IBM-NOTES

Module -1

Globalization

Definition of Globalization

Ø  Charles.W.L.Hill, defines globalization as, “the shift towards a more integrated & interdependent world economy.

Ø  International Monetary Fund, defines globalization as “the growing economic interdependence of countries worldwide through increasing volume and variety of cross border transactions in Goods & Services and of international capital flows and also through the more rapid and widespread of technology”

Meaning of Globalization

Ø  International business means carrying on business activities beyond national boundaries

Ø  Business activities – transaction of economic resources, such as goods, capital, services{comprising technology, skilled labor and transportation etc} and international production {physical goods and service}ex: banking, insurance etc

Emerging global economy

It has following features:

Ø  Operating & planning to expand B throughout the world.

Ø  Erasing the difference b/w domestic & foreign market.

Ø  Buying & selling goods & services from/to any country in the world.

Ø  Product planning & development are based on market consideration of the entire world.

Ø  Global orientation in strategies, organizational structure, organization culture & managerial expertise.

Ø  Setting the mind & attitude to view the entire globe as a single market.

Globalization of production

It is locating the mfg facilities in a number of locations around the globe to take advantages of national differences in cost, quality, & availability of inputs & of reaching various markets at the shortest span of time.

Factors influencing the location of mfg facilities vary from country to country. They may b more favorable in foreign than in home country. Ex: cheap labor in developing country, availability of high quality & cheap Raw materials in other countries etc enable the companies to produce the products of high quality & low cost in various foreign countries.

 Reasons for Globalization of production

Ø  High quality Raw Materials & components in other countries.

Ø  Inputs at low cost in foreign countries.

Ø  Skilled human resources at low cost.

Ø  To reduce the cost of transportation & easy logistics mgt.

Ø  Facility of exporting to other neighboring foreign countries.

Ø  To design and produce the G/S as per the varying tastes of customer in foreign country

Ø  Imposition of restrictions on import by foreign countries forces the MNCs to establish manufacturing facilities in other country

Examples of Globalization of production

¨  IBM - ThinkPad X31 laptop -US(basic design work)

Keyboard & hard disk – Thailand

Display screen and memory- South Korea

Built in wireless card – Malaysia

Microprocessor – US

IBM operation – Mexico (assembly less                                

Labor cost       

Final sale – US (Chinese co, Lenovo)

¨  Boeing co., commercial jet airlines 777 –

      8 Japanese, 1 Singapore, 3 Italy suppliers

Globalization of Markets

It refers to the process of integrating & merging of the distinct world market into a single market. This process involves identification of some common norm, value, taste, preference & convenience & slowly enables the cultural shift towards the use of a common products product or service.

A number of consumer products have global acceptance like coca cola, Pepsi, McDonald's burger, Levi’s jeans, Sony walkman, Indian hyderabadi biryani, KFC etc

Reasons for Globalization of Market

Ø  Large scale industrialization enabled mass production

Ø  Companies in order to reduce the risk diversify the portfolio of countries.

Ø  Companies globalize markets in order to increase their profits & achieve co goals.

Ø  To cater to the demand for their product in foreign market.

Ø  The adverse bus environment in the home country pushed the coy to globalize their market.

Drivers of globalization

There are seven drivers or forces behind globalization are:

1. Increase and expansion of technology: Conducting business on an international level usually involves greater distances than does conducting domestic business. But improved communications and transportation speed up interactions and improve a manager’s ability to control foreign operation. 

2. Liberalization of cross-border trade and resource movements: To protect its own industries, every country restricts the movement across its borders of goods and services and the resources, such as workers and capital, to produce both. Such restrictions make international business more expensive to undertake.

3. Developments of services that support international business: Companies and governments have developed services that ease the conduct of international business.

4. Growing consumer pressures: Business of innovations in transportation and communications, consumers know about products and services available in other countries. Thus, consumers want more, new, better, and differentiated products.

5. Increased global competition: The expansion of competition, forces most companies to seek any means to gain competitive advantages, including a global search for quality improvement or cost reduction advantages.

6. Changing political situations: Political factor relates to governments abilities to respond to pressures to enhance world trade. As incomes have grown, so has tax revenue.

7. Expanded cross-national cooperation: Government increasingly realize that their own countries interest can be enhanced by cooperating with other countries through agreements and consultation.

Modes & Entry strategies of International Business

When a domestic company plans to engage in international B, the co., has to select the mode of entry into the foreign country based on all relevant factors like the size of B, influence of environmental factors, attractiveness of foreign market, market potential cost & benefit & risk factors.

Different modes of entry strategies include:

Ø  Direct exporting                                    

Ø  Indirect exporting                                 

Ø  Franchising

Ø  Direct investments                              

Ø  Mergers & acquisitions

Ø  Joint ventures                                       

Ø  Licensing

Ø  Contract manufacturing

Ø  Management Contracts                    

Ø  Turnkey project

v  Direct Exporting: It is the simplest & widely used mode of entering foreign mkt. It is selling the Globalization n in a foreign country directly through its distribution arrangements or through a host country’s company

v  Indirect exporting: It is exporting the product either in their original form or in the modified form to a foreign country through another domestic coy

v  Licensing: In this mode of entry, the domestic manufacturer leases the right to use its intellectual property i.e. technology, work methods, patents, copyrights, brand name, trade name etc to a mfgr in a foreign country for a fee. Here the mfgr in domestic company is called licensor & foreign coy mfgr is called licensee.

v  Franchising: It is a form of licensing. The franchisor can exercise more control over the franchised compared to that of licensing. Under this an independent organization called the franchisee operates the bus under the name of another coy called the franchisor. Under this arrangement, the franchisee pays the fee to the franchisor. The franchisor provides the following services to the franchisee:  trademarks, operating systems, product reputations, continuous support systems like advertising, employee training, reservation services, quality assurance program etc.  It is more popular in USA. Fast food companies like Mc Donald, dairy queen, Domino’s, Pizza hut, KFC have franchised restaurants worldwide.

v  Contract manufacturing: Some companies outsource their part of our entire production & concentrate on marketing operations which is called contract mfg. Ex: Nike, Bata USA, Europe --- India    garments

v  Management contract: The companies with low level technology & managerial expertise may seek the assistance of a foreign coy. Then the foreign coy may agree to provide technical assistance & managerial expertise. Ex: Air France often provides technical & managerial assistance to the small airline companies owned by government.

v  Turnkey project: It is a contract under which a firm agrees to fully design, construct & equip a manufacturing, bus or service facility & turn the project over to the purchaser when it is ready for operation, for remuneration. It may include nuclear power plants, air ports, oil refinery, highways etc.

v  Foreign direct investment: Companies which enter international bus through FDI invest their money; establish manufacturing & mrg facilities through ownership & control.

v   Joint venture: 2 or more firms join together to create a new bus entity that is legally separate & distinct from its parents. They are established as corporations & owned by the funding partners in the predetermined proportions.

v  Mergers & Acquisitions: A domestic coy selects a foreign company & merges itself with the foreign coy in order to enter international bus. It is called merger. The domestic coy may purchase the foreign coy & acquires its ownership & control is called acquisition.

Globalization debate – FOR or ADVANTAGES

Ø  Free flow of technology

Ø  Increase in industrialization

Ø    Free flow of capital

Ø  Spread of production facilities throughout the globe

Ø  Balanced development of world economies

Ø  Increase in production & consumption

Ø  Lower prices with high quality

Ø  Cultural exchange & demand for a variety of products.

Ø  Increase in employment & income

Ø  Higher standards of living

Ø  Balanced human development

Ø  Increase in welfare & prosperity

AGAINST or Disadvantages

Ø  Globalization kills domestic business

Ø  It exploits human resources

Ø  Violation of labor & environmental laws

Ø  Leads to unemployment & underemployment

Ø  Decline in demand for domestic products

Ø  Widening gap b/w the rich & poor

Ø  Transfer of natural resources

Ø  Leads to political & commercial colonialism

Ø  National sovereignty at  stake

Difference b/w domestic & international business

Ø  Approach - D B approach is ethnocentric. IB’s can be polycentric or regiocentric or geocentric.

Ø  Geographic scope - DB scope is within the national boundaries of the domestic country. IB varies from the national boundaries of minimum  2 countries to maximum of entire world

Ø  Operating Style- DB operating style including production, mrg, investment, R&D etc is limited to domestic country.  IB can be spread to entire globe.

Ø  Environment- DB mostly analyses & scans the domestic environment.                                              IB analyses & scans the relevant international environment

Ø  Quotas- The quotas imposed by various countries do not directly &                          significantly influence DB. The IB has to operate within the quotas imposed by various countries on their exports & imports.

Ø  Tariffs- They do not influence DB. They influence IB

Ø  Foreign exchange rates- They do not directly & significantly influence DB.  They directly & significantly influence IB

Ø  Culture - Mostly domestic culture of the country affects the bus                               operations including product design of DB.  Mostly cultures of various countries affect the bus operations including product design of IB.

Ø  Export import procedures- DB is not influenced by it. IB is influenced by exim procedures.

Ø  Human resources- DB normally employs the people from the same      country. IB normally employs the people from different countries.

Ø  Markets & customers- DB meet the needs of the domestic market & customers. IB should understand markets & customers of various countries.

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Module-2

International Business Environment

Meaning of international business environment

Ø  Environment means surrounding. International Business Environment means the factors/activities those surround/encircle the international business.  In other words business environment means the factors that effects or influence the IB.

Ø  Factors are internal and external

Ø  STEPIN are the important factors to be considered

Ø  Study of environment helps the business to formulate strategies and run the business efficiently in the global market.  Thus business depends on environmental dynamics. 

1. Cultural Aspects or Environment

Edward Tylor defined culture as, “that complex whole which includes knowledge, belief, art, morals, law, custom, and other capabilities acquired by man as a member of society.”

Culture as a system of ideas and argue that these ideas constitute a design for living.

Determinants of culture

Ø  Religion: Religion is defined as a system of shared beliefs & rituals that are concerned with the realm of the sacred.

Ø  Political philosophy: Political system- The political system of a country shapes its economic & legal system. Political system means the system of Government in a nation. Political system can be assessed according to 2 dimensions- The 1st is the degree to which they emphasize collectivism as opposed to individualism. The 2^nd is the degree to which they are democratic or totalitarianism.

Ø   Economic philosophy: It is connected towards trading and industrial activities ( profits) with respect to community system of wealth creation. Economic system is an organization of institutions established to satisfy human needs/wants

Ø  Education: It is the medium through which individuals learn many of the language, conceptual, & mathematical skill that are inseparable in a modern society. It also supplements the family’s role in socializing the young into the values & norms of the society.

Ø   Language: Language is one obvious way in which countries differ. By language it means both spoken and unspoken means of communication.  It is one of the defining characteristics of a culture.

Ø   Legal environment: Law of the land directly affect the I B wherever they operate .Thus the I B Managers should be aware of the legal systems and the law that in force in various foreign country

Values and Norms

Values - form the bedrock of a culture. They provide the context within which a society’s norms are established & justified. They may include a society’s attitudes toward such concepts as individual freedom, democracy, truth, justice, honesty, loyalty, social obligation, and so on .Values  are not just abstract concepts; they are invested with considerable emotional significance. People argue, fight, & even die over values such as freedom.

Norms - are the social rules that govern people’s actions toward one another. Norms can be sub-divided further into two major categories:

Ø  Folkways - These are the routine conventions of everyday life. Generally, folkways are actions of little moral significance. Rather, folkways are social conventions concerning things such as the appropriate dress code in a particular situation, good social manners, eating with the correct utensils, neighborly behavior, & the like.

