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Management Core
MGCR 382
Hermann Juergens

Chapter Six: International Trade and Investment International Trade and the World Economy • trade – the voluntary exchange of goods, services, assets, or money between one person or organization and another • international trade – trade between residents of two countries • international trade occurs because both parties to the transaction believe they benefit from the voluntary exchange • exports spark additional economic activity in the domestic economy • imports can pressure domestic suppliers to cut their prices and improve their competitiveness • failure to respond to foreign competition may lead to closed factories and unemployed workers • Governments use trade theories when they design policies that they hope will benefit their countries' industries and citizens • Managers use trade theories to identify promising markets and profitable internalization strategies Classical Country-Based Trade Theories • the first theories of international trade developed with the rise of the great European nation- states during the sixteenth century • early theories focused on the individual country ◦ these theories are particularly useful for describing trade in commodities • as multinational companies rose to power in the middle of the twentieth century, scholars shifter their attention to the firm's role in promoting international trade ◦ these theories are particularly useful in describing patterns of trade in differentiated goods for which brand name is an important component of the customer's purchase decision Mercantilism th • mercantilism – 16 c. ◦ a country's wealth is measured by its holdings of gold and silver ◦ a country's goal should be to enlarge these holdings by promoting exports and discouraging imports ▪ “unfavorable balance of trade” - when a country's exports are less than its imports th ◦ in the 16 c., this was a sound economic policy ▪ reigning monarchs could afford to hire armies to fight other countries and therefore expanding their realms ▪ popular with manufacturers and their workers • export-oriented manufacturers favored mercantilist trade policies, such as establishing subsidies or tax rebates, which stimulate sales to foreigners • domestic manufacturers threatened by foreign imports endorsed mercantilist trade policies, such as tariffs or quotas, which protected the manufacturers from foreign competition • most members of society are hurt by such business ◦ government subsidies are paid by taxpayers in the form of higher taxes ◦ government import restrictions are paid for by customers in the form of higher prices ▪ domestic firms face less competition from foreign producers ◦ during the age of imperialism, governments often shifted the burden of mercantilist policies onto their colonies ▪ ex. NavigationAct of 1660 • all European goods imported by theAmerican colonies had to be shipped form Great Britain • British government prohibited the colonies from exporting any goods that would compete with those from British factories • British government required some colonial industries to sell their output to only British firms ◦ this contributed to grievances that led to the overthrow of the the British Crown in theAmerican Colonies ◦ neomercantilists (protectionists) – modern supporters of neomercantilist policies ▪ ex. it took Japan 40 years to allow importation of foreign rice; even then it limited rice imports to less than 10 percent of its market ▪ Asian and North American firms criticize the Europeans for imposing barriers against imported goods such as beef, bananas, and other agricultural products ▪ nearly every country has adopted some neomercantilist policies to protect key industries AbsoluteAdvantage • Adam Smith, father of free-market economics ◦ mercantilism's basic problem is that it confuses the acquisition of treasure as the acquisition of wealth ◦ in his book, he demonstrates that mercantilism actually weakens a country by robbing individuals of the ability to trade freely and to benefit from voluntary exchanges ◦ in the process of avoiding imports at all cost, a country must squander its resources producing goods it is not suited to produce ◦ the inefficiencies caused by mercantilism essentially weaken the country as a whole, even though certain special interest groups may benefit ▪ Smith advocated free trade among countries as a means of enlarging a country's wealth • free trade enables a country to expand the amount of goods and services available to it by specializing in the production of some goods and services and trading for others ◦ theory of absolute advantage – a country should export those goods and services for which it is more productive than other countries are and import those goods and services for which other countries are more productive than it is Comparative Advantage • the theory of absolute advantage incorrectly predicts that no trade would occur if one country has an absolute advantage of trade in both products • theory of comparative advantage – a country should produce and export those goods and services for which it is relatively more productive than other countries are and import those goods and services for which other countries are relatively more productive than it is ◦ the difference: comparative advantage incorporates the concept of opportunity cost ▪ opportunity cost – the value of what is given up to acquire the good ◦ it is comparative advantage that motivates trade, not absolute advantage Comparative Advantage with Money • you are better off specializing in what you do relatively best. Produce (and export) those goods and services you are relatively best able to produce, and buy other goods and services from people who are relatively better at producing them than you are ◦ information you need to understand which country holds relative advantage ▪ barriers to trade ▪ someone must pay to transport goods between markets ▪ inputs other than labor are necessary for production • output per hour of labor in each country • hourly wage rate in each country • exchange rate between the two countries' currencies ◦ prices set in a free market reflect a country's comparative advantage Relative Factors Endowments • Swedish economists Eli Heckscher and Bertil Ohlin ◦ theory of relative factor endowments (Heckscher-Ohlin theory) ▪ two basic assumptions: • Factor endowments (or types of resources) vary among countries ◦ ex. Argentina – fertile land ◦ ex. SaudiArabia – large crude oil reserves ◦ ex. Bangladesh – large pool of unskilled labor • Goods differ according to the types of factors that are used to produce them ◦ ex. wheat – fertile land ◦ ex. oil – crude oil reserves ◦ ex. apparel manufacturing – unskilled labor ▪ theory: a country will have a comparative advantage in producing products that intensively use resources it has in abundance • ex. Argentina has a comparative advantage in wheat-growing because of its abundance of fertile land ▪ a country should export those goods that intensively use those factors of production that are relatively abundant in the country • tested after WWII by economist Wassily Leontif using input-output analysis ◦ input-output analysis – a mathematical technique for measuring interrelationships among the sectors of an economy ◦ ex. US is capital-abundant and labor-scarce ▪ therefore, the US should export capital-intensive goods • ex. bulk chemicals and steel ▪ and import labor-intensive goods • ex. clothing and footwear ▪ estimated quantities of labor and capital needed to produce “bundles” of U.S. exports and imports worth USD $1 million in 1947 • ($3.093 million of capital + 170.0 person-years of labor) = US $1 m. EXPORTS ◦ $13,993 capital per person-year of labor • ($2.551 million of capital + 182.3 person-years of labor) = US $1 m. IMPORTS ◦ $18,194 capital per person-year of labor ◦ imports were more capital-intensive than exports ▪ according to the Heckscher-Ohlin theory, the U.S. should be importing labor-intensive goods ▪ in reality, imports were nearly 30% more capital-intensive than exports • a.k.a. The U.S. was importing more capital-intensive goods instead of labor-intensive goods ▪ scholars argue that measurement problems flaw Leontieff's work: • he assumed there are two homogenous factors of production: labor and capital ◦ other factors of production exist: ▪ land ▪ human capital ▪ technology Modern Firm-Based Trade Theories • firm-based theories have developed for several reasons ◦ the growing importance of MNC's in the post-war international economy ◦ the inability of the country-based theories to explain and predict the existence and growth of intraindustry trade ◦ the failure of Leontief and other researchers to empirically validate the country-based Hecksher-Ohlin theory • firm-based theories incorporate factors such as quality, technology, brand names, and customer loyalty into explanations of trade flows • because firms, not countries, are the agents for international trade; new theories explore the firm's role in promoting exports and imports Product Life Cycle Theory • product life cycle theory – traces the role of innovation, market expansion, comparative advantage, and strategic responses of global rivals in international production, trade, and investment decisions ◦ international product life cycle consists of three stages: ▪ new product ▪ maturing product ▪ standardized product ◦ new product stage ▪ firm develops and introduces an innovative product, in response to a perceived need in the domestic market • the firm is uncertain whether a profitable market for the product exists ◦ marketing executives must closely monitor customer reactions • quick market feedback is important ◦ product is likely to be initially produced in a country where its research and development occurred, typically a developed country (U.S., Japan, Germany) • market size is uncertain ◦ firm usually minimizes its investment in manufacturing capacity for the product ◦ output is usually sold in the domestic market ◦ export sales are limited ◦ maturing product stage ▪ demand for the product expands dramatically as consumers recognize its value ▪ innovating firm builds new factories to expand its capacity and satisy domestic and foreign demand for the product ▪ domestic and foreign competitors begin to emerge ◦ standardized product stage ▪ market for the product stabilizes ▪ product becomes more of a commodity ▪ firms are pressured to lower their manufacturing costs as much as possible by shifting production to facilities in countries with low labor costs ▪ product begins to be imported intot the innovating firm's home market ▪ in some cases, imports may result in the complete elimination of domestic production • domestic production: begins in stage 1, peaks in stage 2, slumps in stage 3 • exports by innovating firm's country: begins in stage 1 and peaks in stage 2, becomes a net importer of the product by stage 3 • foreign competition: begins to emerge towards the end of stage 1, foreign competitors expand productive capacity at the beginning of stage 2, and both innovating firm and its domestic and foreign rivals seek to lower production costs by shifting production to low- cost in less-developed countries, less developed countries become net-exporters of the product in stage 3 Country Similarity Theory • country-based theories do a good job of explaining interindustry trade among countries • interindustry trade – exchange of goods produced by one industry in countryAfor goods produced by a different industry in country B • intraindustry trade – trade between two countries of goods produced by the same industry ◦ Swedish economist Steffan Linder sought to explain the phenomenon of intraindustry trade ▪ hypothesized that international trade in manufactured goods results from similarities of preferences among consumers in countries that are at the stage of economic development • firms initially manufacture goods to serve the firms' domestic market • exploring exporting opportunities, they discover the most promising foreign markets are in countries where consumer preferences resemble those of their own domestic market • as each country targets each others home market, intraindustry trade arises • country similarity theory – most trade in manufactured goods should be between countries with similar per capita incomes; intraindustry trade in manufacturing goods should be common ◦ theory is especially good at explaining trade in differentiated goods, for which brand names and product reputations play an important role in consumer decision-making New Trade Theory • Elhanen Helpman, Paul Krugman, Kelvin Lancaster ◦ new trade theory – incorporates the impact of economies of scale on trade in differentiated goods ▪ economies of scale – occur if a firm's average costs of producing a good decrease as its output of that good increases • in industries where economies of scale are important, we would expect firms to be particularly aggressive in expanding beyond their domestic markets ▪ predicts that intraindustry trade will be commonplace • multinational corporations within the same industry will continually play cat- and-mouse games with one another on a global basis as they attempt to expand their sales to capture scale economies • they often seek to harness some sustainable competitive advantage ◦ owning intellectual property rights ◦ investing in R&D ◦ achieving economies of scope ◦ exploiting the experience curve Owning Intellectual Property Rights • a firm that owns intellectual property rights often gains advantages over its competitors Investing in Research and Development • R&D is a major component of the total cost of high-technology products ◦ computer industry ◦ pharmaceutical industry ◦ semiconductor industry • allows a company to maintain competitiveness • large “entry” costs in the industry • “first mover advantage” ◦ firms that invest up-front and secure the first-mover advantage have the opportunity to dominate the world market for goods that are intensive in R&D ◦ national competitiveness and trade flows may be determined by which firms make the necessary R&D expenditures • firs with large domestic markets may have an advantage over their foreign rivals in high- technology markets because these firms often are able to obtain quicker and richer feedback from customers ◦ with this knowledge, firms can fine-tune their R&D efforts to better meet the needs of their domestic customers ◦ this knowledge can be further used to service foreign customers Achieving Economies of Scope • economies of scope offer firms another opportunity to obtain a sustainable competitive advantage in international markets ◦ economies of scope occur when a firm's average costs decrease as the number of different products it sells increases Exploiting the