International Business 9789332547209, 9332547203

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SECOND EDITION

INTERNATIONAL

._ USINESS

SUMATI VARMA

INTERNATIONAL BUSINESS Second Edition

Sumati Varma

Department of Commerce Sri Aurobindo College (Evening) University of Delhi

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No part of this eBook may be used or reproduced in any manner whatsoever without the publisher’s prior written consent. Copyright © 2015 Dorling Kindersley (India) Pvt. Ltd. This eBook may or may not include all assets that were part of the print version. The publisher reserves the right to remove any material in this eBook at any time. ISBN: 987-93-325-4168-9 eISBN: 978-93-325-4720-9 First Impression Head Office: 7th Floor, Knowledge Boulevard, A-8(A) Sector 62, Noida 201 309, India. Registered Office: 11 Community Centre, Panchsheel Park, New Delhi 110 017, India.

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ºÉ¨É{ÉÇhÉ

¨ÉÉiÉÉ Ê{ÉiÉÉ ¤ÉxvÉÖ ºÉJÉÉ MÉÖ° nä´ÉºªÉ: Dedicated to my parents, friends, teachers, and the Almighty

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B.Com (Hons.) Paper No – CH 6.1: Semester – VI INTERNATIONAL BUSINESS Duration: 3 hours Maximum Marks: 100 Lectures: 75 Objective: The objective of the course is to expose students to the concept, importance and dynamics of international business and India’s involvement with global business operations. The course also discusses theoretical foundations of international business to the extent these are relevant to understand the mechanics of global business operations and development.

Unit – I

No. of Lecture Hrs.

1. Introduction to International Business: Globalization and its growing importance in world economy; impact of globalization; international business contrasted with domestic business— complexities of international business; modes of entry into international business.

6

2. International Business Environment: National and foreign environments and their components—economic, cultural and political-legal environments; global trading environment— recent trends in world trade in goods and services; trends in India’s foreign trade.

8

Unit – II 3. Theories of International Trade: An overview; commercial policy instruments—tariff and non-tariff measures; balance of payment account and its components.

7

4. International Organizations and Arrangements: WTO—Its objectives, principles, organizational structure and functioning; an overview of other organizations—UNCTAD, World Bank and IMF; commodity and other trading agreements.

8

Unit – III 5. Regional Economic Co-operation: Forms of regional groupings; integration efforts among countries in Europe, North America and Asia.

7

6. International Financial Environment: International financial system and institutions; foreign exchange markets and risk management; foreign investments—types and flows; foreign investment in Indian perspective.

9

Unit – IV 7. Organizational Structure for International Business Operations: Key issues involved in making international production, finance, marketing and human resource decisions; international business negotiations. 8. Developments and Issues in International Business: Outsourcing and its potentials for India; strategic alliances, mergers and acquisitions; role of  IT in international business; international business and ecological considerations.

7

Unit – V 9. Foreign trade promotion measures and organizations in India; Special Economic Zones (SEZs) and 100 per cent Export Oriented Units (EOUs); measures for promoting foreign investments into and from India; Indian joint ventures and acquisitions abroad. 10. Financing of foreign trade and payment terms.

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Contents

Preface xv About the Author

1. Fundamentals of International Business

Introduction  2 Elements of Globalization   3 Economic Globalization   3 Cultural Globalization  4 Political Globalization  4 International Business  5 Growth of International Business   6 Economic Forces   6 Political Forces  7 Technological Forces  7 International Versus Domestic Business   8 Motives for Firm Internationalization   9 Modes of Entry   10 Trade-related Entry Modes   10 Contractual Entry Modes  12 Investment-related Entry Modes   14 Emerging Trends in International Business   15 FDI Moves in Search of Energy   15 Pharmaceutical FDI Moves in Response to the ‘Patent Cliff’   16 Mega-regional Agreements   16 Chapter Summary  16 Key Terms  17 Discussion Questions  17

2. Political Economy of International Business

Introduction  20 Economic Environment  21 Economic Systems   21 Economic Indicators  23 Economic Growth  24 Economic Development  24 Political Environment  25 Political Ideologies and Systems   25 Political Risk  28 International Business Negotiation   29 Objectives of International Business Negotiation   30 Bargaining Power of the TNC  30 Chapter Summary  30 Key Terms  31 Discussion Questions  31

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3. The International Cultural and Legal Environment

33

4. International Trade Theories

43

5. Commercial Policy Instruments

63

Introduction  34 Elements of Culture   34 Language  35 Non-verbal Communication  36 Religion  36 Values and Attitudes  38 Customs and Manners  39 Aesthetics  39 Legal Environment  39 Global Legal Systems   40 Legal Jurisdiction  40 Ethics in International Business   41 Chapter Summary  41 Key Terms  42 Discussion Questions  42

Introduction  44 International Trade Theories   44 Mercantilist Doctrine   45 Classical Approach  45 Factor Proportions Theory  50 Leontief Paradox  51 Linder’s Income-preference Similarity Theory  51 Product Life-cycle Theory  52 The New Trade Theory  54 National Competitive Advantage  55 Theory Assessment  56 Developments in World Trade  57 Volume of Trade   58 Composition of World Trade  60 Direction of World Trade  60 Service Trade  61 Chapter Summary  61 Key Terms  62 Discussion Questions  62

Introduction  64 Government Intervention in Trade   64 Economic Rationale   64 Non-economic Rationale  65 Instruments of Trade Control   65 Tariff Barriers   66 Non-tariff Barriers  68 Analysis of India’s Foreign Trade   71 Volume of India’s Foreign Trade   71 Composition of India’s Foreign Trade  72 Direction of India’s Foreign Trade  73

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Chapter Summary  74 Key Terms  74 Discussion Questions  74

6. Multilateral Regulation of Trade

76

7. International Trade Finance and Promotion

91

Introduction  77 General Agreement on Tariffs and Trade (GATT)   77 Objectives and Principles   77 Uruguay Round  78 GATT: An Evaluation  78 World Trade Organization (WTO)   79 WTO Agreements  80 General Agreement on Tariffs and Trade (GATT)   80 General Agreement on Trade in Services (GATS)  81 Agreement on Trade-related Aspects of Intellectual Property Rights (TRIPS)  82 Agreement on Trade-related Investment Measures (TRIMS)  82 Organizational Structure of WTO   82 Principles of WTO  83 Most-Favored-Nation (MFN)   84 National Treatment  84 Functions of WTO  85 WTO: An Evaluation   85 Developing Country Issues   85 Dispute Resolution Mechanism  86 Subsidies in Agriculture  86 Future Challenges for WTO   86 United Nations Conference on Trade and Development (UNCTAD)   87 Functions Of UNCTAD   87 unctad: An assessment  88 Chapter Summary  89 Key Terms  90 Discussion Questions  90

Introduction  92 International Trade Payment  92 Cash in Advance   92 Letter of Credit (L/C)  92 Documentary Collection  94 Open Account  95 Terms of Trade  95 Free on board   95 Free alongside Ship  95 Cost, Insurance and Freight  95 Cost and freight  95 International Trade Finance  95 Private Sources   95 Governmental Sources  97 International Trade Credit  98

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 Contents Trade Promotion in India   99 Organizations for Export Promotion  100 Export Incentives   100 Marketing Assistance   101 Market Development Assistance   101 Market Access Initiative   101 Foreign Exchange   101 Trade Fairs and Exhibitions   101 Export Risk Insurance   102 Production Assistance/Facilities   102 Special Economic Zones (SEZs)   102 Export Processing Zones   102 Free Trade Zone (Ftz)   102 Export-oriented Unit (Eou)   103 Export Houses   103 Special Economic Zone   103 Chapter Summary  104 Key Terms  105 Discussion Questions  105

8. Regional Economic Integration

106

Introduction  107 Levels of Economic Integration   107 Free Trade Area (FTA)   107 Customs Union  108 Common Market  109 Economic Union  110 Political Union  110 Effects of Integration   111 Trade Creation and Trade Diversion   111 Reduced Import Prices  112 Increased Competition and Economies of Scale  112 Higher Factor Productivity  112 Regional Trading Agreements—A Global Overview   113 European Union (EU)   113 Euro  115 North American Free Trade Agreement (NAFTA)   116 NAFTA Provisions   117 Importance of NAFTA  117 CARICOM  118 MERCOSUR  118 Andean Pact  119 Association of Southeast Asian Nations (ASEAN)   119 Objectives of ASEAN   120 ASEAN Achievements  120 Asia-Pacific Economic Cooperation Forum (APEC)   120 South Asian Association for Regional Cooperation (SAARC)   121 Closer Economic Relations (CER)   122 Africa  122

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Commodity Arrangements  123 Multi Fibre Arrangement (MFA)   124 Organization of Petroleum Exporting Countries (OPEC)  126 Chapter Summary  127 Key Terms  128 Discussion Questions  128

9. International Financial System

129

10. International Financial Institutions

148

Introduction  130 Basics of Foreign Exchange   130 Exchange Rate Determination   130 Fixed and Flexible Exchange Rate Systems  131 Currency Convertibility  131 Evolution of the Monetary System   132 The Gold Standard (1876–1914)   132 The Inter-war Years and World War II (1914–44)  134 The Bretton Woods System (1944–73)  134 The Post-Bretton Woods System: 1973–Present  135 Contemporary Exchange Rate Systems   135 Fixed Exchange Rate System   135 Independent Float System  135 Currency Board Arrangement  136 Soft Pegs  136 Crawling Peg  136 Pegged Exchange Rates within Horizontal Bands  137 Floating Arrangements  137 International Financial System   138 Foreign Exchange Markets   138 Foreign Exchange Risk and Exposure   140 International Capital Market   143 International Money Markets   144 International Bond Markets  144 International Stock Markets  145 Chapter Summary  145 Key Terms  146 Discussion Questions  147

Introduction  149 International Monetary Fund (IMF)   149 Objectives of the IMF   149 Functions of the IMF  150 World Bank Group   151 Loans  152 Grants  153 Asian Development Bank   153 African Development Bank   154 African Development Fund (ADF)   154 Nigeria Trust Fund (NTF)   155

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 Contents Chapter Summary  155 Key Terms  155 Discussion Questions  155

11. International Balance of Payments

156

12. Foreign Direct Investment

166

13. International Organization Structure and Design

183

Introduction  157 Fundamentals of Balance-of-payments Accounting   157 Defining International Economic Transactions   158 The BOP as a Cash Flow Statement  158 BOP Accounting: Double-entry Book-keeping  159 Types of Balance-of-payments Accounts   159 Current Account   159 Capital and Financial Account  160 Net Errors and Omissions  161 Official Reserves Account  162 The Balance of Payments in Totality   162 Chapter Summary  164 Key Terms  164 Discussion Questions  164

Introduction  167 FDI: A Classification   167 Asset-based View   167 Nature of Business Activity   168 Motive-based View   169 Modes of FDI Entry   170 Branch Office   170 Strategic Alliances  171 Wholly Owned Subsidiary  171 Forms of Wholly Owned Subsidiaries: Greenfield Investment versus Mergers and Acquisitions  172 Umbrella Holding Company  173 Differences Between Joint Ventures and Mergers  173 Global FDI Patterns   174 Trends in FDI   174 Direction of FDI  175 FDI Outflows  175 Foreign Investment in India   176 Policy Perspective   176 Sectoral Dimensions of FDI Flows   178 Geographical Composition  178 Outward Indian FDI  179 Chapter Summary  180 Key Terms  181 Discussion Questions  181 Introduction  184 Early Organizational Structures   184 International Division Structure   186

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Global Organizational Structures   187 Global Product Structure   187 Global Area Structure  189 Global Functional Structure  191 Mixed Structure  192 Matrix Structure  193 Transnational Network Structure  196 Determinants of the Organization Structure   196 Chapter Summary  198 Key Terms  199 Discussion Questions  199

14. International Marketing

200

15. International HRM

212

16. International Operations

223

Introduction  201 International Market Assessment   201 The Marketing Mix   202 Market Segmentation   203 Product  203 Producer Goods  204 Consumer Goods  204 Determinants of Product Adaptation  204 Brand Management  205 New Product Development  206 Promotion Strategy  207 Pricing Strategy  209 Distribution  210 Chapter Summary  211 Key Terms  211 Discussion Questions  211 Introduction  213 Recruitment and Selection   214 Ethnocentric Approach   214 Polycentric Approach  214 Geocentric Approach  215 Regiocentric Approach  215 Training and Development   215 Cross-cultural Training   216 Language Training  216 Specific Skills Training  216 Compensation  217 International Labor Relations   218 International Labor Standards   219 Chapter Summary  221 Key Terms  221 Discussion Questions  222 Introduction  224 Supply-chain Management  224

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 Contents International Logistics  226 Systems Concept   227 Total Cost Concept   227 Trade-off Concept  228 Global Supply Chain Decisions   228 Quality  228 Third-party Logistics (3PL)  229 Location Decisions  229 Production Decisions  230 Purchasing Decision  230 Inventory Decisions  230 International Packaging Issues  233 International Storage Issues  234 Transportation Decisions  234 Transportation Infrastructure  238 Chapter Summary  239 Key Terms  240 Discussion Questions  240

17. International Finance and Accounting

241

18. Global E-commerce

253

Introduction  242 Accounting System  242 National and International Accounting Standards   244 The Incarnation of IFRS: How it Came into Being   245 Consolidation and Currency Translation   246 Taxation  247 Transfer Prices   247 Tax Havens  249 Tax Treaties: The Elimination of Double Taxation  249 Indian Accounting Practices   249 IFRS: A Change for the Better   249 Chapter Summary  252 Key Terms  252 Discussion Questions  252

Introduction  254 E-Commerce vs E-Business   254 Types of E-commerce   255 B2B E-commerce   255 B2C E-commerce  256 B2G E-commerce  256 C2C E-commerce   256 C2B E-commerce  257 M-Commerce  257 E-Commerce—An Evaluation  258 E-commerce Advantages   258 Disadvantages of E-commerce  259 Drivers of E-Commerce   260 Global Factors   260 Demographic Factors  261 Economic and Financial Resources  262

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Information Infrastructure  262 Industry Structure  262 Firm Size  263 Entrepreneurial Environment  263 Consumer Preferences   263 National Policy  264 Chapter Summary  264 Key Terms  265 Discussion Questions  265

19. Environmental Issues in International Business

266

20. Global Outsourcing

276

Introduction  267 Climate Change  268 Trans-boundary Pollution  269 International Legal Frameworks for Environmental Protection   270 Kyoto Protocol  271 International Emissions Trading   274 Chapter Summary  274 Key Terms  275 Discussion Questions  275

Introduction  277 Forms of Outsourcing   277 Drivers of Outsourcing   278 Theory of Comparative Advantage   278 Concentration on Core Competency  279 Developments in Technology  279 Existence of Low-cost, Skilled Manpower  279 Changes in Regulatory Environment  279 Infrastructural and Institutional Development   279 Factors Behind a Decision to Outsource   280 Technical and Institutional Separability   280 Standardization and Automation  280 Cost Minimization  280 Market Size  281 Software Industry in India   281 Large Skilled English Speaking Work Force   283 Time Advantage  283 Location Advantage  283 Developments in the it–BPO Sector   284 Growth Drivers of India’s Ites–BPO Sector  285 Abundant Talent   285 Sustained Cost Competitiveness  285 Continued Focus on Quality  286 World Class Information Security Environment  286 Rapid Growth in Key Business Infrastructure  286 Enabling Business Policy and Regulatory Environment  286 Problems and Pitfalls of the ITES–BPO Industry   286 Changing Value of the Rupee   286 Poor Infrastructure  287

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 Contents Increasing Demand for Trained Manpower  287 Employee Dissatisfaction and High Attrition Rates  287 Intensifying Competition  287 Future Threats  287 Chapter Summary  288 Key Terms  288 Discussion Questions  288 Model Question Papers

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Preface

International business emerged as an important academic discipline in the 1960s. The discovery of the transnational corporation led to a plethora of new issues in academic learning and research. The traditional TNC was a large gigantic global corporation which made its way across the globe in incremental steps of foreign commitment and risk—beginning with trade in its geographical proximity and then moving on to more advanced modes of foreign market entry. Some of the issues in international business pertained to: Why did firms run the risks of internationalizing? What were the sources of competitive advantage for TNCs over their domestic rivals? Were there distinctive patterns in the way that firms internationalized, and did these differ according to the national origins of TNCs? Such were the ‘big questions’ that launched and sustained this field of study during its first few decades. However, with the rise of postwar globalization, which accelerated during the 1980s and 1990s, things began to change. The nature of businesses and the modes of carrying on business such as increasing alliances and the contractual entry form of activity underwent radical transformation. This led to businesses acquiring a more global character. Many more firms internationalized, some staying quite small despite growing as they internationalized, giving rise to the notion of the ‘born global’ firm. This was a pattern quite different from the earlier phase where firms had to be firmly established and large in order to negotiate the perils of internationalization. Now, in the 21st century, the impact of globalization is being felt as many new kinds of international ventures are emerging, and as the possibilities for networking and expanding through partnerships as well as mergers and acquisitions are growing. The world of global business has found new growth drivers in the BRICS and the CIVETS and interesting developments as trade liberalisation is simultaneously accompanied by growing trade and economic integration. The global economy also suffered the worst economic crisis since the days of the Great Depression and continues to battle its after effects. These developments offer new opportunities, new entry points into the global economy, and new pathways for international expansion, and are doubtless involved in the reasons why so many firms have been able to accelerate their internationalization. For the subject to thrive, it is necessary that the frameworks utilized in IB studies be modified and updated in view of the recent economic and political changes. International Business is directed at undergraduate students of commerce and business and takes into account developments in the world of global business, weaving them with the principles and concepts that are at the heart of the subject. It has a strategic emphasis in that it outlines strategies, policies and tools for cross-functional problem solving. It presents a global perspective of business with a special focus on emerging economies. It focuses on businesses and its realities in both the advanced and emerging economies of the world, and reconciles business realities and academic perspectives. Using an integrated approach that goes beyond traditional thought, it helps students to correlate concepts with different dimensions of the subject. It brings the latest developments in the field of international business practices and research to the student with a practical focus to enable its easy assimilation. It intertwines the latest findings, economic developments, business realities with the subject matter to impart a clear understanding of the subject matter.

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 Preface

The textbook is divided into six units which provide current and up-to-date information on all areas of international business: ■■ Unit I provides the introduction to the basic concepts of International Business, and the globalising business environment. It also contains the link between globalisation and evolution of the international business enterprise. It explores different facets of the international business environment—economic, cultural, social and political. This aims to clearly bring out the differences in the multifaceted business environment and its complexities for the TNC. It also discusses the different modes of foreign entry for a TNC. ■■ Unit II deals with the basic framework of international trade. It introduces the student to broad trends in international trade, linking it up with theoretical explanations and the different types of barriers that nations and firms face in free trade. It then explores issues in multilateral regulation of trade and measures of trade promotion and trade fiancé. The section concludes with a discussion on regional economic integration. ■■ Unit III focuses on the International Monetary Environment. It begins with a discussion of the international financial system, followed by the role of international financial institutions—the IMF and the World Bank and concludes with the issues in International Balance of Payments. ■■ Unit IV explores issues in International Investment developing the concept of Foreign Direct Investment (FDI) and the different forms it can take. It then distinguishes between FDI and Foreign Portfolio Investment—FPI. The chapter concludes with a discussion of India’s FDI experience. ■■ Unit V highlights important functional areas and their complexities in the international business environment. It highlights the growing importance of the emerging markets as destinations of international business as well as the strategies adopted by TNCs from the emerging markets in their international forays such as Marico in the MENA region. ■■ Unit VI introduces readers to contemporary issues pertaining to the environment and the growth of the outsourcing industry as a driver of international business. It covers topical issues pertaining to the environment, outsourcing and e-commerce all of which have emerged as important issues in the twenty-first century that are changing the face of international business.

Features of the Book The book follows a clearly formulated methodological structure to introduce the student to the subject. It follows a comprehensive, logical, graded approach based on the concept, environment, structure and strategy of International Business. It looks at the widest possible gamut of issues in the area to give the student an idea of the broad spectrum of issues that subject covers. It incorporates leading-edge research, alongside up-to-date examples and current statistics tracking global developments in this field. It also has the broadest possible geographical coverage as it explores emerging business practices in Africa, TNCs from Latin America and the emergence of new geographies such as Vietnam, Indonesia and Turkey. To provide a well-rounded perspective in a topic, it emphasize the associated conceptual debates along with the facts. In addition, it incorporates several pedagogical features designed to arouse the interest of students and engage them in the subject.

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17 17

International Financeand Accounting

Preface   

231

xvii

The quantity and quality of information provided in a country’s accounting system depends on both INTERNATIONAL FINANCE INTERNATIONAL FINANCE the level of user sophistication and the technical competence of accountants. The organization of the accounting profession and the power and autonomy to auditors and the accountant’s role in formulating 1.  Learning Objectives AND ACCOUNTING AND ACCOUNTING regulation also influences the character of the system. Both the United Kingdom and the United States Learning objectives serve as a guideline for the learning parameters for the student. have strong accounting organizations that influence the direction and function of accountants in many countries. The government has an important role in the setting of accounting standards. It also has a dual role:

LEARNING OBJECTIVES ■ In its role as the tax authority and other agencies it compiles statistics for general use, and going through this chapter, you should be able to: ■ ItAfteralso acts as the regulator in the form of various securities and exchange commissions and ■ Explain why accounting practices and standards differ from country to country LEARNINGresponds OBJECTIVES to the perceived best interests of the public. ■ Describe attempts to harmonize accounting practices in different countries

After going this chapter, you should be able to: ■ Explain the behind consolidated accounts Thethrough major users ofrationale accounting information other than those mentioned above are investors and credi■ Describe the differences in the financial structures required because of the culture and tax ■ Explain why accounting practices and standards differ from country to country

tors. Investorsregimes may of work alone or through institutions such as investment companies, insurance compadifferent countries

and superannuation funds. ■niesDescribe harmonize accounting practices different countries ■attempts Explain theto techniques available for international accountingin management It is important to identify because a focus on different users might result in different finan■ Explain the rationale behind users, consolidated accounts information being reported. example, Germany’s users historically ■cialDescribe the differences in the fiFor nancial structures requiredmajor because of have the culture and taxbeen creditors, 2.  Opening Vignettes so regimes accounting has focused more onTAX theHAVENS balance sheet, which contains a description of the company’s of different countries In the States, however, the users arethrough investors, so accounting has focused more on Opening vignettes introduce the basic concepts in major the chapter real-life situations to stimulate ■assets. Explain theUnited techniques available for international accounting management the income statement. see the income statement of the future success of the A IInvestors FDI I D as an T indication A readers’ interest and curiosity in the chapter. T DTAT U

company, which affectsF the company’s stock and its flow of dividends. A U G Taxation has a big influence on accounting standards and Ipractices in Japan and France, but it is less I important in the United States. ICertain international factors also have weight, such as former colonial T I HAVENS influence and foreign investment.TAX For example, mostI countries that are current or former members of the British Commonwealth have accounting systems similar to the United Kingdom’s. Former French T colonies use the French model, andthrough so forth. Almost 42 per cent of Indian FDI is routed Mauritius. India has a Double Taxation Avoidance Source: I Iaccounting G FDI T R These differences in just influence havecountries, resulted in differences in accounting Treaty (DTAT) with Mauritius, as it has with 65 other including the United States of standards and 1 1 I FDI O 1 practices. As weFrance saw inand theGermany, opening case, existing isdifferences andinvestment convergence towards America, UK, Japan, but Mauritius the preferred route as thea unified standard can complicate for TNCs, because need to prepare and understand companies registered therethings can choose to pay taxes they in the island nation. Investors routingreports their which have investments through Mauritius into not pay capital gains tax either principles in India or Mauritius been generated according toIndia localdo generally accepted accounting (GAAP) as andit to ensure that is an offshore nancial centre no provision capital gains tax. The double taxation avoidance they are ficonsistent withwith the GAAP in theofhome country. ge of business. Accounting is a service activity India whoseand function is to treaty between to have encouraged Indian firmsstandards to ‘roundrecognized trip’ invest- by the profesEach mayMauritius have its seems own GAAP, which are the accounting 3.  Bird’s-eye View Boxcountry throughentities, Mauritiusintended and othertotax haven countries to take advantage of the tax benefits enjoyed imarily financial in nature, aboutment economic be sion as being required in the preparation of financial statements by external users. Bird’s-eye is a new feature all chapters which provides a synoptic view of the chapter contents by overseas investors. Thein money parked in tax havens has therefore been a bone of contention for s and in making reasoned choicesview among alternative courses of action. Accounting finds expression in up profit and loss statements, balance sheets, investment analysis the government, with the opposition raking the issue of black money time and again. at strategic points to facilitate both the teacher and the student. ocess to identify, record and interpret and economic events to bethe ablemeans to by which mantax analysis. It is nal accounting is concerned withSource: accounting and from taxation Information ‘India issues Gets 43for per cent Through Route’, livemint.com, available at http:// agers make different decisions on FDI behalf of Mauritius the 4.  Marginalia Box www.livemint.com/2009/ 04/19143056/India-gets-43-FDI-through-Mau.html, last accessed 3rd October 2013. with diverse operating environments, standards and practices. firm. International accounting involves accountMarginalia capture andforconcepts presented ing key and definitions taxation issues companies that have Bird’s-eye View for easy reference. internationalized their economic activities across countries in which accounting standards and International accounting systems arise out of 240 practices International Business ules, procedures vary. International accounting extends diverse national environment, and therefore eeds of its users. general-purpose, nationally The accounting system is a set of rules, proce- oriented accounting need to be harmonised for practice and applidures and practices geared to fulfil the needs of to identify, meaits broadest sense toforinternational comparative Thein biggest challenge members charged cation. This needs reconciling national differitsM17_9789332526389_C17.indd users. The aimanalysis; of an241accounting is to accounting measureinformation to it will alsosystem includes Bird’s-eye View 9/26/2014 2:12:25 PM with governance be to manage stakeholder ences according to international priorities and identify, measure and communicate economic ment and reporting issues unique to the TNC, cisions by users expectations in terms of meeting targets and key dealing with issues of foreign currency transinformation to allow informed judgements and harmonization of accounting practices onal Accounting accounting are tax being changed performance indicators, declaring dividends and andIndian lation, transferpractices pricing and treaties. decisions by usersand of this information. principles across nations. predecessor, the according to international standards and this explaining variations and volatility in earnings on a rds Committee, 5.  Summary system practices through the move to the quarterly basis. This is a challenging task even now, f leading nations of the world, but identify thearrival following key users ofchallenge is set International Financial Reporting Standards with the of the IFRS, the Summary captures the main points of each chapter System (IFRS). to assume a different dimension. for a quick recapitulation. India implemented the IFRS in 2011.

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C H A P T E R

S U M M A R Y

■ The accounting system is a set of rules, procedures and practices geared to fulfil the needs of its users. The aim of an accounting system is to identify, measure and communicate economic information to allow informed judgements and decisions by users of this information. ■ The origins of differences in accounting systems are essentially based in history, politics, the s arise out of differences in national environment. The national level of development of ecothe country and its economic ties with other countries. National difof inflation, economic and industrial structure, and the nature ferences have resulted of in the a general lack of comparability in financial reporting, and the trend aring on the accounting system. High levels of inflation, for instance, towards transnational financing and investment has exacerbated the problem. orical costing in an enterprise but seem be of no importance in coun■ toThe most significant move towards the harmonization of accounting standards has come from the conomic structure affects how accounting issues of pensions, retained International Accounting Standards Board (IASB), but this body has yet to achieve the desired A01_INTE1689_FM.indd 17 11/20/2014 R&D costs amortization are handled. Thus, while pension accounting

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International Accounting Standards Board (IASB), but this body has yet to achieve the desired

■ The accounting system is a set of rules, procedures and practices geared to fulfil the needs of result of uniform standards. There is an Australian Accounting Standards Board (AASB) with a its users. The aim of an accounting system is to identify, measure and communicate economic charter similar to that of thejudgements IASB. and decisions by users of this information. information to allow informed Theorigins financial interdependence of unitssystems of the are TNC is recognized consolidated financial state■■ The of differences in accounting essentially based in in history, politics, the ments give bothof the andeconomic investorsties a realistic of theNational financialdifstate of the level of that development the corporation country and its with otherview countries. company. It is important to recognize only assets, revenuesand andtheexpenses generferences have resulted in a general lack ofthat comparability in liabilities, financial reporting, trend towards transnational financing and investment has exacerbated the problem. ated with third parties are shown. ■■ The most significant move towards produce the harmonization of accounting standards hascurrency come from Foreign subsidiaries normally their financial statements in the ofthe the country  International  Preface Board (IASB), body yet to achievethese the desired where they Accounting are located.Standards When the accounts ofbut thethis TNC arehasconsolidated, financial stateresult uniform standards. There an Australian mentsofhave to be translated intoisthe currency Accounting of the homeStandards country.Board (AASB) with a charter similar to that of the IASB. ■ Accounting in India is largely governed by the views of the Institute of Chartered Accountants ■ TheTerms financial interdependence of units of the TNC is recognized in consolidated financial state6.  Key of India which is a statutory ments that(ICAI), give both the corporation andregulatory investors a body. realistic view of the financial state of the Key■terms the important terms from Therelist areItthree key aspects that runthat through each chapter. principle downand in IFRS, namely, company. is important to recognize only each assets, liabilities, laid revenues expenses gener-substance overwith form, use of fair ated third parties arevalue, shown.and recognizing the time value or time cost of money. ■ Foreign subsidiaries normally produce their financial statements in the currency of the country where they are located. When the accounts of the TNC are consolidated, these financial stateKEY TERMS ments have to be translated into the currency of the home country. ■ Accounting in India is largely standards, governed byConsolidation, the views of the Translation, Institute of Chartered Accounting system, Accounting TransferAccountants price, Tax havens, of India line (ICAI), which is a statutory regulatory body. Triple bottom accounting. ■ There are three key aspects that run through each principle laid down in IFRS, namely, substance over form, use of fair value, and recognizing the time value or time cost of money.

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DISCUSSION QUESTIONS 7.  Discussion Questions KEY TERMS Discussion questions on the for information based innational the chapter to test the understanding and 1. What are the factorsare thatbased are responsible the development of the accounting system? Accounting system, Translation, price, of Taxkey havens, 2. Describe theAccounting process of standards, evolution of the international accounting system. application of key concepts. They Consolidation, include questions on Transfer application concepts to real life situations. Triple 3. bottom What line is theaccounting. IFRS? Enumerate the factors that have led to its evolution as a global accounting standard.

DISCUSSION QUESTIONS 1. What are the factors that are responsible for the development of the national accounting system? 2. Describe the process of evolution of the international accounting system. M17_9789332526389_C17.indd 240 3. What is the IFRS? Enumerate the factors that have led to its evolution as a global accounting standard.

8.  Tables Tables use240 current data from leading M17_9789332526389_C17.indd international publications such as The World Investment Report and The World Trade Report to substantiate growth in international business. table 4.5

table 4.4

International Trade Theories 

4

Opportunity Costs of Coffee and Cotton

country

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coffee

cotton

Brazil

10/10 = 1

10/10 = 1

India

5/4 = 1.25

4/5 = 0.8

World Output with Trade Between India and Brazil

resource New to the Second Edition country

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(units)

Products

Measure (units per tonne)

Input (units)

output (tonnes)

It is a matter of great pleasure and pride to introduce the second edition of the book, Brazil 100 Coffee 10 100 based on feedback 10 Cotton 10 dynamic nature 0 of the subject, 0 the from students and colleagues. In keeping with the contemporary and second edition has been thoroughly revised and updated. This edition retains the key strengths India 100 Coffee 5 0 0of the Cotton 100 previous edition, and builds on its pedagogical features to make it a4more comprehensive tool for25learning. The following changes have been incorporated in this edition:

total output (tonnes) 10 25

To understand the benefits from trade in such a situation, we use the concept of opportunity co

■■ Thirteen new opening vignettes cost which symbolise important Xlandmarks in the fieldgoods, of inter­ The opportunity of producing a commodity is the amount of other which have to be giv national business. These include the emerging between and Japan, up in order to becases able on to produce one unitrelationship of X. A country has aIndia comparative advantage in producin a product if the opportunity cost forimportance producing itofis the lower at homeeconomy than in a foreign Bitcoin—the virtual currency, and the increasing creative in the country. Thus, t lower the opportunity cost, the higher is the comparative advantage. Table 4.4 shows the opportuni world of global business. for producing coffeeprovides and cottona in Brazil and India, on the information ■■ Bird’s-eye View iscosts a new feature which synoptic view of based the chapter contents atgiven in Figure 4. Table 4.4 shows that Brazil has a lower opportunity cost in producing coffee, while India has a low strategic points to facilitate the readers. opportunity cost in producing cotton. Thus, Brazil has a comparative advantage in the production of co ■■ Additional discussion questions have been added at the end of every chapter, for a more intenfee and India has a comparative advantage in the production of cotton. Therefore, as indicated by Tab sive preparation of the chapter contents. 4.5, if the two countries trade with each other, Brazil will export coffee and import cotton. India, on t ■■ Changing trends other in TNCs, trade and FDI have been incorporated through data updates in hand, will export cotton and import coffee. With trade, India produces 25 units of coffee and Braz Chapters 1, 4, 5 andproduces 12, respectively. 10 units of cotton, with a total output of 35 units. ■■ Model question papers haveasbeen added for an examination-oriented focus.differ between countries, open trade w As long the opportunity costs for the same commodities result in gains for each country through specialization in producing a commodity (or commodities) which a country has comparative advantage viz-à-viz its trading partner(s). The main drawbacks of the classical theory of international trade are as under:

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■ The explanation is based only on labor as a factor of production. In the real world, all other fa tors of production are equally important. ■ The theory assumes that a country has a fixed stock of resources. 11/20/2014 11:26:49 AM

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The Teaching and Learning Package The book includes several resources to facilitate the teaching and learning process. These are available on the companion site of the book—www.pearsoned.co.in/sumativarma.

Acknowledgements Without many invaluable intellectual, professional and personal contributions, this book would not have been written. Intellectually, I owe everything to my parents whose wisdom has no boundaries and who have been my staunchest pillars of strength. The original intellectual impetus for all my work came from the constant encouragement of Late Professor A.K.Seth at the Department of Commerce, Delhi School of Economics. It continues to drive me to strive for greater heights. Friends and well wishers at the Department of Commerce, Delhi School of Economics and at Sri Aurobindo College (Evening ) have likewise been sources of energy and support. I would like to place on record a special word of thanks to my students—at both Sri Aurobindo College (Evening) and the Delhi School of Economics, who have constantly provided the stimulus and ideas for all my work. A special word of thanks to Rishika Nayyar for helping in the revision for this edition. The book has been able to acquire its present form due to the intellectual inputs of the reviewers whose collective wisdom has tremendously improved the contents of the book for the readers. I would also like to thank the team at Pearson—Neeraj Bhalla, Vipin Kumar—for their timely handling of my manuscript and for helping me negotiate difficulties at every step of the way. I have a special word of appreciation for the marketing and sales team–Rohit Chopra and Farhan. Last but not the least, the book would not have been possible without the constant support of my family, especially my husband Arvind who has been a pillar of strength and my son Anirudh whose music is the inspiration for all my work and always manages to find its way into my manuscript! This book has opened several doors for me; I hope it does the same for my readers. Needless to say I look forward to comments and feedback to improve future editions of this book. Sumati Varma [email protected] https://www.facebook.com/IB.SumatiVarma

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About the Author

Sumati Varma is an associate professor at the Department of Commerce at University of Delhi and has taught both undergraduate and postgraduate classes for the past two decades. She was awarded the prestigious post doctoral International Visitor Leadership Programme (IVLP) fellowship in 2011, by the US Department of State, for her contribution to the first ever programme on American Studies for Indian Universities. She is a consultant with the World Bank and has contributed to the latest edition of its flagship publication Investing Across Borders (2012). She is also a consultant in curriculum development at the American Centre and the National Council for Educational Research and Training (NCERT), a nodal agency for curriculum development for Indian schools. Her research interests include Born Global firms, where she has done pioneering work in the Indian context. She is also interested in various facets of firm internationalization, international entrepreneurship, cross border M&As and globalization and inclusion. She has published in reputed national and international journals such as Decision (IIM Calcutta), International Journal of Emerging Markets, and International Journal of Technology Learning and Change. She has also presented in national and international conferences of repute, including the APROS (2007), Academy of International Business (AIB), India chapter (2008), EGOS (2009), Copenhagen Business School (2010), UNU Merit (Netherlands 2013) and AIB Annual Meeting at Vancouver in June 2014. She has eight books to her credit, including one on Currency Convertibility (2007) and the latest on International Business, a text book for post graduate students from Pearson International (2012) and a Delhi University specific edition (2013). She has also co-authored the global editions of the following books published by Pearson— International Business (2013); Money, Banking and Financial Markets (2014); and Making Effective Business Plans—An Entrepreneurial Approach (2014).

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1 FUNDAMENTALS OF INTERNATIONAL BUSINESS LEARNING OBJECTIVES The basic objective of this chapter is to introduce the fundamental concepts of globalization and international business. After reading this chapter, you should be able to:

■ ■ ■ ■

Understand the fundamental concepts and features of globalization Comprehend the evolution and growth of international business Distinguish between domestic and international business Analyse the different modes of entry into international business

A MINI JAPAN IN NEEMRANA Hotel Hirohama is a typical Japanese hotel with minimalist furniture, a Japanese restaurant called Kuuraku complete with a Japanese chef and imported Japanese ingredients and televisions which offer three Japanese channels. So what’s unusual in this, one may ask? It is unusual because the hotel is situated in Neemrana in Rajasthan, India’s desert state in the North. Neemrana is situated on the outskirts of Delhi and a 120 km drive along National Highway 8 suddenly brings you to a landscape that has a strong resemblance with the Land of the Rising Sun, Japan. Restaurants claim to have the best sushi and udon, while the hotels proclaim every Japanese comfort in the world, including a shot of shochu if the Rajasthan sun gets too much for you. The growth of this mini Japan is the outcome of a business pact between the Rajasthan government and the Japanese External Trade Organization (JETRO). This has led to FDI worth crores of rupees and the area boasts of 46 Japanese plants here, including Daikin, Nissin and Nippon. The spacious, well laid out factories employ Indian as well as Japanese workers. Life was tough and culturally alien for the early settlers from Japan. This led Kojiro Honda, managing director of Hirohama India Pvt. Ltd., to set up a hotel that mirrored a typical Japanese lifestyle. The Indian staff has learnt to say arigato (thank you) and ohaiyo gozaimasu (good morning). The housekeeping staff makes it a point to take off their shoes before they enter the rooms.

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Even though the Japanese are keen to find a home away from home, at the same time they also want to get acquainted with local culture and tradition. TNCs like Daikin therefore, hold an annual seminar to introduce Japanese employees to various elements of Indian culture. The greatest barrier seems to be language as the typical Japanese employee cannot speak English apart from a perfunctory ‘yes’, ‘no’ and ‘I understand’. It is interesting to note that for the Japanese back home Bollywood provides the introduction to Indian culture. Hindi films like English Vinglish, Student of the Year and Om Shanti Om have taken the Japanese audience by storm. Kalpana Narain, former director at CII, has a long history of working in Japan. She is optimistic that the acculturation at Neemrana is the beginning to a long and harmonious relationship between the two giants of the East. As India’s prime minister Narendra Modi wings his way to Japan, we hope that wishes come true!!! Sources: http://timesofindia.indiatimes.com/india/Mini-Nippon-in-Rajasthans Neemrana/articleshow/37427439. cms; http://www.livemint.com/Consumer/zIWdiFqJUw1iXdQ7xPCioI/Around-the-world-with-Bollywood.html, last accessed on 29th August 2014.

INTRODUCTION Globalization is a popular term of usage these days. Globalization is the process of increasing interIt is a common expression for a number of changes connectedness in the global economy, such that that can be observed in the global economy over the events in one part of the world have an effect on last couple of decades. It includes various processes people and societies in various other corners of which range from changes in economic systems, the globe. Globalization is the result of the phecultural homogeneity or sameness and worldwide nomenon of convergence, which is the tendency for the tastes and preferences of people in difchanges in the political system. ferent countries to become similar, leading to a Globalization is the process of increasing intersameness or homogeneity. connectedness in the global economy, such that events in one part of the world have an effect on people and societies in various other corners of the globe. However, globalization is not a single, allencompassing process sweeping the globe. It may be described as a series of processes which results in products, people, companies, money and information being able to move freely to different parts of the world regardless of national geographical boundaries. Globalization is the result of the phenomenon of convergence, which is the tendency for the tastes and preferences of people in different countries to become similar, leading to a sameness or ­homogeneity. Convergence is encouraged by increasing global linkages, that is, networks of individuals, institutions and countries which are tied together in terms of trade, financial markets, technology and living standards. Globalization is therefore a shorthand expression for a variety of processes encompassing worldwide integration of financial systems, trade liberalization, deregulation and market opening, and increasing cultural, economic and social homogeneity or sameness. There are two viewpoints which explain the current phenomenon of globalization: 1. The Hyperglobalists consider globalization to be characterized by the declining powers of the nation state and increasing power of the TNC. They emphasize the decline of national cultures and hail the emergence of a global cosmopolitan corporate culture as the basic defining feature of globalization.

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2. The Transformationalists consider globalization to be characterized by a set of uneven processes and shifting patterns of change in the functions and powers of companies and governments. It considers globalization to be a changing global order which is characterized by deepening integration and fragmentation through the emergence of other important forces, such as regionalism. This view of globalization accepts the accelerated impact of economic globalization, at the same time recognizing local differences, with deep social and cultural roots, leading to underlying tensions in the global business environment. As the transformational view takes note of the underlying complexity of the globalization processes, it is widely recognized as a more valid approach than the hyperglobalization school of thought. The process of globalization is not a new phenomenon, but the current phase of globalization is different from earlier episodes in terms of its scope and the degree of interdependence between different participants—individuals, organizations and countries. The increased intensity of the globalization process is the result of advances in international trade and investment as well as developments in technology, transport and electronic commerce. Developments in communication and transportation technologies have moved the world towards becoming a ‘global village’ of interdependent people. Goods and services, as well as people, travel between continents and this has led to an economic system that moves across national boundaries and markets. National markets and their associated economic systems are no longer isolated from one another by distance, time or culture: they have merged into one huge global market. Global linkages result in people in many countries wearing jeans, drinking cola and eating pizza and hamburgers. In a nutshell, globalization refers to the emergence of a single, global business civilization: A remarkable event, which has both positive and negative aspects. For instance, changes in FDI rules in India are opening the doors for the global retail industry. This will give the Indian consumer the choice of a number of global products, but there is a growing fear that this will lead to unemployment of a large number of small indigenous retailers.

ELEMENTS OF GLOBALIZATION Globalization, as discussed earlier, does not have a single unified form. It comprises interconnected, interdisciplinary and diverse elements, which we discuss in this section.

Economic Globalization Economic globalization is characterized by the emergence of increased global flows of international trade and investment. Its main agents are companies, investors, banks, financial institutions, privatesector industries, nation states and international institutions. Economic globalization has led to the growth and development of international business through the creation of globalized business corporations. These global business corporations are known by various names, such as a multinational enterprise (MNE), or multinational corporation (MNC) and the trans­ national corporation (TNC) and are the face of international business. The simplest description of the TNC is that it is a business enterprise which has business activities beyond its national boundaries through the ownership or control of production or service facilities.

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Elements of globalization

Economic globalization

Political globalization

Cultural globalization

Figure 1.1  Elements of Globalization

Cultural Globalization Cultural globalization is a process of cultural homogeneity or having similar tastes, all over the global economy. The globalization of culture, visible in the form of a common preference for things such as McDonald’s burgers, Nike shoes, iPods and BlackBerrys, is a symbol of global similarity of taste. This may be seen in the form of a common global preference for products such as McDonald’s burgers, Nike shoes and iPods. The phenomenon of cultural globalization consists of issues of cultural homogenization versus cultural hybridization. Cultural homogenization is the outcome of the impact of ideas and images that are able to travel globally due to the developments in telecommunication and the Internet. Cultural hybridization is the adaptation of global products and ideas according to local tastes and preferences. Cultural globalization therefore, is actually a process of glocalization, or the ­amalgamation of the global with the local. It assigns a local flavor to global products such as the vegetarian McDonald’s burger, cell phones with vernacular keys, and cartoon characters Tom and Jerry speaking Hindi so that they can fit better in the receiving culture.

Political Globalization Political globalization refers to processes of changes in the rules and structures of global governance. The global economy has seen several changes in political structure and ideology after the end of the two world wars. These include the rise and fall of socialism, the emergence of global and regional institutions of governance such as the International Monetary Fund (IMF), World Bank and the World Trade Organization (WTO). There has also been a move towards both trade and investment liberalization and the emergence of regional trading blocs such as the European Union and NAFTA, all of which you will read about in greater detail in later chapters.

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There are three elements of globalization—economic, political and cultural.

Bird’s-eye View Globalization is the process of increasing interconnectedness of the global economy as a result of convergence of tastes and preferences. Globalization consists of diverse, interconnected and interdisciplinary elements which may be economic, political and cultural in nature.

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INTERNATIONAL BUSINESS International business refers to any business activInternational business refers to any business ity which involves the transfer of resources, goods, activity which involves the transfer of resources, services, knowledge, skills or information across goods, services, knowledge, skills or informanational boundaries. These activities may pertain to tion across national boundaries. These activithe production of physical goods or to the provision ties may pertain to the production of physical of services such as banking, finance, insurance, edugoods or to the provision of services such as banking, finance, insurance, education, concation, construction, etc. The activities that comprise struction, etc. international business are referred to as international transactions and take the form of international trade, international investment, and joint ventures and strategic alliances. International trade is the process of buying and selling of goods and services between nations also known as export and import. International investment is the process of investing resources in business activities outside the home country. Joint ventures and strategic alliances are contractual business arrangements between firms in different countries. The main players in international business are individuals (through tourism or investment in shares and debentures), global business corporations—TNCs, as well as global financial institutions (IMF, World Bank and central banks of different countries) and governments. TNCs, however are the most significant players in international business. The earliest TNCs originated in the developed regions of the world and were characterized by multiple operations at multiple sites in the global economy. These business organizations were gigantic corporations employing thousands of people and earning billions of dollars in revenue across the world. The TNCs of the present day however are found all over the globe and belong to both developed and developing nations. They have used various modes of entry into global markets and span the spectrum across industries as well. The world’s largest non financial TNCs ranked according to assets are General Electric (USA), Royal Dutch Shell plc (UK), Toyota Motor Corporation (Japan), Exxon Mobil Corporation (USA) and Total SA (France). The world’s largest non financial TNCs ranked according to assets from the developing and transition economies are Hutchison Whampoa (Hong Kong-China), CITIC Group (China), Hon Hai Precision Industries (Taiwan), Petronas (Malaysia) and Vale SA (Brazil).1 The term TNC can be defined in several different ways—an easy workable definition is that it is a The term TNC refers to a business enterprise with trade or investment operations in multiple business enterprise with trade or investment operaglobal locations. tions in multiple global locations. A typical TNC has the following characteristics: ■■ It has the ability to coordinate and control various stages of individual production chains within and between different countries. ■■ It has the ability to take advantage of geographical differences in the distribution of factors of production (natural resources, capital, and labor) and state policies (taxes, trade barriers, and subsidies). ■■ It also has the geographical flexibility to be able to switch and re-switch resources and operations between locations at an international level. 1

http://unctad.org/en/pages/DIAE/World%20Investment%20Report/Annex-Tables.aspx, last accessed 7th July 2014.

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The transnationality index (TNI) is a measure of The transnationality index (TNI) is a measure of the degree of interationalization of a business enterthe degree of internationalization of a business prise. The Index has been compiled by the UNCTAD enterprise. since 1990 and is composed of the average of three ratios—foreign assets/total assets; foreign sales/total sales; and foreign employment/total employment. The overall transnationality of the world’s top 100 TNCs grew from 51 per cent in 1990 to 55 per cent in 1997, but fell to 52.6 per cent in 2001. The degree of internationalization of the world’s largest TNCs remained unchanged in 2012–13 as domestic production was in excess of foreign production. The analysis of TNI by industry shows that the majority of large TNCs belong to the manufacturing sector, there is an increased presence of companies in the services sector; from 14 in 1991 to 24 in 1998 to 26 in 2007. Many of these operate in telecommunications and utilities. There are no companies from the agricultural sector, although nine companies in the top 100 belong to the food, beverages, and tobacco industry.

GROWTH OF INTERNATIONAL BUSINESS The following factors have acted as drivers of international business.

Economic Forces Economic Systems The world economy has seen a massive economic change since the end of World War II. The most significant development has been the rise and fall of socialism. Post World War II saw the emergence of USSR and its allies as supporters of socialism as opposed to the capitalist strength of the USA and other European countries. The 1980s saw the followers of socialism move towards free market principles, and led to the creation of 15 independent countries out of the Soviet Union, Czechoslovakia got divided into two nation states and Yugoslavia was divided into five successor states after a fierce civil war. Economic Liberalization in Developing Nations Large parts of the developing world also made a move to a market-based system. This includes countries such as Brazil, China and India. China has a hybrid system since it follows socialist principles, combined with a market orientation since 1978, creating huge opportunities for trade and investment flows. India followed a similar path towards market oriented reform and had since opened up its economy to global flows of capital. The Latin American nations, many of which were under totalitarian rule since the end of World War II, have taken to both democracy and market-oriented reforms since the 1980s. Characterized by cycles of low growth, high debt and high inflation, all of which discouraged investment, these economies have now shown a fairly remarkable turnaround as a result of market-oriented reform packages. Today the BRICS (Brazil, Russia, India, China and South Africa) are among the largest markets in the world. Globalization of Supply Chains It refers to the sourcing of goods and services from different parts of the world as a result of increased mobility of factors of production in order to take advantage of differences in cost and quality. Traditionally, firms in the manufacturing sector have outsourced business operations to reap the benefits of better quality and lower costs. Improvements in modern communication technology, especially the Internet, have now

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enabled the outsourcing of non-core business functions to low-cost destinations of the world. These outsourced functions range from simple back-office functions such as payroll accounting and customer call centres to specialized functions such as legal document processing and medical and hospital functions. Globalization of Demand It is the result of increasing interconnectedness among distinct national markets to form an integrated global structure. Facilitated by trade and invest­ment liberalization, the growing demand for global brands such as McDonald’s, Nike, Coca-Cola, and Apple iPod is a sign of growing global markets and has acted as a driver of international business. International business has grown due to increasing demand for global brands. Emergence of Regional Trading Blocs Trade volumes have increased as a result of a progressive reduction of tariff and on tariff barriers to trade and an increasing trend towards regional unification. The rise of preferential trading arrangements such as the European Union (EU) and the North American Free Trade Arrangement (NAFTA) have helped to create huge markets with increased opportunities for trade and investment.

Political Forces The global political system has also seen major changes since World War II. This includes the rise and fall of socialism in Eastern Europe and parts of Africa beginning in the 1980s. The global financial crisis of 2008 however, has reinforced the role of the state even in purely capitalist economies. There are several hybrid models as well such as China which has a unique model of market socialism, since it opened up its economy to free market forces in 1978, but is guided by the state in its trade and i­ nvestment decisions.

Technological Forces The growth of international business has been significantly driven by advances in communication, information technology and transportation technology through an increased flow of ideas and information across borders. Thus, we find that telecommunications has created a global audience and transport has created a global village. The technological revolution is driven by the following factors. Discovery of the Microchip The microchip is the most important innovation of the twentieth century, enabling an information revolution in the global economy. It has been the basis of the development of satellites, optical fibre and wireless technologies helping to create a global marketplace with the help of the Internet and the World Wide Web. The Internet, cable and satellite TV connects a plethora of small business firms across the globe by giving them access to information on all aspects of business. For instance, global communication networks help manufacturing processes to be co-ordinated at different physical locations worldwide and also for the same advertising message to reach consumers in different countries. Developments in Transportation There have been several major innovations in transportation technology since World War II. The most important of these are the development of commercial jets and super-freighters and the introduction of containerization. The advent of commercial jet travel has effectively shrunk the globe by cutting down

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considerably on travel time. There has also been an increase in the share of cargo travelling by air as a result of improvements in air travel. Widespread containerization in the 1970s and 1980s has resulted in a four-fold growth of the world’s container fleet, reflecting growth in international trade as a result of the use of improvement in the modes of transporting goods across the world. The use of containerised transport has helped to reduce time, labor and cost in moving goods from one part of the world to another. The modern container industry was born as a result of a war surplus oil tanker moving from New Jersey to Houston with aluminium containers welded to its steel frame and has been a major driver of international business. Emergence of Global Governance The growth of international business activities led to the need for global institutions to manage and regulate the global marketplace and led to various multinational treaties in trade and investment. These organizations include the WTO (and GATT, its predecessor) in the area of international trade and the World Bank and the IMF in the area of international finance and the global monetary system. The United Nations, along with its associated institutions, is committed to preserving world peace through inter­ national cooperation and collective security.

INTERNATIONAL VERSUS DOMESTIC BUSINESS International business usually follows domestic busiThe major differences between domestic and ness—traditionally a business firm establishes itself international business arise on account of busiin the domestic market before exploring foreign ness environments, increased risk and uncermarkets. Large international TNCs such as Toyota, tainity and operational complexities. Honda and Mitsubishi began their operations in the domestic market and subsequently expanded their footprints into the international market. The Indian pharmaceutical firm Ranbaxy also started operations ­domestically before making its first foray in the international market as an exporter. Although international business is often an extension of domestic business, there are significant differences between the two. Diverse Business Environments: International business operates in a diverse business environment as it is located in different countries. The business environment of an international business firm has different economic, cultural and politico-legal facets. Countries differ with regard to their currency, inflation and interest rates, economic regulations, political systems, social customs, laws, and government rules and regulations. This gives rise to complexities for business firms, which have to learn to operate in varying situations and adapt to them. The fast-food major McDonald’s, which has a presence in almost all countries of the world, adapts its menu to local taste and religious leanings. In India, it has replaced beef products with chicken, and in the Middle East, it does not serve any products containing pork. Enhanced Risk and Uncertainty: Business firms face risks on account of the unpredictability of operational and financial outcomes. Uncertainty refers to the unpredictability of environmental or organizational conditions that affect firm performance. International business firms operate in situations of increased risk since they operate in multiple work environments. International corporations work in multiple financial environments, receive payments in different currencies and have to deal with the harmonization of firm accounts from subsidiaries in different countries. Market supply and demand conditions in the domestic market differ significantly from the international market.

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Operational Complexities: Operationally, international business is often more difficult and costly to manage than activities in the domestic market alone. These difficulties manifest themselves in all functional areas of the business. For example, local employees and expatriates (employees from a foreign country) may have trouble getting along with each other because of cultural and language Bird’s-eye View differences. The cultural diversity encountered when operating in several countries may create International business is the process of conproblems of communication, coordination and ducting business across national boundarmotivation in the employees of the organization. ies through international trade, international Organizational principles and managerial philosoinvestment and international contracts and phies differ widely across nations, increasing the strategic alliances. International business has complexity of operation and management of intergrown as a result of economic, political and national business. The extent of differences varies technological factors. It differs from domesbetween firms and is determined by factors such tic business in scale, scope, complexity and as geographical proximity, cultural heterogeneity enhanced risk and uncertainty. and political compatibility.

MOTIVES FOR FIRM INTERNATIONALIZATION There are several reasons which motivate a firm to move on the internationalization path. These may be broadly classified as pull and push factors. Pull factors are offensive motives which pull a domestic business firm into foreign markets. Push factors, on the other hand, are defensive motives which force the domestic firm to react and move into the international arena. Firms are motivated to enter inter­national markets as a result of push and pull factors. Some of the reasons of firm internationalization are as follows: Increased Profits: The basic objective of a business The main motives of firm internationalization are enterprise is to maximize profits through increased increased profits, growth, competitive factors revenues and/or reduced costs. International trade and strategic factors. and investment are the means through which a ­business firm is able to benefit from differences in labor costs, availability of resources and capital, and differences in regulatory frameworks, such as ­taxation differences. The rapid growth of the outsourcing industry is an example of the ability of firms in developed parts of the world to take advantage of the low-cost skilled labor force in countries such as India, Ireland and the Philippines. Growth: A business firm is able to grow and maximize its profits through the benefits of large scale production. If the domestic market is saturated or overcrowded, an increase in the scale of operations is possible only by tapping into the demand in foreign markets. This gives the firm the benefits of new markets, reduced costs and consequently leads to profits and growth. Competition: Domestic competition also forces a firm to move to foreign markets. The need to protect its existing market position in the face of a change in the domestic environment is a challenge that forces a firm to look at an overseas market. On the other hand, changes in an international market provide a firm with an opportunity to tap a new market. For instance, the liberalization of the Indian economy since 1991 has provided an opportunity to foreign firms to explore Indian markets, and increased domestic competition has also forced domestic Indian firms to look overseas.

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Strategic Motives: A firm’s decision to internationalize is based on its own capabilities which give it an edge over its rivals and help it to secure a ‘first mover advantage’ in a foreign market. As a result, a firm is able to enjoy the advantages of technological leadership, brand image and competitive positioning.

MODES OF ENTRY A business firm has to make several important decisions when entering a foreign market. International entry strategies concern where (location selection), when (timing of entry), and how (entry mode selection) international companies should enter and invest in a foreign territory during international expansion. These entry strategies are important because they determine an MNE’s investment environment, operation treatment, resource commitment, and evolutionary path. Entry mode refers to the nature of international transaction chosen by a business firm to enter a foreign market. The choice of entry mode for a business depends on the degree of foreign market involvement that it wants to have. Entry mode choices fall into three categories—trade-related, transfer-related, and investmentrelated. There is an increasing level of resource commitment, organizational control, involved risks, and expected returns in this sequence.

Trade-related Entry Modes Trade-related entry modes include exports and imports and countertrade. Exports and Imports Export is the most basic level of entry in international Export is the most basic level of entry in interbusiness in which the firm has domestic production national business in which the firm has domesfacilities and sells its products abroad. Firms may tic production facilities and sells its products export or import either goods or services. Goods are abroad. tangible products which can be seen, hence goods coming into the country are termed visible imports and goods leaving the country are termed visible exports. The difference between the exports and imports is termed trade balance or balance of visible items. Service exports and imports include banking, insurance, travel and tourism related services, which are intangible and personalized. Countries such as Greece and Norway earn a significant amount of

Modes of entry

Trade related

Contractual entry

Investment related

Figure 1.2  Modes of Entry

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foreign exchange from foreign cargo carried on ships owned by citizens of these countries. Similarly tourism is a major foreign exchange earner for countries like the Bahamas and Mauritius. A firm can either export goods directly or through export intermediaries. Export intermediaries are third parties that specialize in facilitating imports and exports. These intermediaries may offer limited services such as handling only transportation, documentation, and customs claims, or they may perform more extensive services, including taking ownership of foreign-bound goods and/or assuming total responsibility for marketing and financing exports. This helps small firms which may not be very knowledgeable about the legal, financial, and logistical details of exporting and importing. Exports as a mode of entry have the following advantages: ■■ Exporting helps the firm to gain first hand knowledge and expertise about the foreign market. ■■ It requires less financial and managerial resources than other advanced modes of entry. ■■ Generally, exporting is a type of international entry open to virtually any size or kind of firm, since it requires fewer resources. Countertrade Countertrade is a form of trade in which a seller and a buyer from different countries exchange goods with little or no cash or cash equivalents, changing hands. Because of this nature, it is also viewed as a form of flexible financing or payment in international trade. Countertrade includes four distinct types of trading arrangements.

Countertrade is a form of trade in which a seller and a buyer from different countries exchange goods with little or no cash or cash equivalents, changing hands. The different forms of countertrade include barter, offset, buyback and counterpurchase.

■■ Barter is the direct and simultaneous exchange of goods between two parties without a cash transaction. Barter trade occurs between individuals, between governments, between firms, or between a government and a firm, all from two different countries. For example, France shipped 138,067 tons of soft wheat to Cuba during the first quarter of 2001, half of which was through the wheat-for-sugar barter arrangement under which French trading companies purchased sugar and agricultural commodities from Cuba’s government-run food trading company. Barter is risky because firms have to be sure that they are exchanging products which have a domestic market to enable them earn a profit. ■■ A counter purchase is a reciprocal buying agreement in which a firm sells its products to another at one point in time and is compensated in the form of the other’s products at some future time (e.g., Russia purchased construction machinery from Japan’s Komatsu in return for Komatsu’s agreement to buy Siberian timber). Counter purchase is more flexible than barter because the volume of trade does not have to be equal. ■■ An offset is an agreement whereby one party agrees to purchase goods and services with a specified percentage of its proceeds from an original sale. For example, the Shanghai aircraft Manufacturing Corp., China, may buy jets from Boeing using its proceeds from manufacturing the tail sections of the jets for Boeing. Offset is particularly popular in sales of expensive military equipment or high cost civilian infrastructure hardware. Switzerland’s Pilatus Aircraft Ltd. has an offset agreement with the Indian Air Force resulting from the sale of the PC-7 MkII Training Aircraft System. As part of India’s defence procurement policy (DPP) 2005, countertrade obligations were imposed on foreign firms that were awarded defence contracts worth more than INR 300 crore for the transfer of critical technologies and production of components.

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At the end of March 2013, India had 23 offset contracts worth USD 4.6 billion were at various stages of execution. The first of these contracts was signed in 2007. ■■ Buyback (or compensation arrangement) occurs when a firm provides a local company with inputs for manufacturing products (mostly capital equipment) to be sold in international markets, and agrees to take a certain percentage of the output produced by the local firm as partial payment. For example, a steel producer might send its goods to a foreign company, which would use the steel to manufacture a product such as shelving. The steel producer would then buy back the shelves at a reduced price, in effect partially paying the manufacturer with the raw steel. Buybacks helps developing country producers to upgrade technologies and machinery and ensure after sale service. Chinatex, a Shanghai-based clothing manufacturer, and Japan’s Fukusuke Corporation, arranged a buyback, whereby the latter sold 10 knitting machines and raw materials to the former in exchange for 1 million pairs of underwear to be produced on the knitting machines.

Contractual Entry Modes Contractual or transfer-related entry modes are those associated with transfer of ownership or utilization of specified property (technology or assets) from one party to the other in exchange for royalty fees. They differ from trade-related entry modes in that the user in a transfer-related mode ‘buys’ certain rights of transacted property (e.g., use of technology) from the other party (owner). These modes are extensively employed in technology-related or intellectual/industrial property rights related transactions. This category includes the following entry modes: International Leasing International leasing is an entry mode in which International leasing is an entry mode in which a foreign firm (lessor) leases out its new or used a foreign firm (lessor) leases out its new or used machines or equipment to the local company (often machines or equipment to the local company in a developing country). International lease arises (often in a developing country) in return for a fee. largely because developing country manufacturers (lessee) do not have financial capability to buy the equipment. In this mode, the foreign lessor retains ownership of the property throughout the lease period during which the local user pays a leasing fee. The major advantages of this mode for TNCs include quick access to the target market, efficient use of superfluous or outmoded, machinery and equipment, and accumulating experience in a foreign country. From the local firm’s perspective, this mode helps reduce the cost of using foreign machinery and equipment, reduces operational and investment risks, and increases its knowledge and experience with foreign technologies and facilities. For example, in the late 1970s, Japan’s Mitsubishi leased 100 new and used heavy trucks to Chinese companies in such industries as conduction, mining, and transportation. International Licensing International licensing is an entry mode in which a firm transfers its intangible property such as expertise, know-how, blueprints, technology and manufacturing design to its own unit or to another firm for a specified period of time in exchange for a royalty fee. The firm transferring the technology is known as the licensor and the firm to whom transfer is being

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International licensing is an entry mode in which a firm transfers its intangible property such as expertise, know-how, blueprints, technology and manufacturing design to its own unit or to another firm for a specified period of time in exchange for a royalty fee.

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made is known as the licensee. Licensing allows the licensee to produce and market a product similar to the one the licensor has already been producing in its home country without requiring the licensor to actually create a new operation abroad. Advantages ■■ A licensor can reap the benefits of exploiting innovative technology by expansion abroad without any additional investment. ■■ It involves less risk than entry through the investment mode. Even if market conditions become very adverse the maximum that the licensor stands to lose is his technical fee. ■■ The licensee also benefits through the technical collaboration as he is able to upgrade his technical capability and improve his competitiveness in the global market. Disadvantages ■■ Loss of quality control is a major disadvantage of this entry mode. It is often difficult for the licensor to maintain satisfactory control over the licensee’s manufacturing and marketing operations. This can result in damage to a licensor’s trademark and reputation. ■■ A licensee overseas can also become a competitor to the licensor. If the original licensing agreement does not specify the region within which the licensee may market the licensed product, the licensee may insist on marketing the product in third-country markets in competition with, the licensor. For example, in the 1960s, RCA licenced its leading edge color television technology to a number of Japanese companies including Matsushita and Sony. Matsushita and Sony quickly assimilated RCA’s technology and used it to enter the US market and to compete directly against it. As a result RCA is now a minor player in its home market, while Matsushita and Sony have a much bigger market share. ■■ Further, a local licensee may benefit from improvements in its technology, which it then uses to enter the MNE’s home market. International Franchising International franchising is an entry mode in which International franchising is an entry mode in the foreign franchisor grants specified intangible which the foreign franchisor grants specified property rights (e.g., trademark or brand name) to the intangible property rights (e.g., trademark or local franchisee, who must follow strict and detailed brand name) to the local franchisee, in return for rules as to how it does business. In exchange for the a royalty fee. franchise, the franchisor receives a royalty payment that amounts to a percentage of the franchisee’s revenues. Compared to licensing, franchising involves longer commitments, offers greater control over overseas operations, and includes a broader package of rights and resources, which is why service TNCs such as KFC often elect franchising (whereas manufacturing firms often use licensing). Production equipment, managerial systems, ­operating procedures, access to advertising and promotional materials, loans, and financing may all be part of a franchise. The franchisee operates the business under the franchisor’s proprietary rights and is contractually obligated to follow the procedures and methods of operation prescribed in the business system. The franchisor generally maintains the right to control the quality of products and services so that the franchisee cannot damage the company’s image. Sometimes the franchisor insists that the franchisee must buy equipment or key ingredients used in the product from the franchisor only. For example, Burger King and McDonald’s require the franchisee to buy the company’s cooking equipment, burger patties, and other products that bear the company name.

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Advantages of Franchising ■■ Franchising allows the franchiser to maintain consistency of its products in different markets. ■■ It is a low risk and low cost mode of entry which ensures a quick global presence for the firm. ■■ It provides a fast and easy avenue for leveraging assets such as a trademark or brand names for a global presence. For example, McDonald’s has been able to build a global presence quickly and at relatively low cost and risk by using franchises. Disadvantages of Franchising ■■ The franchisee may harm the franchiser’s image by not upholding its standards. ■■ Even if the franchiser is able to terminate the agreement, some franchisees still stay in business by slightly altering the franchiser’s brand name or trademark. Differences Between Licensing and Franchising ■■ Franchising refers to a transfer of the total business function whereas licensing is a transfer of just a part of the business, including transfer of right to manufacture or distribute a single product or process. ■■ Franchising gives the company greater control over the sale of the product in the target market, since the franchiser has the right to revoke the franchise if the franchisee fails to abide with the stipulated rules and procedures. ■■ Licensing is common in manufacturing industries, whereas franchising is more common in service industries where the brand name is more important. Turnkey Projects Turnkey projects also called build-operate-transfer Turnkey projects also called build-operate-­ (BOT) is an investment in which a foreign investor transfer (BOT) is an investment in which a forassumes responsibility for the design and construceign investor assumes responsibility for the tion of an entire operation, and, upon completion of design and construction of an entire operation, the project, turns the project over to the purchaser and, upon completion of the project, turns the and hands over management to local personnel project over to the purchaser whom it has trained. In return for completing the project, the investor receives periodic payments that are normally guaranteed. BOT is especially useful for very large-scale, long-term infrastructure projects such as power-generation, airports, dams, expressways, chemical plants, and steel mills. Managing such complex projects requires special expertise. Turnkey projects are mostly administered by large construction firms such as Bechtel (the United States), Hyundai (Korea), or Friedrich Krupp (Germany). Large companies sometimes form a consortium and bid jointly for a large BOT project.

Investment-related Entry Modes In contrast to the preceding trade-related and transfer-related entry modes, investment-related entry modes involve ownership of property, assets, projects, and businesses invested in a host country. Foreign investment takes two forms—foreign direct investment (FDI) and foreign portfolio investment (FPI). Foreign Direct Investment (FDI) It refers to investment in the assets of a company for the purpose of control of overseas operations and economic activities. FDI-related entry modes involve higher risk and greater financial commitment

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than both trade and transfer-related choices. The country making the FDI investment is called the home country and the country receiving FDI is called the host country. Foreign Portfolio Investment It is investment in financial instruments such as stocks and bonds through the stock exchange and other financial markets only to earn a return on the investment. FPI is based on basic portfolio theory according to which individuals or firms invest in large amounts of financial assets in search of the highest possible risk-adjusted net return. The key task of portfolio management is to reduce the variability (or risk) of a group of stocks so that the variability of the whole is less than that of its parts. If it is possible to identify some stocks whose yields will increase when the yields of others decrease, then, by including both types of securities in the portfolio, the portfolio’s overall variability will be reduced. This is why some people interpret this theory as ‘putting eggs in different baskets rather than one basket.’ This logic also applies to the establishment of a conglomerate corporation that diversifies into many product lines rather than specializing in a single one. Differences Between FDI and FPI ■■ FDI investment is done to gain controlling interest or ownership in a foreign company, whereas FPI as a mode of investment is only targeted at earning returns from the investment. ■■ FDI is considered a more stable form of investment as it involves a long term commitment in terms of funds. FPI is more volatile and can exit easily since it is done through investment in the financial markets. FDI brings with it the spill over effects of technology and managerial expertise leading to a more competitive environment and increased consumer welfare. FPI on the other hand helps to increase both the width and depth of host country financial markets and thereby contributes to financial development.

Investment-related entry modes involve ownership of property, assets, projects, and businesses invested in a host country. Foreign investment takes two forms—foreign direct investment (FDI) and foreign portfolio investment (FPI).

Bird’s-eye View There are various modes of entry into international business involving varying degrees of foreign market involvement and associated risk. Traditionally firms have followed a step-by-step approach to enter foreign markets, beginning with exports and gradually moving into contractual forms of entry followed by investment. In recent years, many emerging market firms have skipped some stages of entry and used a higher entry mode to access foreign markets.

EMERGING TRENDS IN INTERNATIONAL BUSINESS This section tracks some important developments in international business.

FDI Moves in Search of Energy FDI, in recent years, has been driven by energy concerns and the need to supplement existing sources. The shale gas revolution is driving FDI in USA. The majority of cross-border mergers and acquisitions in USA were deals from the oil and gas industry in 2013. US based firms with necessary expertise in the exploration and development of shale gas are also becoming acquisition targets or industrial partners of energy firms based in other countries rich in shale resources.

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The search for cheap natural gas is also a driver of FDI and finds TNCs like Chevron Phillips Chemical, Dow Chemical and ExxonMobil Chemical looking towards the United States as greenfield investors. Investing firms include petrochemical enterprises from the Gulf Cooperation Council (GCC) such as NOVA Chemicals (United Arab Emirates) and Sabic (Saudi Arabia).

Pharmaceutical FDI Moves in Response to the ‘Patent Cliff’ Pharmaceutical TNCs have used M&As as their vehicle to access new revenue streams and low-cost production bases in emerging markets. The search for low-cost generic drugs has also targeted acquisitions of successful research firms and start-ups. There have been divesting non-core business segments and outsourcing R&D activities in recent years, while engaging in M&A activity to secure new revenue streams and low-cost production bases.

Mega-regional Agreements Mega-regional agreements are broad economic agreements among a group of countries that have a significant combined economic weight and in which investment is one of the key subject areas covered. There are three mega-regional integration initiatives currently under negotiation—TTIP, TPP and RCEP. These agreements have the potential to either consolidate the existing treaty landscape or they could create further inconsistencies due to an overlap with existing investment treaties. The Transatlantic Trade and Investment Partnership (TTIP) is a proposed agreement between the United States and the European Union. This group had a fall in its combined share of global FDI inflows nearly in half, from 56 per cent in the pre-crisis period to 30 per cent in 2013. The Trans-Pacific Partnership (TPP) is being negotiated between 12 countries in the Asia-Pacific region. It had a share of 32 per cent in the total global FDI flows in 2013. The declining share of the United States in this group was offset by the expansion of emerging economies in the grouping, helping the aggregate share increase from 24 per cent before 2008 to 32 per cent in 2013. Regional Comprehensive Economic Partnership (RCEP), which is being negotiated between the 10 ASEAN member states and their 6 free trade agreement (FTA) partners, accounted for more than 20 per cent of global FDI flows in recent years, nearly twice as much as the pre-crisis level. If concluded, these agreements are likely to have important implications for the current multilayered international investment regime and global investment patterns.

C H A P T E R

S U M M A R Y

■■ Globalization is the process of increasing interconnectedness in the global economy, such that, events in one part of the world have an effect on people and societies in various other corners of the globe. ■■ Globalization is the result of the phenomenon of convergence, which is the tendency for the tastes and preferences of people in different countries to become similar, leading to a sameness or homogeneity. ■■ There are three elements of globalization—economic, political and cultural. ■■ Economic globalization is characterized by the emergence of increased global flows of international trade and investment. ■■ Cultural globalization is a process of cultural homogeneity or having similar tastes, all over the global economy.

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■■ Political globalization refers to processes of changes in the rules and structures of global governance. ■■ International business refers to any business activity which involves the transfer of resources, goods, services, knowledge, skills or information across national boundaries. These activities may pertain to the production of physical goods or to the provision of services such as banking, finance, insurance, education, construction, etc. ■■ The term TNC refers to a business enterprise with trade or investment operations in multiple global locations. ■■ The transnationality index (TNI) is a measure of the degree of interationalization of a business enterprise. ■■ The growth of international business in the last few decades has been driven by economic, political and technological factors. ■■ The major differences between domestic and international business are related to diverse business environments, enhanced risk and uncertainty and operational complexities. ■■ The main motives of firm internationalization are increased profits, growth, competitive factors and strategic factors. ■■ Entry mode refers to the nature of international transaction chosen by a business firm to enter a foreign market. The choice of entry mode for a business depends on the degree of foreign market involvement that it wants to have. ■■ Entry mode choices fall into three categories—trade-related, transfer-related, and investmentrelated. There is an increasing level of resource commitment, organizational control, involved risks, and expected returns in this sequence. ■■ Trade-related entry modes include export and imports and countertrade. ■■ Contractual or transfer-related entry modes are those associated with transfer of ownership or utilization of specified property (technology or assets) from one party to the other in exchange for royalty fees. ■■ Investment-related entry modes involve ownership of property, assets, projects, and businesses invested in a host country. Foreign investment takes two forms—foreign direct investment (FDI) and foreign portfolio investment (FPI).

Key Terms International business, Globalization, Transnational corporation, Modes of entry, Foreign direct investment, Foreign portfolio investment, Export, Import.

Discussion Questions

1. 2. 3. 4. 5.

What is globalization? What are the main elements of globalization? What is international business? What is a transnational corporation (TNC). Explain its main characteristic features. Enumerate the factors that have contributed to the growth of international business in the last few decades. [Delhi University, B.Com (Hons.) 2010] 6. What is international business? List and explain the major differences between domestic and international business. [Delhi University, B.Com (Hons.) 2011]

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7. What do you understand by International Business? Briefly explain the factors that have led to the growth of international business in recent years. [Delhi University, B.Com (Hons.) 2007] 8. Explain clearly the main motive of a business firm for entering the international market. 9. List and explain the different modes of entry for an international business firm.  [B.Com (Hons.) 2008] 10. Distinguish between a. Trade and investment-related modes of entry b. FDI and FPI c. International leasing and international licencing d. International leasing and international franchising 11. Write short notes on a. TNC b. International licencing c. International leasing d. International franchising e. Turnkey projects 12. Plan a class visit to the nearest shopping mall and divide students into groups to make a list of foreign brands and foreign products available. Students may then be asked to map the brand/ product with the company it belongs to, the country of origin and the mode of entry it has used to enter the Indian market. (e.g., McDonalds has used the franchisee mode of entry) 13. What are the complexities involved in international business? Compare and contrast it with domestic business. [Delhi University, B.Com (Hons.) 2014]

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2 POLITICAL ECONOMY OF INTERNATIONAL BUSINESS LEARNING OBJECTIVES This chapter introduces different facets of the international business environment. After reading this chapter, you should be able to:

■ ■ ■ ■ ■ ■

Understand the meaning of the term business environment

■

Appreciate the different dimensions of political risk in business decision making

Distinguish between the International and domestic business environment Understand the basic features of the international business environment Analyse the specific characteristics of the international economic environment Identify the dominant political ideologies of the world Understand the changing role of transnational and regional forces in shaping political systems

PHARmACEUTICAL TROUBLES IN CHINA Mark Reilly, chief executive of GlaxoSmithKline (GSK) Plc in China was recently charged with leading a network of corruption in China’s pharmaceutical industry. Charges against the former boss of GSK’s China business and other colleagues are the biggest corruption scandal to hit a foreign company in China since four Rio Tinto executives were jailed in 2009. Reports in The Legal Daily newspaper, run by the ruling Chinese Communist Party’s political and legal committee, stated that GSK’s transfer pricing policy enabled it to reduce profits artificially which helped it to avoid over 100 million Yuan (USD 16.04 million) in import value added and

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c­ orporate income tax, besides providing tax loopholes for charitable donations. The state has accused GSK of blocking the effort of the Chinese government in the manufacture of generic drugs to treat AIDS, in order to have a monopoly in the hepatitis drug market. The GSK tale has its origins in a massive anti-corruption campaign launched soon after Xi Jinping became China’s Communist Party leader in 2012, with the staggering malpractice in healthcare as one of his primary targets. There have been a series of investigations against various global drug firms since last year, such as Novartis AG, AstraZeneca Plc, Sanofi SA, Eli Lilly & Co and Bayer AG. The pharmaceutical sector has a global reputation rife with tales of bribery between sales staff and doctors. The elevation of the new party leader indicated a massive change in the ‘rules of the game’, especially for the outsiders in China. Analysts have pointed towards members of the bureaucracy attempting to make their presence felt, alongside the complications of western management practices attempting to operate in a fast changing Chinese business culture!!! Source: http://www.reuters.com/article/2014/05/19/us-gsk-china-idUSBREA4I06D20140519, http://www.reuters. com/article/2014/05/15/gsk-china-corruption-idUSL3N0O12LR20140515, http://www.bbc.com/news/world-asiachina-28101310, last accessed on 11th July 2014.

INTRODUCTION The business environment of a firm consists of all the factors and forces which influence its life and development. These factors may be internal or external. Internal factors are generally controllable by the firm, but external factors are largely uncontrollable by the firm. The business environment for a firm engaged in international business has become more complex, with expanding and deepening ties between nations around the world and between the many organizations within these societies. With the growth of international business, many large organizations now see themselves as global in orientation, not rooted in any one society. The business environment for such a business may be visualized in terms of layers, beginning with the immediate internal environment within the organization and moving outwards to the external environment surrounding the business and influencing its organization and operations. The external environment includes an array of dimensions, including economic, legal, political, and technological factors. While these factors influenced only the internal environment of the home country a few decades ago, today, the environmental horizon of business has widened and business is forced to interact with international forces and simultaneously deal with national and local factors. The domestic business environment consists of the factors and forces which originate within the home country. The international business environment is more complex and diverse since it consists of all factors and forces which have an influence on its working environment and are linked to different countries of operation. The international business environment may be broadly classified into the following: ■■ Economic environment ■■ Political–legal environment ■■ Cultural environment

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Economic Environment The economic environment of an international business consists of the economic systems of the home and host country, and various economic variables such as the level of economic growth and development, inflation and the fiscal and monetary policy. A business firm needs to evaluate all these variables in order to succeed in the international arena.

The economic environment of an international business consists of the economic systems of the home and host country, and various economic indicators such as GDP, growth, development and inflation.

Economic Systems An economic system determines the basic rules An economic system determines the basic rules regarding ownership and control of productive of the game regarding ownership and control of resources within an economy. A basic principle in productive resources within an economy. economics is that available resources are scarce and can be put to multiple use. The economic system is the basic decision-making framework which specifies the basic rules regarding the use of economic resources in activities of production and distribution of goods and services for the satisfaction of human wants. Economic systems are classified on the basis of ownership and control of resources. There are two extreme points on the scale—the capitalist or ­market-based system and the command based or stateowned economic system. The mixed economy combines the features both market based and command based systems in different combinations and lies between the two end points on the scale. Capitalist or Free Market Systems The free market economy, also called the capitalist system or the pure market economy may be defined as a system where the market determines the use of productive resources for production and distribution. It is based on the following basic principles: Pursuit of Self Interest: The main objective of a The basic principles of the free market or the business firm is to operate for profit. This is a cenpure market economy are private ownership tral principle of capitalism given by Adam Smith in of the means of production and the freedom of 1759, as the concept of the ‘invisible hand’ which business firms to operate for profit. guides the functioning of the capitalist economy. There are three central elements of the free According to this, an individual’s pursuit of selfmarket system—freedom of enterprise, competitive markets, and private property. interest is the invisible hand which guides him towards economic activity which is focused at profit maximization. Smith argued that the maximization of individual self interest in turn leads to the greater good of society as a whole. This guiding principle is associated with capitalism in its purest form, that is, laissez-faire capitalism. The British and the US economies are examples of pure capitalism and also the countries in which it originated. Freedom of Enterprise: It is the right of all individuals in a society to pursue any economic activity in any form they desire. Freedom of enterprise flourishes in an open society in which individuals are free to compete in the marketplace and accumulate private wealth. In a laissez-faire economy, the government

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takes on a regulatory role. Transparent and fair regimes of business regulation and a stable and impartial legal framework are the pre conditions for a healthy free enterprise. Private ownership of the means of production—the capitalist system is guided by the forces of the market which determine the answers to the central questions of what, how and for whom to produce. In order to maximize profits, firms choose the cheapest methods of production of commodities to produce commodities which are likely to demand the highest prices in the market. An obvious drawback of this system therefore, is that anyone who does not have purchasing power cannot be a part of the process of decision making in this system and there are wide gaps between the rich and the poor. Competition: Competition is the essence of the market economy, which is characterized by various combinations of interaction between buyers and sellers leading to price determination at different l­ evels for goods and services. The central economic decisions of what, how and for whom to produce in an economic system are based on the free forces of demand and supply. The key factors that make the market economy work are consumer sovereignty, that is, the right of consumers to decide what to buy and freedom for companies to operate in the market. The consumer has the freedom to decide how to spend the wages and property incomes generated by his labor and property ownership. The producer or business firm also has the freedom of operation in the market. Command Economy A command economy, also known as a centrally A command economy, also known as a centrally planned economy, is based on the socialist principles planned economy, is based on the socialist of collectivism. It is based on the theory of commuprinciples of collectivism. In this system, all nism originally propagated by Karl Marx, visualizdimensions of economic activity, including ing an idealistic classless society. In this system, all pricing and production decisions, are determined economic activity, including pricing and production by a central government plan. decisions, are determined by a central government plan. The government owns and controls all productive resources, all production is done in state owned factories and labor unions are also controlled by the government. The two leading examples of this system are the erstwhile USSR and China. A basic drawback of socialism is the lack of incentives for the producer. This leads to overproduction, inefficiencies, and inflexibility as recurring problems. The founding fathers of socialism visualized an ideal society, in which all members would be equal. In reality however, there have been stark inequalities under the domination of the State. The production of consumer goods was completely ignored as the focus was on military production. Mixed Economy The mixed economy exists in between the market The mixed economy exists in between the market and command systems. It is characterized by and command systems. It is characterized private enterprise in some sectors and significant by private enterprise in some sectors and state ownership and government planning in significant state ownership and government others. The fundamental concept underlying this planning in others. concept is the notion of the welfare state which originated in the United States after the Great Depression. Countries, such as the United Kingdom, France and Sweden follow this model in the developed world, as do India and Brazil amongst the developing countries.

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Another term used to describe the mixed economy is market socialism. In this system, although the state owns significant resources, the allocation of the resources comes from the market-price mechanism. The model of market socialism gives a dimension of social justice to capitalism and is characterized by state ownership in key sectors and extensive social welfare programmes aimed at reducing the inequalities found in capitalism. The system allows for both state and private ownership of industry. The state usually keeps industries which are crucial for national interest under its control, such as heavy industry, banking, oil and airlines, to ensure that they continue to function even in the absence of profitability. Maintaining public enterprises and running social welfare programmes imposes a huge burden on the state and is responsible for the budget deficits discussed later in the chapter. France is a example of market socialism, where the government owns significant economic resources but it allows supply and demand to set prices. The social market model in Sweden gives great importance to social welfare. Although the market determines prices, a lot of economic activity is controlled by the government through fiscal policies. In the modern world, no economy can be called a purely free market or a completely command economy. Most market economies have some degree of government ownership and control, whereas most command economies are moving towards a market economy and away from command concepts. On the spectrum of economic systems, Hong Kong and the United States represent two countries at the market end of the spectrum, and Cuba and North Korea represent two countries at the command end of the spectrum. In Hong Kong and the United States, the government plays a very small role in economic activity, desiring instead to provide a stable environment in which economic activity can take place. In communist countries, such as Cuba and North Korea, the government still owns and controls most aspects of economic activity. China is an example of a communist country that has made the transition from being a command economy to a market economy with a strong role for the State. Transition Economy A transition economy is one that is making the shift from one economic system to another. The late 1980s and early 1990s saw many countries moving away from centrally planned economies towards free market economies. This included the erstwhile Soviet Union followed by more than 30 countries in Eastern Europe, Asian states like China and Vietnam and African countries like Angola, Ethiopia and Mozambique. The process of transition is characterized by deregulation, privatization and the creation of legal systems to safeguard property rights.