Ø  Mores: These are norms that are seen as central to the functioning of a society & to its social life. They have much greater significance than folkways. Accordingly, violating mores can bring serious retribution. Mores include such factors as indictments against theft, adultery, incest, & cannibalism. In many societies, certain mores have been enacted into law. However, there are also many differences b/w cultures as to what is perceived as mores.

Religious & Ethical systems

Religion is defined as a system of shared beliefs & rituals that are concerned with the realm of the sacred.

Ethical systems refer to a set of moral principles or values that are used to guide & shape behavior. Most of the world’s ethical systems are the product of religions.

1. Christianity

Christianity is the most widely practiced religion in the world. A religious division in the 11^thCentury led to the establishment of two major Christian organizations, Roman Catholic Church and the Orthodox Church. In the 16^th century, the Reformation led to a further split with Rome; the resultant was Protestantism.

2. Islam    

Islam is the second largest of the world’s major Religion. Adherents of Islam are referred to as Muslims. The central principle of Islam is that there is but the One true omnipotent god. Major principles are

1. Honoring and respecting parents.

2. Respecting the rights of others

3. Being of pure heart and mind.

3. Hinduism

Hinduism began in the Indus valley in India more than 4,000 years ago, making it the world’s oldest major religion. Hindus believe that a moral force in society requires the acceptance of certain Responsibilities, into a different body after death.

4. Buddhism

Buddhism: Buddhists also stress spiritual growth and the afterlife, rather than achievement while in this world. Buddhism, practiced mainly in Southeast Asia, does not support the caste system, however, so individuals do have some mobility which is not found in Hinduism and can work with individuals from different classes. There are around 250 million Buddhists, most of who are found in Central and Southeast Asia, China, Korea and Japan.

Eight fold path: right seeing, thinking, speech, action, living, effort, meditation, mindfulness

5. Confucianism

It is practiced mainly in China, Korea, and Japan. This teaches the importance of attaining personal salvation through right action. Unlike other religions, Confucianism is not concerned with the supernatural and has little to say about the concept of a supreme being or an afterlife. The needs for high moral and ethical conduct and loyalty to others are central in Confucianism. Loyalty to one’s superiors is regarded as sacred duty, so it binds the employees to the heads of their organization and reduces the conflict between management & labor.

Language

Ø   Language is one obvious way in which countries differ.

Ø  By language it means both spoken and unspoken means of communication.

Ø  It is one of the defining characteristics of a culture.

Spoken language:

Ø  Language does far more than just enable people to communicate with each other.

Ø  The nature of a language also structures the way we perceive the world.

Ø  It can direct the attention of its members to certain features of the world.

Unspoken language:

Ø  It refers to non verbal communication.

Ø  We all communicate with each other by a host of non verbal cues like rising of eyebrow, smile etc.

Ø  A failure to understand the nonverbal cues of another culture can lead to a communication failure.

Ø  Another aspect of nonverbal communication is personal space which is the comfortable amount of distance between the people who are communicating.

Education

Ø   Formal education plays a key role in the society.

Ø  It is the medium through which individuals learn many of the language , conceptual, & mathematical skill that are inseparable in a modern society.

Ø  It also supplements the family’s role in socializing the young into the values & norms of the society.

Implications of cultural difference

Ø  A society’s culture impacts on values found in the work place.

Ø  The most famous study of how culture relates to workplace values was undertaken by Geert Hofstede.

Ø  As part of his job as a psychologist working for IBM, from 1967 to 1973, Hofstede collected data on employee attitudes and values for over 1, 00,000 individuals.

Ø  This data enabled him to compare dimensions of culture across 40 countries.

Ø  Hofstede identified four dimensions that summarize different cultures:

Power Distance: dimension focused on how a society deals with the fact that people are unequal in physical & intellectual capabilities

·         High power distance cultures were found in countries that let inequalities of power & wealth to grow over time

·         Low power distance cultures were found in societies that tried to reduce these inequalities as much as possible.

Individualism VS Collectivism: dimension focused on relationship between individual & his/her fellows

·         In individualistic societies individual achievement & freedom were highly valued.

·         In collectivistic societies people were born into collectives, such as extended families, & everyone was supposed to look after interest of his/her collective.

Uncertainty Avoidance: dimension measured the extent to which different cultures socialized their members into accepting ambiguous situations and tolerating uncertainty.

·         Members of high uncertainty avoidance cultures are more concerned on job security, career patterns, and retirement benefits and so on.

·         They also had a strong need for rules and regulations, the manager was expected to issue clearer instructions, and subordinates initiatives were highly controlled.

·         Lower uncertainty avoidance cultures were characterized by greater readiness to take risks and less emotional resistance to change

Masculinity VS Femininity: dimension looked at the relationship between gender and work roles.

·         In masculine cultures, values such as achievement & effective exercise of power determined cultural ideals.

·         In feminine cultures, little differentiation was made between men and women in the same job.

Ø  Hofstede created an index score for each of four dimensions that range from 0 to 100 and scored high for high individualism, high power distance, high uncertainty avoidance and high masculinity.

Ø  He averaged the score of all employees from a given country

Ø  Western nations such as US, Canada, Britain score on individualism scale and low on power distance scale.

Ø  Latin American and Asian countries scored high on collectivism and power distance. This fits the standard stereotype of Japan as a Male dominant country and High uncertainty avoidance feature exhibits the life time employment concept.

Cultural Change

Ø  Culture is not a constant, but does evolve over time.

Ø  What was acceptable behavior in the US in the 1960s is now considered “insensitive” or even harassment

Ø  Changes are taking place all the time.

Ø  As countries become economically stronger and increase in the globalization of products bought and sold, cultural change is particularly common

Cultural Change: Implications for Business

There are two implications:

1. Cross Cultural Literacy:

Ø  Individuals and firms must develop cross-cultural literacy.

Ø  International businesses that are ill informed about the practices of another culture are unlikely to succeed in that culture.

Ø  One way to develop cross-cultural literacy is to regularly rotate and transfer people internationally.

Ø  One must also beware of ethnocentric behavior, or a belief in the superiority of one’s own culture

2. Culture and Competitive Advantage:

Ø  Cultural values, norms can influence costs of doing business in that country.

Ø  Understanding what countries may have a competitive advantage has implications both for looking for potential competitors in world markets and for deciding where to undertake international expansion.

2. Legal environment

Ø  Law of the land directly affect the I B wherever they operate

Ø  Thus the I B Managers should be aware of the legal systems and the law that in force in various foreign country

Kinds of Legal systems:

v  Common law

v  Civil law

v  Theocratic law

Ø  Common Law: Court interprets the law according to situation and incidents. Tradition, custom, culture and usage are the basis of common law. Ex: USA, UK. Contract law is more in detail.

Ø  Civil Law: Detailed set of laws which make-up a code is the basis for civil law. It is based on how the law is applied to facts. Ex: France, Germany. Contract law is in less specific.

Ø  Theocratic Law: It is based on religious precepts, unchanged and more moral than the commercial law.

Property Rights

Property refers to a resource over which an individual or business holds a legal title, that is, a resource that it owns. Resources include land, buildings, equipment, capital, mineral rights, businesses & intellectual property. (Ideas which r protected by patents, copyrights & trademarks)

Property rights refer to the bundle of legal rights over the use to which a resource is put & over the use made of any income that may b derived from that resource.

It can b violated in 2 ways:

1.      Private action: refers to theft, piracy, blackmail & the like by private individuals or groups. While theft occurs in all countries, a weak legal system allows for a much higher level of criminal action in some than in others

2.      Public action: to violate property rights occurs when public officials, such as politicians & government bureaucrats, extort income, resources or the property itself from property holders. This can be done through legal mechanism such as levying excessive taxation, requiring expensive licenses or permits from property holders, taking assets into state ownership without compensating the owners. It can be done through illegal means, or corruption, by demanding bribes from businesses in return for the rights to operate in a country, industry or location.

Protection of intellectual properties

Intellectual property refers to property that is the product of intellectual activity, such as computer software, a screenplay, a music store or the chemical formula for a new drug. Patents, copyrights and trademarks establish ownership rights over intellectual property. A patent grants the inventor of a new product or process exclusive rights for a defined period to the manufacture, use or sale of that invention.

Copyrights are the exclusive legal rights of authors, composers, playwright, artists and publishers to publish &disperse their work as they see fit.

Trademarks are design & names, often officially registered by which merchants or manufacturers designate and differentiate their products.

The philosophy behind IP laws is to reward the originator of a new invention, book, musical record, clothes design, restaurant chain and the like, for his or her idea and effort

Product safety and product liability

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

Product liability involves holding a firm & its officers responsible when a product causes injury, death or damage. Product liability can be much greater if a product does not conform to required safety standards.

Both civil & criminal product liability law exists. Civil laws call for payment & monetary damages. Criminal liability laws result in fines or imprisonment. Both civil & criminal liability laws are more extensive in U.S.

3. Political environment or economy

Political system- The political system of a country shapes its economic & legal system. Political system means the system of Government in a nation.

Political system can be assessed according to 2 dimensions- The 1st is the degree to which they emphasize collectivism as opposed to individualism. The 2^nd is the degree to which they are democratic or totalitarianism.

Collectivism & Individualism

Collectivism refers to a political system that stresses the primacy of collective goals over individual goals. When collectivism is emphasized, the needs of society as a whole are generally viewed as being more important than individual freedom. (Public ownership)

Socialism - State ownership as the basic means of production, distribution & exchange. This logic was that if the state owned the means of production, the state could ensure that the workers were fully compensated for their labor. Thus the idea is to manage state owned enterprise to benefit society as a whole rather than individual capitalist.

Communists believed that socialism could b achieved only through violent revolution & totalitarian dictatorship while Social democrats committed themselves to achieving socialism by democratic means.

Individualism this philosophy should have freedom in his/her economic and political pursuits

Democracy and Totalitarianism

Democracy refers to a political system in which government is by the people, exercised either directly or through elected representatives

Totalitarianism

It is a form of government in which one person or political party exercises absolute control over all spheres of human life & prohibits opposing political parties.

Totalitarianism 4 major forms:

Ø  Communist totalitarianism- communism is a version of collectivism that advocates that socialism can be achieved only through totalitarian dictatorship. Ex: China, Vietnam.

Ø  Theocratic totalitarianism- This is found in states where political power is monopolized by a party, group or individual that governs according to religious principles. Ex: Iran, Saudi Arabia.

Ø  Tribal totalitarianism- It has arisen from time to time in African countries such as Zimbabwe, Tanzania, Uganda & Kenya. It occurs when a political party that represents the interests of a particular tribe monopolizes power.

Ø  Right- wing totalitarianism- It generally permits some individual economic freedom, but restricts individual political freedom, frequently on the grounds that it would lead to the rise of communism. Many right wing totalitarian governments are backed by the military & in some cases the government may b made up of military officers.

Political factors

Ø  Political relations and international business – good relationship result in the growth of bilateral or multilateral trade.

Ø  Level of economic development & political stability

Ø  Political risks – change in Government policies or in political parties in power. Risk is from host government.

Confiscation – the process of nationalization of a property without compensation (EX: Chinese Government seizure of US property in 1949 when communists took power)

Expropriation – with compensation (EX: Indian government nationalized banks in 1969)

Nationalization - process of shifting the ownership of private property to Govt.

Domestication - the foreign business firms    relinquish control and ownership in favor of domestic investors either partly or fully

General Instability risk - social, political, religious unrest in the host country

Operation risks - the risks are due to the      imposition of controls on the foreign business operation (production, marketing, HR)by the host government.