Experience Curve • for certain types of products, production costs decline as the firm gains more experience in manufacturing the product ◦ experience curves may be so significant that they govern global competition in an industry ◦ ex. U.S.AndAsian chip manufacturers have often priced their new products below current production costs to capture the sales necessary to generate the production experience that will in turn enable the manufacturers to lower future production costs Porter's Theory of National ComparativeAdvantage • theory of national competitive advantage ◦ Michael Porter ◦ newest addition to international trade theory ◦ success in international trade comes from the interaction of four country and firm specific elements: ▪ factor conditions ▪ demand conditions ▪ related and supporting industries ▪ firm strategy ▪ firm structure ▪ rivalry Factor Conditions • a country's endowment of factors of production affects its ability to compete internationally • factor endowments were the centerpiece of the Hecksher-Ohlin theory, but Porter goes beyond the basic factors of land, labor and capital, and considered more advanced factors such as the educational level of the workforce, and the quality of the country's infrastructure • stresses the role of factor creation through training, research and innovation Demand Conditions • the existence of a large, sophisticated domestic consumer base often stimulates the development and distribution of innovative products as firms struggle for dominance in their domestic markets • in meeting their domestic customers' needs, firms continually develop and fine-tune products that can also be marketed internationally Related and Supporting Industries • the emergence of an industry often stimulates the development of local suppliers eager to meet that industry's production, marketing, and distribution needs • an industry located close to its suppliers will enjoy better communication and the exchange of cost-saving ideas and inventions with those suppliers • competition among those suppliers leads to lower prices, higher quality products, and technological innovations in the input market, in turn reinforcing the industry's competitive advantage in world markets Firm Strategy, Structure, and Rivalry • the domestic environment shapes a firm's ability to compete in international markets • to survive, a firm facing vigorous competition domestically must continuously strive to reduce costs, boost product quality, raise productivity, and develop innovative products • many of the investments they have made to succeed in the domestic market are transferable to international markets at low cost ◦ such firms have an edge as they expand abroad • Porter holds that national policies may also affect firms' international strategies and opportunities in more subtle ways • Porter's theory is a hybrid ◦ blends the traditional country-based theories that emphasize factor endowments with firm-based theories that focus on the actions of individual firms ◦ countries (or their governments) play a critical role in creating an environment that can aid or harm the ability of firms to compete internationally, but firms are the actors that actually participate in international trade no one theory of international trade explains all trade flows among countries • classical country-based theories – useful in explaining interindustry trade of homogeneous, undifferentiated products • firm-based theories – useful in understanding intraindustry trade of heterogeneous, differentiated goods, usually sold on the basis of their brand names and reputations • Porter's theory synthesizes the features of the existing country-based and firm-based theories Country-Based Theories Firm-Based Theories Unit ofAnalysis: Country Unit ofAnalysis: Firm Emerged Prior to WWII EmergedAfter WWII Developed By: Economists Developed by: Business School Professors Explain INTERINDUSTRY Trade Explain INTRAINDUSTRY Trade 1. Mercantilism 1. Country Similarity Theory 2. AbsoluteAdvantage 2. Product Life Cycle Theory 3. ComparativeAdvantage 3. New Trade Theory 4. Heckscher-Ohlin Theory (Relative 4. National CompetitiveAdvantage Factor Endowments) Theory An Overview of International Investment Types of International Investments • international investment is divided into two categories: foreign portfolio investment (FPI) and foreign direct investment (FDI) • foreign portfolio investment – passive holdings of securities such as foreign stocks, bonds, or other financial assets, none of which entails active management or control of the securities' issuer by the investor ◦ modern finance theory suggests that foreign portfolio investments will be motivated by attempts to seek an attractive rate of return as well as the risk reduction that can come from geographically diversifying one's investment portfolio • foreign direct investment – acquisition of foreign assets for the purpose of controlling them ◦ US gov. defines FDI as “ownership or control of 10% or more of an enterprise's voting securities or the equivalent interest in an unincorporated business The Growth of Foreign Direct Investment • accelerated growth in FDI began in the 1990's, reflecting the globalization of the world's economy • most FDI comes from and goes to developed countries Foreign Direct Investment and the United States • most FDI is made by and destined for the most prosperous countries International Investment Theories • obvious answer to why FDI occurs: average rates of return are higher in foreign markets • this is not satisfactory: both Canada and the U.S.Are major sources and destinations for FDI OwnershipAdvantages • ownership advantage theory – a firm owning a valuable asset that creates a competitive advantage domestically can use that advantage to penetrate foreign markets through FDI Internalization Theory • transaction costs – costs of entering into a transaction ◦ costs connected to negotiating, monitoring, and enforcing a contract • internalization theory – FDI is more likely to occur (international production will be internalized within the firm) when the costs of negotiating, monitoring, and enforcing a contract with a second firm are high ◦ conversely, when transaction costs are low, firms are more likely to contract with outsiders and internationalize by licensing their brand names or franchising their business operations Dunning's Eclectic Theory • internalization theory addresses why firms choose FDI, it ignores the question of why production should be located abroad • John Dunning ◦ eclectic theory – FDI reflects both international business activity and business activity internal to the firm ▪ combines ownership advantages, location advantage, and internalization advantage to form a unified theory of FDI ▪ FDI will occur when three conditions are satisfied • ownership advantage – the firm must own some unique competitive advantage that overcomes the disadvantages of competing eith foreign firms on their home turfs ◦ e.g. brand name ◦ ownership of proprietary technology ◦ the benefits of economies of scale • location advantage – undertaking business activity must be more profitable in a foreign location than undertaking it in a domestic location • internalization advantage – the firm must benefit more from controlling the foreign business activity than from hiring an independent local company to provide the service ◦ control is advantageous when ▪ monitoring and enforcing the contractual performance of the local company is expensive ▪ the local company may misappropriate proprietary technology ▪ the firm's reputation and brand name could be jeopardized by poor behavior by the local company Factors Influencing Foreign Direct Investment Supply Factors Demand Factors Political Factors 1. Production Costs 1. CustomerAccess 1. Avoidance of Trade Barriers 2. Logistics 2. MarketingAdvantages 2. Economic Development 3. ResourceAvailability 3. Exploitation of Incentives 4. Access to Technology CompetitiveAdvantages 4. Customer Mobility Supply Factors Production Costs • firms often undertake FDI to lower production costs • foreign locations may be more attractive than domestic sites because of lower land prices, tax rates, commercial real estate rents, or better availability and lower cost of skilled and unskilled labor Logistics • if transportation costs are significant, a firm may choose to produce in the foreign market rather than export from domestic factories Availability of Natural Resources • firms may utilize FDI to access natural resources that are critical to their operations Access to Key Technology • to gain access to technology • firms may find it more advantageous to acquire ownership interests in an existing firm than to assemble an in-house group of research scientists to develop or reproduce an emergin technology Demand Factors • firms may engage in FDI to expand the market for their products CustomerAccess • many types of international businesses require firms to have a physical presences in the market MarketingAdvantages • FDI may generate several types of marketing advantages • the physical presence of a factory may enhance the visibility of a foreign firm's products in the host market • the foreign firm also gains from “buy local” attitudes of host country consumers ◦ “if you build in the Far East, you're too far away [when you're in the battery-packs-for- laptops industry]. You can't do a last-moment modification while the product is on the ocean” Exploitation of CompetitiveAdvantages • FDI may be a firm's best means to exploit a competitive advantage that it already enjoys • an owner of a valuable trademark, brand name, or technology may choose to operate in foreign countries rather than export to them ◦ this decision often depends on the product's nature Customer Mobility • a firm's FDI also may be motivated by the FDI of its customers or its clients • establishing a new facility reduces the possibility that a competitor in the host country will step in and steal the customer Political Factors Avoidance of Trade Barriers • firms often build foreign facilities to avoid trade barriers • other types of government policies (quota) also impact FDI Economic Development Incentives • many government offer incentives to firms to induce them to locate new facilities in the governments' jurisdictions ◦ governmental incentives can be an important catalyst to FDI ◦ these incentives include ▪ reduced utility rates ▪ employee training programs ▪ infrastructure additions ▪ tax reductions or tax holidays • other MNCs benefit from bidding wars among communities eager to attract the companies and the jobs they bring Chapter Seven: The International Monetary System and the Balance of Payments • even domestically oriented companies must be attuned to changes in the global economy • the international monetary system exists because most countries have their own currencies • international monetary system – establishes rules by which countrys value and exchange their currencies ◦ provides a mechanism for correcting imbalances between a country's international payments and its receipts ◦ cost of converting foreign money into a firm's home currency depends on smooth functioning of the international monetary system • balance of payments – records international transactions and supplies vital information about the health of a national economy and likely changes in its fiscal and monetary policies ◦ BOP stats can be used to detect signs of trouble that could eventually lead to governmental trade restrictions, higher interest rates, accelerated inflation, reduced aggregate demand, and general changes in the cost of doing business in any given country History of the International Monetary System • as modern nation-states of Europe took form in the sixteenth and seventeenth centuries, their coins were traded on the basis of their relative gold and silver content The Gold Standard • gold standard – an international monetary system under which countries agree to buy/sell their paper currencies in exchange for gold on the request of any individual or firm ◦ in contrast to mercantilism's hoarding of gold, to allow the free export of gold bullion and coins ◦ in 1821, the UnitethKingdom became the first country to adopt the gold standard ▪ during the 19 c., most other important trading countries did so, as well • ex. Russia, Austria-Hungary, France, Germany and the United States ◦ the gold standard effectively created a fixed-rate exchange system ▪ exchange rate – the price of one currency in terms of a second currency ▪ fixed exchange rate system – the price of one currency does not change relative to each other currency • each country pegged, or tied, the value of its currency to gold • par value – official price in terms of gold ▪ as long as firms had faith in a country's pledge to exchange its currency for gold at the promised rate when requested to do so, many actually preffered to be paid in currency • transacting in gold was expensive ◦ cost of loading gold onto a cargo ship ◦ cost of guarding the gold against theft ◦ cost of insuring the gold against possible disasters ◦ cost of transporting the gold ◦ opportunity cost of the interest that might have been earned while the gold is in transit ▪ from 1821 until the end of WWI in 1918, the most important currency in international commerce was the British pound sterling • reflection of Britain's emergence from the Napoleonic Wars as Europe's dominant military and economic power • this monetary system at this time is often called the sterling-based gold standard • the pound's role in world commerce was reinforced by the expansion of the British empire ◦ in each colony, British banks established branches and used the pound sterling to settle international transactions among themselves ◦ because of the international trust inthritish currency, London became a dominant financial center in the 19 c., a position it still holds ◦ international reputations and competitive strengths of major British firms/banks stem from the role of the pound sterling in the 19 c. gold standard The Collapse of the Gold Standard • the sterling-based gold standard unraveled during World War I • with the outbreak of war, normal commercial transactions between theAllies (France, Russia, U.K.) and the Central Powers (Austria-Hungary, Germany, the Ottoman Empire) ceased to exist • economic pressures of war caused country after country to suspend their pledges to buy or sell gold at their currencies' par values • after the war, conferences at Brussels and Genoa yeilded general agreements among he major economic powers to return to the prewar gold standard ◦ most countries readopted the gold standard in the 1920's, despite increasing rates of inflation, unemployment, and political instability plaguing Europe at the time ▪ the Bank of England was unable to