Bird’s-eye View Economic systems are the basic decision frameworks for an international business. They range from free-market systems on one end to socialist systems on the other extreme. There are several countries which follow a middle path called, ‘mixed economy’ and many other nations are in the process of making a transition from socialism towards a more marketoriented system.

Economic Indicators This section lists some economic indicators that are important for taking decision making by an international business manager. Gross Domestic Product (GDP) GDP is the total market value of all final goods and services produced within the country in a given

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GDP is the total market value of all final goods and services produced within the country in a given period of time, but GNI is a broader measure of economic activity since it includes income earned from abroad as well.

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period of time (usually a calendar year). There are two ways of measuring GDP: Real GDP is the current market value of final output. Nominal GDP is the real GDP adjusted for a price change by dividing it by the price index or GDP deflator. The GDP is a useful economic indicator since it allows us to assess the rate of productivity of the economy and is also an indicator of domestic market potential. Gross National Income (GNI) GNI is the broadest measure of economic activity. It is the market value of final goods and services newly produced by a national economy, including income earned by national residents from overseas operations. It includes gross domestic product (GDP), which is the value of the total economic a­ ctivity produced within the geographical boundaries of a country in a single year, from the efforts of both domestic and foreign residents. Per capita GNI refers to GNI of a nation divided by its total population. Those countries with high populations and high per capita GNI are the most desirable in terms of market potential. Those with low per capita GNI and low populations are the least desirable, and the other countries fit somewhere in between. Why do we use GNI as an economic indicator? The basic demand for a product depends on the income level of the consumer. While deciding to do business abroad, a firm must therefore evaluate the income level of the country to be able to estimate the demand for its products.

Economic Growth Economic growth is the change in GDP of a country from one year to the next. Quantitative and monetary growth of an economy is measured by changes in the gross domestic product, between two time periods.

Economic Development Economic development is a broader concept compared to economic growth. It includes qualitative factors, such as literacy rates, level of health care, quality of housing and levels of health standards. Human Development Index (HDI) The HDI is a measure of economic development. It is a ranking tool based on factors other than just economic and monetary measures. The HDI is an index combining normalized measures of life expectancy, literacy, educational attainment and GDP per capita for various countries. Business Cycles The business cycle refers to phases of fluctuation in output, income and employment generation in an economy. A business cycle may range from 2 to 10 years and consists of four interconnected phases ranging from prosperity, recession, depression followed by recovery. The healthiest phase of the cycle is prosperity with high levels of income and output and low employment, and the worst phase is depression when output, employment and confidence in the economy is at the lowest ­possible level. Inflation Inflation is the increase in the cost of living over a period, usually one year. It refers to a period of continuously rising prices and has a direct effect on the operations of a business firm through its impact on the cost of raw material, wages, prices of finished goods, and the cost of inventory. Economists use

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different types of indices to measure inflation, but the most commonly used measure is the consumer price index (CPI) which compares the prices of a fixed basket of goods and services for a consumer between different periods. Balance of payments Balance of payments is a record of a country’s transBalance of payments is a record of a country’s actions with the rest of the world on account of both transactions with the rest of the world. trade and investment. Surpluses in the balance of payments account are an indication of an excess of foreign exchange inflow over outflow and may lead to an increase in foreign exchange reserves. Deficits, however, are a matter of concern since they indicate foreign exchange scarcity. External Debt External debt is a measure of a country’s borrowings. It can be measured in two ways—the total amount of the debt and debt as a percentage of GDP. Increasing debt levels lead to increasing instability and slow down economic growth.

External debt is a measure of a country’s borrowings.

Exchange Rate The exchange rate is the price of the domestic curBird’s-eye View rency in terms of any foreign currency. For instance the value of the INR in terms of dollar INR/USD. Economic indicators are important decisionThe exchange rate is a very important economic making criteria for an international business. variable since it since it determines an economy’s These include economic growth, economic inflows and outflows of foreign exchange for trade development, inflation, balance of payments, and investment. For example if the INR/USD rate external debt and exchange rate. is 55 it means that an Indian exporter will earn INR 55 for every dollar worth of goods he sells in the foreign market and an importer will have to pay INR 55 for every dollar worth of goods bought inn the foreign market. A change in exchange rate from 55 to 60 will increase the payment burden of the importer but will mean increased earnings for the exporter.

POLITICAL ENVIRONMENT Political Ideologies and Systems The political system refers to the system of goverPolitical systems are based on political ideology nance in an economy. An ideology is a set of intewhich is a set of integrated beliefs, theories and grated beliefs, theories and doctrines, which form doctrines. the basis of a political system. Political ideology can usually be co related with economic philosophy. For example, the political ideology of the United States is based on the constitutional rights of private property and freedom of choice. This finds its counterpart in the economic philosophy of capitalism. Similarly,

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countries of the former Soviet Union, China, Cuba, and North Korea have been followers of communism, which believes in state ownership of property. Political ideology, in turn, gives rise to political systems, which form the basis of governance of nations. There are two broad classifications of political systems: 1. Collectivism 2. Individualism Two other important concepts associated with political systems are the notions of democracy and totalitarianism that are discussed later.

The dominant political ideologies in the world are individualism and collectivism giving rise to socialist and capitalist systems.

Collectivism Collectivism is based on the philosophy of the Greek Collectivism is based on the philosophy of thinker Plato, and emphasizes the supremacy of the the Greek thinker Plato, and emphasizes the needs of the society as a whole over the needs of supremacy of the needs of the society as a the individual. In the modern context, the philosophy whole over the needs of the individual. of collectivism translated itself into the teachings of Karl Marx which gave rise to socialism. The basic teachings of Marxism emphasize the difference between the capitalist owner and the worker in the distribution of profits of the enterprise. Marx felt that the capitalist system exploited the workers who were unable to get fair wages for their labor. He, therefore, advocated state ownership of production and distribution so that the benefits of state enterprise could be shared by society as a whole rather than the individual capitalist. In the early twentieth century, socialist thinking Socialism has two distinct schools of thought, which are communism and social democracy. got split into two distinct schools of thought, which are communism and social democracy. 1. Communism: It believed in achieving socialist goals only through a violent overthrow of the existing social order, such as Russia after the revolution of 1917, China after the defeat of Chiang Kai Chek’s forces in 1949, and Cuba after the defeat of the Batista regime in 1959. Communist thinking ruled the world in the 1970s. It was the political philosophy of the erstwhile Soviet Union and its allies of Eastern Europe (Poland, Czechoslovakia and Hungary); China; the Southeast Asian nations of Cambodia, Laos and Vietnam; Latin American nations of Cuba and Nicaragua; and the African states of Angola and Mozambique. Communism collapsed in most parts of the world by the 1990s, and was replaced by alternative philosophy. The Soviet Union collapsed and was replaced by a collection of 15 independent states. China has also been a traditional communist nation, but has now made the move towards a market-oriented system. In the present context, the only nations which continue to follow communism are North Korea and Cuba. 2. Social democracy: This is the softer version of socialism and believed that socialist goals could be achieved through the existing electoral system instead of the violence which communist thinking believed in. This system is found in countries such as France, Germany, Sweden, the United Kingdom, Australia, Norway, and Spain in the Western context and also developing countries such as India and Brazil. It is also known as social capitalism which kept strategic and heavy industries such as power, coal, telecommunications and railways were under state supervision and allowed the free market forces to operate in other sectors of the economy. However, state-owned companies were largely unsuccessful as business enterprises since they functioned

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as monopolies in a protected environment with guaranteed financial support. This resulted in a change in power in countries like the United Kingdom and Germany towards a more marketoriented system. India and Brazil also adopted liberalization measures and are fast emerging as important markets and investment destinations. Individualism The philosophy of individualism is based on the wellThe philosophy of Individualism is based on the being of the individual as the path to the well-being well-being of the individual as the path to the of society at large. In contrast to ­collectivism, indiwell-being of society at large. vidualism stresses that the interests of the i­ ndividual should take precedence over the interests of the state. The basis of individualism are the teachings of Aristotle, who argued that individual diversity and private ownership of property are far more productive than communal property and is the path to social progress. It was redefined in the works of David Hume (1711–1776), Adam Smith (1723–1790) and J.S. Mill (1806–1873). In recent times, it has again been addressed by economists, like Milton Friedman, Friedrich von Hayek and James Buchanan. Individualism is based on two basic fundamental beliefs:

1. The guarantee of individual freedom and self-expression as an absolute right of the individual 2. The belief in the pursuit of individual self-interest leading to the welfare of the society.

Individualism emerged as the influential political philosophy in the Protestant nations of England and Netherlands and also influenced the thinking of the American colonies of England. The underlying ideological conflict between individualism and collectivism became the basis of the Cold War after the end of the two World Wars, with the United States and the former USSR as their respective champions. Democracy Democracy is a system of government in which the people either directly or through their elected representatives decide the rules of governance. Individualism has strong cultural links with the notion of democracy The basic features of democracy are: ■■ ■■ ■■ ■■ ■■ ■■

Democracy is a system of government in which the people either directly or through their elected representatives decide the rules of governance.

The election of representatives for a fixed period of time. An independent judiciary to protect individual property and rights. Separation of the legislature from the executive arm of the government. The right to express opinions freely. A non-political bureaucracy and defence infrastructure. An accessibility to the decision-making process.

Democracy is a dominant form of government in the world today. It is followed in countries such as the United States, Canada, the United Kingdom, Australia, and India among others. Totalitarianism Totalitarianism is a system of government in which one individual or political party has complete control by virtue of religious belief, tribal power or ­ideology and

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Totalitarianism is a system of government in which one individual or political party has complete control by virtue of religious belief, tribal power or ideology.

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either refuses to recognize other parties or completely suppresses them. Communism and fascism are reflections of totalitarian philosophy, which stress the role of strong central governments, such as that of the former USSR, China, Cuba, North Korea, Germany under Hitler, and Spain under Franco after the Spanish Civil War. Totalitarianism exists in different forms, such as: ■■ Communism is the best-known form of totalitarianism, in which political and economic systems are virtually inseparable. Communists believe in the equal distribution of wealth. Therefore, the government owns all property and takes all decisions regarding production and distribution of goods and services. Since the 1990s however, communism has collapsed almost all over the world. Its staunchest followers like China, Laos and Vietnam also gradually moved towards a marketoriented system. However, they remain totalitarian in denying basic civil rights to their people. ■■ Theocratic totalitarianism is said to exist when a religious group exercises total power and represses or persecutes non-followers. Countries such as Afghanistan, Iran and Saudi Arabia limit the freedom of political and religious expression enforcing a totalitarian regime on the basis of Islamic principles. ■■ Tribal totalitarianism as found in the African states of Zimbabwe, Tanzania, Uganda and Kenya is the monopolization of power by a particular tribe. ■■ Right-wing totalitarianism was found in the fascist regimes of Germany and Italy in the 1930s and the 1940s, under the right-wing Bird’s-eye View dictatorships of Latin America in the 1980s, and in several Asian countries like South The political environment provides a system Korea, Taiwan, Singapore and Philippines. of governance. It is based on political ideology A basic feature of this form of governance which refers to the certain underlying beliefs, is that although it permits some individual theories and doctrines. Political ideology is economic freedom, it restricts individual linked to different methods of governance, political freedom and is against socialist or such as democracy and totalitarianism. communist ideas.

Political Risk Political risk is an important factor to be considered in the evaluation of a country as a potential business destination. It refers to a change in political climate leading to a deterioration of the operating position of the business. Political risk is concerned with political stability, the economic and regulatory climate, and policy continuity. Causes of Political Risk There are three main causes of political risk, which are as follows: 1. Civil disorder: Any unrest that happens due to a sudden change in economic conditions, human rights violations or problems within society leads to civil disorder. 2. External relations: Differences between the host country and the foreign investor’s home country may result in disruption in work, and the loss of supplies and markets. 3. Change in political leadership: Frequent changes in political leadership causes changes in operating regulations. Such changes may lead to the breach of existing contracts or the takeover of an investor’s property.

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Types of Political Risk There are three types of political risks, which are related to each other. They are as follows: 1. Ownership risk: It refers to a likely change in the current ownership or governance structure of a TNC. This can be through nationalization of an existing enterprise or transfer of ownership. Milder forms of ownership risk may arise out of a change in investment rules that force firms to reduce their stake, for example, sharing ownership with a local firm. In the early 1970s, the Indian government established such rules that resulted in a strategic shift toward unrelated diversification and eventually led to the departure of many foreign TNCs from India. 2. Operational risk: This risk refers to a change in the ‘rules of the game’ under which the foreign firm operates, for example, new rules on capital controls discussed in the opening vignette. 3. Transfer risk: It refers to restrictions on the free movement of factors of production, such as changes in visa rules for various categories of workers leading to difficulties in migration of workers.

INTERNATIONAL BUSINESS NEGOTIATION A TNC operates at various levels in both the home and host country and has to therefore deal with different sets of parties. Business negotiation is the tool used by a TNC to conduct its business operations at different levels in its operating environment with different sets of people. The process of international business negotiation may occur at three different levels. 1. Government–Government: The governments of the home and host countries have to deal with issues of loans, investment guarantees, trading and investment terms and overall economic and political issues. All these issues become the subject matter of negotiation between the governments of the two countries. 2. Government–TNC: TNCs are global corporations which wield a lot of power on account of its economic strength. However, TNCs have to negotiate with governments of both the home and host countries regarding a host of issues ranging from monetary and tax policies, price controls, technology transfer and approval to borrow funds. 3. TNC–Subsidiary/Affiliate: A TNC has to deal with its local affiliate or subsidiary which may be a part of a completely different cultural and economic environment. This includes both long term policy issues and day to day operational problems. This creates a set of multiple relationships, which may lead to inter-related negotiation and multilayered bargaining.

Government– Government

Government– TNC

TNC– Affiliate

Figure 2.1  International Business Negotiations

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Objectives of International Business Negotiation The TNC’s Viewpoint The primary goal of business negotiation is to create a favorable business environment. This translates into a non-discriminatory environment and equal treatment of foreign firms. The foreign TNC needs legitimacy and acceptance in the host country. It tries to convince the host country government of its positive role in the local economy and its intended contribution to employment generation, transfer of skills, and overall growth and development of the region. The Government’s Viewpoint Negotiation by the government is driven by considerations of national interest because of which it often imposes restrictions on repatriation of dividend or measures to protect domestic industry. Governments of home countries are also aware of the negative externalities associated with TNCs, such as the effect on the environment and misuse of natural resources or adverse working conditions for labour.

Bargaining Power of the TNC The TNC derives its bargaining power from a variety of different factors: ■■ Ownership of technology: The possession of superior technology is an invaluable asset that has huge bargaining power since it can lead to all round growth and development in the home country. For instance, IBM always demanded 100 per cent ownership in local operations since it offered countries access to instrumental technology. ■■ Global brands: TNCs such as Coca-Cola, MacDonald’s and Chevorlet are global brands which gives them huge bargaining strength. Despite this, they sometimes face difficulties in penetrating regional markets, such as MacDonald’s which got permission to operate in Kerala only last year even though it has been a part of the Indian market since 1991. ■■ Product diversity: TNCs that offer a great deal of product diversity are preferred since they help to produce a wide range of local products which can help save imports for the country. ■■ Export potential: The TNC’s ability to negotiate becomes stronger if its products have export potential which would help the home country to build its export capabilities and also help it to earn foreign exchange. ■■ Investment offered: The TNC’s bargaining strength also depends on the amount of investment it is bringing into the host country. The investment in the form of capital also carries with it attendant benefits of skill, technology and employment generation.

C H A P T E R

S U MM A R Y

■■ The economic environment of an international business consists of several variables, such as the economic system of the home and host country, the level of economic growth and development and the fiscal and monetary policy. All of them have a bearing on the economic aspects of business decision making. ■■ An economic system refers to the rules of the game on economic governance. It determines the rules regarding ownership and control of scarce resources within an economy and is classified as a capitalist or socialist system based on these characteristics.

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■■ The capitalist system also called the pure or free market economy, is characterized by private ownership of the means of production and the freedom of business firms to operate for profit. ■■ The command economy, also known as a centrally planned economy, is based on the socialist principles of collectivism rather than individualism and private property. ■■ The mixed economy exists in between the market and command systems. It is characterized by private enterprise in some sectors and significant state ownership and government planning in others. ■■ A transition economy is one that is making the shift from one economic system to another. ■■ There are many economic indicators that help in deciding market or production locations of international business firms. Some of the important indicators are income level and distribution, inflation, economic growth, infrastructure, population and economic stability. ■■ The political environment in both the home and host countries influences international trade and investment in multiple ways. ■■ The political system is the system of governance in an economy based on an ideology, which is a set of integrated beliefs, theories and doctrines. ■■ Political systems are based on either collectivism or individualism and they may be democratic or totalitarian. ■■ Political risk is the probability of disruption to TNC operations.

Key Terms Economic system, Free market economy, Command economy, Mixed economy, Transition economy, Inflation, Ideology, Collectivism, Individualism, Democracy, Totalitarianism, Political risk.

Discussion Questions



1. What are the different parameters of measuring the economic environment of an international business? 2. ‘The current global environment is proof of the fact that free market systems lead to growth whereas socialist market systems stifle growth’. Elaborate upon the statement with examples from the current global economic context. 3. Explain the importance of economic growth in the internationalization strategy of a TNC. 4. Which economic variables would you consider important the analysis of the economic environment of a TNC? 5. What is meant by the Political environment of international business? 6. Explain the dominant political philosophies of the global economy. 7. What are the defining features of democracy? Discuss how a democratic system is more ­conducive to the world of global business than totalitarianism. 8. Discuss the implications of increasing awareness about ethical issues for the conduct of international business. 9. What is international business negotiation? 10. What are the different levels at which a TNC can have international business negotiation?

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11. ‘A global business firm works in a complex, multifaceted environment’. Explain.  [Delhi University, B.Com (Hons.) 2007] 12. ‘A global business firm operates in an environment which is complex and multidimensional’. Elaborate. [Delhi University, B.Com (Hons.) 2008] 13. ‘The global business firm has to work in a complex and multifaceted business environment.’ Explain clearly giving relevant and contemporary examples.  [B.Com (Hons.) 2009] 14. Explain the salient features of the complex, multidimensional and interrelated business environment in which the multinational corporation has to operate. [B.Com (Hons.) 2011] 15. Discuss how diverse political and economic environment impact international business.  [Delhi University, B.Com (Hons.) 2014]

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3 THE INTERNATIONAL CULTURAL AND LEGAL ENVIRONMENT LEARNING OBJECTIVES After going through this chapter, you should be able to:

■ ■ ■

Identify the different dimensions of culture and its implications for international business

■

Assess the dynamics of ethics in international business

Examine cultural factors influencing countries’ business practices Understand the interrelationship between national, regional, and international legal frameworks in the international business environment

MUSIC IN THE BALCONY The Hansraj Project—a young fusion band from Delhi is characteristic of a new trend in the Indian music scene which combines elements of Indian and Western music to create a new sound. It recently featured on Balcony TV, an online music channel, which originated in a Dublin balcony in 2006. Founded by fi lmmaker Stephen O’Regan and musicians Tom Millett and Pauline Freeman,  the idea of Balcony TV was to use the universal language of good music to link artists all across  the world. The channel has built itself by scouting up-and-coming artists in their regions and fi lming performances on balconies from Dublin, London, Barcelona and Brooklyn to Delhi, Tel Aviv,  Johannesburg and Melbourne. Each week, fi fty new videos are added to BalconyTV.com. Balcony TV has become a tremendous music discovery channel by linking up with artists across the globe,  creating both an active fan component and producers in local markets. The global success of Balcony TV is indicative of the emergence of the creative economy. Creative industries exist at the intersection of the arts, culture, business and technology and use intellectual capital as their primary input. The creative economy includes all forms of performing  arts and crafts including technology-intensive forms of creative expression, such as fi lms, TV and  radio broadcasting, digital animation and video games, and also service-oriented architectural and  advertising services.

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Creativity is not a fixed resource but is subject to change. It is derived from a country’s social and historical past and is fast emerging as an asset which can become the basis for wealth and employment creation. India has a rich culture and heritage of the performing arts—both classical and folk. In recent years, however, there have been sweeping changes in its cultural milieu driven by changes in technology, policy facilitation and a deeper integration of the world economy in general. This is visible in the emergence of contemporary music and dance, which has clear elements of interdisciplinary influence. This growth in the industry is attributable to individuals who have acted as cultural entrepreneurs and contributed to this creative industry, helped by technology and the media. In today’s information age, knowledge and creativity have thus become powerful engines driving economic growth, with profound implications for international business. Sources: http://www.billboard.com/biz/articles/news/digital-and-mobile/5930122/the-orchard-acquires-balconytvexclusive, http://balconytv.tumblr.com/, last accessed on 13 July 2014.

INTRODUCTION The word culture is derived from the Latin word culCulture is learned, shared behavior, acquired tus, meaning cult or worship. The term culture may through education or experience, and passed on be explained as the knowledge acquired through from one generation to another. Culture is the education and experience that leads to social behavbasis of both individual and group behavior. ior. Culture is shared among members of a group, organization or society and as a result, it becomes the basis of individual and group behavior. It is passed from one generation to another and goes through constant change as people adapt to new environments. This process of learning and adjusting to culture is called acculturation and it leads to a learned, shared, interrelated set of symbols which provide specific meaning to members of a society. Based on this, we can say that there are five important characteristics of culture: 1. Culture is learned behavior: The individual learns through the experience of the group. 2. Culture is shared: The group is the basis of cultural change and is more important than the individual. 3. Culture is compelling and determines the behavior of individuals even though they may not be aware of this. 4. Culture is interrelated: Each facet of culture is related to another and cannot be understood in isolation. Culture should therefore be studied as a complete entity. 5. Culture provides orientation to group behavior and is the basis of individual reaction to a given cultural stimulus. Therefore, understanding culture can help to determine how individuals might react in different situations.

ELEMENTS OF CULTURE Culture is a complex, multi-dimensional subject and in order to understand its basic nature, we need to examine some of its critical elements.

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Language Language is the key to culture as it is the primary Language is the key to culture as it is the primary means of transmission of ideas and information, means of transmission of ideas and information. which helps in social interaction and creates a system of shared values and norms. Language is more than the vocabulary and grammar that make up written and spoken expression. It also includes gestures, perceptions and sensibilities. Communication is not only about speaking in the same language but also about being on the same wavelength and having an idea of the perception and sensibilities of the person with whom communication is being done. Spoken languages can act both as a common thread and as a barrier between nations and regions. Africa, for instance, has over a hundred languages for communication but French, is the lingua franca or ‘link language’ of several former French colonies, acting as an effective communication device for managers of international business. Likewise, in India, the principal official language is Hindi and English is the secondary official language with several regional languages being used in different parts of the country. The opening up of the economy since 1991 has seen a large number of TNCs from various countries whose executives use English as their main mode of communication. Communication difficulties for international business managers arise when: ■■ The manager does not speak or understand the local language. ■■ The manager has to rely on the services of a translator who may not be equally fluent in both languages and either misses a point or mistranslates it. Knowing the local language is a good idea for international managers and helps them to communicate better with the local workforce because: ■■ Direct knowledge of a language helps in a clear and explicit understanding of the situation. The manager does not have to rely on someone else to interpret or explain things. ■■ Language provides direct access to local people, who are often more at ease and comfortable in communicating with someone who speaks their language. ■■ An understanding of the local language allows the usage of implied meanings, nuances and other information that is not stated outright. ■■ Knowledge of the local language is also important because direct translation may be inadequate or misleading. The use of technical manuals, catalogues, and advertising material may need the services of a translator. Translation can be difficult if certain technical terms do not exist in a particular language. For example, the Portuguese language has several fishing and marine terms but is limited in its vocabulary for newer industries. This has led to the increasing use of English words mixed with original Portuguese. The same language can often mean completely different things to different cultures. Consider the use of business jargon. In the Indian context, cutting costs can mean anything from cutting down on coffee and biscuits at staff meetings to looking for cheaper sources of raw materials, but in a European or American TNC, it usually means that they are firing some staff. Another instance of different meanings being attributed to the same word is when the Indian country manager of a British TNC was overheard saying that he had fired a subordinate implying that he had scolded a junior; however, his British counterpart thought that he had sacked the employee.

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Non-verbal Communication Non-verbal communication or the unspoken Bird’s-eye View language is as important as the spoken word. Unfortunately, the differences in customs among cultures often cause misinterpretations in such Communication is a key element of culture communication. and refers to verbal and non-verbal transmisGestures are a common form of cross-cultural sion of ideas and information. communication but vary in different parts of the world. Emotional gestures such as hugging, kissing on the cheek, and gesturing with your hands, are commonly accepted practices in Hispanic and Latino cultures. If you live in the USA saying yes would mean shaking your head forward, but if you are Greeks, Turkish or Bulgarian you would move you head sideways to indicate the same meaning. That can lead to a lot of confusion !!!!

Religion Religion refers to common beliefs and rituals related Religion refers to common beliefs and rituals to issues that are considered sacred. Religion has the related to issues that are considered sacred. capacity to influence lifestyles, beliefs, values and attitudes and can have a significant bearing on the behavior of people with each other and with society. There are approximately 15,000 distinct religions and religious movements in the world today. They range from simple folk religions to highly refined systems of beliefs with set rituals, organized worship, sacred texts, and a hierarchy of religious leaders. The leading religions of the world include Christianity, Hinduism, Islam, Buddhism, and Confucianism and each one has its own particular beliefs and customs. It is possible to broadly classify religions of the East such as Hinduism, Buddhism, Jainism, and Sikhism (India); Confucianism and Taoism (China); and Shintoism (Japan) as being significantly different from religions which follow the Judeo–Christian tradition of the West. The Judeo–Christian tradition believes that the world began with God’s creation and will come to an end according to His will and desire. Each human being therefore is significant as time and has only one lifetime to follow God’s word and achieve everlasting life. Asian religions such as Hinduism, Jainism and Buddhism on the other hand, are based on the basic philosophy of Nirvana and Karma. According to them the world is an illusion in which nothing is permanent. They believe that time is cyclical, and all living things, including humans, are in a constant process of birth, death and reincarnation. The basic goal of all living beings is to escape from this cycle to reach the state of eternal bliss called Nirvana, which depends on their own deeds or karma. There is a belief that evil committed in one lifetime is punished in the next and is the motivation for living creatures to do good deeds (karma) and attain a higher spiritual status in their next birth. The Asian sub-continent has been the birth place of seven religions—four of them originated in India (Hinduism, Buddhism, Jainism, and Sikhism), two in China (Confucianism and Taoism), and one in Japan (Shintoism). The impact of this difference can be clearly seen in the approach to business in different countries. According to Protestant belief men had to work hard to glorify God. There was a great deal of importance given to saving and the reinvestment of capital leading to the growth and development of capitalism in the USA. Hinduism Hinduism is practiced by more than 80 percent of India’s population and also in parts of Nepal, Bangladesh, and Bali. Its defining feature is that it does not have a single founder nor a sacred scripture,

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and its followers worship several different Gods through different sets of rituals. Most Hindus believe that the aim of their life is the achievement of eternal bliss (nirvana) through yoga (­purification of mind and body), devout worship of the gods, good works and following the laws and customs (­dharmas) of one’s caste. An important aspect of Hinduism is the caste system which was the basis of social division in India since ancient times. The highest caste, the Brahmins or priesthood, was followed by the warriors or Kshatriyas and then the merchant class or the Vaishyas, and finally the lowest cast or the untouchables were the Shudras. Accordingly, an individual’s position in society and the work he was permitted to do was determined by his caste. Although the government of India has outlawed discrimination based on the caste system, it occupies an important place in India’s social strata even today with both economic and political implications. Buddhism Buddhism originated in India as a reform movement against Hinduism. Buddhism is based on the teachings of an eight-fold path in which an individual goes through different cycles of rebirth to attain nirvana. Although Buddhism rejected the caste system and welcomed everyone into the fold, with the passage of time, two distinct schools appeared in Buddhism—the Hinayana school which emphasized a more austere way of life to be followed by the Monks and the Mahayana school which was more liberal and could be easily followed by the common man. Jainism Jainism was founded by Mahavira, a contemporary of Buddha. It is based on the belief of a self-­regulated universe in which every soul has the potential to achieve divine consciousness (siddha) through its own efforts. Any soul that has conquered its own inner enemies and achieved the state of Supreme Being is called Jina. It believes that the soul has innate qualities of infinite knowledge, perception, power, and bliss. The path to salvation can be attained by following the path of Right Faith (right vision), Right Knowledge and Right Conduct. In the modern context, Jainism is a religious minority in India with followers in North America, Western Europe, the Far East, and Australia. Confucianism Confucianism was founded by Chinese philosopher Confucius in the fifth century B.C. and is based on the philosophy that all reality depends on a mandate from heaven. The family and loyalty towards it basic philosophy of Confucianism The Asian nations of China, Korea and Japan are followers of the faith and, hence, have strong family-based social organizations. Two basic principles of Confucianism are the principle of unselfish love for others, jen, and li, which prescribes a gentle decorum in all actions and translates into the Chinese emphasis on politeness and deference to elders. Taoism Taoism is a philosophy propounded by Lao–Tzu, a contemporary of Confucius. It is based on the ­philosophy that all human beings have both male and female energies—yin and yang—that govern the universe. It is focused on meditation and rituals which help individuals free themselves from distractions and become empty, to benefit from the actions of cosmic forces. Shintoism Shintoism, is Japan’s indigenous religion, which believes that the founding of the Japanese empire was a cosmic act and, therefore, gives a divine status to the emperor, there are no elaborate rituals of worship but a small Shinto shrine adorns many Japanese homes.

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Islam Islam is the second largest religion in the world. The teachings of Islam are based on the Koran, a collection of Allah’s (God’s) revelations to Muhammad, who is viewed by Muslims as the messenger of God. For the Muslim, religious ritual is a part of everyday life. It has a code of conduct in the form of formal prescriptive rules for all aspects of life including social relations, social behavior, rules for the consumption of food and drink, and the role and acceptance of women in society. Islam allows free enterprise and the earning of legitimate profits through trade and commerce, although it forbids the payment or receipt of interest, which is considered usury. Similarly, the Islamic legal system, which traditionally consisted of only religious courts, now has several state courts as well, which are based on both religious law and Western commercial law. Islamic culture is, thus, receptive to international business as long as it follows and respects the accepted tenets of their religion. Religion exerts a significant influence on international business. Banks in Islamic countries do not charge interest from depositors issue shares to depositors since bank interest is prohibited under Islamic law. Instead they charge borrowers’ fees and commissions to maintain profitability. Bird’s-eye View Religion also affects work culture and social customs. We find that in most parts of the world, Religion plays a key role in international busithe working week is from Monday to Friday with ness through its impact on work culture and Saturday and Sunday being holidays but in Islamic social customs. The major religions followed countries of the Middle East such as Qatar and across the globe today include Hinduism, Saudi Arabia, Friday and Saturday are the weekly Islam, Buddhism and Christianity. holidays and the working week begins on Sunday.

Values and Attitudes Values are basic convictions regarding right and Values are basic convictions regarding right and wrong, good and bad, important and unimportant. An wrong, good and bad, important and unimportattitude is a persistent tendency to feel and behave in ant. An attitude is a persistent tendency to feel a particular way towards something or someone. and behave in a particular way towards someValues exert tremendous influence on the cultural thing or someone. environment of business organizations. For instance, most global organizations project themselves as equal opportunity employers implying an attitude of no racial or gender discrimination. Attitudes and beliefs differ all over the world and have a strong influence on all aspects of human behavior and therefore on business. It is therefore useful for international business managers to understand certain key attitudes, since they have to deal with people from different cultures. In the context of international business, attitudes towards time, towards achievement and work, and towards change are of importance. Concepts of time vary widely between cultures. While in some countries, ‘time is money’; in other countries this attitude is considered vulgar and even offensive. In countries of Europe and North America, punctuality is respected and to arrive late for an appointment is considered disrespectful. Waiting past a fixed time for an appointment is considered rude and may lead to the assumption that this person is not giving a meeting the importance it deserves. In Latin America or the Middle East, there is a more casual attitude towards time. It is said that an appointment for noon with a British executive will find them there five minutes before the appointed hour, but their Indian counterpart will probably arrive fifteen minutes late, and the Brazilian executive anytime between noon and 2 o’clock !!!

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Is it often difficult to decide whether to follow the home country or host country custom. In Spain, a general rule is to never be punctual for you will be considered early. Arabian executives in the Middle East, usually will not arrive at the appointed hour even if they have a meeting with an American executive who is known to be punctual.

Customs and Manners Customs are common established practices of b­ ehavior. Manners refer to behavior that is considered appropriate in a particular social setting. Customs dictate how things are to be done; manners are used in carrying them out. Customs and manners thus dictate social behavior. For example, in countries which subscribe to Customs are common established practices of behavior. Manners refer to behavior that is conWestern culture, food is eaten on the table using sidered appropriate in a particular social setting. individual plates with knifes and forks. In Islamic countries, however, food is served on a common platter and eaten by all members of the family sitting on the ground using their hands. Similarly, the Chinese eat with chopsticks while the Indians usually use their fingers to eat. Another example of difference in custom are Arabian countries where it is considered bad manners to shakehands with a person of higher authority unless they make the first move while, in the United States, people offer to shake hands regardless of a person’s social status or rank. Hugging, kissing on the cheek, gesticulating with one’s hands, and using proper respectful titles to address adults and the elderly are fairly common practices in Hispanic and Latino cultures.

Aesthetics Aesthetics refers to the artistic tastes of a culture. Aesthetics refers to the artistic tastes of a culture. The increasing cultural interconnectedness between different parts of the world has resulted in an appreciation of Indian classical music in the West and the emergence of the hugely popular Fusion music. This has created opportunities for international business through the medium of television as well as social media. A basic complexity in international business as compared to domestic business arises out of differences which are rooted in culture. The changing cultural environment of international business offers unlimited opportunities for developing comBird’s-eye View petitive advantages for a business manager. This requires an understanding of cross-cultural differThe cultural environment of international busiences and developing an attitude that combines the ness combines elements of communication, global with the local, that is, a global attitude to religion, values, attitudes, customs, manners bring about a seamless integration of different culand aesthetics in diverse operating situations. tures and harmony in the enterprise.

LEGAL ENVIRONMENT The legal dimension of business has grown in importance with growing trade and investment flows across the globe. The legal environment has h­ istorically been determined by national legal systems

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based on state sovereignty. All commercial transactions across national borders, from the s­implest export contracts to complex joint ventures, have to conform to the provisions of national legal systems.

The legal environment has historically been determined by national legal systems based on state sovereignty. There are three basic legal systems in the world today—common law, civil law and theocratic law.

Global Legal Systems There are mainly three kinds of legal systems in the world today. Common Law Common law is a legal system based on tradition, precedent, and custom and usage. It is associated with an independent judiciary. In other words, it is a system which is based on legal history, cases decided in the past, and the application of law in specific situations. The system originated and developed in Great Britain and is also found in several former British colonies, such as Australia, New Zealand and even the United States. Civil Law Civil law is also known as a codified legal system, and is based on a detailed set of laws that make up a code. This codified system includes rules and regulations for carrying out business activities. Most of continental Europe and Latin America use a civil law system that originated as far back as the Roman Empire. Theocratic Law Theocratic law refers to any legal system that is based on a religious code or teachings. Countries such as Iran and Saudi Arabia, for instance, rely on Islamic law as the basis of their legal system. Indonesia also uses limited elements of Islamic law. Islamic Law, which came into existence in the tenth century, has remained the same over centuries. It is a moral rather than commercial law and is a code of conduct which governs all aspects of life. In the context of international business, the influence of Islamic Law is felt in the area of banking which forbids the payment of interest or benefit on loans. Banks also structure loans in their books to show a share in the profits of the venture rather than receipt of interest. The underlying principle behind all this is that money should be productively employed to earn a return rather than it being earned in financial markets.

Legal Jurisdiction Legal jurisdiction refers to the legal authority under which a legal case will be decided. It is often difficult to determine legal jurisdiction for a TNC, since it is subject to the laws of both the home and host countries which may be different and conflicting. The TNC is governed at a number of jurisdictional levels beginning with the national legal system. At the national level, the laws of both the home and host country remain the most important and relevant for a TNC. At the regional level, a firm is subject to the laws and regulations of a regional entity, such as the EU, or of a trade framework, such as the Association of Southeast Asian Nations (ASEAN). The greater the level of integration within a regional framework, the more important are the laws enacted at that level. At the international level, a firm is subject to international law. Since international law relies on customs (established norms) and treaties (an express agreement under international law entered into by

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different players in international law), it is usually difficult to enforce. For instance, The International Court of Justice in The Hague (Netherlands) is a United Nations (UN) institution that has no jurisdiction in most cases unless the governments involved agree to submit the matter to the court. In the context of international business contracts, parties to the contract often agree in advance to an arbitration authority, such as the International Court of Arbitration, the Inter-American Commercial Arbitration Commission, or the Canadian–American Bird’s-eye View Commercial Arbitration Commission. They may also choose a body such as the International Centre The international legal environment consists of for Settlement of Investment Disputes, which spedifferent legal systems which operate at differcializes in disputes related to foreign direct investent levels of legal jurisdiction. ment (FDI).

ETHICS IN INTERNATIONAL BUSINESS The term ethics refers to accepted principles of right or wrong which govern the behavior of an individual, group or an organization. The use of ethics practices in business has been a subject of discussion ever since the origin of business enterprise, and it has assumed huge importance with the growth of international business. Ethical behavior not only implies following the rule of law but also acting according to the values, norms and concerns of both the home and host country. Since a TNC’s business environment is characterized by diversity, its ethical challenges also arise out of diverse legal and moral issues and the need to accommodate this diversity in a common corporate structure. In a rapidly globalizing world, ethical decision making is the need of the hour. Some important ethical issues that TNCs need to keep in mind while formulating global strategies have been highlighted here.

C H A P T E R

S U M M A R Y

■■ Culture is learned, shared behavior, acquired through education or experience, and passed on from one generation to another. ■■ It becomes the basis of individual and group behavior as it undergoes constant change in the process of being adapted to new environments. ■■ The world of international business today consists of people from different countries and cultures coexisting in real and virtual workplaces. To be successful in international businesses, managers must, therefore, understand the cultures of different countries and how to adapt to them. ■■ The critical elements of culture encompass language, gestures, religion, values, attitudes, customs, manners, and aesthetics. ■■ Thus, these differences in language, customs, religions, etc. constitute the difference in the cultural environments of countries. ■■ Legal systems in different countries may be classified as common law, civil law, or theocratic law. ■■ Legal jurisdiction is the legal authority under which a legal case can be decided. A TNC works through different levels of legal jurisdiction, including the national, regional and international levels.

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■■ Jurisdictional issues are more complex in the context of international business than in domestic business. TNCs often face conflicting demands from overlapping jurisdictions. ■■ Ethics refers to accepted principles of right or wrong which govern the behavior of an individual, group or an organization. The use of ethics is similarly applicable to the world of business and especially to TNCs which work in diverse business environments.

KEY Terms Culture, Language, Religion, Values, Attitudes, Manners, Customs, Aesthetics, Common law, Civil law, Theocratic law, Ethics.

Discussion Questions 1. What is meant by culture? Discuss the key elements of culture. 2. Discuss how different elements of culture can affect an international business. 3. Distinguish between verbal and non-verbal methods of communication for an international business. 4. Using examples, explain the role of religion in international business. 5. What is the basic difference between values and attitudes? 6. List and explain the different kinds of legal systems in the world today. 7. What is legal jurisdiction? What is the importance of different kinds of legal jurisdiction for a global firm? 8. Imagine that you are an Indian engineer who has been offered a job as the CEO of a large American TNC based in Dubai. What are the important cross-cultural issues you are likely to face and how would you resolve them? 9. ‘A global business firm works in a complex, multi-faceted environment’. Explain.  (Delhi University, B.Com (Hons.) 2007] 10. ‘A global business firm operates in an environment which is complex and multidimensional’. [Delhi University, B.Com (Hons.) 2008] Elaborate. 11. ‘The global business firm has to work in a complex and multi-faceted business environment.’ [B.Com (Hons.) 2009] Explain clearly giving relevant and contemporary examples. 12. Explain the salient features of the complex, multi-dimensional and inter-related business ­environment in which the multinational corporation has to operate. [B.Com (Hons.) 2011] 13. Discuss different elements of cultural environment which have an impact on international ­business operations. [Delhi University, B.Com (Hons.) 2010, 2012]

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4 INTERNATIONAL TRADE THEORIES LEARNING OBJECTIVES After reading this chapter, you should be able to:

■ ■ ■ ■ ■

Understand the meaning of international trade Analyse the classical trade theories Compare and contrast the theory of absolute advantage and comparative advantage Relate the importance of the product life-cycle theory with trade and product development Review recent trends in world trade

chIna’s trade WIth latIn aMerIca: Boon or Bane? China is using a tried and tested strategy of market access and fi nancial aid for its forays into  Latin  America. The  giant  from  the  East  has  been  quietly  making  countries  from  this  region  its  new  trade  destination.  Many  Latin  American  countries  are  heavily  indebted,  a  problem  dating  back to the 1980s. The Chinese trade relationship is aimed at helping them reduce their debt and  inequality. China  established  trade  relations  with  Mexico  in  1972,  and  since  then  the  two  countries  have had several cooperative programmes and signed a number of two-way agreements concerning  trade,  technology,  fi nance,  culture,  energy,  shipping,  tourism,  telecommunications,  anti-drug traffi cking, agricultural cooperation, and coordination in cases of criminal jurisdiction.  While Mexico is China’s second largest trading partner in Latin America, it remains at a distinct  disadvantage; China’s exports dwarf what it takes from Mexico. The huge trade imbalance has  prompted mounting concerns amongst Mexican industries over the fl ood of inexpensive Chinese  goods and the negative impact of lower wages in Asia on Mexico’s assembly-for-export factories. In addition, millions of dollars worth of Chinese contraband illegally enters Mexico everyday,  further  undermining  Mexican  commercial  interests.  Chinese-made  goods  have  replaced 

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many indigenous items, from artisan guitars to chilies to statues of Our Lady of Guadalupe, the national patroness. The rise of China has brought benefits for many Latin American countries. Brazil, Chile and Peru have taken advantage of a commodities boom by shipping minerals and agricultural exports to feed a rapidly growing Chinese economy. Chinese demand for pork, beef and poultry products has created a soya bean boom in Brazil. In 2005, for example, China consumed 45 million tonnes of soya bean (250 per cent more than what it produced) out of which 5.5 million tonnes was shipped from Brazil, which doubled to 11 million tonnes in the next year. China also has investments in oil exploration in Ecuador, Colombia and Venezuela, signed a free trade agreement (FTA) with Peru, as well as extended a credit line to Cuba and signed an agreement to buy nickel and sugar. The growth of China has had a negative impact in Mexico however, with a move towards manufacturing instead of commodities. Mexican factories closed amid China’s rise as production moved to Asia where labor costs and other expenses were cheaper. The imports that subsequently poured from China have affected many small producers in Mexico such as artisans who did well making specialized guitars, ceramics and trinkets tied to Mexico’s Day of the Dead festivities. Source: Information from Alana Gutiérrez, ‘China’s Economic Invasion Into Mexico: A Threat to the U.S. or an Opportunity for Mexico?’, Council on Hemisphere Affairs (COHA), 15 October 2005, available at http:// www.coha.org/china%e2%80%99s-economic-invasion-into-mexico-a-threat-to-the-us-or-an-opportunity-formexico, ‘China president visits Mexico amid tension over cheap good’, shttp://www.usatoday.com/story/news/ world/2013/06/04/mexico-china-jinping/2388197/last accessed on 10 September 2013.

Introduction International trade is the exchange of goods and services between countries. Trade is the business of buying and selling goods or services in order to make a profit. Trade can be conducted within a country, or internationally between nations. When a country is a seller of goods or services to another country or region, such a transaction is called export, and a transaction through which goods or services are being purchased into a country or region is called import. In the global economy all kinds of commodities can be traded, from a small quantity of a precious metal such as gold to a supertanker full of oil. Commodities for trade fall into three main categories:

1. Primary products are derived from natural resources, such as tin, wood, grain, and fish, obtained from mining, forestry, agriculture, and fishing. 2. Secondary products are manufactured from primary products, and include cars, computers, ships, and clothes 3. Tertiary products refer to services provided by banks, insurance companies, law firms, and other professional organizations.

International Trade Theories The growth of international trade is explained by a number of theories which attempt to explain differences in trade structure between nations and regions.

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Mercantilist Doctrine The earliest explanation of international trade was known as the mercantilist doctrine. It emerged in England in the middle of the sixteenth century and explained international trade being based on two fundamental goals of foreign economic policy.

The mercantilist doctrine, explains trade between nations to be motivated by a nation’s desire to build its gold reserves.

1. The primary goal of trade was to increase the wealth of the nation by acquiring gold to be used for military conquest. 2. The second goal of international trade was to maximize exports and minimise imports to have a surplus in the balance of trade. Countries used various measures to act as barriers to trade to acieve this goal.

The main drawback of the theory of mercantilism was that it did not recognise anything except gold as the measure of a country’s wealth. It ignored factors such as the quantity of its capital, the skill of its workforce, and the strength of other production inputs including land and natural resources. The theory also considers international trade to be a zero sum game, according to which for one party to benefit from trade the other party has to be a loser.

Classical Approach The classical approach propounded that domestic The classical approach considered domestic production was the prime source of a nation’s wealth production as the prime source of a nation’s and productive efficiency was considered the motiwealth and productive efficiency was considered vating factor behind trade. The classical approach is the motivating factor behind trade. known for two famous theories given by economists Adam Smith and David Ricardo respectively. They are the theory of absolute advantage and the theory of comparative advantage. Theory of Absolute Advantage Adam Smith introduced the theory of absolute The theory of absolute advantage considers advantage in 1776 in his famous book An Inquiry trade between nations to be based on the coninto the Nature and Causes of the Wealth of Nations. cept of absolute advantage. A country has an According to him, trade between nations was based absolute advantage in the production of a prodon the concept of absolute advantage. A country has uct when it is able to produce it more efficiently an absolute advantage in the production of a product than any other country. when it is able to produce it more efficiently than any other country. According to this theory, a country should export those goods and services in which it has a production advantage and import those goods and services in which it has a production disadvantage. According to Smith, a country’s absolute advantage arises from two sources: 1. Natural advantages: A country may have a natural advantage in producing a product because of climatic conditions, access to certain natural resources, or availability of cheap or skilled labor force. Thus, India’s climate and land type support the production of cotton, whereas the climate and land conditions in Brazil support the production of coffee. Producing cotton in Brazil and coffee in India may be possible at a very high cost of production. It will therefore make economic sense for India to produce cotton and import coffee and for Brazil to produce coffee and import cotton.

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2. Acquired advantages: Most of the world trade today is in manufactured goods and services rather than agricultural goods and natural resources. Countries that produce manufactured goods and services competitively have an acquired advantage, usually in either product or process technology. Product technology gives a country’s products an identity that helps them to face global competition by being easily distinguished from those of its competitors. For example, Indian exports of brass items are distinguished for their craftsmanship and quality all over the world based on craftsmanship which has been polished to perfection over centuries. According to this theory, a nation benefits from international trade as it saves costs in importing goods that it would otherwise have to produce in the domestic market. Unlike the mercantilist doctrine which says that a nation could only gain from trade if the trading partner lost (zero-sum game), the absolute advantage theory argues that both countries would gain from an efficient allocation of national resources. Figure 4.1 provides a simple illustration of how a country gains from free trade. Let us assume that two countries Brazil and India have the same amount of resources and these can be used to produce either cotton or coffee. If 100 units of resources are available, we further assume that it takes Brazil four units of resources to produce one tonne of coffee and 10 units of cotton. Thus, Brazil could produce 25 tonnes of coffee and no cotton, or 10 tonnes of cotton and no coffee or some combination between these two. Similarly, we assume that India uses 20 units of resources to produce one tonne of coffee and five units of resources to produce one tonne of cotton. India could, thus, produce five tonnes of coffee and no cotton or 20 tonnes of cotton and no coffee or some combination between these two. This indicates that Brazil has an absolute advantage in producing coffee, whereas India has an absolute advantage in producing cotton. Therefore, Brazil should specialize in the production of coffee and India should specialize in the production of cotton. According to Adam Smith, in a situation such as this, both countries benefit from specialization and trade. World production would increase if both countries specialized in the production of the goods in which they have an absolute advantage and then traded to obtain the other goods in which they have an absolute disadvantage. 25 C

Quantity of coffee (tonnes)

India’s PPF Brazil’s PPF 20

15 A

12.5 10

5 B 2.5

D 0

5

10

15

20

25

Quantity of cotton (tonnes)

Figure 4.1  Production Possibilities with Absolute Advantage

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Table 4.1  World Output Without Trade

Country

Resource (units) Products

Measure (units per tonne)

Input (units)

Output (tonnes)

Total output (tonnes)

Brazil

100

Coffee Cotton

4 10

50 50

12.5 5

17.5

India

100

Coffee Cotton

20 5

50 50

2.5 10

12.5

Measure (units per tonne)

Input (units)

Output (tonnes)

Total output (tonnes)

Table 4.2  World Output with Trade

Country

Resource (units) Products

Brazil

100

Coffee

4

100

25

25

India

100

Cotton

5

100

20

20

What happens if the two countries do not trade with each other? Each country would then devote half the available resources for the production of coffee and half for the production of cotton. Brazil would then produce 12.5 tonnes of coffee and five tonnes of cotton and India would produce 10 tonnes of cotton and 2.5 tonnes of coffee as depicted in Table 4.1. Without trade, the combined production of both countries would be 15 tonnes of coffee (12.5 + 2.5) and 15 tonnes of cotton (5 + 10). This can be explained with the help of Figure 4.1. Points A and B are measures of the output of Brazil and India when they do not trade with each other. If each country produced only that commodity in which it has an absolute advantage, Brazil would produce 25 tonnes of coffee and India would ­produce 20 tonnes of cotton as depicted in Table 4.2. Total global production as a result of trade would be 45 tonnes of output as against 30 tonnes of output in the absence of trade. We can thus see that there is a net benefit of 15 tonnes of output to the world economy as a result of trade. A drawback of this theory is that it does not offer an explanation for a situation in which a nation may have an advantage in producing both commodities. The theory of comparative advantage offers an explanation for such a situation. Theory of Comparative Advantage The theory of comparative advantage, explains trade The theory of comparative advantage explains between nations in a situation where one country trade between nation to be the outcome of posis more efficient in the production of both tradable sessing a relative advantage in the production commodities. It was given by David Ricardo, who of a commodity. A country has a comparative stated that both countries would continue to gain advantage in producing a product if the opportufrom trade even if one is more efficient in the pronity cost for producing it is lower at home than in a foreign country. duction of both goods. Ricardo explained his theory using the concept of comparative advantage. This is illustrated in Figure 4.2. Continuing with the example given in the preceding section, let us assume that India is more efficient in the production of both coffee and cotton. Brazil requires 10 units of resources to produce one tonne of coffee and 10 units to produce a tonne of cotton, whereas it takes India only five units of resources to produce a tonne of coffee and four units to produce a tonne of ­cotton.

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Assuming further that there is no trade between these countries, each will use half its resources for the production of coffee and half for the production of cotton. Thus, without trade, Brazil will produce five tonnes of coffee and five tonnes of cotton (Point A in Figure 4.2), while India will produce 10 tonnes of coffee and 12.5 tonnes of cotton (Point B in Figure 4.2) as depicted in Table 4.3. In the absence of trade, total world output will be 32.5 tonnes, out of which 10 tonnes is contributed by Brazil and 22.5 tonnes from India. The combined production of coffee will be 15 tonnes (5 + 10) and of cotton will be 17.5 tonnes (5 + 12.5). Hence, India has an advantage in the production of both coffee and cotton and produces more of both commodities as compared to Brazil. However, it has a comparative advantage in the production of cotton, since it produces 2.5 times more cotton than Brazil, while it produces only twice as much coffee as Brazil. India’s PPF

20

Brazil’s PPF

Quantity of coffee (tonnes)

15

C

10

B

D 6 5

E A

0

5

10

12.5

15 17.5

Quantity of cotton (tonnes)

20

25

18.75

Figure 4.2  Production Possibilities with Comparative Advantage Table 4.3  India’s Comparative Advantage Without Trade

Country

Resource (units) Products

Measure (units per tonne)

Input (units)

Output (tonnes)

Brazil

100

Coffee Cotton

10 10

50 50

5 5

India

100

Coffee Cotton

5 4

50 50

10 12.5

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Total output (tonnes) 10 22.5

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Table 4.4  Opportunity Costs of Coffee and Cotton Country

Coffee

Cotton

Brazil

10/10 = 1

10/10 = 1

India

5/4 = 1.25

4/5 = 0.8

Table 4.5  World Output with Trade Between India and Brazil

Country

Resource (units) Products

Measure (units per tonne)

Input (units)

Output (tonnes)

Total output (tonnes)

Brazil

100

Coffee Cotton

10 10

100 0

10 0

10

India

100

Coffee Cotton

5 4

0 100

0 25

25

To understand the benefits from trade in such a situation, we use the concept of opportunity cost. The opportunity cost of producing a commodity X is the amount of other goods, which have to be given up in order to be able to produce one unit of X. A country has a comparative advantage in producing a product if the opportunity cost for producing it is lower at home than in a foreign country. Thus, the lower the opportunity cost, the higher is the comparative advantage. Table 4.4 shows the opportunity costs for producing coffee and cotton in Brazil and India, based on the information given in Figure 4.2. Table 4.4 shows that Brazil has a lower opportunity cost in producing coffee, while India has a lower opportunity cost in producing cotton. Thus, Brazil has a comparative advantage in the production of coffee and India has a comparative advantage in the production of cotton. Therefore, as indicated by Table 4.5, if the two countries trade with each other, Brazil will export coffee and import cotton. India, on the other hand, will export cotton and import coffee. With trade, India produces 25 units of coffee and Brazil produces 10 units of cotton, with a total output of 35 units. As long as the opportunity costs for the same commodities differ between countries, open trade will result in gains for each country through specialization in producing a commodity (or commodities) in which a country has comparative advantage viz-à-viz its trading partner(s). The main drawbacks of the classical theory of international trade are as under: ■■ The explanation is based only on labor as a factor of production. In the real world, all other factors of production are equally important. ■■ The theory assumes that a country has a fixed stock of resources. ■■ The theory does not consider differences in transportation cost. ■■ Classical economists also assumed that resources are mobile in the domestic marBird’s-eye View ket but they are immobile internationally. However, labor may be immobile within the The earliest explanations of international trade domestic economy also especially if the job is came from the mercantilist doctrine and the highly technical. In the modern context, outclassical trade theory. These theories explain sourcing has made labor mobile internationtrade as a source of wealth generation for ally, since the skill in an offshore employee is national economies. used across geographical boundaries.

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Factor Proportions Theory The factor proportions theory also called the The Heckscher–Ohlin (H–O) theorem or factor Heckscher–Ohlin (H–O) theorem was developed proportions theory explains international trade by Swedish economists, Eli Heckscher in 1919 as a link between national factor endowments and Bertil Ohlin in 1933. It explains international and the comparative advantage of nations. trade in terms of national factor endowments and the comparative advantage of nations. The theory explains that a country’s exports are based on the differences in the endowment of labor and capital. According to the theory, the cost of production of a country depends upon its factor endowments of labor and capital, in other words, the total cost of production depends on whether an economy is labor-intensive or capital-intensive. This in turn explains its basic trade pattern and behavior. The basic assumptions of this theory are: ■■ Countries have different availability of factors of production, that is, they are differently endowed in terms of labor and capital. This makes them either capital-intensive or labor-intensive in terms of production. ■■ The production function is an input-output function showing the relationship between output and its inputs in terms of capital and labor. Each commodity has its own specific production function but the production function is identical everywhere in the world. This essentially implies that the same quality of labor and capital input will produce the same output of a given commodity everywhere in the world. ■■ It also assumes that technology is constant across the world. Therefore, technological differences have no role to play in a country’s trade. ■■ Another assumption of the theory is that demand for factors of production is identical across the world; therefore, the cost of production is determined by its supply. It is the differences in the relative supply of a factor of production that lead to a difference in its price. Thus, the cost of production of a commodity is determined by whether production in the economy is laborintensive or capital-intensive. According to the factor proportions theory, the comparative advantage of nations is a result of differences in its basic economic structure. A country’s efficiency in production depends on its cost of production, which in turn depends on the availability of its factors of production. A country has a lower cost of production through the use of its abundant factor as compared to its scarce factor of production. This implies that if an economy has more labor in comparison to land and capital, its production costs would be lower if it uses labor-intensive technology as compared to the use of capital-intensive methods of production. These relative factor costs would lead countries to choose the production and export of those products which use its abundant, and, therefore, cheaper factors of production and import those products which it can domestically produce at a higher cost. Thus the comparative advantage of a country arises out of differences in the structure of its economy. For example, the United States has abundant capital in comparison to labor. Hence, it exports capitalintensive commodities such as motor vehicles, whose production requires a greater use of capital than other products, and imports labor-intensive commodities, such as clothing.

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The implications of the H–O theorem for world trade are as follows: ■■ Trade as well as trade gains should be greatest between countries with the greatest differences in economic structure. ■■ Trade would result in countries specializing, producing and exporting goods that are based on their economic structure and distinctly different from their imports. ■■ Trade policy should take the form of trade restrictions rather than trade stimulation. ■■ Countries should export goods that make intensive use of their relatively abundant factors.

Leontief Paradox The Leontief paradox, developed by Wassily Leontief The Leontief paradox contradicted the findings in 1953, is a contradiction of the H–O theorem. of the H–O theorem by testing trade patterns of According to the H–O theorem a country exports the US economy. those goods which make intensive use of its abundant factor and imports those goods which make intensive use of its scarce factor. As per the H–O theorem, the US trade structure should have capitalintensive exports and labor-intensive imports. Leontief tested this using input-output tables covering 200 industries and 1,947 trade figures, and found that US exports were labor-intensive and its imports capital-intensive. Since this result contradicted the predictions of the H–O theorem, these findings came to be known as the Leontief paradox. The Leontief study led to further empirical research, which has shown many paradoxical results and contains has challenged to the general applicability of the factor-endowments theorem in other countries, such as Germany, India, Canada, and Japan. Some of the issues raised by the Leontief paradox were: ■■ Demand bias for capital-intensive goods: The US domestic demand for capital-intensive goods is so strong that it reverses the US comparative cost advantage in the production and export of such goods. ■■ Existence of trade barriers: US labor-intensive imports were reduced by trade barriers (for example, tariffs and quotas) imposed to protect and save American jobs. ■■ Importance of natural resources: Leontief considered only capital and labor inputs, leaving out natural resources inputs. Since natural resources and capital are often used together in production, a country that imports capital-intensive goods may be actually importing natural resourceintensive goods. For example, the United States imports crude oil, which is capital-intensive. ■■ Factor-intensity reversals: A factor-intensity reversal occurs when the relative prices of labor and capital change over time, which changes the relative mix of capital and labor in the production process of a commodity from being capital-intensive to labor-intensive or vice versa.

Linder’s Income-preference Similarity Theory Staffan B. Linder’s income-preference similarity theory is based on actual patterns of world trade which contradict the H–O theorem. It has been observed that since 1970 three fourths of total world exports originate in the developed world with increasing trade volumes between countries of the developed world. This contradicts the H–O theorem, according

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According to the Linder’s income-preference similarity theory, trade potential between nations depends on similarity of demand preferences for different goods.

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to which trade should originate among nations which have different factor endowments. This means that trade should take place largely between developed countries producing manufactured goods and developing countries producing primary products (natural resource commodities such as oil and petroleum) using labor-intensive technology. According to Linder differences in factor endowments can explain trade in natural resource-­intensive products, but not in manufactured goods. According to him, a country’s manufactured exports are mainly determined by internal demand. International trade in manufactured goods takes place largely among developed nations because there is a strong domestic demand for these goods and a country will only export those goods which it manufactures at home. Linder also explained that trade intensity between nations can be explained by similarities in demand for manufactured goods between nations. The more similar the demand preference for manufactured goods in two countries, the more intensive is the potential trade between them. If two countries have the same or similar demand structures, then their consumers and investors will demand the same goods with similar degrees of quality and sophistication. This is known as preference similarity. This similarity boosts trade between the two industrialized countries. According to Linder the most important determinant of demand was average per capita income. Countries with high per capita income will demand high-quality ‘luxury’ consumer goods (for example, motor vehicles) and sophisticated capital goods (for example, telecommunications equipment and machinery), while low per capita income countries will demand low quality, ‘necessity’ consumer goods (for example, bicycles) and less sophisticated capital goods (for example, food processing machinery). As a result, a rich country that has a comparative advantage in the production of high-quality, advanced manufactured goods will find big export markets in other affluent countries, where people demand such products. Similarly, manufactured exports of the poorer countries will find their Bird’s-eye View best markets in other poor countries with similar demand structures. The theory of factor proportions, the Leontif Linder also stated that the effect of per capita paradox and Linder’s income–preference simiincome levels on trade in manufactured goods is larity theory are explanations of international affected by entrepreneurial ignorance, cultural trade based on differences in endowments of and political differences, transportation costs, and two factors of production—labour and capital. obstacles such as tariff barriers.

Product Life-cycle Theory The product life-cycle model, given by Raymond Vernon in the mid-1960s, focused on knowledge as an independent variable in the decision of a firm to trade or invest. Using the same basic tools and assumptions as the factor proportions theory, Vernon added two technology-based assumptions to the existing theory:



1. Technical innovations leading to new and profitable products require large quantities of capital and highly skilled labor. These factors of production are predominantly available in highly industrialized capital-intensive industries. 2. The same technical innovations, both the product itself and more importantly the methods for its manufacture, go through three stages towards maturity as the product becomes increasingly commercialized.

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The theory explains trade between nations for The product life-cycle model focuses on four technology-intensive products using a four stage stages in the the life of a product to explain trade model. It used the example of US exports of manbetween nations. ufactured goods to explain the basic theory. The model assumed that there are two kinds of nations in a trading relationship—the innovator and the imitator. The innovator nation develops its initial exports as a result of its product innovation ability. Over a period of time this ability to innovate gets reduced due to technological diffusion and lower costs of production abroad which enable an imitating nation to produce the same commodity at a lower cost but using similar technology. The life-cycle model includes the following four stages: 1. Introduction: The domestic market (the United States in this case) has an export monopoly in a new product. 2. Growth: Foreign production of this product begins. 3. Maturity: Foreign production of this product becomes competitive in export markets. 4. Decline: The exporter (the USA) now becomes an importer of this no longer new product. The theory stated that a technology-intensive new product is first produced in the domestic market because of the benefits of being close to customers and suppliers. This gives the nation an advantage over other competitors, and gives it an export monopoly. As the product design and production gets standardized, producers in other countries also begin to manufacture the product and the initial export monopoly of the nation declines. This is followed by the displacement of the original exporter as imitators begin to take over. Finally, foreign producers achieve sufficient competitive strength arising out of economies of scale and lower labor costs to export to the former exporting market. On the other hand, an imitating country starts to import the new product from the innovating country at different times. If this imitating country is a high-income, advanced country (for example, Germany), it begins to import around the same time that the innovator (USA) begins exporting. If, however, it is a low-income, developing country (for example, Mexico), then imports will begin some time after the United States begins its exports to the world economy. Local production begins at a time when the local market grows to a sufficient size and cost conditions favor production against imports. If the imitating country is an advanced country, this coincides with the stage when US exports begin to show a decline, but if it is a developing country, this stage comes a bit later. Finally, when production begins to exceed consumption, the imitating country begins to export, and may export first to third countries and later to the innovating country. Vernon’s theory also suggests that the product-cycle model of international trade is associated with the life-cycle stage of the product itself. As the product moves through its life cycle, the life cycle of international trade also changes. The new-product stage in the product life cycle is associated with the first production of the product in the innovating country and the early portion of the export monopoly stage. During this stage, production functions are unstable and rapidly changing techniques are used in production. No economy of scale is reached. This phase is also characterized by a small number of firms and no close substitute products. The growth-product stage is associated with the later portion of the export monopoly and the start of foreign production. During this stage, mass-production methods are used to exploit expanding markets, and, therefore, high returns are achieved from economy of scale and market growth. Finally, the mature-product stage is associated with the third and fourth stages of the product-cycle model of international trade. This last stage is characterized by production of standardized products with stable techniques and intense price competition.

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The product life-cycle theory helps to explain changes in production and trade in new product lines. It is generally true that the United States has been the principal innovator and production has spread rapidly to other countries that have been technically competent (for example, Germany) and to those which have had a comparative advantage in terms of cheap labor (for example, Mexico). It is also useful to remember that since the development of the model in the 1960s, the share of the United States in global gross domestic product (GDP) declined substantially, with other countries, such as Germany and Japan emerging as strong innovators. The product life-cycle theory offers accurate explanations of several global products. A classic example of this is photocopiers, which were developed in the early 1960s by Xerox in the United States and exported to other parts of the world, including Japan. It expanded through joint ventures to meet increasing demand and set up production facilities in countries like Japan and England. With the expiry of original patents, foreign competitors such as Canon in Japan and Oliveti in Italy entered the global market as low-cost competitors causing a decline in US exports. Production has subsequently shifted to other low-cost locations such as Thailand and Singapore, and the United States, Japan and the United Kingdom are now importers of the product. A basic drawback of the theory is its original ethnocentric orientation, and assumption of the United States as the country of origin for most products. In subsequent years, products such as video game consoles have been developed in Japan, and wireless phones in Europe. Recent editions of laptops, digital cameras and compact disks have seen a simultaneous introduction in different parts of the world. As the global value chain gets more and more dispersed, the predictive power of Vernon’s theory keeps losing more value.

The New Trade Theory The new trade theory refers to a series of papers by A. Dixit and V. Norman, K. Lancaster, Paul Krugman, E. Helpman, and W. Ethier, which propound the idea that trade between countries is based on increasing returns, product differentiation, and first mover advantage.

New trade theory explains trade between countries as based on increasing returns, product differentiation, and first mover advantage.

Economies of Scale The theory argues that economies of scale lead to increasing returns leading to specialization in many industries. Economies of scale refers to a reduction in the manufacturing cost per unit as a result of increased production quantity during a given time period. This is the result of using larger and more efficient equipment, financial economies on the bulk purchase of goods, and the allocation of fixed costs such as administrative overheads and R&D over a larger output. Production costs also decline because of the learning curve, which refers to the improvement in productive efficiency arising out of increased production, leading to reduction in costs. Product Differentiation Paul Krugman combined the concepts of economies of scale with the use of differentiated products to explain the pattern of intra-industry trade. According to this explanation, economies of scale determine the geographical concentration of the production of goods. He also explained that the concept of product differentiation was associated with resource constraints and imperfect competition between firms. Product differentiation, in turn, creates a product identity that is responsible for brand loyalty and helps the firm

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attain a monopoly. Thus, firms in the same industry but from different countries produce differentiated products, which become the basis of intra-industry trade creating a larger market for goods and allowing better utilization of internal economies of scale. The theory is along the same lines as Linder’s incomepreference similarity theory and finds empirical support in industries such as automobiles, speciality chemicals and wine, and explains the high proportion of intra-industry trade in overall international trade. First Mover Advantage This explanation of trade emphasizes the economic and strategic benefits to a firm from being an early entrant in the market. These benefits arise in the form of market share from reduced costs and improved technical expertise; benefits which are not available to the late entrant. The theory emphasizes that for products which have significant economies of scale and represent a substantial volume of world trade, the first movers in an industry get a low-cost advantage that later entrants are unable to match. Various studies have proved that first movers have become industry leaders.

National Competitive Advantage Michael Porter of the Harvard Business School proMichael Porter explained national competiposed the theory of national competitive advantage tiveness in terms of four attributes known as to explain what enabled a nation to compete in the ‘Porter’s Diamond’. international arena. Considered an extension of Adam Smith’s theory of absolute advantage, Porter explained national competitiveness in terms of having four attributes—factor endowments, demand conditions, related and supporting industries, and firm strategy, structure and rivalry. They are together known as ‘Porter’s Diamond’. He considered the emergence of countries such as Switzerland in precision instruments and pharmaceuticals, Japan in automobiles, and Germany and the United States in chemicals to be the result of these attributes. Factor Endowments The concept of factor endowments, introduced for the first time in the H–O Theorem refer to a nation’s factors of production such as skilled labor and capital. However, Porter proposed a hierarchy among them and distinguished between basic factors such as natural resources, climate, location and demographics, and advanced factors such as skilled labor, communication technology and research facilities. According to him, advanced factors have a significant role to play in the national competitive advantage and are the result of the efforts of individuals, companies, and governments. The theory explains that basic factors provide a nation with an initial advantage, which is reinforced by the advanced factors. Lack of natural endowments makes nations invest in the creation of advanced factors in order to have the ability to compete globally. For instance, various Caribbean nations have upgraded their communication systems to attract banking and other services into the economy. Japan’s investment in the creation of engineers is likewise responsible for the success of its manufacturing sector. Demand Conditions Competitiveness is not only a function of the size of the demand but also its nature. For instance, if domestic demand is sophisticated, it forces the firm to produce high-quality products through innovative production practices. Japanese cameras are considered the best worldwide because of the demand for sophisticated products by the Japanese consumer. Similarly, Nokia’s global leadership in mobile telephony is the outcome of the domestic demand in Finland.

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Related and Supporting Industries Competitive advantage is strengthened through the presence of efficient backward and forward linkages. A firm’s suppliers and other related industries lead to spillover effects that translate into global competitiveness. For instance, Switzerland’s success in pharmaceuticals is linked to its prior knowledge and leadership in the technologically-related dye industry. Similarly, the leadership of the United States in personal computers and other electronically advanced products is based on its technological leadership in the semi-conductor industry. The emergence of the software industry in the Indian context is the result of its English-speaking qualified labor force located in the golden triangle—the cities of Hyderabad, Chennai and Bangalore—developed with support from the large number of engineering colleges, government assistance in infrastructure, and other facilities creating networks of learning. According to Porter, the existence of related and supporting industries leads to their getting grouped into clusters of related industries. He identified the German textile and apparel cluster as an example where high-quality wool, cotton, synthetic fibres, sewing machine needles, and a wide variety of textile machinery are all grouped together. Such clusters are valuable sources of knowledge, which benefits everyone in the cluster through movements of employees between firms and for professional meetings and conferences. Firm Strategy, Structure and Rivalry This refers to the extent of domestic competition, barriers to entry, and the firm’s management style and organization. The existence of heavy competition in the domestic market forces a firm to develop its skills to be internationally competitive. Market structure also affects a firm’s competitive response. The oligopolistic automobile sector has seen intense competition among auto majors Toyota, Honda, Nissan and Mitsubishi to improve performance through better and superior products. Management styles and beliefs also play a role in building competitive advantage. Porter noted that the emphasis of German and Japanese firms on improving manufacturing processes and product design is the result of a predominance of engineers in their top management teams. In contrast to this, US firms are usually led by people from finance, and, hence, they lack attention to manufacturing details. According to Porter, the degree of a nation’s success is a function of the combined impact of all these factors. Along with these, the government has a role to play through policies on subsidies, education and capital markets, which have an impact on domestic Bird’s-eye View demand and on supporting and related industries. It is difficult to comment on the predictive capaThe technological gap and the product lifebility of Porter’s theory since it has not been subcycle theories explain trade in manufactured jected to too much empirical testing. Just like other goods by a skilled labour force assisted by theories, it offers a partial explanation and completechnological advancements. ments them.

Theory Assessment None of the theories discussed in this chapter individually explain the entire range of motives for international trade between nations, but collectively provide invaluable insights about international trade. The comparative advantage theory, is a powerful explanation of international trade in natural resource products, such as bananas. The factor proportions theory given by the H–O theorem is the most acceptable explanation of the pattern of trade in labor-intensive products. Extending the factor proportions theory by including skilled labor and technologies, the H–O theorem explains current trade patterns between developed and developing countries. Trade between Europe and Southeast Asia is an example of this.

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Major exports from Europe are technology-intensive products, including power generation equipment, petroleum processing machinery, medical equipment, and transportation equipment, whereas exports from Southeast Asia are mostly labor or skilled labor-intensive products, such as garments, furniture, shoes, rubber products, arts and crafts, and standardized electric and electronics products. Meanwhile, the technological gap (human skills and technology-based views) and the product lifecycle theories emerge as powerful explanations of trade in ‘new’ products, that is, manufactures made by a skilled workforce using different technologies. These skills and technologies are the key factors responsible for improving a country’s terms of trade, which is the major concern of both developed and developing countries today. Terms of trade is the relative price of exports, that is, the unit price of exports divided by the unit price of imports, which improves if the country exports more goods that are associated with advanced human skills and technologies. Although the product life-cycle model is less applicable today than when it was first propounded, it still explains key patterns in the evolution of international trade as every new product goes through a series of stages in the global marketplace. The Leontief paradox and Linder’s income-preference similarity theory are perfect explanations for trade in sophisticated manufacturing products and on trade between regions with similar income levels and consumption preferences. These theories view market demand (income levels and demand structure) as important parameters of international trade. Indeed, international trade today is driven not only by national differences in factor endowments but also by national differences in market demand. Intra-regional trade still accounts for a high proportion of world trade because of similarities in income levels and demand structures, as well as efficiencies arising from reduced uncertainty and transaction costs. The limitation of these theories is that they did not explain how trade activities would take place between two nations sharing similar income levels but with different consumption preferences. Due to this weakness, they seem unable to explain the increasing trade between developed countries and newly industrialized (for example, Singapore, South Korea, Taiwan, and Hong Kong) or emerging markets (for example, China, Brazil, India, Russia, and Mexico). These countries are not in the same region, nor do they share similar consumption preferences with the Western world. Increasing incomes and elevated purchasing power seem to be the key driver of this trade phenomenon. The basic contribution of the new trade theory is that it helps to understand intra-industry and intrafirm trade. The theory brings firms into the picture as the link between national factor endowments, firm behavior, and firm incentives in explaining international trade. This link is important because firms rather than countries conduct international trade and investment. The efficiency of international trade is maximized if both differences in national factor endowments and the advantages of economies of scale of firms are combined and realized simultaneously. Since the TNC’s role in international trade and investment is highly visible, the new trade theory has attracted more attention in recent years. The limitation of this theory, however, is that it overlooks other incentives beyond increasing returns from economies of scale.

DEVELOPMENTS IN WORLD TRADE International trade split into three broad groups in the first three decades after World War II. The first group consisted of the ‘old’ industrial countries which functioned as market oriented economies with increasingly liberalized trade regimes under the General Agreement on Tariffs and Trade (GATT ). The second group, comprising the Soviet Union, the rest of eastern Europe and China, consisted of centrally planned economies in which state-owned firms followed government policy in production and trading decisions. International trade played a relatively minor role in these economies, although some cooperation within the group was organized under the umbrella of the Council for Mutual Economic

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Assistance (CMEA). The CMEA was a 1949–1991 economic organization under the hegemony of Soviet Union comprising the countries of the Eastern Bloc along with a number of communist states elsewhere in the world. The third group of developing countries comprised many nations that had recently gained their ­political independence between 1946 and 1962. Many of them opted for a mixed system in which the government played a strong interventionist role to encourage industrialization. This essentially led to a regime of import substituting policies that relied on high tariff and non-tariff barriers to protect domestic industries. This tripartite system led to a rise in the share of industrial countries in world trade, while those of the centrally planned and developing economies decreased. The character of this tripartite trading system began to change with the emergence of the East Asian economies characterized by high per capita income growth with strong trade expansion in manufactured goods. This was simultaneously accompanied by policy re-orientation in Mexico and China in the early 1980s combined with the fall of the Berlin Wall and the dissolution of the Soviet Union a decade later.

Volume of Trade International trade after World War II entered a long period of record expansion with world merchandise exports rising by more than 8 per cent per annum in real terms from 1950 to 1973. Trade growth slowed thereafter under the impact of two oil price shocks, a burst of inflation caused by monetary expansion, and inadequate macroeconomic adjustment policies. In the 1990s, trade expanded again more rapidly, partly driven by innovations in the information technology (IT) sector and partly by the emergence of the Southeast Asian economies. Despite the contraction of trade caused by the dotcom crisis (a crisis generated by IT companies due to the misplaced confidence regarding profits and the speculation resulting from it, which resulted in rapidly rising stock prices and the subsequent crash) in 2001, the average expansion of world merchandise exports continued to be high averaging 6 per cent from 2000 to 2007. World merchandise exports were severely affected by the global financial crisis which started off in mid-2007. They grew by just 2 per cent in volume terms over the course of 20081 and contracted by 12.2 per cent in the following year2, the steepest fall ever. The decline in trade volumes saw short-lived reversal in 2010 when exports surged by 14.5 per cent, enabling world trade to return to its pre-crisis level3 and before decelerating to a growth rate of 5 per cent and 2 per cent in 2011 and 2012, respectively.4, 5 In the last 30 years, trade in merchandise and commercial services have increased by about 7 per cent per year on average, reaching a peak of USD 19 trillion and USD 5 trillion respectively in 2013. In value-added terms, trade in services had a significant role to play. Between 1980 and 2011, the share of developing in world exports increased from 34 per cent to 47 per cent and their share in world imports from 29 per cent to 42 per cent between 1980 and 20116. Asia is playing an increasing role in world trade. The value of world merchandise exports rose from USD 2.03 trillion in 1980 to USD 18.40 trillion in 2012, which is equivalent to 7.1 per cent growth per year on average in current dollar terms. The increase in commercial services trade was even more, recording a growth of USD 367 billion in 1980 to USD 4.35 trillion in 2012, or 8 per cent per year. In terms of WORLD TRADE REPORT 2009 http://www.wto.org/english/res_e/booksp_e/anrep_e/world_trade_report09_e.pdf. WORLD TRADE REPORT 2010 http://www.wto.org/english/res_e/booksp_e/anrep_e/world_trade_report10_e.pdf. 3 WORLD TRADE REPORT 2011 http://www.wto.org/english/res_e/booksp_e/anrep_e/world_trade_report11_e.pdf. 4 WORLD TRADE REPORT 2012 http://www.wto.org/english/res_e/booksp_e/anrep_e/world_trade_report12_e.pdf. 5 WORLD TRADE REPORT 2013 http://www.wto.org/english/res_e/booksp_e/anrep_e/world_trade_report13_e.pdf. 6 http://www.wto.org/english/news_e/pres13_e/pr692_e.htm, last accessed on 10th September 2011. 1 2

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volume (i.e., accounting for changes in prices and exchange rates), world merchandise trade recorded a more than four-fold increase between 1980 and 2011,7 increased by 2.1 per cent in 2013. China has been the world’s leading exporter since 1980, followed by the United States, Germany, Japan and the Netherlands in 2012. The world’s leading merchandise importers in 2012 were the United States, China, Germany, Japan and the United Kingdom. India has the 12th position in the list of importing countries. The top five exporters of commercial services in 2012 were the United States, the United Kingdom, Germany, France and China. The five leading importers of commercial services were the United States, Germany, China, the United Kingdom and Japan. India occupied the 7th position in the list of commercial services importing countries in 2011. Merchandise exports of developed economies grew more slowly than the world average at 1.5 per cent, while shipments from developing countries grew faster than the average growth at 3.3 per cent in 2013. On the import side, developed economies recorded a small decline of 0.2 per cent, while developing economies (such as in Commonwealth of Independent States [CIS]) increased by 4.4 per cent. Asia’s exports grew faster than any other region’s in last year, with a 4.6 per cent rise. It was followed by North America (2.8 per cent), Europe (1.5 per cent), the Middle East (also 1.5 per cent), South and Central America (0.7 per cent), the CIS (also 0.7 per cent) and Africa (–3.4 per cent). Asia’s export growth was held back by Japan, which saw its shipments to the rest of the world declined by 1.8 per cent. Meanwhile, exports of China and India increased by 7.7 per cent and 6.7 per cent, respectively. These performances were better than 2012, but still relatively weak by recent historical standards. The negative figure for Africa was due to sharp reductions in shipments from petroleum exporting countries, including Libya (–27 per cent), Nigeria (–11 per cent) and Algeria (–7 per cent). Turning to imports, the fastest growing region in 2013 was Asia (4.4 per cent), followed by the Middle East (4.4 per cent), Africa (4.0 per cent), South and Central America (2.5 per cent), North America (1.2 per cent), Europe (–0.5 per cent) and the CIS (–1.1). India suffered a sharp drop of 2.9 per cent in its imports as a result of its economic slowdown, but China’s purchases from abroad jumped nearly 10 per cent. Africa was able to increase its imports even its exports fell in 2013 due to continued high primary commodity prices. Although prices for metals, raw materials and beverages (including coffee, tea and cocoa) have fallen in 2012 and 2013, oil prices have been remarkably steady, rising 1 per cent in 2012 and falling 2 per cent in 2013.8 Exports grew faster than the world average in Asia and North America at rates of 15.0 per cent and 23.1 per cent, respectively, whereas Europe (10.8 per cent), the Commonwealth of Independent States (CIS) (10.1 per cent), the Middle East (9.5 per cent), Africa (6.4 per cent) and South and Central America (6.2 per cent) recorded a slower than average growth. Asia’s rapid real export growth in 2010 was led by China and Japan. They recorded an increase of approximately 28 per cent in comparison to the rest of the world. Regions such as Africa, the CIS, the Middle East and South America that have significant exports of natural resources experienced relatively low-export growth in terms of volumes in 2010, but very strong increases in the dollar value of their exports. For example, Africa’s exports were up by 6 per cent in terms of volume, and 28 per cent in terms of dollars. This was due to the rising prices of commodities driven by the increasing demand for imports by India and China. Between 2000 and 2010, prices for metals showed an average annual increase of 12 per cent per annum, which was faster than any other primary commodity group, followed closely by energy with 11 per cent growth per annum. Only agricultural raw material prices stagnated, with increases of just 2 per cent per year on an average, over the last ten years. 7 8

http://www.wto.org/english/res_e/booksp_e/wtr13-2b_e.pdf, last accessed on 10th September 2011. http://www.wto.org/english/news_e/pres14_e/pr721_e.htm.

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Composition of World Trade There has been a long-term shift in the composition of world merchandise trade, with the share of manufactured goods rising dramatically, against a decline in agricultural products and non-fuel minerals. The prominent role played by the industrial economies in world merchandise exports up to the 1990s was closely linked to their very large share in exports of manufactured goods. Manufactures accounted for just 40 per cent of trade in 1900, but this rose to 70 per cent in 1990 and to 75 per cent in 2000 before falling back to 64 per cent in 2012. In contrast to manufactures, agricultural products saw their share in world trade fall steadily. The share of agricultural products (including processed food) declined from more than 40 per cent in 1950 to 12 per cent in 1990, and finally to 9.2 per cent in 2012. Fuels accounted for 18.8 per cent of world merchandise trade in 2012, registering a growth rate of 5 per cent from the previous year. Over the years, the domination of developed countries in world exports of manufactured goods has been greatly diluted, first in labor-intensive goods, such as textiles and clothing, and, subsequently, in electronic products and capital-intensive goods, such as automotive products. Trade in commercial services has grown in line with trade in goods for the last 20 years. Although services trade grew faster than goods trade in the 1980s and 1990s, the rate of increase in services slowed in the 2000s to the point where its average rate fell below that of goods. Furthermore, services trade has been much less volatile than trade in goods since the global financial crisis of 2008–09. Commercial services accounted for roughly 19 per cent of total world trade in world goods and commercial services in 2012.

Direction of World Trade The most dynamic traders of the global economy in the 1950–1973 period were the west European countries and Japan. Post-World War II reconstruction and the Korean War provided a major stimulus to Japanese and European exports in the early 1950s. European integration kept up the pace of intraEuropean trade. The United States remained Japan’s largest export market throughout that period, but there was rapid movement of Japanese export to western Europe and to the Asian newly industrialized economies (NIEs). The six NIEs followed an outward-oriented trade policy and succeeded in sharply increasing their merchandise exports from the early 1960s, leading to a growth in their share of world exports from 2.4 per cent to 9.7 per cent in two decades. Starting out as textile exporters, these economies later diversified into exports of consumer electronics and IT products. The dominant share of the United States in world trade in the early 1950s went down in subsequent decades. During the 1970s and 1980s, the share of regions in world merchandise exports varied, largely due to the fluctuations of commodity prices and exchange rates. The oil-exporting developing countries (especially those in the Middle East) increased their share between 1973 and 1983 but lost almost all their gains when oil prices fell later. In the 1990s, Japan’s share in world exports started to shrink significantly owing to the competitive pressure exerted by the NIEs and China. The stimulus provided by the creation of the North American Free Trade Agreement (NAFTA) in 1994 was not sufficient to reverse the downward trend in the share of Canada and the United States in global trade. Similarly, the European integration process which continued to deepen and expand to cover the central European countries and the Baltic States could not halt the relative decline of European exports. The reduced share of the industrial countries can be attributed first to the rise of China, the recovery of the Commonwealth of Independent States (CIS) and in more recent years to the boom in

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commodity markets. Increased competition from China in the world trade of manufactured goods was concentrated initially on the textiles trade and other labor-intensive goods, such as footwear and toys, but expanded quickly into consumer electronics and IT goods. More recently, China’s biggest gains in market share were in iron and steel products. China more than tripled its share in world exports between 1990 and 2007. In 2013, China surpassed the US as the world trade leader with its combined exports and imports reaching USD 4.16 trillion, 10 per cent of world trade. This leaves no doubt that China, the world’s second-biggest economy, is now the world’s biggest trading nation on an annual basis.

Service Trade Trade in services currently accounts for a significant proportion of global trade and has a rapidly ­growing share. Service trade encompasses the import and export of financial services, information services, the provision of education and training, travel and tourism, health care, consulting and advisory services, and so on. Due to their advantage in services, developed countries tend to push much more aggressively for a removal of barriers to trade in services.