Indicators of political instability

Ø  Corruption and bribery

Ø  Social unrest – caused by clashes between or among       community group, religious group EX: Hindu and       Muslim conflict in India and Pakistan, white and      black    in USA

Ø  Attitudes of nationals – negative attitude towards foreign business

Ø  Policies of the host countries – affects directly are indirectly

Way to minimize political risk

Fully political risks cannot be eliminated but can be minimized to some extent

Ø  Stimulation of local economy – by investing, encourage the local companies by purchasing raw materials, using local company as ancillary units and also export units.

Ø  MNC/employment of nationals – reduce political risks by employing, developing and promoting the local people

Ø  Sharing ownership – local investor participation

Ø  Being civic minded – being good corporate citizen

Ø  Political neutrality – MNC should not involved in political affairs or disputes among local group

4. Economic environment

Ø  It is connected towards trading  and industrial activities ( profits) with respect to community system of wealth creation

Ø  Economic system is an organization of institutions established to satisfy human needs/wants

Forces constituting the economic environment:

A) Micro factors

1. Classification of countries by economic system

A). Centrally planned economy – socialism: Also called communism, it is defined as economy where decisions regarding production & distribution of goods are taken by central authority. The government designs the investments & coordinates the activities of the different economic sectors.

b). Market based economy – capitalism: In this type the decision to produce & distribute goods is taken by individual firms based on the forces of demand & supply. The firms are quite free to take economic decisions. They take such decisions for the purpose of maximizing their profit or wealth. Consumers are sovereign; they are free to decide what they want to buy.

c). Mixed economy or Fabian socialism: Between the two extremes, there is a mixed economic system. Mixed economy, which represents a mixer of state control on one hand and the economic freedom of entrepreneurs and consumers on the other, is the natural outcome.

The Indian economy represents a mixed economic system. Economic activities that are fraught with social considerations are owned & regulated by the government. The others are owned & performed in the private sector.

Ex: India, France, Holland.

2. Countries classified on the basis of income

The World Bank categories economies into one of the following groups according to the per capita, gross national income.

a) Low income countries – Ex: Ethiopia, Bangladesh (third world country)

b) Lower middle income countries – Ex: China, India,          Srilanka (less developed countries)

c) Upper middle income – Ex: Brazil, Malaysia,        Mexico (industrialized countries)

d) Higher income countries – Ex: USA, UK (advanced)

3. Region-wise classification of countries

The final way of classifying is by the region to which a nation belongs.  The major regions are:

1.      East Asia & Pacific

2.      Latin America & the Caribbean

3.      The Middle East & North Africa

4.      South Asia

5.      Sub-Saharan Africa

These designations are important to MNE’s, which tend to organize their   operations along geographic lines. Investors can use the data to analyze where potential growth & risks exist in the regions where their companies operate.

B) Macro economic factors

Ø  Economic growth: The high economic growth rate of the countries lift the quality of life of their citizens in addition to providing an opportunity of expanding market share to IB firms. (stagnation or decline in economic growth difficult situation & more competition for survival) OECD – organization of economic co-operation and development announces the economic growth rate.

Ø  Balance of payment

Ø   Inflation  

Ø   Economic transition

Determinants of Economic Development

Ø  Gross national income:

A common yardstick to measure economic development of a country is GNI. Gross National Income is the value of all goods and services produced with in a nation. It measures the income generated both by total domestic production as well as the international production activities of national companies. It is the market value of final goods and services produced by domestically owned factors of production.GDP is the part of GNI

Ø  Purchasing power parity:

Managers when comparing often convert GNI in one country to the currency of their home country. This may give wrong interpretation as GNI per capita won’t consider cost of living differences from one country to another. So GNI per capita for a particular country will be adjusted in terms of its local Purchasing Power Parity-PPP. One can calculate PPP by estimating the value of Universal basket of goods [like soap, bread, energy] & services [telephone, electricity] that can be purchased with one unit of a country’s currency. The base for adjustment is cost of living in the US.

Ø  Human development:

It has 3 dimensions

      longevity- measured by life expectancy at birth

      Knowledge- measured by literacy rate

      Standard of living- measured by GNI per capita expressed  in PPP for US$

Ø  Political Economy & Economic Progress:

The relationship between political economy and economic progress is as follows:

      Innovation and entrepreneurship are engines of growth

      Innovation and entrepreneurship requires a free market economy system

      Innovation and entrepreneurship requires strong property rights

Ethical Issues in International Business

Ø  Employment practices:

·         When work conditions in a host nation are clearly inferior to those in a multinational’s home nation, what standards should be applied?

·         The standards of the home nation?

·         The standards of the host nation?

·         Something in between?

Ways to guard against ethical abuses:

·         Establishing minimal acceptable standards that safeguard the basic rights and dignity of employees

·         Auditing foreign subsidies and subcontractors on a regular basis to make sure that  those standards are met

·         Taking corrective action if they are not following standards

Ø  Human rights:

·         What is the responsibility of a foreign multinational when operating in a country where basic human rights are not respected?

·         Basic human rights taken for granted in the developed world such as freedom of association, freedom of speech, freedom of assembly, freedom of movement, and so on, are not universally accepted

·         Some people argue that the presence of multinational companies actually helps bring change to countries which won’t follow human rights principles

Ø  Environmental regulations:

·         When environmental regulations in host nations are far inferior to those in the home nation, ethical issues arise

—  The tragedy of the commons occurs when a resource held in common by all, but owned by no one, is overused by individuals resulting in its degradation

Ø  Corruption:

·         In the United States, the Foreign Corrupt Practices Act outlawed the practice of paying bribes to foreign government officials in order to gain business

·         The Convention on Combating Bribery of Foreign Public Officials in International Business Transactions adopted by the Organization for Economic Cooperation and Development (OECD) obliges member states to make the bribery of foreign public officials a criminal offense

·         Some economists suggest that the practice of giving bribes might be the price that must be paid to do a greater good

·         However, other economists have argued that corruption reduces the returns on business investment and leads to slow economic growth

Ø  The moral obligation of multinational companies.

·         Social responsibility - the idea that business people should take the social consequences of economic actions into account when making business decisions, and that there should be a presumption in favor of decisions that have both good economic and good social consequences

Ethical Dilemmas

—  Managers often face situations where the appropriate course of action is not clear

—  Ethical dilemmas - situations in which none of the available alternatives seems ethically acceptable

—  They exist because real world decisions are complex, difficult to frame, and involve various consequences that are difficult to quantify 

Managerial behavior is influenced by

—  Personal ethics

—  Decision making processes

—  Organizational culture

—  Unrealistic performance expectations

—  Leadership

Ø  Personal ethics: Business ethics reflect personal ethics (the generally accepted principles of right and wrong governing the conduct of individuals). Expatriates may face pressure to violate their personal ethics because they are away from their ordinary social context and supporting culture and they are psychologically and geographically distant from the parent company

Ø  Decision making process: Business people may behave unethically because they fail to ask the relevant question—is this decision or action ethical? decisions are made based on economic logic, without consideration for ethics

Ø  Organization Culture: Unethical behavior may exist in firms with an organization culture - the values and norms that are shared among employees of an organization - that does not emphasize business ethics. Values and norms shape the culture of a firm, and that culture influences decision making

Ø  Unrealistic Performance Expectations: Pressure from the parent company to meet performance goals that are unrealistic, and can only be attained by cutting corners or acting in an unethical manner can cause unethical behavior.

Ø  Leadership: leadership also influences managerial behavior. Leaders not only have the leadership qualities but they also behave good manner and should not be rude.

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Module-3

International Trade Theories

Meaning of trade theories

Ø  The theories explain mutual benefit and cost of product/services produced in any countries and has shaped the economic policy.

Ø  So many questions like

Why nations trade?

Which goods to import & export and when?

Selection of one item and rejecting other?

Ø  Thus these theories gives an idea of knowing the benefits of a country to engage in I B

Types of theories

Ø  Theory of Mercantilism

Ø  Absolute Cost Advantage

Ø  Comparative Advantage

Ø  Heckscher-ohlin theory OR Relative factor endowments

Ø  The new product life cycle theory

Ø  The new trade theory

Ø  Porter’s diamond model

Mercantilism: mid-16th century

Ø  It is the oldest theory and foundation of economic thought

Ø  trade theory holding that nations should accumulate financial wealth, usually in the form of gold (forget things like living standards or human development) by encouraging exports and discouraging imports

Ø  A nation’s wealth depends on accumulated treasure

¡  Gold and silver are the currency  of  trade

Ø  Theory says you should have a trade surplus.

¡  Maximize export through subsidies.

¡  Minimize imports through tariffs and quotas

Ø  The flaw with mercantilism was that it viewed  as a zero sum game (a zero sum game is GAIN TO ONE COUNTRY AND LOSS TO ANOTHER COUNTRY  )

Ø  Government imposed restrictions on imports and encouraged export to prevent trade deficit.

Ø  Ex: British(power) with India and Srilanka raw materials imported and finished goods exported, export less & import more value goods

     

Theory of absolute advantage

Ø  Adam Smith challenged the mercantilist philosophy and its zero-sum approach to trade.

Ø  Adam Smith argued that a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it

Ø  Countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries

v  Assume that two countries, Ghana and South Korea, both have 200 units of resources that could either be used to produce rice or cocoa

v  In Ghana, it takes 10 units of resources to produce one ton of cocoa and 20 units of resources to produce one ton of rice 

v  Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of rice and cocoa between the two extremes

Ø  In South Korea it takes 40 units of resources to produce one ton of cocoa and 10 resources to produce one ton of rice

v  South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or some combination in between

Ø  Without trade

v  Ghana would produce 10 tons of cocoa and 5 tons of rice

v   South Korea would produce 10 tons of rice and 2.5 tons of cocoa

Ø  With specialization and trade

v  Ghana would produce 20 tons of cocoa

v  South Korea would produce 20 tons of rice

v  Ghana could trade 6 tons of cocoa to South Korea for 6 tons of rice

Ø  After trade

v  Ghana would have 14 tons of cocoa left, and 6 tons of rice

v  South Korea would have 14 tons of rice left and 6 tons of cocoa

Ø  If each country specializes in the production of the good in which it has an absolute advantage and trades for the other, both countries gain

                         

v  Trade is a positive- sum game; it produces net gain for all involved.

Theory of comparative advantage

v  David Ricardo asked what might happen when one country has an absolute advantage in the production of all goods 

v  Ricardo’s theory of comparative advantage suggests that countries should specialize in the production of those goods they produce most efficiently and buy goods that they produce less efficiently from other countries, even if this means buying goods from other countries that they could produce more efficiently itself.

Ø  Assume

v  Ghana is more efficient in the production of both cocoa and rice

v  in Ghana, it takes 10 resources to produce one ton of cocoa, and 13 1/3 resources to produce one ton of rice

v  So, Ghana could produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or some combination of the two

v  in South Korea, it takes 40 resources to produce one ton of cocoa and 20 resources to produce one ton of rice

v  so, South Korea could produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of the two

Ø  With trade

v  Ghana could export 4 tons of cocoa to South Korea in exchange for 4 tons of rice

v  Ghana will still have 11 tons of cocoa, and 4 additional tons of rice

v  South Korea still has 6 tons of rice and 4 tons of cocoa

v  if each country specializes in the production of the good in which it has a comparative advantage and trades for the other, both countries gain

v  Comparative advantage theory provides a strong rationale for encouraging free trade

The theory of comparative advantage suggests that trade is a positive – sum game in which all countries that participates realize economic gains.

Assumptions and limitations

Ø  Driven only by maximization of production and consumption

Ø  Only 2 countries engaged in production and consumption of just 2 goods?

Ø  What about the transportation costs?

