or are there valid reasons for having it today? 15-7. Many airlines have sometimes been no more than marginally profitable. Is this such a vital industry that governments should intervene to guarantee survival? If so, how?

MyLab Management Go to mymanagementlab.com for the following Assisted-graded writing questions: 15-8 What will be the consequences if a few large airlines or networks dominate global air service? 15-9 What methods could JAL and AA use to divide revenue and expenses on code-shared routes?

Endnotes Scan for Endnotes or go to www.pearsonglobaleditions.com/Daniels

National Environmental Differences

CHAPTER 2 Culture

OBJECTIVES After studying this chapter, you should be able to 2-1 Explain why culture, especially national culture, is important in IB, but tricky to assess 2-2 Grasp the major causes of national cultural formation and change 2-3 Discuss major behavioral factors influencing countries’ business practices 2-4 Recognize the complexities of cross-cultural communications 2-5 Analyze guidelines for cultural adjustment

MyLab Management® Improve Your Performance! When you see this icon , visit www.mymanagementlab.com for activities that are applied, personalized, and offer immediate feedback.

If you see men stroking their beards, stroke yours.

Tower in Riyadh, Saudi Arabia.

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Source: Salem Alforaih. Shutterstock

—Arab proverb

PART TWO

CASE Saudi Arabia (see Map 2.1) can be perplexing to foreign managers as they try to exercise acceptable personal and business behavior.1 Its mixture of strict religious convictions, ancient social traditions, and governmental economic policies results in laws and customs that often contrast with those in other countries, shift with little advance notice, and vary by industry and region. Thus, foreign companies and employees must determine what these differences are and how to adjust to them. A brief discussion of a sample of Saudi traditions, cultural norms, and foreign operating adjustments should help you understand the importance of culture in IB.

A LITTLE HISTORY AND BACKGROUND Although the land encompassing the Kingdom of Saudi Arabia has a long history, during most of that history invaders controlled a divided land and most inhabitants had a tribal rather than national loyalty. Nevertheless, the inhabitants have shared a common language (Arabic) and religion (Islam). In fact, Saudi Arabia is the birthplace of Islam and the location of its two holiest cities, Mecca and Medina. (The opening photo shows the Nabawi Mosque at Medina, the second holiest mosque in Islam.) King Ibn Saud, a descendant of Mohamad, took power in 1901, merged independent areas, created a political and religious entity, and legitimized his monarchy and succession by being the defender of Islamic holy areas, beliefs, and values. The growing importance of oil for Saudi Arabia, particularly since the 1970s, led to rapid urbanization and gave the government the means to offer social services such as free education. These changes have furthered its citizens’ sense of a national identity, while diminishing their traditional (particularly nomadic) ways of living. Cities have modernized physically. However, below the physical surface, Saudis hold some attitudes and values that are neither like the norm elsewhere nor easily discerned. Modernization has been controversial within Saudi Arabia. A liberal group, supported by an elite foreign-traveled segment, wants economic growth to provide more choices in products and lifestyles. A conservative group, supported by religious leaders, is fearful that modernization will upset traditional values and strict Koranic teachings. The government (the Royal Family) must satisfy conservative viewpoints, lest its leadership becomes vulnerable. For instance, Iran’s Islamic Revolution was spearheaded in part by dissenters who viewed the Shah’s modernization movements as too secular. Meanwhile, liberals have been largely pacified by taking well-paid government jobs and slowly gaining the transformation they wish. The government has sometimes made trade-offs to

Saudi Arabia’s Dynamic Culture appease conflicting groups, such as requiring women to wear longer robes (women must wear abayas and men customarily wear thobes) in exchange for advancing women’s education. However, the abayas, traditionally black, are increasingly in more modern designs and bright colors.

THE RELIGIOUS FACTOR If you are accustomed to fairly strict separation between religion and the state, you will probably find the pervasiveness of religious culture in Saudi Arabia daunting. Religious proscriptions prohibit pork products and alcohol. During the holy period of Ramadan, when people fast during the day, restaurants serve customers only in the evening. Restaurants such as McDonald’s dim their lights and close their doors during the five times a day that Muslim men are called to prayer. Many companies convert revenuegenerating space to prayer areas; Saudi Arabian Airlines does this in the rear of its planes, the British retailer Harvey Nichols in its department store. However, there are regional differences. In Riyadh, women customarily wear niqabs that cover their faces. But in Jeddah, which has more contact with foreigners and is less conservative, dress codes are more relaxed and fewer women wear them. Nevertheless, merchants routinely remove mannequins’ heads and hands and keep them properly clad to prevent public objections. IKEA even erased pictures of women from its Saudi catalogue. Rules of behavior may also be hard to comprehend because religious and legal rules have sometimes been adapted to contemporary situations. Islamic law, for instance, forbids charging interest and selling accident insurance (strict doctrine holds there are no accidents, only preordained acts of God). In the case of mortgages, the Saudi government offers interest-free mortgage loans instead. It allows accident insurance because Saudi businesses, like businesses elsewhere, need the coverage. Nor are expected behaviors necessarily the same for locals and foreigners. Non-Muslim foreign women are not required to wear head scarves, although they may be admonished by religious patrols. Saudi Arabian Airlines does not hire Saudi women as flight attendants (being in direct contact with men might tempt promiscuous behavior), but it hires women from other Arab nations. In addition, the government permits residents of compounds, inhabited largely by Americans and Europeans, to dress therein much the way they do back home. However, in an example of a reverse dress code, some compounds prohibit residents and their visitors from wearing abayas and thobes in their public areas.

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Culture

Saudi Arabia and the Arabian Peninsula

The kingdom of Saudi Arabia comprises most of the Arabian Peninsula in Southwest Asia.The capital is Riyadh. Mecca and Medina are Islam’s holiest cities. Jeddah is the most important port. All of the country’s adjacent neighbors are also Arabic—that is, the people speak Arabic as a first language. All the nations on the peninsula are predominantly Islamic.

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