honor its pledge to maintain the value of the pound • September 21, 1931 ◦ Bank of England allowed the pound sterling to float ◦ float - the pound's value would be determined by the forces of supply and demand, and the Bank of England would no longer redeem British paper currency for gold at par value ◦ “sterling area” - primarily member of the British Commonwealth, these countries pegged their currencies to the pound and relied on sterling balances held in London as their international reserves ◦ other countries tied the value of their currencies to the U.S. dollar or the French franc ◦ harmony of the system deteriorated even further os some countries engaged in a series of competitive devaluations of their currencies ▪ ex. U.S., France, the U.K., Italy, Belgium, Latvia, the Netherlands, Switzerland ▪ by deliberately and artificially devaluing the official value of its currency, each nation hoped to make its own goods cheaper in world markets, thereby stimulating exports and reducing imports • any such gains by one country were offset when other countries also devalued their currencies ◦ beggar-thy-neighbor policies – countries raise tariffs they imposed on imported goods in the hope of protecting domestic jobs in import-competing industries ▪ as more and more countries adopted these policies, international trade contracted, hurting employment in each country's export industries ◦ this international economic conflict was soon replaced by an international military conflict – the outbreak of WWII in 1939 The Bretton Woods Era • many politicians and historians believe the breakdown of the international monetary system and international trade after World War I created economic conditions that helped bring about WWII ◦ inflation, unemployment, and costs of rebuilding war-torn economies created political instability that enabled fascist and communist dictators to seize control of their respective governments ◦ detemrined to avoid mistakes that had caused WWI, Western diplomats desired to create a postwar economic environment that would promote worldwide peace and prosperity ▪ in 1944, the representatives of 44 countries met at a resort in Bretton Woods, NH, with that objective in mind • conferees agreed to renew the gold standard on a greatly modified basis • also agreed to two new international organizations that would assist in rebuilding the world economy and international monetary system: ◦ International Bank for Reconstruction and Development (World Bank) ◦ International Monetary Fund The International Bank for Reconstruction and Development • International Bank for Reconstruction and Development (World Bank) ◦ established in 1945 ◦ initial goal was to help finance reconstruction of war-torn European economies ▪ the World Bank accomplished this task (with the assistance of the Marshall Plan) by the mid-1950's ◦ then, the World Bank adopted a new plan, to build the economies of the world's developing countries ◦ as its missino has expanded over time, the World Bank has become the World Bank Group, consisting of: ▪ The World Bank ▪ The International DevelopmentAssociation ▪ The International Finance Corporation ▪ The Multilateral Investment GuaranteeAgency ◦ World Bank currently had $120.1 billion in loans outstanding ◦ in reaching decisions, the World Bank uses a weighted voting system ▪ United States (16.0%) ▪ Japan (9.6%) ▪ Germany (4.4%) ▪ the U.K. (4.2%) ▪ France (4.2%) ▪ Canada, China, India, Italy, Russia, and SaudiArabia (2.7% each) • from time to time, voting weights are re-assessed as economic power shifts or as new members join the World Bank • to finance operations, the World Bank borrows money from international capital markets ◦ interest earned on existing loans it has made provides it with additional lending power ◦ the World Bank has made $44.2 billion in new loans commitments in 2010 ◦ according to its charter, the World Bank may lend only for “productive purposes” that will stimulate economic growth within the recipient's country ▪ will not finance a trade deficit, but will finance infrastructure projects that might boost a country's economy ▪ may lend only to national governments or for projects that are guaranteed by a national government ▪ loans must not be tied to the purchase of goods or services from any country ▪ hard loan policy – it may make a loan only if there is reasonable assurance that the loan will be repaid • this policy was criticized in the 1950's by poorer developing nations, who said it hindered their ability to obtain World Bank loans ◦ W.B. established the International Development Association (IDA) ▪ offers soft loans, or loans that bear some significant risk of not being repaid • these loans carry no interest rate (although there is a small service charge) • loans have long maturities (35-40 years) • borrowers are granted a 10 year grace period before they need to begin repaying their loans • lending efforts focus on the least-developed countries ▪ obtains resources from initial subscriptions its members make when joining it, as well as transferred World Bank profits and periodic replenishments contributed by richer countries ◦ International Finance Corporation (IFC) ▪ created in 1956 ▪ charged with promoting the development of the private sector in developing countries ▪ provides debt and equity capital for promising commercial activities ◦ Multilateral Investment Guarantee Agency (MIGA) ▪ set up in 1988 ▪ goal is to overcome private sector reluctance in developing countries because of perceived political riskiness ▪ encouraged direct investment in developing countries by offering private investors insurance against non-commercial risks • a.k.a. political risk insurance ◦ regional development banks ▪ promote the economic development of the poorer countries in their respective regions ▪ the regional development banks and the World Bank often work together on development projects • ex. African Development Bank, theAsian Development Bank, and the inter-American Development Bank The International Monetary Fund • International Monetary Fund (IMF) – oversee the functioning of the International Monetary System ◦ called for by the Bretton Woods agreement to ensure that the post-WWII monetary system would promote international commerce ◦ the objectives of the IMF are: ▪ to promote international monetary cooperation ▪ to facilitate the expansion and balanced growth of international trade ▪ to promote exchange stability, maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation ▪ to assist in the establishment of a multilateral system of payments ▪ to give confidence to its members by making the general resources of the IMF temporarily available to them and to correct maladjustments in their balance of payments ▪ to shorten the duration and lessen the degree of disequilibrium in the international balance of payments of members ◦ membership is available to any country willing to agree to its rules and regulations ▪ as of 2011, 187 countries were members • to join, a country must pay a deposit (or quota), partly in gold and partly in the country's home currency ◦ size of the quota primarily reflects the global importance of the country's economy ◦ size of the quota is important for several reasons: ▪ Acountry's quota determines voting power within the IMF • in 2010, the IMF Executive Board proposed to shift 6% of the organization's voting power from developed countries to the