Ø  Only resource – labor (that too, non-transferable)

Ø  No consideration for ‘learning theory’

Factor proportions theory

Ø  Heckscher (1919) - Olin (1933) Theory

Ø  Export goods that intensively use factor endowments which are locally abundant

     Corollary: import goods made from locally scarce factors

 Note: Factor endowments can be impacted by government policy - minimum wage

Ø  Patterns of trade are determined by differences in factor endowments - not productivity

Ø  Remember, focus on relative advantage, not absolute advantage

Ø  trade theory holding that countries produce and export those goods that require resources (factors) that are abundant (and thus cheapest) and import those goods that require resources that are in short supply

Ø  Example:

·         Australia – lot of land and a small population (relative to its size)

·         So what should it export and import?

Factor Proportions Trade Theory Considers Two Factors of Production

Ø  Labor

Ø  Capital

A country that is relatively labor abundant (capital abundant) should specialize in the production and export of that product which is relatively labor intensive (capital intensive) 

The Leontief Paradox

Ø  The Test: Could Factor Proportions Theory be used to explain the types of goods the United States imported and exported?

Ø  The Method: Input-output analysis

Ø  The Findings: The U.S. exported labor-intensive products and imported capital-intensive products.  Thus one might argue that U.S. exports commercial aircraft & imports textiles not  because its factor endowments are specially suited to aircraft manufacture & not suited to textile mfg, but it is relatively more efficient at producing aircraft than textiles,

Ø  The Controversy: Findings were the opposite of what was generally believed to be true!

Product life-cycle Theory R.Vernon (1966)

Ø  trade theory holding that a company will begin by exporting its product and later undertake foreign direct investment as the product moves through its lifecycle

Ø  As products mature, both location of sales and optimal production changes

Ø  Affects the direction and flow of imports and exports

Ø  Globalization and integration of the economy makes this theory less valid

Raymond Vernon—the production location for many products moves from one country to another depending on the stage in the product’s life cycle

Stage 1: Introduction

•         Innovation, production, and sales in same country

–        new products developed in response to nearby observed need and markets for them

–        early production occurs in domestic location

•         Location and importance of technology

–        most new technology that results in new products and production methods originates in industrial countries

•         Exports and labor

–        export small part of production

–        production process likely to be labor intensive

–        capital machinery for large-scale production develops later in industrialized countries

Stage 2: Growth

•         Increases in exports by the innovating country

•         More competition

•         Increased capital intensity

–        growing sales offer incentives to companies to develop process technology

•         Some foreign production

Stage 3: Maturity

•         Decline in exports from the innovating country

•         More product standardization

•         More capital intensity

•         Increased competitiveness of price

•         Production start-ups in emerging countries

Stage 4: Decline

•         Production increased in emerging economies

•         Innovating country becoming net importer

Verification and limitations of PLC theory

Ø  High transportation costs limit export opportunities, regardless of the life cycle stage

Ø  Shifts in production site do not change for many types of products

·         innovating country maintains its export ability throughout the life cycle

·         products with very short life cycles

·         luxury products for which cost is not a concern for the consumer

·         products used to promote differentiation strategy

·         products requiring specialized technical labor to evolve

Ø  MNEs increasingly introduce new products at home and abroad simultaneously

New Trade Theory

            This began to emerge in the 1970’s when a number of Economists pointed out that the ability of firms to attain Economies of scale might have imp implications for International trade.

Economies of scale r unit cost reductions associated with a large volume of output. Economies of scale have a number of sources, including the ability to spread fixed cost over a large volume & ability to utilize specialized. Thus world trade in certain products may b dominated by countries whose firms were first movers in production.

Trade allows a nation to specialize in production of certain products, scale economies & lowering costs of producing those products, while buying products that it does not produce from other nations.

By this mechanism, the variety of products available to consumers in each nation is increased, while average cost of those products would fall, as also price, freeing resources to produce other goods & services.

First mover’s ability to benefit from increasing returns creates a barrier to entry. In commercial aircraft industry, the fact that Boeing & Airbus are already in the industry & have the benefit of economies of scale discourages new entry.

New trade theory – applications

Ø  Typically, requires industries with high, fixed costs

·         World demand will support few competitors

Ø  Competitors may emerge because of “ First-mover advantage”

·         Economies of scale may preclude new entrants

·         Role of the government becomes significant

Ø  Some argue that it generates government intervention and strategic trade policy

Porter’s diamond

Ø  Success occurs where these attributes exist.

Ø  More/greater the attribute, the higher chance of success

Ø  The diamond is mutually reinforcing

This theory indicates four important conditions for competitive superiority

1. Factor endowments: - A nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry

Ø  Basic factor endowments: Factors present in a country

·         Natural resources

·         Climate

·         Geographic location

·         Demographics

While basic factors can provide an initial advantage they must be supported by advanced factors to maintain success

Ø  Advanced factor endowments: Are the result of investment by people, companies, government and are more likely to lead to competitive advantage.

·         Communications

·         skilled labor        

·         research

·         Technology

·         education

2. Demand conditions:

·         observation of need or demand

·         usually in home country

·         production started near the observed market

3. Related and supporting industries: Creates clusters of supporting industries that are internationally competitive. Must also meet requirements of other parts of the Diamond.

4. Firm Strategy, Structure and Rivalry:

Ø  Long term corporate vision is a determinant of success

Ø  Management ‘ideology’ and structure of the firm can either help or hurt you

Ø  Presence of domestic rivalry improves a company’s competitiveness.

Porter’s Theory-predictions

Ø  Porter’s theory should predict the pattern of international trade that we observe in the real world.

Ø  Countries should be exporting products from those industries where all four components of the diamond are favorable, while importing in those areas where the components are not favorable.

Implications for international business

Ø  Location implications: Disperse production activities to countries where they can be performed most efficiently

Ø  First-mover implications: Invest substantial financial resources in building a first-mover, or early-mover advantage

Ø  Policy implications: Promoting free trade is in the best interests of the home-country, not always in the best interests of the firm, even though, many firms promote open markets

Meaning of International trade policies

Ø  I B Policies mean the dealings of national governments relating to exports of various countries either on equal terms & condition or on discriminatory terms and condition.

Ø  It aims at protecting the domestic industry from the competition of advanced countries through imposing quotes but some build competencies by providing subsidies.

Tools or instruments of International Business Policies

1. Tariffs

2. Subsidies

3. Import quotas

4. Voluntary export restraints                         

5. Local content requirement

6. Administrative policies

7. Anti- dumping policies

1. Tariffs

Ø  It is the tax or duty imposed on imports to protect the domestic producer from the foreign competition by raising the price of imported goods and earn revenue to the Government

Ø  But consumers and industry of exporting country lose a lot

Ø  2 types of tariffs – specific & Ad valorem

2. Subsidies

Ø  In order to encourage domestic production or protect the domestic producer from the foreign competition government pays to a domestic producer by reducing operation cost such payments are called subsidiaries.

Ø  Ex:  cash grants, loans and advances, tax holidays

3. Import quotas

It is a direct restriction on the quantity of goods which are imported into a country. These restrictions are imposed by issuing import licenses to certain firms and individuals to import a certain quantity of the goods.

4. Voluntary export restraints

It is the opposite of import quotas. Exporting country imposes such restriction mostly at the request of importing country.

5. Local content requirement

Ø  It is a condition that requires some specific fraction of a product imported be produced domestically.

Ø  The requirement in physical terms and value terms

Ø  It is help the country to enhance employment opportunity, utilization of local resources and economic resources.

6. Administrative policies

It is the burecratic rules and procedures. Government, use informal and formal policies to restrict imports and boost exports.

7. Anti dumping policies

Ø  Dumping means selling products in foreign below the cost of production or “unfair” market value

Ø  Anti-dumping policies are designed to punish foreign firms that engage in dumping.

Ø  The ultimate objective is to protect domestic producers from “unfair” foreign competition.

Government intervention

Ø  Political Argument for intervention: It is concerned with protecting the interest of certain groups within nation (normally producer) often at the cost of other group (normally consumers)

Ø  Economic  argument for intervention:  Argument with typical boosting up the overall wealth of a nation (benefit to both producer and consumer)

Political argument for intervention

Ø  National security (reservation of some industries in the hands of Government)

Ø  Protecting industries (from “unfair” foreign competition )

Ø  Protecting  jobs(avoiding the reduction of jobs)

Ø  Retaliation ( government as power & deal with tough approach)

Ø  Protecting consumers (from unsafe products)

Economic argument for intervention

Ø  Infant industry argument: protection from foreign competitors, private industries cannot invest huge capital thus government provide capital and infrastructural facilities

Ø  Strategic trade policy: provides subsidies to create competitive advantage, low cost advantage

GATT – Introduction and origin

Ø  Arguments from both political and economic support unrestricted free trade

Ø  Who is to monitor the government to make sure they are playing by the trade rules?

Ø  And no cheat, a independent body as referred then, GATT – General Agreement on Tariffs and Trade which was later named as WTO in 1995

Ø   Origin on 1947 signed by 23 nations at conference in Geneva and entry into force on 1^st Jan 1948.

Objectives of GATT

Ø  Raise standard of living

Ø  Ensure full employment and large steadily           growing volume of real income and effective demand

Ø  Develop the full use of resources of the world

Ø  Expand production and international trade

The Uruguay Round

Initiated in Sept 1986 and concluded on 15^th Sept 1993 Mr. Arthur Dunkel, the Director General of GATT submitted a proposal on 20^th Dec 1991 popularly known as Dunkel Proposals which looked into areas such as:

Ø   Market

Ø   Agriculture ( Textiles)

Ø   TRIPs– TRADE RELATED INTELLECTUAL PROPERTY RIGHTs: in respects of business and commerce include: Protection of patents, Copy rights, Design, Trademarks, Trade secrets.

Ø   TRIMs – Trade related investment measures: GATT is also concerned with the removal of various controls imposed on the inflow of foreign capital. The TRIMS text provides that the foreign capital would not be discriminated by the member Government  

Ø  Trade in services

Difference between GATT & WTO

GATT

Ø  It is set of rules and multilateral agreement

Ø  It is designed with an attempt to establish international trade organization

Ø  It was applied on a provisional basis

Ø  Its rule applicable to trade in goods

Ø  Its dispute settlement system was not fast and automatic

WTO

Ø  It’s a permanent institution

Ø  It is established to serve its own purpose

Ø  Its activities are full and permanent

Ø  Its rules are for goods, service, intellectual property

Ø  Dispute settlement is fast and permanent

WTO

            In order to implement the final act of the Uruguay Round of GATT the World Trade Organizations (WTO) was established on January 1, 1995.

India is one of the founder members of the WTO. WTO is designed play the watchdog in the spheres of trade in goods, trade in services, foreign investment, and Intellectual property rights etc.

Organization structure of WTO

Functions of WTO:

The World Trade Organization is expected to play its role in the following areas:

Ø   WTO administers the 28 agreements contained in the final act and a number of plurilateral agreements and government procurement through various councils and committees.

Ø  WTO oversees the implementation of the significant tariff cut (averaging 40%) and also reduction of non-tariff measures agreed to in the trade negotiations

Ø  WTO examines regularly the trade regimes of individual member countries. Thus, it acts as a watchdog of international trade.

Ø   WTO acts as a management consultant for world trade. The economists of the WTO observe the pulse of the global economy and provide studies on the main trade issues.

Ø   Technical co-operation and training division is established in the WTO’s secretariat in order to help the developing countries in the implementation of Uruguay Round results.

Ø  Member countries can use the WTO as a forum for continuous negotiation of exchange of trade barriers in the entire world.

Ø  WTO co-operates with other international institutions like IMF, IBRD (World Bank) and ILO involved in global economic policy making.

Future of WTO:

Ø  Antidumping  Actions

Ø  Protectionism in Agriculture

Ø  Protecting  Intellectual  property

Ø   Market Access for Non Agricultural goods and service.