CHA P TER

SU M M AR Y

■■ International trade is the exchange of goods and services across borders. A number of theories help to explain why nations trade with each other. Some of these include the theory of comparative advantage, the theory of absolute advantage, the factor proportions theory, the Leontief paradox and the international product life-cycle theory. All of them propound the case for free trade. ■■ The classical approach has two basic variants—the theory of absolute advantage and the theory of comparative advantage. ■■ The theory of absolute advantage suggests that individual countries should specialize in the exports of goods they are best suited to produce because of natural and acquired advantages. ■■ The theory of comparative advantage believes that a country’s comparative advantage is dependent on differences in comparative production cost, which further depends on the commodity’s production process, and on the prices of production factors linked to the availability of those factors. ■■ The factor proportions theory states that differences in a country’s factor endowments are the basis of trade. This proposition was disputed by the Leontief paradox in a study of trade in the United States. ■■ The product life-cycle theory links trade with developments in a product’s life span encompassing four stages, namely, introduction, maturity, growth, and decline. ■■ Contemporary thinking on trade emphasizes the role of economies of scale as the determinant of trade and strategic thinkers promote the judicious use of subsidies to enable firms to become first movers in emerging industries. ■■ Important aspects that have to be taken into account while reviewing trends in world trade are volume, composition, direction, and trade in services. Trade in services has emerged as an important aspect of international trade especially for countries of the developing world.

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Key Terms International trade, Imports, Exports, Absolute advantage, Comparative advantage, Production factor, Factor endowment, Factor proportions theory, Product life-cycle model, Economies of scale, Product differentiation, National competitiveness.

Discussion Questions

1. Compare the theory of absolute advantage and the theory of comparative advantage and c­ omment on their relevance in the present era of modern trade. 2. How does the factor proportions theory explain trade between nations? How does the Leontief paradox modify its explanation? 3. Explain the importance of the product life-cycle theory in explaining trade between nations. 4. Analyse the product life cycle theory of international trade in detail. What criticisms are ­levelled against it? [Delhi University, (B.Com Hons.) 2010] 5. What are the main differences between the factor proportions and product life cycle theories of international trade? [Delhi University, (B.Com Hons.) 2011] 6. Explain Porter’s theory of national competitive advantage as a theory of international trade.  [Delhi University, (B.Com Hons.) 2009 and 2014]

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5 COMMERCIAL POLICY INSTRUMENTS LEARNING OBJECTIVES After going through this chapter, you should be able to:

■ ■ ■ ■

Examine the rationale behind different forms of trade protection

■ ■

Understand the direction of foreign trade in India

Explain the various forms of trade regulation Distinguish between tariff and non-tariff barriers to trade Appreciate the relevance of the changing trade situation for the international business manager Examine the different avenues of export promotion in the Indian context

no aLPHonSo For eu The European Union imposed a ban on the Indian Alphonso mango this summer since a large number of fruit and vegetable consignments were found infested with pests, such as non-European fruit flies which could be a potential hazard for European agriculture. It also imposed a ban on the import of vegetables, such as Colocasia sp (taro, eddo), Mangifera sp (mango), Momordica sp (bitter gourd), Solanum melongena (eggplant) and Trichosanthes sp (snake gourd) from India stating that there were significant shortcomings in the phytosanitary certification system for these vegetables. The ban imposed until 2015 is symbolic of unilateral protectionist measures which have been used by the EU from time to time. Last year, the EU had imposed rapid tariffs against Chinese solar panel imports, following a complaint by a small consortium of German producers. The danger of certain non-European pests being introduced into EU agriculture and production is a serious issue, but the imposition of a blanket ban on imports till 2015 seems to be indicative of unreasonable trade policy regime which the EU is often criticized for. Source: http://www.telegraph.co.uk/news/worldnews/europe/eu/10825458/The-European-Unions-mango-banis-no-laughing-matter.html, http://www.hindustantimes.com/world-news/european-union-bans-indian-mangoesvegetables-due-to-concerns-over-pests-insects/article1-1200767.aspx, last accessed 13 July 2014.

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Introduction International trade theory in Chapter 4 discusses the theoretical basis of international trade and the advantages of fair and unrestricted trade to the world economy. In actual fact, it is seen that all countries interfere with international trade in varying degrees. This chapter examines the different rationales for protection adopted by nations and then looks at the different forms that protection can take. It also examines trends in global trade, the direction of foreign trade in India and examines the different measures taken by the government to promote exports in India.

Government intervention in trade There are two rationales for government intervention in trade—an economic rationale and a non-­ economic rationale.

Economic Rationale The economic factors for trade intervention are as follows: Protection to Infant and Domestic Industry The infant industry argument proposed in 1792 by Alexander Hamilton is the oldest economic reason for trade intervention. According to this argument, domestic industry needs to be protected from foreign competition in the initial stages of its life. This is a period when the firm secures finance, gains mastery over production techniques, trains its labor force, and begins to reap economies of scale. It is argued that in the absence of these measures, it is impossible for the domestic firm to face competition in low-priced goods. This argument was the basis for protection and an inward-looking Indian industrial policy in the initial stages of the development of its industries as was the case for several other developing countries. It has been seen, however, that protection only helped to foster inefficiency as protected industries rarely made the effort to adopt efficient methods of production due to the security they received in a protected environment. Employment and Industrialization This argument goes hand in hand with the infant industry argument. It argues that setting up domestic manufacturing units lead to the twin benefits of employment and industrialization in the domestic economy. This, in turn, leads to regional and national growth. After the onset of the recent global crisis of 2008, even the USA saw a move to ‘buy American goods’ in the interest of reviving the domestic economy. Balance of Payments Position The balance of payments position is a country’s financial statement based on trade and investment flows. Persistent deficits in a country’s balance of payments often force countries to adopt trade ­restrictions. For example, countries such as India import huge amounts of oil and related products. This often leads to policies such as tied imports, that is, imports which will help in re-export to help its balance of ­payments position. Although protection is meant to be temporary, in reality, it extends over a long time period, as a firm or industry rarely ever admits that it is not required.

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Non-economic Rationale The non-economic rationale for trade protection are: Preservation of National Identity and Culture It has been argued that free trade is a threat to national identity, culture, and institutions. Countries such as Canada and France impose restrictions on foreign media as they consider it a threat to their language and culture. Japan, on the other hand, imposes a high tariff on rice, which is a part of their staple diet and essential to their way of life. Trade as a Bargaining Tool Trade protection is often used as a tool to bargain with trading partners. This may be done as measures of passive or actively reciprocal behavior. For instance, a country may refuse to lower or eliminate its barriers to trade until the other party does the same. On the other hand, a country may withdraw previous concessions or threaten to take retaliatory steps if its trading partner does not respond with similar concessions. As an example, the US government threatened China with stringent trade sanctions to try and get the Chinese to improve their intellectual property laws, which were causing US companies such as Microsoft to lose billions of dollars in trade revenue. The use of trade protection as a bargaining­ tool can be a double-edged sword, which can lead to trade openness and its attendant benefits if it is successful­, but could severely restrict trade if the partner country retaliates through similar measures of protectionism. Protection of Consumer and Human Rights Trade restrictions are often meant to protect domestic consumers against products that are unsafe and hazardous. The European Union (EU), for instance, has strict guidelines and even imposes barriers against agricultural produce entering its markets. This includes the sale of hormone-treated meats and the produce from genetically modified crops. Countries such as the United States have also resorted to measures like not granting the mostfavored-nation (MFN) status to China to protest against its human rights violations.

Bird’s-eye View Government intervention in free trade between nations is based on both economic and noneconomic rationale. Economic rationale is based on protection to domestic and infant industry, issues of employment and industrialization and a country’s balance of payments position. Non-economic rationale is based on factors like preservation of national identity and culture, protection of consumer and human rights and the use of trade as a bargaining tool.

INSTRUMENTS OF TRADE CONTROL Government intervention in trade takes the form of tariff and non-tariff barriers. Tariff barriers are direct Tariff barriers are direct, transparent and official constraints on the import of certain goods non-discretionary constraints on trade. and services that are non-discretionary in application. Non-tariff barriers are indirect measures that discriminate against foreign goods in the domestic market or otherwise distort and constrain trade and have a discretionary application. Tariff barriers affect prices; non-tariff barriers can affect either price or quantity directly.

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Tariff Barriers A tariff (sometimes called duty) is the most common type of trade control and is a tax that governments levy on a good shipped internationally, over and above taxes levied on domestic goods and services. Tariffs are transparent and are typically set on an ad valorem basis, that is, on the basis of the value of the good or service in question. Governments charge a tariff on a good when it crosses an official boundary, whether it is that of a country, for example Mexico, or a group of countries, like the EU, that have agreed to impose a common tariff on goods entering their bloc. Tariffs are of different types: ■■ Tariffs collected by the exporting country are called an export tariff. ■■ Tariff collected by a country through which the goods have passed, is called a transit tariff. ■■ Tariff collected by the importing country, it is called an import tariff. The import tariff is by far the most common. ■■ A government may also assess a tariff on a per-unit basis, in which case, it is applying a specific duty. ■■ A tariff assessed as a percentage of the value of the item is an ad valorem duty. Lastly, a tariff assessed as both a specific duty and an ad valorem duty on the same product, is a compound duty. Figure 5.1 illustrates how tariff and non-tariff barriers affect both the price and the quantity sold, although in a different order and with a different impact on producers. Both parts (a) and (b) of Figure 5.1 have downward-sloping demand curves (D) and upward-sloping supply curves (S). In other words, the lower the price, the higher the quantity that consumers demand; the higher the price, the more that

D

Price

As tax raises price, quantity sold decreases.

Higher price

Higher price

Price

P1

Tax

P2 P1

P2

0

D Import restriction S1 S causes quantity sold to fall.

S

Q2 Q1

0

Q2 Q1

Quantity Higher sales (a) Direct price influence of tariff barriers

Quantity Higher sales (b) Direct quantity influence of non-tariff barriers

Figure 5.1  Impact of Tariff and Non-tariff Barriers on Price and Quantity

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s­ uppliers make available for sale. The intersection of the S and D curves illustrates the equilibrium price (P1) and quantity sold (Q1), determined by market forces without government interference. Part (a) shows the impact of the imposition of a tariff on price and quantity in the market. A tariff acts like a tax and raises the price of the commodity in the market from P1 to P2. As a consequence, the amount consumers are willing to buy will fall from Q1 to Q2. The price rise does not benefit the producers, since it goes to the government as taxes rather than profits. Part (b) shows the impact of a non-tariff barrier on price and quantity. A non-tariff barrier acts as a restriction on supply, giving rise to a new supply curve (S1). The quantity sold now falls from Q1 to Q2. At the lower supply, the price rises from P1 to P2, as equilibrium is attained at a new point due to the interaction of the D and S1 curves. The major difference in the two forms of trade control is that sellers raise the price in part (b), which helps compensate them for the decline in quantity sold. In part (a), producers sell less and are unable to raise their price because the tax has already done it. Impact of Tariff Barriers Import tariffs raise the price of imported goods, thereby, giving domestically produced goods a relative price advantage. A tariff may be protective even though there is no domestic production in direct competition. For example, a country that wants its residents to spend less on foreign goods and services may raise the price of some foreign products, even though there are no close domestic substitutes, in order to curtail demand for imports. Tariffs also serve as a source of government revenue. Generally, import tariffs are of little importance to industrial countries; for example, the EU spends about the same to collect duties as the amount it collects. Tariffs, however, are a major source of revenue in many developing countries. This is because government authorities in developing countries have more control over determining the amounts and types of goods crossing their borders and collecting a tax on them than they do over determining and collecting individual and corporate income taxes. Although revenue tariffs are most commonly collected on imports, many countries that export raw materials charge export tariffs. Transit tariffs were once a major source of revenue for countries, but government treaties have nearly abolished them. There is often a tariff controversy concerning industrial countries’ treatment of manufactured exports from developing countries that seek to add manufactured value to their exports of raw materials (like making tea bags from tea leaves). Raw materials frequently enter industrial countries free of duty; however, if processed, they are assigned an import tariff. Since an ad valorem tariff is based on the total value of the product encompassing the raw materials and the processing combined, developing countries argue that the effective tariff on the manufactured portion turns out to be higher than the published tariff rate. For example, a country may charge no duty on tea leaves but may assess a 10 per cent ad valorem tariff on instant tea. If INR 50 for a package of instant tea bags covers INR 25 in tea leaves and INR 25 in processing costs, the duty is effectively on the manufactured portion, because the tea leaves could have entered duty-free. This anomaly further Bird’s-eye View challenges developing countries to find markets for their manufactured products. At the same time, the Tariff barriers are direct, transparent and nongovernments of industrial countries cannot easily discretionary constraints on trade. Tariff barremove barriers to imports of developing counriers act as a tax levied on exports, imports or tries’ manufactured products largely because these goods in transit and have a direct effect on the imports affect unskilled or unemployed workers price of goods being traded. who are least equipped to move to new jobs.

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Non-tariff Barriers There are two kinds of non-tariff barriers, namely, direct price influences and quantity controls. Direct Price Influences The principal forms of direct price influences are:

Non-tariff barriers are indirect discretio­ nary measures of trade control.

Subsidies: Direct payments made by the government to domestic companies to encourage exports or to protect them from imports are known as subsidies. They can take the form of cash payments, government participation in ownership, low-cost loans to foreign buyers and exporters, and preferential tax treatment. Governments may offer potential exporters many business development services, such as market information, trade expositions, and foreign contacts. From the standpoint of market efficiency, subsidies are more justifiable than tariffs because they seek to overcome, rather than create, market imperfections. There are also benefits to disseminating information widely because governments can spread the costs of collecting information among many users. Aid and Loans Governments also give aid and loans to other countries. The assistance is known as tied loans if the funds are for a specific use. Tied aid helps win large contracts for infrastructure, such as telecommunications, railways, and electric-power projects. However, there is growing scepticism about the value of tied aid. Tied aid can slow the development of local suppliers in developing countries, and it can shield suppliers in the donor countries from competition. Countries also use other means to affect prices, including special fees (such as for consular and cusSubsidies, aids and loans are non-tariff toms clearance and documentation), requirements barriers which act as non-price controls. that customs deposits be placed in advance of shipment, and minimum price levels at which goods can be sold after they have customs clearance. Quantity Controls Governments use other non-tariff regulations and practices to directly affect the quantity of imports and exports. Principal forms of quantity controls include the following: Quotas: The quota is the most common type of quantitative import or export restriction, which proQuota is the most common quantitahibits or limits the quantity of a product that can tive non-tariff barrier to trade and places be imported or exported in a given year. An import a restriction on the quantity that can be quota prohibits or limits the quantity of a product exported or imported. that can be imported in a given year and an export quota prohibits or limits the quantity of a product that can be exported in a given year. Quotas raise prices just as tariffs do but, since they are defined in physical terms, they directly affect the amount of imports by putting an absolute limit on supply, for example, three million DVD players from a particular country in a given year. Therefore, quotas usually increase the consumer price because there is little incentive to use price competition to increase sales. A notable difference between tariffs and quotas is their direct effect on revenues. Tariffs generate revenue for the government. Quotas generate revenues for those companies which are able to obtain a portion of the limited supply of the product by selling it in the domestic market.

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A country may establish export quotas to assure domestic consumers of a sufficient supply of goods at a low price, to prevent depletion of natural resources, or to attempt to raise export processes by restricting supply in foreign markets. To restrict supply, some countries band together in various commodity agreements, such as those for coffee and petroleum, which then restrict and regulate exports from the member countries. The typical goal of an export quota is to raise prices for importing countries. Sometimes, governments allocate quotas among countries based on political or market conditions. This choice can create problems because goods from one country might be trans-shipped, or deflected to another country to take advantage of the latter’s unused quota. Prior to the ending of the Multi Fibre Arrangement (MFA) in 2004, this method was used to bring in USD 2 billion in illegal clothing imports from China to the United States annually. Sometimes, goods are subject to tariff rate quotas, according to which, a certain quantity of goods enter the country duty-free or at a low rate. However, there is a very high duty for subsequent imports. For example, since January 2006, the EU allows tariff-free imports of 775,000 tonnes of bananas annually from the Caribbean and African countries, but beyond that limit, all imports are subject to a duty of 176 euros per ton. Since the EU imports bananas from Central and South America as well, the tariff effectively subsidizes the banana export from the African and Caribbean nations and penalizes the producers from Central and South America. Voluntary Export Restraint A voluntary export restraint (VER) is a generic term used to describe all bilateral agreements that restrict exports. It is voluntary because a country has a formal right to eliminate or modify it at any time. For example, in the 1980s, the United States convinced the Japanese government to ‘voluntarily’ limit their exports of automobiles to the United States to no more than 1.85 million vehicles per year. Therefore, like a quota, a VER limits the quantity of trade between countries and, therefore, raises the prices of imported goods to consumers. It was estimated by the US Federal Trade Commission (FTC) that US consumers overpaid nearly USD 5 billion for Japanese automobiles between 1981 and 1985 due to the automobile industry VER. Procedurally, VERs have unique advantages. A VER is much easier to switch off than an import quota. In addition, the appearance of a ‘voluntary’ choice by a particular VER are bilateral agreements that restrict country to constrain its exports to another country trade between countries. does less political damage to the participating countries than an import quota does. Orderly Marketing Arrangements This is a kind of VER consisting of formal agreements between governments to restrict international competition and keep a part of the domestic market for local producers. The MFA, which began in 1973 and regulated about 80 per cent of the world market in textiles and apparel exports, is an example of this. However, under the provisions of the 1994 GATT negotiations, all textile quotas under the MFA expired on 1 January 2005. Embargo An embargo is a specific quota that prohibits all forms of trade. Countries or groups of countries may place embargoes on either imports or exports, on entire categories of products regardless of destination, on specific products to specific countries, or on all products to given countries. Governments often impose embargoes as a tool to achieve political goals.

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‘Buy Local’ Legislation Another form of quantitative trade control is the ‘buy local’ legislation. Very often, government pur‘Buy local’ legislations are non-tariff barchases, which form a large part of total national riers which compel local producers to buy expenditures, are from domestic producers only. In domestic products. the United States, for example, ‘buy American’ legislation requires government procurement agencies to favor domestic goods. Sometimes, governments specify a domestic content restriction, that is, a certain percentage of the product must be of local origin. Sometimes, they favor domestic producers by establishing floor price mechanisms for competing foreign goods. For example, a government agency may buy a foreign-made product only if the price is at some predetermined margin below that of a domestic competitor. Many countries prescribe a minimum percentage of domestic content that a given product must have for it to be sold legally in their country. Testing Standards Countries often have various classifications, labelling, and testing standards to protect the health and safety of its citizens. For exporting firms, however, these are a source of complex and discriminatory barriers to free trade. The purpose of these is often to promote the sale of domestic products and complicate the sales of foreign products. An example of these is product labels, which need to indicate their source of manufacture. This adds to the firm’s production cost, since it may also need to be translated into different languages for different markets. Further, since raw materials, components, design, and labor increasingly come from various countries; most products today are of mixed origin. For example, provisions in the United States stipulate that any cloth substantially altered (for instance, woven) in another country must identify that country on its label. Consequently, designers like Ferragamo, Gucci, and Versace must declare ‘made in China’ on the label of garments that contain silk from China. The purpose of testing standards is to protect the safety or health of the domestic population. However, some foreign companies argue that testing standards are just another means to protect domestic producers. For example, EU standards keep some US and Canadian products out of the European market such as genetically engineered corn and canola oil. Interestingly, France which is a member of the EU, grows and sells a small amount of genetically engineered corn. Specific Permission Requirements The requirement to obtain permission from government authorities in order to conduct trade transacA licence or specific permission requiretions is known as a licence. Procedures for this vary ment is an approval by the government for between countries and sometimes require the firm the trade of specific commodities between to submit samples to the authorities. This procedure countries. can restrict imports or exports directly by denying permission and indirectly because of the cost, time, and uncertainty involved in the process. Foreign exchange controls similarly limit the availability of foreign exchange for trade and investment. It requires an importer of a given product 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.

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Administrative Delays Government policies such as customs rules often discriminate against trade practices. These are intentional administrative delays such as the Chinese requirement of different rates of duty for different products depending on the port of entry and an arbitrary determination of the value of goods. Other examples are the requirement of the Australian government that all television commercials be shot in the country itself even for foreign media companies. Reciprocal Requirements or Countertrade The exchange of merchandise for other goods or services is called an offset of countertrade transaction. Governments sometimes require exporters to take actual merchandise in lieu of money or to promise to buy merchandise or services in place of cash payment in the country to which they export. This requirement is common in the aerospace and defence industries, sometimes because the importer does not have enough foreign currency. For example, Russia’s commercial airline, Aeroflot, has exchanged Russian crude oil for Airbus aircraft. More frequently, however, reciprocal requirements are made between countries with ample access to foreign currency that want to secure jobs or technology as part of the transaction. For example, Bird’s-eye View McDonnell Douglas Corporation sold helicopters to the British government but had to equip them with Non-tariff barriers are indirect discretionary Rolls-Royce engines (made in the United Kingdom) measures of trade control which have an effect as well as transfer much of the technology and proon both price and quantity of goods and serduction work to the United Kingdom. These sorts of vices being traded. barter transactions are called countertrade or offsets.

ANALYSIS OF INDIA’S FOREIGN TRADE An analysis of foreign trade covers three major aspects—volume, composition, and direction. Volume of trade is the monetary value of goods and services being exported and imported. Composition of trade refers to the goods and services being exported and imported and is indicative of the structure and level of an economy’s development. Direction of trade is indicative of the geographical dispersion or concentration of markets for exports and sources of supply of its imports.

Volume of India’s Foreign Trade India’s exports have increased from INR 6.06 billion in 1950–51 to over INR 8.3 trillion in 2009–10, although the increase has not been uniform over the years. India’s exports touched USD 312.6 billion in 2013. In the pre-reform period, prior to 1990, export growth was stagnant in the 1950s. It picked up and grew at an average rate of 3.6 per cent per annum in the 1960s. However, India’s share in world exports declined from 1.4 per cent during the 1950s to 0.9 per cent during the 1960s. The seventies witnessed a jump to 18 per cent per annum in the growth rate as a result of various export promotion and subsidization measures. This, however, could not be sustained in the first half of the 1980s and Indian exports showed a sharp decline even as world exports turned negative. In the second half of the 1980s, exports grew at 17.8 per cent per annum; the improvement in export competitiveness being attributed to a major depreciation of the exchange rate and increased export subsidies, along with some initial industrial deregulation and liberalization of capital goods imports.

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The post-reform period was characterized by a more supportive industrial policy, a more liberal import policy, and a more realistic exchange rate policy including the move towards greater currency convertibility. During this period, exports grew at an average annual rate of more than 25 per cent in rupee terms. India’s exports grew at 13 per cent per annum during 1993–97, and declined in 1998 due to the Asian crisis. The period 2002–08 saw a growth recovery of 20 per cent per annum, followed by a decline in 2009–10 and 2012–13 due to the shocks of the Euro zone crisis and global slowdown.1 India’s total imports have also increased from INR 6.08 billion in 1950–51 to 13.2 trillion in 2009– 10. There has been an increasing trend in imports from the 1950s as a result of government policy till the 1990s. The government’s import control policy included policies, such as licensing, quotas, and tariff measures. In the post-liberalization period, there has been widespread liberalization of imports with the removal of quantitative restrictions; the lowering of tariffs leading to an increase in imports. Besides policy liberalization, expansion in the manufacturing sector has led to increasing demand of machinery, raw materials, intermediates, and accessories. This has been accompanied by expansion in transport and infrastructure and the increasing domestic demand for fuel, fertilizers and other commodities. India’s imports grew at rates of 6.5 per cent to 8.5 per cent of GDP in the first 30 years of planning, and 8 per cent to 14 per cent in the next 25 years, and at a remarkable rate of 22 per cent of GDP since 2004–05. Exports during the period April 2013 to March 2014 were valued at USD 313542.91 million compared to USD 300400.68 million for the same period last year, registering a growth of 4.37 per cent.2 The value of imports recorded a negative growth of 8.18 per cent during the period April 2013 to March 2014 falling to USD 450593.36 million from USD 490736.65 million during the same period last year.3 As a result of declining imports, India’s trade deficit narrowed down to USD 133050.45 million during April 2013 to March 2014 as against USD 177193.74 million during the same period last year. Hence, India has had a consistent trade deficit as imports have exceeded exports in all years except 1972–73 and 1976–77.

Composition of India’s Foreign Trade Tea, jute manufactures and cotton goods were India’s principal export earners till 1965–66, earning 45 per cent to 50 per cent of total revenue. Besides these, leather, iron ore, cashew, and manufactured tobacco were also important items of export. The export basket has done a complete turnaround since 1965–66 reflecting the growth and industrialization of the economy and its commitment to self-reliance. Important additions to the export basket include engineering goods, leather manufactures, cotton apparel, pearls and precious stones, chemicals and allied products, and woollen products. In other words, non-traditional exports constitute 70 per cent of the total export basket. However, high-technology exports constitute only 5 per cent of total manufactures, and 40 per cent of all manufactured exports consist of textiles, garments, gems, and jewellery. This is the result of the natural competitive advantage that India has in the form of its low-cost labor. However, in order to benefit from world trade, Indian exports must diversify and change towards higher value-added products and products with a higher technology content. http://indiabudget.nic.in/es2013-14/echap-07.pdf, last accessed 9th July 2014. http://commerce.nic.in/eidb/ecnt.asp 3 http://commerce.nic.in/eidb/icnt.asp 1 2

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Noticeable changes have taken place in India’s export basket between 2000–01 and 2013–14. Share of petroleum, crude and products has surged almost 5 times to account for 20.1 per cent of total exports, catapulted by its 33.5 per cent growth (CAGR). The percentage share of primary products has reduced marginally from 16 per cent to 15.6 per cent over the period. In case of manufacturing goods, there has been a fall of 15.1 per cent, mainly on account of decline in export to major destinations like the United States. Despite the overall decline in the share of manufactured goods, its two important components—engineering goods and chemicals—registered an increase of 19 per cent (CAGR) and 13 per cent (CAGR), respectively.4 Indian imports mainly consist of consumer goods, raw materials and intermediates, and capital goods. There has been a radical change in their composition over the years. Consumer goods made up 26 per cent of imports in 1950–51, but constituted barely 2 per cent of the import bill in 2009–10. Raw materials and intermediates had a share of 53.6 per cent in 1950–51 but increased to 84.3 per cent in 2009–10. Lastly, capital goods made up 20 per cent of the import bill in 1950–51, but had a share of 13.4 per cent in 2009–10. The share of capital goods declined in 2013–14. Registering a negative growth of 14.7 per cent, they made up 11.9 per cent of total imports.5 Fuel (Petroleum, Oil and Lubricants [POL]) and gold have traditionally been important items of import. While the value of POL imports increased marginally by 0.7 per cent in 2013–14 to account for 37 per cent of total imports, gold import declined from 1078 tonnes in 2011–12 to 1037 tonnes in 2012–13 and further to 664 tonnes in 2013–14 on the back of several measures taken by the government.6 The changes in the composition of India’s foreign trade reflect the structural changes in its economy in the past six decades. It has changed from being an exporter of primary commodities and an importer of manufactured goods to being an exporter of manufactured goods and an importer of intermediates and capital goods. Taking into account the low-export intensity of its manufacturing sector, it has a long way to go before its exports can drive its growth.

Direction of India’s Foreign Trade The United States and the United Kingdom have been the traditional export destinations of Indian exports with the combined share of more than 40 per cent during 1950–51. The duo continued to absorb nearly a quarter of India’s exports in the late 1990s and in the first half of 2000 before their combined share fell down to 16 per cent in 2013–14.7 Declining volume of trade with these economies, especially with the United Kingdom, was associated with three economies—USA, UAE and China—becoming India’s top three trading partners since 2005. Together, these three economies accounted for 32 per cent of India’s exports in 2004–05. In 2013–14, their combined share was 27 per cent.8 The direction of Indian imports is largely influenced by the nature of its development. As a large part, initial development was tied to aid imports originating in the aid giving countries. The United States was the principal supplier with a more than 35 per cent share in 1965–66, which has subsequently declined to 7 per cent at present. Other important suppliers are the United Kingdom, Belgium, Canada, France, Germany, and Japan. The Organization of the Petroleum Exporting Countries http://indiabudget.nic.in/es2013-14/echap-07.pdf http://indiabudget.nic.in/es2013-14/echap-07.pdf 6 http://indiabudget.nic.in/es2013-14/echap-07.pdf 7 http://commerce.nic.in/eidb/ecntq.asp 8 DATA COMPILED FROM: http://commerce.nic.in/eidb/ecntq.asp 4 5

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(OPEC) have also emerged as important importers, along with China, which had a 11.3 per cent share in the Indian import bill in 2009–10. The top regional destinations in 2013–04 were the European Union, Africa and North America.9 During 2013–14, there was good growth of exports to North America (9.1 per cent) and Africa (7.2 per cent), but low growth to EU 27 (2.2 per cent), as a result of slowdown in the European Union.10 The United States was the principal supplier with more than 35 per cent share in 1965–66, which has subsequently declined to 5 per cent in 2013–14.11 The top three trading partners together made up 23 per cent of India’s import bill for the same period. The top regional destinations in 2013–14 were West and North East Asia with share of 49 per cent followed by European Union (11 per cent), ASEAN Region (9 per cent) and Latin America (6 per cent).12

C H A P TER

S UMMAR Y

■■ There are different rationales for protection adopted by nations and different forms that the ­protection takes. ■■ Government intervention in trade can broadly be classified as tariff and non-tariff barriers, both of which have a distorting effect on the price and quantity determined by the free forces of the market. ■■ Tariff barriers are direct official constraints on the import of certain goods and services that are non discretionary in application. ■■ Non-tariff barriers are indirect measures that discriminate against foreign goods in the domestic market or otherwise distort and constrain trade and have a discretionary application. ■■ Non-tariff barriers may take the form of either price or quantity controls. ■■ Foreign trade in India is a regulated activity aimed at the conservation of scarce foreign exchange for necessary imports and achieving self-reliance in the production of as many goods as possible. ■■ India’s trade policy can be divided into five phases culminating in the new trade policy of 1991. ■■ An analysis of foreign trade covers three major aspects—volume, composition and direction.

Key Terms Tariff barriers, Non-tariff barriers, Subsidies, Quota, Voluntary export restraint, Embargo, Licence.

Discussion Questions

1. Distinguish between tariff and non-tariff barriers to trade between nations. 2. What is the basic rationale of trade intervention by the government? Using various examples, explain the effect of different kinds of intervention.

http://commerce.nic.in/ftpa/rgncnt.asp, last accessed on 10th September 2013. http://indiabudget.nic.in/es2013-14/echap-07.pdf 11 http://commerce.nic.in/eidb/icnt.asp 12 http://commerce.nic.in/eidb/irgn.asp 9

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3. Write short notes on a. Subsidy b. Quota c. Voluntary export restraint d. Embargo e. Buy local legislation 4. Write a short note on the trends and patterns of foreign trade in India. 5. Clearly explain the impact of tariff barriers on trade. 6. Using diagrams explain the differences between the effects of price and quantity as a result of non-tariff barriers on trade. 7. What are barriers to trade? Distinguish between the effects of tariff and non tariff barriers on trade between nations. [Delhi University, B.Com (Hons.) 2008, 2009, 2010, 2014] 8. Comment on the trends in India’s foreign trade in the last decade. [Delhi University, B.Com (Hons.) 2014]

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6 MULTILATERAL REGULATION OF TRADE LEARNING OBJECTIVES After reading this chapter, you should be able to:

■ ■ ■

Understand the institutional framework of the multilateral trade environment Comprehend the objectives, institutional framework, and functioning of the WTO Explain the need for UNCTAD as a multilateral trading institution

food securItY Issues rocK the Wto Boat The World Trade Organization failed to ratify the Trade Facilitation Agreement (TFA), its fi rst landmark deal since its inception in 1995, as India, backed by Cuba, Venezuela and Bolivia, declined to sign the agreement. The TFA was formulated in December 2013 during the ninth ministerial conference of the WTO in Bali, Indonesia, as part of an overall reform effort to boost world trade. The Bali agreement was supposed to be a package of the ‘low-hanging-fruit’ policies to which every country could easily  agree. The talks, which began in 2001 at Doha, have been stuck due to the lack of consensus between member countries, without which WTO proceedings cannot be ratifi ed. The TFA, through a worldwide reform of duties and tariffs, and a reduction in red tape at international borders, aims to ease trade relations between countries. It was estimated that the TFA could add USD 1 trillion in new trade globally and create 20 million new jobs worldwide. The agreement had to be signed by all the member countries by 31 July 31 to become effective from July 2015. India  decided  against  ratifi cation  of  the TFA  on  grounds  of  food  security  issues.  It  wants  an  amendment in the norms for calculation of agricultural subsidies which will determine the minimum support price at which foodgrains will be procured from farmers for sale to the poor. The current WTO norms limit the value of food subsidies at 10 per cent of the total value of foodgrain production. The  support  prices  are  calculated  at  1986-88 as the base year price. India has suggested  a  change  to  a  more  current  base  year,  keeping  in  mind  factors  such  as  infl ation  and  currency  movements.

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Developed countries have complained that India is going back on its promise made at Bali last December where it was agreed that the TFA will prepare a WTO rule by 31 July, while a permanent solution to the food security issue will be found only by 2017. India has maintained that different timelines for various elements of the Bali package is against the WTO rules of a single undertaking where everything need to be implemented simultaneously. Sources:  http://www.livemint.com/Politics/R1fIXweMJHelr9NVlTyoqL/7-reasons-why-Indias-WTO-foodsecurity-stand-is-right.html?utm_source=copy, http://timesofindia.indiatimes.com/india/Indias-tough-stand-on-WTO-gets-support-from-UN-body/articleshow/39616159.cms, last accessed on 28th August 2014.

Introduction International trade regulation is a recent phenomenon which has its roots in the establishment of multilateral trade organizations such as the GATT and the WTO. The basis of multilateral trade is the principles of non-discrimination, reciprocity, market access, and fair competition, which have been embodied in both the GATT and WTO agreements. The WTO is a multilateral trade organization that came into existence on 1 January 1995, and is the successor to the GATT, which was created in 1947 and continued to operate for almost five decades as a de facto international organization.

General Agreement on Tariffs and Trade (GATT) The General Agreement on Tariffs and Trade (GATT) came into existence in 1947 as an international organization for the facilitation of trade liberalization. There were several multilateral institutions established to help in the reconstruction of the world economy after World War II. The International Trade Organization (ITO) was initially established for liberalization of trade but since its charter could not be ratified, it was replaced by the GATT.

Objectives and Principles The GATT was a treaty, not an organization. Its main objective was helping in the growth of international trade through the reduction of tariff barriers, quantitative restrictions, and subsidies on trade through a series of agreements. Its main objectives, listed in the preamble are: ■■ Raising the standard of living ■■ Ensuring full employment, and a large and steadily growing volume of real income and effective demand ■■ Developing the full use of the resources of the world ■■ Expansion of production and international trade For almost half a century, the GATT’s basic legal principles remained much as they were in 1948. There were additions in the form of a section on development added in the 1960s and plurilateral agreements (agreements involving fewer members with a specific interest in an issue) with voluntary membership in the 1970s, while efforts to reduce tariffs further continued. Much of this was achieved through a series of multilateral negotiations known as trade rounds.

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The history of the GATT can be divided into three phases.

1. The first phase from 1947 until the Torquay Round, largely concerned which commodities would be covered by the agreement and freezing existing tariff levels. 2. The second phase, encompassing three rounds, from 1959 to 1979, focused on reducing tariffs. 3. The third phase, consisting only of the Uruguay Round from 1986 to 1994, extended the agreement fully to new areas such as intellectual property, services, capital, and agriculture. The WTO was born out of the negotiations of the Uruguay Round. The achievements of GATT are listed as under:



1. The early GATT trade rounds only concentrated on reducing tariffs. 2. It was the Kennedy Round in the mid-sixties, which introduced an Anti-dumping Agreement and a section on development. 3. The Tokyo Round during the seventies was the first major attempt to tackle non-tariff trade barriers, and to improve the system. 4. The eighth round, that is, the Uruguay Round of 1986–94, was the last and the most extensive round which led to the establishment of the WTO and a new set of agreements.

Uruguay Round The last round of multilateral trade negotiation under the GATT known as the Uruguay Round started in 1986, but remained largely inconclusive on account of the complexities of the issues involved in it. In December 1990, the then director general Arthur Dunkel presented a draft solution called the Dunkel Draft, which was later replaced by an enlarged agreement. This agreement was finally approved on 15 December 1993. The Uruguay Round included the following areas for the first time: ■■ Trade in services leading to the General Agreement on Trade in Services (GATS) ■■ Trade-related aspects of intellectual property leading to the Agreement on Trade-related Aspects of Intellectual Property Rights (TRIPs) ■■ Trade-related investment measures leading to the Agreement on Trade-related Investment Measures (TRIMs)

GATT: An Evaluation Although the GATT was established as a provisional organization with a limited field of action, it has made a significant contribution to the promotion and the liberalization of world trade.



1. Tariff reductions implemented during its lifetime helped to increase world trade to high rates of about 8 per cent growth during the 1950s and 1960s. 2. Growth in world trade was far more than growth in world production as a result of trade liberalization during the GATT era. This was the result of increased trade between member countries which was made possible after the introduction of GATT. 3. There was a rush of new members during the Uruguay Round, which clearly showed that the multilateral trading system was recognized as an anchor for development and an instrument of economic and trade reform.

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However, there were a number of problems which came up with the passage of time and although the Tokyo Round in the 1970s attempted to tackle some of these, it had limited success. Some of these problems are listed below:

1. The GATT’s success in reducing tariffs to a very low level, combined with a series of economic recessions in the 1970s and early 1980s, drove governments to look for other forms of protection for domestic sectors, which were threatened by increased foreign competition. 2. High rates of unemployment and the shutting down of factories led governments in Western Europe and North America to seek bilateral market-sharing arrangements with competitors, and to embark on a subsidies race to maintain their hold on agricultural trade. Both of these changes reduced the credibility and effectiveness of GATT. Besides the deteriorating trade policy environment, by the early 1980s, the GATT was clearly no longer as relevant to the realities of world trade as it had been in the 1940s. There were various reasons for this change:

1. World trade had become far more complex and important in the last 40 years as a result of globalization of the world economy. 2. Trade in services (not covered by the GATT rules) became one of major interests to more and more countries, and international investment expanded even more. 3. Expansion in merchandise trade matched the expansion of services trade. 4. The GATT met with limited success in the realm of agriculture, as loopholes in the multilateral system, were heavily exploited, and efforts at liberalizing agricultural trade were largely ineffective. 5. In the textiles and clothing sector, an exception to the GATT’s normal disciplines was negotiated in the 1960s and in early 1970s, leading to the MFA. 6. Even the GATT’s institutional structure and its dispute settlement system were a cause Bird’s-eye View for concern as it was felt that the developed nations dominated the scene and developThe GATT was established as an international ing countries’ interests were either sidetreaty aimed at trade liberalization. It helped lined or completely ignored. to rationalize tariffs and increase trade across the globe, but it had to be replaced with the These and other factors convinced GATT memWTO due to a deteriorating trade policy envibers of the need for a renewed effort to reinforce and ronment, dominance by the developed nations extend the multilateral system. This effort resulted and the increasing importance of trade in serin the Uruguay Round, the Marrakesh Declaration vices which it did not cover. and the creation of the WTO.

World Trade Organization (WTO) The WTO is a multilateral trade organization aimed at international trade liberalization. It came into existence on 1 January 1995 as the successor to the GATT. The WTO functions on the basis of a set of agreements, which have been negotiated and signed by a large majority of the world’s trading nations, and

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ratified in their parliaments. These agreements are in The WTO is a multilateral trade organization, the form of contracts which guarantee important trade which aims at international trade liberalization. rights to its member nations and are the legal groundrules for international commerce. The WTO presently has 129 members.1 The WTO’s basic role is to ensure that nations follow the rules of trade at a global level. It has got this mandate based on negotiations concluded under GATT especially under the Uruguay Round in 1986– 94. The WTO is governed by a Ministerial Conference, which meets every two years; a General Council, which implements the conference’s policy decisions and is responsible for day-to-day a­ dministration; and a director-general, who is appointed by the Ministerial Conference. The WTO’s headquarters are in Geneva, Switzerland.

WTO Agreements The WTO agreements cover trade in goods, services The WTO agreements cover trade in goods, serand intellectual property and specify the basic prinvices and intellectual property and specify the ciples of liberalization and the exceptions to the rule. basic principles of liberalization and the excepThis includes individual countries’ commitments to tions to the rule. lower customs tariffs and other trade barriers, and to open markets for services. They also include a dispute settlement procedure between member countries and prescribe special treatment for ­developing countries. They require governments to make their trade policies transparent by notifying the WTO about laws in force and measures adopted, through the submission of regular reports to the secretariat on countries’ trade policies. The WTO agreements fall into a simple structure with six main parts:

1. 2. 3. 4. 5. 6.

An overall umbrella agreement establishing the WTO GATT for goods GATS for services TRIPS for intellectual property; Dispute settlement Reviews of governments’ trade policies.

General Agreement on Tariffs and Trade (GATT) The agreement for goods under GATT covers sectorspecific issues, such as agriculture, health regulations for farm products, textiles and clothing, product standards, and issues such as import licensing, rules of origin, subsidies, counter measures and safeguards.

The GATT is an agreement on trade and tariffs for goods. It covers sector-specific issues, such as agriculture, health regulations for farm products, textiles and clothing.

Agriculture The first multilateral agreement on agriculture was introduced in the Uruguay Round, with the basic objective of introducing reform in agriculture to make it more market-oriented. Under the terms of this 1

http://www.wto.org/english/thewto_e/whatis_e/tif_e/org6_e.htm. last accessed 10th September 2013.

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agreement, developed countries agreed to cut tariffs by an average of 36 per cent in equal steps over the period 1995–2000, while developing countries agreed to make tariff cuts of 24 per cent over a 10 year period. However, the least developed countries were exempted from making these tariff cuts. Tariffs on all agricultural products are now bound and have been substantially reduced. Almost all import restrictions, which were in the form of quotas, have been converted into tariffs. Market access commitments on agriculture have also eliminated previous import bans on certain products. The agreement also contains provisions for cutting down domestic support in the form of subsidies or price support. The quantified measure of this is known as aggregate measurement of support (AMS). There are three distinct categories of subsidies in the agricultural sector: amber box, blue box and green box, based on the nature of protection provided by them. Standards and Safety Measures The Agreement on Sanitary and Phytosanitary Measures (SPS) lays down basic rules on food, safety, and plant health standards. It allows governments to set their own rules based on science and health, which is considered necessary for the protection of human, animal and plant life or health, as long as they do not discriminate between countries or act as disguised protectionism. The Agreement on Technical Barriers to Trade (TBT) complements the attempts to make sure that regulations, standards, testing, and certification procedures do not create unnecessary obstacles to trade. Trade in Textiles World trade in textiles was traditionally governed by the Multi Fibre Arrangement (MFA)—a framework for bilateral agreements or unilateral actions that established quotas limiting imports into member countries. Since the MFA went against the basic principles of the GATT, it was replaced by WTO’s Agreement on Textiles and Clothing (ATC) from 1995. The agreement was supervised by a Textiles Monitoring Body (TMB), which monitors actions under the agreement to ensure that they are ­consistent. The ATC came to an end on 1 January 2005 and opened up immense opportunities and challenges for developing countries.

General Agreement on Trade in Services (GATS) GATS is the first set of rules governing international GATS is the first set of rules governing internatrade in services. It came into existence due to the tional trade in services. growing importance of the service sector in the world economy and covers all internationally traded services, such as banking, telecommunications, tourism and other professional services. It covers these services in the following modes: ■■ Mode 1 covers services supplied from one country to another, such as international telephone calls. It is known as cross-border supply. ■■ Mode 2 covers consumers or firms making use of a service in another country, such as tourism. It is known as consumption abroad. ■■ Mode 3 refers to services termed commercial presence, such as a foreign company setting up subsidiaries or branches abroad. ■■ Mode 4 is known as presence of natural persons and includes individuals travelling to foreign countries to supply services, such as fashion models or consultants.

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Agreement on Trade-related Aspects of Intellectual Property Rights (TRIPS) TRIPS lays down the minimum standards for the protection of intellectual property rights as well as the TRIPS lays down the minimum standards for the protection of intellectual property rights as procedures and remedies for their enforcement in a well as the procedures and remedies for their multilateral trading system. The TRIPS agreement is an enforcement in a multilateral trading system. attempt to narrow the gap in the way intellectual property is protected in varying degrees across the world and to bring it under common international rules. It also establishes a mechanism for ­consultation and surveillance at an international level to ensure compliance with these standards by member countries at the national level. Rapid developments in technology have led to increasing trade in films, music, and computer software with increasing invention, innovation research, and design in all of these. The provisions under TRIPS are based on important existing conventions such as the Protection of Industrial Property and the Berne Convention. Its provisions are applicable to intellectual property rights related to patents, copyrights, trademarks, industrial designs, and layout designs of integrated circuits. According to this agreement, developed countries were given one year to ensure that their law and practices were in conformity with TRIPS regulations, whereas developing and transition economies were given five years. The least developed countries were given 11 years to make the grade, but this was subsequently extended to 2016 for pharmaceutical patents.

Agreement on Trade-related Investment Measures (TRIMS) TRIMS aims to regulate international investment as it recognizes that governments often impose conditions on foreign investors to encourage investment according to national priorities. The provisions of TRIMS, therefore, stipulate that no member shall apply any measures in violation of the national ­treatment principles of the GATT and discriminate against foreigners or foreign products. It also prohibits investment measures that place a restriction on quantities and measures requiring a certain percentage of local procurement (local content requirement), and discourages measures which limit imports or set targets for exports (trade balancing requirements).

TRIMS aims to regulate international investment between member nations of WTO.

Bird’s-eye View The WTO is a multilateral trade organization which aims at trade liberalization in the global economy. It is based on a set of six agreements which cover trade in goods, services, intellectual property, trade policy and dispute settlement.

ORGANIZATIONAL STRUCTURE OF WTO The WTO has the following important organs in its organizational structure ■■ The Ministerial Conference is the highest decision-making body of the WTO responsible for deciding its strategic direction and for making all final decisions on agreements under its purview. It is a body of all international trade ministers from its member countries and it meets at least once every two years. Although voting can take place, decisions are generally taken by consensus, a process that can at times be difficult, particularly in a body composed of 160 members.2 2

http://www.wto.org/english/thewto_e/whatis_e/tif_e/org6_e.htm, last accessed on 28th August 2014.

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■■ The General Council is a body of senior representatives of its member countries and is responsible for the day-to-day business and management of the WTO. It is based at the WTO headquarters in Geneva and is the key decision-making arm of the WTO for most issues. Several of the bodies described below report directly to the General Council. In different situations and under different rules, it meets as the Trade Policy Review Body and the Dispute Settlement Body. ■■ The Trade Policy Review Body A key function of the WTO is surveillance of national trade policies of its member countries. The WTO performs this function in accordance with its trade policy review mechanism (TPRM) which was established under the Uruguay Round. This requires a periodic review of all WTO members; the frequency of each country’s review is varying according to its share of world trade. These reviews are intended to make sure that member states are implementing their obligations according to the mandate of the WTO. ■The ■ Dispute Settlement Body consists of all WTO members and is constituted to ensure that all disputes under the WTO are resolved and that members follow the decisions on these disputes. A dispute arises when a member government believes another member government is violating an agreement or a commitment that it has made in the WTO. Disputes are heard and ruled on by dispute resolution panels chosen individually for each case, and the permanent Appellate Body that was established in 1994. Dispute resolution is mandatory and binding on all members. A final decision of the Appellate Body can only be reversed by a full consensus of the Dispute Settlement Body (DSB). ■■ The Councils on Trade in Goods and Trade in Services and the Council for the Agreement on Trade-related Aspects of Intellectual Property Rights operate under the mandate of the General Council. These councils consist of all members and are responsible for developing and supervising a mechanism to oversee the details of the general and specific agreements on trade in goods, trade in services and trade-related aspects of Intellectual Property Rights. The Goods Council has 10 committees dealing with specific subjects (such as agriculture, market access, subsidies, anti-dumping measures and so on). ■■ The Secretariat and Director General of the WTO are based in Geneva, in the old home of GATT. The Secretariat has no legal decision-making power. It looks after the administrative functioning of the WTO and provides vital services and also has an advisory function. The Secretariat is headed by the Director General, who is elected by the members. ■The ■ Committee on Trade and Development and the Committee on Trade and Environment are two of the several committees continued or established under the Marrakech Agreement in 1994. They have specific mandates to focus on these relationships, which are especially relevant to how the WTO deals with sustainable development issues. The Committee on Trade and Development was established in 1965. The forerunner to the Committee on Trade and Environment (the Group on Environmental Measures and International Trade) was established in 1971, but did not meet until 1992. Both Committees are now active as discussion grounds, but do not actually negotiate trade rules.

Principles of WTO The WTO is governed by certain basic guiding All WTO agreements are based on two basic prin­principles which are contained in the form of c­ omplex ciples—most favored nation (MFN) and national agreements covering a wide range of activities. The treatment. basic areas they deal with are agriculture, textiles and clothing, banking, telecommunications, g­ overnment purchases, industrial standards and product safety, food sanitation regulations, and intellectual property. These principles are as follows.

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Most-Favored-Nation (MFN) According to the WTO agreements, countries cannot normally discriminate between their trading partners. If a country gives a special favor, advantage, or privilege to one country (such as a lower customs duty rate for one of their products), it has to be similarly granted to all other WTO members. This is known as the most-favored-nation (MFN) status, which is granted by WTO members to each other. The MFN treatment is a basic pillar of multilateral trade negotiations and was also the first article of the General Agreement on Tariffs and Trade (GATT), which governs trade in goods. MFN is also a priority in the General Agreement on Trade in Services (GATS) and the Agreement on Trade-related Aspects of Intellectual Property Rights (TRIPS). Although in each agreement, the principle is handled slightly differently, together, these three agreements cover all three main areas of trade handled by the WTO. There are some exceptions to the MFN rule. ■■ Countries can set up a free trade agreement that applies only to goods traded within the group but discriminates against goods from outside. ■■ They can also give developing countries special access to their markets or raise barriers against products that are considered to be traded unfairly from specific countries. ■■ Limited discrimination is allowed in the area of services too. However, the agreements only permit these exceptions under strict conditions. In general, MFN means that every time a country lowers a trade barrier or opens up a market, it has to do so for the same goods or services from all its trading partners—whether rich or poor, weak or strong.

National Treatment This principle implies that imported and locally-produced goods should be treated equally once they are in the domestic market. The same should apply to foreign and domestic services, and to foreign and local trademarks, copyrights and patents. This principle of national treatment (giving others the same treatment as one’s own nationals) is also found in all the three main WTO agreements, although once again the principle is handled slightly differently in each of these. National treatment only applies once a product, service or item of intellectual property has entered the domestic market. Therefore, charging customs duty on an import is not a violation of national treatment even if locally-produced products are not charged an equivalent tax. There are some exceptions to the above stated WTO principles: ■■ The WTO allows members to establish bilateral or regional customs unions, or free trade areas (FTAs). Members in such areas enjoy more preferential treatment than those outside the group. ■■ The WTO also allows members to lower tariffs to developing countries without lowering them for the developed ones. The United States, for example, offers such treatment to developing countries through the Generalized System of Preferences (GSP). Due to this system, US companies that are more vulnerable to import competition from developing countries, face greater pressure on cost reduction. If a developing country is not a WTO member, it cannot enjoy such preferences. ■■ The WTO also allows escape clauses, which are special allowances permitted by the WTO to protect infant industries or to safeguard the economic interests of newly admitted developing countries. These countries may modify or withdraw concessions on customs duties if this is required for the establishment of a new industry that will improve standards of living. They may also restrict imports to safeguard their balance of payments equilibrium, or obtain the necessary exchange for

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the purchase of goods for the implementation of development plans. Their governments are also allowed to provide assistance to these industries if it helps to safeguard their economies.

Functions of WTO The WTO was set up to achieve the following functions: ■■ Elimination of discrimination: The WTO follows the MFN and national treatment The main functions of the WTO are elimination of discrimination, fighting against protection and principles for the elimination of discriminatrade barriers and dispute resolution among its tion among its member nations. This is done members. to ensure the overall economic development of all member nations based on the principles of free trade. ■■ Combating protection and trade barriers: The WTO is committed to the removal of all types of protection against free trade whether it is in the form of import duties or quotas, for whatever reasons they are implemented. The WTO’s trade policy review body regularly monitors the trade policies of its members in order to increase the degree of market access to members’ markets. ■■ Resolution of disputes: The WTO functions as a forum for the resolution of disputes of its members through the establishment of panels for this specific purpose. The judicial reach of the WTO is, however, restricted to its members, and non-members cannot benefit from this facility. ■■ Providing a forum for emerging issues: The WTO is a forum for dealing with emerging issues in the world trading system, such as intellecBird’s-eye View tual property, environmental issues, regional agreements, as well as special sectors such as The WTO has two main principles—most agriculture, telecommunications, financial favoured nation (MFN) and national treatservices and maritime services. The forum ment—based on which it works towards serves to develop new rules through these elimination of discrimination, combating prodiscussions, such as TRIPS for the govertection and trade barriers and dispute resolunance of issues related to patents, copytion between member nations. rights, trade secrets, and related matters.

WTO: an evaluation The WTO has been fairly successful in its efforts to promote free trade in the global economy although it has met with quite a few setbacks and there still remains a large unfinished agenda.

Developing Country Issues Developing countries criticise the WTO as that they fail to benefit from the trade liberalization and protection of intellectual property under the WTO framework, since they have neither a good supply base necessary for trade expansion nor strong intellectual property rights (IPRs) for financial gains. Developed countries often take advantage of escape routes and loopholes in the WTO agreements. For instance, the ATC left the choice of products to importing countries. Developed countries chose only those products for liberalization which were not under import restraints without actually liberalizing their textile imports.

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Dispute Resolution Mechanism The WTO’s dispute settlement mechanism suffers is criticized for suffering from a complete lack of transparency and is extremely opaque in revealing how settlements were reached. Whether settling disputes or negotiating new trade relations, it is never clear which nations are in on the decision-making processes. In this context, the WTO is seen as a clique of the developed nations forcing agreements that allow them to exploit less developed nations. This clique uses the WTO to open up developing nations as markets to sell, while protecting their own markets against weaker nations’ products. This view has its valid points, as the most economically powerful nations seem to set the WTO agenda, and were the first to pass anti-dumping acts to protect favored domestic industries, while also opposing similar actions by less powerful nations. A substantial amount of negotiations take place in small groups where developing nations are not present, but they are expected to ratify these when they are discussed in large groups.

Subsidies in Agriculture Agriculture continues to be an important source of livelihood for large parts of the developing and the less developed world. Its members have, therefore, been insisting on special and differential treatment in several aspects of WTO dealings, including agriculture, in the Doha Round. It is in this context that countries like India have been insisting that the Doha agricultural outcome must include the removal of distorting subsidies and protection to ensure a level playing field. It also wants appropriate provisions to safeguard food and livelihood security to meet rural development needs.

Future Challenges for WTO Some of the challenges being faced by the WTO and will continue in the future are: Farm Subsidies: The WTO has had a deadlock over farm subsidies as a result of a clash of interests between the United States and the EU. While the United States is in favor of the elimination of subsidies on a priority basis, the EU with its politically powerful farm lobby and long history of farm subsidies was unwilling to take this step. Labor Practices: The United States wanted the WTO to allow governments to impose tariffs on goods imported from countries which did not follow what the United States considered fair labor practices. This led to violent protests from the developing world which considered this a legal route to restrict imports from poor, low-cost developing countries. Anti-dumping Actions: As per the WTO rules, member nations are allowed to impose anti-dumping duties on foreign goods being sold cheaper in foreign markets than the home market. The provision is hugely exploited on account of its rather vague definition and interpretation. The members reporting the highest number of new initiations during January–June 2010 were India with 17 new initiations, followed by the EU with eight new initiations, Argentina with seven new initiations, and Brazil and Israel with five each. Agriculture: The high level of tariffs in agriculture is another cause for concern at the WTO. The biggest defaulters of this have been the developed nations in order to defend their agricultural sectors from developing nations’ low-cost competition. Tariff rates on agricultural commodities have been much higher than corresponding rates on manufactured products or services. In addition to tariffs, agricultural

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producers also benefit from substantial subsidies. Both these facts result in significant distortions in the trading system in the form of increased prices and reduced volumes for sale. Intellectual Property: The TRIPS regulation of the WTO makes it an obligation for members to grant and enforce patents for 20 years and copyrights for 50 years with grace periods for the poor nations. This is based on the belief that innovation, which is the engine of economic growth, is driven by a protected patent regime. An instance of this is the Indian pharmaceutical industry, which was known for producing generic versions of patented drugs through reverse engineering, earning itself the title of a ‘copycat’. With the ending of the grace period for the industry in 2005, there has been a flurry of activity, including alliances, as the industry has geared up to cope with the change. Similar issues plague other industries, such as software and music, which need strict enforcement of intellectual property rights. Doha Development Agenda: The Fourth Ministerial Conference in Doha, Qatar, in November 2001, was the longest negotiating round since World War II. Following the fiasco at the Seattle Ministerial Conference, which ended inconclusively, the Doha Round mandated negotiation on a range of subjects. The entire package is called the Doha Development Agenda (DDA) and included cutting tariffs on industrial goods and services, phasing out subsidies on agricultural produce, reducing barriers on cross border investment, and limiting the use of anti-dumping laws. Both the WTO and its predecessor, the GATT, have been considered the ‘club of rich nations’ by the developing world. Considered beneficial to world trade as a whole, the benefits of the WTO are largely dependent on the bargaining power of its members. Consequently, countries of the developing world are of the opinion that they are victims of unfair trade practices and policies adopted by rich nations. They have long been asking the affluent nations to honor commitments to open more markets or remove unfair treatment. There are also concurrent issues on environmental problems, human rights issues, and national supremacy compounding things even further.

UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT (UNCTAD) The United Nations Conference on Trade and Development (UNCTAD) was established in 1964 in response to the growing concerns about the place of developing countries in international trade. The UNCTAD is a knowledge-based institution, which promotes the development-friendly integration of developing countries into the world economy and whose work aims to help shape current policy debates and thinking on development, with a particular focus on ensuring that domestic policies and international action are mutually supportive in bringing about sustainable development. The first United Nations Conference on Trade and Development was held in Geneva in 1964. Considering the magnitude of the problems at stake and the need to address them, the conference was institutionalized to meet every four years, with intergovernmental bodies meeting between sessions and a permanent secretariat providing the necessary substantive and logistical support. Simultaneously, the developing countries established the Group of 77 (G77) to voice their concerns. The present strength of the G77 is 131.

Functions of UNCTAD The organization has three key functions: 1. It functions as a forum for intergovernmental deliberations, supported by discussions with experts and exchanges of experience, aimed at consensus building.

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2. It undertakes research, policy analysis, and data collection for the debates of government representatives and experts. 3. It provides technical assistance tailored to the specific requirements of developing countries, with special attention to the needs of the least developed countries and of economies in transition. When it is considered appropriate, the UNCTAD cooperates with other organizations and donor countries in the delivery of technical assistance. In performing its functions, the secretariat works together with member governments and interacts with organizations of the United Nations (UN) system and regional commissions, as well as with governmental institutions, non-governmental organizations, the private sector including trade and industry associations, research institutes and universities worldwide.

UNCTAD: An Assessment The UNCTAD has gone through three phases till date. Phase 1: The 1960s and 1970s In the early decades of the UNCTAD’s operation (the 1960s and the 1970s), the UNCTAD gained authoritative standing as an intergovernmental forum for North–South dialogue and negotiations on issues of interest to developing countries, including debates on the ‘new international economic order’, and for its analytical research and policy advice on development issues. Some of the agreements initiated by the UNCTAD during this time include: ■■ The Generalized System of Preferences (GSP), whereby developed economies granted improved market access to exports from developing countries. ■■ A number of International Commodities Agreements, which aimed at stabilizing the prices of export products crucial for developing countries. ■■ The Convention on a Code of Conduct for Liner Conferences, which strengthened the ability of developing countries to maintain national merchant fleets. ■■ The adoption of a Set of Multilaterally Agreed Equitable Principles and Rules for the Control of Restrictive Business Practices; this work later evolved into what is today known as Trade and Competition Policies. ■■ The identification of the Group of Least Developed Countries (LDCs) in the 1970s, which drew attention to the particular needs of these poorest countries. The UNCTAD became the focal point within the UN system for tackling LDC-related economic development issues. Phase 2: The 1980s In the 1980s, the UNCTAD was faced with a changing economic and political environment. There was a significant transformation in economic thinking. Development strategies became more market-oriented, focusing on trade liberalization and privatization of state enterprises. A number of developing countries were plunged into severe debt crises, generally as a consequence of their inward-looking policies. Despite structural adjustment programmes by the WB and the IMF, most developing countries were not able to recover quickly and often experienced negative growth and high rates of inflation. For this reason, the 1980s become known as the ‘lost decade’, particularly

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in Latin America. In the light of these developments, the UNCTAD multiplied its efforts in the ­following areas: ■■ It aimed at strengthening the analytical content of its intergovernmental debate, particularly regarding macroeconomic management and international financial and monetary issues. ■■ It also tried to broaden the scope of its activities to assist developing countries in their efforts to integrate into the world trading system. In this context, the technical assistance provided by it to developing countries was particularly important in the Uruguay Round of trade negotiations. UNCTAD played a key role in supporting the negotiations for the General Agreement on Trade in Services (GATS). ■■ The UNCTAD’s work on trade efficiency (customs facilitation, multimodal transport, etc.) made an important contribution to enabling developing economies to reap greater gains from trade. ■■ The UNCTAD assisted developing countries in the rescheduling of official debt in the Paris Club negotiations. ■■ The UNCTAD played a key role in promoting South–South cooperation. In 1989, the Agreement on the Global System of Trade Preferences (GSTP) among developing countries came into force. It provided for the granting of tariff as well as non-tariff preferences among its members. Till date, the Agreement has been ratified by 44 countries. ■■ The UNCTAD was instrumental in addressing the concerns of the poorest nations by organizing the first UN Conference on least developed countries in 1981. Since then, two other international conferences have been held at 10-year intervals. Phase 3: From the 1990s Till the Present This period was marked by the conclusion of the Uruguay Round of trade negotiations under the GATT, which resulted in the establishment of the WTO in 1995, and a strengthening of the legal framework governing international trade. Concurrently, there was a spectacular increase in international financial flows, which led to increasing financial instability and volatility. Foreign direct investment flows Bird’s-eye View became a major component of globalization. Against this background, the UNCTAD’s analyThe UNCTAD was established to address the sis gave early warning concerning the risks and the trade concerns of developing nations. It funcdestructive impact of financial crises on developtions as a forum for intergovernmental deliberment. Consequently, the UNCTAD emphasized the ations and provides technical assistance based need for a more development-oriented ‘internaon research and policy analysis. tional financial architecture’.

CHA P TER

SUMMAR Y

■■ The basis of multilateral trade are the principles of non-discrimination, reciprocity, full market access, and fair competition. ■■ Multilateral regulation of trade began with the GATT which aimed at reducing trade barriers, mainly tariff barriers, in its deliberations. ■■ The eighth GATT round known as the Uruguay Round was much broader in coverage and included aspects such as TRIMS, TRIPS and GATS as a part of its agenda.

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■■ The WTO was the successor to the GATT and is also a multilateral trade organization. ■■ It is governed by certain basic guiding principles that are in the form of complex agreements covering a wide range of activities. ■■ These principles are: the most-favored-nation principle and the principle of national treatment. ■■ The UNCTAD is a knowledge-based institution, which promotes the development-friendly integration of developing countries into the world economy and whose work aims to help shape current policy debates and thinking on development.

KEY Terms General Agreement on Tariffs and Trade (GATT), World Trade Organization (WTO), General Agreement on Trade in Services (GATS), TRIPS, TRIMS, United Nations Conference on Trade and Development (UNCTAD).

DISCUSSION QUESTIONS

1. Explain the factors which led to the creation of the GATT. 2. ‘The failure of the GATT led to the creation of the WTO’. Do you agree? Give reasons. 3. Explain the role of the WTO as a regulator of world trade.  [Delhi University, B.Com (Hons.) 2012, 2008] 4. Discuss the organizational structure, basic principles and functions of the WTO.  [Delhi University, B.Com (Hons.) 2011] 5. Enumerate the principles which are the basis of multilateral trading under the WTO framework. 6. List the major functions of the WTO and how they are achieved. 7. Explain the need for the establishment of the UNCTAD as a multilateral trade negotiation body. 8. Explain the role of WTO as a regulator of world trade. [Delhi University, B.Com (Hons.) 2014]

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7 INTERNATIONAL TRADE FINANCE AND PROMOTION LEARNING OBJECTIVES After reading this chapter, you should be able to:

■ ■ ■ ■

Understand the importance of finance for trade Highlight the different sources of trade finance Explain the importance of trade promotion List the different sources of trade promotion in India

US EXIM BANK The US EXIM Bank was created 80 years ago with the basic objective of boosting domestic exports through a wide range of programs, including guaranteeing loans to foreign buyers and providing credit insurance. The future of the EXIM bank is presently in jeopardy as the House Majority Leader Kevin McCarthy is against reauthorizing the charter of the Export-Import Bank. The future of the EXIM Bank is determined by the US Congress which decides its lending capital and has to reauthorize its charter, which is due to expire in September 2014. The Bank’s credit-exposure limit was raised to USD 140 billion from USD 100 billion in 2012. In 2013, the bank authorized USD 27 billion to support an estimated USD 37.4 billion in US export sales. The bank’s basic function is to provide loans for which it borrows money from the Treasury Department and pays interest on the funds to the Treasury. It then lends some of that money out in direct loans and charges at a higher interest rate which, along with its fees for providing loan guarantees, generates its revenue. Without reauthorization, the Bank will be able to continue servicing the loans it already has made and backed, but it will not be able to authorize new loans. The EXIM Bank has been criticized for excessive interference in markets and for creating excessive risks for taxpayers which should rightfully be taken by the creditors. It has also been branded as a form of ‘crony capitalism’ as it helps support exporters at the expense of domestic companies. Supporters of the EXIM Bank say failure to renew its charter would put US companies at a disadvantage because other rivals from the Europe and South Korea get support from similar type of agencies in their countries.

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Beneficiaries include big manufacturers such as the Boeing Company (BA) and Caterpillar, Inc. (CAT). Boeing’s biggest rival Airbus Group NV receives export-credit support from agencies in the UK, France and Germany. Boeing, therefore, fears that without EXIM Bank financing, it could lose business to overseas competitors. Similar sentiments were echoed by FirmGreen, Inc., a firm which manufactures biogas. The firm has about 80 per cent of its business outside of the US which it could lose in countries such as the Philippines, Brazil and Mexico without EXIM Bank backing. Source:  http://online.wsj.com/articles/mccarthy-wont-reauthorize-export-import-bank-charter-1403450288, last accessed on 28th August 2014.

INTRODUCTION International trade is an important aspect of global business. This chapter explores various aspects of finance for international trade. There are two major issues in the process of the financing of international trade:

1. The methods of payment used and 2. The sources of finance for the exporter.

INTERNATIONAL TRADE PAYMENT There are four main modes of payment used in international trade—cash in advance, letter of credit (L/C), documentary collection, and open account terms. The risk of bad debts for the exporter increases along this sequence.

Cash in Advance Cash in advance refers to payment that is received either before shipment or upon arrival of the goods. It is a desired mode of payment in the following situations:

Cash in advance refers to payment that is received either before shipment or upon arrival of the goods.

■■ The credit standing of the buyer is not known or is uncertain, ■■ The buyer belongs to a country that has political or economic instability. ■■ It is also used where the production needs a huge initial capital investment specifically for the product under contract. However, buyers are usually reluctant to use this mode of payment because it blocks a large amount of their working capital till sale of goods takes place. The method is popular only where there is an order for custom made goods.

Letter of Credit (L/C) The letter of credit (L/C) is the most commonly used payment method in international trade. The L/C is a document of commitment made by the bank on behalf of its customer (the importer) in which the bank promises to honor its customer’s commitment to pay. It is a

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A letter of credit is a document issued by the buyer’s bank in which the bank promises to pay the seller a specified amount under specified conditions.

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letter addressed to the seller, written and signed by a bank acting on behalf of the buyer, in which the bank promises to honor drafts drawn on itself if the seller meets the specific conditions that are given in the letter of credit. These conditions are usually the same as contained in\an export contract or sales agreement. An L/C has the following advantages for an exporter: ■■ It eliminates credit risk arising out of non-payment and reduces the risk of delayed payment due to exchange controls or other political reasons. ■■ It reduces uncertainty for the exporter as all requirements for payment are clearly given in the L/C itself. ■■ It helps to stabilize production for the exporter who has the assurance of payment even if the contract is cancelled for some reason. ■■ It is a safe and assured source of export financing if the L/C is irrevocable and confirmed. An L/C has the following advantages for an importer: ■■ The L/C issuance often requires an importer to pre-deposit or have a saving account in the issuing bank. ■■ The importer is assured of the goods having actually been loaded on the ship and of their quality and quantity being in accordance with regulations. ■■ Any discrepancies in documentation are the responsibility of the bank, especially in the case of commercial L/Cs, for which banks deal in documents and not in goods. ■■ The L/C increases the importer’s bargaining power, and allows the importer to ask for a price reduction from the exporter. Types of L/Cs There are several types of L/Cs: ■■ Documentary L/Cs: They are issued in connection with commercial transactions. For this, the exporter must submit, together with the draft, any necessary invoices and other documents such as the custom invoice, certificate of commodity inspection, packing list and certificate of country of origin. ■■ Clean L/Cs: They are those which do not require any documents. A clean L/C may be used for overseas bank guarantees, escrow arrangements, and security purchases. ■■ Revocable L/Cs: These documents can be revoked or taken back without notice at any time up to the moment a draft is presented to the issuing bank. They do not carry any guarantee with them. ■■ Irrevocable L/Cs: They cannot be revoked without the specific permission of all parties concerned, including the exporter. Most credits between unrelated parties are irrevocable. ■■ Confirmed L/Cs: They are issued by one bank and confirmed by another, making it obligatory for both banks to honor any drafts drawn in compliance. ■■ Unconfirmed L/Cs: They are the obligation of only the issuing bank. Naturally, an exporter will prefer an irrevocable letter of credit by the importer’s bank with confirmation by another (domestic or foreign) bank. ■■ Transferable L/Cs: They are those under which the beneficiary has the right to instruct the paying bank to make the credit available to one or more secondary beneficiaries. No L/C is transferable unless specifically authorized and it can be transferred only once. The stipulated documents are transferred along with the L/C. In effect, the exporter is the intermediary in a transferable credit, and usually has the credit transferred to one or more of its own suppliers. When the credit is transferred, the exporter is actually using the creditworthiness of the opening bank, thus avoiding having to borrow or use its own funds to buy the goods from its own suppliers.

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■■ Back-to-back L/Cs: These documents are used simultaneously or together where the exporter, as beneficiary of the first L/C, offers their credit as security in order to finance the opening of a second credit. He may do this in favor of his own supplier of goods needed for shipment under the first or original credit from the advising bank. The bank that issues a back-to-back L/C not only assumes the exporter’s risk but also the risk of the bank issuing the primary L/C. If the exporter is unable to produce documents or the documents contain discrepancies, the bank ­issuing the back-to-back L/C may be unable to obtain payment under the credit because the importer is not obligated to accept discrepant documents of the ultimate supplier under the backto-back L/C. Thus, many banks are reluctant to issue this type of L/C. ■■ Revolving L/Cs: They exist where the tenor (maturity) or amount of the L/C is automatically renewed as a result of the of terms and conditions contained in them. An L/C with a revolving maturity may be either cumulative or non-cumulative. When cumulative, any amount not utilized during a given period may be applied or added to a later period. If non-cumulative, any unused amount is simply no longer available. If a revolving L/C is used, it must be clearly stated so in the export contract.

Documentary Collection Documentary collection is a method of payment Documentary collection is a payment mechaunder which the exporter retains ownership of the nism under which the exporters retain ownership goods until payment is received or he is certain that of the goods until payment is received or there is it will be received. In this method of payment, the certainty that it will be received. bank, acting as the exporter’s agent, regulates the timing and sequence of the exchange of goods by holding the title documents until the importer either pays the draft, termed documents against payment (D/P), or accepts the obligation to do so, termed documents against acceptance (D/A). The two principal documents used in the process of documentary collections are a draft and a bill of lading (B/L). 1. The draft is a document written by the drawer (exporter) to the drawee (importer) and requires payment of a fixed amount at a specific date to the payee (usually the exporter himself). A draft is a negotiable instrument that normally needs to be physically presented as a condition for payment. A draft may be either a sight draft (payable upon presentation) or a time draft (payable on a specified future date). 2. A bill of lading is a document of title of the goods being shipped along with the documents for shipment and the carrier’s receipt for the goods being shipped. A sight draft is commonly used for D/P payment. However, for export sales that take several months in ocean transportation, exporters and importers may agree to use D/P of 30, 60, 90 or 180 days. In practice, D/A are usually accompanied by a time draft ranging from 30 days up to perhaps two years, which is why time draft-based collections are also viewed as an important commercial or corporate financing approach that is granted by the exporter to the importer. The disadvantage of this method of financing is the high risk of receivable collection for the exporter. D/A is a riskier collection method than D/P because the importer can claim the title of goods under the ‘promise’ of payment rather than actual payment. For this reason, most bad debts accumulated in international trade have been transactions that used D/A as terms of payment.

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Open Account Under this method of payment, goods to be sold are first shipped and the importer is billed for them later. The method can be used only if the customer is reliable, as there is no guarantee of payment from the buyer and all risk is borne by the seller. Very often exporters who prefer less risky modes of payment lose business to competitors. Large global firms such as Mercedes Benz prefer to use the open account method as against the more expensive letters of credit. In recent years, open account sales have increased because of the increase in international trade, more accurate credit information about ­importers, and the greater familiarity with exporting in general.

TERMS OF TRADE Free on board A price quotation in which the seller covers all costs and risks up to the point whereby the goods are delivered on board the ship in a designated shipment (export) port, and the buyer bears all costs and risks from that point on. This means that the buyer is responsible for the insurance and freight expenses in transporting goods from the shipment port to the destination port.

Free alongside Ship A price quotation in which the seller covers all costs and risks up to the ship at the designated shipment (export) port. The buyer bears all costs and risks thereafter, including the loading of goods.

Cost, Insurance and Freight A price quotation in which the seller covers cost of the goods, insurance and all transportation and miscellaneous charges to the final destination port in a foreign country.

Cost and freight This price quotation is similar to CIF except that the buyer purchases and bears the insurance.

Bird’s-eye View There are four main modes of payment used in international trade—cash in advance, letter of credit (L/C), documentary collection and open account terms. The risk of bad debts for the exporter increases along this sequence. There is least risk for the exporter if payment is in cash and highest risk if there is an open account.

INTERNATIONAL TRADE FINANCE External sources of export financing include both private sources and governmental sources. These sources offer different types of financing for exporters.

Private Sources Private sources of trade financing include commercial banks, export finance companies, factoring houses, forfeit houses, international leasing companies, in-house finance companies and private insurance companies.

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Bank Finance Banks as a source of trade credit play an important role in the world of global finance in several different ways. Commercial bank financing for foreign trade business includes bank guarantees, bank line of credit and buyer credit.

A bank guarantee is a financial instrument that guarantees a specified sum of payment to either the exporter or importer.

■■ A bank guarantee is a financial instrument that guarantees a specified sum of payment to either the exporter or importer. Apart from regular bank guarantees, there are three other types of guarantees used in international trade. These include –– The loan guarantee, in which a loan is granted on the condition of security provided by the borrower –– A distraint guarantee, which helps a debtor to recover his seized assets; –– A bill of lading guarantee, which ensures that the carrier will hand over the goods to the consignee when individual bills of lading are lost. ■■ A bank line of credit is a sum of money allocated to an exporter by a bank to finance its export business. This could also be meant to finance a specific export transaction from the foreign customer’s side, and allows the exporter to extend competitive credit terms to foreign customers. ■■ Buyer credit refers to credit extended by one or more financial institutions in the exporter’s country. This form of finance is mostly used to finance capital equipment purchases, but other goods with payment terms of up to one year can also be financed by buyer credits. Buyer credits are normally arranged under an export credit insurance programme. Export Factoring Export factoring is particularly suited for small and medium-sized exporters as it enables them to be more Export factoring involves the sale of export accounts receivable to a third party, which competitive by selling on open account rather than assumes the credit risk. using more costly methods such as letters of credit. It involves the sale of export accounts receivable to a third party that assumes the credit risk. This technique can be used through factoring houses that not only provide financing but also perform credit investigations, g­ uarantee ­commercial and ­political risks, assume collection responsibilities, and finance accounts receivables. In addition, these houses can perform such services as letters of credit, term loans, marketing assistance, and all other necessary services a small-to-medium-sized exporter cannot afford to handle. Often, a factoring house’s service charges are quoted on a c­ ommission basis. Commissions can range anywhere between 1 and 3 per cent of total transaction value. While factoring is a well-known export financing technique in the United States, forfaiting has been widely used for export financing in Europe. Forfaiting This term is derived from the french term a forfeit. Forfaiting is purchasing an account receivable Forfaiting refers to purchasing an account receivable where the credit term exceeds the permissible where the credit term exceeds the permissible limit for limit for factoring. factoring. It is a transaction in which an exporter transfers responsibility of commercial and political risks for the collection of a trade-related debt to a forfaiter (often a financial institution), and in turn receives immediate cash after the deduction of its interest charge (the discount). The purchase of obligations arising out of the sale of goods and services where payment is due beyond the 90 to 180 days is covered in a factoring agreement.

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The forfait market has two segments—a primary and secondary market. The primary market consists of banks and forfait houses that buy properly executed and documented debt obligations directly from exporters. The secondary market consists of trading these forfait debt obligations among themselves. In general, a forfait financing transaction involves at least four parties to the transaction: an exporter, the forfaiter, the importer and the importer’s guarantor. The financial instruments in f­orfaiting are ­usually time drafts or bills of exchange and promissory notes. Forfaiting is used to finance the export of capital equipment where transactions are usually medium term (that is, three to eight years) at fixed-rate financing. The discount used by the forfaiter is based on its cost of funds plus a premium, which can range anywhere from 0.5 to 5 per cent, depending on the country of importation and level of risks involved. Banker’s Acceptance The banker’s acceptance (BA) is a time draft drawn The banker’s acceptance is a time draft drawn on and accepted by one bank on another one. It is a on and accepted by one bank on another one. method of inter-bank financing in which one branch is the financier and the other is the investor. The bank first creates the BA by accepting a draft presented by its customer (that is, the drawer), which it then discounts (it pays the drawer a sum less than the face value of the draft), and resells the BA to an investor in the acceptance market. A banker’s acceptance is a time draft (30, 60, 90 to 180 days after sight or date) drawn on and accepted by a bank. The fee charged by the accepting bank varies depending on the maturity of the draft as well as the creditworthiness of the borrower. BA is mainly used for the export trade in raw materials, components and general commodity financing. A deep, secondary market for bankers acceptances combined with the lack of reserve requirements often enables the bank to obtain funding for eligible transactions at a cost significantly lower than alternative sources. Corporate Guarantee A corporate guarantee is a method of finance where A corporate guarantee is a method of finance one company undertakes to pay the principal debts where one company undertakes to pay the prinof another corporate house. The method is used cipal debts of another corporate house. when creditors ask the corporate or parent company to guarantee an obligation of one or more of its ­overseas subsidiaries or offshore affiliates that the ­creditor may consider not creditworthy for the export-related financing or credit limit.

Governmental Sources Government sources of trade finance include export–import bank financing and foreign credit insurance. Export–Import Bank Financing Many countries have put in place export–import financing programmes to provide finance for exports, imports and overseas investments. The loans are low-cost for a medium-to-long-term period arranged in collaboration with larger commercial banks throughout the world. Their purpose is to encourage the export of capital goods and services, overseas investment, and major resource development. For example, South Korea’s Exim Bank offers such services as direct lending to both suppliers and buyers, relending facilities to foreign financial institutions, and the issuance of guarantees and export insurance. In the United States, the primary function of its Exim Bank is to give US exporters the necessary financial backing to compete in other countries. Today this is done through a variety of different export

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financing and guarantee programmes (for example, direct loans, discount loans, guarantees and export credit insurance) to meet specific needs. All these measures are designed to directly support US exports, whether the eventual recipient of the loans or guarantees are foreign or domestic firms. Generally, export–import banks do not compete with private sources of export financing. Their main purpose is to step in where private credit is not available in sufficiently large amounts at low rates or long terms to allow home country exporters to compete in a foreign market. Foreign Credit Insurance Many industrialized and developing countries have set up foreign credit insurance or guarantee programmes to assist their exporting companies. These programmes are usually run by and are dependent on the government. In the Unites States, such insurance programmes are offered by both Exim Bank and the Foreign Credit Insurance Association. In Canada, these services are provided by Export Credits Insurance Corporation (ECIC). In Asia, Japan’s International Trade Bureau (Export Insurance Section), Hong Kong’s Export Credit Insurance Corporation, India’s Export Credit and Guarantee Corporation Ltd, and Taiwan’s Central Trust of China all offer such programmes. In Latin America, similar programmes can be found, including in Compania Argentina de Seguros de Credito a la Exportacion in Argentina and Instituto Bird’s-eye View de Resseguros do Brasil in Brazil. Europe has an even longer history in providing Export finance for trade is available from both export credit insurance. Les Assurances du Credit in private and government sources. The main Belgium, Export Credit Council in Denmark, Finnish sources of private finance are bank finance, Guarantee Board in Finland, Compagnie Francaise export factoring and forfeiting, banker’s D’Assurance pour le Commerce Exterieur in France, acceptance and corporate guarantee. Trade Hermes Kreditversicherungs in Germany, and Istituto finance from government sources is mainly in Nazionale delle Assicurazioni in Italy, for example, the form of foreign credit insurance and export are all leading institutions offering foreign credit insurimport banks. ance and backed by their respective governments.

INTERNATIONAL TRADE CREDIT The time lag between receipt of an order and receipt of actual payment makes the exporter look for ­different sources of credit. He needs credit for expenses on purchase of materials and components, processing, packaging and warehousing among various other kinds of cost. Very often he has to extend credit to his overseas buyer and arrange for credit during this period. In order to meet these credit needs of the exporter, there are provisions for both pre-shipment and postshipment credit. ■■ Pre-shipment credit is extended to enable the exporter to meet his working capital requirements for the purchase of raw materials and components, processing, packing, transportation and warehousing. It is a form of short-term finance and may be given in advance against an export order. In India, commercial banks who are members of the Foreign Exchange Dealers Association extend this form of credit under the Packing Credit Scheme of the Reserve Bank of India. ■■ Post-shipment credit is provided to the exporter to enable him to extend credit to his buyers in the international market. It therefore acts as an export promotion measure that enhances the exporter’s competitiveness. Post-shipment credit could be extended as buyer’s credit or as a line of credit.

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Under the buyer’s credit system, an overseas buyer gets credit from either one or a consortium of financial institutions. This enables him to pay for the goods he imports without any actual transfer of funds taking place. The exporter may obtain the payment directly from the bank on presentation of relevant export documents. Buyer’s credit is generally advanced for capital goods. In a situation where the exporter has several buyers, the financial institution in the home country extends a line of credit to another institution instead of dealing with each buyer separately. The credit is disbursed through the host country institution to the parties involved. This not only saves time in having to deal with individual buyers, it also puts the onus of judging the creditworthiness of the buyers on the home country institution.

TRADE PROMOTION IN INDIA Foreign trade in India has been a regulated activity aimed at the conservation of scarce foreign exchange for necessary imports and achieving self-reliance in the production of as many goods as possible. India’s trade policy can be divided into five distinct phases.









1. The first phase from 1947 to 1948 saw restrictions on both imports and exports and was a continuation of wartime controls on trade, since there was a restriction on the use of sterling balances by the United Kingdom. The adverse balance of payments position also led to a devaluation of the rupee in 1949. 2. Liberalization of foreign trade was adopted as a goal of trade policy in the second phase from 1952–53 to 1956–57. Exports were encouraged by relaxing export controls, reducing export duties, abolishing export quotas, and providing export incentives. Import licences were also granted liberally, and led to a considerable increase in the import volume, but exports did not show much improvement. As a result, the foreign exchange reserves declined sharply and trade policy had to be reversed. 3. The third phase began in 1956–57, during which trade policy was re-oriented to meet the requirements of planned economic development. Import policy was very restrictive and import controls were used to further prune the list of imported goods. A vigorous export promotion drive was launched on the assumption that the balance of payments problem would be solved only through export promotion and diversification. It focused on expansion of traditional items of trade and the simultaneous addition of new ones, and on establishing import-substituting industries as well. 4. The fourth phase began after the devaluation of the rupee in 1966, which became necessary on account of a deteriorating balance of payments position. Despite implementation of the recommendations of the Mudaliar Committee, such as increased allocation of raw materials to exportoriented industries, income tax relief on export earnings, export promotion through import entitlement, removal of disincentives, and the establishment of an Export Promotion Advisory Council and a Ministry of International Trade, the balance of payments position continued to decline. The Government continued with a policy of import liberalization and export promotion in the period 1975–76 and followed it up with a revised policy in 1985 based on the recommendations of the Abid Husain Committee. 5. During the fifth phase, the Government adopted an overhauled trade policy in the wake of the programme of economic reform and liberalization adopted in 1991. This was the new trade policy of 1991. It was based on the rationale of reduced control and licences to be replaced by decontrol and opening up. Over a period of time, this has led to a change in the nature and volume of exports and imports accompanied by major changes in industrialization and foreign investment policy as well.