emerging and developing countries in recognition of their growing importance in the world economy ▪ Acountry's quota serves as part of its official reserves ▪ Acountry's quota determines the country's borrowing power from the IMF • each country has an unconditional right to borrow up to 25% of its quota from the IMF • additional borrowings are contingent on a member country's agreement to IMF-imposed restrictions ADollar-Based Gold Standard • the Bretton Woods agreement led all countries to peg the value of their currencies to gold ◦ BUT only the United States agreed to redeem its currency for gold at the request of a foreign central bank ▪ thus, the U.S. Dollar became the keystone of the Bretton Woods system ▪ countries had faith in the U.S. Economy and were therefore willing to accept U.S. Dollars to settle their transactions ▪ U.S. Dollar-Based Gold Standard ◦ thus, the result was a fixed exchange rate system ▪ each country pledged to keep its currency within +/- 1% of its par value • if the market value of its currency fell outside that range, a country was obligated to intervene in the foreign market to bring the value back within +/- 1% of par value • adjustable peg – currencies were pegged to gold, but the pegs themselves could be altered under certain conditions • in the event that pessimism about the economy of a certain country causes their currency's market value to fall, that country would be required to defend the value of their currency by selling some of its gold or U.S. dollar holdings to buy their currency back, increasing the demand for that currency and returning it to the legal range The End of the Bretton Woods System • the Bretton Woods arrangement worked well as long as pessimism about a country's economy was temporary ◦ if a country suffered from structural macroeconomic problems, major difficulties could arise ▪ ex. United Kingdom • 1960's: as the Bank of England continuously drained its official reserves to support the pound, the fears of the currency-market participants that the Bank would run out of reserves were worsened • a.k.a. run on the bank ◦ the Bretton Woods system was particularly susceptive to “runs on the bank” because there was little risk of betting against a currency in times of doubt ▪ if they guess right • the pound is devalued and they could make a quick financial killing converting pounds into dollars ▪ if they guess wrong • the Bank of England maintains the pound's par value, and speculators can re-convert their dollar holdings back into pounds with little penalty ◦ the U.K. Faced this type of run on the bank in November, 1967 ▪ result: Bank of England devalued the pound from $2.80 to $2.40 ◦ France faced a similar situation in 1969 and had to devalue the franc ◦ in the early 1970's, the value of the dollar came under attack ▪ the reliance of the Bretton Woods system on the dollar ultimately led to the system's undoing • the supply of gold did not expand in the short run, and the only source of liquidity needed to expand international trade was the U.S. dollar • expansion of international liquidity depended on foreigners' willingness to continually increase their holdings of dollars ◦ as foreign dollar holdings increased, people began to question the ability of the U.S. to live up to its Bretton Woods obligation ◦ Triffin paradox – because foreigners needed to increase their holdings of dollars to finance expansion of international trade; but the more dollars they owned, the less faith they had in the ability of the U.S. to redeem those dollars for gold ▪ the less faith foreigners had in the U.S., the more they wanted to rid themselves of the dollar and get gold in return ▪ if they did this, the international monetary system would collapse because the U.S. did not have enough gold to redeem all the dollars held by foreigners ▪ IMF members agreed in 1967 to create special drawing rights • special drawing rights (SDRs) – members can use SDRs to settle official transactions at the IMF ◦ SDRs sometimes called “paper gold” ◦ introduced as a means of injecting more liquidity into the international monetary system while reducing the demands placed on the dollar as a reserve currency ◦ an SDRs value is currently calculated daily as a weighted average of the market value of four major currencies (weight revisits every 5 years): ▪ U.S. dollar ▪ Euro ▪ Japanese yen ▪ British pound sterling ◦ IMF members currently hold about 204 billion SDRs ◦ SDRs id not reduce the fundamental problem of the mass of dollars held by foreigners ▪ by mid-1971, the U.S. had been forced to sell 1/3 of its gold reserves to maintain the dollar's value • Smithsonian conference – meeting of the Group of Ten ◦ held in Washington D.C., December 1971 ◦ central bank reps from the Group of Ten agreed to restore the fixed exchange rate system, but with restructured rates of exchange between the major trading currencies ◦ U.S. dollar was devalued to $38 per ounce, but remained inconvertible to gold ◦ par values of strong currencies such as the yen were revalued upward ◦ currencies were allowed to fluctuate around new par values by +/- 2.25 % Performance of the International Monetary System since 1971 • free-market forces disputed the new par values set by the Smithsonian conferees • speculators sold both the dollar and the pound (thought to be overvalued) and hoarded currencies they believed to be undervalued (Swiss franc/ German mark) ◦ in June 1972, the Bank of England allowed the pound to float downward ◦ in early 1973, the Swiss allowed the franc to float upward ◦ in February 1973, the U.S. devalued the dollar by 10% ◦ in March 1973, the central banks conceded they could not successfully resist free-market forces, and so establish a flexible exchange rate system ◦ flexible (floating) exchange rate system – supply and demand determine a currency's price in the world market ▪ many currencies are primarily established this way • central banks sometimes try to affect exchange rates by buying or selling currencies on the foreign-exchange market ◦ managed (dirty) float – exchange rates are not determined purely by private sector market forces ◦ Jamaica agreement – each country was free to adopt whatever exchange rate system best met its own requirements ▪ U.S. adopted a floating exchange rate system ▪ other countries adopted a fixed exchange rate by pegging their currencies to the dollar, the French franc, or some other currency ▪ other countries used crawling pegs, allowing the pegs to change gradually, over time ▪ the E.U. Believed that flexible exchange rates would hinder their ability to create an integrated European economy • European Monetary System (EMS) – created by the E.U. to manage currency relations among themselves ◦ most EMS members choose to participate in the E.U.'s exchange rate mechanism ▪ ERM participants pledged to maintain fixed exchange rates among their currencies within a narrow range of +/- 2.25% of par value and a floating rate against the U.S. dollar and other currencies ▪ ERM facilitated the creation of the euro in 1999 ▪ under the current international monetary system, the currencies of one country grouping float against the currencies of other country's groupings Other Post-World War II Conferences • the central banks have met numerous times to iron out policy conflicts amongst themselves • Plaza accord – central banks agreed to let the dollar's value fall on currency markets ◦ from its peak in February 1985 to the beginning of 1987, the dollar fell ~46% against the German mark and ~41% against the Japanese yen • Louvre accord – February 1987 ◦ signaled the commitment of the Group of Five to stabilizing the dollar's value • the foreign-exchange market was once again thrown into turmoil in 1990 by the onset of the Persian Gulf hostilities • fluctuations of currency values are of great importance to international businesses ◦ when the value of their domestic currency increases in the foreign-exchange market, firms find it harder to export their goods, more difficult to protect their domestic markets from the threat of foreign imports, and more advantageous to shift production from domestic factories to foreign factories ◦ a decrease in the value of a country's domestic currencies has the opposite effect ◦ the problems caused by these exchange rate fluctuations have called for some experts to call for the restoration of the Bretton Woods system The International Debt Crisis • the flexible exchange rate system instituted in 1973 was immediately put to a severe test ◦ in response to the Israeli victory in theArab-Israeli War of 1973,Arab nations imposed an oil embargo on oil shipments to countries such as the United States and the Netherlands, which had supported the Israeli cause ◦ in general, the currencies of the oil exporters strengthened, while those of oil importers weakened ▪ higher oil prices acted as a tax on the economies of the oil-importing countries ▪ economists feared that international liquidity would dry up as dollars amassed in oil- exporters' accounts OR that a worldwide depression would develop as consumer demand fell in the richer countries • in reality, the differences even out, as oil-exporting countries went on spending sprees, using new wealth to expand infrastructures or invest in projects to produce wealth for future generations • unspent petrodollars were deposited into international money centers (London and NYC) and recycled through international lending activities to help revive economies ravaged by rising oil prices ◦ international banks were more aggressive in recycling those dollars ◦ in total, more than 40 countries inAsia,Africa, and LatinAmerica sought relief from external debts • Baker Plan (1985) ◦ stressed the importance of debt rescheduling, tight IMF-imposed controls over domestic monetary and fiscal policies, and continued lending to debtor countries in hopes that economic growth would allow them to repay their competitors ▪ debtor nations made little progress in repaying their loans • Brady Plan (1989) ◦ focused on the need to reduce the debts of the troubled countries by writing off parts of the debts or by providing the countries with funds to buy back their loan notes at below face value • international debt crisis receded during the 1990's as debt-servicing requirements of debtor countries were made more manageable via a combination of IMF loans, debt rescheduling, and changes in governmental economic policies ◦ many experts consider the 80's a “lost decade” for economic development in Latin America ◦ Asian currency crisis – July 1997 ▪ Indonesia hit the worst ▪ “Asian Contagion” • latest international debt crisis began with the “subprime meltdown”, a result of the bursting of the U.S. housing bubble • analysts who had been monitoring the affected countries' BOP accounts were not surprised at the latest debt crisis The Balance of PaymentsAccounting System • BOP accounting system – double-entry book-keeping system designed to measure and record all economic transactions between residents of one country and residents of all other countries during a particular time period ◦ helps policymakers understand the performance of each country's economy in international markets ◦ signals fundamental changes in the competitiveness of countries ◦ assists policymakers in designing appropriate public policies to respond to these changes ◦ international businesspeople should pay attention to BOP stats because: ▪ BOP stats help identify emerging markets for goods and services ▪ BOP stats can warn of possible new policies that may alter a country's business climate, thereby affecting the profitability of a firm's operations in that country ▪ BOP stats can indicate reductions in a country's foreign-exchange reserves which may mean that the country's currency will depreciate in the future ▪ BOP stats can signal increased riskiness of lending to particular countries • Four important aspects of the BOP accounting system: ◦ records international transactions made during some time period ◦ records only economic transactions (involving monetary value) ◦ records transactions between residents of one country and residents of all other countries ▪ individuals ▪ businesses ▪ government agencies ▪ nonprofits ◦ double-entry system ▪ in most international business dealings, the first entry involves the purchase or sale of something ▪ the second entry records the payment, or receipt of payment ▪ CREDIT – sources of funds ▪ DEBIT – uses of funds The Major Components of the Balance of PaymentsAccounting System • the BOP accounting system can be divided conceptually into four major accounts ◦ current and capital accounts – record purchases of goods and services and assets by the private and public sectors ◦ official reserves – reflects the impact of central bank intervention in the foreign exchange market ◦ errors and omissions captures mistakes made in recording BOP transactions CurrentAccount • records four types of transactions among residents of different countries ◦ exports and imports of goods ▪ merchandise exports and imports (trade in visibles) ▪ balance on merchandise trade - the difference between a country's exports of merchandise and its imports of merchandise • when exporting more than importing – merchandise trade surplus • when importing more than exporting – merchandise trade deficit ◦ exports and imports of services ▪ service exports and imports (trade in invisibles) ▪ balance on services trade - the difference between a country's exports of services and its imports of services ◦ investment income ▪ export of the services of capital - income earned by a country's residents on foreign investments ▪ import of the services of capital – income earned by foreigners from their investments in a foreign country • includes interest and dividends paid by a country's firms on stocks, bonds and deposit accounts owned by foreign residents, as well as profits that are repatriated by foreign-owned incorporated subsidiaries in that country back to their corporate parents ◦ gifts (or unilateral transfers) ▪ unilateral transfers – gifts between residents of one country and another • current account balance – measures the net balance resulting from merchandise trade, service trade, investment income, and unilateral transfers ◦ broadly reflects a country's current competitiveness in international markets CapitalAccount • capital account – records capital transactions (purchases and sales of assets) between residents of one country and those of other countries ◦ U.S. system makes a distinction between a CapitalAccount and a FinancialAccount, but the book combines the two ◦ capital transaction can be divided into two categories: ▪ FDI (Foreign Direct Investment) • any investment made for the purpose of controlling the organization in which the investment is made, typically