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Module-4

Regional Integration

Regional Integration

            Regional integration refers to agreements among countries in a geographic region to reduce & ultimately, remove tariff & non-tariff barriers to the free flow of goods, services & factors of production b/w each other. WTO members are required to notify the WTO of any regional trade agreements in which they participate.

Levels of economic integration

Ø  Free trade area- All the barriers to trade & services among member countries r removed. In an ideal FTA, no discriminatory tariffs, quotas, subsidies or administrative impediments are allowed to distort trade b/w members.

Ø  Customs Union- It is one step further than FTA. It eliminates trade barriers b/w member countries & adopts a common external trade policy. It necessitates significant administrative machinery oversee trade relations with non-members.

Ø  Common market- It has no trade barriers b/w member countries, includes a common external trade policy & allows factors of production to move freely b/w members. Labor & capital r free to move because there are no restrictions on immigration, emigration or cross border flows of capital b/w member countries.

Ø  Economic Union- It includes the free flow of product & factors of production b/w member countries & the adoption of a common external trade policy, but it also requires a common currency, harmonization of member’s tax rates & a common monetary & fiscal policy.

Ø  Political Union- In this a central political apparatus co ordinates the economic, social & foreign policy of the member states. The EU is on the road towards a partial political union. The European parliament, which is playing an ever imp role in the EU has been directly elected by citizens of EU countries since the late 1970’s. The council of ministers is composed of government ministers from each EU member. 

Case for regional integration

Ø  Economic case for integration- Integration is an attempt to achieve additional gains from the free flow of trade & investment b/w countries beyond those attainable under intl agreements such as the WTO. They can specialize in production of goods & services they can produce most efficiently.

Ø  Political case- Despite the strong economical & political arguments in support, integration has never been easy to achieve or sustain for 2 reasons- 1^st although eco integration ails the majority, it has its costs. While a nation as a whole may benefit significantly from a regional FTA, certain groups may lose. 2^nd impediment arises from concerns over national sovereignty.

Case against integration

            Although there is strong arguments in favor of regional FTA in recent years. Some economists have expressed concern that the benefits of regional integration have been oversold while the costs have often been ignored. They mention, the benefits of integration were determined by the extent of trade creation as opposed to trade diversion.

Trade creation occurs when high cost domestic products r replaced by low cost producers within the FTA. It may also occur when higher cost external producers r replaced by lower cost external producers within the FTA.

Trade diversion occurs when lower cost external suppliers r replaced by higher cost suppliers within the FTA.

A regional FT agreement will benefit the world only if the amt of trade it creates exceeds the amt it diverts.

Regional Trading Blocks

Ø  European Union (EU)

Ø  Association of South-East Asian Nations(ASEAN)

Ø  Asia-Pacific Economic Co-operation  (APEC)

Ø  North America Free Trade Area (NAFTA)

Ø  south-Asian Association for Regional Co-operation (SAARC)

Ø  Sub regional organization and institution comprising the Andean integration system (ANDEAN PACT)

Ø  Treaty of Asuncion (MERCOSUR)

European Union

            The origin of the EU goes back to the European Coal & Steel community which was formed with the than West Germany, France, Italy, Belgium, Netherlands & Luxembourg in 1952. This treaty gave rise to European Economic Community. It came into being on 1^st Jan 1958.

Objectives- Elimination of customs duties, quantitative restrictions with regard to exports & imports of goods among member countries, formulation of a common custom tariff & commercial policy with regard to non member countries, formulation of common policy in area of agreement, transport, fisheries etc.

Organization of EU

European council is the main administrative body of the EU. European commission, Court of justice, Council of EU, European parliament.

European commission- It is responsible for proposing EU legislation, implementing it & monitoring compliance with EU laws by member states. Headquarters in Brussels, Belgium, it has more than 24000 employees. There are 25 commissioners, one from each member state. President is chosen by member states & he then chooses other members.

Council of EU- It represents the integration of member states. It is clearly the ultimate controlling authority within the EU since the draft legislation from the commission can become EU law only if the council agrees. It is composed of 1 representative from the government of each member state.

European parliament- It now has 732 members directly elected by the population of the member states. It is a consultative rather than legislative body. It debates legislation proposed by the commission & forwarded to it by the council. It can propose amendments to that legislation.

Court of justice- It is comprised of 1 judge from each country is the supreme appeal court for EU law. Like commissioners the judge’s r required to act as independent officials rather than as representatives of national interest.

ANDEAN community

            Bolivia, Chile, Ecuador, Colombia & Peru signed an agreement in 1969 to create the Andean pact. It was largely based on EU model, but was less successful at achieving its stated goals.

The integration steps began in 1969 included an internal tariff reduction program, a common external tariff, transportation policy, common industrial policy & special concession for smaller members, Bolivia & Ecuador. By mid 80’s it had collapsed & had failed to achieve any of its stated obj.

In 1990, the heads of 5 members met in Galapagos Islands & effectively re-launched Andean pact which was renamed Andean community in 1997. The declaration objective included establishment of a FTA by 1992, Customs Union by 1994, common market by 1995. This last milestone has not been reached.

MERCOSUR

            It was originated in 1988 as a free trade pact b/w Brazil & Argentina. The modest reduction in tariffs & quotas accompanying this pact reportedly helped bring about an 80% increase in trade b/w 2 countries. This success encouraged expansion of pact in March 1990 to include Paraguay & Uruguay. The 4 countries of this have a combined population of 200 million.

In Dec 1995, the members agreed to a 5 yr program under which they hoped to perfect their FTA & move toward a full customs union which is not yet achieved.

For 1^st 8 yrs, it seemed to b making a positive contribution to the eco growth rates of its member states. The combined GDP of the 4 member states grew at an annual average rate of 3.5% b/w 1990 & 96.

ASEAN (Association of Southeast Asian Nations)

            Formed in 1967 it includes Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand & Vietnam. It has created a regional grouping of 500 million people with a combined GDP of some $740 billion.

Objective - To foster freer trade between member countries and to achieve cooperation in their industrial policies. Until recently only 5% of Intra ASEAN trade consisted of goods whose tariff had been reduced through an ASEAN preferential trade agreement.

In 2003, ASEAN FTA b/w members came into effect. It has cut tariffs on manufacturing & agricultural products to less than 5%.

APEC (Asia-Pacific Economic Cooperation)

            It was founded in 1990 at the suggestion of Australia. It currently has 21 member states including such power houses has U.S, Japan & China. Collectively the member states account for about 60% of the worlds GDP, 47%of world’s trade & much of growth in the world economy.

The aim of this is to increase multilateral cooperation in view of the Eco rise of the Pacific nations & the growing interdependence within the region.  

APEC commits itself to the formation of a FTA; it would transform this from a geographical expression into world’s largest FTA.

The heads of state met again. They have formally committed APEC’s industrialized members to remove their trade & investment barriers by 2010 & for developing economies to do by 2020.

SAARC (South Asian Association for Regional Cooperation)

            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: almost 1.5 billion people, the combined population of its member states. It was established on December 8, 1985 by Bangladesh, Bhutan, Maldives, Nepal, Pakistan, India and Sri Lanka. In April 2007, at the Association's 14th summit, Afghanistan became its eighth member

The objectives of the Association as defined in the Charter are:

Ø  To promote the welfare of the people of South Asia and to improve their quality of life.

Ø  To accelerate economic growth, social progress and cultural development in the region and to provide all individuals the opportunity to live in dignity and to realize their full potential.

Ø  To promote and strengthen collective self-reliance among the countries of South Asia.

Ø  To contribute to mutual trust, understanding and appreciation of one another's problems.

Ø  To promote active collaboration and mutual assistance in the economic, social, cultural, technical and scientific fields.

Ø  to strengthen cooperation with other developing countries;

Ø  to strengthen cooperation among themselves in international forums on matters of common interest; and

Ø  To cooperate with international and regional organizations with similar aims and purposes.

The Declaration on South Asian Regional Cooperation was adopted by the Foreign Ministers in 1983 in New Delhi. During the meeting, the Ministers also launched the Integrated Programme of Action (IPA) in nine agreed areas, namely, Agriculture; Rural Development; Telecommunications; Meteorology; Health and Population Activities; Transport; Postal Services; Science and Technology; and Sports, Arts and Culture. The South Asian Association for Regional Cooperation (SAARC) was established when its Charter was formally adopted on 8 December 1985 by the Heads of State or Government of Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan and Sri Lanka.

SAARC has intentionally laid more stress on "core issues" mentioned above rather than more decisive political issues like the Kashmir dispute and the Sri Lankan civil war. However, political dialogue is often conducted on the margins of SAARC meetings. SAARC has also refrained itself from interfering in the internal matters of its member states. During the 12th and 13th SAARC summits, extreme emphasis was laid upon greater cooperation between the SAARC members to fight terrorism.

NAFTA (North American Free Trade Agreement)

It went into effect in January 1; 1994.It is signed by three countries:

Ø  Mexico

Ø  United States

Ø  Canada

NAFTA Provisions

NAFTA called for immediately eliminating duties on half of all U.S. goods shipped to Mexico and gradually phasing out other tariffs over a period of about 14 years. Restrictions were to be removed from many categories, including motor vehicles and automotive parts, computers, textiles, and agriculture. The treaty also protected intellectual property rights (patents, copyrights, and trademarks) and outlined the removal of restrictions on investment among the three countries. Provisions regarding worker and environmental protection were added later as a result of supplemental agreements signed in 1993.

“Transnational Corporations” have tended to support NAFTA in the belief that lower tariffs would increase their profits.

Labor unions in Canada and the United States have opposed NAFTA for fear that jobs would move out of the country due to lower wage costs in Mexico.

Multinational corporations

Strategy and the Firm

Ø  A firm’s strategy can be defined as the actions that managers take to attain the goals of the firm.

Ø  For most firms prominent goal is to maximize the value of the firm for its owners, its shareholders.

Ø  To maximize the value of a firm, managers must pursue strategies that increase profitability of the enterprise and its rate of profit growth overtime.  

Ø  Profitability is measured in number of ways, but it is the rate of return that the firm makes on its invested capital – ROIC [calculated by dividing net profits of the firm by total invested capital]

Ø  Profit growth is measured by percentage increase in net profits over time.

Ø  Higher profitability and higher rate of profit growth increase value of a firm.

Determinants of Enterprise Value

Ø  Firms need to identify and take action that lowers the cost of value creation and/or differentiates the firm’s product through superior design, quality, service, or functionality

Ø  Firms create value by either lowering the costs of production or raising the value so that consumers will pay more.

Ø  A firm can add more value to a product when it improves the product’s quality provides a service to the consumer or customize the product to consumer needs in such a way that the consumers will pay more for it.

Ø  There are two basic strategies for improving a firm’s profitability

Ø  a differentiation strategy and

Ø  A low cost strategy.

The Firm as a Value Chain

Ø  Firm is value chain composed of a series of distinct value creation activities, including production, marketing, materials management, R&D, human resources information systems and the firms;’ infrastructure

Ø  These value creation activities are classified into primary activities and support activities

Ø  Primary activities:

      These have to do with creating the product, marketing and delivering the product to buyers and providing support and after sales service to the buyers of the product.

      Efficient production can reduce the costs of creating value (by realizing scale economies) and can add value by increasing product quality (by reducing the number of defective products)

Ø  Support activities:

      These provide the inputs that allow the primary activities of production and marketing to occur.

      The material management function controls the transmission of physical materials through the value chain from procurement through production into distribution. It also can monitor the quality of inputs into the production process.

      The R&D function develops new products and process technologies, which can reduce production costs and can result in the creation of more useful and more attractive products than can demand a premium price.

      An effective human resources function ensures that the firm has an optimal mix of people to perform the primary function efficiently.