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Organizations for Export Promotion In order to help in exports, the Government established or sponsored a number of organizations to provide different types of assistance to exporters. At the helm of affairs is the Ministry of Commerce, which looks into various aspects of trade promotion and regulation. The various autonomous bodies for export promotion and their functions are discussed here: ■■ The Export Inspection Council is a statutory body, responsible for the enforcement of quality control and compulsory pre-shipment inspection of various exportable commodities. ■■ The Indian Institute of Foreign Trade is engaged in activities like training of personnel in modern techniques of international trade; organization of research in problems of foreign trade; organization of marketing research, area surveys, commodity surveys and market surveys; and dissemination of information arising from its activities relating to research and market studies. ■■ The Indian Institute of Packaging undertakes research on raw materials and organizes training programmes for the packaging industry. ■■ Export Promotion Councils work for both advisory and executive functions under the Ministry of Commerce. ■■ Commodity Boards have been set up for the promotion, development, and export of commodities, such as spices, coir, and tea. ■The ■ Export Development Authority looks into the promotion of various other commodities not under the earlier Boards. The Marine Products Export Development Authority (MPEDA) is responsible for the development of the marine products industry with special reference to exports. The Agricultural and Processed Food Products Export Development Authority, set up in 1986, serves as the focal point for agricultural exports, particularly the marketing of processed foods in value-added forms. ■■ The Federation of Indian Export Organizations (FIEO) is an apex body of various export promotion organizations and institutions. It also functions as a primary servicing agency to provide integrated assistance to government-recognized export houses and as a central coordinating agency with respect to export promotion efforts in the field of consultancy services in the country. ■■ The Indian Council of Arbitration, set up under the Societies Registration Act, promotes ­arbitration as a means of settling commercial disputes and popularizes arbitration among traders, particularly those engaged in international trade.

Export Incentives Export incentives are a widely employed strategy of export promotion aimed at increasing the profitability of export. Some of these incentives are discussed here: ■■ The duty exemption/drawback scheme aims to compensate the exporter for the increase in cost borne by him on account of customs and excise duties. Duty exemption as an export promotion measure had its origin in India during the second five-year plan. Under this scheme, exporters are either exempted from the payment of duty while procuring inputs like raw materials and intermediates or, in cases where the duty is paid on the inputs, the duty is refunded. There are two types of drawback rates—an all industry rate applicable to a group of products and a band rate applicable to individual products not covered by the industry rate. ■■ The cash compensatory support (CCS) was a cash subsidy scheme designed to compensate exporters for un-rebated indirect taxes and to provide resources for product/market development. The CCS enabled the exporters to increase the profit or to reduce the price to the extent of the subsidy without incurring a loss. With the devaluation of the rupee in July 1991, the CCS was abolished.

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■■ Another important incentive was the system of import replenishment (REP) licences, which were related to the free on board (FOB) value of exports. The REP was, for the most part, a facility that enabled exporters to import inputs where the domestic substitutes were not adequate in terms of price, quality, or delivery rates; it was also an incentive in so far as there was a premium on REP licences, which were transferable. The new trade policy of July 1991, renamed it the Exim scrip scheme. However, it was abolished with the introduction of the partial convertibility of the rupee since April 1992. ■ The ■ international price reimbursement scheme (IPRS) was designed to make available specified inputs to exporters at international prices. The scheme which was initially available to steel was later extended to aluminium, and there was also a proposal to extend to other items. The IPRS has been replaced by the engineering products exports (replenishment of iron and steel intermediates) scheme.

Marketing Assistance A number of steps have been taken to assist exporters in their marketing effort. These include conducting, sponsoring or otherwise assisting market surveys and research; collection, storage and dissemination of marketing information; organizing and facilitating participation in international trade fairs and exhibitions; credit and insurance facilities; release of foreign exchange for export marketing activities; assistance in export procedures; quality control and pre-shipment inspection; identifying markets and products with export potential; and helping buyer-seller interaction. Some of the schemes and facilities, which assist export marketing, are mentioned here.

Market Development Assistance An important export promotion measure taken by the Government is the institution of market development assistance (MDA). Assistance under the MDA is available for market and commodity researchers; trade delegations and study teams; participation in trade fairs and exhibitions; establishment of offices and branches in foreign countries; and grants-in-aid to Export Promotion Councils (EPCs) and other approved organizations for export promotion on export credit by commercial banks. Approved cooperative banks also enjoy a subsidy out of the MDA. Most of the MDA expenditure in the past was absorbed by the CCS. The CCS helped the exporters to increase the price competitiveness of Indian products in foreign markets.

Market Access Initiative In 2001, the Government announced the launching of the market access initiative scheme for undertaking marketing promotion efforts abroad on a country-product focus approach basis. This scheme is in line with market promotion and development schemes being implemented by many other countries. The Exim policy, 2002–2007, further broadened the scope of this scheme to include activities considered necessary for focused market promotion efforts.

Foreign Exchange Foreign exchange is released for undertaking approved market development activities, such as participation in trade fairs and exhibitions, foreign travel for export promotion, advertisement abroad, market research, procurement of samples, and technical information from abroad.

Trade Fairs and Exhibitions Trade fairs and exhibitions are effective media for promoting products, and facilities are provided for enabling and encouraging participation of Indian exporters/manufacturers in such events. Foreign

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exchange is released for such purpose, the cost of participation is subsidized, and the Indian Trade Promotion Organization (ITPO) plays an important role in organizing and facilitating participation in trade fairs/exhibitions.

Export Risk Insurance As international business is prone to different types of risks, measures have been taken to provide insurance covers against such risks. The export credit guarantee corporation (ECGC) has policies covering different political and commercial risks associated with export marketing, certain types of risks associated with overseas investments, and risks arising out of exchange rate fluctuations. Further, ECGC extends the export credit risks to cover commercial banks. Marine insurance is provided by the General Insurance Corporation and its subsidiaries.

Production Assistance/Facilities Exports depend on exportable surplus and the quality and price of the goods. The Government has, therefore, taken a number of measures to enlarge and strengthen the production base, to improve the productive efficiency and quality of products and to make products more cost-effective. Measures in these directions include making raw materials and other inputs of required quality available at reasonable prices; facilities to establish and expand productive capacity, including import of capital goods and technology; facilities to modernize production; and provision of infrastructure for the growth of export-oriented industries.

Special Economic Zones (SEZs) A special economic zone (SEZ) is a geographical region with special economic and other laws aimed at promotion of exports and foreign investment. The category SEZ covers a broad range of more specific zone types, including free trade zones (FTZ), export processing zones (EPZ), free zones (FZ), industrial estates (IE), export-oriented units (EOUs), export houses, free ports, and urban enterprise zones.

Export Processing Zones Export processing zones (EPZs) are industrial estates which form enclaves within the national customs territory of a country and are usually situated near seaports or airports. The entire production of such a zone is normally meant for exports. These zones have well-developed infrastructural facilities, and industrial plots/ sheds are normally made available at concessional rates. Units in these zones are allowed foreign equity even up to 100 per cent and are permitted to import capital goods and raw materials for export production without payment of duty. Domestically procured items are also eligible for duty exemption. The main objectives of an EPZ are to earn foreign exchange, generate employment opportunities, facilitate transfer of technology through foreign investment and, thereby, contribute to overall economic development. India’s first EPZ was established at Kandla, Gujarat in 1965 as a multi-product zone. It has been followed by several others. Later, the government also introduced schemes for electronic hardware technology park (EHTP) units and software technology park (STP) units.

Free Trade Zone (Ftz) A free trade zone (FTZ) is different from an EPZ. Goods imported to a free trade zone may be ­re-exported without any processing, in the same form. However, goods exported by units in an EPZ are expected to

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go through some additional manufacturing or other processing before being exported. A free port is a port in which imports and exports are free from trade barriers. A FTZ may be a part of or adjacent to a port; the rest of the port being subject to the national customs regulation.

Export-oriented Unit (Eou) A hundred per cent export-oriented unit (EOU) unlike an EPZ is an industrial unit located anywhere in the country (duty tariff areas), which offers its entire production for export, excluding permitted levels of rejects. EOUs were allowed in industries which had export potential and the capacity to create additional export capacity.

Export Houses An export house is a registered exporter established to boost exports and provide a channel for the products of the small scale sector.

Special Economic Zone India was one of the first Asian countries to recognize the effectiveness of the export processing zone (EPZ) model in promoting exports, with Asia’s first EPZ set up in Kandla in 1965. With an aim to overcome the shortcomings experienced on account of the multiplicity of controls and clearances, absence of world-class infrastructure, and an unstable fiscal regime, and with a view to attract larger foreign investments in India; the special economic zones (SEZs) policy was announced in April 2000. To instil confidence in investors and signal the Government’s commitment to a stable SEZ policy regime, the Special Economic Zones Act was passed by Parliament in May 2005. The Act, 2005, supported by SEZ Rules, came into effect on 10 February 2006, providing for drastic simplification of procedures and for single window clearance on matters relating to central as well as state governments. The main objectives of the SEZ Act are: ■■ ■■ ■■ ■■ ■■

Generation of additional economic activity Promotion of exports of goods and services Promotion of investment from domestic and foreign sources Creation of employment opportunities Development of infrastructure facilities

The SEZ Rules provide for different minimum land requirement for different classes of SEZs. Every SEZ is divided into a processing area where alone the SEZ units would come up and a non-processing area where the supporting infrastructure would be created. Incentives and Facilities Offered to the SEZs The incentives and facilities offered to the units in SEZs for attracting investments into the SEZs include: ■■ Duty-free import/domestic procurement of goods for development, operation and maintenance of SEZ units ■■ 100 per cent income tax exemption on export income for SEZ units, under Section 10AA of the Income Tax Act for the first five years, 50 per cent for the next five years and 50 per cent of the ploughed back export profit for the next five years

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■■ Exemption from minimum alternate tax under Section 115JB of the Income Tax Act ■■ External commercial borrowing by SEZ units up to US USD 500 million in a year without any maturity restriction through recognized banking channels ■■ Exemption from central sales tax and service tax ■■ Single window clearance for central and state level approvals ■■ Exemption from the state sales tax and other levies as extended by the respective state governments The major incentives and facilities available to SEZ developers include: ■■ Exemption from customs/excise duties for development of SEZs for authorized operations approved by the Board of Approval (BOA) ■■ Income tax exemption on export income for a block of 10 years in 15 years under Section 80-IAB of the Income Tax Act ■■ Exemption from minimum alternate tax under Section 115JB of the Income Tax Act ■■ Exemption from dividend distribution tax under Section 115O of the Income Tax Act ■■ Exemption from central sales tax (CST) ■■ Exemption from service tax Benefits of SEZs SEZs carry multiple benefits, such as employment generation, boosting investment, augmenting exports, and building infrastructure of international standards. SEZs make local recruitments, and ­provide ­training for their operations. The gem and jewellery SEZ in Hyderabad, the textile SEZ of the Mahindras in Chennai, the Nokia SEZ in Sriperambedur, the Flextronics SEZ in Chennai, the Apache SEZ in Nellore, the Brandix Apparel SEZ in Vishakhapatnam, the Divi Laboratories SEZ in Andhra Pradesh and the Bird’s-eye View Rajiv Gandhi Technology Park SEZ in Chandigarh are example of SEZs that have created employment There are a number of organizations and in their respective zones. schemes set up by the Indian government for SEZs also help to attract foreign investment trade promotion. These aim to provide export which augments domestic investment. It is estiincentives, marketing assistance, insurance mated that investment from SEZ developers will and special terms of finance for export promotouch US USD 60 billion by 2012, if all SEZtion in India. approved projects are implemented.

C H A P T E R

S U M M A R Y

■■ There are a number of accepted payment forms in international trade, ranging from cash in advance, to letter of credit (L/C), documentary collection (such as D/P and D/A), to open account terms. ■■ Cash in advance is a method of payment which is received either before shipment or upon arrival of the goods. ■■ A letter of credit is a document issued by the buyer’s bank in which the bank promises to pay the seller a specified amount under specified conditions. ■■ L/C is particularly desirable for the exporter because it eliminates credit risk, reduces uncertainty and facilities financing, whereas for the importer it ascertains the quality and quantity of a purchase.

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■■ Documentary collection is a payment mechanism under which the exporters retain ownership of the goods until payment is received or there is certainty that it will be received. ■■ Bill of lading is a document of title of the goods being shipped along with the documents for shipment and the carrier’s receipt for the goods being shipped. ■■ External sources of export financing include both private sources and governmental sources. These sources offer different types of financing for exporters. ■■ A bank guarantee is a financial instrument that guarantees a specified sum of payment to either the exporter or importer. ■■ Export factoring involves the sale of export accounts receivable to a third party, which assumes the credit risk. ■■ Forfaiting is purchasing an account receivable where the credit term exceeds the permissible limit for factoring. ■■ The time lag between receipt of an order and receipt of actual payment makes the exporter look for different sources of credit. ■■ In order to meet these credit needs of the exporter, there are provisions for both pre-shipment and post-shipment credit.

Key Terms Cash in advance, Letter of credit, Documentary collection, Bill of lading, Bank guarantee, Export ­factoring, Forfaiting, Banker’s acceptance, Corporate guarantee, pre-shipment credit, post-shipment credit, export promotion, SEZ, EOU.

DISCUSSION QUESTIONS

1. 2. 3. 4.

Enumerate the main modes of payment for international trade transactions. What is a letter of credit? How is it different from documentary collection? List and explain the different types of letters of credit. Distinguish between a. Export forfaiting and export factoring b. SEZ and EOU c. Pre-shipment and post-shipment credit 5. Write a short note on a. Export promotion organizations in India [Delhi University, B.Com (Hons.) 2011] b. EOUs [Delhi University, B.Com (Hons.) 2012] c. Role of SEZs in the Indian economy [Delhi University, B.Com (Hons.) 2012] d. Export promotion organizations in India [Delhi University, B.Com (Hons.) 2010] e. Export incentives in Indian trade [Delhi University, B.Com (Hons.) 2010] 6. What measures have been taken by the indian government to promote foreign trade. Mention the various organisations set up for the same. [Delhi University, B.Com (Hons.) 2014] 15 marks 7. Distinguish between the following: a. FAS and FOB b. C&F and CIF [Delhi University, B.Com (Hons.) 2014]

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8 REGIONAL ECONOMIC INTEGRATION LEARNING OBJECTIVES After reading this chapter, you should be able to:

■ ■ ■

Define different forms of economic integration and their effects on international business

■

Explain the rationale for international commodity agreements

Examine the costs and benefits of integration Explore different regional trading groups and their impact on the world and regional economy

MEXICO LEADS IN AUTO MANUFACTURING Mexico’s auto production has grown in leaps and bounds since it became a member of NAFTA. The country now produces almost 20% of all North American light vehicles, compared to a 6% share in 1990. Mexico manufactures 63% of its cars for export to USA and the rest to Asia and Europe. Mexico is the world’s fourth-largest auto exporter, and finds automakers from all over the world at its doorstep to make the most of its low production costs and export-friendly environment. The global auto industry has zeroed down on Mexico in its quest for an efficient production hub as climate change and rising gas prices have reduced profit margins on automobile sales. Mexico’s cost advantage comes from its abundant and, therefore, cheap skilled labour and land. This is coupled with long working hours in its factories. Nissan’s plant in Aguascalientes runs almost 20 hours a day. Mexico is an exporters’ paradise on account of its geographical location at the midpoint of the Americas, and its lengthy border with the world’s biggest economy. Auto majors like Audi find its proximity to USA the key reason for locating production there. Mexico also has 44 free trade agreements with the EU, Japan, Israel and many other countries—making trade a favourable option.

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As auto majors Mazda, Honda, Renault Nissan, Daimler and Audi have all announced their future plans to invest in Mexico, it is an uphill drive all the way for this once underdeveloped NAFTA partner. Sources: http://qz.com/81739/adios-motor-city-how-mexico-is-becoming-the-worlds-best-place-to-make-cars/, http://www.chicagofed.org/digital_assets/others/events/2013/automotive_outlook_symposium/klier_053013. pdf, http://www.autonews.com/article/20140627/OEM01/140629880/renault-nissan-daimler-plan-$1.4-billionsmall-car-plant-in-mexico, last accessed on 25 July 2014.

INTRODUCTION Economic integration is the process of removal of trade barriers between two or more nations and Economic integration is the process of removal of trade barriers between two or more nations the establishment of cooperation and coordination and the establishment of cooperation and coorbetween them. It is a part of the ongoing process of dination between them. globalization which is concerned with the growing economic interdependence of countries. Thus, economic integration may be viewed as a spectrum of understanding between nations. At one end of the spectrum, lies a truly global economy in which all countries share a common currency and agree to a free flow of goods, services, and factors of production. At the other extreme, are a number of closed economies, where each is independent and self-­sufficient. In actual fact, most agreements on regional economic integration are actually found somewhere in the middle of this spectrum. Market integration is the extent to which one or more separated markets combine to form a single market. Integration leads to increased cross-border flows of goods, services, capital, and labor. The process of regional economic integration is pushed by the efforts of institutional and policy coordination of both the government and private market players. This is further encouraged by advancements in technology, global institutional growth and advances in transportation and communications. The key to market integration is the elimination of barriers to trade and investment in the form of tariffs, quotas, import licensing, limits on the amount of foreign ownership in a particular firm or industry, and the differential treatment of foreign and domestic investors. This chapter begins with an explanation of different levels of economic integration. It then takes you through some important regional agreements and explores their effects on the regional and world economic system. It also outlines the implications of integration for international business managers.

LEVELS OF ECONOMIC INTEGRATION There are five levels of economic integration as illustrated in Figure 8.1(a) and (b).

Free Trade Area (FTA) A free trade area is the loosest form of economic integration between nations. It is an agreement in which member nations remove all trade restrictions among themselves, but may continue to have any

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A free trade area is an agreement in which member nations remove all trade restrictions among themselves, but continue to have any number of such restrictions vis-à-vis their other trading partners.

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n

FTA

io Customs un

et ark m Common ion Economic un on u ni Political

Figure 8.1(a)  Layers of Economic Integration

number of such restrictions vis-à-vis their other trading partners. No discriminatory taxes, quotas, tariffs or other trade barriers are allowed between member countries, but they can be used between non-members. The North American Free Trade Agreement (NAFTA) and the Latin American Free Trade Area (LAFTA) now replaced by the Latin American Association of Integration (ALADI) are examples of this form of cooperation. The United States similarly has free trade agreements with Israel, Jordan, Chile and Singapore, and is negotiating with countries of the Central American Common Market (CACM).

Customs Union This is the next step in the process of regional ecoA customs union is characterized by the removal nomic integration. A customs union is characterof barriers between member countries and the ized by the removal of barriers between member establishment of a common trade policy with countries and the establishment of a common trade respect to non-member countries. policy with respect to non-member countries. This typically takes the form of a common external tariff, where exports from non-members are subject to the same tariff when sold to any member country. Tariff revenues are shared among members according to a predetermined formula. The South African Customs Union is the oldest example of this form of integration. Other examples are the CACM and the Caribbean Community and Common Market (CARICOM).

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Political union

Economic union

Common market

Customs union

FTA

• Economic union • Common parliament and other institutions of governance

• Common market conditions • Common monetary and fiscal policy • Common currency

• Custom union conditions • Free factor mobility

• FTA conditions • Common external tariff on imports • Common trade policy for nonmembers

• No internal tariffs

Figuer 8.1(b)  Stages in Regional Economic Integration

Common Market The next stage in economic integration is the A common market has no barriers to trade ­common market. At this stage, there are no barriers among members and a common external trade to trade among members and a common external policy along with free mobility of the factors of trade policy between members and non members. In production. addition to this, there is free mobility of the factors of production including labor, capital and technology among member countries. Thus, restrictions on immigration, emigration and cross-border investments are abolished. Free mobility of the factors of production leads to capital, labor and technology being employed in their most productive uses contributing to economic growth. Members of a common market need to cooperate in terms of ­fiscal and monetary policies. Furthermore, while a ­common market is beneficial for its members in the aggregate, it is not clearly proved that it is ­beneficial for

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individual members as well. The Southern Common Market Treaty (MERCOSUR) is an example of this form of cooperation.

Economic Union An economic union is a common market which has An economic union is a common market which unified fiscal and monetary policies. This requires has unified fiscal and monetary policies and a harmonization of monetary, fiscal and government common currency. policies among member countries and the adoption of a common currency. The formation of an economic union implies giving up a significant portion of national sovereignty to a supranational authority in community-wide institutions such as the European Parliament. This leads to member countries becoming the states of a larger ‘economic community’ which has the same features as a country. For example, the ratification of the Maastricht Treaty by 12  member countries led to the creation of the European Union with effect from 1 January 1994. This treaty jointly with the treaty of Amsterdam laid the foundation for the Economic and Monetary Union (EMU) with the euro as the common currency.

Political Union This is the final stage of integration which requires The political union is the final stage of integration participating nations to become unified in both an which requires the establishment of a common economic and political sense. It involves the estabparliament and other political institutions. lishment of a common parliament and other political institutions. The features of each level of economic integration have been further discussed in Table 8.1. Table 8.1  Levels of Economic Integration Levels

Examples

Members

Features

Free trade area

North American Free Trade Agreement (NAFTA), Closer Economic Relations (CER)

United States, Canada, Mexico, Australia, and New Zealand

• There are no internal tariffs. Each country determines its own trade policies toward non-members.

Customs union

Andean Pact

Bolivia, Colombia, Ecuador, and Peru

• It shares all the features of a free trade area. Common external tariff is imposed on goods imported from outside.

Common market

The European Community (EC) before January 1994. There has not been another common market.

12 European countries

• It shares all the features of a custom union. • Labor and capital are free to move and there are no restrictions on migration. (Continued)

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Table 8.1  (Continued) Levels

Examples

Members

Features

Economic union

The European Union (EU) since January 1999

25 European countries

• It shares all the features of a common market. • It has a common currency (the European monetary unit called the ‘Euro’), harmonized tax rates, and common monetary and fiscal policies.

Political union

The EU has some elements of a political union. The ultimate aim is a ‘United States of Europe’.

27 European countries, 2 more waiting to be considered

• There is a European parliament directly elected by citizens of EU countries. There is a council of ministers consisting of government ministers from each EU country. • There is an administrative bureaucracy. There is a court of justice, which is the official interpreter of EU law.

EFFECTS OF INTEGRATION There are four major effects of regional economic integration.

Trade Creation and Trade Diversion

Bird’s-eye View Regional economic integration is a process of economic co-operation and co-ordination which proceeds in five stages to combine a geographical region into a common economic area. There are a number of closed independent and self-sufficient economies at one end of the spectrum of integration. The other extreme is an integrated global unit with a free flow of goods, services and factors of production with a common currency and common institutions of governance.

The most prominent economic benefits of integration given by economist Jacob Viner are trade creation and trade diversion. Trade creation is the benefit of increased exports to members of a customs union due to the elimination of tariff barriers. Viner explained this with the example of the United States and Spain. Both countries were wheat producers and exporters and subject to a common tariff rate in the world economy, but the cost of production was lower in the United The major benefits of regional economic integraStates than in Spain. However, when Spain joined tion include trade creation and trade diversion, the EU as a member, its products were no longer increased competition, reduced prices, and subject to the common external tariff which nonhigher factor productivity. members had to pay. Exports of wheat to EU countries from Spain now cost less than they would from the United States which was subject to the external tariff. This resulted in increased exports from Spain to other EU countries. This benefit of increased exports to Spain as a result of its EU membership is termed trade creation.

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As a result of EU membership, trade between the EU and Spain increased, while trade between the EU and the United States declined. Thus, when the source of trading competitiveness shifts in this manner from one country to another, it is known as trade diversion. Trade creation brings with it the benefits of free trade in the form of lower prices. For ­consumers of EU member nations, the cost of wheat from Spain declined as it was a member nation and its products were subject to a lower tariff rate. Trade diversion, on the other hand, has the negative impact of shifting the competitive advantage away from the once low-cost producer (United States) to the highcost ­producer (Spain). Hence, while economic integration benefits both the producer and consumers of member nations, it has a negative impact on other global producers and their exports. Economic integration is, therefore, beneficial for members but not for non-members.

Reduced Import Prices We saw in an earlier chapter that imposing a tariff increases the price of goods as the seller increases his price to cover the tariff. This, in turn, leads to a fall in demand. If the tariff is imposed by a bloc of countries, the fall in price may lead to a substantial fall in demand forcing the producer to reduce the price to boost demand. The possibility of reduced prices is the result of increased market power of the bloc of nations relative to that of a single country. This may result in an improved trade position for the importing bloc of countries but would be disadvantageous for the exporting country.

Increased Competition and Economies of Scale Economic integration increases market size, and helps to reduce the monopoly power of large producers. This is because a larger market increases the number of competing firms, leading to greater efficiency and lower prices for consumers. Industries such as steel and automobiles, which require large-scale production in order to be viable, benefit from the creation of a large trading bloc and, thus, a market. The creation of a large market then results in lower production costs called internal economies of scale. In a common market, there may be external economies of scale as well resulting from the free flow of factors of production such as capital, skilled labor, and superior technology.

Higher Factor Productivity Free movement of the factors of production in a common market makes them look for areas of higher productivity. This has a two-fold effect:

1. The movement of people leads to the movement of ideas, skills, and values embodied in them, fostering greater cross-cultural understanding. 2. Free movement of the factors of production in a common market does not necessarily benefit all members equally as the much needed resources of a country may move to another area of higher productivity. A poorer country may lose talented workers to better opportunities in other ­countries. For example, multinationals such as Koninklijke Philips Electronics N.V. and Goodyear Corporation have shifted their MERCOSUR production from Argentina to Brazil to take advantage of lower costs and incentives provided by the Brazilian government.

Despite the arguments in favor of regional economic integration, an objective analysis reveals that the real benefits of regional integration depend on the amount of trade creation as against trade ­diversion. A regional free trade agreement benefits the world economy only if the amount of trade it c­ reates exceeds the amount of trade it diverts.

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REGIONAL TRADING AGREEMENTS—A GLOBAL OVERVIEW There are a number of regional trading agreements that are in force across the world today. Some of the important ones have been discussed here.

European Union (EU) The European Union (EU) is a political and economic union of 28 member states, located primarily in Europe. It was established on 1 January 1995, as a result of the signing of the Treaty on European Union, also known as the Maastricht Treaty. The treaty was signed in February 1992 and enforced in November 1993. The first EU members comprised 15 countries: Belgium, the Netherlands, Luxembourg, France, Germany, Italy, Denmark, Ireland, the United Kingdom, Greece, Spain, Portugal, Finland, Sweden, and Austria. These EC member states constitute the core as well as the deepest level of European economic integration. The outer tier of trade and economic liberalization around the European Community is composed of countries in Central and Eastern Europe, as well as Mediterranean countries (for example, Slovenia, Malta, and Turkey), with which the European community has reciprocal trade agreements. In 2013 EU had a population of 506.7 million and a combined GDP of USD 17.35 trillion dollars.1 Stages in the Formation of the European Union Coal and Steel Treaty: The Coal and Steel Treaty signed in 1952 by six members with the objective of the formation of a common market in coal, steel, and iron ore. In this way, none of them could make weapons of war on their own to turn against the other, as in the past. The six were Germany, France, Italy, the Netherlands, Belgium, and Luxembourg—the founding members of the European Union. Treaty of Rome (1957): The Treaty of Rome created the European Economic Community (EEC), or ‘common market’. The idea was for people, goods, and services to move freely across Europe. European Community (1967): The European Coal and Steel Community (ECSC) and EEC, as well as the European Atomic Energy Community (EURATOM) were merged to form the European Community (EC). Maastricht Treaty (1992): The Treaty on European Union was signed in Maastricht. It was a major EU milestone, setting clear rules for the future single currency as well as for foreign and security policy and closer cooperation in justice and home affairs. Under the treaty, the name ‘European Union’ officially replaced the name ‘European Community’ on 1 January 1993. This led to the establishment of the single market and its four freedoms, making the free movement of goods, services, people, and money a reality. Schengen Agreement (1995): The Schengen Agreement was signed between seven countries— Belgium, Germany, Spain, France, Luxembourg, the Netherlands, and Portugal. It meant that people could travel on a single passport across any of these countries. The Schengen Agreement presently covers 26 countries. Euro—The Common Currency: On 1 January 1999, the euro was introduced in 11 countries (joined by Greece in 2001) for commercial and financial transactions only. 1

http://data.worldbank.org/country/EUU

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EU Characteristics Single Market: The EU is a single market which functions through a standardized system of laws which apply in all member states, guaranteeing the freedom of movement of people, goods, services, and capital. Common Policy Framework: It maintains a common trade policy, agricultural and fisheries policies, and a regional development policy. It has developed a role in foreign policy, representing its members in the World Trade Organization (WTO), at G8 summits, and at the United Nations. Common Currency: 18 member states have adopted the euro as its common currency. Latvia is the most recent member and the Council of the EU has approved Lithuania’s membership from January 2015.2 Common Passport: Every citizen in each of its member states is eligible to obtain a common European passport for travel between member states. Hybrid Organization: The EU is a hybrid organization characterized by intergovernmental and ­supranational features. It is a unique entity with characteristics that distinguish it from any other ­existing organization or body. It is neither a federation of states like the United States nor an organization for cooperation between governments like the United Nations and nor is it a state intended to replace existing states. It is a body of states which have voluntarily agreed to set up common institutions to which they delegate some of their sovereignty so that decisions on specific matters of joint interest can be taken democratically in the interest of Europe. This pooling of sovereignty has led to the EU acquiring a character over and above its member nation states which can be termed supranational. Institutions of the EU The EU functions through the following institutions. The European Parliament: It represents the EU’s citizens and is directly elected by the people of the member states every five years. The Parliament is one of the EU’s main law-making institutions, along with the Council. It meets in Strasbourg, France and is primarily a consultative body. It debates and passes European laws with the Council; scrutinises other EU institutions, particularly the Commission, to make sure that they are working democratically; and debates and adopts the EU’s budget with the help of the Council. The Council of the European Union: It consists of the governments of the member states defines the general political direction and priorities of the European Union. It consists of the heads of state or government of the member states, together with its president and the president of the Commission. It meets every six months at Brussels in Belgium and most of its decision making is based on consensus. The number of votes that a country gets in the council depends on its size; England, for instance, has 29 votes compared to Denmark which is much smaller and, therefore, gets only 7 votes. The European Commission: It is the executive body, is responsible for proposing new laws to the Parliament and the Council, managing the EU’s budget and allocating funding, enforcing EU law (together with the Court of Justice), and representing the EU internationally, for example, by negotiating 2

https://www.ecb.europa.eu/euro/html/index.en.html

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agreements between the EU and other countries. The Commission acts as a policeman and is also responsible for ensuring compliance with EU laws, most of which are delegated to member states for implementation. European Court of Justice: The European Court of Justice represented by one judge from each of its member countries attempts to interpret EU law to ensure its uniform application in all EU countries. It is also the forum for the settlement of legal disputes between EU governments and EU institutions. Individuals, companies, or organizations can also bring cases before the Court if they feel that their rights have been infringed on by an EU institution. European Central Bank: The European Central Bank (ECB) is one of the key EU institutions. The Bank has a pivotal role as it works with the central banks in all 28 EU countries which together are known as the European System of Central Banks (ESCB). It also ensures close cooperation between central banks in the euro area—the 16 EU countries that have adopted the euro—known as the ­eurozone. The cooperation between this smaller, tighter group of banks is referred to as the eurosystem. The ECB’s main functions include: ■■ Keeping inflation under check, especially in countries that use the euro. ■■ Ensuring stability in the financial system by making sure that financial markets and institutions are properly supervised by national authorities, and that payment systems function smoothly. ■■ Setting key interest rates for the eurozone and controlling the money supply. ■■ Managing the eurozone’s foreign-currency reserves and buying or selling currencies when necessary to keep exchange rates in balance. ■■ Authorizing central banks in eurozone countries to issue euro banknotes. ■■ Monitoring price trends and assessing the risk they pose to price stability.

Euro The euro is the common European currency. It was initially adopted by 11 EU member countries on 1 January 1999 and is presently adopted by 18 member nations. However, important EU members such as the United Kingdom, Denmark, and Sweden have still not adopted the euro. It was initially introduced in 1999 as a virtual currency and used only for accounting purposes till 2002, when it came into circulation as notes and coins. In order to be able to adopt the common currency, member countries had to fulfil important economic criteria such as a high degree of price stability, a sound fiscal situation, stable exchange rates, and converged long-term interest rates. It also meant having to give up control over national monetary policy in the interest of the Union. All participating nations have a fixed parity against the euro and by implication against each other. Benefits of the Monetary Union Savings in Transaction Costs: The use of a common currency has led to huge savings in transaction costs and the elimination of exchange rate uncertainty. It was said that people travelling across Europe came back with half the original amount they started out with, on account of conversion costs before the introduction of the common currency. Having a common currency has benefited all participants of the EU—individuals, companies, and governments.

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Reduced Exchange Rate Uncertainty: The common currency reduced exchange rate uncertainty of dealing with many currencies and helped companies save on costs of hedging against foreign exchange risks. The common currency makes it easier to compare prices across Europe, with added benefits of channelizing resources towards more competitive firms and giving more choice to the consumer. Macroeconomic Discipline: The euro also imposes strong macroeconomic discipline on participating governments to ensure overall stability in the Union. For instance, Greece had to impose austerity measures on its domestic economy to be able to get international funding for its huge domestic debt and save its economy from bankruptcy. Creation of a Continental Capital Market: The common currency has also helped to create a ­continental capital market instead of several small, fragmented, illiquid national markets with a ­localized regulatory framework. Costs of the Monetary Union The main cost of the monetary union is the loss of monetary and exchange rate policy independence for member countries. Being part of a union imposes a penalty on all member states as a result of problems in the economy of any member nation. It is similarly difficult for countries to adhere to fiscal discipline, according to the provisions of the Stability and Growth Pact signed in 1997, which commits them to keeping budget deficits within 3 per cent of GDP.

Bird’s-eye View The European Union (EU) is the world’s largest and the most successful regional integrative agreement. It has a membership of 28 countries, with a population of over 500 million and a combined GDP of USD 17.35 trillion dollars.

NORTH AMERICAN FREE TRADE AGREEMENT (NAFTA) The North American Free Trade Agreement (NAFTA) The North American Free Trade Agreement is a comprehensive economic and trade agreement that (NAFTA) is a comprehensive economic and establishes a free trade area between Canada, Mexico, trade agreement that establishes a free trade and the United States. NAFTA is structured as three area encompassing Canada, Mexico, and the separate bilateral agreements: the first between Canada United States. and the United States, the second between Mexico and the United States, and the third between Canada and Mexico. NAFTA establishes rules on tariffs and quotas in accordance with the provisions of the WTO. It also sets out key principles regarding the treatment of foreign investors, It also prohibits the imposition of certain performance requirements, such as a minimum amount of domestic content in production, on foreign investors. It also includes side agreements on labor adjustment, environmental protection, and import surges.

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NAFTA Provisions The key provisions under NAFTA are: ■■ Sanitary and phytosanitary measures: The NAFTA imposes discipline on the development, adoption, and enforcement of sanitary and phytosanitary (SPS) measures. These are measures taken to protect human, animal and plant life or health from risks that may arise from animal or plant pests or diseases, or from food additives or contaminants. Disciplines contained in NAFTA are meant to prevent the use of SPS measures as disguised restrictions on trade, while still safeguarding each country’s right to protect consumers from unsafe products, or to protect domestic crops and livestock from the introduction of imported pests and diseases. Although NAFTA encourages trading partners to adopt international and regional standards, the agreement explicitly recognizes each country’s right to determine the necessary level of protection. Such flexibility permits each country to set more stringent standards, as long as they are scientifically based. NAFTA also allows state and local governments to enact standards more stringent than those adopted at the national level, so long as these standards are scientifically defensible and are administered clearly and quickly. ■■ Export subsidies: The three NAFTA countries work towards the elimination of export ­subsidies worldwide. The United States and Canada are allowed to provide export subsidies into the Mexican market to counter subsidized exports from other countries. Neither Canada nor the United States is allowed to use direct export subsidies for agricultural products being sold to the other, and both countries are required to consider the export interests of the other whenever subsidizing agricultural exports to third world countries. ■■ Internal support: Under NAFTA, the parties are expected to try and move towards domestic support policies that have minimal trade or production distorting effects, or toward policies exempt from domestic support reduction commitments under the WTO. ■■ Grade and quality standards: The United States and Mexico agreed that when either Bird’s-eye View country applies a measure regarding the classification, grading, or marketing of a The NAFTA is an important FTA among USA, domestic product destined for processing, Canada and Mexico consisting of three sepait will provide no less favorable treatment rate bilateral agreements. for products imported for processing.

Importance of NAFTA The NAFTA is an important pact for the following reasons: ■■ It is the first ever reciprocal free trade accord between the developed and the developing world. ■■ Its creation led to the formation of a tri-national market of more than 360 million people with a combined purchasing power of about USD 6.5 trillion. ■■ The establishment of the NAFTA helped producers of North America (especially the United States) to compete globally. It has also helped to improve the investment climate in the region and has given companies a larger market than before. ■■ NAFTA has mainly affected trade and employment in North America especially between USA and Mexico. It has been estimated that US agricultural exports to Canada and Mexico helped to create about 243,000 jobs in the US economy in 2006.

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CARICOM The Caribbean Community and Common Market (CARICOM) was established by the Treaty of Chaguaramas, which was signed by Barbados, Jamaica, Guyana, and Trinidad and Tobago, and came into effect on 1 August 1973. The membership subsequently grew and presently it has a membership of 20–15 member states and 5 associated members. The objectives of the CARICOM are: ■■ The major objective is to achieve economies of scale in the regional production of services such as transportation, education, and health. ■■ It also aims to pool financial resources for investment in a regional development bank. ■■ It also targets the coordination of economic policies and development planning.

MERCOSUR The MERCOSUR originated as a free trade pact The MERCOSUR was created as a free trade between Brazil and Argentina in 1988. This agreepact between Argentina and Brazil and was ment is one of the many agreements falling under extended to include Paraguay and Uruguay in the ALADI. The success of this pact in bringing March 1991. down ­tariffs and quotas by about 80 per cent led to the addition of Paraguay and Uruguay in March 1991 with the signing of the Treaty of Asuncion. The Asuncion Treaty is based on the doctrine of the reciprocal rights and obligations of the member states. MERCOSUR was initially formed as a free trade zone, to be followed by customs unification, and, finally, the common market, where, the free movement of the workforce and capital across the member nations’ international frontiers was to be possible, and depended on equal rights and duties being granted to all signatory countries. During the transition period, as a result of the chronological differences in actual implementation of trade liberalization by the member states, the rights and ­obligations of each party had to be initially equivalent but not necessarily equal. In addition to the reciprocity doctrine, the Asuncion Treaty also contained provisions regarding the most-favorednation concept, according to which the member nations had to automatically extend (after actual formation of the common market) to the other Treaty signatories any advantage, favor, entitlement, immunity, or privilege granted to a product originating from or intended for countries that were not party to the ALADI. The Treaty of Ouro Preto of 1994 added much to the institutional structure of MERCOSUR and initiated a new phase in the relationship between the countries, when they decided to start implementing a common market. A transition phase was set—the phase was to begin in 1995 and to last until 2006— with a view to realizing the common market. In 1996, association agreements were signed with Chile and Bolivia, establishing free trade areas with these countries on the basis of a ‘4 + 1 formula’, which led to the addition of other countries besides the original four. During this period, MERCOSUR also created a common mechanism for political consultations, which was formalized in 1998, in which the original four countries as well as Bolivia and Chile participated as full members of the so-called ‘political MERCOSUR’.

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The objectives of MERCOSUR are: ■■ Free transit of production goods, services, and factors between the member states with the elimination of customs rights and lifting of non-tariff restrictions on the transit of goods or any other measures with similar effects. ■■ Fixing a common external tariff (TEC) and adopting a common trade policy with regard to nonmember states or groups of states, and the coordination of positions in regional and international commercial and economic meetings. ■■ Coordination of macroeconomic and sectoral policies of member states relating to foreign trade, agriculture, industry, taxes, monetary system, exchange and capital, services, customs, transport and communications, and any others they may agree on, in order to ensure free competition between member states. ■■ Ensuring the commitment of the member states in making the necessary adjustments to their laws in pertinent areas to allow for the strengthening of the integration process.

ANDEAN PACT The Andean Pact began life with five member nations in 1969 and was based on the EU model, but has been far less successful in achieving its stated objectives. Its integration program included an internal tariff reduction program, a common external tariff, a transportation policy, a common industrial policy, and special concessions for Bolivia and Ecuador. The pact almost collapsed by the mid-80s without achieving most of its stated objectives. It could not survive because of the magnitude of its problems with low economic growth, hyperinflation, high unemployment, political unrest, and high debt. The dominant political ideology of radical socialism was also inherently opposed to market philosophy further hampering any chances of integration. Changes in the political ideology of Latin American governments resulted in another attempt, and the Andean Pact was re-launched in 1990 with five members (including four of the members of the original pact)—Bolivia, Colombia, Ecuador, Peru, and Venezuela. The aim was the creation of a free trade area with the objectives of a common internal tariff by 1994 and a full common market by 1995. This did not succeed, partly because Peru and Ecuador conducted a border war in early 1995. Significant differences between the more economically advanced countries, Venezuela and Colombia, and the less advanced Bolivia and Ecuador, also made it difficult to achieve harmonization of economic policies and the building up of a true common market. The Andean community now operates as a customs union, and has restarted negotiations for the creation of a free trade area with MERCOSUR.

ASSOCIATION OF SOUTHEAST ASIAN NATIONS (ASEAN) The Association of Southeast Asian Nations (ASEAN), an economic and political association, was established on 8 August 1967 in Bangkok by Indonesia, Malaysia, Philippines, Singapore, and Thailand. Subsequently, the State of Brunei Darussalam joined on 8 January 1984, Vietnam on 28 July 1995, Lao People’s Democratic Republic and Myanmar on 23 July 1997, and Cambodia on 30 April 1999.

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Objectives of ASEAN The stated objectives of the ASEAN are: ■■ To accelerate economic growth, social progress, and cultural development in the region. ■■ To promote regional peace and stability through abiding respect for justice and the rule of law in the relationship among countries in the region and adherence to the principles of the United Nations Charter. The highest decision-making organ of ASEAN is the meeting of the ASEAN heads of state and government which is convened every year. The ASEAN Ministerial Meeting comprising foreign ministers of member countries is also held annually. Ministerial meetings on sectors such as agriculture and forestry, economics (trade), energy, environment, finance, health, information, investment, labor, law, regional haze, rural development and poverty alleviation, science and technology, social welfare, telecommunications, transnational crime, transportation, tourism, and youth are also held regularly. Supporting these ministerial bodies are committees of senior officials, technical working groups, and task forces.

ASEAN Achievements The various achievements of the ASEAN are: ■■ There has been a significant reduction in the tariff levels on most goods in the Inclusion List of the ASEAN-6. More than 60 per cent of these products have zero tariffs. The average tariff for ASEAN-6 has been brought down from more than 12 per cent when AFTA started to 2 per cent as of 2011. ■■ The roadmap for financial and monetary integration of ASEAN in four areas, namely, c­ apital market development, capital account liberalization, liberalization of financial services, and ­currency cooperation. ■■ Trans-ASEAN transportation network consisting of major inter-state highways and railway ­networks, including the Singapore to Kunming Rail-Link, principal ports and sea lanes for ­maritime traffic, inland waterway transport, and major civil aviation links. ■■ The adoption of a roadmap for integration of air travel. ■■ Initiative for ASEAN Integration (IAI) focusing on infrastructure, human resource development, information and communications technology, and regional economic integration p­ rimarily in Cambodia, Myanmar, Lao PDR, and Vietnam.

ASIA-PACIFIC ECONOMIC COOPERATION FORUM (APEC) The Asia-Pacific Economic Cooperation (APEC) came into existence in November 1994 and has 21 members as of 2011. The APEC members are Australia, Brunei Darussalam, Canada, Chile, People’s Republic of China, Hong Kong–China, Indonesia, Japan, Republic of Korea (South Korea), Malaysia, Mexico, New Zealand, Papua New Guinea, Peru, Philippines, Russia, Singapore, Chinese Taipei, Thailand, United States, and Vietnam. In 1994, APEC leaders gathered in Bogor, Indonesia, and agreed to build on the commitments made in the Uruguay Round of GATT, by accelerating their implantation and broadening and deepening those commitments.

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The APEC works in three broad areas to meet the Bogor Goals of free and open trade and investment in the Asia-Pacific, to be implemented by 2010 for developed economies and 2020 for developing economies. Known as the APEC’s three pillars, these key areas are: 1. Trade and investment liberalization: Trade and investment liberalization aims to reduce and eventually eliminate tariff and non-tariff barriers to trade and investment to protect member states from the harmful effects of protectionism. It is aimed at opening markets to increase trade and investment among economies, resulting in economic growth for APEC member economies and increased standard of living for all. 2. Business facilitation: Business facilitation focuses on reducing the costs of business transactions, improving access to trade information, and aligning policy and business strategies to facilitate growth and free and open trade. Essentially, business facilitation helps importers and exporters in the Asia-Pacific region to meet and conduct business more efficiently, thus, reducing costs of production and leading to increased trade, cheaper goods and services, and more employment opportunities due to an expanded economy. 3. Economic and technical cooperation (ECOTECH): It is dedicated to providing training and cooperation to build capacities in all APEC member economies to take advantage of global trade. This area builds capacity at the institutional and personal level to assist APEC member economies and their people gain the necessary skills to meet their economic potential. The major benefits of the APEC are: ■■ Economic growth: Since its inception in 1989, the APEC region has consistently been the most economically dynamic part of the world. In its first decade, APEC member economies generated nearly 70 per cent of global economic growth and the APEC region consistently outperformed the rest of the world, even during the Asian financial crisis. By progressively reducing tariffs and other barriers to trade, APEC member economies have become more efficient and exports have expanded dramatically. ■■ Benefits to the people: The outcomes of APEC’s three areas of intervention have enabled APEC members to strengthen their economies by pooling resources within the region and achieving efficiencies. Tangible benefits are also delivered to consumers in the APEC region through increased training and employment opportunities, greater choices in the marketplace, cheaper goods and services, and improved access to international markets.

SOUTH ASIAN ASSOCIATION FOR REGIONAL COOPERATION (SAARC) The South Asian Association for Regional Cooperation (SAARC) is an economic and political organization of eight countries in southern Asia. In terms of population, its sphere of influence is the largest of any regional organization; the combined population of its member states is almost 1.5 billion people. It was established on 8 December 1985 by India, Pakistan, Bangladesh, Sri Lanka, Nepal, Maldives, and Bhutan. In April 2007, at the Association’s fourteenth summit, Afghanistan became its eighth member. In August 1983, the SAARC members adopted the Declaration on South Asian Regional Cooperation and agreed on five areas of cooperation:

1. Agriculture and rural development 2. Telecommunications, science, technology, and meteorology

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3. Health and population activities 4. Transport 5. Human resource development Afghanistan was added to the regional grouping at the behest of India on 13 November 2005 and became a member on 3 April 2007. With the addition of Afghanistan, the total number of member states was raised to eight. In April 2006, the United States and South Korea made formal requests to be granted observer status. The European Union also indicated interest in being given observer status, and made a formal request for the same to the SAARC Council of Ministers meeting in July 2006. On 2 August 2006, the foreign ministers of the SAARC countries agreed in principle to grant observer status to the United States, South Korea, and the European Union. On 4 March 2007, Iran also requested observer status. The SAARC Secretariat was established in Kathmandu on 16 January 1987. Its role is to coordinate and monitor the implementation of SAARC activities, service the meetings of the Association and serve as the channel of communication between SAARC and other international organizations. The Secretariat consists of the secretary general, the seven directors, and the general services staff. The heads of states or governments of SAARC have taken some important decisions and bold initiatives through the years to strengthen the organization and to widen and deepen regional cooperation. Over the years, the SAARC members have expressed their reluctance to sign a free trade agreement. Though India has several trade pacts with Maldives, Nepal, Bhutan, and Sri Lanka, similar trade agreements with Pakistan and Bangladesh have been stalled due to political and economic concerns on both sides. India has been constructing a barrier across its borders along Bangladesh and Pakistan. In 1993, SAARC countries signed an agreement in Dhaka to gradually lower tariffs within the region. Eleven years later, at the twelfth SAARC Summit at Islamabad, SAARC countries devised the South Asia Free Trade Agreement which created a framework for the establishment of a free trade area covering 1.4 billion people. This agreement went into force on 1 January 2006. Under this agreement, SAARC members had to bring their duties down to 20 per cent by 2007. The SAARC’s inability to play a crucial role in integrating South Asia is often credited to the ­political and military rivalry between India and Pakistan. It is due to these economic, political, and territorial disputes that South Asian nations have not been able to harness the benefits of a unified economy. Over the years, the SAARC’s role in South Asia has greatly diminished and it is now reduced to being a platform for annual talks and meetings between its members.

CLOSER ECONOMIC RELATIONS (CER) A small but viable free trade area exists in the form of Closer Economic Relations (CER) between Australia and New Zealand. The CER Agreement which came into effect on 1 January 1983 provided for free trade in goods from 1 July 1990. The CER is also being extended into trade in services and used for increased harmonization of the commercial environment. However, difficulties have been experienced regarding rules concerning the origin of goods, divided payments, business laws, and recognition of standards and qualifications.

AFRICA African integration is difficult because market sizes and resource endowments are small. There are nevertheless nine economic blocs trying to achieve some form of economic integration, most at a fairly

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low level. In general, the countries involved are so poor and economic activity is so low that there is an insignificant base for cooperation resulting in little progress. The Economic Community of West African States (ECOWAS) was formed in 1975 but remained inactive for the first one and a half decades. It was only in 1992 that fresh initiatives were taken to establish a customs union and then a common market. The ECOWAS includes the countries of Benin, Burkina Faso, Cape Verde, Gambia, Ghana, Guinea, Guines–Bissau, Côte d’Ivoire, Liberia, Mali, Mauritania, Niger, Nigeria, Senegal, Sierra Leone, and Togo. The group has been striving to give a shape to its integration scheme, but the low rate of economic development and other economic problems in the region have hindered its progress. There is considerable overlap in the membership of the nine groups which reflects their differing objectives. For example, the ECOWAS has four commissions: one for trade, one for industry, one for transport, telecommunications and energy, and one for socio-cultural affairs. The aim is to make ECOWAS a union similar to the EC, but it is doubtful whether member governments have the commitment necessary for success. ■■ The Central African Economic and Customs Union (UDEAC): It consists of Congo, Gabon, the Central African Republic, Equatorial Guinea, and Cameroon. The UDEAC provides a framework for the free movement of capital throughout the area and for the harmonization of fiscal incentives, as well as the coordination of industrial development. ■■ The East African Economic Community (EAEC): It was established in 1967 by Kenya, Tanzania, and Uganda as a common market. It was dissolved in 1979 and the three members later joined with other states to establish the Preferential Trade Area for Eastern and Southern African States (PTA) in 1981. Its goals include the establishment of a common market and the promotion of economic cooperation among its members. ■■ The Gulf Cooperation Council (GCC): It was established in 1981 in the Middle East. It was established as a free trade area covering industrial and agricultural products (excluding petroleum products). It has the United Arab Emirates, Bahrain, Saudi Arabia, Oman, Qatar, and Kuwait as members. The GCCCC has traversed the path to becoming a common market. ■■ The Arab Maghreb Union: It was set up in 1989 to lay the foundations for a Maghreb e­ conomic area. It was established by Algeria, Libya, Mauritania, Morocco, and Tunisia with rotating leadership between members. However, traditional rivalries between Morocco and Algeria have currently put all its activities into cold storage.

COMMODITY ARRANGEMENTS A distinguishing feature of international economic relations of the present day is the existence of international commodity agreements or organizations. These take the form of commodity price agreements and cartels in which countries cooperate with each other to control the production, pricing, and sale of primary products that are traded internationally. A commodity cartel is a group of producing countries that wish to protect themselves from the fluctuations that often occur in the prices of primary commodities (for example, oil, coffee, rubber, cocoa, etc.) which are traded internationally. The basic objective of a cartel is to look for higher as well as more stable prices for their goods by limiting overall output and assigning production quotas to individual member countries.

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Countries which rely on export earnings through the sale of primary commodities may be distinguished from exporters of manufactured goods in the following ways: ■■ There is usually greater price competition among sellers of primary commodities since they are larger in number and also because primary commodities are more or less homogeneous. The manufacture of computers, for example, needs copper. While there are only three to four countries which manufacture computers, there are at least a dozen different producers of copper making its supply more abundant and making it difficult for an individual producer to dictate its price. ■■ There is also greater supply variability in the market for primary goods because production often depends on uncontrollable factors such as the weather. This causes a great deal of volatility in the prices and export earnings of primary cartels. The two most important commodity cartels influencing the world economy today are the Organization of Petroleum Exporting Countries (OPEC) and the former Multi Fibre Arrangement (MFA).

Multi Fibre Arrangement (MFA) The Multi Fibre Arrangement (MFA) governed the world trade in textiles and garments from 1974 to 2004, imposing quotas on the amount that developing countries could export to developed countries. It expired on 1 January 2005. The MFA was introduced in 1974 as a short-term measure intended to allow developed countries to adjust to imports from the developing world. This was especially because developing countries have a natural advantage in textile production since they use labor-intensive technology which is cost-effective. Although the MFA was signed in 1974, its roots stretch back to the 1930s. At that time, during a period of global economic distress, Japan emerged as the largest exporter of cotton textiles, and the United States and Europe moved to limit imports from Japan to preserve their domestic markets for their own textile industries. These restraints never really went away. By the 1960s, they had been extended to Hong Kong, Pakistan, and India. As the restraints on textile trade became globalized, multilateral negotiations ensued, leading to a series of agreements. Initially, the agreements covered only cotton, but they eventually expanded into ‘multi fibre’ arrangements covering textiles and clothing made from all fibres; cotton accounts for about 38 per cent of world fibre consumption. A commodity cartel is a group of producing countries that wish to protect themselves from the fluctuations that often occur in the prices of primary commodities (for example, oil, coffee, rubber, cocoa, etc.) which are traded internationally. At the heart of the MFA were a set of bilateral agreements between developed-country importers, such as the United States, and developing-country exporters, such as China and Bangladesh. The MFA did not apply to trade among the developed countries. The number of US bilateral export restraint agreements grew from a single agreement with Japan in 1962 to agreements with 30 countries by 1972 and with 40 by 1994. Each agreement governed trade in as many as 105 categories of textiles and clothing, with new categories added to the agreements as the need to avoid market disruption arose. Impact of MFA The MFA had a multifarious impact on different countries of the world. ■■ The impact on the United States and the EU was fairly simple. By limiting imports, the United States and the EU raised their domestic prices of clothing. Domestic production rose, and domestic consumption fell.

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■■ Outside of these two markets, however, the effects were more complex, as the restraints on one set of countries created opportunities for others, driving changes in world clothing markets. Limits on exports by Japan and Hong Kong increased export opportunities for Taiwan and South Korea. Restraints then imposed on Taiwan and South Korea increased opportunities for Thailand and Indonesia. In this way, the MFA grew, but investment in clothing production also spread. Entrepreneurs from countries limited by the MFA shifted capital and expertise to countries that otherwise lacked the ability to export significant amounts of clothing. So, for some countries, the attempt to limit global exports actually spurred an increase in their exports. ■■ Another twist to the MFA’s impact came from the NAFTA and from similar regional trade arrangements between the EU and its neighboring countries. Typically, these agreements relax or remove the quota restrictions on neighboring exporters. Examples include Mexico in the case of the United States, and Turkey and other Mediterranean countries for the EUEU. In this way, Mexico and Turkey benefited indirectly from the MFA’s restraints on their competitors. Life After MFA According to the pre-expiration academic literature, the MFA expiration was expected to have the following effects on South Asia: ■■ Benefit to consumers: Elimination of quotas would benefit consumers, basically due to lower prices and an increase in apparel exports. ■■ Increased trade: The MFA expiration would enlarge world trade of textile and apparel products, and developing countries would further gain market share. ■■ Production shift to low-cost countries: Production would be reallocated away from high-cost countries that were producing only to take advantage of their quota. Predicted big losers were countries in which more than three-quarters of all apparel exports were in highly restricted quota categories, such as Lesotho, Haiti, Honduras, El Salvador, Nicaragua, and Kenya (Okun 2004). Countries like Pakistan, Vietnam, South Korea, Hong Kong, and Taiwan with preferential access to US and EU markets would, however, benefit. ■■ Shift to lower-value products: As quotas are measured by quantity, not value, manufacturers seek to produce the highest value products possible under a given quota. Experts, thus, expected a shift to production of lower-value products. ■■ Shift from Latin America to South Asia: Small exporting countries were at a historical advantage in the MFA system because they were less likely to bump up against quota limits than bigger countries like China and India. Since the mid-1990s, however, relatively large suppliers like Mexico, Turkey, and Central European countries benefited from the quota system as they were given preferences by the dominant importing countries. Thus, experts expected a Bird’s-eye View rejuvenation of market share for South Asia vis-à-vis these countries and regions. Commodity arrangements are price agree■■ Incentive to rationalize production: As ments and cartels in which countries co-operate market share is fixed, quotas reduced the with each other to control the production, incentive to upgrade technologically to cappricing and sale of primary products that are ture market share, thereby, stunting productraded internationally. The MFA and the OPEC tivity growth. Quotas also kept exporters like have been among the world’s most important Hong Kong in the textile and apparel busicommodity arrangements. ness long past the time when manufacture

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in Hong Kong made sense from a pure labor-cost perspective. Therefore, greater post-MFA competition would provide incentives to upgrade facilities and to rationalize production processes. It is expected that countries such as India, in particular, would benefit from reforms aimed at generating more efficient factory-produced outputs of consistent quality. The MFA had encouraged a highly decentralized organization in India that focused on the capture of niche markets leading to more sub-contracting of output than in any other country. Consequently, it is hoped that production would be more regulated and rationalized in the post-MFA regime.

Organization of Petroleum Exporting Countries (OPEC) The Organization of the Petroleum Exporting Countries (OPEC) is an intergovernmental organization, created at the Baghdad Conference on 10–14 September 1960, by Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. The OPEC was created in response to the imposition of import quotas on crude oil and refined products by the United States in 1959. The US government established the Mandatory Oil Import Quota program (MOIP), which restricted the amount of imported crude oil and refined products allowed into the United States and gave preferential treatment to oil imports from Canada, Mexico, and, somewhat later, Venezuela. This partial exclusion of Persian Gulf oil from the US market depressed prices for Middle Eastern oil; as a result, posted oil prices (price paid to the selling nations) were reduced in February 1959 and August 1960. The five founding members were later joined by nine other members: Qatar (1961), Indonesia (1962), Great Socialist People’s Libyan Arab Jamahiriya (1962), United Arab Emirates (1967), Algeria (1969), Nigeria (1971), Ecuador (1973–1992), Gabon (1975–1994), and Angola (2007). OPEC had its headquarters in Geneva, Switzerland, in the first five years of its existence. This was moved to Vienna, Austria, on 1 September 1965. OPEC’s basic objectives are: ■■ To coordinate and unify petroleum policies among member countries, in order to secure fair and stable prices for petroleum producers. ■■ To ensure an efficient, economic and regular supply of petroleum to consuming nations. ■■ To assure a fair return on capital to those investing in the industry. All OPEC decisions are taken by a decision-making centre called the Conference, consisting of national delegations of oil ministers, which meets twice each year to decide overall oil output, prices, and to assign output quotas for the individual members. Those quotas are upper limits on the amount of oil each member is allowed to produce. The Conference may also meet in special sessions when deemed necessary, particularly when downward pressure on prices becomes acute. OPEC faces the classic cartel enforcement problem—overproduction and price cheating by members. At a higher cartel price, less oil is demanded. As a result, output quotas are necessary so that each member of OPEC has an incentive to sell more than its quota by ‘shaving’ (cutting) its price because the cost of producing an additional barrel of oil is usually well below the cartel price. The methods available to engage in such cheating are numerous—sellers can extend credit to buyers for periods longer than the standard thirty days, sellers can sell higher grades (or blends) of oil for prices applicable to lower grades, sellers can give transportation credits, sellers can offer buyers side payments or rebates, and so on. This tendency of individual producers to cheat on a cartel agreement is a long-standing feature of OPEC behavior. Individual producers have usually exceeded their production quotas, and so official

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OPEC prices have been somewhat unstable. However, unlike the classic ‘textbook’ cartel, OPEC is unusual as it has one producer, Saudi Arabia, which is much larger than the others. This condition has caused Saudi Arabia to serve, from time to time, as the OPEC swing producer, that is, the producer that adjusts its output in order to preserve the official price in the world market. One reason for the Saudis to act as swing producers is that downward pressure on the official price imposes larger total losses on them than on the other OPEC producers in the short run. The Saudis, in their efforts to defend the official OPEC price, have periodically reduced their sales (at times dramatically), thus, reducing their revenues substantially. In 1983, 1984, and 1986, for example, the Saudis produced only about 3.5 million barrels per day, despite their (then) production capacity of about 10 million barrels per day. OPEC rose to international prominence during the 1970s, as its member countries took control of their domestic petroleum industries and acquired a major say in the pricing of crude oil in world markets. There were two oil pricing crises, triggered by the Arab oil embargo in 1973 and the outbreak of the Iranian Revolution in 1979, but fed by fundamental imbalances in the market; both resulted in oil prices rising steeply. In the 1980s, prices initially peaked, before beginning a dramatic decline, which culminated in a collapse in 1986—the third oil pricing crisis. Prices rallied in the final years of the decade, without approaching the high levels of the early-1980s, as awareness grew of the need for joint action among oil producers if market stability with reasonable prices was to be achieved in the future. Environmental issues began to appear on the international agenda. A fourth pricing crisis was averted at the beginning of the 1990s, on the outbreak of hostilities in the Middle East, when a sudden steep rise in prices in panic-stricken markets was moderated by output increases from OPEC Members. Prices then remained relatively stable until 1998, when there was a collapse, in the wake of the economic downturn in Southeast Asia. Collective action by OPEC and some leading non-OPEC producers brought about a recovery. As the decade ended, there was a spate of mega-mergers among the major international oil companies in an industry that was experiencing major technological advances. For most of the 1990s, the ongoing international climate change negotiations threatened heavy decreases in future oil demand. The early twenty-first century brought the oil market to new heights as demand soared, particularly due to growth in Asia. OPEC members enjoyed the benefits of the boom, with prices rising to an all-time high. However, as the old adage goes, ‘what goes up must come down’. The 2008 global economic crisis created a plunge in revenue, as prices fell by roughly 80 per cent. However this time, OPEC proved to be more unified, as on 18 December 2008, OPEC members announced the largest production cut in history, which helped them deal with the crisis. Thus, by 2009, oil prices had substantially recovered. Given the continued world demand for oil, OPEC continues to occupy a prominent place in the world economy.

C H A P T E R

S U M M A R Y

■■ Economic integration is concerned with the removal of trade barriers or impediments between at least two participating nations and the establishment of cooperation and coordination between them. ■■ There are five levels of economic integration—free trade area, customs union, common market, economic union, and political union. ■■ The benefits of economic integration include trade creation and trade diversion, increased competition, lower prices, and higher factor productivity.

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■■ Regional economic integration takes several different forms, including common markets (for example, EU and MERCOSUR), free trade areas (for example, NAFTA and ALADI), customs union (for example, CACM and CARICOM), economic cooperation forums (for example, APEC), and economic and political associations (for example, ASEAN). ■■ International economic integration also occurs at the commodity level via the establishment of commodity cartels like OPEC which is an intergovernmental organization and the strongest collective force in the international oil market today.

KEY TERMS Economic integration, Free trade area, Customs union, Common market, Economic union, Political union, EU, NAFTA, MERCOSUR, Commodity cartel.

DISCUSSION QUESTIONS 1. What is economic integration? Explain the different stages in the integration of economies ­giving suitable examples. 2. Trace the different stages in the formation of the European Union. 3. NAFTA has produced significant benefits for the Canadian, Mexican and US economies. Discuss these benefits. 4. Write short notes on (a) ASEAN (b) APEC (c) SAARC (d) MERCOSUR 5. Discuss the costs and benefits of economic integration. 6. What are commodity arrangements? Briefly discuss the functioning of OPEC as a leading commodity arrangement. 7. MERCOSUR got off to a promising start but faltered and has made little progress since 2000. How can the functioning of MERCOSUR be made more efficient? 8. ‘Regional economic integration results in trade creation and trade diversion’. Critically evaluate this statement, giving suitable examples. [Delhi University, B.Com (Hons.) 2010] 9. ‘Economic integration is achieved after passing through different stages’. Analyse the statement giving suitable examples. [Delhi University, B.Com (Hons.) 2009, 2012] 10. ‘The Common Market, Economic Union and Customs Union are different stages in the growth of regional economic integration’. Elaborate. [Delhi University, B.Com (Hons.) 2008, 2010, 2014] 11. Write short notes on any two of the following: (a) NAFTA (b) SAARC (c) ASEAN  [Delhi University, B.Com (Hons.) 2014]

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9 INTERNATIONAL FINANCIAL SYSTEM LEARNING OBJECTIVES After reading this chapter, you should be able to:

■ ■ ■ ■ ■ ■

Identify the characteristics of the international monetary system Understand the forces that determine exchange rates Outline the history of the Bretton Woods Agreement Explain the functioning of the foreign exchange market Discuss the structure and functions of the international capital market Explain the implications of the evolution and functioning of the international monetary system for international business

BITCOIN—THE VIRTUAL CURRENCY The Bitcoin is the new kid on the currency block. It was born in 2009 as the world’s first cryptocurrency, developed by Satoshi Nakamoto. It is a digital currency consisting of a string of data created (or mined) by the computation of blocks in the system using appropriate software. It originated as a new form of money that was controlled by used peer-to-peer technology rather than by a central authority or a central bank. It is an open source, decentralized payment system which means that it has no central regulating authority and does not involve banks in transactions. Transactions are carried out directly between the involved parties. From the viewpoint of users, Bitcoin works like a mobile application or a computer program that provides a personal Bitcoin wallet and allows a user to send and receive Bitcoins with them. Just like e-mail, no single individual or body controls the Bitcoin—it is controlled by all Bitcoin users around the world who have a strong incentive to keep it going since the Bitcoin system only works on consensus. Bitcoins have value as a form of money, determined by the demand and supply for the currency. The total supply of Bitcoins was decreed to be limited to 21 million at the time of creation, and can

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be divided up to 8 decimal places (0.000 000 01 BTC) and potentially even smaller units if that is ever required in the future. There is a growing number of businesses and individuals using Bitcoin. This includes brick and mortar businesses like restaurants, apartments, law firms and popular online services such as Namecheap, WordPress, Reddit and Flattr. Germany, Finland, Singapore and Canada are among the countries that have issued tax guidance on Bitcoin, while Ireland, Israel and Slovenia have indicated that they are also planning to do so. The future of this virtual currency may be an interesting phenomenon to watch out for!!! Source: https://bitcoin.org/en/faq#why-do-bitcoins-have-value, http://live.wsj.com/video/what-a-bitcoin/D79FF38C7816-435B-B3B0-F9B177BCA0A8.html#!69A7E180-62EB-4D4A-847E-2B989574F391, last accessed 16 July 2014.

INTRODUCTION The international financial and monetary system may be defined as the institutional framework within which international payments are made, national currencies are exchanged and cross currency exchange rates are determined. It is a complex system consisting of policies, institutions, practices, regulations and mechanisms. It includes the collective financial institutions that facilitate and regulate the flow of investment and capital funds worldwide. Its key players include national stock exchanges, commercial banks, central banks and finance ministries, in addition to specialized institutions such as the IMF and World Bank. The system has evolved over a period of time conditioned by both political and economic factors in the global economy. It has two broad components: the foreign exchange market and the international capital market.

BASICS OF FOREIGN EXCHANGE Cross-border transactions of trade and investment occur through an exchange of currencies between buyers and sellers. A currency is a form of money and a unit of exchange. There are 175 currencies in the world today which are used for international trade and investment transactions between nations. This makes the world of international money somewhat complicated to understand. Therefore, we start with an overview of certain basic features of foreign exchange. There are two major aspects of exchange rates that are of relevance in the understanding of foreign exchange policy.

Exchange Rate Determination The exchange rate is a price. It is the price of domesThe exchange rate is the price of domestic curtic currency in terms of a foreign currency. For rency in terms of a foreign currency. instance, the value of the Indian rupee in terms of the dollar is INR 61.17 on 20th September 2013 but it was 62.17 the next day. This means that to buy something in the foreign exchange market for a dollar would cost INR 61.17 on a certain day of the month but would cost more the next day. How and why does this happen? To understand this we need to examine the fundamentals of the foreign exchange market.

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The foreign exchange market is the place where prices of currencies are fixed and decided. Just as the price of a commodity is fixed in the market for goods and services, the price of the exchange rate is also determined in the market for foreign exchange. The demand for a foreign currency is linked to p­ ayments for imports or for making investments abroad, by residents of the home country. The supply of foreign currency comes from export earnings and from investments into the home country by residents of other countries. However, sometimes governments or their central banks intervene in the foreign exchange market in order to satisfy certain domestic economy requirements.

Fixed and Flexible Exchange Rate Systems Exchange rates are classified on a scale that has Under the fixed exchange rate system, the monfixed exchange rates at one end and flexible/floating etary authority or the central bank of the country exchange rates at the other. There are several other determines the value of foreign exchange. gradations on the scale, and, in reality, most currencies exist somewhere in the middle of this scale. The exchange rate is said to be fixed if the monThe exchange rate is said to be floating if it is etary authority or the central bank of the country determined by the free forces of demand and determines its value, in response to certain policy supply of the foreign exchange market. requirements. China for instance keeps its ex­change rate fixed at a rate that benefits its exporters, since exports are a very important source of foreign exchange and revenue. On the other hand, the exchange rate is said to be floating if it is determined by the free forces of demand and supply of the foreign exchange market. In between the two extremes lies the managed exchange rate system, which is also known as the dirty float. Under this system the exchange rate is determined by market forces, but its value is maintained within a specified range according to the need of the economy. Movements of exchange rates are known as devaluation or depreciation and revaluation or The devaluation of a currency refers to a decline in the domestic currency value in terms of the appreciation. The devaluation of a currency refers foreign currency under a fixed exchange rate to a decline in the domestic currency value in terms system. Revaluation is the upward movement or of the foreign currency when it is determined under increase in the value of the domestic currency in the fixed exchange rate system. For example, if the terms of the foreign currency. value of the rupee falls from 40 to 45 per USD, the rupee is said to undergone devaluation. Revaluation is the opposite of devaluation, and refers to the Under the floating exchange rate system a upward movement or increase in the value of the decline in the domestic currency value in terms domestic currency in terms of the foreign currency. of the foreign currency is called depreciation and Depreciation refers to a fall in value of domestic curan upward movement or increase in the value rency in terms of a foreign currency under a flexible of the domestic currency in terms of the foreign currency is called appreciation. or floating exchange rate system, and appreciation is the increase in value of domestic currency vis-à-vis foreign currency under the system.

Currency Convertibility The second aspect of exchange rate policy is concerned with the purpose for which currencies need to be exchanged for each other. For example, if an Indian tourist is going on vacation to Thailand, he will need

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the Malaysian Ringgit to be able to purchase goods and services there. On the other hand, Indian imports from Korea have to be paid for in the Won. Similarly, if an Indian business magnate wants to purchase a flat in London, he will have to pay for it in pounds and he can only do so if the government’s exchange rate policy permits such a transaction. This aspect of exchange rate determination is called convertibility. Currency convertibility refers to the freedom to exchange domestic currencies for foreign currencies for a given purpose and at a given conversion rate. The rules regarding exchange rate determination and currency convertibility vary from country to country, and depend on a host of factors—its balance of payments position, the state of its internal economy, and various other policy considerations. Currency convertibility is measured on a scale which ranges from full convertibility to full inconvertibility. In practice however, there are two main points on the convertibility scale which are important:



1. Current account convertibility refers to the freedom to convert domestic currency into other convertible currencies for current account transactions, that is for the purchase and sale of goods and services in international trade. For example, if the Indian rupee is convertible on current account, an Indian firm should be able to freely convert rupees into yen to purchase goods from a Japanese company. 2. Capital account convertibility, therefore, refers to convert domestic currency into foreign currency for transactions in financial and other assets. For example, if a currency is convertible on capital account, the residents of the domestic currency can freely convert it into other (convertible) currencies to purchase and maintain bank accounts abroad. Similarly, residents of other countries should also be able to freely convert their currencies into the domestic currency to purchase domestic capital and money market instruments. In other words, capital account convertibility is associated with the vision of free capital mobility.

A country can restrict the convertibility of its currency through several different measures. Some of these are as follows: ■■ ■■ ■■ ■■ ■■ ■■ ■■ ■■

Import restrictions such as license or quota systems Restrictions on the remittance of foreign exchange such as profits, dividend or royalty Surrender of hard currency export earnings to the central bank Mandatory government approval for using a firm’s retained foreign exchange earnings Bird’s-eye View Pre-deposit of foreign exchange expenditure for import business in interest free accounts The exchange rate mechanism of a country with the central bank for a certain period has two basic features—the manner in which Credit ceilings for foreign firms the exchange rate is determined (price) and the Restriction or prohibition on offshore purpose for which currency exchange takes deposits or investment of hard currencies place (convertibility). The exchange rate and Use of multiple exchange rates simultathe degree of convertibility may both be meaneously for different items of balance of sured on a scale. payments

EVOLUTION OF THE MONETARY SYSTEM The Gold Standard (1876–1914) The concept of money has a history dating back at least 2500 years. Money, as we see it today, is essentially paper and plastic money, but before the invention of paper, money consisted of coins generally

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made of gold or silver. Money had (and still has) intrinsic value because of its comparative rarity, and, thus, perceived value, of previous metals such as gold and silver. The origin of the gold standard can be traced to the practice of using gold coins as a medium of exchange, unit of account and store of value in ancient times. When international trade was limited in volume, payment for goods purchased from other nations was in gold and silver coins. However, as international trade expanded after the Industrial Revolution, shipping large quantities of gold and silver coins became impractical. This gave rise to the need for paper currency, and governments of the world agreed to convert paper currency into gold on demand at a fixed rate. The history of the gold standard can be traced to 1717 when the price of gold was fixed at three pounds 17 shillings, 10 1/2 pence per ounce. Great Britain officially adopted the gold standard in 1821 and established the conversion of gold into currency, or vice versa, until World War I. In 1879, Germany, France and the United States adopted gold as the monetary standard. The gold standard was accepted as an international monetary system during the 1870s. Under this system, each country pegged (fixed the value of) its money to gold. The government of each country using the gold standard agreed to buy or sell gold on demand at its own fixed parity rate. This established the value of each individual currency in terms of gold and also fixed a parity or equation of equivalence for conversion between different currencies of the world. Under this system, it was very important for a country to maintain adequate gold reserves as a backing for its currency’s value. The gold standard worked adequately, until the outbreak of World War I interrupted trade flows and the free movement of gold and major trading nations suspended the gold standard. The relationship between countries using gold was determined by the amount of gold of a given quality that backed the respective currency. For example, before 1914, the British pound sterling contained 113.066 grains of pure gold and the United Sates dollar contained 23.22 grains. Thus, the gold content of the pound was 4.866 times greater than that of the dollar. The exchange rate at the time was logically GBP 1 = USD 4.866. The limited supply and uneven distribution of gold prevented its widespread use in international transactions. As a result, the gold standard was given up in 1914. After World War I, the gold standard was re-established, but it was finally given up by Britain in 1931, the United States in 1933, and in all other countries by 1937. The gold standard was linked to classical economic theory, which assumed that: ■■ There was full employment of resources and, thus, a rise in the quantity of money could ensure an increase in the general price level. ■■ Prices and wages are flexible (that is, they would move up or down). However, the Great Depression of the 1930s disproved these assumptions. Keynesian economic theory explained that the assumption of full employment was a special rather than a general case, and the assumption of price and wage flexibility was not valid for our modern economic system. This meant that government had to intervene in the economic system to ensure full employment and fight depression, rather than waiting for automatic adjustments to take effect as classical economists had recommended. The gold standard had the desirable quality of exchange stability, but it subjected the economy to the undesirable processes of deflation or inflation. This is why it was totally abandoned before World War II. The destruction of many of the powerful economies of the world led to a global need for economic reconstruction and for a better basis for an international monetary system.

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The Inter-war Years and World War II (1914–44) The United States returned to a modified gold standard in 1934, when the US dollar was devalued to USD 35 per ounce of gold from the USD 20.67 per ounce price in effect, prior to World War I. Although the United States returned to the gold standard, gold was traded only between foreign central banks, not between individual citizens. From 1934 to the end of World War II, exchange rates were determined, in theory, by each currency’s value in terms of gold. During World War II and its immediate aftermath, however, many of the main trading currencies lost their convertibility into other currencies. The dollar was the only major trading currency that continued to be convertible into gold.

The Bretton Woods System (1944–73) In 1944, at the height of the World War II, representatives from 44 countries met at Bretton Woods in New Hampshire to design a new international monetary system. The system was aimed at facilitating economic growth and post-war reconstruction of the war-ravaged economies. This led to a consensus on the desirability of the fixed exchange rate mechanism for the global economy. The meeting also established two multinational institutions, the International Monetary Fund (IMF) and the World Bank (WB), to act as regulators of the global economy. Their respective tasks were to maintain order in the international monetary system and promote general economic development. Under the provisions of the Bretton Woods Agreement signed in 1944, the government of each ­member country pledged to maintain a fixed, or pegged, exchange rate for its currency vis-à-vis the dollar or gold. Since one ounce of gold was set equal to USD 35, fixing a currency’s gold price was equivalent to setting its exchange rate relative to the dollar. For example, the Deutsche mark was set equal to 1/140 of an ounce of gold, meaning it was worth 50.25 USD 35/DM140. Participating countries agreed to try to maintain the value of their currencies within a 1 per cent band by buying or selling foreign exchange or gold as needed. Devaluation was not to be used as a competitive trade policy, but a devaluation of up to 10 per cent was allowed without formal approval by the IMF. A devaluation of more than 10 per cent was allowed only if the IMF agreed that a country’s balance of payments was in a ‘fundamental disequilibrium’. It was felt that devaluation saved the country in question from the painful adjustment process of a persistent trade deficit that would lead to a balance of payments restoration only through a steep rise in prices. During this period, the US 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 on its balance of payments during this period. 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 abroad resulted in a lack of confidence in the ability of the United States to meet its commitment to convert dollars to gold. On 15 August 1971, the United States responded to a huge trade deficit by making the dollar inconvertible into gold. A 10 per cent surcharge was placed on imports, and a programme of wage and price controls was introduced. Many of the major currencies were allowed to float against the dollar. The dollar then began a decade of decline. In December 1971, the major trading nations of the world signed the Smithsonian Agreement in Washington DC, according to which the United States agreed to devalue the dollar to USD 38 per ounce of gold. In return, the other counties present agreed to revalue their own currencies upward in relation to the dollar by specified amounts. Actual revaluation ranged from 7.4 per cent by Canada to 16.9 per cent by Japan. Furthermore, the allowed floating band around par value was expanded from +1 per cent to +2.25 per cent.

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Due to high inflation in the United States, the dollar devaluation remained insufficient to restore stability to the system. By 1973, the dollar was under heavy selling pressure even at its devalued rates. By late February 1973, a fixed rate system appeared no longer feasible given the speculative flows of currencies. The major foreign exchange markets were actually closed for several weeks in March 1973. Where they reopened, most currencies were allowed to float to levels determined by market forces. This marked the beginning of change to a floating exchange rate system.

The Post-Bretton Woods System: 1973–Present This period is characterized by a floating exchange rate system and has since given way to several hybrid systems that are prevalent all over the world today. We look at the prominent exchange rate mechanisms in the global economy today.

Bird’s-eye View The present monetary system originated with the gold standard and developed in different phases over the years. The present global monetary system evolved out of the Bretton Woods Conference held in 1973.

CONTEMPORARY EXCHANGE RATE SYSTEMS The classification of current exchange rate systems given here is based on a taxonomy developed by the IMF since 1971, which was revised in 1998 and again in 2009. The basic purpose of revision was to allow greater consistency and objectivity of classifications across countries, expedite the classification process, conserve resources and improve transparency, with benefits for the IMF’s bilateral and multilateral surveillance.

Fixed Exchange Rate System Under a fixed rate system, governments (through their central banks) buy or sell their currencies in the foreign exchange market whenever exchange rates deviate from their stated par values. In the presentday context a purely fixed rate system is employed by only a few centrally planned economies such as Cuba and North Korea. In these economies, it is generally mandatory that a local firm’s foreign exchange earnings be surrendered to the central bank, which in return pays the firm a corresponding amount of local currency on the basis of governmental priorities.

Independent Float System The floating exchange rate regime was formalized in January 1976 following the collapse of the fixed exchange rate system. Approximately 55 countries currently allow full flexibility through an independent float, also known as a clean float. Under the floating exchange rate system, an exchange rate is allowed to adjust freely to the supply and demand of one currency for another. This category contains currencies of both developed countries (such as the United States) and developing countries (Peru, for example). Central banks of these countries allow exchange rates to be determined by market forces alone. Although some central banks may intervene in the market from time to time, such intervention usually attempts to reduce speculative pressures on their currency. Further, central banks intervene only as one of many anonymous participants in the free market in an occasional, non-continuous manner.

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Currency Board Arrangement The currency board arrangement is an example of The currency board arrangement is a system a hard peg. Under this system, a country commits under which a country commits itself to conitself to converting its domestic currency on demand verting its domestic currency on demand into into another currency at a fixed exchange rate. To another currency at a fixed exchange rate. make this commitment credible, the currency board holds reserves of foreign currency at the fixed exchange rate equal to 100 per cent of the currency issued. The currency board can issue additional domestic notes and coins only if it has foreign exchange reserves to back it. This limits the ability of the government to print money and create inflationary pressures. Another advantage of this system is that it has greater political commitment, often reflected in a central bank law or constitutional amendment, thereby making it hard to reverse, and acting as a deterrent to speculative attacks. Two prominent examples of the currency board arrangement are Hong Kong and Argentina. Hong Kong established a currency board arrangement in 1983, Argentina in 1991 (which it subsequently abandoned in 2001), and Bulgaria, Estonia and Lithuania in recent years.

Soft Pegs Under a conventional pegged exchange rate regime, a country aligns or pegs the value of its currency to that of a major currency like the US dollar. Pegged exchange rates are a common practice among small nations with weak economies—China is an exception, as it has also pegged its currency, the yuan to the US dollar since 1994. A government can peg its currency to either another single currency or to a ‘basket’ of foreign currencies. Today, 62 of the 167 members of the IMF peg their currency to some other currency. The US dollar is the base for 20 other currencies (for example, Argentina, Iraq, Panama, Venezuela, Dominica, and Hong Kong). The French franc is the base for 14 currencies (all issued by former French colonies in Africa). Similarly, six of the new countries created with the break-up of the Soviet Union peg their currency to the Russian rouble. Other countries peg their currency to a composite basket of currencies, where the basket consists of a portfolio of currencies of their major trading partners. The base value of such a basket is more stable than any single currency. Under this regime, a country can peg its currency to the standard basket such as the Special Drawing Rights or SDR peg, (such as Libya and Myanmar), or to its own basket, designed to fit the country’s unique trading and investing needs (such as Bangladesh, Cyprus, Czech Republic, Iceland, Jordan, Kuwait, Nepal, Thailand, and Morocco). In the latter approach, the basket normally contains currencies of major trading partners, weighted according to trading relations with the focal country.

Crawling Peg The crawling peg system is situated between the fixed-rate and floating-rate systems. It is an automatic system for revising the exchange rate, establishing a par value around which the rate can vary up to a given percentage point. The par value is revised regularly according to a formula determined by the authorities. Once the par value is set, the central bank intervenes whenever the market value approaches a limit point. Suppose, for example, that the par value of the Indian rupee is 30 rupees for one dollar, and that it can vary +2 per cent around this rate, between INR 30.60 and INR 29.40. If the dollar approaches the rate of INR 30.60, the central bank intervenes by buying rupees and selling dollars. If the dollar

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approaches INR 29.40, the central bank intervenes by selling rupees and buying dollars. If it hovers around a limit point for too long, causing frequent central bank intervention, a new par value closer to this point is established. Suppose the dollar was hovering around 30.60. The government might then establish the new par value at 30.60 with new limit points at INR 31.21 and INR 19.99.

Pegged Exchange Rates within Horizontal Bands Under this arrangement, the value of the currency is maintained within certain margins of fluctuation of at least ±1 per cent around a fixed central rate, or the margin between the maximum and minimum value of the exchange rate exceeds 2 per cent. It includes arrangements of countries in the Exchange Rate Mechanism (ERM) of the EMS, which was replaced with the ERM II on 1 January 1999, for those countries with margins of fluctuation wider than ±1 per cent. The central rate and width of the band are public or notified to the IMF.

Floating Arrangements A floating exchange rate is a market determined currency. Under this arrangement the central bank may intervene either directly or indirectly in the market to prevent undue fluctuations in the exchange rate, but it is never done to get the exchange rate at a specific level. Indicators for managing the rate are broadly judgmental (for example, balance of payments position, international reserves, parallel market developments). Free Float A floating exchange rate can be classified as free floating if intervention occurs only exceptionally, aims to address disorderly market conditions, and if the authorities have provided information or data confirming that intervention has been limited to three instances at most during the previous six months, each lasting no more than three business days. If the information or data required are not available to the IMF staff, the arrangement will be classified as floating. Managed Float The managed float, also known as a dirty float, is employed by governments to preserve an orderly pattern of exchange rate changes and is designed to eliminate excess volatility. Each central bank sets the nation’s exchange rate against a predetermined goal, but allows the rate to vary. In other words, rate change is not automatic but based on the government’s view of an appropriate rate in the context of the country’s balance-of-payments position, foreign exchange reserves and rates quoted outside the official market. Rather than resist the underlying market forces, the authorities occasionally intervene by buying or selling domestic currency to smooth the transition from one rate to another. At other times they intervene to moderate or counteract self-correcting cyclical or seasonal market forces. The rationale for the managed float is to improve the economic and financial environment by reducing uncertainty. For instance, government intervention may reduce exporter’s uncertainty caused by disruptive exchange rate changes. Currently, about 40 countries (including Brazil, China, Egypt, Hungary, Korea, Israel, Poland, Turkey and Russia) maintain a managed float system. The challenge behind this approach is to define just what is meant by ‘excess volatility’. It is also questionable whether governments are more capable than markets in determining what is fundamental and what is temporary and self-correcting.

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Target-zone Arrangement The target-zone arrangement is virtually a joint Bird’s-eye View float system cooperatively arranged by a group of nations sharing some common interests and goals. Under a target-zone arrangement, countries adjust Contemporary global exchange rate systheir national economic policies to maintain their tems exist on a scale with the fixed or pegged exchange rates within a specific margin around exchange rate at one end and floating exchange agreed-upon, fixed central exchange rates. Such rate at the other end. Actual systems in use are a an arrangement exists for the major European curcombination of above-mentioned two systems rencies participating in the EMS. Members of the including the managed float, the crawling peg, European Union have a cooperative agreement to target zone arrangements and currency boards. maintain their currencies within a set range against other members of their group. The EMS is, essentially a peg of each country’s currency to all the others, as well as a joint float of all member currencies together against non-EMS currencies.

INTERNATIONAL FINANCIAL SYSTEM The international financial system consists of the activities of firms, banks and financial institutions engaged in different kinds of financial activities. Since the 1960s it has grown substantially in terms of volume and structure triggered by growth in world trade and investment activity, and aided by rapid developments in telecommunication and Internet technology. The large-scale liberalization of large parts of the developing world including India, the breakdown of the former Soviet Union and the opening up of China are among the factors responsible for the growth of global finance. ■■ The growing volume and changing structure of the international financial system can be attributed to the following factors ■■ The large-scale monetary and financial deregulation of the developing world ■■ The development of new technologies and payment systems and the use of the Internet in global financial activities ■■ Increased global and financial interdependence of financial markets ■■ The growing role of single-currency systems such as the euro The international financial system consists of two major components—foreign exchange markets and international capital markets. These in turn consists of ■■ ■■ ■■ ■■

International money markets International stock markets International bond markets International loan markets

Foreign Exchange Markets The word ‘market’ means a place where goods are offered for sale, but it also means the business of buying and selling a specified commodity. Nearly all international business activity requires the transfer of money from one country to another, so ‘foreign exchange market’ means a place where one form of money (for example, the Indian rupee) is changed for another form (for example, the USD). The term also encompasses the business of converting from one currency to another.

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Let us examine some commonly used terms in this context and understand what they mean. Foreign exchange is the money of a foreign country in the form of bank notes, drafts and checks. A foreign exchange transaction is an agreement between a buyer and a seller for the delivery of a certain amount of one currency at a specified rate in exchange for some other currency. Exchange rates are expressed as real exchange rates if they have been adjusted for inflation and as nominal exchange rates if they have not. The global foreign exchange business is concentrated in four centres, which account for about two-thirds of all reported turnover. These are called the major trading centres at London, New York, Singapore and Tokyo. Other important trading centres, known as the secondary trading centres, are at Zurich, Frankfurt, Paris, Hong Kong, San Francisco, Toronto, Brussels, Bahrain and Sydney. The dollar is the major trading currency, followed by the deutsche mark and the Japanese yen. Due to differences in the world’s time zones there are only three hours out of every 24 that the major centres—London, New York and Tokyo—are all shut down. Foreign Exchange Rate Quotations Foreign exchange rate quotations are of three kinds as discussed here. Direct and Indirect Quote: The foreign exchange Foreign exchange rate is the price of one currate is the price of one currency expressed in terms rency expressed in terms of a foreign currency. of a foreign currency, for example INR/ USD. The exchange rate can be expressed as a direct quote, which is the home currency price of a foreign currency unit, or as an indirect quote, which is the foreign currency price of a home currency unit. Let us take an example, in the Indian context INR 40/USD 1 is a direct quote; USD 1/INR 40 is an indirect quote. Under a direct quote, an increase of the exchange rate for example INR 45/USD 1 is a depreciation of the home currency or appreciation of the foreign currency. Bid and Ask: A bid is the exchange rate in one currency at which a dealer will buy another currency. An ask is the exchange rate at which a dealer will sell another currency. The difference between the bid and the ask rate is known as the bid–ask spread. Spot and Forward: A spot rate is the exchange rate for a transaction that requires immediate delivery of foreign exchange (usually on the second business day). A forward rate is the exchange rate for a transaction that requires delivery of transactions at a specified future date (for example, 30, 90 or 120 days). A forward transaction occurs between a bank and a customer and calls for delivery of a specified amount of foreign exchange at a fixed future date. The exchange rate is established at the time of entering into the deal, but the payment and delivery are made at the time of maturity. Customers may buy a foreign currency forward from a bank (for example, in an import business) or may sell a foreign currency forward (as in an export bank). If the initial transaction represents an asset or future ownership claim to foreign currency, it is known as a long position. If the market position represents a liability or future obligation, the position is called a short position. A swap is a simultaneous spot and forward transaction. For example, an Australian firm might need British pounds for 30 days, so it makes a spot transaction to exchange dollars for pounds and a simultaneous forward transaction to exchange the pounds for dollars in 30 days when its need for British pounds has ended.

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Market Participants The market for foreign exchange consists of individuals, corporations, banks and brokers who engage in various transactions. Banks are linked together through telephone, internet, telex and a satellite communications network called the Society for Worldwide Interbank Financial Telecommunications (SWIFT), based in Brussels, Belgium. This computer-based communication system makes all communication almost instantaneous, contributing to a worldwide market with narrower spreads for participants. Despite being a part of a global market, each country has its own unique tradition contributing to an institutional and regulatory framework. In Frankfurt and Paris, for example, representatives of commercial banks and central banks meet everyday to fix a rate known as the fixing rate. This rate serves as the benchmark that guides the pricing of small to medium transactions between banks and their customers. This practice of fixing a rate is common in Japan, Germany, France, Italy and the Scandinavian countries. The United States, UK, Canada and Switzerland do not follow this practice. The foreign exchange market is a 24-hour market. When the market in the Far East closes, trading in the Middle Eastern financial centres has been going on for a couple of hours, and trading in Europe is just beginning. As the London market closes, the one in New York opens. A few hours later, the market in San Francisco opens and trades with the East Coast of the United States and with the Far East as well. Banks dominate in the foreign exchange market, with about 90 per cent of foreign exchange trading consisting of inter-bank transactions. Non-bank participants in foreign exchange trading include commodity dealers, multinational corporations and non-bank financial institutions. Functions of the Foreign Exchange Market The foreign exchange market performs three major functions:

1. It is part of the international payments system and provides a mechanism for exchange or transfer of the national currency of one country into the national currency of another, thereby facilitating international business. 2. It assists in supplying short-term credits Bird’s-eye View through the eurocurrency markets and swap arrangements. The international financial system consists of 3. It provides foreign exchange instruments firms, banks and financial institutions engaged of hedging against exchange rate risk. either in foreign exchange markets or in the interAlthough most commercial banks handle national capital markets. The foreign exchange actions for their clients, many banks also market deals with the price determination and act as market-makers, with each prepared issue of currencies and money. The capital marto deal with other banks at any time. This ket, through its various components, deals with activity constitutes the interbank market, the intermediation of foreign exchange between where portfolio positions are adjusted and different parties in the global economy. exchange rates determined.

FOREIGN EXCHANGE RISK AND EXPOSURE Foreign exchange risk is a critical issue in international business. Any company that operates in more than one market or currency area or has cash flows across nations will face foreign exchange risk and foreign exchange exposure, which are different but related concepts.

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Foreign Exchange Risk: Concerns the variance Foreign exchange risk concerns the variance or change in the domestic-currency value of an or change in the domestic-currency value of an asset, liability or operating income that takes place asset, liability or operating income that takes place due to unanticipated changes in exchange rates. due to unanticipated changes in exchange rates. This means that foreign exchange risk is not the unpredictability of foreign exchange rates themselves, but rather the uncertainty of values of a firm’s assets, liabilities or operating incomes owing to uncertainty in exchange rates. Therefore, volatility or fluctuation in exchange rates is responsible for exchange-rate risk only if it translates into volatility in real values of assets, liabilities or operating incomes. Foreign exchange risk in turn depends on foreign exchange exposure. A firm may not face foreign exchange risks unless it is ‘exposed’ to foreign exchange fluctuations. For example, General Electric (GE) and Hitachi both invest and operate in Mexico. Unlike Hitachi, which imports many parts for its production plants in Mexico, GE has built up its own supply base within Mexico. In this case, GE faces lower foreign exchange risks than Hitachi because GE is not exposed to fluctuations of the Mexican peso in the process of supply procurement. Foreign Exchange Exposure: Refers to the senForeign exchange exposure refers to the sensisitivity of changes in the real domestic-currency tivity of changes in the real domestic-currency value of assets, liabilities or operating incomes value of assets, liabilities, or operating incomes to unanticipated changes in exchange rates. This to unanticipated changes in exchange rates. means that exposure involves the extent to which the home currency value of assets, liabilities or incomes is changed by variations in exchange rates. The ‘real’ domestic currency value means the value that has been adjusted by the nation’s inflation. Domestic currency-denominated assets can be exposed to exchange rates if, for example, unanticipated depreciation of the country’s currency causes its central bank to increase interest rates. The difference between foreign exchange risk and foreign exchange exposure is as follows: ■■ Foreign exchange risk is the variability in the domestic currency price of an asset, liability or operating income caused by exchange rate fluctuations. Foreign exchange exposure, on the other hand, is the degree to which an asset, liability or income is affected by changes in foreign exchange rates. ■■ Variability in foreign exchange rates leads to foreign exchange risk only if there is foreign exchange exposure. Foreign exchange exposure leads to foreign exchange risk only when exchange rates are unpredictable and keep changing. ■■ Foreign exchange risk is a positive function of both foreign exchange exposure and the variance of unanticipated changes in exchange rates. Uncertainty of exchange rates does not mean foreign exchange risk for items that are not exposed. Similarly, exposure on its own will not lead to foreign exchange risk if exchange rates are perfectly predictable. ■■ The levels of foreign exchange risk and exposure often differ between asset/liability items and operating income. Because current asset and current liability items, especially accounts receivable and payable, have fixed face value and are short-term oriented, they are extremely sensitive to the uncertainty of foreign exchange rates. Unlike these asset or liability items, operating incomes do not have fixed face values. Exposure of operating incomes depends not only on unexpected changes of exchange rates but also on such factors as the elasticity of demand for imports or exports, and the flexibility of production to respond to changes in exchange rate movements.

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TNCs encounter three types of foreign exchange exposure:

1. Transaction exposure 2. Economic (or operating) exposure 3. Translation (or accounting) exposure

Transaction Exposure: Transaction exposure is Transaction exposure is the change in income the change in income levels as a result of changes levels as a result of changes in exchange rates. in exchange rates for transactions that the business has already entered into, including the borrowing or lending of funds. It leads to a change in value of anticipated cash flows because commitments are subject to settlement at a later date. This essentially means that a business may realize a different amount than anticipated by it due to changes in the value of a currency for future settlements. Suppose for example an Indian exporter ships goods worth USD 2000 when the spot rate is USD 1 = INR 40. The settlement for this is equivalent to INR 80,000. On the day of settlement however, if the spot rate is USD 1 = INR 38, the exporter’s earnings are INR 76,000. The exporter suffers a loss of INR 4,000 if he does not manage his exposure and risk properly. Transaction exposure can arise on account of the following reasons: ■■ ■■ ■■ ■■

Purchasing or selling goods and services on credit. Borrowing or depositing funds denominated in foreign currencies. Transacting a foreign-exchange contract. Various transactions denominated in foreign exchange.

Economic Exposure: Also called operating expoEconomic exposure, also called operating exposure, refers to the change in the present value of sure, refers to the change in the present value the firm due to changes in the future operating cash of the firm due to changes in the future operatflows caused by unexpected changes in exchange ing cash flows caused by unexpected changes rates and macroeconomic factors. The change in in exchange rates and macroeconomic factors. value depends on the effect of the exchange rate change on future sales volume, prices or costs. In contrast to transaction exposure, which is concerned with pre-existing cash flows that will occur in the near future, economic exposure emphasizes expected future cash flows that are likely to be affected by unanticipated changes of exchange rates and macroeconomic conditions such as unexpected changes in interest rates and inflation rates. Some of the factors affecting economic exposure are: ■■ Export orientation: The higher an economy’s export orientation, the more it is likely to be affected by changes in exchange rate. ■■ Pricing flexibility: This refers to the ability of the firm’s ability to raise its foreign currency selling price by a large enough margin to be able to preserve its profit margin in the case of foreign currency depreciation. This in turn depends on price elasticity of demand. ■■ Production/outsourcing flexibility: This refers to the TNC’s ability to shift production and outsourcing of inputs among different nations. TNCs with worldwide production systems can cope with currency changes by shifting production to a low-cost locations. Translation Exposure: Translation exposure is associated with the accounting process followed by a TNCs. Foreign financial statement translation is a two-step process. First, the accounts must be made consistent by being restated according to the same accounting principles (for example, Australian or

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American), such as those relating to the valuing of inventories and assets, and determining depreciation. After the basis of the accounts has been adjusted for consistency, the foreign currency amounts in the results are converted into the reporting or home currency. Translation must not be confused with conversion. Translating is merely the restating of Bird’s-eye View currencies, while conversion refers to the actual physical trade or exchange of units of one curForeign exchange transactions involve risk and rency for another. There are four methods of exposure. Foreign exchange risk refers to the translating statements to the reporting or home possibility of change in the value of assets or currency: incomes due to the changes in the exchange 1. The current rate method rate. Foreign exchange exposure is the degree 2. The temporal method of change in asset or income values associated 3. The monetary-non-monetary method with changes in foreign exchange rates. 4. The current-non-current method

International Capital Market A capital market is the place where investors and A capital market is the place where investors and borrowers meet, generally with the assistance of borrowers meet, generally with the assistance of brokers. Investors may be individuals, companies or brokers. institutions—such as insurance companies, superannuation funds and the like—who have money to invest. Borrowers may be individuals, companies or governments who need money to create goods and services needed by society. Brokers in the capital market may be financial institutions such as the shortterm money market, life insurance offices, building societies, finance companies, credit unions, savings and trading banks, commercial banks (for example, National Australia, Westpac, Dresdner, Citibank) and investment banks (for example, Bankers Trust, Rothschild, Merrill Lynch). The function of a capital market is of course to provide capital (that is, money) and the cost of this capital is called interest. However, money may be loaned in two forms, only one of which attracts ­interest. This form is a debt loan in which the borrower pays interest at some agreed rate at particular times (for example, monthly or annually). The interest must be paid regardless of whether or not the borrower has made a profit. Debt loans may be cash loans from banks or funds raised through the sale of corporate or government bonds. Interest is paid on the bonds until their maturity date. The other way of raising money through the capital market is in the form of equity, which relates to the sale of a company’s shares. A share entitles the holder to a claim on the firm’s profits, which are known as dividends. Dividends are like interest paid on a debt loan, but they do not carry a guarantee. Dividends are subject to the dividend policy of the company: they may or may not be paid each year, and the rate is likely to vary according to the company’s profits. The international capital market has the following characteristic features: ■■ The global capital market could not exist, nor could it have grown as it has, without modern communication technology. Technology has had several consequences in this respect: –– Twenty-four-hour trading is possible –– All players have instant access to movements in the market –– An event in one place has the potential to cause a reaction around the world

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■■ The world’s history and geography both have an impact on the location of major trading centres. London is the busiest trading centre because it was the economic hub of the former British Empire. It is still a hub for British companies with massive investments around the globe. London also is a convenient link between Europe to the east and America to the west. New York is a major centre because of the underlying strength of the US economy and because it is the base for many US companies with overseas investments. Tokyo’s importance reflects the postWorld War II growth of the Japanese economy and the strength of its currency. ■■ The third and last point in this trio is the composition of the financial institutions in the global capital market. The major banks in the market are not just British, American and Japanese. Germany and France are also major players.

International Money Markets International money markets are those in which forThe eurocurrency market is a short-term market eign money is financed or invested. TNCs use interfor bank deposits and loans denominated in any national money markets to finance global operations currency except that of the country where the at lower cost than is possible domestically. They market is located. borrow currencies that have low interest rates and are expected to depreciate against their own currency. They incur the risk that the currencies borrowed may appreciate, however, which will increase their cost of borrowing. Investors, on the other hand, may achieve substantially higher returns in foreign markets than in their domestic markets when investing in currencies that appreciate against their home currency. Firms often conduct transactions in the money market through the eurocurrency market, which is a largely short-term market for bank deposits and loans denominated in any currency except that of the country where the market is located. In London, for example, the eurocurrency market is a market for bank deposits and loans denominated in dollars, marks, yen and any other currency except British pounds. In Paris, the market deals in dollars, marks, yen, pounds and every currency except the euro. The banks offering eurocurrency services are either local banks or foreign bank subsidiaries in a host country. Growing international trade and capital flows as well as cross-border differences in interest rates are the primary reasons for the growth of the eurocurrency market. Similarly, the eurobond ­market is a long-term market for bonds denominated in any currency except the currency of the country in which the market is located. The eurobond market is the long-term counterpart to the eurocurrency market.

International Bond Markets Money is a financial claim on current goods; bonds are a financial claim on future goods. For example, if you hold USD 100 in cash for one year, at any time during the year you have only USD 100. However, if you forego the right to purchase goods during the year and hold USD 100 worth of bonds for one year, at the end of the year you receive USD 100 plus some nominal rate of interest. That will suffice for our purposes: to go further would involve the theory of open economies in which money, goods and bonds interact to produce equilibrium. The bond is a traditional form of lending, and theoretically anyone may issue bonds. In most countries bonds are typically issued by governments and the term ‘government securities’ is a synonym for bonds. Bonds may carry varying interest rates, but the most common type of bond is the fixed-rate bond.

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Two types of bonds are of interest to us in this chapter: Foreign bonds are bonds sold outside the issuer’s country and are denominated in the currency of the country in which they are issued. Bonds issued in Britain are called bulldog bonds; bonds issued in Japan are called samurai bonds, bonds issued in the United States are called Yankee bonds and bonds issued in Australia are called kangaroo bonds. Eurobonds are a bond issued in countries other than the one in whose currency the bond is denominated. The eurobond market grew rapidly during the 1980s largely as a result of the deregulation of financial markets. Interest and principal on eurobonds has typically been payable in US dolEurobonds are a bond issued in countries other lars. However, the weakening of the dollar in 1985 than the one in whose currency the bond is denominated. caused a shift out of dollars toward euro–yen and euro–deutschemark issues.

International Stock Markets A stock exchange is a facility for the trading of securities and other financial instruments. The traded securities include the shares issued by companies, trust funds and pension funds, as well as corporate and government bonds. Stock exchanges are a major source of funds for firms to engage in international business. Information technology has revolutionized the functioning of stock markets/equity markets, providing huge advances in speed and cost of transactions. Today, most stock exchanges are electronic networks not necessarily tied to a fixed location. Each country sets its own rules for issuing and redeeming stock. Trade on a stock exchange is by members only. For example, the Tokyo Stock Exchange (TSE) is the home stock market to firms such as Toyota, Sony and Canon. The TSE is the major vehicle through which some 2,000 Japanese firms raise capital to fund their business activities. Several foreign companies, such as BP and Chrysler, are also listed on the TSE. Today, TNCs often list on a number of exchanges worldwide to maximize their ability to raise capital. The character of markets varies worldwide. For example, corporations hold the majority of the shares in the Japanese market, while in Britain and the United States shares are held much more by individuals. Despite these differences, stock exchanges are being increasingly integrated into a global securities market.

C H A P T E R

S U M M A R Y

■■ The international financial and monetary system consists of policies, institutions, practices, ­regulations and mechanisms that determine foreign exchange rates. Its key players include national stock exchanges, commercial banks, central banks and finance ministries in addition to specialized institutions. ■■ Exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another. The exchange rate system is termed as fixed if the central banks fix the value of the domestic currency vis-à-vis the foreign currency and as floating if the value is market-determined. Another aspect of the exchange rate policy is convertibility, which refers to the ease with which domestic currency can be traded for foreign currency, for a particular usage and at a given exchange rate. ■■ The earliest monetary system was the gold standard, which began in 1821 and finally expired in 1937. The gold standard was a fixed exchange system. A newer version, the gold exchange

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standard system, was instituted in 1945 as a consequence of the Bretton Woods Agreement. This fixed exchange system had its demise in 1976 following the Jamaica conference of the IMF. The failure of this system was due largely to the decline in the US balance of payments and the inability of the United States with its original large stock of gold to continue to support the dollar. The US dollar, you will recall, was the international currency after World War I. The foreign exchange market, which is a global network of banks, brokers and dealers, is linked by electronic communications systems. Its main trading centres are London, New York and Tokyo, but other centres permit the market to operate 24 hours a day. The primary function of the market is to convert one currency into another. A second function is to provide insurance against foreign exchange risk. International businesses participate in the foreign exchange market to facilitate trade transactions, to invest spare cash in short-term money markets abroad and to engage in currency speculation. The spot exchange rate is the exchange rate at which a dealer converts one currency into another on a particular day. The forward exchange rate is an exchange of currencies at some specified date in the future and is a means of reducing foreign exchange risk. A swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Eurocurrency is defined as any currency banked outside its country of origin, and we noted that it owes its popularity to the absence of government control. This characteristic applies also to eurobonds in the international bond market, where there are both foreign bonds and eurobonds. Shares in companies are increasingly available for buying and selling on stock exchanges around the world. Foreign exchange risk and exposure are two related yet distinct concepts. Foreign exchange risk is the change in domestic currency values of assets, liabilities and income caused by a sudden, unpredictable change in exchange rates. The extent of foreign exchange risk faced by a firm depends on its level of foreign exchange exposure. Foreign exchange exposure refers to the sensitivity of changes in the home-currency value of an asset, liability or income to unanticipated changes in exchange rates. Risk is an increasing function of exposure and the variance of unanticipated changes in exchange rates. TNCs encounter three types of foreign exchange exposure—transaction exposure, translation (accounting) exposure, and economic (operating) exposure. Transaction exposure can be hedged through financial instruments such as forward and options and production initiatives such as input sourcing. Economic exposure refers to the change in the present value of the firm due to changes in the future operating cash flows caused by unexpected changes in exchange rates and macroeconomic factors. In the case of translation exposure, there are four methods of translating statements to the reporting or home currency—current rate method, temporal method, monetary-non-monetary method, and current-non-current method.

Key Terms Foreign exchange rate, Foreign exchange transaction, Bid, Spot rate, Forward rate, Swap fixed exchange rate system, Floating exchange rate system, Currency board arrangement, Crawling peg ­ system, Managed float, Target-zone arrangement, Currency convertibility, Currency crisis, Capital ­market, Eurocurrency, Eurobond.

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DISCUSSION QUESTIONS

1. Trace the different stages of the evolution of the modern monetary system. 2. Distinguish between the fixed and floating exchange rate regime. Which system do you think is suitable in the current international business scenario? 3. List and explain the constituents of the international financial market. How do they affect the working of the global business environment? 4. Explain the characteristic features of the international capital market. 5. Critically examine the evolution of the Indian rupee on its path to convertibility. Is it true that the cautious approach of the Reserve Bank of India has helped to insulate the Indian economy from the turmoil of the global financial markets? 6. What is currency convertibility? Explain its importance as an aspect of a country’s exchange rate policy. 7. Write short notes on the following: a. Managed float vs independent float b. Currency board arrangement c. Crawling peg vs fixed peg d. Target zone arrangement 8. Distinguish between: a. Direct and indirect quote b. Bid and ask rate c. Spot and forward rate 9. What is foreign exchange risk? How is it different from foreign exchange exposure? 10. Explain the following concepts with clear calculations: a. Transaction exposure b. Economic exposure c. Translation exposure 11. Write short notes on: a. International capital market b. International money market c. International bond market d. International stock market 12. Briefly explain the evolution of the international monetary system from the Bretton Woods era till the present. [Delhi University, B.Com (Hons.) 2011] 13. Distinguish between a. Fixed and flexible exchange rate systems b. Foreign exchange risk and foreign exchange exposure  [Delhi University, B.Com (Hons.) 2010, 2012] 14. What are the different functions of the foreign exchange market?  [Delhi University, B.Com (Hons.) 2009, 2012] 15. Write short notes on: Floating exchange rate system [B. Com (Hons) 2014]

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10 INTERNATIONAL FINANCIAL INSTITUTIONS LEARNING OBJECTIVES After reading this chapter, you should be able to:

■ ■ ■ ■ ■

Understand the need for International Financial Institutions in the global economy Explain the role of the IMF as a regulator of global finance Analyse the importance of the World Bank Group as a source of development finance Distinguish between the objectives and functions of the IMF and World Bank Examine the regional financial institutions in Asia and Africa

THE NEW BRICs BANK The five BRICS nations—Brazil, Russia, India, China and South Africa have agreed to establish a development bank for the financing of infrastructure projects. It has been christened ‘The New Development Bank’, and established with a corpus of USD 50 million contributed equally by all the members giving them an equal stake. The bank will have its headquarters in Shanghai and will have India as its first President, followed by Brazil and Russia. The members also signed a treaty to establish the BRICS Contingent Reserve Arrangement (CRA) with an initial corpus of USD 100 billion to be held as reserves of the member countries, as a safeguard against potential or actual balance of payment difficulties. It is scheduled to start lending in 2016 and will be open to membership by other countries, but the capital share of the BRICS cannot drop below 55 per cent. The idea of a development bank by and for the developing countries was initially voiced by India in 2012. It was visualised as an alternative to the IMF and the World Bank which have often been perceived to have a developed nation slant in policy and functioning. The countries under BRICS represent 42 per cent of the world population, have a 17 per cent share in world trade, contribute 20 per cent to global GDP and are considered potential growth leaders. It is hoped that the New Development BRICS Bank will accelerate economic growth through the much needed financial intermediation for the infrastructure needs of countries like India and others in Africa using the

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surplus funds of China and other oil exporting nations which are currently being recycled through the capital markets of the developed world. Source: http://economictimes.indiatimes.com/news/international/business/india-to-head-the-brics-bank-forfirst-five-years-hopes-high-on-safeguarding-nations-interests/ar ticleshow/38504770.cms?utm_ source=Facebook&utm_medium=FBETMain&utm_campaign=afterbudgetstory, http://in.reuters.com/article/ 2014/07/15/brics-summit-bank-idINKBN0FK08620140715, last accessed 17 July 2014.

INTRODUCTION A major development in global finance was the establishment of the IMF and World Bank at the Bretton Woods Conference in 1945. These institutions were visualized as the guardians of the international financial and monetary system with a clearly stated mandate. The IMF was established to provide the rules of the game and determine the code of conduct for the international monetary system. The World Bank on the other hand, was set up to promote general economic development beginning initially with the reconstruction of war torn Japan and Europe. Over the years it has evolved into an agency that looks after the development needs of its member countries worldwide. Other international financial institutions at the regional level are the ADB, the African Development Fund, the African Development Bank and the Nigeria Trust Fund.

INTERNATIONAL MONETARY FUND (IMF) The International Monetary Fund was e­stablished on 27 December 1945 at the Bretton Woods Con­ ference to promote international monetary coopera­ tion, exchange rate stability and orderly exchange arrangements; to foster economic growth and high levels of employment; and to provide temporary financial assistance to countries to help ease bal­ ance-of-payments adjustment. It came into existence with an initial membership of 29 countries and has a present strength of 188 members.

The International Monetary Fund was established at the Bretton Woods Conference in 1945 to promote international monetary cooperation, exchange rate stability, and orderly exchange arrangements; to foster economic growth and high levels of employment; and to provide temporary financial assistance to countries to help ease balance of payments adjustment.

Objectives of the IMF The basic objectives of the IMF are as follows: ■■ To promote international monetary cooperation through a permanent institution that provides the machinery for consultation and collaboration on international monetary problems. ■■ To facilitate the expansion and balanced growth of international trade, leading to the promotion and maintenance of high levels of employment, real income and the development of the produc­ tive resources of all members.

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■■ To promote exchange rate stability and to maintain orderly exchange arrangements among mem­ bers, and to avoid competitive exchange depreciation. ■■ To assist in the establishment of a multilateral system of payments in respect of current transac­ tions between members and in the elimination of foreign exchange restrictions that hamper the growth of world trade. ■■ To make the general resources of the Fund temporarily available to all members under adequate safeguards, thus providing them with the opportunity to correct maladjustments in their balance of payments. ■■ To shorten the duration and lessen the degree of disequilibria in the international balances of payments of members.

Functions of the IMF The IMF was established as a specialized agency of the United Nations system, and it seeks to fulfil these objectives by carrying out three basic opera­ tions, which are as follows.

The three main functions of the IMF are financial assistance, technical assistance and surveillance.

Financial Assistance A core responsibility of the IMF is to provide loans to countries experiencing balance-of-payments problems. This financial assistance enables countries to rebuild their international reserves; stabilize their currencies; continue paying for imports; and restore conditions for strong economic growth. IMF lending usually takes place under an ‘arrangement’, in the form of an economic programme which contains specific macro-economic conditionalities. Unlike development banks, the IMF does not lend for specific projects. The volume of loans provided by the IMF has fluctuated significantly over time. The oil shock of the 1970s and the debt crisis of the 1980s were both followed by sharp increases in IMF lending. In the 1990s, the transition process in Central and Eastern Europe and the crises in emerging mar­ ket ­economies led to further surges of demand for IMF resources, which have largely been repaid as ­conditions improved. Over the years, the IMF has developed various loan instruments, or ‘facilities’, that are tailored to address the specific circumstances of its diverse membership. ■■ Low-income countries may borrow at a concessional interest rate through the Poverty Reduction and Growth Facility (PRGF) and the Exogenous Shocks Facility (ESF). ■■ Non-concessional loans are provided mainly through Stand-By Arrangements (SBA), and occa­ sionally using the Extended Fund Facility (EFF), the Supplemental Reserve Facility (SRF) and the Compensatory Financing Facility (CFF). ■■ The IMF also provides emergency assistance to support recovery from natural disasters and conflicts, in some cases at concessional interest rates. Except for the PRGF and the ESF, all facilities are subject to the IMF’s market-related interest rate, known as the ‘rate of charge’, and some carry a surcharge. The rate of charge is based on the SDR interest rate, which is revised weekly to take account of changes in short-term interest rates in major international money markets. The amount that a country can borrow from the Fun is called its ‘access limit’, and varies according to the type of loan, but is typically a multiple of the country’s IMF quota.

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Technical Assistance IMF technical assistance supports the development of the productive resources of member coun­ tries by helping them to effectively manage their economic policy and financial affairs. The IMF provides technical assistance in its areas of core expertise: macro-economic policy, tax policy and revenue administration, expenditure management, monetary policy, the exchange rate system, finan­ cial sector sustainability, and macroeconomic and financial statistics. In recent years the demand for IMF technical assistance has increased as the global economy is looking to strengthen the international financial system. Technical assistance is generally provided free of charge to any requesting member country, within IMF resource constraints. About 90 per cent of IMF technical assistance goes to low and lower-middle income countries. Post-conflict countries are also major beneficiaries. Apart from the immediate benefit to recipient countries, by helping individual countries reduce weaknesses and vulner­ abilities, technical assistance also contributes to a more robust and stable global economy. Surveillance The IMF has been given the mandate of overseeing the international monetary system and monitoring the economic and financial policies of its 185 member countries in order to promote global economic stability. This activity is known as surveillance. IMF surveillance provides an expert assessment of economic and financial developments, both globally and in individual countries. It advises on risks to stability and growth and if policy adjustments are warranted. In this way, the IMF helps the international monetary system serve its essential purpose of providing a framework that facilitates the exchange of goods, services and capital among countries and sustains sound economic growth. The IMF promotes international monetary Bird’s-eye View cooperation, exchange rate stability and orderly exchange arrangements, and also encourages The IMF is a multilateral financial institution countries to adopt sound economic policies. These aimed at promoting international monetary functions are critical, and aim at preventing various co-operation through the provision of financial kinds of economic and financial crises in the world and technical assistance and surveillance ser­ economy, for crises destroy jobs, slash incomes, vices to member nations. and cause great human suffering and misery.

WORLD BANK GROUP The World Bank Group (WBG) came into formal The World Bank Group is a family of five interexistence on 27 December 1945 following interna­ national organizations responsible for providing tional ratification of the Bretton Woods agreements. finance and advice to countries for the purposes It is a family of five international organizations res­ of economic development and eliminating poverty. ponsible for providing finance and advice to coun­ tries for the purposes of economic development and eliminating poverty. It functions through five major agencies:

1. 2. 3. 4. 5.

International Bank for Reconstruction and Development (IBRD) International Development Association (IDA) International Finance Corporation (IFC) Multilateral Investment Guarantee Agency (MIGA) International Centre for Settlement of Investment Disputes (ICSID)

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The term ‘World Bank’ generally refers to the IBRD and IDA, whereas the World Bank Group is used to refer to the institutions collectively. The World Bank’s (i.e., the IBRD and IDA’s) activities are focused on developing countries, in fields such as human development (e.g., education, health), agriculture and rural development (e.g., irrigation, rural services), environmental protection (e.g., pollution reduction, establishing and enforcing regula­ tions), infrastructure (e.g., roads, urban regeneration, electricity), and governance (e.g., anti-corruption, legal institutions development). The IBRD and IDA provide loans at preferential rates to member countries, as well as grants to the poorest countries. Loans or grants for specific projects are often linked to wider policy changes in the sector or the economy. For example, a loan to improve coastal environmental management may be linked to development of new environmental institutions at national and local levels and the implemen­ tation of new regulations to limit pollution. The activities of the IFC and MIGA include investment in the private sector and providing insurance respectively. The World Bank Institute is the capacity development branch of the World Bank, providing l­earning and other capacity-building programs to member countries. All the 185 member countries of the World Bank are its shareholders, who are generally represented by the board of governors. The Board of Governors in the World Bank group and IMF meet once a year. The World Bank’s two closely affiliated entities—the IBRD and the IDA—provide low or no-interest loans and grants to countries that have unfavorable financial sources or no access to international credit mar­ kets. Unlike other financial institutions, they do not operate for profit. The IBRD is market-based, and uses its high credit rating to pass the low interest it pays for money on to its borrowers—developing countries. IBRD lending to developing countries is primarily financed by selling AAA-rated bonds in the world’s financial markets. While IBRD earns a small margin on this lending, the greater proportion of its income comes from lending out its own capital. This capital consists of reserves built up over the years and money paid in from the Bank’s 185 member country shareholders. IBRD’s income also pays for World Bank operating expenses and has contributed to the IDA and debt relief.

Loans IDA is the world’s largest source of interest-free loans and grant assistance to the poorest countries, and is There are two basic types of loans and credits offered by the World Bank Group through the: replenished every three years by 40 donor countries. investment loans and development policy loans. Additional funds are regenerated through repayments of loan principal on 35-to-40-year, no-interest loans, which are then available for re-lending. IDA accounts for nearly 40 per cent of our lending. There are two basic types of loans and credits offered by the World Bank Group through the IBRD and IDA: investment loans and development policy loans. 1. Investment loans are made to countries for goods, works and services in support of economic and social development projects in a broad range of economic and social sectors. 2. Development policy loans (formerly known as adjustment loans) provide quick-disbursing financing to support countries’ policy and institutional reforms. IDA loans are interest-free. During loan negotiations, the Bank and borrower agree on the development objectives, outputs, per­ formance indicators and implementation plan, as well as a loan disbursement schedule. While the Bank supervises the implementation of each loan and evaluates its results, the borrower implements the proj­ ect or programme according to the agreed terms. IDA long-term loans (credits) are interest-free, but do carry a small service charge of 0.75 per cent on funds paid out. IDA commitment fees range from zero to 0.5 per cent on undisbursed credit balances.

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The World Bank Treasury is at the heart of IBRD’s borrowing and lending operations, and also performs treasury functions for other members of the World Bank Group.

Grants Grants are designed to facilitate development projects by encouraging innovation, co-operation between organizations and local stakeholders’ participation in projects. In recent years, IDA grants have been used to: ■■ Relieve th e debt burden of heavily indebted poor countries ■■ Improve sanitation and water supplies ■■ Support vaccination and immunization programmes to reduce the incidence of communicable diseases like malaria ■■ Combat the HIV/AIDS pandemic ■■ Support civil society organizations ■■ Create initiatives to cut the emission of greenhouse gases ■■ Analytic and advisory services While the World Bank is best known as a financier, it also provides analysis, advice and information to member countries so they can deliver the lasting economic and social improvements their people need. This is done in several different ways: through economic research on broad issues such as the environment, poverty, trade and globalization and through country-specific economic and sector work, where a country’s economic prospects are evaluated by examining its banking systems and financial markets, as well as trade, infrastructure, poverty and social safety net issues. The Bank also draws upon the resources of its knowledge bank to educate clients so they can equip themselves to solve their development problems and promote economic growth. The analytic and advi­ sory services of the Bank focus on the following issues: ■■ ■■ ■■ ■■ ■■ ■■

Poverty assessment Public expenditure reviews Country economic memoranda Social and structural reviews Sector reports Topics in development

The IMF and the World Bank often work together. While the IMF focuses on countries’ economic per­ formance, the World Bank emphasizes longer-term development and the reduction of poverty. While the IMF makes short-term loans to help stabilize foreign exchange, the World Bank makes long-term loans to promote economic development.

Bird’s-eye View The World Bank Group is a family of five insti­ tutions established for the purpose of global economic development and elimination of poverty through the provision of low cost loans and grants.

Asian Development Bank The Asian Development Bank was established in 1966. It is headquartered in Manila, and owned and financed by its 67 members, of which 48 are from the region and 19 are from other parts of the globe. Its main instruments for helping its developing member countries are low-interest loans, grants, advice and knowledge. The Bank is committed to reducing poverty through inclusive economic growth,

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e­nvironmentally sustainable growth, and regional integration in partnership with governments, the pri­ vate sector, non-government organizations, development agencies, community-based organizations and foundations. Although most lending is in the public sector—and to governments—the Bank also provides direct assistance to private enterprises of developing countries through equity investments, guarantees, and loans. In addition, its triple-A credit rating helps mobilize funds for development. The Bank was conceived amid the post-war rehabilitation and reconstruction of the early 1960s. The vision was of a financial institution that would be Asian in character and foster economic growth and cooperation in the region, which was then one of the poorest in the world. Dynamic economic development has substantially helped reduce poverty in Asia and the Pacific. The number of people struggling on USD 1 a day or less has come down from 900 million in 1990 to less than 600 mil­ lion today. This translates into more education, better health, longer lives and greater opportunity. The region’s ­economic growth has, however, been accompanied by widening disparities both within and between countries. Such disparities, together with climate change and the mounting environmental costs of growth, threaten to undermine the region’s development. To fulfil its mission and realize its vision of an Asia and Pacific free of poverty, the Bank is commit­ ted to the following three complementary strategic agendas, as set out in Strategy 2020, its long-term strategic framework:

1. Inclusive growth 2. Environmentally sustainable growth 3. Regional integration

In this context, it will focus on five core areas of operation:

1. Infrastructure 2. Environment, including climate change 3. Regional cooperation and integration 4. Finance sector development 5. Education

African Development Bank The African Development Bank is a multilateral development bank whose shareholders include 53 African countries (regional member countries—RMCs) and 24 non-African countries from the Americas, Asia, and Europe (non-regional member countries—non-RMCs). It was established in 1964, with its headquarters in Abidjan, Côte d’Ivoire, and officially began operations in 1967. However, due to political instability in Côte d’Ivoire, the Governors’ Consultative Committee (GCC), at a meeting in February 2003 in Accra, Ghana, decided to move the Bank to its current temporary location in Tunis, Tunisia. The Bank has been operating from this Temporary Relocation Agency since February 2003.

African Development Fund (ADF) Established in 1973, the ADF, which comprises the ADB and State Participants, became operational in 1974. Its main objective is to reduce poverty in RMCs by providing low-income RMCs with conces­ sional loans and grants for projects and programmes, as well as technical assistance for studies and capacity-building activities.

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Nigeria Trust Fund (NTF) The NTF is a special ADB fund created in 1976 by agreement between the Bank Group and the Government of the Federal Republic of Nigeria. Its objective is to assist the development efforts of lowincome RMCs whose economic and social conditions and prospects require concessional financing. The NTF became operational in April 1976 following approval of the Agreement establishing the Nigeria Trust Fund by the Board of Governors. Its initial capital of USD 80 million was replenished in 1981 with USD 71 million. In April 2003, the ADB Board of Governors considered and approved a number of proposals aimed at enhancing the effectiveness of the NTF.

C H A P T E R

S U M M A R Y

■■ The Bretton Woods Agreement of 1944 also led to the creation of the IMF and the World Bank. ■■ The role of the IMF was originally to extend short-term loans for development while the World Bank undertook longer term development loans. ■■ The three main functions of the IMF are financial assistance, technical assistance and surveillance. ■■ The World Bank Group consists of five organizations: IBRD, IFC, MIGA, ICSID and IDA. The term ‘World Bank’ generally refers to the IBRD and IDA, whereas the World Bank Group is used to refer to the institutions collectively. ■■ Other financial institutions at the regional level are the ADB, the African Development Fund, the African Development Bank and the Nigeria Trust Fund.

KEY Terms IMF, World Bank, Financial assistance, Technical assistance, Surveillance, Loans, ADB.

DISCUSSION QUESTIONS

1. 2. 3. 4. 5. 6. 7.

Discuss the role of the IMF and World Bank in fostering global financial cooperation. What are the basic objectives of the IMF? What are the different forms of assistance that is available under IMF? Discuss the various sources of fund generation by the World Bank. What are the different types of assistance available to members of the World Bank? Discuss the role of the Asian Development Bank as a development finance institution. Write short notes on a. Asian Development Bank b. Sources of Development Finance in Africa 8. Explain the structure functioning and major objectives of the IMF.  [Delhi University, B.Com (Hons.) 2009] 9. Explain the structure functioning and major objectives of the World Bank.  [Delhi University, B.Com (Hons.) 2010] 10. Compare and contrast the role of the IMF and World Bank as global financial regulators.  [Delhi University, B.Com (Hons.) 2008]

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11 INTERNATIONAL BALANCE OF PAYMENTS LEARNING OBJECTIVES After reading this chapter, you should be able to:

■ ■ ■

Discuss the fundamentals of the balance of payments of a country

■

Understand the significance of the official reserves account in balance of payments accounting

■

Understand the different components of the balance-of-payments account Explain the concept of equilibrium and disequilibrium in a country’s balance-of-payments account

Be conversant with trends in India’s balance-of-payments account over the years

INDIA’S BALANCE OF PAYMENTS CRISIS The Indian economy faced a balance of payments crisis in July 2013 as its foreign exchange reserves touched a low of USD 280 billion—enough to cover only seven months of imports. India has traditionally had a deficit on its current account as a result of a heavy import bill on account of imported energy, gold and technology. It has funded this by foreign inflows into stocks, bonds and corporate investment. The economy’s troubles in July were compounded by the fact that global investors looked away from emerging markets in anticipation of the US Federal Reserve starting to wind back its stimulus. The situation is better than it was in 1991 when India had barely enough reserves to cover three weeks of imports, the government was forced to pledge its gold in order to pay its bills and had to push through reforms to start opening up the economy.

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INTRODUCTION An international transaction involves two different An international transaction involves two differcountries and is, therefore, in two different currenent countries and is, therefore, in two different cies. These transactions occur in many different currencies. forms over the course of a year. The measurement of all international economic transactions between the residents of a country and foreign residents is done with the help of a statement called the balance-of-­ payments (BOP) account. Government policymakers need such measures of economic activity to evaluate the general competitiveness of domestic industry, to set exchange-rate or interest-rate policies or goals, The balance-of-payments account is the measurement of all international economic transacand for many other purposes. Individuals and busitions between the residents of a country and nesses use various BOP measures to gauge the foreign residents. growth and health of specific types of trade or financial transactions by country and regions of the world against the home country. International transactions take many forms. Each of the following examples is an international economic transaction that is counted and captured in a country’s balance of payments. ■■ An Indian car manufacturer imports automobile parts, which are manufactured in Japan. ■■ The Indian subsidiary of a US firm, pays profits (dividends) back to the parent firm in Santa Clara. ■■ Daimler AG, the well-known German automobile manufacturer, purchases a small automotive parts manufacturer outside Chicago, Illinois. ■■ An Indian tourist purchases blue pottery in Turkey. ■■ An Indian professor pays a fee of 400 euros to attend a conference in Amsterdam. This is just a small sample of the hundreds of thousands of international transactions that occur each year. The balance of payments provides a systematic method for the classification of all of these transactions. There is one rule of thumb that will always help in the understanding of BOP accounting: Watch the direction of the movement of money, in this case the foreign exchange. The balance of payments is composed of a number of sub-accounts, out of which the two major subaccounts, the current account and the capital account, are significant and important. Before describing these two sub-accounts and the balance of payments as a whole, it is necessary to understand the rather unusual features of how balance-of-payments accounting is conducted.

FUNDAMENTALS OF BALANCE-OF-PAYMENTS ACCOUNTING A basic fundamental rule is that the balance of payments must balance. If it does not, something has not been counted properly. It is therefore improper 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. Sub-accounts of the BOP, such as the merchandise trade balance, may be imbalanced, but the entire BOP of a single country is always balanced.

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There are three main elements to the 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 book-keeping procedures for BOP accounting, called double entry.

Defining International Economic Transactions International transactions refer to trade, investment or alliances between firms from two different countries. 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 any other country of the world each year. Many other international transactions are not so obvious. The purchase of a glass figure in Venice by an Indian tourist is classified as a US merchandise import. In fact, all expenditures made by American tourists around the globe that are for goods or services (meals, hotel accommodations and so forth) are recorded in India’s balance of payments as imports of travel services in the current account. The purchase of a US Treasury bill by a foreign resident is an international financial transaction and is dutifully recorded in the capital account of the US balance of payments. A rule of thumb, therefore, for identifying an international transaction is that it involves two different countries and is therefore in two different currencies.

The BOP as a Cash Flow Statement The BOP is often misunderstood to be a balance sheet because of its name. The BOP is actually a The BOP is a cash-flow statement that records the flow of foreign exchange from all internacash-flow statement that records the flow of foreign tional transactions over a period of time. exchange from all international transactions over a period of time. It is a statement that tracks the continuing flow of receipts and payments between a country and all other countries for different categories of international transactions. It is thus a record of the flow of foreign exchange and not a statement of the final value of all assets and liabilities of a country like a balance sheet of an individual firm. There are two types of business transactions that dominate the balance of payments: 1. Real assets: The exchange of goods (for example, automobiles, computers, watches, textiles) and services (for example, banking services, consulting services, travel services) for other goods and services (barter) or for the more common type of payment, money. 2. Financial assets: The exchange of financial claims (for example, stocks, bonds, loans, purchases or sales of companies) in exchange for other financial claims or money. Although assets can be separated by whether they are real or financial, it is often easier to simply think of all assets as being goods that can be bought and sold. An American tourist’s purchase of a handwoven area rug in a shop in Bangkok is not all that different from a Wall Street banker buying a British government bond for investment purposes.

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BOP Accounting: Double-entry Book-keeping The balance of payments employs an ­ accounting Double-entry book-keeping is a method of technique called double-entry book-keeping. Doubleaccounting in which every transaction proentry book-keeping is the age-old method of accountduces a debit and a credit of the same amount ing in which every transaction produces a debit and a simultaneously. credit of the same amount simultaneously. It has to. A debit is created whenever an asset is increased, a liability is decreased, or an expense is increased. Similarly, a credit is created whenever an asset is decreased, a liability is increased or an expense is decreased. An example will clarify this process. An Indian retail store imports USD  52 million worth of ­consumer electronics from Japan. A negative entry is made in the merchandise-import subcategory of the current account for the amount of 52 million. Simultaneously, a positive entry of the same 52 million is made in the capital account for the transfer of a 52 million bank account to the Japanese manufacturer. Obviously, the result of hundreds of thousands of such transactions and entries should theoretically result in a perfect balance. That said, it is now a problem of application, and a problem it is. The measurement of all international transactions in and out of a country over a year is a daunting task. Mistakes, errors and statistical discrepancies will occur. The primary problem is that although double-entry book-keeping is employed in theory, the individual transactions are recorded independently. Current and capital account entries are recorded independent of one another, not together as double-entry book-keeping would prescribe. It must then be recognized that there will be serious Bird’s-eye View discrepancies between debits and credits, and the possibility in total that the balance of payments The balance-of-payments account is a record may not balance. of foreign exchange transactions of a counThe next section describes the various balancetry recorded using double entry principles of of-payment accounts, their meanings, and their accounting. relationships with each other.

TYPES OF BALANCE-OF-PAYMENTS ACCOUNTS The balance of payments is composed of two primary sub-accounts, the current account and the financial or capital account. In addition, the official reserves account tracks government currency transactions, and a fourth statistical sub-account, the net errors and omissions account, is produced to create and keep the balance in the BOP.

Current Account The current account includes all international economic transactions with income or payment flows occurring within the current year. The current account consists of four subcategories: Goods Trade This is the record of export and import of goods. Merchandise trade is the oldest and most traditional form of international economic activity. Although many countries depend on imports of many 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.

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Services Trade This is the export and import of services. Some common international services are financial services provided by banks to foreign importers and exporters, the travel services of airlines, and construction services of domestic firms in other countries. For the major industrial countries, this sub-account has shown the fastest growth in the past decade. Income This category is predominantly current income associated with investments that were made in previous periods. For instance, if a Japanese steel major has established a marketing subsidiary in India. The profit made by this subsidiary that will be repatriated back to Japan as dividend is the current investment income. Wages and salaries paid to non-resident workers are also included in this category. Current Transfers Transfers are financial settlements associated with the change in ownership of real resources or financial items. Any transfer between countries that is one-way, a gift, or a grant, is termed a current transfer. A common example of a current transfer would be funds provided by the United States government to aid in the development of a less-developed nation. Transfers associated with the transfer of fixed assets are included in a new separate account, the capital account, which now follows the current account. The contents of what previously had been called the capital account are now included within the financial account. All countries possess some amount of trade, most of which is merchandise. Many smaller and lessdeveloped countries have little in the way of service trade, or items that fall under the income or transfers sub-accounts. The current account is typically dominated by the first component described—the export and import of merchandise. For this reason, the balance on trade (BOT ), which is so widely quoted in the business press in most countries, refers specifically to the balance of exports and imports of goods trade only.

Capital and Financial Account The capital and financial account of the balance of payments measures all international economic transaction of financial assets. It is divided into two major components, the capital account and the financial account.

The capital and financial account of the balance of payments measures all international economic transaction of financial assets.

Capital Account The capital account is made up of transfers of financial assets and the acquisition and disposal of nonproduced or non-financial assets. The magnitude of capital transactions covered is a relatively minor amount, and will be included in principle in all the following discussions of the financial account. Financial Account The financial account consists of three components: direct investment, portfolio investment and other asset investment. Financial assets can be classified in a number of different ways, including the length of the life of the asset (its maturity) and by the nature of the ownership (public or private). The financial account, however, uses a third way. It is classified by the degree of control over the assets or operations

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the claim represents: portfolio investment, where the investor has no control, or direct investment, where the investor exerts some explicit degree of control over the assets. The major sub-categories of India’s capital account balance are direct investment, portfolio investment, and other long-term and short-term capital. Direct Investment: This is the net balance of capital flows into and out of a country for the purpose of exerting control over assets. For example, if an Indian firm either builds a new automotive parts facility in another country or purchases a company in another country, this would fall under direct investment in India’s balance-of-payments accounts. When the capital flows out of the United States, it enters the ­balance of payments as a negative cash flow. If, however, foreign firms purchase firms in the United States (for example, India’s), it is a capital inflow and enters the US balance of payments positively. Whenever 10 per cent or more of the voting shares in a company is held by foreign investors, the company is classified as an affiliate of a foreign company, and a foreign direct investment. Similarly, if investors hold 10 per cent or more of the control in a company outside their country, that company is considered the foreign affiliate of a domestic company. Portfolio Investment: Portfolio investment is capital invested in financial markets, in activities that are purely motivated by returns, rather than ones made in the prospect of controlling or managing the investment. Investments that are purchases of debt securities, bonds, interest-bearing bank accounts, and the like are only intended to earn a return. They provide no vote or control over the party issuing the debt. Purchases of debt issued by the government (Treasury bills, notes and bonds) by foreign investors constitute net portfolio investment in the United States. If a US resident purchases shares in a Japanese firm, but does not attain the 10 per cent threshold, it is considered a portfolio investment (and in this case an outflow of capital). Other Investment Assets/Liabilities: This final category 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. In current and financial account balance relationships, there is an inverse relationship between the current and financial accounts of the BOP account. This inverse relationship is not accidental. The methodology of the balance of payments, double-entry book-keeping requires that the current and financial accounts be offsetting. Countries experiencing large current-account deficits ‘finance’ these purchases through equally large surpluses in the financial account and vice versa.

Net Errors and Omissions As noted before, because current account and financial account entries are collected and recorded separately, errors or statistical discrepancies will occur. The net errors and omissions account (this is the title used by the International Monetary Fund) makes sure that the BOP actually balances. Statistical discrepancies arise for several reasons: ■■ They occur due to difficulties in data collection, as they come from several different sources. ■■ There may be leads or lags ( time difference) between actual transactions and their flow of funds. ■■ Certain figures such as earnings on travel and tourism are estimated on the basis of sample cases that may be defective, leading to errors. ■■ Errors and omissions also occur due to unrecorded illegal transactions, which may not be recorded in the official accounts.

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Official Reserves Account The official reserves account refers to the total currency and metallic reserves held by official monetary authorities within the country. These reserves are usually composed of the major currencies used in international trade and financial transactions (so-called ‘hard currencies’ like the US dollar, German mark, and Japanese yen) and gold. The significance of official reserves depends generally on whether the country is operating under a fixed exchange rate regime or a floating exchange rate system. If a country’s currency is fixed, this means that the government of the country officially declares that the currency is convertible into a fixed amount of some other currency. For example, for many years, the South Korean won was fixed to the US dollar as 484 won equal to 1 US dollar. It is the government’s responsibility to maintain this fixed rate (also called parity rate). If for some reason there is an excess supply of Korean won on the currency market, to Bird’s-eye View prevent the value of the won from falling, the South Korean government must support the won’s value by The balance-of-payments account has four purchasing won on the open market (by spending its main components—the current account, the hard currency reserves, its official reserves) until the capital and financial account, the official excess supply is eliminated. Under a floating rate reserves account and the net errors and omissystem, the government possesses no such responsisions account. bility and the role of official reserves is diminished.

THE BALANCE OF PAYMENTS IN TOTALITY The BOP current account and capital account add up to the total BOP account, which must always balance as it is prepared on the double entry principle. If debits on the current account exceed its credit-side transactions, a flow of funds on capital account is needed to wipe out the deficit. Thus, a deficit in the current account is always matched by a surplus in the capital account and vice versa. The BOP is, therefore, based on the concept of accounting equilibrium, according to which: ■■ ■■ ■■ ■■

Current account + Capital account = 0 Balance of trade = Export of goods - Import of goods Balance of current account = Balance of trade + Net earnings on invisibles Balance of capital account = Foreign exchange inflow - Foreign exchange outflow (on account of foreign investment, foreign loans, banking transactions and other capital flows). ■■ Balance of payments = Balance on current account + Balance on capital account + Statistical discrepancy. The BOP account may, thus, have either a surplus or a deficit. If it has a surplus, the amount may be utilized for repaying past loans such as those taken from the IMF, and the balance amount transferred to the official reserves account. However, if the overall account has a deficit, the monetary authorities may transfer funds from the official reserves account or officially borrow from the IMF. In other words, if capital inflows are meant for meeting the BOP deficit and getting it to balance, they are termed accommodating flows. On the other hand, if capital inflows take place of their own volition, such as a FDI inflow or repayment of a loan, they are termed autonomous flows. Thus, accommodating capital flows go ‘above the line’ and autonomous capital flows go ‘below the line’.

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The accounting balance is an ex post concept, which describes what actually happened over a specific past period. This often leads to an accounting disequilibrium when the two sides of the autonomous flows differ in size. In such cases, accommodating flows bring the BOP back into equilibrium. In other words the BOP account does not always balance automatically; it may have to be brought into a state of equilibrium through policy induced measures. In economic terms, a BOP disequilibrium is a state of surplus or deficit—and equilibrium is the elimination of either of these. The normal situation for a BOP account is a state of disequilibrium, which is caused by the influence of external economic variables. These include: ■■ National output and national spending: If national income exceeds national spending, the excess saving needs to be invested, and a part of it may be invested abroad. The outflow of funds on capital account represents a capital account deficit. Conversely, excess of national spending over national income makes it necessary for the economy to borrow from abroad leading to a capital account surplus. ■■ Money supply: An inflow of foreign capital increases money supply in a fixed exchange rate regime. This in turn causes inflation, making exports expensive and uncompetitive, and imports relatively cheaper. As a result, there is a decline in exports and an increase in the country’s imports, leading to a trade deficit. ■■ Exchange rate: If the exchange rate regime is floating, an inflow of capital causes the exchange rate to appreciate; the price of the domestic currency rises relative to the foreign currency. An outflow, on the other hand, causes an exchange rate depreciation that makes exports competitive and reduces imports, leading to a trade and current account surplus. ■■ Interest rate changes: Rising domestic interest rates attract foreign capital flows leading to a capital account surplus. Conversely, low domestic interest rates cause an outflow of foreign capital and a deficit on capital account. Capital inflows which are meant for meeting the BOP deficit and getting it to balance are termed as accommodating flows. If capital inflows take place of their own volition such as a FDI inflow or repayment of a loan they are termed as autonomous flows. Let us understand this with an example—if an inflow on current account is matched by an outflow on capital account, the debit-side entry matches the credit entry, and the BOP is in equilibrium. Such flows are known as automatic, because they automatically work to bring the BOP account into a state of equilibrium. However, if the country has excessive imports, this reflects in current account deficit, as it leads to an outflow of foreign exchange. In such a situation, in the absence of a corresponding inflow of foreign exchange, the BOP will be in a state of disequilibrium. In order to bring it into equilibrium, the central bank could transfer foreign exchange reserves out of the official reserves account, or it may have to borrow funds to tide over its deficit. This assistance is usually taken from organizations such as the IMF. Such flows are known as accommodating flows. The meaning of the BOP has changed over the past 30 years. As long as most of the major industrial countries were still operating under fixed exchange rates, the interpretation of the BOP was relatively straightforward. A surplus in the BOP implied that the demand for the country’s currency exceeded the supply, and that the government should then allow the currency value to increase (revalue) or to intervene and accumulate additional foreign currency reserves in the Official Reserves Account. This would occur as the government sold its own currency in exchange for other currencies, thus building up its

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stores of hard currencies. A deficit in the BOP implied an excess supply of the country’s currency on world markets, and the government would then either devalue the currency or expend its official reserves to support its value. But the transition to floating exchange rate regimes during the 1970s changed the focus from the total BOP to its various sub-accounts like the current and financial account balances. These are the indicators of economic activities and currency repercussions to come.

C H A P T E R

S U M M A R Y

■■ The measurement of the flow of funds as a result of all international economic transactions between the residents of a country and foreign residents is called the balance of payments (BOP). ■■ It is composed of two primary sub-accounts, the current account and the financial/capital account. ■■ The balance of payments employs an accounting technique called double-entry book-keeping, in which every transaction produces a debit and a credit of the same amount. ■■ 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: goods trade, services trade, income and current transfers. ■■ The capital and financial account of the balance of payments measures all international economic transaction of financial assets. It is divided into two major components, the capital account and the financial account. ■■ The official reserves account refers to the total currency and metallic reserves held by official monetary authorities within the country. ■■ These reserves are normally composed of the major currencies used in international trade and financial transactions.

KEY Terms Balance-of-payments account, International transaction, Double-entry book-keeping, Current account, Capital and financial account, Official reserves account.

DISCUSSION QUESTIONS

1. 2. 3. 4. 5. 6.

Explain the term balance of payments. What are the different components of a country’s balance-of-payments account? Explain the term ‘disequilibrium’ in the context of a country’s balance of payments. What is the relationship between official reserves and a country’s exchange rate? Distinguish between the balance of trade and balance of payments. Do the balance on current account and balance on trade refer to the same accounting entities? Explain clearly. 7. Explain the purpose of having an official reserves account as part of the balance-of-payments account. What information does it give?

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8. Explain clearly how a country’s balance-of-payments account always balances, that is, the debit and credit sides are always equal. 9. ‘The balance of payments account is a country’s cash flow statement, not its balance sheet.’ Do you agree? Explain clearly giving examples. 10. What is the balance of payments account? What are its different components?  [Delhi University, B.Com (Hons.) 2011, 2012] 11. a. ‘The balance of payments account is a cash flow statement that records the flow of foreign exchange from all international transactions over a period of time.’ Discuss. b. List the constituents of the current account and capital and financial account of the balanceof-payments account.  [Delhi University, B. Com (Hons.) 2014]

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12 FOREIGN DIRECT INVESTMENT LEARNING OBJECTIVES After reading this chapter, you should be able to:

■ ■ ■

Identify the different forms of foreign direct investment (FDI) in the global economy

■ ■

Determine the costs and benefits of FDI for home and host countries

Examine the economic rationale underlying FDI behavior Understand why firms often prefer direct investment as a strategy for entering a foreign market over alternatives such as exporting and licensing Understand FDI flows in the global and Indian context

CARREFOUR SHUTS SHOP IN INDIA The French multinational retailer Carrefour SA has decided to shut down its Indian operations and close its wholesale stores in the country as part of a broad policy decision to pull out of underperforming markets and focus on plans to revive the domestic market. Carrefour entered the Indian market in 2010 and presently has five wholesale stores in the cash and carry mode, which is the permissible form of FDI in retail at present. The retail giant, which has a presence of around 10,000 stores in 34 countries, has exited markets like Greece, Colombia, Singapore and Malaysia under similar circumstances. American retail giant Walmart had parted ways with its Indian joint venture partner Bharti in October 2013, and set up a wholly owned subsidiary later in 2014 and has recently forayed into the e-commerce space. India allowed FDI in retail in 2012, but TNCs need to source 30 per cent of their input from small and medium enterprises locally, and different states also have individual policies on FDI, both of which has been a stumbling block for large TNCs such as Apple in setting up wholly owned stores. Luxury stores such as Gucci and LMVH also consider it a problem to source high-end goods locally, and are hopeful that the clause may be removed. Other problems for the retail industry have been the underdeveloped infrastructure including the lack of refrigerated carriers and complex bureaucracy in interstate transport, leading to regional price differences.

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There is the additional issue of competitive pressures for local players such as Reliance, who often have connections with the government which they use to influence government policy in their favour and thwart the ambitions of others. Source: http://in.reuters.com/article/2014/07/08/carrefour-india-idINKBN0FD02E20140708, http://economic times.indiatimes.com/industry/services/retail/walmart-to-expand-network-brings-in-rs-623-crore-funds/arti cleshow/38762793.cms, last accessed 21 July 2014.

INTRODUCTION This chapter examines the economic rationale behind foreign direct investment (FDI). It also explores different theories, which explain the growth of FDI as a means of growing international presence and the different forms it takes, and examines the factors driving a firm to choose FDI and the benefits FDI has for both home and host countries. FDI as a mode of foreign entry occurs when a FDI as a mode of foreign entry occurs when a firm firm invests directly in production or other faciliinvests directly in production or other facilities in a foreign country over which it has effective control. ties in a foreign country over which it has effective control.

FDI: A CLASSIFICATION FDI can be classified in several different ways. We classify it on the basis of whether it is aimed at asset creation or asset acquisition, nature of business activity, and on the motives driving it.

FDI can be classified according to the asset-based view, according to the nature of business activity and according to the motives for which it is done.

Asset-based View According to this viewpoint, FDI can be classified into four categories:



1. Greenfield investment is an investment Greenfield investment results in the creation of process which results in the creation of new new assets and production facilities in the host assets and production facilities in the host country. country. It is a long-term proposition in which an overseas production facility is set up from scratch. 2. A merger is the amalgamation of two existA merger is the amalgamation of two existing ing enterprises. It is a voluntary and permaenterprises. nent combination of two businesses which integrate their operations and identities with those of the other. The merged enterprise then functions as a new entity. For example, both Daimler-Benz and Chrysler ceased to exist when the two firms merged, and a new company, Daimler Chrysler, was created.

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3. An acquisition is the purchase of an existAn acquisition is the purchase of an existing ing business venture in a foreign country. It business venture in a foreign country. is a mode of FDI entry which allows a firm to establish itself in a short period of time since it takes over a running enterprise. From a legal point of view, the target company ceases to exist, the buyer ‘swallows’ the business and the buyer’s stock continues to be traded. It can be through the purchase of a minority stake (where a firm purchases 10 per cent to 49 per cent of the company’s stock) or a majority stake (where a firm acquires over 50 per cent stock). An acquisition can be hostile if the acquired company is unwilling to be bought, or it can be friendly and with the consent of the acquired enterprise. 4. Brownfield investment is a combination Brownfield investment is a combination of greenof greenfield investment and mergers and field investment and mergers and acquisitions. acquisitions. It denotes an investment where an existing firm acquires another firm and infuses it with fresh capital and assets after the acquisition.

Nature of Business Activity According to this classification, FDI can be classified into three categories: 1. Horizontal FDI takes place when a firm Horizontal FDI takes place when a firm invests invests abroad in the same industry in which abroad in the same industry in which it operates it operates in the home country. It therefore in the home country. represents, a geographical diversification of the TNC’s established domestic product line. Most Japanese TNCs, for instance, begin their international expansion with horizontal investment because they believe that this approach helps them to share experience, resources, and knowledge already developed at home, and helps to reduce the risk of operation in a foreign market. The acquisition of Ranbaxy Laboratories Limited, a leading Indian pharmaceutical TNC by Japan’s Daiichi Sankyo is an example of horizontal FDI. 2. Vertical FDI refers to investment in activiVertical FDI refers to investment in activities ties along the firm’s existing supply chain to along the firm’s existing supply chain to avail the avail the benefits of vertical integration. It benefits of vertical integration. occurs when the TNC enters a foreign country to produce intermediate goods that are intended for use as inputs in its home country’s (or in other subsidiaries) production process (this is called backward vertical FDI), market its homemade products overseas, or produce final outputs in a host country using its home-supplied intermediate goods or materials (this is called forward vertical FDI). Global firms such as Royal Dutch Shell p.l.c., BP p.l.c., and Consolidated Goldfields Corporation are classic examples of vertically integrated multinationals. An example of backward vertical FDI is offshore extractive investments in petroleum and minerals. For example, ONGC, which is in the business of petroleum refining in India, has purchased oil fields in South Africa, and has won exploration rights for a major project in Venezuela through a tie-up with Spain’s Repsol. This is an example of backward integration for assured supply of inputs into a firm’s downstream operations. An example of forward vertical

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integration is the establishment of an assembly plant or a sales branch overseas to be able to sell the firm’s domestic output abroad. For example, when Volkswagen entered the US market, it acquired a large number of dealers to distribute its product rather than distribute its product through independent US dealers. 3. Conglomerate FDI refers to investment Conglomerate FDI refers to investment made by a made by a TNC to manufacture products TNC to manufacture products which are not being which are not being manufactured by the manufactured by the parent company at home. parent company at home. For example, TNCs based in Hong Kong often set up foreign subsidiaries or acquire local firms in mainland China to manufacture goods that are unrelated to the parent company’s product portfolio. The main purpose is to seize emerging market ­opportunities and capitalize on their established business and personal networks with the ­mainland, which Western TNCs do not have. Horizontal FDI is the fastest route for the firm to establish its competitive advantage in the host country, since its key competencies, whether technological or organizational, are generally more transferable and applicable to the host-country operations through horizontal FDI than through conglomerate or vertical FDI. Conglomerate FDI is relatively less popular because it involves establishing market power and a competitive position in the host country in unrelated areas of work.

Motive-based View FDI can also be classified on the basis of the motive of investment. ■■ Resource-seeking FDI is motivated by the Resource-seeking FDI is an attempt to acquire desire to acquire particular resources at a particular resources at a lower real cost than lower real cost than could be obtained in the could be obtained in the home country. home country. Resource-seekers can be further classified into three groups—those seeking physical resources; those seeking plentiful supplies of cheap and/or skilled labor; and those seeking technological, organizational, and managerial skills. Recent incidents by Indian and Chinese firms in search of oil and in other extractive industries in Africa are all examples of resource-seeking FDI. ■■ Market-seeking FDI is targeted at increasMarket-seeking FDI is targeted at increasing maring market share and sales growth in a forket share and sales growth in a foreign market. eign market. Apart from market size and the prospects for market growth, the reasons for market-seeking FDI are to follow the firm’s main suppliers or customers who may have set up foreign producing facilities abroad or the firm may want to service markets in which its competitors have a presence. For instance, the Essar group from India acquired a controlling stake in the telecom assets of UAE-based Warid Telecom, which has a presence in Uganda and Congo. It already had a presence in Africa in the mobile telephony services in Kenya where it operates under the brand name ‘YU’ and services over 600,000 customers. Thus, the Essar group hopes to become an active player in the growing telecom market in Africa by providing assistance for network expansion and for marketing in these markets.

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■ ■ Efficiency-seeking FDI aims to take advanEfficiency-seeking FDI aims to take advantage tage of different factor endowments, economic of different factor endowments, economic syssystems, policies, and market structures to contems, policies, and market structures to concencentrate production in a limited number of locatrate production in a limited number of locations tions and reduce cost of operation. It attempts to and reduce cost of operation. rationalize the structure of established resourcebased or marketing-seeking investment in such a way that the firm can gain from the common governance of geographically dispersed activities. Efficiency gains are the results of synergies arising out of the pooling of management resources, and revenue enhancement is through the use of common facilities and the economies of large-scale production. Recent acquisitions by Indian IT firms such as Navion Software Corporation in China by MphasiS and eJiva by Mascot Office Systems Limited in the United States led to increased value as a result of increase in the employee strength. Skill-set enhancement can also lead to increased ­efficiency as in the case of the acquisition of Orbitech by Polaris Software Lab Limited. While Polaris was looking for a specialized product suite, Orbitech needed efficient marketing and service support; since the merger, Polaris has become a large, s­ pecialized company in the banking, financial services and insurance (BFSISI) sector offering solutions, products, and transaction services. ■■ Strategic asset-seeking FDI attempts to sustain or enhance international competitiveness through asset acquisition. Merger with or acquisition of an existing company is the most inexpenStrategic asset-seeking FDI attempts to sussive method of acquiring strategic assets tain or enhance international competitiveness such as R&D, technical know-how, patents, through asset acquisition. brand names, local permits, licences, and supplier and distributor networks. Strategic created assets may take years to develop Bird’s-eye View and may be crucial to increase the firm’s competitive advantage. For example Wipro, FDI is a mode of foreign entry which gives which is a diversified Indian conglomerate, the investing TNC the right of control over bought out the business of Yardley, one of productive assets in another country. FDI may the world’s oldest cosmetics brands in Asia, take several forms such as greenfield investthe Middle East, Australasia, and North and ment, brownfield investment or a merger. It West Africa. The acquisition hopes to give may be motivated by the search for markets, a strategic boost to Wipro’s foothold in the resources, increased efficiency or a combinahigh growth markets of the Middle East and tion of all these. to double its revenue earnings.

MODES OF FDI ENTRY A TNC can make its FDI investment in a foreign market through different modes of entry.

Branch Office A branch office is a legal extension of an existing parent foreign entity engaged in production and operating activities, but with no legal existence of its own. Branch offices are entitled to run businesses within a specified scope or location.

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A branch office is a legal extension of an existing parent foreign entity engaged in production and operating activities, but with no legal existence of its own.

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This distinguishes them from representative offices which are prohibited from direct profit-making business activities and can only serve as liaison offices. Branch offices can be opened in another country or even in another region of the host country to expand its operations there. Branch offices are usually used for expansion by transnational banks, law firms, and accounting or consulting companies. Establishing a branch office is the easiest and a low-risk mode of foreign entry. However, since it does not have an independent legal status, the parent often has to bear the additional risk of any charges brought against it.

Strategic Alliances Strategic alliances are cooperative agreements between potential or actual competitors. They can be formal agreements with equity stakes or short-term contractual agreements for cooperation in a specific task. These agreements are aimed at sharing or co-developing of products, technologies or services through exchange between firms. These alliances are of two types—equity joint ventures and cooperative joint ventures. Equity Joint Venture An equity joint venture entails establishing a new entity that is jointly owned and managed by two or more parent firms in different countries. To set up an equity joint venture, each partner contributes cash, facilities, equipment, materials, intellectual property rights, labor, or land use rights. These collaborative arrangements could have an equal ownership pattern, that is, a 50–50 ownership or in any other proportion, according to the law of the land. Cooperative Joint Venture A cooperative joint venture (also known as contractual joint venture) is a collaborative agreement in which both profit sharing and responsibility sharing are defined as per the terms of a contract between the two parties. The profit-sharing arrangement is not necessarily according to each partner’s percentage of the total investment. Each partner/co-venturer cooperates as a separate legal entity and bears their liabilities. Most cooperative joint ventures do not involve the creation of an independent corporate entity but follow carefully defined rules regarding allocation of tasks and costs, and revenue sharing. The increase in the number of such alliances among TNCs all over the world is transforming the global business environment as it facilitates foreign market entry, and helps firms share fixed costs and risks and benefits from the synergies of complementary skills and assets. These alliances are gaining importance worldwide as global competition intensifies for access to markets, products, and technologies. Most large TNCs such as Motorola, Inc., Siemens AG, Sony Corporation, General Motors (GM), Daimler AG, and Toyota Motor Corporation have built such alliances. For example, in Japan alone, Royal Dutch Shell has established more than 30 joint ventures. As a means of survival and growth, strategic alliances have become a fundamental element of many TNCs’ key global business strategies.

Wholly Owned Subsidiary A wholly owned subsidiary is an entry mode in which the investing firm owns 100 per cent of the new entity in a host country. This new entity may be built from scratch by the investing firm (greenfield investment) or through a merger and acquisition with a local business. During the 1990s, Japan’s Kao Corporation established a large number of wholly

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A wholly owned subsidiary is an entry mode in which the investing firm owns 100 per cent of the new entity in a host country. This new entity may be built from scratch by the investing firm (greenfield investment) or through a merger and acquisition with a local business.

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owned manufacturing and marketing subsidiaries overseas. The establishment of a large, wholly owned project abroad can be a complex, costly, and lengthy process. TNCs must choose between the importance of protecting core technology and manufacturing and marketing processes on the one hand, and the costs of establishing a new operation on the other. Many TNCs choose this alternative only after expanding into markets through other modes that have helped them accumulate host-country experience. Advantages The advantages of a wholly owned subsidiary are: ■■ It is a preferred mode of entry when a firm has a strong competitive advantage in technological competence, since it offers increased flexibility and control. ■■ It allows international managers the freedom to make their own decisions without the burden of an uncooperative partner. ■■ A firm is able to get 100 per cent profits for itself instead of having to share them. ■■ Wholly owned subsidiaries also allow foreign investors to set up and protect their own processes and procedures, which leads to more careful strategic and operational management. Disadvantages The disadvantages of a wholly owned subsidiary are: ■■ It entails both high costs and risks. The firm has to incur the entire capital expenditure of setting up in a foreign market and the risks associated with it. ■■ It has to rely on indigenous agents to make liaisons on its behalf and help procure land, materials, and services. ■■ Host governments often impose restrictions on investment and operation in industries that are vital to its economy. ■■ Since wholly owned subsidiaries operate without the control of local partners, investment approval authorities often require higher standards on pollution control, technological level, capital contribution, foreign exchange administration, etc. from them as preconditions for approval.

Forms of Wholly Owned Subsidiaries: Greenfield Investment versus Mergers and Acquisitions A TNC can set up a wholly owned subsidiary, through either greenfield investment or international mergers and acquisitions (M&As). A greenfield investment refers to the setting up of a new business through the establishment of fully owned new facilities and operations by a TNC in another country. An international merger and/or acquisition (M&A) is a cross-border transaction in which a foreign investor acquires an established local firm and makes the acquired local firm a subsidiary business within its global portfolio. A merger and acquisition has the following advantages as compared to a greenfield investment: ■■ The international acquisition of a local firm or another foreign company with local ventures is the quickest way to expand one’s investment in the target country. ■■ An acquisition is useful for entering sectors where entry for new investment is restricted. ■■ An acquisition begins to generate cash flows and profits faster than a greenfield investment since it is a running enterprise.

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■■ An acquisition gives the acquirer immediate access to local resources such as land, manufacturing facilities, distribution channels, supply networks, skilled labor and customer base. Foreign investors generally target enterprises with strong market niches in sectors with potential for growth. A merger and acquisition has the following risks/disadvantages as compared to a greenfield investment: ■■ Gaining government approval for the transfer of ownership and clearance of property titles is often difficult to get. ■■ Foreign investors need to be careful to obtain accurate information, particularly concerning existing liabilities, when buying into an existing business. ■■ International mergers and acquisitions inevitably face many challenges, especially during early operations. The fundamental challenges are often rooted in cross-national differences in culture, managerial styles, and corporate values. To overcome these challenges, international managers need to develop a new corporate mission, vision, and strategic objectives. It is also important to integrate communications and human resources. The new organization must develop mechanisms to identify the most appropriate organizational structures and management roles in order to enhance administrative efficiency and operational effectiveness.

Umbrella Holding Company An umbrella holding company is an investment company that brings all the firm’s existing investments An umbrella holding company is an investment company that brings all the firm’s existsuch as branch offices, joint ventures, and wholly ing investments such as branch offices, joint owned subsidiaries under one umbrella in order to ventures, and wholly owned subsidiaries under combine sales, procurement, manufacturing, trainone umbrella in order to combine sales, proing, and maintenance within the host country. It is curement, manufacturing, training, and mainteoften seen that many large TNCs try to combine nance within the host country. production divisions for different sub-units under a common umbrella in an important destination. For example, DuPont set up DuPont China Ltd as its holding company to unite various joint ventures in the pharmaceutical and plastics divisions under a common coordinated management.

Differences Between Joint Ventures and Mergers ■■ The major difference between joint ventures and mergers is that the former involves formation of a third entity (for example, an equity joint venture) whose duration is often limited and specified in the contract, whereas the latter does not have a specific duration and may or may not lead to the formation of an independent new entity. ■■ Joint venture parties remain independent Bird’s-eye View after forming a venture but two parties are integrated into a single organization after a There are several modes of foreign market merger. entry which may be classified as FDI. These ■■ Also, mergers combine all of the partners’ include the branch office, strategic alliances, assets (though some may be combined wholly owned subsidiary and an umbrella later), while a joint venture involves only holding company. some of those assets.

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GLOBAL FDI PATTERNS The last few years have witnessed several changes in the nature and magnitude of global trade and investment flows. Among these changes is the new phenomenon of outward foreign direct investment (OFDI) from developing countries with a significant influence on the trade and on investment across the world. Traditionally, developing countries have been dependent upon the developed countries for trade and investment. The developed countries not only provided the developing countries with markets for their goods, but also acted as a source of foreign capital for these capital-scarce countries. As developing countries competed amongst themselves to receive a pie of the market share and foreign capital from these countries, it led to an unequal distribution of economic power, where the developed countries had a lot more leverage and control over the developing countries. However, the phenomenon of South–South trade and investment cooperation is bringing about significant changes in this power imbalance in the international economy. Moreover, for the capital-scarce, least developed countries, such FDI from developing countries is of immense importance. It is in this context that the new phenomenon of increased FDI from India and China, to the continent of Africa assumes importance.

Trends in FDI The past 30 years have seen a marked increase in both the flow and stock of FDI in the world economy. FDI flows refer to the amount of investment flows over a given period of time, whereas stock refers to the total accumulated value of foreign-owned assets at a given time. The average yearly flow of FDI increased from about USD 25 billion in 1975 to a record USD 1.3 trillion in 2000, before slumping dramatically in 2004 to USD 620 billion. Global FDI flows were severely affected worldwide by the economic and financial crisis. Global FDI inflows fell from a historic high of USD 1,979 billion in 2007 to USD 1,697 billion in 2008, but recovered and began to bottom out in the latter half of 2009, and were recorded at USD 1.45 billion in 2013, which is an increase of 9 per cent over 20121. FDI inward stock rose by 15 per cent to USD 18 trillion in 2009 and rose by a further 9 per cent to USD 25.5 trillion in 2013. FDI inflows to developed countries and transition economies contracted further in 2010. In contrast, FDI flows to developing economies recovered strongly, and taken together with transition economies, equalled 50 per cent mark of total global FDI flows in 2010 and 54 per cent of global inflows in 2013, recorded at an all time high of USD 778 billion2. The flow of FDI in the last three decades has not only increased but has increased faster than the growth in world trade. FDI has grown more rapidly than world trade and world output for several reasons. ■■ Although there has been a general decline in trade barriers over the past 30 years, business firms still fear protectionist pressures and see FDI as a way of getting around future trade barriers. ■■ The international investment regime is evolving rapidly through both the conclusion of new treaties and an increasing number of arbitral awards. In 2009, 211 new international investment agreements (II As) were concluded, 82 bilateral investment treaties (BITs), 109 double taxation treaties (DTTs) and 20 other IIAs. 1 2

http://unctad.org/en/PublicationsLibrary/wir2014_overview_en.pdf, last accessed 7th July 2014. http://unctad.org/en/PublicationsLibrary/wir2014_overview_en.pdf, last accessed 7th July 2014.

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Direction of FDI Historically, most FDI has been directed at the developed nations of the world as firms based in advanced countries invested in the other’s markets. The United States has often been the favorite target for FDI inflows. This trend continued in the late 1990s, when the United States remained the largest recipient of FDI. In 2000, the United States was again the largest national recipient of FDI, accounting for USD 281 billion of the USD 1.3 trillion in global FDI, while Western Europe was the largest single regional recipient of FDI, with USD 124 billion and USD 323 billion respectively, reflecting the drop in economic activity. Historically, the United States has been an attractive target for FDI because of its large and wealthy domestic markets, its dynamic and stable economy, a favorable political environment, and the openness of the country to FDI. Investors have included firms based in the United Kingdom, Japan, Germany, the Netherlands, and France. The share of the developed nations in general and USA in particular has gradually declined and is reduced to 39 per cent of the global total at USD 566 billion in 2014. The developing countries had an average annual FDI inflow of USD 27.4 billion or 17.4 per cent of the global total, which had increased to 35 per cent in 2002 and has reached a record level of 57 per cent of the global total in 2013, which is USD 200 billion more than the developed countries’ share. The largest FDI recipients include a significant proportion of developing and transition economies— three developing and transition economies ranked among the six largest foreign investment recipients in the world in 2009, and China was the second most popular FDI destination with the United States at the top position among host countries in 2009. FDI flows to developing economies rose by 12 per cent (to US USD 574 billion) in 2010, and in 2013 FDI flows to the developing world were recorded at US USD 788 billion, an increase of 28 per cent over the last year. 9 of the 20 largest recipients of FDI flows were developing countries found in regions of developing Asia and Latin America.

FDI Outflows Global FDI outflows were USD 14.1 trillion in 2013, an increase of 5 per cent from USD 1.35 trillion in 2012. TNCs from developed countries account for the majority of FDI flows since they have traditionally possessed greater ownership or monopolistic advantages, have been global innovators (and, therefore, at the beginning of the product life cycle), and have had the dynamic capabilities necessary for successful venturing abroad. During 1998–2000, the Triad countries (United States, Europe, and Japan) accounted for 85 per cent of FDI outflow and 78 per cent of outward FDI stock, with much of it going to other Triad countries. In 2007, the developed countries continued to remain the largest net outward investors as outflows rose to record levels of USD 1,692 billion. The largest investors were the United States, the United Kingdom, France, Germany and Spain, which accounted for 64 per cent of the total global FDI outflow. Developing countries remain a secondary yet steadily growing source of FDI. From 1980 to 1999, the share of developing countries in FDI outflows grew from 3 per cent to 8 per cent. Contributing to this outflow were mostly Asian firms, although Latin American firms also increased their FDI outflows. It is important to note that such TNCs rely on a different kind of competitive advantage and are often motivated by a search for knowledge rather than by a desire to leverage existing knowledge resources. Since 2007 developing countries have become important sources of outward FDI, with their share increasing from USD 253 billion in 2007 to USD 454 billion in 2013, accounting for 39 per cent of global outflows. FDI outflows from the developed countries have stagnated at USD 857 billion since 2012.