      Information systems helps in getting the information it needs to maximize the efficiency of its value chain and to exploit information based competitive advantages.

      Firm’s infrastructure with factors such as organizational structure, general management, planning, finance and legal environment also help the firm achieve more value in the primary activities.

Profiting from Global Expansion

Firms that operate internationally have the ability to

(1)   Earn a greater return from their distinctive skills or core competencies,

(2)   Realize location economies by dispersing individual value creation activities to those locations where they can be performed most efficiently, and

(3)   Realize greater experience curve economies, thereby lowering the costs of value creation

1. Core Competencies/ distinctive skills

Ø  Refers to the skills within the firm that competitors cannot easily match or imitate

Ø  These skills may exist in any of the value creation activities of the firm like Production, marketing, R&D, human resources, general management etc

Ø  EX: Mc Donald has a core competency in managing fast food operations,

      Animatronics and Show Design

      Storytelling, Story Creation and Themed Atmospheric Attractions

      Efficient operation of theme parks

2. Location Economies

Ø  Means economies that arise from performing a value creation activity in the optimal location for that activity, wherever in the world that might be

Ø  Due to national differences, a firm places each of its value creation activity at that location where economic, political, and cultural conditions, including relative factor costs, are most conducive to the performance of that activity (transportation costs and trade barriers permitting)

Ø  EX: General Motors’s Pontiac is marketed widely in United States, the car was designed in Germany, key components were manufactured in Japan, Taiwan, Singapore, the assembly operations was performed in South Korea, and the advertising strategy was formulated in Great Britain

3.      Experience Curve economies

Ø  Experience curve is the systematic reductions in the production costs that occur over life of a product.

Ø  Generally the production of any good or service shows the experience curve effect. Each time cumulative volume doubles, value added costs (including administration, marketing, distribution, and manufacturing) fall by a constant percentage.

Ø  This relationship was 1^st observed in aircraft industry where each time cumulative output of airframes was doubled, unit costs typically declined to 80% of their previous level.

      Production cost for 4^th airframe would be 80% of production cost for 2^nd airframe

      8^th airframe’s production cost’s 80% of the 4^th,

      The 16^th’s 80% of the 8^th’s and so on...

Experience curve normally allows costs to be reduced with additional output.

2 Reasons; Learning Effects and Economies of Scale

Learning Effects

Ø  Refer to cost savings that come from learning by doing.

Ø  For example: labour learns by repetition how to carry out a task most efficiently. Production costs decline due to increasing labour productivity and management efficiency, which increases the firm’s profitability

Ø  Learning effects tend to be more effective when a technologically complex task is repeated

Economies of Scale

Ø  Refer to the reductions in unit cost achieved by producing a large volume of a product.

Ø  The main reason is firm can spread its fixed costs over large volume. [Fixed costs are costs required to set up a production facility, develop a new product etc]

Ø  By building sales volume more rapidly, international expansion can assist a firm in the process of moving down the experience curve.

Ø  By lowering the costs of value creation, experience economies can help a firm to build barriers to new competition.

Four Basic Strategies

1. Global Standardization Strategy

Ø  Firms pursuing a global standardization strategy focus on increasing profitability and profit growth by reaping the cost reductions that come from economies of scale, experience curve and location economies.

Ø  Their strategic goal is to pursue a low cost strategy on a global scale.

Ø  The production, marketing and R&D activities of firms pursuing global standardization strategy are concentrated in a few favorable locations.

Ø  They try not to customize their product offerings and market strategy to local conditions.

Ø  However, they may suffer from a lack of local responsiveness.

Ø  This strategy makes sense where there are strong pressures for cost reductions and where demands for local responsiveness are minimal.

Ø   Intel, Texas Instruments, Motorola etc follow global strategy

2. Localization/ Multi Domestic Strategy

Ø  Focuses on increasing profitability by customizing the firm’s goods & services so that they provide a good match to tastes and preferences in different national markets

Ø  By customizing the product to local demands, firm increases value of the product in the local market [EX: MTV]

Ø  They tend to transfer skills and products developed at home to foreign markets.

Ø  They have the tendency to establish a complete set of each major value creation activities including productions, marketing and R&D in each major national markets in which they do business.

Ø  Most of the multi domestic firms have a high cost structure

Ø  This strategy makes sense when there are high pressures for local responsiveness and low pressures for cost reductions.

Ø  The high cost is due to the duplications of production facilities

3. Transnational Strategy

Ø  Firms try to simultaneously achieve low costs through location economies, economies of scale and learning effects; differentiate their products across geographic markets to account for local differences; and foster multidirectional flow of skills between different subsidiaries. 

Ø  The strategy is not so easy to implement as differentiating product to respond to local demands in different geographic markets raises cost, which runs counter to the goal of reducing costs [Companies like Ford, ABB have tried it and failed]

Ø  This strategy makes sense when a firm has high pressures for cost reductions and high pressures for local responsiveness. E.g.; Caterpillar, Unilever etc.

4. International Strategy

Ø  Taking products first produced for their domestic market and selling them internationally with only minimal local customization

Ø  They tend to centralize product development functions at home (R&D). They also tend to establish manufacturing and marketing functions in each major country in which they do the business

Ø  They sell a product that serves universal needs, but they don’t face significant competitors, thus they won’t confront pressures for cost reduction

Ø  They may undertake some local customization of product and marketing strategy

Ø  Head offices retain a fairly tight control over marketing and product strategy

Ø  EX: P&G and Microsoft

Organization, Design & Structures

Ø  Organizational Architecture refers to the totality of a firm’s organization, including formal organizational structure, control systems and incentives, organizational culture, processes and people

Ø  Organization Structure includes;

1.      Formal division of the organization into subunits such as product divisions, national operations, and functions –organization charts

2.      Location of decision making responsibilities within that structure- centralized or decentralized

3.      Establishment of integrating mechanisms to coordinate the activities of subunits including cross functional teams

Organizational Architecture

1. Control Systems: are the metrics used to measure the performance of sub units and make judgments about how will the mangers are running the sub units.

EX: Unilever measured the performance of its subsidiary companies according to profitability. Profitability was the Metric

2. Incentives: are the devices used to reward the appropriate managerial behavior. Incentives are very closely tied to performance metric EX: Bonus for exceeding performance targets

3. Processes: are manners in which decisions are made and work is performed within the organization. EX: processes for formulating strategy, for deciding how to allocate the resources within the firm, or for evaluating the performance of managers and giving feedback

4. Organizational Culture: the norms and value systems that are shared among the employees of an organization. Organization culture can have profound impact on how a firm performs.

5. People: not just the employees of the organization, but also the strategy used to recruit, compensate and retain those individuals and the types of people that they are in terms of their skills values and orientation

6. Organization Structure

It has 3 dimensions:

1. Vertical differentiation
2. Horizontal differentiation
3. Integrating mechanisms

1. Vertical Differentiation

Ø  Concerned with identifying where in a hierarchy decision making power should be concentrated.

Ø  Related to centralization and decentralization of decision-making responsibilities

4 main arguments for centralization

      Facilitating coordination,

      Ensuring consistency between decisions and organizational objectives,

      Providing top managers the means to push through major changes, and

      Avoiding duplication of activities

Arguments for decentralization

      Overburdened and hence poor decision-making at the top of the organization,

      Increased motivation at lower levels,

      Greater flexibility,

      Better decisions on the spot by the people directly involved, and

      Increased accountability and control

Strategy & Centralization in an International Business

      It makes sense to centralize some decisions or to decentralize other decisions, depending on the type of decision and the firm’s strategy

      Decisions regarding overall firm strategy, major financial expenditures, financial objectives & legal issues are typically centralized at firm’s head quarters.

      Operating decisions such as those relating to production, marketing, R&D, human resources management, may or may not be centralized depending on the firm’s strategy

      Global standardization strategy: firm must decide how to disperse its production activities around the globe so that location & experience economies can be realized

      This creates pressure for centralizing some operating decisions

2. Horizontal Differentiation: The Design of structure

Ø  Concerned with how the firm decides to divide itself into subunits

Ø  Decision normally made on the basis of function, type of business, or geographical area.

Ø  Structure of domestic firms: most firms begin with no formal structure and run by a single entrepreneur or a small team of individuals

Ø  As they grow demands of management become too great for one individual or a small team to handle.

Ø  At this stage organization is split into functions reflecting firm’s value creation activities [production, marketing, R&D, sales]

Ø  These functions are typically coordinated and controlled by top management

Ø  Decision making in this functional structure tends to be centralized

Functional Structure

Ø  Most firms begin with no formal structure and are run by single entrepreneur or a small team of individual.

Ø  As they grow, the demands of management become to great for one individual or a small team to handle. At this point the organization is split into functions.

Ø  These functions are typically coordinated and controlled by top management. Decision making in this structure tends to be centralized.

Product Structure

Ø  Further horizontal differentiation may be required if the firm significantly diversifies its product offering, which takes the firm into different business areas.

Ø  To solve the problems of coordination and control, most firms switch to a product divisional structure

Ø  Each division is responsible for a distinct product line EX: Dutch multinational company Philips

The International Division structure

Ø  When firms initially expand abroad, they often group all their international activities into an international division

Ø  This has tended to be the case for firms organized on the basis of functions and for firms organized on the basis of product divisions

Ø  Regardless of the firm’s domestic structure, its international division tends to be organized on geography

Ø  Many firms expanded internationally by exporting product manufactured at home to foreign subsidiaries to sell and in time they might add production facilities in each country they operate

Ø  Conflict and coordination problems may arise

Ø  EX: Wal-Mart

World Wide Area Structure

Ø  Tends to be favored by firms with a low degree of diversification and a domestic structure based on functions

Ø  World is divided into geographic areas

Ø  An area may be a country or group of countries

Ø  Each area tends to be self contained, largely autonomous entity with its own set of value creation activities

Ø  Operations authority & strategic decisions relating to each of these activities are typically decentralized to each area with headquarters retaining authority for the overall strategic direction of the firm and financial control

Ø  Structure facilitates local responsiveness as decision making responsibilities are decentralized, each area can customize product offerings, marketing strategy to local conditions

Worldwide Product Divisional Structure

Ø  Tends to be adopted by firms that are reasonably diversified

Ø  Originally had domestic structures based on product divisions.

Ø  Each division is a self contained, largely autonomous entity with full responsibility for its own value creation activities

Ø  Headquarters retains responsibility for the overall strategic development and financial control of the firm.

Global Matrix Structure

Ø  The previous structures fail to achieve a balance between the need to be both locally responsive and to achieve location and experience curve economies

Ø  So, many multinationals adopt matrix type structures.

Ø  The Global Matrix Structure contains simultaneous, intersecting differentiation bases, with employees reporting to a functional and a product manager simultaneously

Ø  However, global matrix structures have typically failed to work well, primarily due to bureaucratic problems

3. Subsidiary & Headquarter Relationship: Integrating Mechanisms

Ø  Need for coordination between subunits varies with the strategy of the firm

Ø  Need for coordination follows the following order on an ascending basis

1.      Localization

2.      International

3.      Global

4.      Transnational

Impediments to Coordination

Ø  Differing goals and lack of respect

Ø  Different orientations due to different tasks

Ø  Differences in nationality, time zone, and distance

Ø  Particularly problematic in multinational enterprises with their many sub-units both home and abroad

Formal Integrating Mechanisms

Ø  Direct contact between sub-unit managers

Ø  Liaison roles: an individual assigned responsibility to coordinate with another sub-unit on a regular basis

Ø  Temporary or permanent teams from sub-units to achieve coordination

Ø  Matrix structure: all roles viewed as integrating roles

      Often based on geographical areas and worldwide product divisions

Informal Integrating Mechanisms

Ø  Informal management networks supported by an organization culture that values teamwork and a common culture

Ø  Non-bureaucratic flow of information

Ø  It must embrace as many managers as possible

Ø  Two techniques used to establish networks

      Information systems

      Management development policies

–     Rotating managers through various sub-units on a regular basis

Managers A, B and C all know each other personally, as do managers D, E, and F. Although manager B does not know manager F personally, they are linked through common acquaintances (managers C and D). Thus, we can say that managers A through F are all part of the network, and also that manager G is not

Types of control systems

Ø  Personal controls: it is control by personal contact with subordinates. This type of control tends to be most widely used in small firms, where it is seen in the direct supervision of subordinate’s action.