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FDI outflows from Latin America and the Caribbean leaped from an average of USD 15 billion a year in 1991–2000 to USD 48 billion annually in 2003–2009, driven by the emergence of TNCs from the region since 2003. Outward FDI from developing and transition economies reached USD 388 billion in 2010, a 21 per cent increase over 2009. Outflows from the largest FDI sources—Hong Kong (China) and China—have increased by more than USD 10 billion each, reaching historical highs of USD 76 billion and USD 68 billion, respectively, while Chinese companies have continued their buying spree, actively acquiring overseas assets in a wide range of industries and countries, and overtaking Japanese companies in total outward FDI. All of the big outward investor countries from Latin America—Brazil, Chile, Colombia, and Mexico—bolstered by strong economic growth at home, increased their acquisitions abroad, particularly in developed countries where investment opportunities have arisen in the aftermath of the 2008 crisis. In contrast, outflows from major investors in West Asia fell significantly, due to largescale divestments and redirection of outward FDI from government-controlled entities to support their home economies weakened by the global financial crisis. An important development has been the increase in the number of State-owned TNCs to 550 from both the developed and developing countries, accounting for USD 2 trillion global foreign assets in 2013. The majority of the State-owned enterprises (SOEs) that acquired foreign assets in 2012 were from developing countries; and the majority of the acquisitions carried out by them have been s­ trategic asset seeking (e.g., technology, intellectual property, brand names) and natural resource seeking. Sovereign Wealth Funds (SWFs) contributed USD 6.7 billion, with cumulative total of USD 130 billion. Cumulative FDI by SWFs is estimated at USD 127 billion, most of it in finance, real estate, construction and utilities. In terms of geographical distribution, more than 70 per cent of SWFs’ FDI in 2012 was targeted at developed economies. The combined assets of the 73 recognized SWFs around the world were valued at an estimated USD 6.4 trillion—which has the potential to become a huge resource for development financing.

FOREIGN INVESTMENT IN INDIA The trade channel has traditionally been considered the main mode of global integration of economies. Since the 1970s, however, with increasing mobility of capital, investment is the new face of economic and global integration. The Indian economy has been an increasing part of global inter-connectedness with changes in policy contributing to both change in nature and magnitude of capital flows.

Policy Perspective A historical account of the policy approach to international investment in India suggests that, in the early 1950s, there was a complex network of controls imposed on all external transactions between residents and non-residents, with the view to developing the domestic economy. External financing, therefore, was predominantly done through official flows made up of aids and grants from the 1950s to the 1970s. In the 1980s, a widening current account deficit, increasing financial requirements, and the diminishing role of official aid led to a shift in the policy choice towards commercial borrowings from international capital markets. External commercial borrowings (ECBs) were, however, regulated by an approval procedure subject to conditions on cost, maturity, end use, and ceiling. In the second half of the 1980s, financial institutions and public sector undertakings (PSUs) increased their participation in the international bond market, as a result of which the share of ECBs in net capital flows to India more than doubled to 27 per cent in the 1980s from that in the 1970s.

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The 1990s marked a regime shift in capital flows with private flows in the form of ECBs, which became the dominant flow of capital along with non-resident Indian (NRI) deposits and short-term trade credits. Policy changes in the 1990s were the result of the adoption of an overall macroeconomic stabilization and reform package in the aftermath of the balance of payment crisis of 1991. The major characteristics of this policy change are as follows: ■■ There was a hierarchy assigned to different kinds of flows with FDI being preferred in comparison to foreign portfolio investment (FPI). ■■ Within the hierarchy, there was a preference for inflows which were liberalized earlier and faster as compared to outflows. ■■ Restriction on capital inflows continued to exist and took the form of both quantity and price controls. Controls on outflows, however, were only quantity-based. Following the global financial crisis and consequent to downgrading of sovereign ratings, firms’ access to global markets virtually dried up. Due to the global financial crisis, the sensitivity of capital flows to financial shocks has been highlighted. As a result, the Reserve Bank of India (RBI) has adopted a policy of adjustment of interest rates on NRI deposits, relaxing the ECBs for corporates, allowing ECBs access to non-banking financial companies and housing finance and relaxation in interest rates for trade credit. Overall, there has been a prudent management of the capital account. Based on this, India’s foreign investment policy can be broadly classified into four phases:



1. Cautious non-discrimination in controls from 1948 to the mid-1960s 2. Selective restrictions and control from the mid-1960s to the end of the 1970s. During this period, the Monopolies and Restrictive Trade Practices Act (MRTP) (1969), the Foreign Exchange Regulation Act (FERA) (1973) and the Industrial Licensing Act (1973) were the main instruments of policy control. 3. Gradual and partial liberalization in the 1980s with special incentives for investment in exportoriented units. 4. Wide ranging liberalization since 1991, under which FDI up to 100 per cent is allowed under the automatic route in most activities, but some sectors have a ceiling on investment from the view point of financial stability or other domestic economy considerations.

Prior to the economic reforms in 1991, FDI in India was adversely affected by the following factors: ■■ The public sector was assigned a monopoly, or a dominant position, in the most important industries and, therefore, the scope of private investment, both domestic and foreign, was limited. ■■ When the public sector enterprises needed foreign technology or investment, there was a marked preference for foreign government sources, such as aid or loans. ■■ Government policy towards foreign capital was very selective. Foreign investment was normally permitted only in high-technology industries in priority areas, and in export-oriented industries. ■■ Foreign equity participation was normally subject to a ceiling of 40 per cent, although exceptions were allowed on merit. ■■ Payment of dividends abroad, repatriation of capital, as well as inward remittances were subject to stringent laws like the Foreign Exchange Regulation Act (FERA) of 1973, which discouraged foreign investment. ■■ Corporate taxation was high and tax laws and procedures were complex.

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Sectoral Dimensions of FDI Flows FDI is prohibited in the following activities/sectors: ■■ ■■ ■■ ■■ ■■ ■■ ■■ ■■

Retail trading (except single-brand product retailing) Lottery business including government/private lottery and online lotteries Gambling and betting including casinos Business of chit fund Nidhi company Trading in transferable development rights (TDRs) Real estate business or construction of farm houses Manufacturing of cigars, cheroots, cigarillos, and cigarettes of tobacco

Activities/sectors not opened to private sector investment include atomic energy and railway transport (other than mass rapid transport systems). Besides foreign investment, foreign technology collaboration in any form including licensing for a franchise, trademark or brand name, and management contracts are also completely prohibited for the lottery business, and gambling and betting activities. The sectoral dimensions of FDI flows provide important insights of sector-specific pull factors as well as industry-specific FDI policies and regulations. FDI in India has been concentrated in a number of sectors as discussed here: ■■ Unlike the dominance of manufacturing in East Asian economies, FDI in India is concentrated in the services sector. Information technology has enabled a greater growth potential and ­tradability of a number of business and professional services. With greater potential for growth of such services, FDI has emerged as a vehicle for cross-border delivery of services. ■■ Within the services sector, financing, insurance, real estate and business services have witnessed a large increase in their share in FDI flows to India between 2002–2003 and 2007–2008. Computer services have also remained a key sector for FDI as captive business process outsourcing (BPOs) or subsidiaries have been the principal mode of offshore delivery. ■■ The manufacturing sector which constituted about 50 per cent of total FDI in the 1990s, has witnessed a sharp fall in its share to about 19 per cent in 2007–2008. Although the growth of FDI in the manufacturing sector has remained steady, it is the rapid expansion of FDI in services that has resulted in the shrinking of its share in manufacturing. ■■ The construction sector has emerged as the next important sector attracting FDI with an average share of around 10 per cent during 2002–2008.

Geographical Composition The major geographical sources of FDI flows to India are Mauritius, the United States, the United Kingdom, Singapore, Germany, Japan, and the Netherlands contributing 71 per cent of total FDI during the 1990s. They continued to dominate FDI in India during the 2000s current decade as well, with a share exceeding 70 per cent; however, their shares have been volatile. For example, although FDI from Mauritius has dominated in volume since the 1990s, it has been fluctuating between 62 per cent and 49 per cent from 2007 to 2008. Table 12.1 shows FDI inflows to India from 1991–1992 till 2013–2014.

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Table 12.1  FDI Inflows to India 2010–11 Cumulative total (percentage of total inflows)

2013–14 Cumulative total (percentage of total inflows)

Country

1991–92 Cumulative total (percentage of total inflows)

2000–01 Cumulative total (percentage of total inflows)

Mauritius

62.3

44.1

41

36

United States

12.2

16.8

7

6

United Kingdom

1.5

3.2

6

10

Singapore

1.8

1.2

10

12

Germany

2.5

5.9

3

3

Netherlands

2.3

4

4

5

Japan

4.8

8.2

4

8

France

2.9

4.9

2

2

Others

9.7

11.7

23

18

100

100

Total

100

100

Source: Information from Department of Industrial Policy and Promotion, Ministry of Commerce and Industry, Government of India, ‘FDI Statistics’, available at http://dipp.nic.in/English/Publications/FDI_Statistics/FDI_Statistics. aspx, last accessed 20 July 2014. For 2013–14: http://dipp.nic.in/English/Publications/FDI_Statistics/2014/india_FDI_April 2014.pdf .

Outward Indian FDI OFDI from India is not a new phenomenon, although it has gathered steam in the last few years. The earliest examples of OFDI were investments by the Arvind Mafatlal Group in textiles in 1920, in a cottonspinning operation in Uganda. The Aditya Birla Group similarly invested in Africa in the 1950s and in Southeast Asia between 1965 and 1981. In the early 1960s, large Indian conglomerates such as the Tata Group and Kirloskar Brothers Limited expanded their activities into Africa and Sri Lanka and Ranbaxy set up its first joint venture abroad in Nigeria in 1977. These investments were, however, modest and hardly detectable in FDI statistics. In the late seventies and early eighties, there was a more perceptible increase in OFDI, but it was only with economic reforms in 1991 that OFDI from India picked up in earnest; and, since 2001, investment has surged. The growing competitiveness of Indian firms and their desire to venture abroad to access wider global markets, operate near client locations, and acquire technology, raw materials and brands are the key drivers pushing Indian firms to invest abroad. The significant policy changes that began in 2000, have contributed to the rapid expansion of OFDI from India. Subsequent to the phased liberalization in the regime for foreign investment, investment in joint ventures and wholly owned subsidiaries emerged as the key vehicles for facilitating global expansion by Indian companies. The existence of bilateral investment and double taxation treaties helped to increase the confidence of the Indian investing firm.

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The major policy initiatives responsible for increase in outward FDI are: ■■ Increasing permission to invest in joint ventures and wholly owned subsidiaries up to 400 per cent of capital by way of special-purpose vehicles. ■■ Permission for the swap of shares put under the automatic route, to hedge exchange risk on ­overseas investment and to invest in the financial sector subject to certain conditions. ■■ Permission to invest in the financial sector subject to certain conditions In terms of numbers, outward FDI from India touched a record high of USD 13 billion between April and December 2008. After reaching the historic high of USD 44 billion during the financial year 2010, India’s OFDI plummeted during the next two years, reaching USD 27 billion, owing to global financial crisis and its domestic economic problems. However during 2013–2014, investment activity showed moderate signs of recovery and were recorded at USD 36 billion, accounted for by 5128 Indian firms as against 4524 firms in 20103. While there had been waves of Indian OFDI in the 1980s, the OFDI of the 1990s was larger and more durable and included more industries and a broader selection of developing countries. Thus, the level of investment increased from an average of USD 5 million a year before 1991 to USD 132 million after 1991, and the stock of OFDI rose from an average of USD 95 million in 1980–1990 to USD 720 million in 1991–2000. The total number of approved OFDI projects was 2,562 in the 1990s, almost 11 times more than the number of projects approved in 1975–1990. In terms of location, a very significant shift took place as well. While 86 per cent of OFDI previously went to developing countries, this share fell to approximately 40 per cent during this period. Among the developed countries, it was particularly the United Kingdom and the United States that dominated. The last couple of years have seen developing economies again accounting for a majority of India’s investment, receiving about 60 per cent of the total outflows (UNCTAD FDI Statistics 2013)4. During the start-up phase, a very significant movement from manufacturing to services took place, in which manufacturing accounted for 65 per cent of equity and services for 33 per cent; this relation was almost reversed in the period between 1991 and 2000, so that services accounted for 59 per cent and manufacturing for 39 per cent. Investors in this phase of Indian OFDI went from escape and simple market-­seeking investments of the initial OFDI-phase to increasingly advanced market-seeking strategies, where firms were moving into developed countries to access markets and to access strategic assets in these countries.

C H A P T E R

S U M M A R Y

■■ FDI occurs when a firm invests directly in production or other facilities in a foreign country over which it has effective control. ■■ As a mode of foreign entry, FDI reflects the desire of a firm to utilize its competitive advantage for growth and profit through investment in foreign lands. ■■ The emergence of FDI flows between countries has benefits and costs for both the home and the host country. 3

Data complied from RBI: http://www.rbi.org.in/scripts/Data_Overseas_Investment.aspx. UNCTAD Bilateral FDI Statistics—India. http://unctad.org/en/Pages/DIAE/FDI%20Statistics/FDI-StatisticsBilateral.aspx.

4

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■■ FDI is classified according to three factors—asset creation or asset acquisition, nature of ­business activity, and motives driving the investment. ■■ Horizontal FDI takes place when a firm invests abroad in the same industry in which it operates in the home country. ■■ Horizontal FDI is a safe way to enter a foreign market because it produces the same product as the parent company, and so experience and infrastructure are easily shared. ■■ Vertical FDI refers to investment in activities along the firm’s existing supply chain to avail the benefits of vertical integration. ■■ Vertical FDI acts as an intermediary or finishing stage in the production process, offering either inputs to the parent or final access to a foreign market. ■■ Lastly, if the investment produces a product entirely unrelated to the parent’s products, it is a conglomerate FDI. ■■ FDI can be resource-seeking, market-seeking, efficiency-seeking, and strategic asset-seeking. ■■ FDI entry is of four types—branch offices, strategic alliances, wholly owned ­subsidiaries, and umbrella holding companies. ■■ There have been three waves of outward FDI from the developing world. The first wave was from the 1960s to the mid-1980s, the second wave was from the mid-1980s to the 1990s and the third wave was from the 1990s to the 2000s. ■■ With changes in policy since the 1990s, the Indian economy has contributed to both change in nature and magnitude of capital flows. Indian OFDI has increased substantially with Indian firms emerging as global gaints.

KEY Terms Greenfield investment, Merger, Acquisition, Brownfield investment, Horizontal FDI, Vertical FDI, Conglomerate FDI, Resource-seeking FDI, Market-seeking FDI, Efficiency-seeking FDI, Strategic asset-seeking FDI, Branch office, Strategic alliances, Wholly owned subsidiary, Umbrella holding company, FDI flows, Stock.

DISCUSSION QUESTIONS

1. 2. 3. 4.



5. 6. 7.



8.

Discuss the different forms that FDI activity can take. What are the different modes of entry for a firm undertaking FDI activity? Enumerate the basic features of the theories which explain FDI behavior. Distinguish between FDI theories for firms from developed and developing countries. To what extent are these theoretical explanations borne out by the experiences of real business? Discuss the effects of FDI on home and host countries. Explain the policy framework for FDI in the Indian context. ‘Liberalization of the economy has been a driving force for FDI flows in the Indian context’. Do you agree? Explain with reference to both policy and experience. Distinguish between: a. Horizontal and vertical FDI b. Market-seeking and strategic asset-seeking FDI c. Greenfield and brownfield investment d. Branch office and umbrella holding companies

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9. Briefly explain the policy and flow of outward FDI (OFDI) from India. 10. Write short notes on a. Indian joint ventures abroad [Delhi University, B.Com (Hons.) 2010] b. Indian joint ventures and acquisitions abroad [Delhi University, B.Com (Hons.) 2009] 11. What are the measures taken by the Government of India to promote FDI into India?  [Delhi University, B.Com (Hons.) 2011, 2008] 12. Write short notes on: a. Types of FDI b. Strategic alliances [Delhi University, B.Com (Hons.), 2014]

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13 INTERNATIONAL ORGANIZATION STRUCTURE AND DESIGN LEARNING OBJECTIVES After reading this chapter, you should be able to:

■ ■

Understand the evolution of organizational structures for a globalizing firm

■

List the determinants of a firm’s choice of organizational structure

Enumerate the basic characteristics of a global product structure, a global area structure, a matrix structure, and a transnational network structure

A CENTURY OF ChANGE ITC Limited was founded in 1910 as the Imperial Tobacco Company of India, a British-owned firm. The past century has witnessed its evolution from being a single-product company to one of the largest multi-business corporate enterprises in India, with a turnover of around USD 6 billion. Its diversified business includes five segments—fast moving consumer goods, hotels, paperboards, paper and packaging and agri business. The company’s non-tobacco businesses, including foods, personal care, hotels, paper, agriculture and information technology, currently account for around 40 per cent of its revenues. The process of transformation into a diverse and diversified multi-business enterprise has led to the emergence of a unique strategy of organization and governance based on the principles of distributed leadership. It has a three-tier governance structure, with the board of directors entrusted with strategic supervision, a corporate management committee with the responsibility of strategic management of the company, and divisional management committees for executive management of each business. This clarity in roles enables the top management to function with a venture capitalist mindset to optimize shareholder value through appropriate resource allocation across the portfolio. Source: Information from ‘History and Evolution’, available at http://www.itcportal.com/about-itc/itc-profile/ history-and-evolution.aspx, last accessed on 30th September 2013.

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INTRODUCTION An organization is a group of individuals who come Organizational structure refers to the formal together for the purpose of achieving a common objecarrangement of individuals, activities and relative through effectively coordinated collective activity. tionships to achieve a common goal. It helps to Organizational structure refers to the formal arrangeclearly determine formal power and authority ment of individuals, activities, and relationships to relationships, and is represented in the com­ pany’s organization chart. achieve a common goal. It helps to clearly determine formal power and authority relationships, and is represented in the company’s organization chart. Once an organization decides to go international, it must begin to implement the decision by incorporating changes in its organizational structure. This needs a reconfiguration of the firm’s structure and strategy according to its planned dispersal of global activities. The firm needs to strategically plan this change and analyse the strengths and weaknesses of its internal and external environment. According to the traditional theory of firm internationalization a firm begin its foreign market activity with sales through a third party. The path of internationalization usually begins with shipping of goods to a foreign market and having a third party handle sales activities. As the firm’s international market begins to grow, it may need to review this strategy and decide whether to play a more active role in the distribution and sale of its products. As this happens, the company’s organization structure and strategy will change. Multinational enterprises cannot implement their strategies without an effective structure. The ­strategy indicates the firm’s plan of action, but the structure is critical in ensuring that the desired goals are met efficiently. There are a number of choices available to a transnational corporation (TNC) in deciding on an organizational arrangement, and a number of factors influence this choice. For example, firms that are just getting into the international arena are likely to choose a structure that differs from that of firms with seasoned overseas operations. Conversely, companies that use their structures as worldwide sales organizations will have a different arrangement from those that locally manufacture and sell goods in various international markets. International structures will change according to the firm’s strategic plan and, if a structure is proving to be unwieldy or inefficient, it will be scrapped in favor of one that addresses these problems. This chapter examines some of the most common organizational arrangements used by TNCs.

EARLY ORGANIZATIONAL STRUCTURES When a company first begins international operations, its foreign operations usually are extensions of domestic operations. A domestic firm begins its life as a small organization with a structure based on functional division of activities such as production, marketing and sales, which is coordinated by top management. Decision-making in such an organization is usually centralized. Its decision to tap the international market has an ethnocentric orientation (based on its home market activities), as its primary focus continues to be the local market, with international involvement getting secondary importance. International transactions are conducted on a case-by-case basis, and there is no attempt to consolidate these operations into a separate department. Under this arrangement, international sales are viewed as additional income which supplements the earnings from home-country operations. As international operations increase, however, a TNC makes structural changes to address this growth. It usually begins by diversification of its existing product portfolio into different markets. For instance, Dutch TNC Koninklijke Philips Electronics N.V. (more popularly known as only Philips) began life as a lighting company but gradually diversified into consumer electronics, industrial electronics, and medical systems. Similarly Indian IT major Wipro began life as an oil company and has since diversified into

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Chief Executive Officer

Vice President Production

Vice President Marketing (b)

Vice President Personnel

Vice President Finance

(a) Head of export

Export marketing staff

Administration

Distribution

Overseas representatives

Figure 13.1  Export Department Structure various other fields of activity including IT. As a first step, a TNC establishes a separate marketing department to handle international sales, and all overseas operations are coordinated through this. This helps the company to develop marketing specialists who learn the specific needs and ­marketing techniques to employ in overseas selling. Alternatively, the firm sets up a separate export department that reports directly to the chief executive officer (CEO) (Figure 13.1, line [a]) or it may be a sub-department within the marketing area (Figure 13.1, line [b]). If the department operates independently of the marketing department, it is either staffed by in-house marketing people whose primary focus is on the international market or it is operated by an outside export management company that is hired for the purpose of providing the company with an international arm. Whichever approach is taken, it is important to realize that TNCs planning to increase their international presence must ensure that the export department is a full-fledged marketing department and not just a sales organization. Another possible arrangement is the establishment of overseas subsidiaries (see Figure 13.2) to manage individual ventures in different geographies of the world. In this arrangement, the head of the venture has a great deal of autonomy and reports directly to the CEO. Chief Executive Officer

Vice President Production

Vice President Marketing

Vice President Personnel

Vice President Finance

Independent overseas subsidiaries

Korea

Australia

Hong Kong

Great Britain

Figure 13.2  Structure of Overseas Subsidiaries

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Increasing involvement in foreign markets leads the TNC to discard the export department structure or subsidiary arrangement and adopt more evolved and sophisticated structures in tandem with joint ventures and FDI as the mode of operation.

INTERNATIONAL DIVISION STRUCTURE The international division structure handles all the international operations of a business firm (see Figure 13.3). For instance, as Philips grew in size and products, coordination and control became difficult within the functional framework. The firm therefore switched to a product-divisional structure, where each product division is set up as a self contained autonomous unit responsible for a distinct product line. This structure has a number of advantages. ■■ It reduces the CEO’s burden of directly overseeing the operations of overseas subsidiaries along with domestic operations. ■■ It raises the status of overseas operations to that of the domestic divisions. There is greater clarity and transparency in the flow of all information, authority and decision-making related to external operations, and the division becomes the single central clearing point for all international activities. ■■ This structure also helps the TNC to develop a cadre of internationally experienced managers. However, the international division structure also has some significant drawbacks. ■■ It leads to the creation of rivalries between the domestic and international division as the dual structure faces problems of coordination and control. The head of the international division is

Chief Executive Officer Home office departments Production

Marketing

Personnel

Finance

Operating divisions Domestic division Machinery

Domestic division Tools

Korea

Domestic division Electronics

Domestic division Computers

Germany

International division

Spain

• Office operations • Marketing • Government relations

Figure 13.3  International Division Structure

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usually considered to be at the second tier of the organizational hierarchy, with less authority and decision-making power than his domestic counterparts. ■■ There is also a lack of coordination between domestic and foreign operations as these are isolated from each other in the organizational hierarchy. This becomes an obstacle in the ability of the firm to reap the benefits of experience and scale economies that may arise out of global production.

187

Bird’s-eye View A firm’s organization structure changes with the scale and scope of its international business operations. This leads to the organization structure adding an export division in the initial stages of internationalization, followed by an international division structure and finally a global structure to suit its global operations.

GLOBAL ORGANIzATIONAL STRUCTURES As a result of these drawbacks, as firms continue their international expansion they adopt one of the global structures identified below. As the international orientation of the TNC becomes more global and begins to generate more and more revenue from its overseas operations, its strategies become more global in focus, and the structures used to implement these strategies also change. Organizations making the changeover do so for the following reasons: ■■ They are better able to develop competitive advantages to face growing competition. ■■ It leads to the benefits of lower costs as a result of global product standardization. ■■ It leads to a more optimum allocation of company resources and enables transfer of technology. There are six basic types of global structures—global product, global area, global function, mixed, matrix, and transnational network.

Global Product Structure A global product structure is a. structural arrangeA global product structure is a structural arrangement in which domestic divisions are given worldment in which domestic divisions are given wide responsibility for product groups. It is adopted worldwide responsibility for product groups. by firms that have a reasonably diversified product portfolio and were organized along product division lines even as domestic companies. Figure 13.4 ­provides an example. Just like in domestic divisions, international divisions are also autonomous, self-contained units responsible for their profits. In this arrangement, each product division sells its output throughout the world. As seen in the case of Product Division C, the European group operates in a host of countries. The same would be true for the other four geographic areas noted in Figure 13.4. In each case, the manager of the product division would have internal functional support for the entire product line. All production, marketing, personnel and finance activities associated with Product C would be under the control of this individual. In recent years, Procter & Gamble Co. has used this arrangement to market its wide assortment of products from paper goods to beauty care, and Ford Motors has worked to establish a single automotive operation that relies on a global product structure. This arrangement employs a product division structure that relies on the ‘profit centre’ concept. Each product line is expected to generate a predetermined return on investment (ROI), and the performance of each line is measured on this profit basis. Each product line is also operated like an autonomous

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Chief Executive Officer Home office departments Production

Personnel

Marketing

Finance

Operating divisions Product division A

Product division B

Product division C

Product division D

North America

South America

Europe

Ausralia

Product division E

Far East

Production Marketing Personnel Finance Great Britain

Germany

Spain

Portugal

France

Netherlands

Belgium

Figure 13.4  Global Product Structure

business, with the product division manager given a great deal of authority with regard to how to run the operation. As long as the product line continues to generate the desired ROI, the division is usually allowed to operate without any interference by home management controls. The only major exception is budgetary constraints that are imposed by central management from the home country. There are a number of benefits associated with a global product division structure. ■■ If the firm produces a large number of diverse products, the structure allows each major product line to focus on the specific needs of its customers. This would be particularly difficult to achieve if the company were trying to sell all these products out of one centralized marketing department. ■■ This approach also helps to develop a cadre of experienced, well-trained managers who understand a particular product line. ■■ It helps the company to match its marketing strategy to the specific needs of the customer and the stage of life the product is in. For example, in some areas of the world a product may be in the introduction stage, while in other areas it may be in the growth, maturity or decline stage. These differing life cycles require close technological and marketing coordination between the home market and the foreign market, and this can be best achieved by a product division approach. ■■ The product structure also helps the organization to establish and maintain the necessary link between the product development people and the customer. Continuous feedback from the field to the home office ensures that the product division personnel have new product offerings that are able to meet consumer needs.

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189

At the same time, there are drawbacks to the product division arrangement. ■■ It becomes necessary to duplicate facilities and staff personnel within each division. ■■ Products that sell well are often given primary attention and those that need special handling or promotion are often sidetracked, even though this may result in the long run loss of profit. ■■ An effective product division requires managers who are knowledgeable about the worldwide demand for their products. Most managers know the local market but do not know a lot about international markets. So it takes time to develop the necessary managerial staff to run this type of structure. ■■ A further shortcoming is the difficulty of coordinating the activities of different product divisions. For example, the electronics division may decide to subcontract components to a plant in Germany, while the computer division is subcontracting work to a firm in France. If the two divisions had coordinated their activities, it might have been possible to have all the work done by one company at a lower price. ■■ Finally, lack of cooperation among the various product lines can result in lost sales, given that each division may have information that can be of value to the other. However, because of the profit centre concept, each product line operates independently, and communication and cooperation are downplayed, if not discouraged.

Global Area Structure A global area structure is organized on the basis of A global area structure is one in which primary geography. Under this structure, the primary operaoperational responsibility is delegated to area tional responsibility is delegated to area managers, managers, each of whom is responsible for a each of whom is responsible for a specific geospecific geographic region. graphic region. It is usually adopted by firms with a low degree of diversification and a domestic structure organized along functional lines. In this polycentric (host-country-oriented) structure, the area manager reports directly to the CEO. Figure 13.5 provides an example of this. Under this arrangement, each regional division is responsible for all functions within its area, that is, production, marketing, personnel, and finance. Operational authority and strategic decision-making are decentralized to individual area managers, but overall strategic direction and financial control remains with the headquarters. Although there appears to be some structural similarity between a global area and a global product arrangement, they operate in very different ways. With a global product arrangement, each product division is responsible for its output throughout the world. With a global area structure, on the other hand, the individual product lines are subsumed within each of the geographic areas. So the manager in charge of Belgian operations, for example, will be responsible for each of the product lines sold in that region. Suitability of Structure The global area structure is suitable in a number of areas. ■■ A global area structure is commonly used by TNC s that are in mature businesses. ■■ It is also used by firms with diverse products that have different product requirements, competitive requirements and political risk. Consumer products like food items and pharmaceuticals are a good example of these. For instance, in the United States, soft drinks have less sugar than in

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Chief Executive Officer Home office departments Production

Personnel

Marketing

Finance

Operating division North America

South America

Europe

Ausralia

Far East

Production Marketing Personnel Finance Great Britain

Product division A

Germany

Spain

Product division B

Portugal

France

Product division C

Netherlands

Product division D

Belgium

Product division E

Figure 13.5  Global Area Structure

India, so the manufacturing process must be slightly different in these two regions. Similarly, in England people prefer bland soups, but in France the preference is for mildly spicy ones and in India the spice level has to be much more. In Turkey, Italy, Spain and Portugal people like dark, bitter coffee; Americans prefer a milder, sweeter blend. In northern Europe, Canada and the United States people prefer less spicy food; in the Middle East and Asia they like more heavily spiced food. Cereal-maker Kellogg’s discovered that in India even cornflakes had to be fruitflavored to suit the traditional taste buds. ■■ The global area structure works well where economies of scale in production require a regionsized unit for basic production. For example, by setting up operations in the EU, a US company is able to achieve production cost advantages that would not otherwise be possible. ■■ It is also suitable for firms where the product has a rather low, stable technological content, but which requires strong marketing ability. Advantages: The advantages of the global area structure are: ■■ The global area structure provides division managers with the autonomy to make rapid decisions that depend on local tastes and preferences. ■■ As a result of this, the firm is more responsive to the local market. ■■ The company also gains a wealth of experience regarding how to satisfy these local tastes and, in the process, often builds a strong competitive advantage. ■■ Finally, under this structure the company can eliminate costly transportation associated with importing goods produced overseas.

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Disadvantages: The disadvantages of the global area structure are: ■■ Under the area structure the product must be adapted to local tastes, which means that the usual product emphasis in a company must be a part of the company’s geographic orientation and the authority of the area managers. ■■ Another shortcoming with this organizational structure is the expense associated with duplicating facilities. Each division has its own functional areas and is responsible for both production and marketing. Since production efficiency is often based on the amount of output, small plants are usually less efficient than large ones. ■■ Companies using a global area division structure also find it difficult to coordinate geographically dispersed divisions into the overall strategic plan. ■■ Quite often international cooperation and synergy among divisions end up being sacrificed. ■■ Finally, companies that rely heavily on R&D to develop new products often find that the global area divisions do not readily accept these offerings. This is because each group is trying to cater to the specific needs of its current market, and new products often require modification to meet the needs of these local customers. Research shows that division managers prefer to sell products that have already been accepted by the market and are reluctant to take on new, untried products. Unfortunately, since most products have fairly short life cycles, this attitude is potentially dangerous to the long-term success of the TNC, and the home office must continually fight this ‘anti-new product’ drift.

Global Functional Structure A global functional structure is one that is built around the basic functional tasks of the organization. For example, in manufacturing firms, production, marketing and finance are the three primary functions that must be carried out for the enterprise to survive. Figure 13.6 shows such an arrangement.

A global functional structure is one that is built around the basic functional tasks of the organization.

Chief Executive Officer

Production

Finance

Marketing

Domestic production

Foriegn production

Domestic production

Foriegn production

Product A Product B Product C Product D

Product A Product B Product C Product D

Product A Product B Product C Product D

Product A Product B Product C Product D

Figure 13.6  Global Functional Structure

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Here the head of the production department is responsible for all domestic and international manufacturing. Similarly, the head of marketing is responsible for the sales of all products both in the domestic and foreign market. This structure is most commonly used by TNCs that have a narrow product line which has reached a stable plateau of global coverage and a level of demand that does not face major changes in a competitive attack. Advantages: The advantages of the global functional structure are: ■■ The primary advantage of the global functional structure is that it allows a small group of managers to maintain control over a wide-reaching organization. ■■ There is little duplication of facilities. ■■ Finally, the structure allows tight, centralized control. Disadvantages: The disadvantages of the global functional structure are: ■■ It can be difficult to coordinate the production and marketing areas as each operates independently of the other. This can be particularly troublesome if the TNC has multiple product lines. Responsibility for profits rests primarily with the CEO because there is little diffusion of operating authority far down the line. ■■ Researchers have found that the global functional arrangement is most common among raw materials extractors with heavy capital investment, oil-refining companies and aircraft manufacturers. Energy firms also use it. However, this is not a structure that suits many other kinds of businesses.

Mixed Structure A mixed structure is a hybrid organization design The mixed structure is a hybrid organization that combines structural arrangements in a way that design that combines structural arrangements best meets the needs of the enterprise. Figure 13.7 in a way that best meets the needs of the provides an illustration. Different businesses with enterprise. different patterns of global demand, supply and competition demand different management structures. However, sometimes the mixed structure is a temporary one, and the organization opts for a more common form (global product, area or functional) after a year or two. In other cases, the structure remains in place indefinitely or a new mixed structure replaces the old one. The primary advantage of this organizational arrangement is that it allows the enterprise to create the specific types of design that best meets its needs. On the other hand, the arrangement sometimes is so flexible and different from anything the enterprise has used previously that personnel have trouble operating efficiently. It is often seen that when a TNC acquires another firm with distinct products and a functioning marketing network, the newly acquired firm may be incorporated as a product division even though the rest of the firm is organized on a regional basis. Problems emerge with communication flows, chains of command and groups going their own way. In deciding whether or not to use the mixed structure, TNCs must carefully weigh the benefits and drawbacks. Sometimes these firms will also have subsidiaries or affiliates that are integrated into the overall structure. For example, Mitsubishi has 28 core groups that are bound together by cross-ownership and other financial ties, interlocking directorates, long-term business relationships, and social and historical ties. Among these are The Bank of Tokyo-Mitsubishi UFJ; Mitsubishi Heavy Industries, Ltd;

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Chief Executive Officer Home office departments

Production

Marketing

Area President North America

Subsidiary Head 1

Subsidiary Head 2

Finance

Personnel

President Product A Worldwide except North America

Subsidiary Head 1

Subsidiary Head 2

President Product B Worldwide except North America

Subsidiary Head 1

Subsidiary Head 2

Figure 13.7  Mixed Structure

Asahi Glass Co., Ltd, Tokyo Marine & Nichido Fire Insurance Co., Ltd, Nikon Corporation and Kirin Brewery Company, Ltd. The Mitsubishi group obviously needs a carefully designed global structure that allows it to integrate and coordinate the activities of these many businesses. Sometimes this undertaking involves more time and effort than the formulation of the strategic plan.

Matrix Structure A matrix structure is a geocentric organizational A matrix structure is a geocentric organizational arrangement that blends two organizational arrangement that blends two organizational responsibilities such as functional and product responsibilities such as functional and product structures or regional and product structures. It structures or regional and product structures. It attempts to combine product, regional and funcattempts to combine product, regional and functional expertise while maintaining clear lines of tional expertise while maintaining clear lines of authority. authority. The functional emphasis provides attention to the activities to be performed, whereas the product emphasis provides attention to the good that is being produced. This structure is characterized by a dual command s­ ystem—for instance, a functional area manager, such as from marketing, has a multiple reporting relationship. He will report to his area manager in his geography and to an international or worldwide marketing manager at headquarters. This helps the organization to develop a geocentric attitude. Figure 13.8 illustrates a geocentric matrix structure. There are three types of managers in this geocentric matrix structure—regional managers, product managers, and matrix managers.

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Regions Products

Country A

Country B

Country C

Product 1 Product 2 Product 3

Figure 13.8  Geocentric Matrix Structure

1. Regional managers are charged with business in their markets. Budgets for these operations include selling any of the products made by the TNC, subject to the decision of each regional manager. These regional managers have a polycentric focus. 2. Product managers are responsible for coordinating the efforts of their people in such a way as to ensure the profitability of a particular business or product line. These managers have an ethnocentric attitude. 3. The matrix managers are responsible to both regional and product managers; they have two bosses. Figure 13.9 also depicts a matrix structure. The matrix design in Figure 13.9 is more complex than that in Figure 13.8, as it has three dimensions. It illustrates how the matrix organizational arrangement can be used to coordinate and manage wide-reaching international operations. Resource managers are charged with providing the people for operations, whereas business managers are response business managers are concerned with outputs. At the bottom of Figure 13.9 there are functional specialists from such areas as marketing, manufacturing and research. Individuals from each of these areas are assigned to each of the company’s nine businesses. In turn, these nine profit centres operate in five different areas of the world, including the United States, Europe and Asia. Each business is run by a business board that (although not shown in Figure 13.9) reports to senior-level management. The matrix design in Figure 13.9 is sometimes referred to as a three-dimensional model because, when it is drawn, it has width, height and depth. Additionally, it is interesting to note that this multidimensional matrix addresses three major areas: function, product and geography. So the structure is really a combination of some of the designs discussed earlier. The matrix structure is found in large TNCs such as Nokia Corporation (Finland), which has a structure comprising four business groups—mobile phones, multimedia, networks and enterprise solutions—and two functional divisions—customer and market operations, and technology platforms. Similarly, the British oil major BP is organized as a matrix for coordinating the efforts of these people to make profits for the product line. The resource managers are concerned with inputs; the on three businesses (spread over Europe, the Americas, Africa, the Middle East, Russia, the Caspian, Asia, the Indian subcontinent, and Australasia) and ten functional groups. Advantages: The advantages of the matrix structure are: ■■ One of the major advantages of the multinational matrix is that it forces management to address more than one primary area of consideration. ■■ Decision-making is subject to the consensus of two or three managers, leading to diverse ­perspectives and a broad viewpoint.

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Function cost centres es

ntr

e it c

f

pro

Business cost centres

a Are

Business A

Business managers

Business B Business C Business D Business E Business F Business G

Asia Australia South America Europe United States

Business H Business I Cost centres Mktg. Mfg.

Res. TS&D Eval./Cont.

Resource managers

Figure 13.9  Multinational Matrix Structure

Disadvantages: The disadvantages of the matrix structure are: ■■ The complexity of the design and the use of dual command can result in confusion regarding what everyone is responsible for doing and to whom one reports on various matters. There are considerable delays in decision-making and coordination. ■■ A large number of meetings and discussions often result from the efforts to coordinate a variety of different groups, each with its own agenda. Decision-making is subject to the consensus of two or three managers, leading to less than optimum compromises, delayed responses and power politics. ■■ It often takes time for managers to learn to operate in a matrix structure and, if the enterprise has rapid turnover, there is always a significant portion of the personnel who do not fully understand how to function effectively in this environment. ■■ The matrix structure is seldom the first choice of TNCs. The design typically evolves gradually as the organization realizes that other structural designs are not adequate. However, some companies have abandoned the matrix structure. Skandia, the Swedish insurance firm, for example, has scrapped its matrix design and moved back to a more classical organizational arrangement. As with mixed structures, the matrix is sometimes a temporary arrangement as

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the enterprise searches for some hybrid design that will help it to operate more efficiently in the international arena.

Transnational Network Structure One of the newest forms of international organizaThe transnational network structure combines tional arrangements to emerge is the transnational elements of functional, product and geographic network structure, which is designed to help TNCs designs, while relying on a network arrangement take advantage of global economies of scale while to link the various worldwide subsidiaries. also being responsive to local customer demands. This structural design combines elements of functional, product and geographic designs, while relying on a network arrangement to link the various worldwide subsidiaries. At the centre of the transnational network structure are nodes, which are units charged with coordinating product, functional and geographic information. Different product group units and geographical area units have different structures depending on what is best for their particular operations. A good example of how the transnational network structure works is provided by Philips, which has operations in more than 60 countries and produces a diverse product line ranging from light bulbs to defense systems. In all, the company has six product divisions with a varying number of subsidiaries in each, and the focus of the latter varies considerably. Some specialize in manufacturing, others in sales; some are closely controlled by headquarters, others are highly autonomous. The basic structural framework of the transnational network consists of three components— dispersed subunits, specialized operations and interdependent relationships. 1. Dispersed subunits are subsidiaries that are located anywhere in the world where they can ­benefit the organization. Some are designed to take advantage of low factor costs, while others are responsible for providing information on new technologies or consumer trends. 2. Specialized operations are activities carried out by subunits that focus on particular product lines, research areas and marketing areas, and are designed to tap specialized experBird’s-eye View tise or other resources in the company’s worldwide subsidiaries. TNCs can have six different global structures 3. Interdependent relationships are used to depending on a host of different factors. These share information and resources throughout structures may be the global product, global the ­dispersed and specialized subunits. area, global functional structure, mixed strucThe transnational network structure is diffiture, matrix structure and the transnational cult to draw in the form of an organization chart network structure. because it is complex and continually changing.

Determinants of the Organization Structure Research has shown that effective organizations follow the rule ‘from strategy to structure’. They begin by formulating a strategy, and only then design a structure that will efficiently implement this plan. In determining the best structure, three questions must be answered:

1. Can the company operate efficiently with domestic divisions or are international divisions also necessary?

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2. On what basis should the organization be structured: product, area, function, mixed or matrix? 3. How can the necessary coordination and cooperation be most effectively achieved?

These answers are usually determined on the basis of an analysis of five key variables that help a firm to decide between alternative organizational structures. In some cases, one of these variables will prove to be more important than the others, and the structure will be designed to accommodate this one. In most cases, however, there are three or four interacting variables that the structure must address. Scope of Foreign Operations The first decision variable is the extent of present and projected foreign operations of the TNC. For instance, if the firm’s current foreign operations are an insignificant proportion of its total operations, an export department may be sufficient. However, if the firm anticipates significant growth in the next few years, it may consider adopting an international division of other global structures. Past History and Experience The firm’s choice of structure should also be determined by its past history and experience in the international arena. If the firm has done very little business abroad, it is likely to choose a simple structure that is easy to understand and control. If the company has been doing business overseas for many years, it will probably have experienced managers who can work well in a more sophisticated structure, and so it may choose a mixed design or a matrix. Business and Product Strategy A third area of consideration is the company’s business and product strategy. If the company offers a small number of products and there is little need to adapt them to local tastes, a global functional structure may be the best choice. On the other hand, if the products must be tailored for local markets, a global product arrangement will usually be more effective. If the company is going to be doing business in a number of diverse geographic areas, a global area structure will typically be used. The Coca-Cola Company, for example, has this organizational arrangement by putting new managers into positions overseeing operations in Europe and Asia in an effort to improve sales growth in these regions. Operating Philosophy A fourth influencing variable is management’s philosophy of operating. If the company wants to expand rapidly and is prepared to take risks, the firm will choose a structure that is quite different from that used by a TNC that wants to expand slowly and is conservative in its risk-taking. Similarly, if the home office wants to keep a tight rein on operations, it will not use the same structure as a firm that gives local subsidiaries autonomy and encourages them to make decisions about how to keep the unit competitive at the local level. French and German subsidiaries, for example, tend to be more centralized than US units. There are also differences in the way operations are controlled. For example, Japanese TNCs like to use face-to-face, informal controls, while US multinationals prefer budgets, financial data and other formalized tools. Organizational Flexibility A final key variable is the enterprise’s ability to adjust to organizational changes. Increasing global sales and commitment requires continuous modifications in structure. For example, when the company

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is small, the domestic divisions will dominate. As the international side of operations grows, the managers of the domestic divisions will have to give up some of their authority and influence. If they are unable or unwilling to do this, the structure will be affected. Similarly, if international execuBird’s-eye View tives begin gaining greater authority and there is a need to revamp overseas operations, their willingA TNCs choice of organizational structure ness to adjust to organizational changes will affect depends upon the scope of its foreign operathe structure. In some cases, TNCs have found that tions, past history and international market overseas managers, just like their domestic counexperience, business and product strategy, operterparts, build small empires and often are unwillating philosophy and organizational flexibility. ing to give up this power.

C H A P T E R

S U M M A R Y

■■ Organizational structure refers to the formal arrangement of individuals, activities and relationships to achieve a common goal. It helps to clearly determine formal power and authority relationships and is represented in the company’s organization chart. ■■ As firms move on the path of internationalization they need to modify their organizational structure to meet the demands of their new operating environment. ■■ At initial stages of internationalization, a firm establishes an independent export department or as a part of the marketing department. As the next step, it establishes an independent international division. ■■ As the firms orientation changes from being ethnocentric and polycentric to geocentric it moves towards global structures based on either product or geography and later towards more complex structures such as the matrix or the transnational network structure. ■■ A global product structure is a structural arrangement in which domestic divisions are given worldwide responsibility for product groups. The structure allows each major product line to focus on the specific needs of its customers; to develop a cadre of experienced, well-trained managers who understand a particular product line; and helps the company to match its marketing strategy to the specific needs of the customer and the stage of life the product is in. ■■ A global area structure is one in which primary operational responsibility is delegated to area managers, each of whom is responsible for a specific geographic region. It is suitable for TNCs that are in mature businesses, with diverse products that have competitive requirements. ■■ A global functional structure is one that is built around the basic functional tasks of the organization. Commonly used by TNCs that have a narrow product line with a stable plateau of global coverage, its main advantage is it allows a small group of managers to maintain tight, centralized control over a wide-reaching organization. ■■ A mixed structure is a hybrid organization design that combines structural arrangements in a way that best meets the needs of the enterprise. Its primary advantage is that it allows the enterprise to adopt a design that best meets its needs. However, the arrangement is sometimes so flexible and different from anything the enterprise has used previously that personnel have trouble operating efficiently. ■■ A matrix structure is a geocentric organizational arrangement that blends two organizational responsibilities such as functional and product structures or regional and product structures.

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■■ The transnational network design combines elements of functional, product, and geographic designs while relying on a network arrangement to link various worldwide subsidiaries. It is designed to help TNCs take advantage of global economies of scale while also being responsive to local customer demands. ■■ The evolution of the organizational structure is determined by the degree of internationalization of the firm, its projected growth, its risk-taking propensity and flexibility to adapt to organizational change.

KEY TERMS Organizational structure, Global product structure, Global area structure, Global functional structure, Mixed structure, Matrix structure, Transnational network.

DISCUSSION QUESTIONS

1. What is the importance of organizational structure in international business? 2. What are the main strengths and weaknesses of the creation of an international division as part of a company’s organizational structure? Under what circumstances is the use of such a structure appropriate for a firm? 3. Compare and contrast the geographic and product structure for use in international business. 4. It is usually said that the formulation of new strategies, causes management to change its ­organizational structure. Is the reverse also possible? 5. Distinguish between: a. Global product structure and global area structure b. Global functional structure and global area structure c. Global product structure and global functional structure d. Matrix structure and transnational network structure

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14 INTERNATIONAL MARKETING LEARNING OBJECTIVES After reading this chapter, you should be able to:

■ ■

Understand the differences between domestic and international marketing

■ ■ ■

Identify the issues in a global marketing mix and problems in its standardization

Describe the advantages and disadvantages of a standardized, global approach to marketing against an adapted, differentiated approach Discuss the different promotional strategies for the international market Explain the distribution strategies of global marketers

STARBUCKS COFFEE COMPETES WITH LOCALLY BREWED KAAPI Starbucks is India is an equal joint venture between Starbucks Coffee Company and Tata Global Beverages. The first Starbucks store opened in Mumbai in 2012 and marked its half century—the 50th store with a Chennai opening in July 2014. Its stores boast of expresso coffee ‘grown in India for India’ and finds all its brew competitively priced against other coffee chains. Chennai in Tamil Naidu may well be considered the coffee capital of the country as it accounted for almost 40 per cent of the national coffee consumption of 90,000 tonnes in calendar year 2013. Starbucks in Chennai will therefore face stiff competition from traditional low priced outlets such as Madras Coffee House, Sarvana Bhavan and the various Kumbakonam degree coffee outlets all over the city, alongside vying for space with upmarket rivals such as Cafe Coffee Day, Costa Coffee and Gloria Jean’s. Penetrating the market of coffee connoisseurs will certainly not be easy and Starbucks in Chennai definitely has an uphill task!! Source: http://articles.economictimes.indiatimes.com/2014-07-08/news/51191656_1_costa-coffee-cafe-coffeeday-starbucks-coffee-company, http://www.livemint.com/Industry/LI85XqTas9YKRKSsssazvK/Starbucks-opensits-first-store-in-India.html, last accessed on 21st July 2014.

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INTRODUCTION The earliest ideas on exploring the international market came from Theodore Levitt in 1983, in an article titled ‘The Globalization of Markets’. Levitt explained that technological advances in communication, transportation and travel have made cultural differences insignificant and the consumer all over the world only wants the best that is available. A homogenization of tastes and preferences ensures that ‘everywhere everything gets more and more like everything else’. He used the examples of CocaCola and Pepsi as globally standardized products sold everywhere and welcomed by everyone. Both succeeded across multitudes of national, regional and ethnic taste buds trained to a variety of deeply ingrained local preferences of taste, flavor, consistency, effervescence and aftertaste. Levitt’s ideas became the basis for TNCs to develop advanced, functional, reliable and standardized products, at the right price, on a global scale. There is a global convergence of taste visible in marketing functions of brands like Gillette. During the 1970s, Gillette had multiple campaigns for its diverse markets. Its most recent product, Sensor, is now being pushed worldwide under the promotion ‘The best a man can get.’ Its world promotion is expected to be completely in place within two years, whereas in the past it was not uncommon for the promotion of one product to take more than five years to launch in Europe alone. In particular, large TNCs, recognizing the convergence of the culture of capitalism, are reaping the rewards through largescale economies and quick market penetration. The moot question that arises, therefore, is concerned with the issue of globalization versus localization in the arena of international marketing. This chapter examines the issue in the context of increasing interconnectedness of markets and a convergence of global tastes and preferences.

INTERNATIONAL MARKET ASSESSMENT The first step in international marketing strategy is market assessment, an analysis of total m ­ arket potential through an evaluation of goods and s­ ervices that can be sold in it. This is followed by developing an appropriate marketing mix to meet that potential. In this context, a firm should examine three basic market indicators:

Market assessment is an analysis of total market potential through an evaluation of goods and services that can be sold in it.

1. Market size is the relative size of the market compared to the total world market. This is usually a function of the population of the country and the purchasing power of its citizens. 2. Market intensity is the degree of purchasing power in terms of per capita income as well as propensity to purchase and buying patterns. 3. Market growth is the propensity for growth based on the above features as well as economic development and infrastructure. Potential markets may be gauged by the current imports, demographic profiles and changing political and economic conditions. In this context, the break up of socialist economies and the move to a marketbased system in much of the developing world has been a marketing and sales opportunity for many TNCs. The opening vignette clearly explains how Marico initially targeted the Middle East markets due to the demand for its hair oil in the expatriate Indian community.

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Forecasting market demand can be an uncertain proposition, as luxury car maker BMW ­discovered in Korea. It had estimated that there would be few buyers for a convertible, but when it launched the 3-Series convertible, it sold 500 convertibles in the first year. In a fast changing world, there are no given patterns and therefore predictions are hard to make. The next step is to examine the financial aspects of the potential markets. This includes factors such as the cost of setting up (rentals, availability of finance, interest rates, etc.), the income distribution of the consumer and buying habits. The existence of entry barriers, limits on ownership and rules regarding remittance of profits are other factors to be considered. Legal rules regarding protection of patents, trademarks and copyrights similarly have a bearing on decisions regarding potential markets.

THE MARKETING MIX The marketing mix refers to a set of strategy decisions made in the areas of product, promotion, ­pricing and distribution to meet consumer needs in a target market. Also known as the 4Ps, it basically pertains to:

1. 2. 3. 4.

How to develop the firm’s products? How to price these products? How to sell (promote) these products? How to distribute (place) these products to consumers?

The marketing mix refers to a set of strategy decisions made in the areas of product, promotion, pricing and distribution to meet consumer needs in a target market.

Product, place, promotion and price—the 4Ps of marketing—are collectively known as the marketing mix.

In the context of the TNC, it is important to distinguish between marketing standardization and marketing adaptation of the marketing mix. Standardization refers to the use of the same marketing mix in all world markets, whereas marketing adaptation refers to local responsiveness, that is, changing a part or all of the marketing mix according to conditions in various local markets. A globally standardized marketing mix has many advantages for an international company. If a firm could export a standard domestic product, it would be able to avail economies of scale arising out of production as well as out of its own learning curve. Similarly, if the firm has a product or service that is homogeneous and consistently used around the globe, a single advertising message can convey its attributes in spite of cultural and national differences. Standardization of advertising campaigns, promotional materials and sales, as well as art work is a huge saving in costs. The efficiencies achieved by global marketing can be translated into cost savings that lead to lower prices for customers that, in turn, give the global marketer a competitive advantage. Despite these advantages, firms often find it necessary to modify their existing marketing mix or develop a new one. The extent of change depends on a host of factors including the type of product, the firm’s cultural environment and the degree of market penetration that is considered desirable. The marketing mix for products such as steel, chemicals, petroleum, cement, agricultural equipment, computers, electronic instruments, pharmaceuticals and telecommunications equipment are generally standardized. Consumer products such as Coca-Cola, McDonald’s burgers, Levi’s jeans and MTV also have a mass appeal and global usage across different cultures and countries, but undergo adaptation to suit local taste. Take the case of McDonald’s, where adapting to local culture is the way to survive. In the last 50 years, the chain has opened more than 30,000 restaurants in 120 countries, including 155 in India, by adapting its menu and operations to complement the existing eating-out options. While the iconic all-beef Big Mac has been replaced by the mutton and chicken Maharaja Mac in India, a kosher

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variant in Israel is served minus the cheese. In China, McDonald’s introduced red bean pies, and Norwegian restaurants offer the salmon McLaks burger. It helps that McDonald’s uses the franchising mode of market entry, and about 70 per cent of the chain’s restaurants are owned and operated by local entrepreneurs. Local players understand what their customers want, and know what is acceptable to local customs and values. Since differences in cultures across countries makes it impractical to use the same marketing mix, adaptation to suit local conditions becomes imperative. This essentially requires market segmentation.

Market Segmentation Market segmentation is the process of ­dividing the Market segmentation is the process of dividing market into sets of homogeneous customers. Markets the market into sets of homogeneous customers may be segmented on the basis of geography, demogon the basis of geography, demography, socioraphy, socio-cultural factors and psychological factors. cultural factors and psychological factors. The basic purpose is to optimize consumer satisfaction and buying behavior through an altered marketing mix. This process enables the marketing manager to adapt to the differences among customers regarding their needs, wants, willingness and ability to purchase a product or service. There are three approaches to market segmentation in international marketing: segmenting the world, segmenting foreign markets and international market segmentation. For example, refrigeration manufacturers market refrigerators with large freezer compartments in the West, where people shop over the weekends and stock up for the entire week or even longer. The same manufacturers market refrigerators with smaller freezer compartments in locations like India, due to the weather, frequent electricity outages and the large vegetarian population. Markets within a geography or country may be further segmented on the basis of consumers’ geographic, demographic and socio-economic characteristics; their lifestyles, personalities and attitudes; as well as their backgrounds, benefits sought, brand loyalty and sensitivity to changes in price, product quality and promotion methods. McDonald’s in India uses a demographic segmentation strategy with age as the parameter. The main target segments are children, youth and the young urban family. Promoted as an affordable place to eat for young urban families, children are McDonald’s most important customers. In order to attract children, McDonalds introduced the Happy Meal, which has a Walt Disney toy in it, as well as special facilities like a ‘Play Place’ where children can Bird’s-eye View play arcade games and air hockey. Pricing of products is especially aggressive for the teenager, who International marketing is concerned with the is McDonald’s most price-sensitive customer. In issues of market assessment, determining the addition, facilities like Wi-Fi are also provided to marketing mix and market segmentation. attract students to its outlets.

Product A product is a bundle of attributes including the physical product, brand name, after-sales service, ­warranty, instructions for use, packaging, and the company image. It is the central focus of the marketing mix, and directly responsible for customer satisfaction. It is important to remember that the product

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A product is a bundle of attributes including the physical product, brand name, after-sales service, warranty, instructions for use, packaging, and the company image.

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is more than the physical item, and includes a host of other attributes that make up the ‘total product’. For example, Coca-Cola is a global ‘total product’, but the physical product is multi-domestic; its sweetness varies according to local tastes. We can divide products into two broad categories: industrial products, which generally lend themselves to global demands with little or no modification, and consumer products or services, which generally require greater adaptation to meet the demands of the world’s markets. Let us consider the adaptation requirements of each of these categories.

Producer Goods Producer goods, also known as industrial products, can be marketed without any major changes, and the changes made are often cosmetic, such as converting gauges to the metric system or printing instructions in another language. Goods such as the laptop and the photocopying machine may need minor modifications in electrical equipment, which is designed for 110/120 volts in Japan and the United States, but for 220 volts in Europe and 240 volts in Australia. Adaptations may often be necessary because of legal requirements such as noise, safety or emissions standards. Similarly, international engineering and construction firms also have identical product strategies, as do goods with a very strong brand appeal such as Intel, which requires very little adaptation in the different markets of the world.

Consumer Goods There is a huge range of goods that fall in this category, some of which require modification to meet local market requirements, but others can be sold unchanged to certain market segments. Consumers with a similar economic status, buyer behavior, tastes and preferences, such as foreign-educated and well-travelled citizens and expatriates, typically have similar demand for luxury items like expensive cars, perfumes and sporting equipment. A bottle of BVLGARI perfume can be sold in the same packaging in Mumbai, Dubai and New York, but the McDonald’s burger has to be modified to meet local tastes and preferences. Re-engineering the menu using a regiocentric approach has helped it adapt to the customer’s tastes, value systems, lifestyle, language and perception. Globally McDonald’s was known for its hamburgers, beef and pork burgers. Most Indians are barred by religion not to consume beef or pork. So McDonald’s came up with chicken, lamb and fish burgers to suite the Indian palate. To cater to the vegetarian customer segment, the company came up with a completely new line of vegetarian items like the McVeggie burger and McAlooTikki. The separation of vegetarian and non-vegetarian sections is maintained throughout the various stages of product preparation. It is generally seen that as you go down the socio-economic ladder there are greater dissimilarities among consumers with respect to social and cultural values.

Determinants of Product Adaptation Income: This is a key determinant of demand for consumer goods. At higher levels of income, consumer’s goods in demand often fall in the category known as Veblen goods, meaning they are in demand for ostentation rather than for their utility. At lower levels of income, the consumer demands goods for their inherent utility and the demand is therefore elastic. For example, Singer Sewing Co. sells simple, hand-powered sewing machines in parts of Africa; in Europe it sells a complex line of electrical machines.

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Education: The general level of education affects product decisions both directly and indirectly. A highly literate market typically demands more complex products such as computers and other electronic equipment, but demand for such products is limited in areas of high illiteracy. Consumer Tastes and Preferences: For years, Oreo cookies, manufactured by the US TNC Kraft Foods Inc., were difficult to sell in China. Consumers found the traditional US version of the Kraft Foods cookie too sweet and too expensive. The package was also too big for small Chinese families. Like many other global companies, Kraft also had to ‘dress’ a signature product differently to gain acceptance in the world’s most populous market. Similarly, Campbell Soup Company had to change the flavor of its tomato soup for the European consumer, and Nestlé sells dozens of varieties of its instant coffee around the world to be able to satisfy the taste buds of its varied consumers. The French prefer top-loading washing machines, the British prefer front loading, the Germans want high-speed machines that remove most of the moisture in the spin-dry process; Italians prefer low-speed machines because they dry their clothes in the warm Mediterranean sun. There is just as much variation in color preferences. Green is unpopular in parts of East Asia because the color is associated with the dangers of the jungle. Gold is popular in many countries as a symbol of quality and prestige. In the Netherlands, blue is considered warm and feminine, but in Sweden blue is considered cold and masculine. Product Life Cycle: Product modification often has to be done because of the limited product life cycle. Ford Motor Company was an extremely profitable venture in Europe during the 1980s, but failure to develop new products soon eroded its competitive advantage. Gillette used a combination of technology and marketing to introduce new products into the market to make up for the declining market shares of its old products.

Bird’s-eye View A product is the central focus of the marketing mix and directly responsible for customer satisfaction. Products need to be adapted for the market according to the consumer’s income, taste and preferences and the product life cycle.

Brand Management A brand is the identity of a specific product, service A brand is the identity of a specific product, seror business. A brand can take many forms, including vice, or business. A brand can take many forms, a name, sign, symbol, color combination or slogan. including a name, sign, symbol, color combinaBrand management in global markets is a tricky and tion or slogan. difficult business, contrary to Levitt’s prediction of monolithic global brands. Modern-day managers find that there are actually only a handful of truly global brands in existence. In addition, experience has shown that companies need not always create one-size-fits-all global brands just because the world appears to be shrinking. Indeed, firms recognize that adapting brands to local conditions is often the best approach, and at times they have no choice in the matter because of local conditions. It is true that global companies need global brands to some extent. However, global branding is not an all-or-nothing proposition. There is a continuum along which firms can decide how global they wish their brands to be, with a single global brand at one extreme and an assortment of nothing but local brands at the other. Global and local brands can be part of a successful marketing mix at any spot along the continuum. Decisions to use a combination of local and global brands—called the ‘hybrid’ approach— depend on many factors, including products, industry, local cultures and the nature of the competition.

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The world’s top global brands in 2013 are Apple, Google, Coca Cola. These rankings are presented by Interbrand1 based on the following criterion—the financial performance of the branded products, the extent of influence on consumer choice and the ability of the brand has to command a premium price. This year’s rankings were a nasty surprise for Coca Cola which lost its top rank after 14 years. These brands and others share some common features: They have a consistent name that is easy to pronounce; corporate sales are globally balanced with no dominant market; the essence and positioning of the brand is the same the world over; they address the same customer needs, or the same target segment, in every market; and there is great similarity in execution (pricing, packaging, advertising, etc.) across cultures. What kinds of products are difficult to become global brands? Food is one category where, literally, differences in tastes from culture to culture compel global companies to adapt to local conditions. At the other end of the spectrum is a company like Intel Corporation, whose products and markets make it easier for executives to establish a truly global brand with a memorable catch-phrase: ‘Intel inside’. However, MacDonalds and KFC dominate as global brands as a result of their ability to adopt a hybrid approach. Global and local brands can be part of a successful marketing mix at any spot along the continuum. Decisions to use a combination of local and global brands—called the ‘hybrid’ approach — depend on many factors, including products, industry, local cultures and the nature of the competition. Kentucky Fried Chicken, has 5,000 restaurants in the United States and 6,000 in other countries. It has learned that it cannot open restaurants globally based on its US model. In Japan, KFC sells tempura crispy strips, potato-and-onion croquettes in Holland, and in China, KFC’s chicken gets spicier the farther inland one travels. Another countervailing force is entrenched local brands. Conditions favoring local over global brands include unique market needs; low frequency of purchase so that brand loyalty passes from one generation to another through family traditions; and the relative importance of advertising, which makes it harder for global companies to change loyalty patterns. A third force going against global brands is the growing concentration of retail buying power, which can lead to heightened price sensitivity on the part of the buyer. For instance, Walmart’s goal to offer low prices everyday can constrain companies wishing to sell their products through Walmart stores.

New Product Development For most firms, new products are the path to success and growth despite their development being a timeconsuming, costly affair fraught with immense challenges. It becomes a gigantic issue when it has to be coordinated across regions or across the world. Every new product starts with an idea and may originate in any of the firm’s 4 Cs: company, customers, competition and channels. Many new products originate in the R&D labs of large TNCs, which often create organizational structures to foster global or regional innovation. TNCs also capitalize on their global know-how by transplanting new product ideas that were successful in one country to other markets. McDonald’s, for instance, developed the concept of McCafe—an Australian coffee innovation in 1993, and it was successful in the markets of New Zealand, Cyprus and Austria, but failed to take off in the US markets. Technology plays a dual role in new product development. First it is technological development that has made it necessary for firms to develop new products on account of increasingly short product 1

http://www.interbrand.com/en/best-global-brands/2013/Best-Global-Brands-2013.aspx

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life-cycles. Second, technology ensures rapid product development to replace the obsolescence taking place in the market. Firms that are considered market leaders have managed to stay ahead on the strength of their continuous innovation; Apple Inc. is known for the iPod, the iPhone and now the iPad, and Sony Corporation’s successes include the Walkman, the compact disk and the PlayStation. New product development needs cross-functional integration among R&D, production and ­marketing to ensure that new products are driven by customer needs and are easy to manufacture, development costs do not escalate too high, and the product reaches the market in minimum time. Large and successful TNCs often apportion R&D work across global research centres attached to global product divisions for new product development. At this level, the emphasis is on commercialization of technology and design for manufacturing. Further customization of the product for individual markets is done by R&D teams in that particular country. This includes companies like Hewlett-Packard (HP), which has four basic research centres in California, England, Israel and Japan. HP’s thermal inkjet technology was pioneered at its California lab, but was customized at the Singapore subsidiary for the Japanese and other Asian markets.

Promotion Strategy Promotion is the process of motivating demand for a Promotion is the process of motivating demand firm’s goods and services towards a sale. Promotion for a firm’s goods and services towards a sale. is the strategy of using communication designed to motivate consumer demand, and is a mix of advertising, sales promotion, personal selling and public relations. Promotional strategies may broadly be classified as push and pull strategies. A push strategy emphasizes personal selling by directing promotion primarily to intermediaries by pushing the product through the distribution system. A pull strategy is directed at the final customer and is designed to coax (‘pull’) the product through the distribution system to the customer. In practice, firms follow strategies that have a mix of both push and pull elements. A firm’s choice of promotion strategy depends on a host of factors. Nature of Product The nature of the product being promoted has a huge bearing on the promotion strategy chosen by the firm. Standardized products such as industrial goods and goods with high brand value allow the firm to follow a uniform promotion strategy worldwide. Consumer goods require greater adaptation in promotion strategy. Automobiles, for instance, may be promoted on the basis of their luxury or convenience characteristics in the US market, but in an emerging market like India they are promoted on the strength of their fuel efficiency and value for money. General Motors Europe has a global promotional strategy, but when it launched its Omega Sedan it held a separate campaign for Germany and Switzerland. Similarly, products like hair oils are marketed on different platforms in different countries, depending on the perception of the consumer. Products where standardized promotion may be successful are: ■■ Luxury products (for example, Rolex watches, which appeal to their buyers worldwide); ■■ Industrial products (for example, ball bearings, which offer users worldwide the same benefits); ■■ ‘Youth’ products (for example, blue jeans and rap music, which appeal to young people to a marked degree around the world); ■■ Products in other categories need localized promotion strategies to cope with cultural differences.

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Customer Sophistication Sophistication in this context refers to the consumer’s education and awareness about the product and its features. A sophisticated consumer is pulled towards the product, but an unsophisticated one has to be pushed towards it to create an awareness about product features and the consumer’s demand for it. Channel Length This refers to the number of intermediaries in the distribution chain. The chain is likely to be much longer in international business than in domestic business, and this has many implications for the ­communication process. Media Availability Media availability refers to the number of media—such as newspapers, magazines, radio and television, including cable and satellite television—that are available to advertisers. Some countries have all of these media; African countries in general have few of them, whereas Latin America and some Middle Eastern countries have a huge number of newspapers and magazines. However, media availability also has other connotations. Governments place limiting regulations on radio and television. Since 1991, member nations of the European Union require European broadcasters to reserve a majority of broadcasting time (including advertising) for Europeans. This limits advertising by Americans. There are also restrictions on advertisers generally. For example, tobacco advertising is banned in the European Union; there are guidelines on alcohol advertising; advertising as a whole is limited to a percentage of programming time in some countries, and in others, television advertising is restricted to the break between programmes. There are some televising channels that have uninterrupted programming because it is believed that commercial breaks mar the viewing pleasure of consumers. A firm has the following choices in promotional strategies: Advertising: It is a non-personal form of promotion attempting to influence consumer buying ­behavior. It is done through a variety of media and attempts to lead to buyer action through the impact of its message. As stated earlier, the message and its contents have global appeal and impact for some products, such as Nike, Inc., which uses the slogan ‘Just do it’ all over the world. Panasonic Corporation, on the other hand, uses a local promotion strategy for its dishwashers in Japan. It uses the hygiene and hot water conservation argument to convince the Japanese housewife, who feels guilty about purchasing a gadget just for the sake of her convenience. Danish toymaker LEGO Group’s successful campaign in the United States was a complete flop in Japan because of linguistic, cultural and social differences. Swatch advertisements target the youth around the globe, and use Olympic trackstar Michael Johnson and supermodel Tyra Banks along with the catchphrase ‘time is what you make of it’. The orange drink Tang is marketed as a breakfast drink in the United States but as a ‘throughout the day drink’ in Latin America. Personal Selling: It is a form of direct promotion, useful for products that require an explanation or detailed description. Cosmetic companies such as Avon Products, Inc. and Oriflame Cosmetics SA have used this method very successfully in different parts of the world. Direct mail: It is a method of personalized advertising by directly approaching the target audience with publicity material. It allows an organization to use its resources effectively and has a very high response rate leading to increased sales.

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Sales promotion: It is a widely used tool of marketing. It entails the use of coupons, special offers, ­distribution of free samples, etc. for a variety of objectives. These include stimulating an impulse purchase, encouraging customer loyalty, penetrating new markets and ensuring repeated purchasing. Promotional techniques need to relate to the specific aim of the exercise (free samples to enter new markets or reduced price offers to encourage repeat purchasing). The use of sales promotion techniques in cross-border campaigns, however, often face serious practical difficulties. For instance, many Bird’s-eye View sales ­promotion techniques are considered unfair competition in some countries; discount vouchers Promotion strategy of a firm depends on a host are considered legal in Spain but not in Germany, of factors, such as nature of the product, avail‘lower price for the next purchase’ offers are legal ability of media and channel length. in Belgium but illegal in Denmark.

Pricing Strategy Pricing: It is an integral aspect of the marketing mix and determines the profitability of the enterprise. Proper pricing ensures both short-term profits and long-term resources, as well as the viability of the enterprise. Pricing in international markets is much more complex due to varying cost structures such as transportation costs and tariffs. For instance, the Ford Escort, which sold at about USD 10,000 in the United States, cost double that amount in the UK, and 10–12 per cent more in other EU markets. Important factors in the pricing decisions include government controls, market diversity, currency fluctuations and price escalation forces. Government regulations such as floor and support prices are among the important things to be factored in by a TNC. Floor prices intend to support local companies from the cheaper products of more efficient TNCs. Pricing regulations also pertain to dumping, or the selling of goods at cheaper prices in the foreign market as compared to the local market. Differences in the perception of the consumer about the same product in different markets of the world also permits differential pricing. The TNC is able to offer the same product at different prices in different markets because of the differences in demand elasticity. This is often the case with publishing houses, which introduce a book at a higher price in the domestic market but sell it at a lower price in the foreign market, especially in the developing countries. Fluctuations in exchange rates cause a product to be priced differently even when there is no change in production cost. For instance, Chinese exports are attractively priced and are huge foreign exchange earners as the government keeps their prices at a devalued rate. US products were similarly attractive in European markets in the 1980s as a result of a devalued dollar and declined in competitiveness as the dollar strengthened in the 1990s. Some commonly used pricing techniques are as follows: ■■ Predatory pricing: This involves using price as a weapon to drive competitors out of a national market. A good example worldwide was the Japanese practice in the 1970s and early 1980s of selling motor vehicles at a loss in Europe and elsewhere to undercut the competition and ­establish a Japanese (for example, Toyota Motor Corporation or Honda Motor Co., Inc.) ­presence. Similarly, television companies such as Panasonic used predatory pricing to enter the US television market. ■■ Multipoint pricing: This compares the effect that a firm’s pricing strategy in one market may have on a rival’s pricing strategy in another market. ■■ Experience curve: This is aggressive pricing designed to increase volume and help the firm realize experience curve economies.

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Distribution Distribution channels provide the essential link connecting the producer with the consumer. A firm’s efforts at market assessment, promotion and pricing would all be wasted if the goods in question did not reach the final consumer. Distribution is the most difficult and longest decision of the marketing mix as it cannot be altered easily and also means some loss of control by the firm over the marketing of the product. There are significant differences in distribution systems across the world. Some countries have a concentrated retail system and, thus, a short distribution channel. Other countries have fragmented wholesale/retail systems with long distribution channels. Long distribution channels generally lead to higher prices for consumers, but they may also lead to lower selling costs and thus assist a firm to gain access to the market. The customer profile, especially the assessment of demand and perceived need, often results in ­different strategies for different consumers. Competitive channels indicate general acceptability and likelihood of success. Walmart, for instance, has to rely on a joint venture with Bharati Enterprises to access the Indian market to conform with host country FDI policy. IKEA Systems B.V., on the other hand, has chosen to use a completely different strategy in furniture retail to develop its competitive advantage. The cost of distribution is an important element to be factored in, and often includes the cost of forward and backward linkages that a firm has to establish to get the product to the final consumer. McDonald’s had to ensure that it had the perfect potato for its fries and lettuce for the burger, which involved a five-year investment in farming methods in India. Distribution norms differ over countries. Finland has a predominance of general retail stores but Italy has a fragmented retail and wholesale structure. In the Netherlands, buyers’ cooperatives deal directly with manufacturers, but Japan has cash-and-carry wholesalers for retail services that do not need financing. One aspect of distribution strategy is exporting, which is the process of getting products to foreign markets. In this section, we deal with the distribution of products within each market. Distribution systems may differ for a variety of reasons, including the following: ■■ Physical environment: This may make delivery by air more feasible than delivery by truck. For example, the highlands of New Guinea rely in part on air delivery of goods. ■■ Social customs: For example, door-to-door selling is acceptable in some societies while in ­others it would be considered anti-social. ■■ Availability of services: The national infrastructure of road, rail, air and telecommunication services will influence the choice of distribution system. ■■ Tradition: For example, in Japan it is common to use many intermediaries between the manufacturer and the final retailer, and it is difficult to avoid these agents even though they add several layers to the distribution system. The complications in distribution get compounded in a foreign market. The greatest stumbling block is the lack of adequate infrastructure, such as roads and warehousing facilities. In countries such as Nigeria, TNCs like Nestlé have constructed their own small warehouses, and allow movement of goods only during the day to prevent robbery. In certain countries such as Japan, there is a multilayered distribution system where national wholesalers sell to regional ones and in turn to local ones. The increase in intermediary levels in turn adds to the price and can also be a hindrance in the case of perishable goods like vegetables. The issue gets further compounded where the retailer is small and has limited space for stocking inventory, causing frequent lack of adequate stock.

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■■ Product attributes need to be varied from country to country to satisfy consumer tastes and preferences. These differences in tastes and preferences are due to differences in culture and the country’s stage of economic development. ■■ There are significant differences in distribution systems across the world. Some countries have a concentrated retail system and, thus, a short distribution channel. Other countries have fragmented wholesale/retail systems with long distribution channels. Long distribution channels generally lead to higher prices for consumers, but they may also lead to lower selling costs and thus assist a firm to gain access to the market. ■■ The third P of the marketing mix is promotion, or communication strategy. Barriers to communication include cultural differences, source effects, and noise levels. A communication strategy may be a push strategy that emphasizes personal selling, or a pull strategy that emphasizes use of the advertising media. ■■ Whether a push or a pull strategy is better depends on the type of product, customer sophistication, channel length and the availability of the various types of media. Standardized global advertising suits products such as luxury goods, chemicals and bulk commodities, but for most products some degree of specialized advertising is necessary to meet local tastes and preferences. ■■ The final P is pricing. Price discrimination relates to differential pricing between countries. For price discrimination to be profitable, national markets must be separate (no cross-border traffic) and their price elasticities of demand must differ. ■■ Predatory pricing is aggressive pricing designed to undercut the opposition and force it out of the market. Predatory pricing may go hand-in-hand with experience curve pricing to build volume quickly and thus move down the experience curve towards lower production costs. ■■ Multipoint pricing is concerned with the effects of rival firms’ pricing strategy in different ­markets. The ability of firms to use price discrimination and predatory pricing is often limited by government anti-dumping regulations and competition policies.

KEY TERMS Market assessment, Market size, Market intensity, Market growth, Marketing mix, Market segmentation, Product, Brand, Promotion, Pricing, Distribution channels.

DISCUSSION QUESTIONS 1. Explain the issues involved in the globalization-versus-localization debate in international marketing. 2. What are the elements of a successful marketing mix in international business? 3. Enumerate the complexities of distribution in the global market. 4. What are the various promotional strategies a firm can use? 5. Short notes: a. The marketing mix b. Brand management c. Product adaptation

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15 INTERNATIONAL HRM LEARNING OBJECTIVES After going through this chapter, you should be able to:

■ ■ ■ ■ ■

Define international human resource management and discuss human resource strategies in overseas operations Illustrate the importance of human resources in international business Examine different policies of companies for recruitment, selection, compensation, development, and retention of international managers Discuss how companies differ in terms of labor policies Understand the selection and screening criteria used in choosing people for overseas assignments

POLLUTION HAZARD ALLOWANCE IN CHINA Expats in China are being offered a hefty ‘environmental hardship allowance’ by American beverage giant Coca Cola to entice them to come and stay on in a country that is known for its chronic pollution problems. Only three out of 74 Chinese cities met minimum government standards on pollution, causing problems for firms desirous of sending workers to China, especially to Beijing or Shanghai. China’s environmental problems are the result of three decades of growth coupled with weak environmental regulation. The present allowance, is approximately 15 per cent over an employee’s base-salary. Coke thus joins the ranks of several other TNCs which offer allowances such as better medical insurance benefits, more paid trips home and subsidies for air filters to the roughly half a million foreigners working in China. Japanese TNC Panasonic was the first large TNC to include ‘hazard pay’ as part of its workers’ remuneration package. Australian TNC Hassell provides its staff in China with face masks to travel to and from work and also changes its air filters every week during periods of heavy pollution.

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Besides the allowance, Coke is also working on a green supply chain program with the institute of public and Environmental Affairs, indicating its responsibility in partly causing the problem. Source: http://www.afr.com/p/world/coca_cola_offers_expats_china_pollution_FBZsoK1FVABDoeu21RMKHN, last accessed on 23rd july 2014.

INTRODUCTION A successful international company needs an appropriate structure and controls to put its strategy into effect. Accordingly, International Human Resource Management (IHRM) is the process of selecting, training, developing and compensating personnel in accordance with the firm’s overall strategy. The aim of the HRM policies of a firm is to match people with the firm’s strategy, structure and controls. We may find, for example, that the CEO and staff required to effectively manage a multi-domestic company are quite different from the team required to effectively manage a transnational company. In the following sections we will discuss the role of various HRM activities in matching people to strategy, structure and control systems. A TNC has three basic sources of human resources.

1. The first is its home country nationals, who may be residents abroad but are citizens of the home country. They are known as expatriates. An example would be an Indian manager who works at the Infosys office in New Jersey. 2. The second category consists of host-country nationals, consisting of domestic staff hired by the TNC. An example of this is a British national working for BMW in London. 3. The third category consists of third-country nationals, who are citizens of other countries and work for the TNC in a foreign location. An example is a German manager working for Panasonic in Japan.

The advantages of using home-country staff for foreign assignments is that it ensures that senior management has full knowledge of the capabilities, experience, attitude and perspectives of those in charge of foreign operations; since expatriate managers are fully conversant with company policies and procedures, communication is fast and efficient. The interests of the parent company are also looked after as the expatriate manager depends upon the parent organization for career advancement. On the other hand, the disadvantages of using expatriates include their lack of familiarity with the local language, culture and business practices, a long settling-in period during which time productivity is low, dealing with racial and other biases, and blocking promotion opportunities of locally recruited staff. The major steps in the process of IHRM are as follows: ■■ ■■ ■■ ■■ ■■ ■■ ■■ ■■

Human resource planning (this is part of the organization’s strategic plan) Recruitment Selection Induction and orientation Training (to improve job skills) Development (to educate people beyond the requirements of their present position) Remuneration and rewards Transfers.

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RECRUITMENT AND SELECTION There are four choices in recruitment and selection policy—the ethnocentric approach, the polycentric approach, the geocentric approach and the regiocentric approach. The IHR policy of the TNC, a feature of its long-term strategy, depends on its business orientation and its age as a TNC. There are four choices in policy—the ethnocentric approach, the polycentric approach, the geocentric approach and the regiocentric approach.

Ethnocentric Approach In initial stages of global venturing, a business firm Ethnocentric orientation is based on the belief of prefers to use home-country managers for its oversuperiority of one’s own ethnic group, and refers seas units. This is characteristic of the firm’s ethnoto the preference for home-country managers in centric orientation, based on the belief of superiority overseas units. of one’s own ethnic group. It has been observed that most Japanese TNCs prefer to use home-country managers for their senior staff positions. European TNCs similarly assign home-country managers for their entire career. US TNCs, however, view overseas assignments as temporary, and are often found working under host-country managers. Large TNCs such as Procter & Gamble, and Samsung Group had their important overseas subsidiaries manned by home-country nationals as they place a high value on corporate culture. The firm basically believes that parent-country nationals are better qualified and more trustworthy than host country nationals. For firms which are transferring core competencies through a foreign operation, it is best done with the help of staff familiar with organizational processes and routines that are associated with these competencies. It also considers the ethnocentric approach more suited for maintaining a unified corporate culture. The basic merit in this approach is the benefit of the experience curve effects derived from standardization of production. The firm produces in the home country initially and transfers its core competency to the host country under the guidance of expatriate managers. However, host country nationals are denied the opportunity of decision-making and advancement, leading to resentment among them. Expatriate managers are also expensive to maintain, and may often become insular in their attitudes and prone to cultural myopia. This often results in management overlooking niche market opportunities.

Polycentric Approach Polycentricity or polycentrism is a belief that local Polycentricity or polycentrism is the belief that people know the local environment better than outlocal people know the local environment better siders. Under this orientation, a firm recruits hostthan outsiders, thus a firm recruits host country country nationals to manage their subsidiaries and nationals to manage their subsidiaries while parent-country nationals occupy key positions at parent-country nationals occupy key positions ­ the corporate headquarters. The basic advantages of at the corporate headquarters. this approach is quick and flexible responsiveness, as local managers react to market needs in the areas of pricing, production, product life cycle, and ­political activity. There is greater sensitivity to cultural issues and continuity in the management of foreign subsidiaries.

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A major drawback of this approach is that host-country nationals remain limited in their experience, and thus opportunities for professional growth are consequently limited. This leads to resentment and high turnover among the staff. There also exists a barrier between home and host-country managers regarding language barriers, national loyalties and a host of other cultural differences. This in turn may lead to the isolation of the corporate headquarters from national units and lead to lack of integration and corporate inertia.

Geocentric Approach A geocentric staffing policy is based on the notion A geocentric staffing policy is based on the that the best people should be employed, regardless notion that the best people should be employed, of their nationality. It ensures optimum utilization of regardless of their nationality. the firm’s human resources, and helps it to develop a global workforce that can work anywhere in the world, under any cultural constraints. It also allows the firm to reap the advantages of scale economies and experience curve effects, and also enjoys the benefits of local responsiveness and cultural adaptation. It is, however, an expensive policy as it entails huge cross-cultural training and orientation, costs of relocation and immigration. The adoption of a geocentric policy may be limited by local laws and policies that require foreign subsidiaries to employ local staff.

Regiocentric Approach Regiocentricity is the variation of staffing policy to suit particular geographic areas. It is particularly suited in geographical regions that are culturally proximate and similar. For instance, firms operating in the MENA region find it useful to employ Muslim staff as it creates a sense of cultural affinity and eases the working atmosphere in the region. The policy shows sensitivity to local conditions and provides a stepping stone for a firm wishing to move from an ethnocentric or polycentric approach to a geocentric approach.

TRAINING AND DEVELOPMENT

Regiocentricity is the variation of staffing policy to suit particular geographic areas. It is particularly suited in geographical regions that are culturally proximate and similar.

Bird’s-eye View The International Human Resource policy of a TNC is a feature of its long-term strategy and depends on its basic business orientation and on its age as a TNC. A TNC can thus have any of the following four approaches or a combination of all—the ethnocentric approach, the polycentric approach, the geocentric approach and the regiocentric approach.

Training and development refers to the acquisition of knowledge, skills and behavior pertaining to the job. For an international business, training and development procedures and methods vary depending on whether the individual is from the home country, host country or a third country. The training and development are two different but related issues. Training is concerned primarily with the acquisition of skills (for example, learning a language), but may also refer to the acquisition of awareness (for example, cultural training). Development is the term used to describe a process of change through the acquisition of knowledge via some form of education programme, which may include some training.

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Training programmes designed for individuals who are going overseas provide information related to local customs, cultures and work habits to help them interact and work effectively with the local workforce. Training should include at least two phases. Pre-departure training should focus on language, history and culture for the whole family and include job-specific training for the manager. On arrival in the new country, the expat should be allowed some time away from too much job-related activity to allow him to adapt to the new culture. Transition training should continue with language and culture training as well as meetings at which the new expatriates have the chance to mix with local residents and other foreign nationals. The home office must remain alert to the need to provide psychological support in a variety of ways and to convince expatriates that they will not be at a disadvantage for promotion by service in a foreign country. In this context, the expatriate should get out of the host culture on a regular basis once or twice a year. The ability to ‘touch base’ with the home culture gives reassurance to expatriates that they are valued servants of the organization. It also helps in avoiding ‘culture shock’ when they finally return to the home country. People need to be prepared for re-entry to the home culture, and the organization needs to provide the support facilities for this. Training in the context of the expat employee takes the following forms:

Cross-cultural Training This entails learning about the host country’s culture, history, politics, economy, religion and social and business practices. There are two facets of this: In the first module, the expat is given information consisting of living conditions, cultural awareness and the country’s macro conditions. The second aspect consists of cognitive and behavioral techniques to acquire skills such as transition-stress management, relationship-building, cross-cultural communication and negotiation. Effective cross-cultural training is based on five basic guidelines:

1. 2. 3. 4. 5.

Awareness of skills required to function well in the target culture. To understand the appropriate use of certain behavior. Keep this understanding contextual and appropriate based on the target culture. Acquire proficiency through practice. Anticipate emotional changes and deal with them appropriately.

Language Training Proficiency in a foreign language is a critical factor in the effective adjustment of expatriates in the host country. For the longest time this has meant being fluent in English, but with the emergence of business opportunities in Latin America and China, there is an increased emphasis on learning Spanish and Mandarin. Knowledge of the local language enhances communication and makes the process of settling in easier and more comfortable for the expat.