Ø  Bureaucratic controls: it is through a system of rules & procedures that directs the actions of subunits. The most important Bureaucratic controls in subunits within multinational firms are budgets and capital spending rules.

Ø  Output controls: it involve setting goals for subunits to achieve and expressing those goals in terms of relatively objective performance metrics such as profitability, productivity, growth, market share and quality.

Ø  Cultural controls: it is by adopting the company values, norms employees can control their own behavior.

Incentive systems

Refer to devices used to reward appropriate behavior. Closely tied to performance metrics used for output controls

Factors That Influence Incentive Systems

Ø  Seniority and nature of work

      Reward linked to output target that the employee can influence

Ø  Cooperation between managers in sub-units

      Link incentives to profit of the entire firm

Ø  National differences in institutions and culture

Ø  Consequences of an incentive system should be understood

Organization Culture

Ø  Values and norms shared among people

Ø  Sources

      Founders and important leaders

      National social culture

      History of the enterprise

      Decisions that result in high performance

Ø  Cultural maintenance

      Hiring and promotional practices

      Reward strategies

      Socialization processes

      Communication strategy

Culture and Performance

Ø  A “Strong” Culture

      Not always good

      Sometimes beneficial, sometimes not

      Context is important

Ø  Adaptive cultures

      Culture must match an organization’s architecture

      Culture does not necessarily translate across borders

Organizational Change

Ø  Firms need to periodically alter their architecture to conform to changes in environment and strategy

Ø  Hard to achieve due to organizational inertia

Ø  Sources of inertia

      Possible redistribution of power and influence among managers

      Strong existing culture

      Senior manager’s preconceptions about the appropriate business model

      Institutional constraints such as national regulations including local content rules regarding layoffs

Ø  Change to match competitive and strategy environment

      Hard to change

–     Existing distribution of power and influence

–     Current culture

–     Manager’s preconceptions about the appropriate business model or paradigm

–     Institutional constraints

Ø  Principles for change

      Unfreeze the organization

      Moving to the new state

      Refreezing the organization

***********

Module 5

Foreign Exchange Market

Foreign Exchange Market

Ø  The foreign exchange market is a market for converting the currency of one country into that of another country.

Ø    Without the foreign exchange market, international trade and international investment on the scale that we see today would be impossible.

Ø  The foreign exchange market is the lubricant that enables companies based in countries that use different currencies to trade with each other.

Ø  Consists mainly of large commercial banks in world financial centers (concentrated in London, New York, Tokyo, Singapore)

Ø  Other players – retail customers, brokers, central banks

Nature of Foreign Exchange Market

Ø  The foreign exchange market is not located in any one place. It is a global network of banks, brokers and foreign exchange dealers connected by electronic communications systems.

Ø  When the companies wish to convert currencies, they typically go through their own banks rather than entering the market directly.

Ø  The most important trading centers are London, New York, Tokyo and Singapore.

Ø  The major secondary trading centers include Paris, Hong Kong, San Francisco and Sydney.

Ø  London’s dominance in the foreign exchange market is due to both history and geography.

Two features of the foreign exchange market are of particular note.

v  The first is that the market never sleeps. Tokyo, London, and New York are all shut for only 3 hours out of every 24.

v  The second feature of the market is the integration of the various trading centers around the globe effectively created a single market.

Objectives of Foreign Exchange Market

This includes three main objectives, they are

Ø  The first is to explain how the foreign exchange market works.

Ø  The second is to examine the forces that determine exchange rates, and to discuss the degree to which it is possible to predict future exchange rate movements.

Ø  The third objective is to map the implications for international business of exchange rate movements and the foreign exchange market.

Participants

Ø  Individuals: tourists, migrants

Ø  Firms: importers and exporters

Ø  Banks: short position, long position, square position

Ø  Governments/ monetary authorities: market intervention

Ø  International agencies: lending

Ø  Two tier market:

–     First tier: ultimate customer and banker

–     Second tier: between banks

Functions of Foreign Exchange Market

The foreign exchange market serves two main functions.

Ø  The first is to convert the currency of one country into the currency of another.

Ø  The second is to provide some insurance against foreign exchange risk.

1.      Currency conversion:

      Each country has a currency in which the prices of goods and services are quoted.

      The exchange rate is the rate at which the market converts one currency into another. Ex: An exchange rate of $1=Y120, specifies that one US dollar has the equivalent value of 120 Japanese Yen.

      Tourists are minor participants in the foreign exchange market

2.      Insuring against foreign exchange risk:

      The second function of the foreign exchange market is to provide insurance to protect against the possible adverse consequences of unpredictable changes in exchange rate.

      To explain how the market performs this function, we must first distinguish among spot exchange rates, forward exchange rates, and currency swaps.

Types of markets

1.      Spot exchange rate: When two parties agree to exchange currency and execute the deal immediately. Exchange rates governing such “on the spot” trade are referred to as spot exchange rates. Spot exchange rates are reported daily in the financial pages of news paper. Spot exchange rate change continually, often on a day-by-day basis.

2.      Forward exchange rate: A forward exchange occurs when two parties agree to exchange currency and execute and the deal at some specific data in the future. Exchange rates governing such future transactions are referred to as forward exchange rates. For most major currencies, forward exchange rates are quoted for 30 days, 90 days, and 180 days into the future. 

3.      Currency swaps: A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Swaps are transacted between international businesses and their banks, between banks and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange risk. A common kind of swap is spot against forward. Ex: Apple computer.  

Spot Market vs. Forward Market

      Spot market involves purchase and sale of currencies for current delivery (actually takes about two days to clear)

      Forward market involves purchase and sale of currencies for future delivery (one-month, three-month, six month contracts)

      provides means of hedging against risk

Uses of Foreign Exchange Market

International businesses have four main uses of FEM.

Ø  First, the payments a company receives for its export, the income it receives from the foreign investments, or the income it receives from licensing agreement with foreign firms may be in foreign currencies.

Ø  Second, international businesses use foreign exchange markets when they must pay a foreign company for its product or services in its countries currency. Ex: Dell computers.

Ø  Third, international businesses use foreign exchange markets when they have spare cash that they wish to invest for short terms in money markets.

Ø  Finally, currency speculation is another use of foreign exchange markets. Currency speculation typically involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates.

Trading Mechanism

Ø  Foreign Exchange Market is an organizational selling within which various parties to trading, buy and sell foreign exchange

Ø  Most of the transactions in the market involve the transfer in bank deposits and a small portion of the transactions involve transfer of currency

Ø  Most of the countries’ currencies traded in the market

Ø  However, some currencies, which are vulnerable to political instabilities, economic uncertainties and inactive economic operations are not normally traded in the market

Ø  Foreign exchange markets mostly don’t have organizational structure, centralized meeting place and formal requirements to participate

Ø  Banks normally engage in 3 types of foreign exchange transactions: spot, forward and swap.

Economic Theories of Exchange Rate Determination

Ø  Transactions in the foreign exchange market [buying and selling foreign currency] take place at a rate which is called ‘exchange rate’.

Ø  Exchange rate is the price paid in the home currency for a unit of foreign currency

Ø  At the most basic level exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another.

Ø  Most of the economic theories of exchange rate movements seem to agree that 3 factors have an important impact on future exchange rate movements in a country’s currency

      country’s price inflation

      Its interest rate

      Market psychology

1. Country’ inflation rates: Prices and Exchange rates: contextual backdrop

Ø  The law of one price: Identical products sold in different countries must sell for one price if their price is expressed in one currency

Assumptions:

      Competitive markets

      No transportation costs; no trade barriers

Ø  Purchasing power parity [PPP]: theory states that given relatively efficient markets, the price of a ‘basket of goods’ should be roughly equivalent in each country.

      If the law of one price holds for all goods / services, the PPP exchange rate is found by comparing prices of identical products in different countries

v  An efficient market is one which has no or less barriers to free flow of goods and services

v  The Economist- Big Mac Index, Big Mac PPP is the exchange rate that would have hamburgers costing the same in each country.

2. Interest rates and Exchange Rates

Ø  In countries where inflation is expected to be high, interest rates also will be high, as investors want compensation for the decline in the value of their money.

Ø  Economist named Irvin Fisher observed this phenomena and this effect is known as Fisher Effect.

Ø  Fisher effect states that a country’s nominal interest rate [i] is the sum of required real rate of interest [r] and the expected rate of inflation over the period for which the funds are to be lent [I].

      Fisher Effect:  i = r + I

      i: “nominal” interest rate in a country

      r: “real” interest rate

      I: inflation over the period the funds are to be lent

3. Investor Psychology and Bandwagon Effect

Ø  Various psychological factors play an important role in determining exchange rates

Ø  Ex: in September 1992, famous international financier George Soros made a huge bet against the British pound.

Ø  Soros borrowed billions of pounds, using assets of his investment funds as collateral[security] and immediately sold these pounds for German deutschmarks

Ø  This technique is known as short selling, which earns speculator huge earnings

Ø  By selling pounds and buying deutschmarks, Soros helped to start pushing down the value of pound in foreign exchange market

Ø  Value of the currency declines not because of any shift in macroeconomic fundamentals, but because of investor’s psychology.

Balance of Trade

Ø  Deals with export and import of visible items only

Ø  It does not take into account the exchange of invisible items like services of banking sector, transport sector etc

Ø  It is the difference between the monetary value of exports and imports of output in an economy over a certain period.

Ø  A positive balance is known as a trade surplus if it consists of exporting more than is imported;

Ø  A negative balance is referred to as a trade deficit or, informally, a trade gap

Ø  The trade balance is identical to the difference between a country's output and its domestic demand

Ø  Means the difference between what goods a country produces and how many goods it buys from abroad

Ø  Measuring the balance of trade can be problematic because of problems with recording and collecting data.

Factors affecting balance of trade include:

Ø  The cost of production in the economy

Ø  The cost of availability of raw materials and other inputs

Ø  Exchange rate movements

Ø  Restrictions on trade- taxes, non tariff barriers [like safety, environmental, health standards]

Ø  The availability of adequate foreign exchange with which to pay for imports

Stability of Exchange Rate

Ø  Countries, especially developing ones, pursue stable exchange rates to attract foreign capital.

Ø  They usually accomplish this by fixing their currencies to that of a more stable country, a practice called pegging.

Ø  A country's central bank may increase or decrease the money supply to maintain this rate.

Ø  If a country maintains its currency value [i.e., if its not facing high inflation rate] then it can stabilize exchange rate.

Ø  Many countries have their currencies pegged to the U.S. dollar, but some such as China and Kuwait have dropped the connection in recent years as the dollar has lost strength.

Currency Convertibility

Ø  Due to government restrictions, a significant number of currencies are not freely convertible into other currencies.

Ø  A country’s currency is said to be freely convertible when the country’s government allows both residents and non residents to purchase unlimited amounts of a foreign currency with it.

Ø  A currency is said to be externally convertible when only nonresidents may convert it into a foreign currency without any limitations

Ø  A currency is nonconvertible when neither residents nor nonresidents are allowed to convert it into a foreign currency.