Specific Skills Training The expat as a manager needs specific skills of communication, negotiation skills and survival that are contextual and help in adjustment. This also includes training in performance appraisal and total quality management. Management development includes a range of activities such as skills training; in-house programmes on company-related topics; external seminars and conferences; university courses; job rotation and/or transfers

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within the company, including overseas postings; exchange visits to other departments and organizations; and networking with other managers within the company, government officials, suppliers and customers. Performance appraisal is an important aspect of training and development. Managers at all levels use appraisal to communicate expectations and to help subordinates improve personal deficiencies. However, in international business, performance appraisal has problems not usually encountered in the domestic company. These problems usually pertain to bias arising out of the expatriate manager’s location. Expatriate managers are assessed by their superiors in both the host country and the home country. Host-country assessors may be biased by their cultural frame of reference and set of expectations. Home-country assessors may be negatively influenced by their distance from the home country and by their own lack of experience in the host country. Their cultural frame of reference may be the same as that of the person being assessed, but their expectations of that person may or may not be realistic. Home-country assessors rely on facts and figures in making their assessment: facts and figures do not take account of the ‘soft’ variables associated with working in another culture. It is usually very difficult for an expatriate manager to counter an adverse performance appraisal arising from these biases. This often becomes the cause of frustration in overseas postings. Companies that are aware of this focus their performance evaluation on factors that are within the scope of control of the person being evaluated. This in itself presents difficulties because there are many types of decisions over which expatriate managers have little or no control.

COMPENSATION A compensation programme of a TNC focuses on attracting and retaining qualified employees, facilitation of transfer between the head office and its affiliates, creation of consistency and equity in compensation, and maintaining competitiveness. On selection and recruitment, you will recall that international firms may adopt an ethnocentric, polycentric, regiocentric or geocentric approach. The firm’s strategic approach combined with hostcountry laws, regulations and cultural traditions determine the compensation policy. You will also recall that one aspect of the geocentric approach is the creation of a pool or cadre of international managers who are, theoretically at any rate, capable of being employed anywhere in the world. The geocentric approach leads to more compensation problems than the other approaches. The various approaches to staffing relate to compensation by being concerned primarily with: ■■ Parent-country nationals (PNCs): Ethnocentric and geocentric ■■ Locals or host-country nationals (HCNs): Polycentric ■■ Third-country nationals (TCNs): Geocentric and regiocentric The cost of employing an expatriate is almost three to five times the cost of a domestic hire. Expatriate compensation usually consists of the following elements: ■■ Salary: This is the basic pay, including incentives such as profit sharing and bonus plans, and may be cash-based or a deferred payment. ■■ Housing allowance: The expat may be given an allowance, company accommodation or the facility to rent a house. All these are provided at a level equivalent to the expat’s living standard in his home country. ■■ Service allowances and premiums: These allowances are meant to cover the differences in expenditure and cost of living between home and host country. These include the cost of ­relocation, children’s education and home country visits. The allowance is based on the expected level of hardship and the job type.

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■■ Tax equalization: The allowance is meant to provide an adjustment to the expat based on tax rates in the home country. Depending on tax treaties between the home and host country and duration of stay, the expat may be taxed on income tax rules of both home and host country. This allowance helps to smooth out the tax liability for the expat. There are three basic approaches or policies to international compensation. These policies are:

1. Home-based policy: This policy links the base salary for PCNs and TCNs to the salary structure of the relevant home country. For example, a US executive transferred to France would have a compensation package based on the US base salary rather than that applicable to France. All PCNs and TCNs are treated equitably in relation to their home countries, but they may be paid different amounts for doing the same work. For example, in the London branch of an American bank, a US expatriate and an Australian (TCN) may perform the same banking duties, but the American will receive a higher salary than the Australian because of differences in their respective home-country base salary levels.   This policy is usually applicable in temporary assignments where the number of people from a single nationality is usually low and there is a predominance of international staff at top-level positions in the host country. It facilitates mobility of personnel and makes repatriation to the home country easy. However, it creates discontent within the organization as staff at the same organizational position but from different parts of the world are paid differently. 2. Host-based policy: The base salary is linked to the salary structure of the host country but supplementary allowances for cost of living, housing, schooling and so on are linked to the home-country salary structure. This policy is attractive to TCNs where host-country salaries are greater than those in their home countries, but unattractive to expatriates whose home-country salary levels are greater than those of the host country.   The policy is used when international assignments are of an indefinite duration in a location where the compensation is high and host-country local staff occupy a large number of top positions. It is an easy system to administer as all employees get equivalent compensation, and leads to a happier workplace.   The system is at risk when there are huge fluctuations in exchange rates. It is also an expensive policy, as host country salaries improve as a result of improvements in living standards. 3. Hybrid compensation policy: This is something of a compromise between the home-based and host-based policies, whereby expatriates working in their home regions (for example, an Italian in Germany) are comBird’s-eye View pensated at lower levels than those working in regions far from home, for example, an Training and development and compensation American working in Saudi Arabia. are two important aspects of human resource   The policy is equitable and enables the management. Training is concerned with the transfer and development of an international acquisition of skills which become agents of management cadre. It is also complicated to change through development. administer and difficult to communicate.

INTERNATIONAL LABOR RELATIONS International labor relations is a vast topic of considerable complexity and is variously called industrial relations, employer–employee relations and workplace relations—different terms that are indicative of different perspectives. Labor relations by whatever name is commonly the domain of the HRM

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f­unction, but some organizations manage their labor relations through a department that is separate. A TNC needs to manage its relations with labor in its own country and in other countries where ­subsidiaries are located, and they will all be different. You will probably know from your reading of newspapers and magazines, and from your own experience, that labor relations is a subject with political, sociological and emotional overtones. It is sometimes felt that labor unions are the enemy of TNCs. This may be so in some cases, but it need not. Unions, or organized labor, are usually thought to be concerned about pay, job security and working conditions. In fact, unions are concerned about many other issues, including quality of life, equal opportunity and superannuation. In the international context, unions are concerned about the power of TNCs to move production facilities from one country to another (or even from one part of one country to another part) with the consequent loss of jobs. TNCs typically make such decisions through negotiation with governments, and unions are thus potentially at a great disadvantage unless they have influence with the government in power. The power of unions ultimately lies in the strike, but there are also about 20 forms of non-strike activity such as go slow, work to rule and overtime bans. Another concern of unions is the ability of TNCs to move some production facilities so that lowskill jobs are ‘exported’ from the home country to countries where labor costs are lower. There is also the desire of some TNCs to transpose work practices from one country (for example, Japan) to the home country. In Australia, for example, Mitsubishi and Toyota have been fairly successful in implementing some Japanese employment practices in their Australian factories. However, this was done in consultation with unions. In the United States, Japanese auto companies have been able to establish non-union plants—a practice that is feasible in the United States because of the low level of unionization of the private sector workplace (about 9 per cent), but not feasible in Australia where unions are much stronger, even though membership is declining (now about 25 per cent of the total workforce). There are two broad approaches to international labor relations: centralized and decentralized. Both approaches are necessary and one must dovetail into the other. 1. Centralization is desirable when decisions are concerned with labor and transportation costs, skill levels, availability of natural resources and the political climate in countries in which the TNC operates. 2. Decentralization is desirable when decisions are concerned with labor laws, union power, the nature of collective bargaining and the work culture. Increasingly, the way work is organized in particular countries is seen as a source of competitive advantage. Employee participation has a long history and comes in many forms.

INTERNATIONAL LABOR STANDARDS It has been the effort of developed nations to establish internationally agreed norms and standards of behavior for the conduct of employee relations. The main objective of this is to prevent unfair competition among countries by reducing labor conditions to unacceptably low levels. The International Labour Organization (ILO), founded in 1919, is the most important body concerned with the setting of labor standards. It is the only tripartite UN agency with government, employer and worker representatives. This tripartite structure makes the ILO a unique forum in which the governments and the social partners of the economy of its 183 member states can freely and openly debate and elaborate labor standards

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and policies. Since its inception, the ILO has maintained and developed a system of international labor standards aimed at promoting opportunities for women and men to obtain decent and productive work, in conditions of freedom, equity, security and dignity. In today’s globalized economy, international labor standards are an essential component in the international framework for ensuring that the growth of the global economy provides benefits to all. The constitution of the ILO requires it to: ■■ ■■ ■■ ■■

Encourage the improvement of workers conditions Discourage particular countries from failing to adopt humane conditions of labor Promote the principle that labor not be regarded as a mere ‘commodity or article of commerce’ Support the view that the price of labor be determined by human need and that workers are entitled to a reasonable standard of living.

Standards refer to minimum levels of work condition for the employed and to levels of social security for the unemployed. Standards are usually formally incorporated into the laws of member countries based on the recommendations of bodies that set international standards. Achieving the goal of decent work in a globalized economy requires action at the international level. Over a period of time international legal instruments on trade, finance, environment, human rights and labor have emerged. The ILO contributes to this legal framework by elaborating and promoting international labor standards aimed at making sure that economic growth and development go along with the creation of decent work. The ILO’s unique tripartite structure ensures that these standards are backed by governments, employers and workers alike. International labor standards therefore lay down the basic minimum social standards agreed upon by all players in the global economy. An international legal framework on social standards ensures a level playing field in the global economy. It helps governments and employers to avoid the temptation of lowering labor standards in the belief that this could give them a greater comparative advantage in international trade. In the long run, such practices do not benefit anyone. Lowering labor standards can encourage the spread of low-wage, low-skill and high-turnover industries, and prevent a country from developing more stable high-skilled employment, at the same time making it more difficult for trading partners to develop their economies upwards. International labor standards are sometimes perceived as entailing significant costs and thus hindering economic development. A growing body of research indicates, however, that compliance with international labor standards often accompanies improvements in productivity and economic performance. Higher wage and working time standards and respect for equality can translate into better and more satisfied workers and lower turnover of staff. Investment in vocational training can result in a better-trained workforce and higher employment levels. Safety standards can reduce costly accidents and health-care fees. Employment protection can encourage workers to take risks and to innovate. Social protection such as unemployment schemes and active labor market policies can facilitate labor market flexibility; they make economic liberalization and privatization sustainable and more acceptable to the public. Freedom of association and collective bargaining can lead to better labor-management consultation and cooperation, thereby reducing the number of costly labor conflicts and enhancing social stability.

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■■ The firm’s IHRM policies should be congruent with the firm’s international strategy, its structure and its control systems. ■■ There are four approaches to staffing, namely, an ethnocentric approach, a polycentric approach, a geocentric approach and a regiocentric approach. ■■ An ethnocentric approach emphasizes the importance of parent-country nationals (PCNs) in key positions. It is congruent with an international strategy, but it may breed cultural myopia. ■■ A polycentric approach uses host-country nationals (HCNs) to manage subsidiaries and PCNs to manage corporate headquarters. This approach avoids cultural myopia but may produce tensions between home and host country operations. This approach suits a multi-domestic strategy. ■■ A geocentric approach employs PCNs, HCNs and third-country nationals (TCNs) to get the best people for the job regardless of nationality. This approach builds a strong organization culture and is suited to both global and transnational strategies. ■■ In a regiocentric approach, PCNs, HCNs and TCNs are used to employ the best person within a region rather than worldwide as in the geocentric approach. The regiocentric approach might be viewed as a scaled-down version of the geocentric approach or a transition stage between an ethnocentric and a polycentric approach. ■■ Training is directed at the acquisition of skills and the development of the acquisition of knowledge and wisdom. ■■ Management development is used as a strategic tool to build a strong organization culture and to promote informal networking, both of which support global and transnational strategies. ■■ Performance appraisal has noted the existence of bias in the host country because of cultural factors, and in the home country because of distance and lack of familiarity with the local scene on the part of home-country assessors. ■■ There are three approaches to compensation—the home-country approach, the host-country approach and the regional approach. ■■ The most common form of expatriate compensation is based on the home country. It contains six elements—the home-country base salary, and five categories of outlays, namely, goods and services, housing, income tax, contribution to savings, education expenses and social security taxes, and shipment and storage charges on personal and household effects. ■■ There is considerable disparity in the conduct of labor relations across countries, and for this reason a decentralized management approach is logical. However, the need to conduct operations globally or on a transnational basis makes it desirable to centralize some management decisions. ■■ Unions are concerned about pay, job security and working conditions and especially about the power of TNCs to switch operations from one country to another. Unions have been generally unsuccessful in countering the bargaining power of TNCs, but there is potential for gaining a competitive edge if employees are allowed to participate in decision-making through quality circles, semi-autonomous work groups and the like.

Key Terms Expatriate, Ethnocentric orientation, Polycentricity, Geocentric staffing policy, Regiocentricity, Training and development, Compensation programmes.

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DISCUSSION QUESTIONS 1. Write short notes on: a. Cross cultural training b. International labour relations 2. What do you understand by international HRM? Discuss the salient features of international HRM policy in terms of a firm’s strategic orientation. 3. Distinguish between training and development of an expatriate manager. 4. What are the basic approaches to compensation for an expatriate manager? 5. ‘International HRM includes the important issues of labor unions and their intervention’. Comment.

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16 INTERNATIONAL OPERATIONS LEARNING OBJECTIVES After reading this chapter, you should be able to:

■ ■ ■ ■ ■

Understand the increasing importance of logistics and supply-chain management as crucial tools for competitiveness Learn about material management and physical distribution Learn about the complexities of international logistics Explore the importance of transportation infrastructure Understand the importance of inventory management for the success of the business firm

THE PHARMA SUPPLY CHAIN Tasmania, an island of Australia’s southern coast, marks the beginning of a global supply chain that includes the world’s largest pharmaceutical companies and produces USD 12 billion a year of opiate painkillers. Tasmania’s gentle climate alongside perseverance in breeding techniques and tight regulation of the sector has ensured its control over raw material for some of the world’s most popularly used painkillers. For instance, almost 85 per cent of the world’s thebaine, an opium poppy extract used to make OxyContin and other similar powerful prescription drugs for pain management are grown in Tasmania. It produces the entire global supply of oripavine, which is used to treat heroin overdoses almost a quarter of the world’s morphine and codeine, two older painkillers from opium poppies that are still widely used, particularly outside North America. The supply chain has USA as the largest buyer of Tasmanian opium poppy extract as it consumes almost three-fourths of the entire produce. Tasmania’s monopoly in producing opiate painkillers has become a cause of worry for the global pharmaceutical industry and it finds pharmaceutical majors GlaxoSmithKline and Johnson & Johnson looking at diversifying their sources of supply. Their diversification strategies include efforts to cultivate opium poppies for export near Melbourne and persuading the Tasmanian government to legalize genetic engineering for poppies to be able to produce more robust and reliable varieties of narcotics and keep the supply chain in good health. Source: http://www.nytimes.com/2014/07/20/business/international/tasmania-big-supplier-to-drug-companiesfaces-changes.html?_r=0, last accessed on 24 July 2014.

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INTRODUCTION A defining characteristic of the international firm today is the wide dispersal of customer locations and sourcing opportunities. In order to maintain its competitive position, firms need to successfully ­manage complex international networks consisting of vendors, suppliers, customers and other third parties. Neglecting the links within these complex networks can result in more expensive supplies and lower profits, leading to a loss of competitiveness and market share. This chapter discusses the important issues in the supply chain and logistics for the international business firm. It focuses on the links between the firm, its suppliers and customers as well the related issues of transportation, inventory, packaging and storage.

SUPPLY-CHAIN MANAGEMENT Supply-chain management refers to a series of valueThe business supply chain is a co-ordinated adding activities that connects the supply side of the activity encompassing materials, information, business with its demand side. It may be defined as and funds from the initial raw material supplier to the integration of business processes which link the the end consumer. buyer with the original suppliers and includes all the products, services and information included in this value-adding process. The business supply chain is a co-ordinated activity encompassing materials, information, and funds from the initial raw material supplier to the end consumer. A comprehensive global supply-chain strategy has elements of customer-service requirements, There are four major decision areas in supply chain management: location, production, invenplant and distribution centre network design, inventory, and transportation (distribution), and there tory management, outsourcing and third party are both strategic and operational elements in logistics relationships, key customer and supplier each of these decision areas. relationships, business processes, information systems, organizational design and training requirements, performance metrics and performance goals. Managing the supply chain may be considered synonymous with managing the value chain. The concept of the firm’s value chain, (Figure 16.1 illustrates a generic value chain) developed by Michael Porter, refers to a chain of value-creating activities meant for the satisfaction of the final consumer. They encompass the firm’s supply chain and are divided into two categories:

1. Primary activities 2. Support activities

This approach views the supply chain of the entire extended enterprise, beginning with the supplier’s suppliers and ending with consumers or end users. The perspective encompasses the entire flow of funds, products and information that form one cohesive link to acquire, purchase, convert/manufacture, assemble and distribute goods and services to the ultimate consumers. The value chain is an important source of competitive advantage for the firm. A supply chain consists of all parties involved, directly or indirectly, in fulfilling a customer request. The supply chain not only includes the manufacturer and suppliers, but also transporters, warehouses, retailers and customers themselves. Within each organization, such as a manufacturer, the supply chain

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Support activities Firm infrastructure Human resource

Inbound logistics

Operations

Outbound logistics

Marketing and sales

Service

IT Purchase Primary activities

Figure 16.1  Generic Value Chain includes all functions involved in receiving and filling a customer request. These functions include, but are not limited to, new product development, marketing, operations, distribution, finance, and customer service. A supply chain is dynamic and involves the constant flow of information, product, and funds between different stages. Take the example of Walmart, an international giant soon to be based in India as well. Walmart provides the product as well as pricing and availability information to the customer. The customer transfers funds to Walmart, which conveys point-of-sales data as well as replenishment order via trucks back to the store. It transfers funds to the distributor after the replenishment. The distributor also provides pricing information and sends delivery schedules to Walmart. Similar information, material and fund flows take place across the entire supply chain. A typical supply chain may involve a variety of stages. These supply chain stages include: ■■ ■■ ■■ ■■ ■■

Customers Retailers Wholesalers/distributors Manufacturers Component/raw-material suppliers

Each stage need not be presented in a supply chain. The appropriate design of the supply chain will depend on both the customer’s needs and the roles of the stages involved. In some cases, companies such as Dell, may fill customer orders directly. Dell builds to order; that is, a customer order initiates manufacturing at Dell. Dell does not have a retailer, wholesaler or distributor in its supply chain. In other cases, such as the famous mail-order company L.L. Bean in the United States, manufacturers do not respond to customer orders directly. In this case, L.L. Bean maintains an inventory or product from which they fill customer orders. Compared to the Dell supply chain, the L.L. Bean supply chain contains an extra stage (the retailer, L.L. Bean itself) between the customer and the manufacturer. In the case of other retail stores, the supply chain may also contain a wholesaler or distributor between the store and the manufacturer. These examples illustrate that the customer is an integral part of the supply chain. The primary purpose of the existence of any supply chain is to satisfy customer needs in the process of generating profits. Supply chain activities begin with a customer order and end when a satisfied customer has paid for his or her purchase. The term ‘supply chain’ conjures up images of products or supply moving

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from suppliers to manufacturers to distributors to retailers to customers along a chain. It is important to visualize information, funds and product flows along both directions of this chain. The term may also imply that only one player is involved at each stage. In reality, a manufacturer may receive material from several ­suppliers and then supply several distributors. Thus, most supply chains are actually networks. It may be more accurate to use the term ‘supply network’ or supply web to describe the structure of most supply chains. Expert supply-chain management skills facilitate the identification of attractive sources of ­supply and help firms develop a low-cost competitive supply position in export markets. They also help develop good relationships with suppliers, and ensure quality inputs at reasonable prices delivered on a timely basis. For example, it has permitted Walmart, the largest US retailer, to reduce inventories by 90 per cent, saved the company hundreds of millions of dollars in inventory holding costs, and allows it to offer low prices to its customers. Advances in information technology have been crucial to progress in supply-chain management. Dell, for example, has reduced the length of its supply chain by removal of the retailer and taking orders online from the customer. These developments open up supplier relationships for companies outside the buyer’s domestic market; however, the supplier’s capability of proBird’s-eye View viding goods and services that are able to satisfy consumer demand completely will play the most Supply-chain management refers to a series critical role in securing long term contracts. In of value-adding activities which connect the addition, the physical delivery of goods often can demand side of the business with its supply be old-fashioned and slow. Nevertheless, the use of side. These activities exist all along the chain such strategic tools will be crucial for international from the initial procurement of raw material to managers to develop and maintain key competitive the final consumer. advantages.

INTERNATIONAL LOGISTICS International logistics is the design and management International logistics is the design and manageof a system that controls the forward and reverse flow ment of a system that controls the forward and of materials, services and information into, through reverse flow of materials, services and informaand out of the international corporation. It encomtion into, through and out of the international passes the total movement concept by covering the corporation. entire range of operations concerned with movement, including, therefore, both exports and imports. By taking a systems approach, the firm explicitly recognizes the links among the traditionally separate logistics components within and outside a corporation. By incorporating the interaction with outside organizations and individuals such as suppliers and customers, the firm is able to build on jointness of purpose by all partners in the areas of performance, quality and timing. As a result of implementing these systems considerations successfully, the firm can develop just-in-time (JIT) delivery for lower inventory cost, electronic data interchange (EDI) for more efficient order processing, and early supplier involvement (ESI) for better planning of goods development and movement. In addition, the use of such a systems approach allows a firm to concentrate on its core competencies and to form outsourcing alliances with other companies. For example, a firm can choose to focus on manufacturing and leave all aspects of order filling and delivery to an outside provider. By working closely with customers such

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as retailers, firms can also develop efficient customer response (ECR) systems, which can track sales activity at the retail level. As a result, manufacturers can precisely coordinate production in response to actual shelf-replenishment needs, rather than based on forecasts. Two major phases in the movement of materials are of logistical importance.

1. The first phase is materials management, or the timely movement of raw materials, parts and supplies into and through the firm. 2. The second phase is physical distribution, which involves the movement of the firm’s finished product to its customers. In both phases, movement is seen within the context of the entire process and includes storage and inventory. The basic goal of logistics management is the effective coordination of both phases and their various components to result in maximum cost ­effectiveness while maintaining service goals and requirements.

The key to business logistics is based on three major concepts.

Systems Concept This is based on the notion that materials-flow activSystems concept is based on the notion that ities within and outside of the firm are so extensive materials-flow activities within and outside of and complex that they can be considered only in the the firm are so extensive and complex that they context of their interaction. Instead of each corpocan be considered only in the context of their rate function, supplier and customer operating with interaction. the goal of individual optimization, the systems concept stipulates that some components may have to work sub-optimally to maximize the benefits of the system as a whole. The systems concept intends to provide the firm, its suppliers and its customers, both domestic and foreign, with the benefits of synergy, which is the result of the coordinated application of size. The systems concept is successful only in the presence of proper information flows and partnership trust. Logistics capability is highly information dependent, since information availability is the key to planning and to process implementation. Long-term partnership and trust are required in order to forge closer links between firms and managers.

Total Cost Concept A logical outgrowth of the systems concept is the The purpose of the total cost concept is to minidevelopment of the total cost concept. To evaluate and mize the firm’s overall logistics cost by impleoptimize logistical activities, cost is used as a basis for menting the systems concept appropriately. measurement. The purpose of the total cost concept is to minimize the firm’s overall logistics cost by implementing the systems concept appropriately. Implementation of the total cost concept requires that the members of the system understand the sources of costs. To develop such understanding, a system of activity-based costing has been developed, which is a technique designed to more accurately assign the indirect and direct resources of an organization to the activities performed based on consumption. In the international arena, the total cost concept must also incorporate the consideration of total after-tax profit by taking the impact of national tax policies on the logistics function into account. The objective is to maximize aftertax profits rather than minimizing total cost.

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Trade-off Concept This recognizes the links within logistics systems that result from the interaction of their components. For example, locating a warehouse near the customer may reduce the cost of transportation. However, additional costs are associated with new warehouses. Similarly, a reduction of inventories will save money, but may increase the need for costly emergency shipments. Managers can maximize performance of logistics systems only by formulating decisions based on the recognition and analysis of such trade-offs.

GLOBAL SUPPLY CHAIN DECISIONS The key to making supply chains work is informaEnterprise resource planning is a software tion. The use of electronic data interchange (EDI) that links information flows from different parts is the central link between suppliers, manufacturers of a business and from different geographical and customers used by leading global firms such as regions. Walmart. However, EDI has limited usage and does not adapt easily to the global marketplace. It is also fairly expensive, so small and medium enterprises find it difficult to install and implement. Another useful technological resource in a supply chain is enterprise resource planning (ERP), which is a software that links information flows from different parts of a business and from different geographical regions. Its only drawback is its inability to link up with the customer. The evolution of e-commerce has been a major breakthrough in supply-chain management. For instance, Dell in the opening vignette is an example of e-commerce, in which the company takes orders via the Internet. It also has an extranet for its suppliers to link them to its information system.

Quality Another key ingredient of global supply-chain management is total quality management. Quality may be defined as the ability of a product or a service to conform to certain norms or specifications of value, fitness for use, support and psychological impression. There are various ways of looking at this. The Japanese approach to quality is through the Total quality management is a process that concept of total quality management (TQM). emphasizes customer satisfaction, employee TQM is a process that emphasizes customer satinvolvement and continuous quality improveisfaction, employee involvement and continuous ment by focusing on benchmarking world-class quality improvement by focusing on benchmarking standards, product and service design, and world-class standards, product and service design, purchasing. and purchasing. The goal of TQM is to eliminate all defects. The belief in the zero-defects philosophy is reflected in a process of continuous improvement called Kaizen, which is the essence of TQM. Six Sigma is a highly focused system of qualAn alternate tool of quality management, called ity control that aims to eliminate defects, reduce Six Sigma, is a highly focused system of quality product cycle times and cut costs after a scrutiny of the firm’s entire production system. control that aims to eliminate defects, reduce product cycle times and cut costs after a scrutiny of the firm’s entire production system. Introduced in the 1980s by Motorola, it has been subsequently adopted by several TNCs, including General Electric Company, GlaxoSmithKline plc and Lockheed Martin Corporation.

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We classify the decisions for supply-chain management into two broad categories—strategic and operational. As the term implies, strategic decisions are typically made over a longer time horizon. These are closely linked to the corporate strategy, and guide supply-chain policies from a design perspective. On the other hand, operational decisions are short-term, and focus on activities on a day-to-day basis. The effort in these types of decisions is to effectively and efficiently manage the product flow in the ‘strategically’ planned supply chain.

Third-party Logistics (3PL) The process of outsourcing logistics is known as third-party logistics. The use of 3PL enables a firm to save time and money and have a major increase in revenues if the 3PL provider is reputed and reliable. Customers have greater faith in business enterprises that are likely to deliver goods on time and accurately. As firms look towards global expansion they find that in-house development of the supply-chain function is both costly and time-consuming. This makes them look towards outsourcing the function and utilizing the services of a 3PL service provider. Global logistics as an industry encompasses transportation, warehousing and storage facilities. Increasing globalization has led to the growth of new technologies related to both physical and informational flows. Some commonly used logistical strategies are as follows. Cross Docking The strategy of cross docking pertains to directly linking inbound flows of goods from suppliers to customers with a minimal use of warehousing. The distribution centre directly receives goods from the supplier and sorts them to be shipped as a consolidated batch to a group of customers. Milk Runs This refers to a schedule meant to make full use of vehicle capacity and reduce transportation costs. The same vehicle is used for delivery of products to the customer and to collect empty cans, giving customers the benefit of frequent deliveries at a low cost. It involves having fixed routes and destinations for loading and unloading. Kitting This is the process of organizing components into logically interrelated bins before assembly to ensure effective JIT manufacturing process, and is a critical element of inventory control. It helps in easy storage and quick shipment and delivery.

Location Decisions The geographic placement of production facilities, stocking points and sourcing points is the natural first step in creating a supply chain. The location of facilities involves a commitment of resources to a long-term plan. Once the size, number, and location of these are determined, so are the possible paths by which the product flows to the final customer. These decisions are of great significance to a firm as they represent the basic strategy for accessing customer markets, and will have a considerable impact on revenue, cost and level of service. These decisions should be determined by an optimization routine that considers production costs, taxes, duties and duty drawback, tariffs, local content, distribution costs and production limitations. Although location decisions are primarily strategic, they also have implications on an operational level.

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Production Decisions The strategic decisions include what products to produce; which plants to produce them in; and allocation of suppliers to plants, plants to distribution centres, and distribution centres to customer markets. A basic dilemma the firm faces is the make-or-buy decision. In taking a call on this the firm should focus on manufacturing parts that are critical to the product and in which it has a distinct edge. It should outsource those where the comparative advantage form scale of operations, low costs and strong performance incentives lies elsewhere. In taking the decision to outsource, the TNC establishes various kinds of supplier relationships. For instance, Toyota Motor Corporation pioneered the Toyota Production System, where it sent a team of manufacturing experts to each of its key suppliers to observe production and other processes and advise them on methods that help to cut costs and boost quality. This helps it to ensure uniform quality according to its high performance metrics. Another interesting strategy employed by Toyota is to ­create competition between two suppliers and give greater business to the one who performs better. This is typical of the Japanese approach of developing close relationships with their suppliers, which helps it to reduce the number of supplier relationships it has to keep. For instance, Toyota has 150 parts suppliers for its British operations, a small number compared to the 500 to 1,000 suppliers that European carmakers typically have. As before, these decisions have a big impact on the revenues, costs and customer service levels of the firm. These decisions assume the existence of the facilities, but determine the exact path(s) through which a product flows to and from these facilities. Another critical issue is the capacity of the manufacturing facilities, and this largely depends on the degree of vertical integration within the firm. Operational decisions focus on detailed production scheduling. These decisions include the construction of the master production schedules, scheduling production on machines and equipment maintenance. Other considerations include workload balancing, and quality control measures at a production facility.

Purchasing Decision The TNC’s procurement decision goes through four distinct phases: domestic purchasing, foreign need-based purchasing, foreign procurement strategy and the integration of procurement into a global strategy. The procurement decision moves from the simple to the complex based on the firm’s internationalization strategy. As the TNCs orientation becomes more global it faces a centralization/ decentralization dilemma of whether to keep procurement a centralized activity or to let a subsidiary handle some of it. Firms usually begin by domestic purchasing and then move towards integrating and coordinating procurement globally. Large firms sometimes coordinate global purchasing with competitors to keep costs under check. For instance, in 2003, Hyundai Motor Company, DiamlerChrysler and Mitsubishi Motors made joint worldwide purchases of motor parts and helped to establish localized supply chains.

Inventory Decisions Inventories exist at every stage of the supply chain as either raw materials, or semi-finished or finished goods. They can also be work-in-process between locations. Their primary purpose is to act as a buffer against any uncertainty that might exist in the supply chain. Since holding of inventories can cost anywhere between 20 to 40 per cent of the firm’s total cost of production, their efficient management is

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critical in supply-chain operations. Inventory decisions are strategic in the sense that top management sets the goals, but have an operational perspective. These include deployment strategies (push versus pull), control policies—the determination of the optimal levels of order quantities and reorder points, and setting safety stock levels at each stocking location. These levels are critical, since they are primary determinants of customer service levels. Inventories tie up a major portion of corporate funds. Capital used for inventory is not available for other corporate opportunities. Annual inventory carrying costs (the expense of maintaining inventories), though heavily influenced by the cost of capital and industry specific conditions, can account for 15 per cent or more of the value of the inventories themselves. Therefore, proper inventory policies should be of major concern to the international logistician. Firms are, therefore, increasingly using just-in-time inventory policies, which minimize the volume of inventory by making it available only when it is needed. The just-intime method is increasingly required by multinational manufacturers and distributors engaging in supply-chain management. They choose suppliers on the basis of their delivery and inventory performance, and their ability to integrate themselves into the supply chain. Proper inventory management may therefore become a determining variable in obtaining a sale. The purpose of establishing inventory systems—to maintain product movement in the delivery pipeline and to have a cushion to absorb demand fluctuations—is the same for domestic and international operations. The international environment, however, includes unique factors such as currency exchange rates, greater distances and duties. At the same time, international operations provide the corporation with an opportunity to explore alternatives not available in a domestic setting, such as new sourcing or location alternatives. In international operations, the firm can make use of currency fluctuation by placing varying degrees of emphasis on inventory operations, depending on the stability of the currency of a specific country. Entire operations can be shifted to different nations to take advantage of new opportunities. International inventory management can therefore be much more flexible in its response to environmental changes. An important aspect of inventory management is the quality of inventory. Defective inventory is not only a waste, it also incurs carrying costs. The geographical distance between the buyer and the supplier and language and cultural differences results in increased time to educate suppliers on methods of supplying quality products. Shoemaker Nike outsources the manufacture of its shoes to various factories in China but has a team of its own personnel to keep a check on quality. The quality of inventory also has implications for JIT, which typically implies sole sourcing for specific parts to be able to keep up with a stringent delivery schedule. If the firm uses a foreign supplier, it is a risky proposition to have just one, and multiple suppliers lead to loss in terms of being unable to get the benefits of volume pricing. Firms often use a sole supplier for critical inputs and cultivate alternate suppliers for others. The ­following variables are considered critical to inventory management: Order Cycle Time The period between the placement of an order and the receipt of the merchandise is referred to as order cycle time. Two dimensions are of major importance to inventory management—the length of the total order cycle and its consistency. In international business, the order cycle is frequently longer than in domestic business. It comprises the time involved in order transmission, order filling, packing and preparation for shipment, and transportation. Order transmission time varies greatly internationally depending on the method of communication.

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Supply-chain driven firms use EDI rather than fax, telex, telephone or mail. EDI is the direct transfer of information technology between computers of trading partners. The usual paperwork the partners send each other, such as purchase orders and confirmations, bills of lading, invoices and shipment notices are formatted into standard messages and transmitted via a direct link network or a third-party network. EDI can streamline processing and administration and reduce the costs of exchanging information. The order-filling time may also increase because a lack of familiarity with a foreign market makes the anticipation of new orders more difficult. Packing and shipment preparation require more detailed attention. Finally, of course, transportation time increases with the distances involved. Larger inventories may have to be maintained both domestically and internationally to bridge the time gaps. Consistency, the second dimension of order cycle time, is also more difficult to maintain in international business. Depending on the choice of transportation mode, delivery times may vary considerably from shipment to shipment. The variation may require the maintenance of larger safety stocks to be able to fill demand in periods when delays occur. Customer Service Levels The level of customer service denotes the responsiveness that inventory policies permit for any given situation. A customer service level of 100 per cent would be defined as the ability to fill all orders within a set time—for example, three days. If, within the same three days, only 70 per cent of the orders can be filled, the customer service level is 70 per cent. The choice of customer service level for the firm has a major impact on the inventories needed. In highly industrialized nations, firms frequently are expected to adhere to very high levels of customer service. Corporations are often tempted to design international customer service standards to similar levels. Yet, service levels should not be oriented primarily around cost or customary home-country standards. Rather, the international service level should be based on expectations encountered in each market. These expectations are dependent on past performance, product desirability, customer sophistication, and the competitive status of the firm. Since high customer service levels are costly, the goal should not be the highest customer service level possible, but rather an acceptable level. Different customers have different priorities. Some will be prepared to pay a premium for speed, some may put a higher value on flexibility, and another group may see low cost as the most important issue. Flexibility and speed are expensive, so it is wasteful to supply them to customers who do not value them highly. If, for example, foreign customers expect to receive their merchandise within 30 days, it does not make sense for the international corporation to promise delivery within 10 or 15 days. Indeed, such delivery may result in storage problems. In addition, the higher prices associated with higher customer service levels may reduce the competitiveness of a firm’s product. By contrast, in a business-to-business setting, sometimes even a delay of a few hours in the delivery of a crucial component may be unacceptable because the result may be a shutdown of the production process. In such instances, strategically placed depots in a region must ensure that near- instantaneous Bird’s-eye View response becomes possible. For example, Storage Technology Corporation, a maker of storage Global supply-chain decisions involve issues devices for mainframe computers, keeps parts at of quality and third party logistics as well as seven of its European subsidiary offices so that in decisions on purchase, location and inventory an emergency it can reach any continental customer issues. within four hours.

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International Packaging Issues Packaging is instrumental in getting the merchandise to the ultimate destination in a safe, maintainable and presentable condition. Packaging that is adequate for domestic shipping may be inadequate for international transportation because the shipment will be subject to the motions of the vessel by which it is carried. Added stress in international shipping also arises from the transfer of goods among different modes of transportation. Packaging decisions must also take into account differences in environmental conditions, like climate. When the ultimate destination is very humid or particularly cold, special provisions must be made to prevent damage to the product. The task becomes even more challenging when one considers that dramatic changes in climate can take place in the course of long-distance transportation. A famous case is the firm in Taiwan that shipped drinking glasses to the Middle East. The company used wooden crates and padded the glasses with hay. Most of the glasses, however, were broken by the time they reached their destination. As the crates travelled into the dry Middle East, the moisture content of the hay dropped. By the time the crates were delivered, the thin straw offered almost no protection. The weight of packaging must also be considered, particularly when airfreight is used, as the cost of shipping is often based on weight. At the same time, packaging material must be sufficiently strong to permit stacking in international transportation. Another consideration is that, in some countries, duties are assessed according to the gross weight of shipments, which includes the weight of packaging. Obviously, the heavier the packaging, the higher the duty will be. The shipper must pay sufficient attention to instructions provided by the customer for packaging. For example, requests by the customer that the weight of any one package should not exceed a certain limit or that specific package dimensions should be adhered to are usually made for a reason. Often they reflect limitations in transportation or handling facilities at the destination. Although the packaging of a product is often used as a form of display abroad, international packaging can rarely serve the dual purpose of protection and display. Therefore, double packaging may be necessary. The display package is for future use at the point of destination; another package surrounds it for protective purposes. One solution to the packaging problem in international logistics has been the development of intermodal containers—large metal boxes that fit on trucks, ships, railroad cars and airplanes and ease the frequent transfer of goods in international shipments. Developed in different forms for both sea and air transportation, containers also offer better utilization of carrier space because of standardization of size. The shipper therefore may benefit from lower transportation rates. In addition, containers can offer greater safety from pilferage and damage. Of course, at the same time, the use of containers allows thieves to abscond with an entire shipment rather than just parts of it. On some routes in Russia, for example, theft and pilferage of cargo are so common that liability insurers refuse to cover container haulers in the region. Nowadays, several countries such as Germany also require biodegradable packaging for import consignments. Container traffic is heavily dependent on the existence of appropriate handling facilities both domestically and internationally. In addition, the quality of inland transportation must be considered. If transportation for containers is not available and the merchandise must be unpacked and reloaded, the expected cost reductions may not materialize. Overall international packaging must pay attention to cost issues. The customer who ordered and paid for the merchandise expects it to arrive on time and in good condition. Even with replacements and insurance, the customer will not be satisfied if there are delays. Dissatisfaction will usually translate directly into lost sales.

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International Storage Issues Although international logistics is discussed as a movement or flow of goods, a stationary period is involved when merchandise becomes inventory stored in warehouses. Heated arguments can arise within a firm over the need for and utility of warehousing internationally. On the one hand, customers expect quick responses to orders and rapid delivery. Accommodating the customer’s expectations would require locating many distribution centres around the world. On the other hand, warehouse space is expensive. In addition, the larger volume of inventory increases the inventory carrying cost. Fewer warehouses allow for consolidation of transportation and therefore lower transportation rates to the warehouse. However, if the warehouses are located far from customers, the cost of outgoing transportation increases. The international logistician must consider the tradeoffs between service and cost to the supply chain in order to determine the appropriate levels of warehousing. The location decision addresses how many distribution centres to have and where to locate them. The availability of facilities abroad will differ from the domestic situation. For example, while public storage is widely available in some countries, such facilities may be scarce or entirely lacking in others. Also, the standards and quality of facilities can vary widely. As a result, the storage decision of the firm is often accompanied by the need for large-scale, long-term investments. Despite the high cost, international storage facilities should be established if they support the overall logistics effort. In many markets, adequate storage facilities are imperative to satisfy customer demands and to compete successfully. For example, since the establishment of a warehouse connotes a visible presence, in doing so a firm can convince local distributors and customers of its commitment to remain in the market for the long term. Once the decision is made to use storage facilities abroad, the warehouse conditions must be carefully analysed. As an example, in some countries warehouses have low ceilings. Packaging developed for the high stacking of products is therefore unnecessary or even counterproductive. In other countries, automated warehousing is available. Proper bar coding of products and the use of package dimensions acceptable to the warehousing system are basic requirements. In contrast, in warehouses still stocked manually, weight limitations will be of major concern. And, if no forklift trucks are available, palletized delivery is of little use. To optimize the logistics system, the logistician should analyse international product sales and then rank order products according to warehousing needs. Products that are most sensitive to delivery time might be classified as ‘A’ products. These would be stocked in all distribution centres, and safety stock levels would be kept high. Alternatively, the storage of products can be more selective, if quick delivery by air can be guaranteed. Products for which immediate delivery is not urgent could be classified as ‘B’ products. They would be stored only at selected distribution centres around the world. Finally, products for which there is little demand would be stocked only at the headquarters. Should an urgent need for delivery arise, airfreight could again assure rapid shipment. Classifying products enables the international logistician to substantially reduce total international warehousing requirements and still maintain acceptable service levels.

Transportation Decisions The choice of mode of transport has huge strategic implications as the best choice of mode is often found by trading-off the cost of using the particular mode of transport with the indirect cost of inventory associated with it. While air shipments may be fast, reliable and warrant lesser safety stocks, they are expensive. On the other hand, shipping by sea or rail may be much cheaper, but they necessitate holding relatively large amounts of inventory to buffer against the inherent uncertainty associated with

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them. Therefore customer service levels and geographic location play vital roles in such decisions. Since transportation is more than 30 per cent of total cost, decision such as routing and scheduling of equipment are key variables in effective management of the firm’s transport strategy. For example, close collaboration with suppliers is required to develop a just-in-time inventory system, which in turn may be crucial to maintaining manufacturing costs at globally competitive levels. Yet, without electronic data interchange, such collaborations or alliances are severely handicapped. While most industrialized countries can offer the technological infrastructure for such computer-to-computer exchange of business information, the application of such a system in the global environment may be severely restricted. It may not be just the lack of technology that forms the key obstacle to modern logistics management, but rather the entire business infrastructure, ranging from ways of doing business in fields such as accounting and inventory tracking, to the willingness of businesses to collaborate with each other. Modes of Transport International transportation frequently requires ocean The two basic modes of transportation are or airfreight modes, which many corporations only ocean shipping and air shipping. rarely use domestically. In addition, combinations such as land bridges or sea bridges may permit the transfer of freight among various modes of transportation, resulting in intermodal movements. The international logistics manager must understand the specific properties of the different modes to be able to use them intelligently. Water transportation is a key mode for international freight movement. Three types of vessels operating in ocean shipping can be distinguished by their service—liner s­ ervice, bulk service, and tramp or charter service. 1. Liner service offers regularly schedule passage on established routes. 2. Bulk service mainly provides contractual services for individual voyages or for prolonged ­periods of time. 3. Tramp service is available for irregular routes and scheduled only on demand. Vessels can also be distinguished by the type of cargo a vessel can carry. Most common are conventional (break bulk) cargo vessels, container ships and roll-on-roll-off vessels. ■■ Conventional cargo vessels are useful for oversized and unusual cargoes, but may be less efficient in their port operations. ■■ Container ships carry standardized containers that greatly facilitate the loading and unloading of cargo and intermodal transfers. As a result, the time the ship has to spend in port is reduced, as are the port charges. ■■ Roll-on-roll-off (RORO) vessels are essentially oceangoing ferries. Trucks can drive onto builtin ramps and roll off at the destination. ■■ Lighter aboard ship (LASH) is a vessel similar to the RORO vessel. LASH vessels consist of barges stored on the ship and lowered at the point of destination. The individual barges can then operate on inland waterways, a feature that is particularly useful in shallow water. The availability of a certain type of vessel, however, does not automatically mean that it can be used. The greatest constraint in international ocean shipping is the lack of ports and port services. For example, modern container ships cannot serve some ports because the local equipment cannot handle the resulting traffic. The problem is often found in developing countries, where local authorities lack

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the funds to develop facilities. In some instances, governments may purposely limit the development of ports to impede the inflow of imports. Increasingly, however, governments have begun to recognize the importance of an appropriate port facility structure and are developing such facilities in spite of the large investments necessary. Air shipping is available to and from most countries. This includes the developing world, where it is often a matter of national prestige to operate a national airline. The total volume of airfreight in relation to total shipping volume in international business remains quite small. However, 40 per cent of the world’s manufactured exports (by value) travel by air. Clearly, high-value items are more likely to be shipped by air, particularly if they have a high density, that is, a high weight-to-volume ratio. Over the years, airlines have made major efforts to increase the volume of airfreight. Many of these activities have concentrated on developing better, more efficient ground facilities, introducing airfreight containers, and providing and marketing a wide variety of special services to shippers. In addition, some airfreight companies and ports have specialized and become partners in the international logistics effort. Changes have also taken place within the aircraft. As an example, 40 years ago, the holds of large propeller aircraft could take only about 10 tonnes of cargo. Today’s jumbo jets can load up to 120 metric tonnes of cargo with an available space of 636 cubic metres, and can, therefore, transport bulky products such as locomotives. In addition, aircraft manufacturers have responded to industry demands by developing both jumbo cargo planes and combination passenger and cargo aircraft. The latter carry passengers in one section of the main deck and freight in another. These hybrids can be used by carriers on routes that would be uneconomical for passengers or freight alone. From the shipper’s perspective, the products involved must be appropriate for air shipment in terms of their size. In addition, the market situation for any given product must be evaluated. Airfreight may be needed if a product is perishable or if, for other reasons, it requires a short transit time. The level of customer service needs and expectations can also play a decisive role. For example, the shipment of an industrial product that is vital to the ongoing operations of a customer may be much more urgent than the shipment of packaged consumer products. Selecting a Mode of Transport The international logistics manager must make an appropriate selection from among the available modes of transportation based on the needs of the firm and its customers. The manager must consider the performance of each mode on four dimensions—transit time, predictability, cost and non-economic factors.

Selection of an appropriate mode of transport is based on four dimensions—transit time, predictability, cost and other non-economic factors such as preferential treatment.

Transit Time: The period between departure and arrival of the carrier varies significantly between ocean freight and airfreight. For example, the 45-day transit time of an ocean shipment can be reduced to 24 hours if the firm chooses airfreight. The length of transit time can have a major impact on the overall operations of the firm. As an example, a short transit time may reduce or even eliminate the need for an overseas depot. Also, inventories can be significantly reduced if they are replenished frequently. As a result, capital can be freed up and used to finance other corporate opportunities. Transit time can also play a major role in emergency situations. For example, if the shipper is about to miss an important delivery date because of production delays, a shipment normally made by ocean freight can be made by air. Overall, it has been estimated that each day that goods are in transit adds about 0.8 per cent to the cost of the goods. Therefore, an extra 25 period spent at sea adds the equivalent of a 16 per cent tariff on those goods, drastically reducing their competitiveness.

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Perishable products require shorter transit times. Transporting them rapidly prolongs the shelf life in the foreign market. Air delivery may be the only way to enter foreign markets successfully with products that have a short life span. International sales of cut flowers have reached their current volume only as a result of airfreight. At all times, the logistics manager must understand the interactions between different components of the logistics process and their effect on transit times. Unless a smooth flow throughout the supply chain can be assured, bottlenecks will deny any timing benefits from specific improvements. For example, Levi Strauss & Co., the blue jeans manufacturer, offers customers the chance to be measured by a body scanner in some of its stores. Less than an hour after this measurement, a Levi factory has begun to cut the jeans of their choice. Unfortunately, it then takes 10 days to get the finished jean to the customer. Predictability: Providers of both ocean freight and airfreight service wrestle with the issue of reliability. Both modes are subject to the vagaries of nature, which may impose delays. Yet, because reliability is a relative measure, the delay of one day for airfreight tends to be seen as much more severe and ‘unreliable’ than the same delay for ocean freight. However, delays tend to be shorter in absolute time for air shipments. As a result, arrival time via air is more predictable. This has a major influence on corporate strategy. For example, because of the higher predictability of airfreight, inventory safety stock can lie kept at lower levels. Greater predictability also can serve as a useful sales tool, as it permits more precise delivery promises to customers. If inadequate port facilities exist, airfreight may again be the better alternative. Unloading operations for oceangoing vessels are more cumbersome and time consuming than for planes. Merchandise shipped via air is likely to suffer less loss and damage from exposure of the cargo to movement. Therefore, once the merchandise arrives, it is more likely to be ready for immediate delivery—a fact that also enhances predictability. An important aspect of predictability is also the capability of a shipper to track goods at any point during the shipment. Tracking becomes particularly important as corporations increasingly obtain products from and send them to multiple locations around the world. Being able to coordinate the smooth flow of a multitude of interdependent shipments can make a vast difference in a corporation’s performance. Tracking allows the shipper to check on the functioning of the supply chain and to take remedial action if problems occur. Cargo also can be redirected if sudden demand surges so require. However, such enhanced corporate response to the predictability issue is only possible if an appropriate information system is developed by the shipper and the carrier, and is easily accessible to the user. Due to rapid advances in information technology, the ability to know where a shipment is has increased dramatically, while the cost of this critical knowledge has declined. Cost of Transportation: International transportation services are usually priced on the basis of both cost of the service provided and value of the service to the shipper. Due to the high value of the products shipped by air, airfreight is often priced according to the value of the service. In this instance, of course, price becomes a function of market demand and the monopolistic power of the carrier. The manager must decide whether the clearly higher cost of airfreight can be justified. In part, this will depend on the cargo’s properties. The physical density and the value of the cargo will affect the decision. Bulky products may be too expensive to ship by air, whereas very compact products may be more appropriate for airfreight transportation. High-priced items can absorb transportation costs more easily than low-priced goods because the cost of transportation as a percentage of total product cost will be lower. As a result, sending diamonds by airfreight is easier to justify than sending coal. Alternatively, a shipper can decide to mix modes of transportation in order to reduce overall cost and time delays. For example, part of the shipment route can be covered by air, while another portion can be covered by truck or ship.

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Most important, however, are the supply-chain considerations of the firm. The manager must determine how important it is for merchandise to arrive on time, which, for example, will be different for standard garments versus high fashion dresses. The effect of transportation cost on price and the need for product availability abroad must also be considered. Simply comparing transportation modes on the basis of price alone is insufficient. The manager must factor in all corporate, supplier and customer activities that are affected by the modal choice and explore the full implications of each alternative. For example, some firms may want to use airfreight as a new tool for aggressive market expansion. Airfreight may also be considered a good way to begin operations in new markets without making sizable investments for warehouses and distribution centres. The final selection of a mode will be the result of the importance of different modal dimensions to the markets under consideration. Non-economic Factors The transportation sector, nationally and internationally, both benefits and suffers from government involvement. Even though transportation carriers are one prime target in the sweep of privatization around the globe, many carriers are still owned or heavily subsidized by governments. As a result, ­governmental pressure is exerted on shippers to use national carriers, even if more economical alterBird’s-eye View natives exist. Such preferential policies are most often enforced when government cargo is being Transport is a vital issue in international sup­transported. Restrictions are not limited to develply-chain decisions and involves decisions oping countries. For example, in the United States, on modes of transport, based on cost factors, the federal government requires that all travellers transit time involved as well as predictability on government business use national flag carriers of various modes of transport. when available.

Transportation Infrastructure In industrialized countries, firms can count on an established transportation network. Around the globe, however, major infrastructural variations will be encountered. Some countries may have excellent inbound and outbound transportation systems but weak internal transportation links. This is particularly true in some developing countries, where the original transportation systems were designed to maximize the extractive potential of the countries. In such instances, shipping to the market may be easy, but distribution within the market may represent a very difficult and time-consuming task. Infrastructure problems can also be found in countries where most transportation networks were established between major ports and cities in past centuries. The areas lying outside the major transportation networks will encounter problems in bringing their goods to market. New routes of commerce have also opened up, particularly between the former East and West political blocs. Yet, without the proper infrastructure, the opening of markets is mainly accompanied by major new bottlenecks. On the part of the firm, it is crucial to have wide market access to be able to appeal to a sufficient number of customers. The firm’s logistics platform, which is determined by a location’s ease and convenience of market reach under favorable cost circumstances, is a key component of a firm’s competitive position. As different countries and regions may offer alternative logistics platforms, the firm must recognize that such alternatives can be the difference between success and failure. Policymakers in turn must recognize the impact they have on the quality of infrastructure. It is governmental planning that enables supply-chain capabilities and substantially affects logistics performance on the corporate level. In an era of foreign direct investment flexibility, the public sector’s investment

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priorities, safety regulations, tax incentives and transport policies can have major effects on the logistics decisions of firms. The logistics manager must therefore learn about existing and planned infrastructures abroad and at home and factor them into the firm’s strategy. In some countries, for example, railroads may be an excellent transportation mode, far surpassing the performance of trucking, while in others the use of railroads for freight distribution may be a gamble at best. The future routing of pipelines must be determined before any major commitments are made to a particular location if the product is amenable to pipeline transportation. The transportation methods used to carry cargo to seaports or airports must be investigated. Mistakes in the evaluation of transportation options can prove to be very costly. One researcher reported the case of a food processing firm that built a pineapple cannery at the delta of a river in Mexico. Since the pineapple plantation was located upstream, the company planned to float the ripe fruit down to the cannery on barges. To its dismay, however, the firm soon discovered that at harvest time the river current was far too strong for barge traffic. Since no other feasible alternative method of transportation existed, the plant was closed and the new equipment was sold for a fraction of its original cost. Extreme variations also exist in the frequency of transportation services. For example, a particular port may not be visited by a ship for weeks or even months. Sometimes only carriers with particular characteristics, such as small size, will serve a given location. All of these infrastructural concerns must be taken into account in the planning of the firm’s location and transportation framework. The opportunity of a highly competitive logistics platform may be decisive for the firm’s investment decision, as it forms a key component of the cost advantages sought by multinational corporations. If a location loses its logistics benefits, due to, for example, a deterioration of the railroad system, a firm may well decide to move on to another, more favorable locale. Governments must keep the transportation dimension in mind when attempting to attract new industries or trying to retain existing firms.

C H A P T E R

S U M M A R Y

■■ Supply-chain management refers to a series of value-adding activities that connects a company’s supply side with its demand side. It may be defined as the integration of business processes from end user through original suppliers, which provide products, services and information that add value for customers. ■■ A typical supply chain may involve a variety of stages including customers, retailers, whole­ salers/distributors, manufacturers and raw material suppliers. ■■ International logistics is the design and management of a system that controls the forward and reverse flow of materials, services, and information into, through, and out of the international corporation. ■■ There are four major decision areas in supply chain management: location, production, inventory, and transportation (distribution), and there are both strategic and operational elements in each of these decision areas. ■■ The two basic modes of transportation are ocean shipping and air shipping. Selection of an appropriate mode of transport is based on four dimensions: Transit time, predictability, cost and other non-economic factors such as preferential treatment.

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KEY TERMS Supply-chain management, International logistics, Total quality management, Enterprise resource planning, Six sigma, Cross docking, Milk run, Kitting, Order cycle time.

DISCUSSION QUESTIONS

1. 2. 3. 4. 5. 6.

What is supply chain management? Discuss its importance for an international business firm. Explain the concept of international logistics. Enumerate the various issues involved in supply chain decisions of the firm. Discuss the basic international inventory issues. What are the basic determinants of an appropriate mode of transport? Short notes: a. Total cost concept b. Systems concept c. Trade off concept 7. Explain some of the commonly used strategies in third party logistics. 8. Discuss some of the critical variables in inventory management decisions. 9. Discuss the factors which determine the choice of different modes of transport.

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17 INTERNATIONAL FINANCE AND ACCOUNTING

LEARNING OBJECTIVES After going through this chapter, you should be able to:

■ ■ ■ ■

Explain why accounting practices and standards differ from country to country

■

Explain the techniques available for international accounting management

Describe attempts to harmonize accounting practices in different countries Explain the rationale behind consolidated accounts Describe the differences in the financial structures required because of the culture and tax regimes of different countries

TAX HAVENS Almost 42 per cent of Indian FDI is routed through Mauritius. India has a Double Taxation Avoidance Treaty (DTAT) with Mauritius, just as it has with 65 other countries, including the United States of America, UK, Japan, France and Germany, but Mauritius is the preferred investment route as the companies registered there can choose to pay taxes in the island nation. Investors routing their investments through Mauritius into India do not pay capital gains tax either in India or Mauritius as it is an offshore financial centre with no provision of capital gains tax. The double taxation avoidance treaty between India and Mauritius seems to have encouraged Indian firms to ‘round trip’ investment through Mauritius and other tax haven countries to take advantage of the tax benefits enjoyed by overseas investors. The money parked in tax havens has therefore been a bone of contention for the government, with the opposition raking up the issue of black money time and again. Source: Information from ‘India Gets 43 per cent FDI Through Mauritius Route’, livemint.com, available at http:// www.livemint.com/2009/ 04/19143056/India-gets-43-FDI-through-Mau.html, last accessed 3rd October 2013.

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INTRODUCTION Accounting is known as the language of business. Accounting is a service activity whose function is to provide quantitative information, primarily financial in nature, about economic entities, intended to be useful in making economic decisions and in making reasoned choices among alternative courses of action. It is important for the accounting process to identify, record and interpret economic events to be able to assist in decision-making. International accounting is concerned with accounting and taxation issues for firms with international operations with diverse operating environments, standards and practices.

ACCOUNTING SYSTEM The accounting system is a set of rules, procedures and practices geared to fulfil the needs of its users. The accounting system is a set of rules, procedures and practices geared to fulfil the needs of The aim of an accounting system is to identify, meaits users. The aim of an accounting system is to sure and communicate economic information to identify, measure and communicate economic allow informed judgements and decisions by users information to allow informed judgements and of this information. The International Accounting decisions by users of this information. Standards Board (IASB) and its predecessor, the International Accounting Standards Committee, which is a key professional body of leading nations of the world, identify the following key users of financial information: ■■ ■■ ■■ ■■ ■■ ■■ ■■

Investors Employees Lenders Suppliers and other trade creditors Customers Governments and their agencies The public

Differences in accounting systems arise out of differences in national environment. The national economic system, comprising the level of inflation, economic and industrial structure, and the nature of the business organization—all have a bearing on the accounting system. High levels of inflation, for instance, prevalent in most countries affect historical costing in an enterprise but seem to be of no importance in countries where the inflation rate is low. Economic structure affects how accounting issues of pensions, retained earnings, dividends, depreciation and R&D costs amortization are handled. Thus, while pension accounting is an issue of great importance in the United States, it is of relatively recent origin in countries like India. In the United States, pension accounting is handled through companies, whereas in countries like India, Hong Kong and Chile, pensions are handled by the state. The complexity of business organizations that dominate an economy affect the complexity of the internal accounting information system and management accounting in general. If companies are small or family-owned, there would be little need for external sophisticated accounting systems. As a company increases in size, the need for a sophisticated system increases, with related issues of control, performance evaluation and decision-making assuming importance. The political and legal system similarly influences the accounting system. Countries that follow the codified legal system, such as France, Germany and Argentina, have a concrete and comprehensive accounting system. On the other hand, countries that follow common law have accounting practices that are decided by accountants themselves and are more flexible, innovative and adaptive.

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The quantity and quality of information provided in a country’s accounting system depends on both the level of user sophistication and the technical competence of accountants. The organization of the accounting profession and the power and autonomy to auditors and the accountant’s role in formulating regulation also influences the character of the system. Both the United Kingdom and the United States have strong accounting organizations that influence the direction and function of accountants in many countries. The government has an important role in the setting of accounting standards. It also has a dual role: ■■ In its role as the tax authority and other agencies it compiles statistics for general use, and ■■ It also acts as the regulator in the form of various securities and exchange commissions and responds to the perceived best interests of the public. The major users of accounting information other than those mentioned above are investors and creditors. Investors may work alone or through institutions such as investment companies, insurance companies and superannuation funds. It is important to identify users, because a focus on different users might result in different financial information being reported. For example, Germany’s major users have historically been creditors, so accounting has focused more on the balance sheet, which contains a description of the company’s assets. In the United States, however, the major users are investors, so accounting has focused more on the income statement. Investors see the income statement as an indication of the future success of the company, which affects the company’s stock and its flow of dividends. Taxation has a big influence on accounting standards and practices in Japan and France, but it is less important in the United States. Certain international factors also have weight, such as former colonial influence and foreign investment. For example, most countries that are current or former members of the British Commonwealth have accounting systems similar to the United Kingdom’s. Former French colonies use the French model, and so forth. These differences in accounting influence have resulted in differences in accounting standards and practices. As we saw in the opening case, existing differences and convergence towards a unified standard can complicate things for TNCs, because they need to prepare and understand reports which have been generated according to local generally accepted accounting principles (GAAP) and to ensure that they are consistent with the GAAP in the home country. Each country may have its own GAAP, which are the accounting standards recognized by the profession as being required in the preparation of financial statements by external users. Accounting finds expression in profit and loss statements, balance sheets, investment analysis and tax analysis. It is the means by which managers make different decisions on behalf of the firm. International accounting involves accounting and taxation issues for companies that have Bird’s-eye View internationalized their economic activities across countries in which accounting standards and International accounting systems arise out of practices vary. International accounting extends diverse national environments, and therefore general-purpose, nationally oriented accounting need to be harmonised for practice and appliin its broadest sense to international comparative cation. This needs reconciling national differanalysis; it also includes accounting measureences according to international priorities and ment and reporting issues unique to the TNC, dealing with issues of foreign currency transand harmonization of accounting practices and lation, transfer pricing and tax treaties. principles across nations.

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Pertinent issues in this context relate to: ■■ Country differences in accounting and international harmonization ■■ Foreign currency translation ■■ Cross-border transfer pricing issues ■■ Tax treaties and strategies

NATIONAL AND INTERNATIONAL ACCOUNTING STANDARDS Accounting standards are rules for preparing financial statements. They lead logically to auditing standards, which specify the rules for performing an audit. These rules become legal requirements, and the following national standards illustrate clearly how cross-country accounting can be an accountant’s nightmare. The Netherlands uses current values for replacement of assets; Japan uses historic cost. Capitalization of financial leases is required in Britain, but not in France. For example, R&D costs are written off in the year they are incurred in the United States; R&D costs in Spain need not be written off as long as benefits arising from the R&D continue. This essentially translates into the need for the TNC to adjust to different accounting systems around the world, thus making the accounting function more complex and costly. The financial statements of a company include not only the statements themselves but also the accompanying footnotes. Companies that list on stock exchanges usually provide an income statement, a balance sheet, a statement of stockholder’s equity, and a cash flow statement. In addition, they provide extensive footnotes, depending on the country where they list. The financial statements of one country differ from those in another country in six major ways:

1. Language 2. Currency 3. Type of statements (income statement, balance sheet, etc.) 4. Financial statement format 5. Extent of footnote disclosures 6. Underlying GAAP on which the financial statements are based

A company wishing to provide financial information for investors throughout the world needs to deal with all six issues. As far as language goes, English tends to be the first choice of companies choosing to raise capital abroad, but other languages do appear. Intel Corporation and Marks & Spencer Group plc also provide their information in English, although Intel uses American English and Marks & Spencer uses British English. Many companies also provide a significant amount of information on their home pages on the Internet in different languages. Managers can just click on the desired language button, and all the information is provided in that language. For example, Ericsson, the Swedish telecommunications company, has a home page full of information for people all over the world. A second issue in classifying systems is currency. Intel’s financial statements are in US dollars, and Marks & Spencer’s reports are in British pounds. Not only does Ericsson provide its balance sheet and income statement in Portuguese to Brazilian readers, but it also provides the information in Reals, Brazil’s currency. As noted earlier, a company can issue several major financial statements. Most countries require the balance sheet and income statement. Not all require a statement of cash flow, but such a statement is becoming more common. Foreign corporations that want to list the securities on the New York Stock Exchange must provide a statement of cash flows, because it is required for US companies as well. Financial statement format is not a big issue, but it can be confusing for a manager to read a balance sheet prepared in an analytical format, as is the case with Marks & Spencer, when the manager is used to

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seeing it in the balance format, as is the case with Intel. A major area of difference is the use of footnotes. Footnote disclosures in the United States tend to the most comprehensive in the world. For example, US companies go into great details describing the way certain information is determined as well as the detail behind the numbers. Greater transparency is synonymous with more extensive footnote disclosures. Finally, the most problematic area is that of differences in underlying Generally Accepted Accounting Principles (GAAP). A major hurdle in raising capital in different countries is dealing with widely varying accounting and disclosure requirements. In Germany and the Netherlands, for example, the principle of mutual recognition is applicable. This means that a foreign registrant that wants to list and have its securities traded on the Frankfurt or Amsterdam stock exchange need only provide information prepared according to the GAAP of the home country. However, other exchanges, like the New York Stock Exchange and NASDAQ, require foreign registrants either to reconcile their home-country financial statements with the local GAAP or to recast their financial statements in accordance with local GAAP.

The Incarnation of IFRS: How it Came into Being International Financial Reporting Standards (IFRS) International Financial Reporting Standards are emerging as the primary accounting language of (IFRS) are emerging as the primary accounting the world. At least 100 countries have already adopted language of the world. IFRS, and 30 others have declared their intention to adopt or converge with IFRS over the next two to three years. The history of International Accounting Standards (IAS, or international GAAP, or generally accepted accounting principles) goes back to 1967, when a study group was established comprising key accounting bodies from the UK, the United States and Canada. This study group went on to become the International Accounting Standards Committee (IASC), which was instrumental in rolling out the IAS. The IASC resulted from an agreement between the accountancy bodies of 10 countries: the United States, Canada, Mexico, the UK, Ireland, France, Germany, the Netherlands, Japan and Australia. As its membership grew, the IASC also developed close interaction with global economic bodies such as the Organization for Economic Co-operation and Development, the World Bank, the United Nations, the Asian Development Bank and the International Organization of Securities Commissions (IOSC). IASC had its first formal meeting with the Securities and Exchange Commission (SEC) in 1984, and started its comparability project with the US GAAP in 1987. As businesses became transnational, companies and investors started realizing the importance of having one set of global accounting standards. In 1996, the US Congress acknowledged the need for a high-quality comprehensive international accounting standard. By 1998, more than 100 countries had become IASC members, and some European countries passed laws permitting large companies to use the IAS for domestic reporting and filing purposes. A year later, IOSCO supported the use of IASC standards by multinational firms for cross-border offerings and listings. In 2001, the European Commission (EC) legislated use of the IAS for all listed companies from 2005. In 2001, IASC was renamed the International Accounting Standards Board (IASB), and concluded the Norway Agreement in 2002, which laid down a framework for bridging the gap between the IAS and the US GAAP. The epicentre for world economic growth was by then moving away from the United States towards West Asia, Latin America, Africa, India and China. As many of these countries at some point in history had been under European colonial rule and influence, the local GAAP in these countries were based on and reflected GAAP in various European countries such as the UK, France and Germany. For example, in India, the accounting standards and Companies Act were largely modelled along the UK lines. In fact, some Indian standards are almost replicas of the UK IAS standards.

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For a long time, multiple versions of GAAP existed in Europe, as its countries were divided. The unification of Europe (EU) and the emergence of the euro as an alternative currency to the US dollar led to the IFRSRS gaining prominence in European markets. This led countries across Latin America, Africa and Asia to do the same and adopt the IFRS rather than the US GAAP. Events in the United States did not help the US GAAP either. The dot-com bust and rigorous Sarbanes– Oxley compliances made the US markets vulnerable and shook investor confidence worldwide. Being a new initiative, the IFRS was more contemporary and able to adequately reflect the changing needs of business and investors. Also, being principle-based, it offered a more comprehensive solution vis-à-vis the US GAAP, which is largely rule-based, too voluminous and cumbersome. By 2006, more than 100 foreign private issuers had registered with the SECSEC. The American Institute of Certified Public Accountants and the SECSEC could see that with strong global International Financial Reporting Standards (IFRS) are emerging as the primary accounting language of the world support for IFRS, it would be difficult for the United States to remain isolated. In November 2007, the SECSEC allowed foreign private issuers listed in the United States to file IFRS financial statements without any reconciliation with the US GAAP, and proposed a road map for IFRS adoption in the United States. Although it delays adoption for a majority of the companies until 2014, it also permits large US firms (some 100 of them meeting specified criteria) to file IFRS financial statements with SEC for the years ending on or after 15 December 2009. With this, the IFRS may have conquered the last stumbling block in its journey towards being a truly global standard. What enabled IFRS to come into existence was the long-felt need for unification of business systems and financial reporting platforms, greater comparability of financial results and free movement of financial and human capital. Investors, stakeholders and corporate managements were tiring of multiple GAAP reporting and reconciliations. IFRS has proved to be the right catalyst for driving change towards this global convergence of accounting GAAP.

CONSOLIDATION AND CURRENCY TRANSLATION Even though TNCs receive reports from their subsidTranslation is the process of the restating of iaries in a variety of different currencies, they must assets and liabilities in a particular currency into eventually produce one set of financial statements in another one for accounting purposes. the home currency so that both management and investors can have an aggregate view of the TNC’s activ­ ities. The process of converting foreign subsidiary financial statements into the home currency is known as translation. The combination of these translated financial statements into one is known as consolidation. The financial interdependence of units of the TNC is recognized in consolidated financial statements that give both the corporation and investors a realistic view of the financial state of the company. It is important to recognize that only assets, liabilities, revenues and expenses generated with third parties are shown. Foreign subsidiaries normally produce their financial statements in the currency of the country where they are located. When the accounts of the TNC are consolidated, these financial statements have to be translated into the currency of the home country. Consolidation is an accounting process in which Consolidation is an accounting process in which the financial statements of a parent company and the financial statements of a parent company its subsidiaries are added to yield a unified set of and its subsidiaries are added to yield a unified set of financial statements. financial statements. The underlying reason is that, although subsidiaries are usually separate legal

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e­ ntities, they are not separate economic entities. The consolidated financial statements acknowledge the economic interdependence of the parent and its subsidiaries. The consolidated financial statements include only: ■■ ■■ ■■ ■■

Assets Liabilities Revenues Expenses with external third parties

Translation is the process of the restating of assets and liabilities in a particular currency into another one for accounting purposes. There are four methods of translating statements to the reporting or home currency:

1. 2. 3. 4.

The current rate method The temporal method The monetary-non-monetary method The current-non-current method

TAXATION Tax planning is crucial for any business because taxes can profoundly affect profitability and cash flow. This is especially true in international business. Domestic taxation, with all its complexities, is simple compared to the intricacies of international taxation. The international tax specialist must be familiar with both the home country’s tax policy on foreign operations and the tax laws of each country in which the international company operates. Taxation has a strong impact on several choices: ■■ ■■ ■■ ■■ ■■

Location of the initial investment Choice of operating form, such as export or import, licensing agreement and overseas investment Legal form of the new enterprise, such as branch or subsidiary Method of financing, such as internal or external sourcing and debt or equity Method of setting transfer prices

This section examines taxation for the company with international operations. Principles of taxation for TNCs faced at home and abroad are applicable to companies domiciled in any country.

Transfer Prices A major tax challenge as well as an impediment to A transfer price is a price on goods and services performance evaluation is the extensive use of transsold by one member of a corporate family to fer pricing in international operations. A transfer another, such as from a parent to its subsidiary price is a price on goods and services sold by one in a foreign country. member of a corporate family to another, such as from a parent to its subsidiary in a foreign country. Because the price is between related entities, it is not necessarily an arm’s-length price; that is, a price between two companies that do not have an ownership interest in each other. The assumption is that an arm’s-length price is more likely than a transfer price to reflect the market accurately. A high-transfer price coming from the parent to the subsidiary will reduce the profits of the parent company and show

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increased profits for the subsidiary. Sometimes firms charge a transfer price that is lower than the price of inputs, and may be accused of dumping. Companies establish arbitrary transfer prices primarily because of differences in taxation between countries. For example, if the corporate tax rate is higher in the parent company’s country than in the subsidiary’s country, the parent could set a low transfer price on products it sells the subsidiary in order to keep taxable profits low in its country and high in the subsidiary’s country. The parent also could set a high transfer price on products sold to it by the subsidiary. Companies may also set arbitrary transfer prices for competitive reasons or because of restrictions on currency flows. In the former case, if the parent ships products or materials at a low transfer price to the subsidiary, the subsidiary would be able to sell the products to local consumers for less. In the latter case, if the subsidiary’s country has currency controls on dividend flows, the parent could get more hard currency out of the country by shipping in products at a high transfer price or by receiving products at a low transfer price. Because prices can be manipulated for reasons other than market conditions, arbitrary transfer pricing makes evaluating subsidiary and management performance difficult. In addition, the tax authorities of a country (such as the Internal Revenue Service in the United States) can audit the transactions of a TNC to determine whether the prices were made on an arm’s-length basis. If not, they can declare a penalty and collect back taxes from the company. Differences in tax practices around the world often cause problems for TNCs. Lack of familiarity with laws and customs can create confusion. In some countries, tax laws are loosely enforced. In others, taxes generally may be negotiated between the tax collector and the taxpayer—if they are ever paid at all. Variations among countries in the GAAP can lead to differences in the determination of taxable income. This, in turn, may affect the cash flow required to settle tax obligations. For example, companies in France can depreciate assets faster than would be the case in the United States, which means that they can write off their value against income, thus lowering taxable income. In Sweden, companies can reduce the value of inventories, which increases their cost of goods sold and lowers taxable income. Taxation of corporate income is accomplished through one of two approaches in most countries: the separate entity approach, also known as the classical approach, or the integrated system approach. In the separate entity approach, which the United States uses, each separate unit—company or indiIn the separate entity approach to taxation, each vidual—is taxed when it earns income. For example, separate unit—company or individual—is taxed a corporation is taxed on its earnings, and stockholdwhen it earns income. ers are taxed on the distribution of earnings (dividends), which results in double taxation. Most other developed countries use an integrated system to eliminate double taxation. The British give a dividend credit to shareholders to shelter them from double taxation. That means that when shareholders report the dividends in their taxable income, they also get a credit for taxes paid on that income by the company that issued the dividend. That keeps the shareholder from paying tax on the dividend because the company had already paid a tax on it. Germany follows a split-rate system, according to which two different tax rates are levied on corporate earnings. Since shareholders have to pay tax on dividends, the corporation pays a low tax on dividend and a higher tax on its retained earnings. Besides this, the shareholder gets a credit for taxes paid by the corporation on that dividend. Countries also have unique systems for taxing the earnings of the foreign subsidiaries of their domestic companies. Some, such as France, use a territorial approach and tax only domestic-source income. Others, such as Germany and the UK, use a global approach, taxing the profits of foreign branches and the dividends received from foreign subsidiaries.

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Tax Havens Tax havens are countries where the rate of tax is lower than in the home country. A TNC locates itself in a tax haven to avoid high taxation in the home country. Locations such as the Bermuda Islands, Vanuatu, the Cayman Islands and Bahrain have no or lower taxes, whereas others like Switzerland, the Solomon Islands and countries such as Brazil and Luxembourg permit special privileges. In order to benefit from a tax haven, a TNC sets up a subsidiary there in order to evade payment of high-income tax.

Tax Treaties: The Elimination of Double Taxation The primary purpose of tax treaties is to prevent international double taxation or to provide remedies when it occurs. The United States has active tax treaties with more than 48 countries. The general pattern between two treaty countries is to grant reciprocal reductions on dividend withholding and to exempt royalties and sometimes interest payments from any withholding tax.

INDIAN ACCOUNTING PRACTICES Accounting in India is largely governed by the views of the Institute of Chartered Accountants of India (ICAI), which is a statutory regulatory body. The setting of accounting standards in India is based on an associationist system, which prescribes accounting regulation to be done through professional organizations. The issuance of statements, standards and guidance notes prescribes desirable accounting practices even though they have no legal force. Besides this, the Department of Company Affairs, the Securities and Exchange Board of India, the Reserve Bank of India and the Income Tax department are some of the organizations that influence accounting practice in India. The ICAI established the Accounting Standards Board (ASB) to harmonize the accounting practices in use in India. The ICAI is a member of the IASC and has agreed that it will give due consideration to the international accounting standards (IASs) and try to integrate them with domestic standards.

IFRS: A Change for the Better The basic concepts underlying preparation of financial statements will undergo significant change upon implementation of International Financial Reporting Standards (IFRS) in India. There are three key aspects that run through each principle laid down in IFRS:

There are three underlying principles of Indian accounting—substance over form, use of fair value, recognizing time value or time cost of money.

■■ Substance over form ■■ Use of fair value ■■ Recognizing time value or time cost of money. These three items need to be understood carefully. Substance Over Form Indian GAAPs (generally accepted accounting prin­ ciples), like any other GAAP, also recognizes the imp­ ortance of substance over form. Accounting Standard AS 1 on ‘Disclosure of Accounting Policies’ states that substance rather than form should be the guiding

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Accounting Standard AS 1 on ‘Disclosure of Accounting Policies’ states that substance rather than form should be the guiding principle in selection and application of accounting policies.

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principle in selection and application of accounting policies. However, the true application of this principle will happen only under the IFRS. That is because the IFRS is more contemporary and has prescribed the treatment for evolving issues. Also, unlike Indian GAAPs, it does not recognize the concept of a legal override. Thus, IFRS will always go by the core substance of the transaction. The IFRS will mean several changes. For instance, under Indian GAAPs, redeemable preference capital (shares that do not come with voting rights but which have a higher priority over ordinary shares in terms of dividend payments, and which can be redeemed at the discretion of the issuer or shareholder) has to be treated as equity. The IFRS, however, will require it to be treated as debt. Based on substance of terms, instruments such as convertible debentures are likely to be shown partly under debt and partly under equity, as the embedded warrant option in such instruments will be separately identified and presented at its fair value. Contracts for the supply of goods and services may get concluded (wholly or partly) as leases (and it could be financial lease as well). The IFRS will bring with it the concept of functional currency. Indian entities may need to maintain their books and report in US dollars to the National Stock Exchange and the Bombay Stock Exchange if the dollar is the primary currency for the economic environment in which it is operating. This is subject to regulatory approval. In rare circumstances, the IFRS even allows users to adopt a policy contrary to IFRS principles if the management believes the treatment prescribed under the latter would be misleading and the policy proposed to be adopted better represents the substance of the underlying transactions. These concepts are unheard of in most other GAAP frameworks. Use of Fair Value The use of fair value in measuring assets and liabilities will increase considerably upon adoption of the IFRS, which mandates the use of fair value in measurement of financial instruments, employee compensation, share-based payments, and assets and liabilities acquired in a business combination, to name a few. It will allow use of fair value, as opposed to cost, in relation to property, plant and equipment, intangible assets and investment properties. The application of these fair value principles would require a company’s management to use considerable judgement in making estimates about the future, and the role of valuation experts in the preparation of financial statements would increase significantly. Thus, the IFRS will be far more complex and challenging in its application compared with the existing regime of accounting standards. In the case of derivatives, held-for-trading investments and investment properties, the IFRS allows gains or losses on fair valuation to be recognized in profit-or-loss accounts for the period. Undoubtedly, to allow even unrealized gains to be captured in profit-or-loss accounts is quite a bold move. In such a situation, there will be greater onus on the management to exercise better financial discipline; otherwise, the company may end up declaring dividends out of unrealized profits. Recognizing Time Value or Time Cost of Money The IFRS recognizes that value of money changes with time. The value of INR 100 is different in the present from what it was in the past, whether it is looked at as income or as cost. Hence, the IFRS requires receivables and payables, that is, financial assets and liabilities or monetary items to be reflected at current value. Thus, the value of INR 100 payable in three months will be different from INR 100 payable after 36 months. Consequent to these aspects, the IFRS will focus on reflecting the working results and state of affairs of a business more on a current-state basis rather than on a holistic long-term or historical-cost basis. It will not place undue premium on prudence but push for recording of market gains and reflection of market-related realities over the reporting period. The IFRS will allow flexibility in choosing the right

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accounting policy, but will also lead to enhanced disclosure requirements. Therefore, estimation efforts, subjectivity and judgement will increase manifold in preparing IFRS financial statements, and time lines and costs will also go up accordingly. However, at the same time, the benefits of the IFRS are expected to far outweigh the costs and hassles. It will integrate domestic businesses with the global investor and financial community so that there is no language gap and barrier. It will enhance the global competitiveness of Indian businesses as well as finance professionals. And IFRS-literate people will fuel the next wave of the knowledge-processing outsourcing boom. Characteristics of the Ifrs System ■■ One of the basic features of the IFRS is that it is a principle-based standard, unlike the US GAAP, which is rule-based. ■■ The IFRS involves extensive use of judgement in selection of appropriate accounting policies and alternative treatments, including at the time of adoption. ■■ Also, the IFRS requires valuations and future forecasts, which will involve use of estimates, assumptions and management’s judgements. It has been observed that the combination of all these factors can have a significant impact on the reported earnings and financial position of an enterprise. So far, audit committees and boards of directors largely had an oversight role on accounting matters. With the IFRS, this role is set to get enhanced considerably. Audit committees and boards in India, therefore, need to specifically focus on how well companies are geared for the transition to IFRS. The members responsible for governance will have to spend considerable time in ensuring appropriate convergence of the Indian GAAP with the IFRS. They must be aware of the options available under the IFRS, the choices made and the reasons for making these choices. Further, they must understand the impact of convergence on significant accounting matters and their likely effect on financial statements. The IFRS will not only be a technical accounting conversion. Convergence will impact most business aspects, including structuring of contracts with customers and vendors, performance appraisal parameters and reward plans, and managing external investor relations and communication. Therefore, it will be imperative for governing members to have a detailed knowledge of the impact of the IFRS on a company’s business. How will it impact business processes, including the IT system? Is the core team leading the IFRS conversion process adequately trained or not? How will the company communicate the impact of the IFRS to its investors and lenders? Will this result in any tax or regulatory issues? It will be most critical for boards to monitor the quality and robustness of the conversion process and the road map to the IFRS. Essentially, the IFRS will be a significant change that will need to be managed properly. Under the IFRS, prior years’ errors and omissions will have to be effected through restatement of previously declared results, which will be a critical change from prevailing practices in India. With the IFRS, the complexities involved in preparing financial statements will increase manifold, thereby increasing the risk of errors and omissions. There is a strong likelihood that Indian companies will start restating accounts soon, much like their peers in the United States do. As many as 1,538 restatements were filed in 2006 by US companies. Usually, investors and regulators look at any restatement negatively, so audit committees and board members will need to manage and address this risk effectively. Moreover, restatements may be viewed with suspicion by tax authorities in India, who may not be able to understand the changes emanating from convergence with the IFRS reporting framework.

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The biggest challenge for members charged with governance will be to manage stakeholder expectations in terms of meeting targets and key performance indicators, declaring dividends and explaining variations and volatility in earnings on a quarterly basis. This is a challenging task even now, but with the arrival of the IFRS, the challenge is set to assume a different dimension. India implemented the IFRS in 2011.

C H A P T E R

Bird’s-eye View Indian accounting practices are being changed according to international standards practices through the move to the International Financial Reporting Standards System (IFRS).

S U M M A R Y

■■ The accounting system is a set of rules, procedures and practices geared to fulfil the needs of its users. The aim of an accounting system is to identify, measure and communicate economic information to allow informed judgements and decisions by users of this information. ■■ The origins of differences in accounting systems are essentially based in history, politics, the level of development of the country and its economic ties with other countries. National differences have resulted in a general lack of comparability in financial reporting, and the trend towards transnational financing and investment has exacerbated the problem. ■■ The most significant move towards the harmonization of accounting standards has come from the International Accounting Standards Board (IASB), but this body has yet to achieve the desired result of uniform standards. There is an Australian Accounting Standards Board (AASB) with a charter similar to that of the IASB. ■■ The financial interdependence of units of the TNC is recognized in consolidated financial statements that give both the corporation and investors a realistic view of the financial state of the company. It is important to recognize that only assets, liabilities, revenues and expenses generated with third parties are shown. ■■ Foreign subsidiaries normally produce their financial statements in the currency of the country where they are located. When the accounts of the TNC are consolidated, these financial statements have to be translated into the currency of the home country. ■■ Accounting in India is largely governed by the views of the Institute of Chartered Accountants of India (ICAI), which is a statutory regulatory body. ■■ There are three key aspects that run through each principle laid down in IFRS, namely, substance over form, use of fair value, and recognizing the time value or time cost of money.

KEY TERMS Accounting system, Accounting standards, Consolidation, Translation, Transfer price, Tax havens, Triple bottom line accounting.

DISCUSSION QUESTIONS

1. What are the factors that are responsible for the development of the national accounting system? 2. Describe the process of evolution of the international accounting system. 3. What is the IFRS? Enumerate the factors that have led to its evolution as a global accounting standard.

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18 GLOBAL E-COMMERCE LEARNING OBJECTIVES This chapter introduces different facets of the international business environment. After reading this chapter, you should be able to:

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Outline the foundations of e-commerce Confirm the principles underlying e-commerce Determine the origins of the Internet Outline the role of the Internet in business and commerce

THE INTERNET HALL OF FAME The Internet Hall of Fame is a report on the world’s largest Internet companies across the globe. As per the study spanning 50 countries, the report is the latest input from the World Startup Report (WSR) and includes well-known names such as Google (USA) and the Alibaba Group (China) which have individual valuations in excess of the rest of the firms in the entire report. The report also features less well-known names such as Yandex (Russia), Checkpoint (Israel), Naver (South Korea) and Naspers (South Africa). The analysis lists search companies and gaming companies, most of which originated in 2000–01 as the world’s ‘most mature’ Internet industries and the B2B industry on the other hand was listed as the ‘quickest way to get rich’!!! India’s top three were Flipkart, Just Dial and InMobi. Flipkart is a Bengaluru based Indian e-commerce company. Founded in 2007 by entrepreneurs Sachin Bansal and Binny Bansal with an initial investment of INR 4 lakhs only, the company started out as an online seller of books, but had become the market leader in online retail through its diversification into digital movies, music and games as well as electronics. Source: Adapted from ‘ET Awards 2012-13: How IIT-alumnus Sachin Bansal built Flipkart into a big online brand’, http://economictimes.indiatimes.com/news/news-by-company/corporate-trends/et-awards-2012-13-how-iitalumnus-sachin-bansal-built-flipkart-into-a-big-online-brand/articleshow/23065635.cms, http://techcrunch. com/2014/06/13/internet-hall-of-fame/, last accessed on 15 July 2014.