Ø  Free convertibility is not universal. Many countries place some restrictions on their resident’s ability to convert the domestic currency into a foreign currency.

Ø  Restrictions range from the relatively minor to the major

Ø  Minor restrictions - restricting the amount of foreign currency they may take with them out of the country on trips

Ø  Major restrictions - restricting domestic business’s ability to take foreign currency out of the country

Indian Rupee Convertibility

Ø  Convertibility essentially means the ability of residents and non-residents to exchange domestic currency for foreign currency, without limit, whatever be the purpose of the transactions

Ø  Currency convertibility policy of a government has two aspects:

(a)    Current account convertibility and

(b)   Capital account convertibility.

Current account

It refers to currency convertibility required in the case of transactions relating to exchange of goods and services, money transfers and all those transactions that are classified in the current account. In Short, Current account includes all transactions, which give rise to or use of our National income

Indian Rupee Convertibility on Current Account:

      India is fully convertible on the current account

      A full convertibility means movement of funds in & out of India without any restrictions & permissions.

      Provides full freedom to both residents and non-residents to trade in goods/services.

      RBI has placed a cap in creation of a capital asset

      In India, most current account transactions have been freed from controls over the years.

Capital Account Convertibility

      Capital Account consist of short term and long term capital transactions

      As per FEMA "capital account transaction" means a transaction which alters the assets or liabilities, including contingent liabilities, outside India of persons resident in India or assets or liabilities in India of persons resident outside India

      Capital Account Transactions: are classified as :-

1.      Portfolio investment involves trade in securities like stocks, bonds, bank loans, derivatives, etc.

2.      Direct investment involves purchase of real estate, production facilities, or equity investment.

3.      Other investment involves holdings in loans, bank accounts and currencies

International monetary system

Ø  The international monetary system refers to the institutional arrangements that govern exchange rates

Ø  A floating exchange rate system exists in countries where the foreign exchange market determines the relative value of a currency

Ø  The world’s four major trading currencies: the US Dollar, the European Union’s Euro, the Japanese Yen, and the British Pound- are all free to float against each other.

Ø  Thus their exchange rates are determined by market forces and fluctuate against each other day to day.

The Gold Standard

Ø  The gold standard has its origin in the use of gold coins as medium of exchange, unit of account and store of value-a practice that dates back to ancient times

Ø  When international trade was limited in volume, payments of goods purchased from another country was typically made in gold and silver

Ø  However as the volume of international trade expanded after the industrial revolution, a more convenient means of financing international trade was needed.

Ø  Shipping large quantities of gold and silver around the world was impractical

Ø  The gold standard refers to the practice of pegging currencies to gold and guaranteeing convertibility

Ø  Countries pegged their currency to gold by agreeing to exchange a particular quantity of money for an ounce or grain of gold.

The end of Gold Standard

Ø  The gold standard worked fairly well from the 1870s until the start of World War I

Ø  After the war, in an effort to encourage exports and domestic employment, countries started regularly devaluing their currencies

Ø  Confidence in the system fell, and people began to demand gold for their currency putting pressure on countries' gold reserves, and forcing them to suspend gold convertibility

Ø  The Gold Standard ended in 1939

The Role of IMF

1. Discipline:

Ø  Need to maintain a fixed exchange rate puts a brake on competitive devaluations and brings stability to the world trade environment

Ø  A fixed exchange rate regime imposes monetary discipline on countries thereby curtailing price inflation

2. Flexibility:

Ø  The policy was recognized as a rigid policy of fixed exchange rates and too inflexible

Ø  Sometimes, a country’s attempts to reduce its money supply growth and correct a persistent balance-of-payments deficit could force the country into recession and create high unemployment

—  The architects of Bretton Woods’s agreement wanted to avoid high unemployment so they built limited flexibility into the system.

—  2 major features of the IMF Articles of Agreement fostered this flexibility

Ø  IMF lending facilities

Ø  Adjustable parties

1.  IMF Lending Facilities

Ø  IMF lend foreign currencies to members to tide them over during short periods of balance-of-payments deficits, when a rapid  tightening of monetary or fiscal policy would hurt domestic employment

Ø  A pool of gold and currencies  contributed by IMF members provided the resources for these lending operations

Ø  Heavy borrowers from the IMF must agree to monetary and fiscal conditions set down by the IMF, which typically included IMF mandated targets on domestic money supply growth, exchange rate policy, tax policy, government spending and so on

2. Adjustable Parties

Ø  The system of adjustable parties allowed for the devaluation of a country’s currency by more than 10% if the IMF agreed that a country’s balance of payments was in ‘fundamental disequilibrium’

Ø  Fundamental disequilibrium happens when a country suffers permanent adverse shifts in the demand for their products

Ø  Without devaluation such a country would experience high unemployment and trade deficit until the domestic price level falls far enough to restore a balance-of-payments equilibrium. [this time devaluation works as a competitive weapon]

The Role of World Bank

Ø  The official name for the World Bank is the International Bank for Reconstruction and Development [IBRD]

Ø  When the Bretton Woods participants established the World Bank, the need to reconstruct the war-torn economies of Europe was foremost in their minds

Ø  Bank’s initial mission was to help finance the building of Europe’s economy by providing low-interest rates

Ø  But under Marshall Plan, US lent money directly to European nations to help them rebuild. This overshadowed World Bank

Ø  So the Bank turned its attention to Development and began lending money to Third World nations

Ø  In 1950s, the bank concentrated on public sector projects [power stations, road  building and other transportation investments were much in favor]

Ø  During 1960s the bank also began to lend heavily in support of agriculture, education, population control and urban development

Ø  Bank lends money under 2 schemes:

      IBRD Scheme: money is raised through bond sales in the international capital market

      Borrowers pay a market rate of interest [ bank’s cost of funds+ a margin for expenses]

      This rate is lower than commercial banks market rate

      Under this scheme bank offers low interest loans to risky customers whose credit rating is often poor, such as underdeveloped nations

Ø  Second scheme is  IDA- International Development Agency

Ø  It’s an arm of the bank created in 1960

Ø  Resources to fund IDA loans are raised through subscriptions from wealthy members such as the US, Japan, and Germany

Ø  IDA loans go only to the poorest countries

Ø  Borrowers have 50 years to repay at an interest rate of 1 % a year

Ethical dimension of international business

      Business refers to accepted principles of right or wrong that govern the conduct of business people.

      Business strategy refers to course of action that does not violate these accepted principles.

      Many ethical issues and dilemmas in IB are rooted in the fact that political system, law, economic development and culture that significantly vary from nation to nation.

      Employment practices – shifts, compensation packages, welfare measures

      Human rights – basic rights : speech, movement, assembly

      Environmental pollution – dumping toxic chemicals, use of toxic materials in the workplace

      Corruption – foreign corrupt practices act Ex: corrupt Govt officials, gift giving etc

      Moral obligations – social responsibilities from power and control of resources by MNC

Expatriation

A major issue for an MNC is staffing overseas facilities, whether to use home country national, a host country national or a 3^rd country national. Home country nationals are citizens of country where the headquarters are located. Home country nationals who live & work in foreign countries are called Expatriates. Host country nationals are citizens of country where subsidiary exists.

Types of expatriates

1.      Traditional Expatriate- They are older & experienced, selected for his/her managerial or technical skill for a period of 1-5 yrs.

2.      Permanent Expatriate-They are individuals who move from 1 foreign assignment to another, returning to their home country, sometimes becoming permanent expatriates who stay in overseas assignments for extended periods of time or even permanently.

3.      Young Expatriates-They normally stay for 6 months to 5 yrs.

4.      Temporary Expatriates- They go on short assignments up to 1 yr.

5.      Expatriate trainee- He is placed abroad for training purposes as part of initiation into a MNC.

Expatriate selection

A  MNC can assess the potential of aspiring Intl executive on 14 dimensions. Cultural Sensitivity, Business Knowledge, Courage, Motivational Ability, Integrity, Insight, Commitment, Risk taking, Seeking feedback, Using feedback, Communication Skills, Desire to learn, Openness to criticism, Flexibility.

      Or 4 steps of development of expatriate

      self orientation

      Other orientation

      perceptual orientation

      cultural toughness

Expatriation failure

      Managers inability to adjust

      Inability of spouse to adjust

      Other family problems

      Personal or emotional problem

      Difficulties in new environment

      Lack of technical competencies

      Inability to cope with larger overseas responsibility

Repatriation

Repatriation is the process of bringing the expatriates back to the home country after the completion of overseas assignment.

Repatriation should be seen as the final link in an integrated, circular process that connects good selection and cross-cultural training expatriate managers with completion of their term abroad and reintegration into their national organization.

Exchange Rate Policies

 The exchange rate policies can be

1.      Fixed exchange rate or pegged exchange rate.

2.      Flexible or Fluctuating or Floating exchange rate.

Fixed Exchange Rates

Ø  IMF member govt. used to fix or determine exchange rate by exchange control.

Ø  Under this govt. used a fixed exchange rate and central bank operate it by creating exchange stabilization fund to create stabilized exchange rate.

Ø  Central bank buys foreign currency when exchange rates fall and sell foreign exchange when exchange rate increases.

Advantages

      Ensures certainty and confidence

      Promote long term investment

      Results in economic Stabilization

      Stabilize international business and avoid foreign risks to a greater extent.

Disadvantages

      Results in large scale destabilizing speculation in forex market

      Changes in IMF economic policies and foreign exchange policies of countries are rarely coordinated

      Globalization and liberalization economies prefer flexible system 

Flexible Exchange Rate

Ø  It is also called as ‘Floating exchange rate’ which is determined by market forces like demand and supply of forex market.

Ø  A floating exchange rate system provides two attractive features

      Monetary policy autonomy

       Automatic trade balance adjustments

Advantages

      Simple system to operate without problem of deficit

      Adjustment of exchange rate under this system is a continuous process

      Promotion of foreign trade

      System permit free trade and convertible currencies on a continuous basis

      Eliminate expenditure of maintenance of foreign exchange reserves.

Disadvantages

      Raises speculation and fluctuation in supply and demand

      Reduction in exchange rates leads to inflation

      Difficult to define changing exchange rates

Funding Facilities & Strategies

1.      Credit Tranches:

      The remaining balance of quota, after drawing 25% of reserve tranche is called  credit tranche, (the short fall of the member’s currency with fund over its quota is Reserve Tranche).

      Drawing from the credit tranche is conditional.

      The member countries can draw up to 300% of their new quotas on the total net use of the funds resources. 

2.      Buffer Stock Facility :

      IMF created Buffer Stock Financing facility for financing buffer stock by member countries in 1969.

      The assistance was provided to the member country equivalent to 30% of its quota.

3.      The Extended Fund Facility:

      The Extended fund facility was provided in1974 in order to provide credit to member countries to meet the BOP deficits for longer periods.

      Members are allowed to get the loan facility members are allowed to get the loan facility equal to 100% of their quota.

      Duration of this loan is for 10 years.  Mostly utilised by developing countries.

      The duration of this loan would be for 10 years.

      This is mostly used by developing countries.

4.      The Supplementary Financing Facility:

       The IMF created the supplementary facing the serious problem of BOP.

      This facility is meant for developing countries.

      The IMF created subsidy account in 1980 to make subsidy payment to member countries.

5.      Structural Adjustment Facility:

      The IMF provides loans to the poorer countries to solve the problem of persistent BOP problem and to carry out structural adjustment programmes.

      The IMF created this facility with special drawings rights (SDR) 2.7 billion

6.      Compensatory and Contingency Financing Facility (CCFF):

       The IMF, in order to provide timely compensation for temporary short falls.

      Or excess in cereal import costs created this facility.

Notes by

      -Chandana

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