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INTRODUCTION Electronic commerce (or e-commerce) refers to the E-commerce is the conduct of commercial activiuse of the Internet to conduct business. This network ties using electronic processes or tools that are can be accessed using devices such as computers, enabled by information and communications handheld (wireless) devices and mobile phones. technologies. People use the Internet both to access information and services created by others, and to present their own information and services. The Internet thus allows people to communicate and conduct business across the world, at any time, and almost instantaneously. Internet communication often involves text, pictures, video and sound. It is typically represented in the form of electronic mail and Web sites. People communicate about many different things using the Internet, including business. Some examples of Internet-based e-commerce activities include: ■■ ■■ ■■ ■■ ■■

Visiting an online bookstore to select and purchase books Sending electronic mail to people and businesses Checking the location and status of parcels in transit Using an online marketplace to find suppliers of stationery Searching for suppliers of truck spare parts

E-COMMERCE VS E-BUSINESS One of the important definitional issues in any study of e-commerce is its relationship with e-business. E-commerce is the conduct of commercial activities using electronic processes or tools that are enabled by information and communications technologies. Some people use the term ‘electronic ­trading’ to mean much the same thing. Others use ‘electronic procurement’, ‘electronic purchasing’ or ‘electronic marketing’. At its most basic level, e-commerce is about the deployment of ICTs to enable buyers and sellers to undertake transactions electronically, especially over the Internet. At a more complex level e-commerce can be considered the enablement of all transaction processes by ICTs. In such a case, e-commerce can be thought to extend beyond a simplistic purchase and sale to encompass the entire supply chain, or the chain of transactions that permits the sale of goods and services to the final customer. Essentially all processes related to the electronic enablement by ICTs of commercial activities in goods and services will be considered part of e-commerce. This includes e-procurement, e-purchasing, e-fulfilment and related activities. E-business on the other hand, is a business using ICTs to enable commercial processes, and especially to attain advantage through implementation of an e-commerce strategy. E-commerce and e-business differ on three main levels:

1. An e-business consciously makes the deployment of ICTs for commerce an integrated component of its business strategy. 2. An e-business considers ‘connections of these electronic processes to other parts of the organization’ and not just the ‘buying and selling of products and services electronically’. 3. An e-business automates the relationships between multiple suppliers and partnering organizations.

E-commerce therefore, is a wider term used to describe not only goods and services that are selected, ordered and paid for via the Internet, but also for the various services, electronic processes

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and transactions that occur within and between businesses. E-business can more specifically refer to the strategy and business model encompassing e-commerce.

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E-business is the strategy and business model of e-commerce. E-commerce is thus a wider term than e-business.

TYPES OF E-COMMERCE The major different types of e-commerce are—business-to-business (B2B), business-to-consumer (B2C), business-to-government (B2G), consumer-to-consumer (C2C), and mobile commerce (m-commerce).

B2B E-commerce Business-to-business (B2B) e-commerce is simply defined as e-commerce between companies. This is Business-to-business e-commerce is simply de­fined as e-commerce between companies. the type of e-commerce that deals with relationships between and among businesses. About 80 per cent of e-commerce is of this type, and is growing faster than any other. The B2B market has two primary components—e-frastructure and e-markets. E-frastructure E-frastructure is the architecture of B2B, primarily consisting of the following: ■■ Logistics: Transportation, warehousing and distribution. ■■ Application service providers: Deployment, hosting and management of packaged software from a central facility (e.g., Oracle and LinkShare Corporation). ■■ Outsourcing of functions in the process of e-commerce, such as Web-hosting, security and customer care solutions (e.g., outsourcing providers such as eShare, NetSales, iXL Enterprises and Universal Access). ■■ Auction solutions software for the operation and maintenance of real-time auctions in the internet (e.g., Moai Technologies and OpenSite Technologies). ■■ Content management software for the facilitation of Web site content management and delivery (e.g., Interwoven and ProcureNet). ■■ Web-based commerce enablers (e.g., Commerce One, a browser-based, XML-enabled purchasing automation software). E-markets E-markets are simply defined as Web sites where E-Markets are websites for the interaction of buybuyers and sellers interact with each other and coners and sellers to conduct business transactions. duct transactions. Most B2B applications are in the areas of supplier management (especially purchase order processing), inventory management (managing order-ship-bill cycles), distribution management (especially in the transmission of shipping documents), channel management (information dissemination on changes in operational conditions), and payment management (electronic payment systems or EPS). The more common B2B examples and best practice models are IBM, Hewlett-Packard, Cisco Systems and Dell. Cisco, for instance, receives over 90 per cent of its product orders over the Internet.

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B2B e-commerce provides opportunities for worldwide sourcing for all sectors, including raw materials, components and services. The Internet can save costs by streamlining purchasing, distribution and marketing. While the benefits have been apparent to multinationals, SMEs have also benefited. SMEs are able to form networks linked to multinational companies, opening up new avenues for the cooperative development of technology as well as markets. The transnational ‘web’ of global production networks is transforming supply chains.

B2C E-commerce Business-to-consumer (B2C) e-commerce, or comBusiness-to-consumer (B2C) e-commerce, or merce between companies and consumers, involves commerce between companies and consumers, customers gathering information; purchasing physiinvolves customers gathering information; purcal goods (tangibles such as books or consumer chasing physical goods or information; and, for products) or information goods (electronic material information goods, receiving products over an or digitized content such as software, or e-books); electronic network. and, for information goods, receiving products over an electronic network. This is the second largest and the earliest form of e-commerce. Its origins can be traced to online retailing (or e-tailing). Thus, the more common B2C business models are the online retailing companies such as Amazon.com, Drugstore.com, Beyond.com, Barnes & Noble and Toys ‘R’ Us. Other B2C examples involving information goods are E-Trade and Travelocity. The more common applications of this type of e-commerce are in the areas of purchasing products and information, and personal finance management, which pertains to the management of personal investments and finances with the use of online banking tools (such as Quicken).

B2G E-commerce Business-to-government (B2G) e-commerce, or Business-to-government (B2G) e-commerce, or B2G, is generally defined as commerce between B2G, is commerce between companies and the companies and the public sector. It refers to the public sector. It refers to the use of the Internet use of the Internet for public procurement, licensfor public procurement, licensing procedures ing procedures and other government-related and other government-related operations. operations. Although Web-based purchasing policies increase the transparency of the procurement process (and reduce the risk of irregularities), the size of the B2G e-commerce market as a component of total e-commerce is insignificant, as government e-procurement systems remain undeveloped.

C2C E-commerce Consumer-to-consumer (C2C) e-commerce is simply commerce between private individuals or consumers. This type of e-commerce is characterized by the growth of electronic marketplaces and online auctions, particularly in vertical industries where

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Consumer-to-consumer (C2C) e-commerce is simply commerce between private individuals or consumers.

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firms/businesses can bid for what they want from among multiple suppliers. It perhaps has the greatest potential for developing new markets. This type of e-commerce comes in at least three forms:

1. Auctions functioning at a portal, such as eBay, which allows online real-time bidding on items being sold in the Web, 2. Peer-to-peer systems, such as the Napster model (a protocol for sharing files between users used by chat forums similar to IRCRC) and other file exchange, and later money exchange models, and 3. Classified advertisements at portal sites where buyers and sellers can negotiate and which feature ‘Buyer Leads and Want Ads’.

C2B E-commerce Consumer-to-business (C2B) transactions involve Consumer-to-business transactions involve re­ reverse auctions, which empower the consumer to verse auctions, which empower the consumer to drive transactions. A concrete example of this when drive transactions. competing airlines gives a traveller best travel and ticket offers in response to the traveller’s post that she wants to fly from New York to San Francisco. There is little information on the relative size of global C2C e-commerce. However, C2C figures of popular C2C sites such as eBay and Napster indicate that this market is quite large. These sites produce millions of dollars in sales every day.

M-Commerce M-commerce (mobile commerce) is the buying and M-commerce is the buying and selling of goods selling of goods and services through wireless techand services through wireless technology, i.e., nology, that is, handheld devices such as cellular handheld devices such as cellular telephones telephones and personal digital assistants (PDAs). and personal digital assistants. Japan is seen as a global leader in m-commerce. As content delivery over wireless devices becomes faster, more secure and scalable, some believe that m-commerce will surpass wireline e-­commerce as the method of choice for digital commerce transactions. This may well be true for the Asia-Pacific where there are more mobile phone users than there are Internet users. Industries affected by m-commerce include: ■■ Financial services, including mobile banking (when customers use their handheld devices to access their accounts and pay their bills), as well as brokerage services (in which stock quotes can be displayed and trading conducted from the same handheld device). ■■ Telecommunications, in which service changes, bill payment and account reviews can all be conducted from the same handBird’s-eye View held device. ■■ Service/retail, as consumers are given the The major different types of e-commerce are ability to place and pay for orders on the fly. business-to-business (B2B), business-to-con■■ Information services, which include the sumer (B2C), business-to-government (B2G), delivery of entertainment, financial news, consumer-to-consumer (C2C) and mobile sports figures and traffic updates to a single commerce (m-commerce). mobile device.

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E-COMMERCE—AN EVALUATION E-commerce provides many new ways for businesses and consumers to communicate and conduct business. There are a number of advantages and disadvantages of conducting business in this manner.

E-commerce Advantages Some advantages that can be achieved from e-commerce include: Ability to Conduct Business Each Day Through the Year: E-commerce systems can operate all day every day. Your physical storefront does not need to be open in order for customers and suppliers to be doing business with you electronically. Access to the Global Marketplace: The Internet spans the world, and it is possible to do business with any business or person who is connected to the Internet. Simple local ­businesses such as ­specialist record stores are able to market and sell their offerings internationally using e-­commerce. This global opportunity is assisted by the fact that, unlike traditional communications methods, users are not charged according to the distance over which they are communicating. Speed: Electronic communications allow messages to traverse the world almost instantaneously. There is no need to wait weeks for a catalogue to arrive by post: that communications delay is not a part of the internet/e-commerce world. Increased Market Space: The market in which Web-based businesses operate is the global market. It may not be evident to them, but many businesses are already facing international competition from Web-enabled businesses. Opportunity to Reduce Costs: The Internet makes it very easy to ‘shop around’ for products and s­ ervices that may be cheaper or more effective than we might otherwise settle for. It is sometimes possible to, through some online research, identify original manufacturers for some goods, thereby bypassing wholesalers and achieving a cheaper price. Computer Platform-Independent: Many, if not most, computers have the ability to communicate via the Internet independent of operating systems and hardware. Customers are not limited by existing hardware systems. Efficient Applications Development Environment: In many respects, applications can be more efficiently developed and distributed because they can be built without regard to the customer’s or the business partner’s technology platform. Application updates do not have to be manually installed on computers. Rather, Internet-related technologies provide this capability inherently through automatic deployment of software updates. Allowing Customer Self-service and ‘Customer Outsourcing’: People can interact with businesses at any hour of the day that it is convenient to them, and because these interactions are initiated by customers, the customers also provide a lot of the data for the transaction that may otherwise need to be entered by business staff. This means that some of the work and costs are effectively shifted to customers, this is referred to as ‘customer outsourcing’.

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New Marketing Channel: The Internet provides an important new channel to sell to consumers. As a marketing channel, the Internet has the following characteristics: ■■ The ability to inexpensively store vast amounts of information at different virtual locations. ■■ The availability of powerful and inexpensive means of searching, organizing and disseminating such information. ■■ Interactivity and the ability to provide information on demand. ■■ The ability to provide perceptual experiences that are far superior to a printed catalogue, although not as rich as personal Bird’s-eye View inspection. ■■ The capability to serve as a transaction The main advantages of e-commerce include medium. the ability to conduct business 24 × 7 in a global ■■ The ability to serve as a distribution medium market place speedily, with reduced costs in an for certain goods (like software). environment which is independent of operating ■■ Relatively low entry and establishment systems and hardware. costs for sellers.

Disadvantages of E-commerce Some disadvantages and constraints of e-commerce include the following. Time for Delivery of Physical Products: It is possible to visit a local music store and walk out with a compact disc, or a bookstore and leave with a book. E-commerce is often used to buy goods that are not available locally from businesses all over the world, meaning that physical goods need to be delivered, which takes time and costs money. In some cases there are ways around this, for example, with electronic files of the music or books being accessed across the Internet, but then these are not physical goods. Physical Product, Supplier and Delivery Uncertainty: In some respects, e-commerce purchases are made on trust. The reasons are: ■■ This is because not having had physical access to the product, a purchase is made on an expectation of what that product is and its condition. ■■ This is also because supplying businesses can be conducted across the world, it can be uncertain whether or not they are legitimate businesses and are not just going to take your money. It’s pretty hard to knock on their door to complain or seek legal recourse. ■■ Lastly, even if the item is sent, it is easy to start wondering whether or not it will ever arrive. Perishable Goods: Though specialized or refrigerated transport can be used, goods bought and sold via the Internet tend to be durable and non-perishable, they need to survive the trip from the supplier to the purchasing business or consumer. This results in perishable and/or non-durable goods being sold through traditional supply-chain arrangements, or through relatively more local e-commerce-based ­purchases, sales and distribution. In contrast, durable goods can be traded from almost anyone to almost anyone else, leading to competition for lower prices. In some cases this leads to disintermediation in which intermediary people and businesses are bypassed by consumers and by other businesses that are seeking to purchase more directly from manufacturers.

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Limited and Selected Sensory Information: The Internet is an effective channel for visual and auditory information such as, seeing pictures, hearing sounds and reading text. However, it does not allow full scope for our senses. We can see pictures of the flowers, but not smell their fragrance, we can see pictures of a hammer, but not feel its weight or balance. Further, when we pick up and inspect something, we choose what we look at and how we look at it. This is not the case on the Internet. If we were looking at buying a car on the Internet, we would see the pictures the seller had chosen for us to see but not the things we might look for if we were able to see it in person. And, taking into account our other senses, we can’t test the car to hear the sound of the engine as it changes gears or take in the smell and feel of the leather seats. There are many ways in which the Internet does not convey the richness of experiences of the world. This lack of sensory information means that people are often much more comfortable buying generic goods via the Internet—things that they have seen or experienced before and about which there is little ambiguity, rather than unique or complex things. Returning Goods: Returning goods online can be an area of difficulty. This increases the uncertainties surrounding the initial payment and delivery of goods. The various questions that come up are, will the goods get back to their source?, who pays for the return postage?, will the refund be paid?, how long will it take?, etc. Privacy, Security, Payment, Identity, Contract: E-commerce transactions involve issues such as ­privacy and security of information and payment details, and problems of identity theft. Feasibility of Transactions: E-commerce is most often conducted using credit card facilities for ­payments, and as a result very small and very large transactions tend not to be conducted online. The size of transactions is also impacted by the economics of transporting physical goods. For examBird’s-eye View ple, any benefits or conveniences of buying a box of pens online from a US based business tend to be The main disadvantages of e-commerce are eclipsed by the cost of having to pay for them to be concerns about perishable goods, customer disdelivered to a customer in Australia. The delivery satisfaction at being unable to physically examcosts also mean that buying individual items from ine the product before purchase and problems a range of different overseas businesses is signifiof safety and security in virtual transactions. cantly greater.

DRIVERS OF E-COMMERCE The various factors driving e-commerce are discussed here.

Global Factors Global production networks and increasing global competition are the two main global factors which have acted as drivers of e-commerce.

Global drivers of e-commerce include growing production networks and increasing competition.

Global Production Networks The growth of global production networks in industries such as automobiles, electronics and textiles are the primary drivers of e-commerce as these networks rely heavily on IT and e-commerce for coordination.

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Some countries have domestic firms who participate in these global networks as suppliers or subcontractors (such as Taiwan) or as bases for subsidiaries of multinational corporations (such as Singapore), while others are coordinators of such networks (such as the United States and Japan). Although the roles differ, the integration of countries into global production networks often involves the adoption of B2B e-commerce by firms in these countries as a condition for participating in such networks. Increasing Global Competition Global competition is perhaps the most significant force driving e-commerce development across countries. A country’s integration in global production networks, the presence of TNCs and the extent of trade liberalization are all factors that increase the level of global competition and, by extension, the pressure for countries to adopt e-commerce as a means of reducing costs and/or expanding markets. In summary, global factors by definition potentially influence adoption in all countries. However, they appear to have more prominence in shaping e-commerce diffusion in countries that are part of open trade regimes, have a high proportion of TNCs, have more firms that are part of global production networks and have more firms engaged in global competition. While these factors represent global pressures for countries to adopt e-commerce, their influence will depend upon characteristics of each country. Some countries, such as Singapore, which has historically been a centre of entrepôt trade in East Asia, are more trade-oriented, and, therefore, more open, TNC-friendly and part of global networks. Others, such as Mexico, which is a supplier to global TNC TNCs, are heavily engaged in production networks by virtue of trade liberalization and being located next to the large US market.

Demographic Factors Country demographics have a huge influence on e-commerce development, as they relate to market size and concentration, consumer needs and ease of access to technology.

Country demographics such as population density, an IT literate labour force, general IT literacy and wealth distribution also act as drivers of e-commerce

Population Density It is seen that densely populated nations, such as Singapore and Germany, enjoy strong IT infrastructures, whereas large countries with low population density, such as China and Brazil, suffer from underdeveloped infrastructures, plus distribution and delivery problems. IT Labour Force The presence of an IT labour force is another enabling condition for e-commerce, in that it provides needed skills for IT production and use. For example, countries like India and China have a large IT workforce whereas countries such as Singapore and Germany import IT workers. Taiwan and Denmark restrict immigration that could supplement their small domestic IT workforces. IT Literacy General IT literacy enables access to both B2C and B2B e-commerce, and is influenced by demographic factors such as income, education, age and gender. IT literacy is generally higher among the highly educated across countries, and is highest among the younger generation. The United States has an equal gender distribution on Internet use, whereas use is heavily male-dominated in the other countries.

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Wealth Distribution The distribution of wealth is also a major barrier or limit to IT usage. In Brazil and Mexico, where income is unevenly distributed, a large percentage of the population is cut off from PC and Internet access due to their inability to afford such technologies. A more equal distribution of wealth, such as in Japan, Germany, France and Taiwan, creates conditions which are conducive for e-commerce since a greater proportion of the population has access to IT resources.

Economic and Financial Resources The availability of financial resources such as venture capital to support online businesses and start-ups is another enabler of e-commerce across countries. Such support through venture capital is more widely available in the United States, Denmark, Germany, Singapore, Taiwan and Brazil. The availability of online payment methods is also an enabler of e-commerce. The use of credit cards is a universal phenomenon, although the use of debit cards is more common in Europe. In Asian countries stored-value cards are used as well as wireless payment, money orders, bank transfers and COD. In Taiwan and Japan hybrid methods are popular such as ordering goods online and picking them up and paying for them through convenience stores. At this point, most online purchases are not paid for online except in the United States.

Information Infrastructure A widely available and affordable information infrastructure is another important enabler of e-­commerce diffusion. Availability includes both the extent of coverage and the range of technologies in use. High penetration of multiple technologies (teledensity, wireless, Internet, broadband and PCs) enables e-commerce in that several channels are available for conducting it. Countries such as Taiwan and Germany have experienced particularly high penetration and rapid wireless growth since 1995, whereas the United States now ranks relatively low on mobile phone penetration. This is probably because of the high penetration of fixed lines and higher competitiveness of the local and long distance market in the United States, compared to Europe and Asia, where mobile phones are more affordable and fixed lines less prevalent. Additional reasons for the rapid growth of wireless in Europe and Asia may be the use of a common standard, namely GSM, and the all-digital network that allows for integration of additional features such as text messaging. The cost of Internet access can be an inhibitor to e-commerce diffusion. High costs of Internet access limit the amount of time consumers use the Web for information or purchases. Countries with metered access such as France, Germany, Denmark and Japan have had higher costs of access than countries in which users are not charged by the minute but pay a monthly fee for unlimited access. High access costs in these countries have, however, been reduced over the past few years and rates have become more uniform across countries.

Industry Structure The adoption of e-commerce also depends on industry structure. In each country, some industries are leaders in e-commerce, while others lag behind. E-commerce is commonly found in finance/banking, distribution (wholesale and retail), IT, electronics manufacturing and automotive manufacturing. In general, industries driving e-commerce have been found in sectors that are information-intensive (such as finance/banking) and/or internationally competitive (such as electronics and automobiles).

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Firm Size Firm size is another factor identified in the cases. Large domestic firms tend to be leaders in adopting e-commerce, as they possess the IT resources (technology, financial and human) needed for e-commerce and can leverage e-commerce investments over a large revenue base. In certain cases, SMEs may have advantages such as being more flexible and innovative and more capable of adapting to organizational changes required by e-commerce than large firms. It is generally seen that SMEs are an inhibitor to the spread of e-commerce due to their lack of technological expertise and lack of funds to implement e-commerce solutions. The existence of strong traditional retail networks also acts as a stumbling block in the way of e-­commerce diffusion such as in France, Japan and Taiwan. While such outlets compete with online commerce, sometimes they also encourage e-commerce because such retail networks are located in urban areas with concentrated economic activity and high Internet usage, and they might adopt ‘click and mortar’ strategies of integrating their physical and virtual infrastructures for competitive advantage.

Entrepreneurial Environment An entrepreneurial business culture facilitates e-commerce. The organizational and legal environment in the United States and Taiwan, for example, encourages entrepreneurial and innovative business cultures, for example, by making it possible for bankrupt individuals to financially survive and encouraging them to take another chance to try again without being stigmatized by failure. The lack of entrepreneurial support is evident in Japan, Singapore and Germany. For example, Japanese financial institutions are reluctant to fund entrepreneurial start-ups through venture capital or equity. In Asian countries, such as Taiwan, personal relationships are important in doing business, and anonymous online relationships are considered impersonal and discouraged. In highly unionized countries such as Denmark, e-procurement and automation of public services is perceived as a threat to job security by government and public officials. In most countries, organizational readiness for e-commerce is still restricted by high perceived costs of IT, security concerns and lack of integration of information systems with business partners.

Consumer Preferences B2C e-commerce is driven by consumer desires for valuable and useful content, convenience, lifestyle enhancements, and greater product and service selection. High acceptance of IT and the Internet is a key enabler of B2C. Internet fever has caught on internationally and has generated high hopes and expectations for positive economic and social impacts. However, consumers have significant reservations about purchasing online, which stems from lack of trust in business practices, privacy/security concerns regarding credit card and other personal information, resistance to using credit cards, and preferences for in-store shopping and inspection of products. These concerns are particularly acute in countries such as India and China, where no legal consumer protection exists and buyers and sellers have little legal backup for faulty products or negligent payment. Language acts as a barrier among nonEnglish-speaking consumers due to the prevalence of English content on the Web. Beyond language, preferences for local content (even among those who speak English) are evident across countries. As the Web becomes increasingly multilingual and incorporates more local content, consumers are likely to participate more in online commerce.

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National Policy Key policy factors that effect e-commerce diffusion include liberalization of telecommunications, ­government promotion of e-commerce and IT, and specific legislation to promote e-commerce and IT. The liberalization of markets over the last two decades has enabled e-commerce through increased competition. Firms in competitive markets are motivated to adopt e-commerce technologies in order to enhance productivity and provide better services. Telecommunications liberalization in particular, has encouraged IT and Internet diffusion by making rates more affordable and giving consumers a wider selection of services and options.

C H A P T E R

Bird’s-eye View The main drivers of e-commerce are global factors such as production networks and competition; demographic factors like population density, an IT literate labour force and general IT literacy and wealth distribution. Other important drivers include economic and financial resources, information infrastructure, industry structure, firm size, entrepreneurial environment and consumer preferences.

S U M M A R Y

■■ E-commerce is the conduct of commercial activities using electronic processes or tools that are enabled by information and communications technologies. ■■ Business-to-business e-commerce is simply defined as e-commerce between companies. ■■ Business-to-consumer (B2C) e-commerce, or commerce between companies and consumers, involves customers gathering information; purchasing physical goods or information; and, for information goods, receiving products over an electronic network. ■■ Business-to-government (B2G) e-commerce, or B2G, is commerce between companies and the public sector. It refers to the use of the Internet for public procurement, licensing procedures and other government-related operations. ■■ Consumer-to-consumer (C2C) e-commerce is simply commerce between private individuals or consumers. ■■ M-commerce is the buying and selling of goods and services through wireless technology, i.e., handheld devices such as cellular telephones and personal digital assistants. ■■ The list of environmental factors affecting e-commerce diffusion is long, and these factors have differential influence in different countries. ■■ Demographic factors (income, education, IT skills, etc.) define the size and characteristics of the potential market for e-commerce and the availability of skills to support e-commerce deployment. ■■ Economic and financial factors determine whether there are sufficient resources (venture c­ apital) to invest in e-commerce and mechanisms (payment systems, secure systems) to facilitate it. ■■ Industry structure reflects both business demand for e-commerce and the capabilities of firms to engage in it. ■■ Information infrastructure defines a country’s technical readiness for e-commerce, and the cost of online access in particular is a critical determinant in that countries with lower costs are more likely to have wider diffusion and use.

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KEY Terms Technology, Invention, Innovation, Patent, National innovation system, Patent right, International technology transfer, Electronic commerce, E-business, Business-to-business e-commerce, Businessto-consumer e-commerce, Consumer-to-consumer e-commerce, Consumer-to-business transactions, M-commerce.

DISCUSSION QUESTIONS 1. What is e-commerce? Distinguish between e-commerce and e-business. 2. Enumerate the advantages and disadvantages of e-commerce for an international business. 3. List some of the factors that pose a challenge to global e-commerce activity in the global economy. 4. List and explain with examples the different types of e-commerce activities. 5. What are the primary components of B2B e-commerce? 6. Distinguish between e-infrastructure and e-markets. 7. List and explain the different factors which act as drivers of e-commerce? 8. Explain how demographic factors act as drivers of e-commerce. 9. Name the main global factors which act as drivers of e-commerce. 10. Write a short note on the role of e-commerce for global business. [B.Com (Hons.) 2008] 11. Discuss the significance of e-commerce in the context of a modern global organization.  [Delhi University, B.Com (Hons.) 2009] 12. What is e-commerce? Briefly enumerate the factors responsible for the growth of e-commerce in the last few decades. [Delhi University, B.Com (Hons.) 2010]

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19 ENVIRONMENTAL ISSUES IN INTERNATIONAL BUSINESS LEARNING OBJECTIVES After reading this chapter, you should be able to:

■ ■

■ ■

Understand the nature and causes of major environmental challenges such as climate change and trans-boundary pollution Appreciate the interconnections between local, regional and global concerns of the environment Get an insight into the role of national and international governments in tackling environmental challenges Identify the initiatives of the modern business in the area of environmental management and sustainable development

GREEN INITIATIVES BY COKE Beverage giant Coke has introduced a colourless can design in an effort towards getting greener. The new cans have a convex logo on a colourless can as an alternative to the present can which is full of colour. By eliminating some of its colour, Coca-Cola cans could become greener. Designed at the studio Ryan Harc, the concept packaging of the colourless can aims to eliminate toxic manufacturing materials while retaining elements of the brand. The can will reduce the cost of recycling and pollution. The colourless design keeps the paint from seeping into the aluminium which is processed in a pressing machine that inserts the logo onto the can, replacing it with the toxic paint which was earlier sprayed on to the can. A similar green initiative documented in Coke’s annual sustainability report was an innovative ice bottle created for consumers in Columbia in the summer of 2013. The bottles were made out of micro-filtered water poured into silicone moulds, then frozen to −13°F. The ice bottles were shipped empty and filled with soda right before handing them over the consumer. They were fitted with a label that protected the consumers’ hands from the cold as it melted away after use.

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As critics raised a stink over hygiene issues concerning the consumption of the entire bottle and environmentalists over the need for more refrigeration, the ice bottle was obviously not a product for regular use. Sources:   http://www.psfk.com/2013/06/coca-cola-ice-bottle.html#!bjLidy,  http://www.foxnews.com/leisure/ 2013/07/09/coca-cola-unveils-new-bottle-made-ice/,  http://www.businessweek.com/articles/2013-07-12/howcoca-cola-made-ice-bottles, last accessed on 21 July 2014.

INTRODUCTION Environmental issues such as climate change, the Environmental degradation refers to changes depletion of natural resources and pollution are caused in the environment due to human activissues of global significance concerning governity, including industrialization and urbanization. ments, business and consumers worldwide. Changes in the environment can occur naturally due to changes in climate and weather conditions over a period of time, but environmental degradation refers specifically to changes caused in the environment due to human activity. Economic development over centuries is considered the major factor responsible for much of past and present environmental degradation. Processes such as industrialization, changes in farming m ­ ethods and depletion of natural resources are some of the factors responsible for damaging the environment. The development of society and civilizations over a period of time have led to the misuse of natural resources causing changes in ecosystems with alarming consequences. The development of agriculture in Europe and North America in the seventeenth and eighteenth centuries led to huge expansion in the area of cultivable land, technological innovations and the emergence of capital market relationships in agriculture. This resulted in the cutting down of forests, destruction of fertile land and a decline in different species of wildlife due to loss of their natural habitat. The advent of industrialization through the Industrial Revolution led to a dramatic increase in both the intensity and geographical scope of environmental degradation. Although industrial development brought much-needed employment and income, it also led to resource depletion and pollution. Industrial production required land for factories, housing and other services such as roads and infrastructure. It is estimated that nearly 23 per cent of the entire world’s cropland, pasture, forest and woodland have been degraded since the 1950s. During the same time period, nearly one-fifth of all tropical forests have been cleared, most of them in the developing world. This results in a severe threat to biodiversity as many plants and animals that are unique to particular areas become extinct when the ecosystem is disrupted. Factory production relying on power sources such as coal was joined by newer industries such as synthetic chemicals, which generated a mixture of old and new pollutants. Industrialization in turn leads to urbanization, as the rural population moves to urban areas in search of work in new industries. The processes of industrialization and urbanization began in the advanced economies of the world almost two centuries ago, but it is the developing world that is the centre of large-scale industrialization today. Urbanization then begins to encroach into hitherto agricultural areas while growing urban populations place increasing pressures on supplies of food, water and energy. The rapid growth and development taking place in large parts of the developing world along with the concurrent pressure of increasing population is contributing to the increasing environmental pressures.

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Growth of the multinational enterprise has also had an impact on the environment. While g­ overnments in host countries welcome the investment flows and the attendant benefits of technology, jobs and growth potential, environmental damage does not seem to be a major issue. It is only when a forest is cleared to build a factory, waterways are polluted by waste from that factory and the air is polluted through emissions that we begin to see the environmental effects of international business. For instance, in Guiyu Township, Guangdong Province of China, where residents and labourers have conducted extensive computer scrapping, water in local rivers and lakes and even groundwater turned brown and became non-drinkable. Analysis of sediment samples showed severe contamination. In the town of Yandang, where chemical processes have been used for extracting gold from waste computers for more than ten years, 80 per cent of the wells have been contaminated. Many of the area’s trees have withered; fish and shrimp have become extinct; polluted crop lands lie in waste. In addition, 90 per cent of workers surveyed suffered from red edema, and 50 per cent from asthma.

CLIMATE CHANGE Climate change is basically a process of global Climate change is basically a process of global warming caused by a build up of heat-trapping warming caused by a build up of heat-trapping greenhouse gases. Issues of climate change focus on greenhouse gases. changes in the earth’s atmosphere as well as matters such as pollution of the oceans, dryland degradation, damage to the ozone layer, and the rapid extinction of plant and animal species. The atmosphere is like a blanket around the Earth, made up mostly of nitrogen (78 per cent) and oxygen (21 per cent); traces of other gases like carbon dioxide (CO2), methane (CH4) nitrous oxide (N2O), also known as the Greenhouse gases; and traces of water vapour. Human activity over decades has led to a thickening of the Earth’s atmosphere through changes in the balance of gases, especially the greenhouse gases. For example, when we burn coal, oil and natural gas we release huge amounts of carbon dioxide into the air. Similarly, the cutting of trees for setting up factories or for residential purposes reduces the oxygen available to combat carbon dioxide. Other basic activities, such as raising cattle and planting rice, emit methane, nitrous oxide and other greenhouse gases. Deforestation such as in the rain forests of South America also diminishes the capacity of the environment to absorb carbon dioxide, further accelerating global warming. The notion that the sea may be able to absorb some of the rise in carbon dioxide has also become a refuted claim as the capacity of the sea to act a sink is more limited than was previously imagined. Increasing levels of the greenhouse gases in the Increasing levels of the greenhouse gases in the Earth’s atmosphere are leading to a slow process of earth’s atmosphere is leading to a slow process global warming. It is estimated that the phenomenon of global warming, with complex and interrelated of global warming is likely to lead to an increasing reactions including rising average temperatures. temperature of 1 to 3.5°C over the next 100 years, at least some of which may be due to past greenhouse gas emissions. If emissions continue to grow at current rates, it is almost certain that during the 21st century atmospheric levels of carbon dioxide will double from pre-industrial levels. If no steps are taken to slow greenhouse gas emissions, it is quite possible that levels will triple by the year 2100. The average sea level rose by 10 to 20 cm during the twentieth century, and an additional increase of 18 to 59 cm is expected by the year 2100 as higher temperatures cause ocean volumes to expand,

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and melting glaciers and ice caps add more water. It is estimated that as the higher end of that scale is reached, the sea could overflow the heavily populated coastlines of such countries as Bangladesh, cause the disappearance of some nations entirely (such as the island state of the Maldives), foul freshwater supplies for billions of people, and become the cause of mass migrations. Agricultural yields are expected to drop in most tropical and sub-tropical regions and in temperate regions too if the temperature increase is more than a few degrees. Drying of continental interiors, such as central Asia, the African Sahel, and the Great Plains of the United States, has also been forecasted. It is expected that global warming will have complex interconnected reactions in climate patterns and ecology all over the globe. There is likely to be severe flooding in some parts and increasing desertification in other parts of the world. Arid and semi-arid areas in Africa and Asia will have higher temperatures, causing loss of vegetation and depletion of water resources. Melting of the polar icecaps may cause sea levels to rise and island nations and low-lying areas to get submerged under the sea. Extremes of drought and flood as well as extreme events such as storms are a risk to agriculture. There is the attendant problem of the spread of airborne and waterborne diseases. And although the increasing evidence on global warming points to the need to curtail emissions, arriving at a consensus on how to achieve it has been difficult.

TRANS-BOUNDARY POLLUTION Trans-boundary pollution refers to the transmission Trans-boundary pollution refers to the transmisof pollutants through water, soil and air from one sion of pollutants through water, soil and air from national territory to another. The transmission may one national territory to another. be intentional, as in the case of hazardous waste, or it may be unintentional, as in an accident at a nuclear power plant. The working of industrial enterprises leads to the release of waste into rivers and emissions such as sulphur dioxide into the atmosphere. There has been a dramatic increase in the capacity for ­pollution in the twentieth century, with potentially devastating effects. Among the worst disasters ever witnessed by mankind in this context was the Chernobyl nuclear power station in the former Soviet Union. The fire that raged for five days released more than 50 tonnes of radioactive poison into the atmosphere, affecting Belarus, the Baltic States and the Scandinavian countries. Closer home, the Bhopal Gas tragedy in 1985 saw emissions of methylisocyanate (MIC) gas from the Union Carbide India Limited (UCILs) pesticide plant at Bhopal in the wee hours of the morning, causing death and destruction to a few thousand immediately and maiming others for life. Other instances in recent times have been the BP oil spill off the coast of Mexico and the pollution in Ecuadorian forests by Temaxo. Acid rain is a form of pollution in the atmosphere, caused by the burning of fossil fuels such as coal for the generation of electricity. Acid rain refers to acid that precipitates from the atmosphere in the form of rain, fog and snow, affecting the soil on which plants and animals depend. It may also be dry in form, such as acidic gases and particles that may blow into buildings, trees and homes. It consists of sulphur Acid rain refers to acid which precipitates from dioxide and nitrogen oxides, and its visible effects the atmosphere in the form of rain, fog and snow, began to appear only when rivers and ­forests graduaffecting the soil on which plants and animals depend. ally begin to die. Aquatic ecosystems are particularly endangered by acid rain. International cooperation

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for reducing acid rain emissions in Europe and a North America has had a positive impact, but industrialization in the developing world has increased the problem. Take the case of China, which relies on coal-burning power stations for nearly 70 per cent of its power generation. It aims to reduce reliance on coal as an energy source to 60 per cent by 2020, as it builds gas and nuclear power stations. China’s rapid economic growth has relied on increasing its output of coal for both power generation and steel production. Thus, while reliance on the use of coal is decreasing for developing countries and also for Eastern Europe and Russia, it is on the increase for China and India. The impact of growth and development on pollution is clearly visible in the case of China, where the use of the private car as a sign of its thriving economy has resulted in smog and water pollution all along the Pearl River Delta in Guangdong province to neighboring Hong Kong. Nuclear power is being promoted on account of its low level of emissions and on account of being a non-depleting source of energy compared to coal and oil. Countries such as France and Japan, which are lacking in these natural energy resources, have Nuclear power is a low emission, non-depleting switched to the use of nuclear power for electricity. source of energy, but is risky requiring safe treatment and storage of nuclear waste and its safe Nuclear power, however, has its own risks, requiring transportation to reprocessing sites. safe treatment and storage of nuclear waste, including its safe transportation to reprocessing sites. The risks associated with nuclear-related industries have become geographically dispersed as these industries have grown. The use of nuclear energy is also considered risky on account of its repossessing and recycling as well as the safe treatment and storage of nuclear waste. The safe transportation of nuclear waste is a problem because of the likelihood of accidents as well as the fear of a terrorist attack. This has led to the exploration of alternative energy sources such as solar and wind power. Improvements in transportation accompanied by the growth of the Chinese and Indian economies have led to increased vehicular movement and pollution. In the Indian context the Maruti became the ‘people’s car’ in the 1980s because of its affordability for the growing middle class. Similarly, the recently launched Tata Nano is targeting the hitherto neglected Indian consumer who has relied on two wheeler or public transport so far. Targeted as the ‘people’s car’ for the common Indian as a result of its friendly price of USD 2500 (INR 1,00,000) as well as expected superior performance in terms of ­mileage, the Nano is already causing nightmares of congestion, pollution and traffic problems. Damage caused by trans-boundary pollution is long-lasting and spread over decades, as in the case of Bird’s-eye View the Bhopal Gas tragedy. Important issues pertain to the problem of apportioning responsibility and compelEnvironmental issues of climate change and ling the polluter to pay. The problem is compounded trans-boundary pollution are caused by develby the fact that legal action involves various jurisdicopment processes such as industrialization tions, and the lack of adequate legal protection in the with repercussions for business, consumers developing countries can lead to weak enforcement and governments all over the globe. and the indeterminate stretching of these problems.

INTERNATIONAL LEGAL FRAMEWORKS FOR ENVIRONMENTAL PROTECTION The earliest attempt towards cooperation between nation states on environmental issues was the The United Nations Environment Programme (UNEP) in 1972.

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In 1992, the United Nations Framework Conven­ Sustainable development refers to meeting the tion on Climate Change (UNFCCC) adopted the needs of present generations without comproconcept of sustainable development as the basis for mising the ability of future generations to do the a global response to the problem of climate change. same. Sustainable development refers to meeting the needs of present generations without compromising the ability of future generations to do the same. Several important conventions were adopted at this meeting. The conference led to the Declaration on Environment and Development, also called the Rio Declaration, which aimed to respect the interests of all and protect the integrity of the global environmental and developmental system. The declaration includes principles that are applicable to a variety of activities and incidents involving both states and corporations. It also acknowledges the principle of state sovereignty over resources, but is qualified by the ‘polluter pays’ principle. It also links sustainable development with poverty reduction and lays emphasis on resource allocation according to social priorities and concerns in the context of market-based economies. The Convention has been signed by 194 nations. The ultimate objective of the Convention is to stabilize greenhouse gas concentrations in the ­atmosphere at a level that will prevent dangerous human interference with the climate system. The Rio conference also adopted the Convention on Biological Diversity and the Convention on Climate Change. The Convention on Biological Diversity aimed to sustain biodiversity through a number of measures, including national monitoring of biodiversity, environmental impact assessments and national progress reports from individual countries. It reinforced the principle of sustainable development. The Convention on Climate Change was the beginning of an international framework and process to tackle the issue of climate change. It was an agreement signed by countries to take steps to reduce the effects of climate change, taking into account matters such as agriculture, energy, natural resources and activities involving sea-coasts. It was an agreement to develop national programmes to slow climate change, encouraging countries to share technology and to cooperate in other ways to reduce greenhouse gas emissions, especially from energy, transport, industry, agriculture, forestry and waste management, which together produce nearly all greenhouse gas emissions attributable to human activity. In 1992, the UN also adopted a Convention on the Trans-boundary Effects of Industrial Accidents, placing an onus on states to take preventive steps and also to respond responsibly when accidents occur. A Convention on Nuclear Safety was signed in 1994. Although all these international instruments focus on state responsibility for implementation of their provisions within their own jurisdictions, states vary in their commitment to prevent and control ­harmful activities. Awareness of environmental implications by business enterprises is therefore a crucial factor in the battle to protect the environment. In this context, TNCs need to shoulder major responsibility as global leaders in the protection of the environment.

KYOTO PROTOCOL The Kyoto Protocol was adopted at the third Conference of the parties to the UNFCCC in Kyoto, Japan, on 11 December 1997. The Kyoto Protocol is a commitment by member nations to stabilize GHG emissions and was therefore meant to have more power than the earlier convention. The detailed rules for its implementation were adopted at Marrakesh in 2001, and are called the Marrakesh Accords.

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The convention has 194 parties, 37 industrialized countries and the European Community, who have committed to reducing their emissions by an average of 5 per cent by 2012 against 1990 levels. It needs industrialized countries to first and foremost take domestic action against climate change. The Protocol also allows them to meet their emission reduction commitments abroad through so-called ‘market-based mechanisms’. The Kyoto Protocol is considered to be the most far-reaching agreement on environment and sustainable development. A protocol is an international agreement that stands on its own but is linked to an existing treaty. This means that the climate protocol shares the concerns and principles set out in the climate convention. It then builds on these by adding new commitments, which are stronger and far more complex and detailed than those in the Convention. This complexity is a reflection of the enormous challenges posed by the control of greenhouse gas emissions. It is also a result of the diverse political and economic interests that had to be balanced in order to reach an agreement. Billion-dollar industries needed to be reshaped; some would profit from the transition to a climate-friendly economy, others would not. Ratification of the Protocol suffered many years of delay as the United States and Australia, two major greenhouse gas emitters, did not ratify the treaty. The Protocol finally came into force on 15 February 2005 when Russia ratified the treaty. The Protocol addresses six main greenhouse gases. These gases are to be combined in a ‘basket’, so that reductions in each gas are credited towards a single target number. This is complicated by the fact that, for example, a kilo of methane has a stronger effect on the climate than does a kilo of carbon dioxide. Cuts in individual gases are therefore translated into CO2 equivalents that can be added up to produce one figure. Cuts in the three major gases—carbon dioxide, methane and nitrous oxide—were to be measured against a base year of 1990 (with exceptions for some countries with economies in transition). Cuts in the three long-lived industrial gases—hydro fluorocarbons (HFCs), per fluorocarbons (PFCs), and sulphur hexafluoride (SF6)—can be measured against either a 1990 or 1995 baseline. Carbon dioxide is by far the most important gas in the basket. It accounted for over four-fifths of total greenhouse gas emissions from developed countries in 1995, with fuel combustion making a major contribution. Fortunately, CO2 emissions from fuel are relatively easy to measure and monitor. Table 19.1 lists the six gases that the Kyoto Protocol deals with and their global warming potential. The Climate Change Convention calls on rich countries to take the initiative in controlling emissions. In line with this, the Kyoto Protocol sets emission targets for the industrialized countries only— although it also recognizes that developing countries have a role to play. Agreeing how to share the responsibility for cutting emissions amongst the 40 or so developed countries was a major challenge. Table 19.1  Gases Covered by the Kyoto Protocol and Their Global Warming Potential Gas

Global warming potential

Carbon dioxide (CO2)

1

Methane (CH4)

21

Nitrous oxide (N2O)

310

Hydrofluorocarbons (HFCs)

140–11,700

Perfluorocarbons (PFCs)

7,000–9,200

Sulphur hexafluoride (SF6 )

23,900

Source: Information from Intergovernmental Panel on Climate Change (IPCC), ‘Climate Change 2001’, IPCC Third Assessment Report.

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Lumping all developed countries into one big group risks ignoring the many differences between them. Each country is unique, with its own mix of energy resources and price levels, population density, ­regulatory traditions and political culture. For example, the countries of Western Europe tend to have lower per capita emissions than do countries such as Australia, Canada, and the United States. Western Europe’s emissions levels have generally stabilized since 1990, the base year for measuring emissions, while other developed countries have seen their emissions rise. Japan made great strides in energy efficiency during the 1980s, while countries such as Norway and New Zealand have relatively low emissions because they rely on hydropower or nuclear energy. Meanwhile, the energy-intensive countries of Central and Eastern Europe and Russia have seen emissions fall dramatically since 1990 due to their transition to market economies. These differing national profiles make it difficult to agree on a one-size-fits-all solution. The Protocol assigns a national target to each country not on the basis of any rigorous or objective formula but based on political negotiation and compromise. Developed countries have an overall 5 per cent target to be met through cuts of 8 per cent in the European Union (EU), Switzerland, and most Central and East European states; 7 per cent in the United States; and 6 per cent in Canada, Hungary, Japan and Poland. New Zealand, Russia and the Ukraine are to stabilize their emissions, while Norway may increase emissions by up to 1 per cent, Australia by up to 8 per cent, and Iceland by 10 per cent. The EU has made its own internal agreement to meet its 8 per cent target by distributing different rates to its member states, just as the entire developed group’s 5 per cent target was shared out. These targets range from a 28 per cent reduction by Luxembourg and 21 per cent cuts by Denmark and Germany to a 25 per cent increase by Greece and 27 per cent increase for Portugal. Delegates meeting at the 16th Conference of the Parties to the UN Framework Convention on Climate Change (UNFCCC), in December 2010, dubbed the Cancún Agreements, also agreed to formalize mitigation pledges and ensuring increased accountability for them, as well as taking concrete action to protect the world’s forests, which account for nearly one-fifth of global carbon emissions. Agreement was also reached on establishing a fund for long-term climate financing to support developing countries, and bolstering technology cooperation and enhancing vulnerable populations’ ability to adapt to the changing climate. The Kyoto Protocol uses different mechanisms The Kyoto Protocol uses Emissions Trading for the implementation of the treaty and to help (known as ‘the carbon market’), the Clean Develcountries meet their emission reduction targets. opment Mechanism (CDM) and Joint ImplemenThe three Kyoto mechanisms are: tation (JI) as the three different mechanisms for 1. Emissions Trading (known as ‘the carbon market’) 2. Clean Development Mechanism (CDM) 3. Joint Implementation (JI)

implementation of the treaty.

The carbon market spawned by these mechanisms is a key tool in reducing emissions worldwide. It was worth 30 billion US D in 2006 and is set to increase. JI and CDM are the two project-based mechanisms that feed the carbon market. JI enables industrialized countries to carry out projects with other developed countries (usually countries with economies in transition), while the CDM involves investment in sustainable development projects that reduce ­emissions in developing countries. Since the beginning of 2006, the estimated potential of emission reductions to be delivered by the CDM pipeline has grown dramatically to 2.9 billion tonnes of CO2 equivalent, approximately the

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c­ ombined emissions of Australia, Germany and the UK. More than 1,230 CDM projects have been registered as of November 2008, with around 4,200 more in the project pipeline.

International Emissions Trading As per the provisions of the Protocol, each industrialized country has a certain number of emission allowances (the amount of CO2 it can emit) in line with its Kyoto reduction targets. If a country’s GHG emissions are below their emission allowances (that is, meeting Kyoto targets) they can sell these allowances to other industrialized countries that are emitting more than the allowance and not meeting their Kyoto targets. Let us take an example to understand this: A Bird’s-eye View company in Brazil (a non-industrialized country) switches from coal power to biomass. The CDM There have been several initiatives between board certifies that by doing this the company has governments for mitigating the effects of envireduced CO2 emissions by 100,000 tonnes per ronmental destruction caused by industrializayear. It is issued with 100,000 Certified Emission tion and growing international business. The Reductions (CERs) which is also called a carbon most popular among these is the Kyoto Protocol credit. Under the Kyoto Protocol, the UK has to which is a commitment among member nations reduce its green house gas emissions by 1 million for sustainable development through control tonnes of CO2 each year. If it purchases the 100,000 over greenhouse gas emissions. CERs from the Brazilian company, this target reduces from 1 million tonnes per year to 900,000 tonnes per year, making the goal easier to achieve. Certified Emission Reductions is a ‘certificate’ just like a stock and is representative of Certified Emission Reductions is a ‘certificate’ just like a stock, given by the CDM Executive Board a carbon credit. A CER is given by the CDM to projects in developing countries to certify that Executive Board to projects in developing counthey have reduced green house gas emissions tries to certify that they have reduced greenhouse by one tonne of carbon dioxide per year. gas emissions by one tonne of CO2 per year. For example, if a project generates energy using wind power instead of burning coal, it can save 50 tonnes of CO2 per year, and can claim 50 CERs (as one CER is equivalent to one tonne of CO2 reduced).

C H A P T E R

S U M M A R Y

■■ Environmental issues, including climate change, the depletion of natural resources and pollution are issues of concern for the governments and businesses of the modern world. ■■ A major problem in the global economy is environmental degradation, which is the result of human activity such as industrialization and urbanization. ■■ Climate change is a process of global warming caused by a build up of heat-trapping greenhouse gases. ■■ International legal frameworks such as the Rio Declaration form the basis of sustainable international development.

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■■ The Kyoto Protocol is a major step towards greenhouse gas reduction, aiming to achieve 1990 levels by 2012. ■■ Trans-boundary pollution such as acid rain also has wide ranging effects that call for cooperation between countries. ■■ The challenges of sustainable development are particularly acute for the developing world, where development is often equated with the Western lifestyle.

Key Terms Environmental degradation, Climate change, Sustainable development, Global warming, Transboundary pollution, Acid rain, Certified Emissions Reductions.

Discussion Questions 1. 2. 3. 4. 5. 6. 7. 8.  9. 10.

What is environmental degradation and what are its effects? Discuss the role of industrialization and urbanization in environmental degradation. What are the major causes of climate change? Discuss the role of the Kyoto Protocol in achieving sustainable economic development. What is trans-boundary pollution? How does it impact the environment? Discuss the major environmental issues for firms in the global context. Wirte short notes on: a.  Kyoto Protocol b.  International Emission Trading c.  Transboundary pollution d.  Greenhouse gases Discuss the importance of environmental management for global business. [B.Com (Hons.) 2010] Write a short note on environmental degradation. [B.Com (Hons.) 2011, 2012] Discuss the important environmental issues for a global business.  [Delhi University, B.Com (Hons.) 2007] 11. Briefly discuss international initiatives to combat the effects of environmental change in the context of global business firms. [Delhi University, B.Com (Hons.) 2009]

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20 GLOBAL OUTSOURCING LEARNING OBJECTIVES After going through this chapter, you should be able to:

■ ■ ■ ■

Define the term ‘outsourcing’ in the context of the modern world economy

■

Understand the contribution of the IT/ITES industry in the Indian context

Examine the different forms of outsourcing Understand the factors that have acted as drivers of outsourcing Review the factors responsible for the emergence of India as a major outsourcing destination

PAST, PRESENT AND FUTURE OF OUTSOURCING The earliest examples of outsourcing may be traced to early developments in the automobile industry. In the early twentieth century, the manufacture of a T-Ford needed 700 different parts and was possible only through large-scale mass production and a high degree of specialization within a single plant. The gains from this were a reflection of Adam Smith’s gains from specialization, as specialized workers performed a single task along an automated assembly line while the plant was vertically integrated and produced the car from scratch. As the industry grew and competition increased, so did the demands of the consumer with regard to their expectations from the product. As a result, it was no longer possible to combine mass production and specialization within one plant. The multitude of tasks and skills required organizational and managerial innovations in order to accommodate increased complexity while remaining cost effective. This led to focused attention and in-house production of strategically important tasks and competencies, and the purchase of non-core tasks and competencies from outside suppliers. Similar developments in the service industries led to the emergence of outsourcing in of lowcost, low-skill jobs to countries like India, Ireland, Philippines and even China in the context of the IT industry. The Indian IT industry is an established global brand of service companies which have established themselves firmly on the global stage. More than two-thirds of Fortune 500 firms turn to firms such as Tata Consultancy Services (TCS), Wipro Technologies and Infosys Technologies

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for their IT and busi­ness process outsourcing needs. Indian IT companies like Infosys, Wipro, and TCS have scored over their global counterparts like IBM and Accenture as global leaders in the outsourcing market. The BPO-as-commodity era is over as work at the higher end of the value chain makes options like the KPO more exciting. The typical Indian IT firm also needs to diversify from the US market and consider countries like Brazil, China, the African nations, the Middle East and Australia. The presence of firms like GE and IBM in the emerging economies helped them bounce back unscathed from the economic crisis.

INTRODUCTION Outsourcing as a business phenomenon has its roots in David Ricardo’s theory of comparative advantage and has been a major growth driver for countries such as India, Ireland and the Philippines in the 1990s. The concept of outsourcing is a commonly used term in the context of economies such as India. Although there is no commonly accepted definition it may be described as the transfer of a firm’s non core functions and activities to an outside service provider in order to improve overall business performance. The origin of the term may be traced to Ricardo’s theory of comparative advantage, where an organization transfers some of its repeated core and non-core business processes to an outside provider to achieve cost reductions, improve service quality and increase shareholder value. The organization is thus able to concentrate on activities in which it has a comparative advantage. The growth of outsourcing is a phenomenon of the 1990s, attributable to the rebounding of the information technology industry, which had slowed down considerably after the bursting of the dotcom bubble in the 1980s. For countries such as India, the basis of the outsourcing phenomenon was the time-tested principle of comparative advantage, helped by factors such as developments in telecom and internet facilities, the existence of a low-cost English-speaking skilled labor force and a geographical distance of 12.5 hours from the United States, which was its principal outsourcer in initial years.

FORMS OF OUTSOURCING The terms ‘outsourcing’ and ‘offshoring’ are often used interchangeably, although they are not quite identical. In order to understand the terms better, we may classify outsourcing into four main categories using location and control/ownership as distinguishing criteria:1 1. Captive onshore outsourcing is a shift in intra-firm supplies to an affiliated firm in the home economy. 2. Non-captive onshore/local or domestic outsourcing refers to the shift in sourcing of supplies to a non-affiliated firm in the home economy. 3. Captive offshoring describes a situation in which future supplies are sourced from an affiliated firm abroad. 1 World Trade Organization (WTO), ‘Offshoring Services: Recent Developments and Prospects’, World Trade Report 2005, available at http://www.wto.org/english/res_e/booksp_e/anrep_e/wtr05-3c_e.pdf, last accessed on 9 September 2011.

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Table 20.1  Types of Outsourcing Located in home economy Shifting intra-firm inputs/supplies to

Located abroad

Non-affiliated firm

Local/domestic/ onshore outsourcing

Offshore outsourcing/ offshoring

Affiliated firm

Captive onshore outsourcing

Captive offshore outsourcing/captive offshoring

Source: Reproduced with permission from the World Trade Organization (WTO), ‘Off shoring Services: Recent Developments and Prospects’, World Trade Report 2005, available at http://www.wto.org/english/res_e/booksp_e/ anrep_e/wtr05-3c_e.pdf, last accessed on 9 September 2011.

4. Non-captive offshoring is the fourth variant of outsourcing and refers to the case when the new supplier is a non-affiliated firm and located abroad. From an international perspective, the latter two categories of outsourcing, namely captive and noncaptive offshoring, are of particular interest. Table 20.1 illustrates the four concepts. There are also uncertainties of outsourcing. The requirement of delivering an agreed quality and quantity of goods and services may be subject to the possession of a certain skill set, equipment and product development techniques in the outsourced destination. For example, BPO workers in India knew how to speak English, but had to learn the American accent to be able to service clients in the United States. Alternately, a task may require a particular software. However, the software may then be rendered useless after it has been used if it is task-specific.

DRIVERS OF OUTSOURCING The following factors have been the major drivers or factors facilitating the outsourcing phenomenon.

Theory of Comparative Advantage The theories of comparative advantage and intra-industry trade together explain why a firm outsources certain operations abroad. Trade between countries, which are significantly different in terms of factor endowments, is driven by comparative advantage. Thus while trade between nations happens because of different factor endowments, trade between countries that are similarly endowed is motivated by a desire to obtain a wider variety of goods and services. The process of offshoring enables countries to exploit competitive advantage as well as obtain a wider variety of goods and services. For example the offshoring of IT enabled services and business processes is an example of vertical trade within the same industry on the principle of comparative advantage. The offshored services are usually less skill-intensive and capital-intensive than those retained in the home country. Offshored services, whether low-skilled, such as payroll accounting or telemarketing, or high skilled, such as legal process outsourcing, are all sources of cost-saving and driven by desire to obtain comparative advantage. The use of these services may lead to the final production of commodities such as cars, computers or services such as banking and financial services, and helps to increase the variety of goods and services available for the final consumer.

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Concentration on Core Competency From the firm’s point of view, offshoring certain services helps it to concentrate on those functions that are responsible for its core competency. A total business process consists of a multitude of complex tasks and skills, all of which do not have equal strategic significance for the business firm. By outsourcing its non-core business functions, a firm is able to concentrate on those functions and processes that are of strategic significance and value. Outsourcing thus helps a firm to save on costs in terms of both time and managerial capabilities, enabling greater innovation and growth.

Developments in Technology New networking technologies have made it possible for global companies to seek the lowest cost solutions from anywhere in the world for activities that can be digitized. Companies can outsource their non-core functions such as human resource, finance and management accounting, customer relationship management and IT services to a third party to be able to focus their resources on their core activities and hence reduce their operational costs. Developments in infrastructure and privatization of telecommunication services have further catalysed the outsourcing boom.

Existence of Low-cost, Skilled Manpower The existence of an educated, low-wage seeking, language and technically proficient labor force has been a major growth driver for the outsourcing industry. India and Ireland’s success in attracting offshoring business from the United States and the UK has been partly attributed to their English-speaking workforce. Outsourcing from the other leading industrial countries is much lower to these destinations and more to countries that are closer home geographically and/or culturally. A large share of German outsourcing contracts thus go to Central Europe, and a large share of Spain’s outsourcing contracts go to Latin America.

Changes in Regulatory Environment Improvement in the regulatory environment, such as trade liberalization for imported inputs, lifting of foreign investment restrictions, favorable taxation and low-interest export credits have been the major driving forces responsible for the growth of the two largest IT traders, namely Ireland and India.

Infrastructural and Institutional Development It should also be noted that institutional and infrastructural quality at the national level is also a relevant variable to look at. In some cases, notably in India, software technology parks and other special economic zones have excellent infrastructure and effective one-stop-shops for sorting out the legal formalities of establishing and running a business, even if the average quality in the country as a whole leaves much to be desired.

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Bird’s-eye View Outsourcing is the transfer of a part of firm’s business processes to another business unit which may be affiliated or non-affiliated with it and may be based in the same country or abroad. The basic objective of outsourcing is cost saving, improvement in service quality and increase in shareholder value.

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FACTORS BEHIND A DECISION TO OUTSOURCE How do firms decide which activities to conduct in-house and which ones to outsource? The following parameters may help a firm to determine its make-or-buy/outsource decisions.

Technical and Institutional Separability The ability to distinguish and separate functions and services is an obvious precondition for outsourcing. A firm’s decision to outsource depends on the possibility of separation of tasks, standardization and Recent innovations, particularly in IT, have made an automation, cost minimization, and market size. increasing number of service tasks separable in time and space. Services that deal with the collection, manipulation or organization of information and can be codified, digitized and separated from other tasks within the firm can be outsourced. A number of entirely new information-based services and occupations have also emerged with the diffusion of IT. This includes software developers and IT consultants, search services, and also new types of media and content that have resulted in new opportunities for independent service suppliers.

Standardization and Automation Once information-based services have been codified, digitized and separated, they can also be standardized and in some cases automated. Some can even be reduced to a set of instructions or tasks that workers can follow routinely. Examples of information-based services that can be codified, standardized and outsourced are accounting, billing, the payroll, booking and many more. These are typically non-core tasks, both in manufacturing and services companies, and are increasingly outsourced to specialized external suppliers. In addition, as computer software has become standardized, many IT services have also become non-core and can be outsourced.

Cost Minimization The decision to outsource is essentially a make-or-buy decision for a firm and is based on finding the balance between fixed and variable costs that results in the lowest total costs. The relevant costs here are production costs and managerial costs. Being independent of the production volume, fixed costs have an inverse relationship with the volume of production—they decrease as the volume of production increases. In the context of outsourcing, these are the costs of searching for a supplier and negotiating a contract, and are lower in the case of outsourcing than if production is an in-house activity. Variable costs such as monitoring and coordinating production are usually lower with in-house production, and make outsourcing less attractive. Production Costs If the outside supplier is located in the same country as the outsourcing firm, one would expect that production costs would be the same, since the factors of production are purchased in the same market. If the activity in question can be offshored to a low-cost location, there are additional gains in terms of lower production costs, but there are also additional managerial costs. These managerial costs depend on whether offshoring is through foreign direct investment (captive offshoring) or by entering a contract with an independent foreign supplier. In the case of captive offshoring, the costs of acquiring local knowledge about laws and regulations, the availability of non-tradable local inputs and so on have to be incurred in addition to the cost of setting up or acquiring the foreign firm.

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Managerial Costs Managerial costs can be considerable within large companies and probably increase more than proportionally with the complexity of the task and the number of tasks being conducted. Furthermore, many of these costs are independent of the production volume (they are fixed costs) and constitute a higher share of total cost the smaller the scale of production. With outsourcing, such fixed managerial costs are limited to searching for a supplier and negotiating a contract, and can be considerably lower than setting up in-house production. This is the most important reason why outsourcing is attractive. There are also variable managerial costs such as monitoring and coordinating production. These costs are usually lower with in-house production than with outsourcing, and make outsourcing less attractive. Variable managerial costs related to offshoring also arise due to differences between the two countries involved in terms of language, laws, government regulations, currency and usually also due to distance, as even digitized service provision requires some face-to-face communication between the contracting parties. Fixed managerial costs differ between the four types of outsourcing as follows:

1. 2. 3. 4.

Captive offshoring Local in-house production Non-captive offshoring Local outsourcing.

Market Size The relevance of market size for the make-or-buy decision is based on the need of a firm to break even. If firms must reach a minimum scale in order to break even, the number of firms that can operate profitably is limited by the size of the market. Likewise, within a firm a minimum scale is needed in order to employ specialists in all tasks and keep them fully occupied. But as firms grow, a larger administration is needed in order to coordinate activities and govern relations between divisions and individuals. At one point the cost of additional administration exceeds the benefits of additional tasks or components being produced in-house. Outsourcing is thus a way of avoiding expanding unit costs, but the existence of a network of outside suppliers requires a sufficiently large market. Market size is also related to the risks related to outsourcing. The outsourcing firm must be sure that the supplier delivers the agreed quantity and quality of inputs at the agreed time, whether it is a service or a component. If not, the production process can be brought to a halt and in an environment with justin-time production systems this can be extremely costly. Furthermore, if quality is not as agreed, the value of the outsourcing firm’s brand name can deteriorate. If the market is large and there are a large number of alternative firms available, the chance of finding a good match is better and so is the chance of finding an alternative if a supplier fails.

SOFTWARE INDUSTRY IN INDIA The origins of an independent global software industry can be traced to IBM’s decision in 1969 to sell software separately instead of bundling it with hardware. This gave customers the option of buying their hardware and software from different vendors in the

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The genesis of an independent global software industry can be traced to IBM’s decision in 1969 of selling software separately instead of bundling it with hardware.

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world computer market. A few years later, in 1972, Intel’s invention of the microprocessor led to the development of powerful mini- and micro-computers, challenging the dominance of the larger and more expensive mainframes that had been in use till then. The availability of more powerful and inexpensive hardware created a simultaneous huge demand for software, and was the beginning of the global software industry. A basic characteristic of but software production is that it is a craft-like, labor-intensive affair unlike hardware which can be mass produced. This also implies that software production is prone to delays and cost overruns with uneven productivity and quality. Over a period of time, software engineering has developed along the lines of industrial engineering. Software development is a process of structured programming aimed at achieving coordination and control over a team of programmers working on a large project. In recent times, the use of industry-wise certification norms has helped to strengthen the process of development. The growth of the industry therefore depended not only on demand generated for the development of new software, but also for the maintenance of older software. This resulted in the emergence of time-specific and labor-intensive demand that grew in magnitude in the 1990s into a full-blown software industry. The emergence of the Indian software industry as a global leader requires an understanding of the macro environment in which it has grown and flourished. The globalization of the semi-conductor industry during the 1960s largely bypassed India, which was committed to self-sufficiency and self-reliance within a broader state dominated strategy of import substitution led industrialization. The highlight of Indian computer policy in the 1970s was forcing IBM to shut its operations in 1978. There was no Indian software industry to speak of, despite development efforts in state firms as part of unsuccessful attempts to build a commercially viable computer; nor did efforts to promote exports by permitting the import of hardware in exchange for a guarantee to export a certain amount of software prove effective. There was essentially no government policy for the software industry till the 1980s. A change came about during the early 1980s through a policy of cautious liberalization to encourage private investment and trade. There were two important initiatives taken by the state for the development of the software industry:



1. The Computer Policy of November 1984, besides easing the local manufacture and availability of computers, recognized software as an ‘industry’, making it eligible for investment allowances and other incentives. It also lowered duties on software imports, and made software exports a priority. 2. The Computer Software Export, Development and Training Policy of December 1986 explicitly aimed at increasing India’s share of world software production. This was done with a procedure known as ‘flood in, flood out’ feature, where firms in India were provided with liberal access to global technologies to encourage the development of thousands of small software companies.

This phase of industry development is known as body shopping, or the practice of providing inexpensive on-site (that is, at customer locations overseas) labor on an hourly basis for low value-added programming services such as coding and testing. In 1988, the National Association of Software and Service Companies (NASSCOM) was formed to promote the interests of the software industry. Subsequent policy measures tried to promote the industry more pro-actively. The clearest instance of this was the establishment, in 1990, of the Software Technology Parks (STPs). As export zones dedicated to the software industry, the STPs offered data communication facilities, allowing firms to offer offshore services, that is, service provision from India, instead of having to work at customer sites overseas.

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The shift to offshore services in a more liberal economic environment marked the beginning of a new relationship between the Indian software industry and the global market. The growth of the Indian ­software industry may be attributed to conscious policy changes in the context of the IT industry and certain hidden benefits which were incidental benefits which the industry got as a result of earlier policies. The Indian software industry’s comparative advantage emerged out of the following factors.

Large Skilled English Speaking Work Force Despite widespread illiteracy, Indian education policies managed to create a large pool of skilled labor that suffered from under-employment and unemployment. This became a ready skilled resource for the industry since most of them were English speaking as a result of the colonial education policy of the government. The exit of IBM’s, and the unsuccessful local efforts to build a commercially viable computer, led to a huge reliance on imports. Since high duties were a disincentive to import, mainframes never had a significant presence in India, and the few that were imported were of various vintages and from various sources. As Indian programmers had worked on a variety of platforms in the 1970s, it proved helpful in acquiring contracts to maintain various older systems in the 1980s.

Time Advantage A geographical accident benefiting Indian firms is the 12.5 hours difference with the United States, their main market, allowing them to undertake offshore maintenance and re-engineering after regular users there leave for the day. This meant lower costs and profitability as professionals in India are paid an Indian wage whereas, once abroad, they are also paid an overseas allowance. Offshore development also offers the advantage of having most employees under one roof, instead of them being scattered across customer sites, allowing the firm to build a repository of knowledge to compete for subsequent projects, and to move employees from one project to another in a critical situation. It was against the backdrop of such conscious efforts and unforeseen benefits that the STPs helped transform the industry during the 1990s. Software factories emerged in India with the infrastructure, technology, training programmes, quality processes, productivity tools and methodologies of the customer workplace.

Location Advantage Within India, software factories and development centres began sprouting in regions with skilled labor and communications facilities, both of which were available in the golden triangle of Bangalore, Hyderabad and Chennai. During the 1980s, prominent domestic firms such as Infosys, India’s second largest software exporter by 1999–2000 and the first Indian firm to be listed on the NASDAQ, was among the early trickle of TNCs to India located in Bangalore. They were attracted by the concentration of skilled labor in the region, initially in public sector manufacturing industries and laboratories in sectors such as aerospace, defence electronics and telecommunications, and subsequently replenished by the large numbers of graduates from the engineering colleges of Karnataka and adjoining provinces. Thus, the IT industry in India began as a domestic industry and eventually spread to international markets, while the BPO industry started with a strong export focus. The changing policy environment

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with regard to foreign investment, rising quality of the offshore environment and improved management capabilities all led global firms to increasingly locate development centres within India. The mid-1990s saw the growth of new centres of software development in Hyderabad, Pune, Chennai, Mumbai and Kolkata and today there are a large number of big and small cities which are part of the IT industry’s map.

Bird’s-eye View The Indian IT industry emerged as a prominent global player since it had a position of comparative advantage in a large skilled English speaking work force, alongside a time advantage for USA and a location advantage of being situated in the hub of India’s engineering colleges.

DEVELOPMENTS IN THE IT–BPO SECTOR According to a review by NASSCOM, The IT–BPO sector is estimated to aggregate revenues of USD 88.1 billion by the end of 2011, with the IT software and services sector (excluding hardware) accounting for USD 76.1 billion of revenues. It is expected to result in direct employment of nearly 2.5 million through an addition of 240,000 employees, while indirect job creation is estimated at 8.3 million. The growth in this sector is apparent from the sectoral revenues which have grown from 1.2 per cent of GDP in 1986, to an estimated 6.4 per cent in 2010. The industry exported software and services worth USD 25 billion in 1985; this has touched USD 69 billion in 2012. The industry has 58 per cent of the global market share in the outsourcing industry, and provides direct employment to about 2.8 million, and indirectly employs 8.9 million people. The industry’s share of total Indian exports (merchandise plus services) increased from less than 4 per cent in 1998 to about 25 per cent in 2012. Software and services revenues (excluding Hardware), comprise nearly 87 per cent of the total industry revenues; within Software and services exports, IT services accounts for 58 per cent, BPO is nearly 23 per cent and ER&D and Software Products account for 19 per cent of the revenue break up. The contribution of the IT–BPO sector to exports (merchandise plus services) has increased from less than 4 per cent in 1998 to 26 per cent in 2011. The United States continues to be India’s largest market, with an increased share of 61.5 per cent. Other important geographies are the emerging markets of Asia Pacific. The sector’s vertical market mix is well balanced across several mature and emerging sectors. Demand is broad based across traditional segments such as banking, financial services and insurance (BFSI), but also new emerging verticals of retail, healthcare, media and utilities. The IT Services segment was the fastest growing among exports, recording a growth of 22.7 per cent over 2010, and aggregating export revenues of USD 33.5 billion, accounting for 57 per cent of total exports. Indian IT service offerings have evolved from application development and maintenance to emerge as full service players providing testing services, infrastructure services, consulting and system integration. The decade of 2010 marked a strategic shift for IT services organizations, from a ‘one factory, one customer’ model to a ‘one factory, all customers’ model. A key aspect of this strategy is the growing customer acceptance of Cloud-based solutions that offer the best in class services at reduced capital expenditure levels. The BPO segment has grown by 14 per cent to reach USD 14.1 billion in 2011. The year has also witnessed the next phase of BPO sector evolution, BPO 3.0, characterized by greater breadth and depth of services, process re-engineering across the value chain, increased delivery of analytics and knowledgebased services through platforms, and strong domestic market focus and SMB-centric delivery models. The engineering design and products development segments have generated revenues of USD 9 billion

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in 2011; growing by 13.6 per cent, driven by increasing use of electronics, fuel efficiency norms, convergence of local markets and localized products. Domestic IT–BPO revenues excluding hardware are expected to grow at almost 16 per cent to reach 787 billion in 2011. Growth in this sector is driven by strong economic growth, rapid advancement in technology infrastructure, increasingly competitive Indian organizations, enhanced focus by the government and the emergence of business models that help introduce IT to new customer segments. The fastest growth is visible in IT services rising by 16.8 per cent to reach 501 billion, driven by localized strategies designed by service providers. The domestic BPO segment is expected to grow by 16.9 per cent in 2011, to reach 127 billion, driven by demand from voice-based services, in addition to adoption from emerging verticals, new customer segments and value-based transformational outsourcing platforms. The software product segment is estimated to grow by 14 per cent to reach 157 billion, fuelled by replacement of in-house software applications to standardized products from large organizations and innovative start-ups The government sector has been a key catalyst for increased IT adoption- through sectors reforms that encourage IT acceptance, National eGovernance Programmes (NeGP) , and the Unique Identification Development Authority of India (UIDAI) programme, which creates large scale IT infrastructure and promotes corporate participation.

GROWTH DRIVERS OF INDIA’S ITES–BPO SECTOR The factors driving the growth of India’s ITES–BPO sector are:

Abundant Talent India’s young demographic profile is an inherent The existence of a large English speaking labour advantage complemented by an academic infraforce, world class information security environstructure that generates a large pool of Englishment and an enabling business policy and reguspeaking talent. Talent suitability concerns are latory environment are the enabling factors of being addressed through a combination of governthe Indian IT industry. ment, academia and industry-led initiatives. These initiatives include national rollout of skill certification through NAC (NASSCOM assessment of Competence), setting up finishing schools in association with the Ministry of Human Resource Development to supplement graduate education with training in specific technology areas and soft skills, and MOUs with education agencies like UGC and AICTE to facilitate industry inputs on curriculum and teaching, and to develop faculty development programmes.

Sustained Cost Competitiveness India has a strong track record of delivering a significant cost advantage, with clients regularly reporting savings of 25–50 per cent over the original cost base. The ability to achieve such high levels of cost advantage by sourcing services from India is driven primarily by the ability to access highly skilled talent at significantly lower wage costs and the resultant productivity gains derived from having a very competent employee base. This is further complemented by relative advantages in other elements of the cost structure (for example, telecom) that contribute to India’s cost competitiveness, even when compared to other low-cost destinations.

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Continued Focus on Quality Demonstrated process quality and expertise in service delivery has been a key factor driving India’s sustained leadership in global service delivery. Since the inception of the industry in India, players within the country have been focusing on quality initiatives to align themselves with international standards. Over the years, the industry has built robust processes and procedures to offer world-class IT software and technology-related services.

World Class Information Security Environment Stakeholders of Indian BPO recognize fool-proof security as an indispensable element of global service delivery. Individual-firm-level efforts are complemented by a comprehensive policy framework established by Indian authorities, which has built a strong foundation for an ‘info-secure’ environment in the country. These include strengthening the regulatory framework through proposed amendments to further strengthen the IT Act 2000, scaling up the cyber lab initiative, scaling up the National Skills Registry (NSR) and establishing a self regulatory organization.

Rapid Growth in Key Business Infrastructure Rapid growth in key business infrastructure has ensured unhindered growth and expansion of this sector. The BPO sector has been a key beneficiary with the cost of international connectivity declining rapidly and service level improving significantly. The growth is taking place not only in existing urban centres but increasingly in satellite towns and smaller cities. Critical business infrastructure such as telecom and commercial real estate is well in place; improving other supporting infrastructure is a key priority for the government. STPI infrastructure available across the country and the magnitude of investments shows government support to the industry.

Enabling Business Policy and Regulatory Environment The enabling policy environment in India was instrumental in catalysing the early phases of growth in this sector. Policy-makers in India have laid special emphasis on encouraging foreign participation in most sectors of the economy, recognizing its importance not only as a source of financial capital but also as a facilitator of knowledge and technology transfer. The Indian ITES–BPO sector has benefited from this approach, with participating firms enjoying minimal regulatory and policy restrictions along with a broad range of fiscal and procedural incentives.

PROBLEMS AND PITFALLS OF THE ITES–BPO INDUSTRY The IT industry has boasted annual growth rates of nearly 30 per cent in the past ten years, with revenues now nearing USD 88 billion. The following are some of the problems faced by the industry today:

Changing Value of the Rupee

Intensifying competition, loss of the low cost advantage, increasing demand for trained manpower and employee dissatisfaction and high attrition rates are some of the problems faced by the industry.

The most immediate difficulty faced by the industry is the constant change in the value of the rupee against the dollar. As a predominantly export oriented industry a depreciation in the value of the rupee against the dollar helps to increase export earnings, and an appreciation works against the interests of the industry.

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Poor Infrastructure Poor quality of infrastructure continues to be a problem in cities like Bangalore, where workers can spend four hours a day in traffic. Although state-of-the-art technology was used for telecom networks, getting a connection can still take as long as three months. The problem of erratic power supplies forces units to use their own back-ups.

Increasing Demand for Trained Manpower Indian engineering schools award around 200,000 diplomas each year, and produce around 250,000 graduates, but only half are employable by the IT industry. Employees have learnt to switch jobs for better pay, but that only leads to increasing costs for the industry.

Employee Dissatisfaction and High Attrition Rates Call centres and other outsourced businesses such as software writing, medical transcription and backoffice work employ more than 1.6 million young men and women in India, mostly in their twenties and thirties, who make much more than their contemporaries in most other professions. They do, however, face sleep disorders, heart disease, depression and family discord. Most call centre jobs involve responding to phone calls through the night from customers in the United States and Europe—some of whom can be angry and rude. It is monotonous and there is little meaningful personal interaction among co-workers. That can also be true of other jobs such as software writing and back-office work. All these factors have led to an increasingly dissatisfied workforce, especially at the lower end of the job pyramid, which is increasingly viewing work in the IT industry as a job more than a career.

Intensifying Competition IT industries in other parts of the world, such as Central Europe, may never match India’s in size, but they can still pick off valuable contracts. Meanwhile, foreign IT firms have been beefing up their Indian subsidiaries. In 2002 the six biggest—including Accenture, IBM and HP—had fewer than 10,000 employees in total in the country. Their combined Indian workforce now exceeds 150,000. This enables them to rival the Indian firms in scale and cost, while exploiting their stronger brands and international scope.

Bird’s-eye View

Future Threats In the longer term, Indian firms must keep abreast of technological changes. Many of the services they now provide will eventually be automated; this is already starting to happen, for example, in software testing. Western firms, meanwhile, increasingly want Indian providers to do more than just keep systems running; they want help in developing new solutions to business problems—something few Indian firms are set up to do.

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The Indian IT sector’s growth has been driven by a skilled work force which flourished in a world class work environment amidst twin advantages of cost and quality competitiveness. It has been challenged by the fluctuating value of the rupee, poor infrastructure, increasing demand for trained manpower due to a high rate of employee dissatisfaction and attrition and intensifying global competition.

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C H A P T E R

S U M M A R Y

■■ Outsourcing as a business phenomenon has its roots in David Ricardo’s theory of comparative advantage—it is the process of transferring recurring business activities to a low-cost supplier outside the business. ■■ The major drivers of outsourcing have been a low-wage-seeking English-speaking workforce; developments in technology; changes in the regulatory environment and institutional and infrastructural developments. ■■ A firm’s decision to outsource certain business processes depends on the ability to standardize and digitize certain functions, cost considerations and market size. ■■ The Indian Software Industry came into existence with the passing of the Computer Policy of November 1984, the Computer Software Export, Development and Training Policy of December 1986 and the establishment of NASSCOM in 1988. ■■ Bangalore, Pune, Hyderabad, Chennai and Gurgaon have been important centres of the IT Industry; however, smaller satellite towns are also becoming increasingly important. ■■ Key growth drivers of Indian ITES–BPO exports are a talented workforce, sustained cost competitiveness, continued focus on quality, world-class information security environment, rapid growth in key business infrastructure and an enabling business policy and regulatory environment. ■■ Major problems of the ITES–BPO industry are an appreciation of the rupee, intensifying competition, insufficient trained manpower, poor quality infrastructure, rising employee dissatisfaction and high attrition rate.

KEY terms Outsourcing, Captive onshore outsourcing, Non-captive onshore outsourcing, Captive offshoring, Noncaptive offshoring, IT value chain.

DISCUSSION QUESTIONS

1. What does the term ‘outsourcing’ mean? Discuss the different forms of outsourcing in the global economy. 2. Enumerate the different factors that play a key role in a firm’s decision to outsource certain business operations. 3. List the factors that have acted as drivers in the process of outsourcing in the global economy. 4. Write a short note on the growth of the software industry in India. 5. Discuss the contribution of the software industry in the context of the Indian economy. 6. What are the key growth drivers of India’s ITES–BPO industry? 7. Discuss the main problems faced by the IT industry in India today. 8. What is outsourcing? Discuss the importance of outsourcing in the context of the Indian ­economy. [Delhi University, B.Com (Hons.) 2010] 9. What is the significance of outsourcing for the modern global business?  [Delhi University, B.Com (Hons.) 2007, 2009] 10. What is outsourcing? Discuss the different factors which play a key role in a firm’s decision to outsource certain business operations. [B.Com (Hons.) 2011, 2012] 11. What is the role of IT in international business? [Delhi University, B.Com (Hons.) 2014]

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Model Question Papers Paper One B.Com (Hons) Part 3 Paper CH 6.1 International Business Time: 3 Hours Note: Attempt all questions All questions carry equal marks

Marks: 75

1. (a) What is international business? What are the complexities involved in international business? How are they different from domestic business? (8) (b) Explain the salient features of the political and economic environment in which the multi­ national corporation has to operate. (7) Or (a)  Elaborate on the trends of growth in Indian foreign trade in the last ten years. (8) (b) What is the contractual entry mode of foreign market entry? Discuss its main features and usefulness in the world of international business. (7) 2. (a)  What is a country’s balance of payments account? What are its different components? (7) (b) ‘The balance of payments account is a cash flow statement that records the flow of foreign exchange from all international transactions over a period of time.’ Discuss the main features of the balance of payments account based on this statement. (8) Or Write short notes on any two of the following: (i)  ASEAN (ii)  SAARC (iii) NAFTA  (iv)  EU (15) 3. (a)  Explain the role of the WTO as a regulator of world trade. (7) (b) Briefly explain the contribution and relevance of Porter’s theory of National Competitive Advantage as a theory of international trade. (8) Or What is meant by barriers to trade? What are the major differences between the effects of tariff and non-tariff barriers to trade between nations. (15) 4.

Write short notes on any two:  (i)  Floating exchange rate system (ii)  Types of FDI (iii)  Strategic alliances Or

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  Model Question Papers

List and explain the process of regional economic integration from the free trade agreement to the political union, giving suitable examples. (15) 5. List and explain the various measures of foreign trade promotion undertaken by the Indian Government. Briefly enumerate the different organizations set up for trade promotion. (15) Or (a)  Distinguish between (any two)  (i)  FAS and FOB   (ii)  C&F and CIF (iii)  International joint ventures and M&As

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Paper Two

Time: 3 Hours Note: Attempt all questions All questions carry equal marks

B.Com (Hons) Part 3 Paper CH 6.1 International Business

Marks: 75

1. (a) What is globalization? Clearly explain the relationship between globalization and international business.(7) (b)  What are the major differences between domestic and international business? (8) Or What are the main features of the international economic environment? List and explain the different kinds of economic systems and their influence on international business. (15) 2. What is the WTO? Explain its main principles and functions. Distinguish between GATT and WTO.(15) Or Distinguish between the product life cycle theory and factor proportions theory of trade between nations. Also briefly list the criticisms of both these theories. (15) 3. Distinguish between the international product structure and international matrix structure. List the advantages and disadvantages of both. (15) Or What is outsourcing? Clearly explain the factors which influence a firm’s decision to outsource some of its business operations to an outside party. (15) 4. (a) List and explain the different functions of the foreign exchange market. (7) (b) Distinguish between foreign exchange risk and foreign exchange exposure in international (8) financial transactions. Or ‘Regional economic integration is a process that passes through different stages’. Explain the state­ ment with clear contemporary examples. (15) 5. (a)  Write short notes on any two: (i)  Environmental degradation (ii)  Indian joint ventures abroad (iii) SAARC  (iv)  ASEAN  (v)  Measures to promote FDI in India Or (a)  What are the different methods of payment in foreign trade? (b)  List and explain the different methods of export financing.

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Paper Three

Time: 3 Hours Note: Attempt all questions All questions carry equal marks

B.Com (Hons) Part 3 Paper CH 6.1 International Business

Marks: 75

1. ‘Entry into international business is an incremental process in which a firm gradually increases its foreign market presence.’ Clearly explain with examples. Or ‘A global business firm operates in an environment which is complex and multidimensional’. Explain the main features of the international political and legal environment. 2. Distinguish between the theory of absolute advantage and the theory of comparitive advantage as explanations of trade between nations. (15) Or Compare and contrast the role of the IMF and World Bank as global financial regulators. (15) 3. What is economic integration? Explain the process of evolution of regional economic integration in Europe. (15) Or (a)  What is foreign exchange risk? How is it different from foreign exchange exposure? (b)  Briefly explain the changes in foreign investment flows since 1991 in India. 4. (a)  List the factors which determine the choice of global organizational structures. (8) (b)  Distinguish between the global product structure and the global area structure. (7) Or (a)  Discuss the significance of e-commerce in the context of a modern global organization. (b) Briefly discuss international initiatives to fight against the negative effects of environmental change in the context of global business firms. 5. Write short notes on any two: (i) EOUs (ii) SEZs  (iii) EXIM bank Or (a)  List and explain the different modes of payment for foreign trade. (b)  Explain the different forms of outsourcing of business operations.

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