through ownership of significant blocks of common stock with voting privileges ◦ under U.S. law, control is defined as ownership of at least 10% of a company's voting stock ▪ FPI (Foreign Portfolio Investment) • any investment made for purposes other than control ◦ short-term foreign portfolio investments – financial instruments with maturities of one year or less ◦ long-term foreign portfolio investments – stocks, bonds, and other financial instruments issued by private and public organizations that have maturities greater than one year and are held for purposes other than control ◦ Capital inflows – CREDITS ▪ foreign ownership of assets in a country increases ▪ ownership of foreign assets by a country's residents declines ◦ Capital outflows – DEBITS ▪ ownership of foreign assets by a country's residents increases ▪ foreign ownership of assets in a country declines Official ReservesAccount • official reserves account – records the level of official reserves held by a national government ◦ these reserves are used to intervene in the foreign-exchange market and in transactions with other central banks ◦ official reserves comprise four types of assets: ▪ Gold • official gold holdings are measured using a par value established by a country's treasury or financial ministry ▪ Convertible currencies • currencies that are freely exchangeable in world currency markets • most common: U.S. dollar, the euro, and the yen ▪ SDRs ▪ Reserve positions at the IMF Errors and OmissionsAccount • errors and omissions account – used to make the BOP balance in accordance with the equation: Current Account + Capital Account + Official Reserves Account + Errors and Omissions = 0 ◦ account can be quite large ◦ experts suspect that a large portion of the errors and omissions account balance is due to underreporting of capital account transactions ▪ sometimes, they are due to deliberate actions by individuals who are engaged in illegal activities such as drug smuggling, money laundering, or evasion of currency and investment controls imposed by their home governments • flight capital – money sent abroad by foreign residents seeking a safe haven for their assets • residents who distrust the stability of their own country's currency may also choose to use a stronger currency to transact their business or to keep their savings ▪ errors may appear in the E&O account as well • few countries tax exports • customs services have less incentive to assess the accuracy of statistics concerning merchandise exports • many service trade statistics are generated by surveys U.S. Balance of Payments in 2010 • U.S. tends to import more goods from its major trading partners than it exports to them • U.S. tends to export more services to its major trading partners than it imports from them • foreigners bought more U.S. assets than U.S. residents bought foreign assets • errors and omissions for the U.S. in 2010 = $216.8 billion Defining Balance of Payments Surpluses and Deficits • news sometimes talks about deficits or surpluses ◦ if BOP always balances, how can their be a deficit/ surplus? ◦ when knowledgeable people talk about deficits and surpluses, they are only talking about a subset of the BOP accounts ▪ balance on trade in goods and services • trade surplus – when a country exports more goods and services than it imports • trade deficit – when a country imports more goods and services than it exports • official settlements balance – reflects changes in a country's official reserves ◦ records the net impact of the central banks' interventions in the foreign exchange market in support of the local currency • there is no single measure of a country's global economic performance • each balance represents a different perspective on the nation's position in the international economy ◦ balance on merchandise trade – reflects the competitiveness of a country's manufacturing sector ◦ balance on services – reflects the service sector's global competitiveness ▪ growing in importance because of the expansion of the service sector in many national economies ◦ balance of goods and services – reflects the cobined international competitiveness of a country's manufacturing and service sectors ◦ current account balance – shows the combined performance of the manufacturing and service sectors and also reflects the generosity of the country's residents (unilateral transfers) as well as the income generated by past investments ◦ official settlements balance – reflects the net quantity demanded and supplied of the country's currency by all market participants, other than the country's central bank Chapter Eight: Foreign Exchange and International Financial Markets • one factor that distinguishes international business from domestic businesses is the use of more than one currency in commercial transactions • the foreign-exchange market exists to facilitate the conversion of these currencies, allowing firms to conduct trade more efficiently across international boundaries ◦ also facilitates international investment and capital flows and then use the foreign exchange market to convert the foreign funds they obtain into whatever currency they require ◦ exchange rates also affect the prices that consumers pay, the markets in which they shop, and the profits of firms The Economics of Foreign Exchange • foreign exchange – a commodity that consists of currencies issued by countries other than one's own ◦ the price of foreign exchange is set by demand and supply in the marketplace ▪ derived demand curve • demand for a currency is derived from foreigners' desire to acquire a country's goods, services, and assets • to buy that country's goods, other countries need that country's currency • curve is downward sloping ◦ as the price of a currency falls, the quantity demanded increases ▪ derived supply curve • derived from the desire of the country's residents to acquire foreign goods, services, and assets • selling a currency is the equivalent of supplying that currency to the foreign- exchange market ▪ the intersection of the supply curve and the demand curve yields the market-clearing, or equilibrium price, and the equilibrium quantity demanded and supplied • this equilibrium price is called the exchange rate – the price of one currency in terms of another country's currency ▪ exchange rates are quoted in two ways: • direct quote – price of foreign currency in terms of home country's currency • indirect quote – price of home currency in terms of foreign country's currency ◦ mathematically, the direct quote and indirect quote are reciprocals of each other ◦ you normally buy things using the direct rate ▪ ex. a loaf of bread costs $2.89 • the indirect rate would be .346 loaves of bread per dollar The Structure of the Foreign-Exchange Market • the foreign exchange market comprises buyers and sellers of currencies issued by the world's countries • the largest foreign-exchange market is in London, followed by New York, Tokyo, and Singapore • approximately 85% of transactions involve the U.S. dollar, a dominance stemming from the dollar's role in the Bretton Woods system ◦ for this, the U.S. dollar is known as the primary transaction currency for the foreign exchange market The Role of Banks • the foreign exchange departments of large international banks play a dominant role in the foreign-exchange market ◦ JPMorgan Chase ◦ Barclays ◦ Deutsche Bank • these banks stand ready to buy or sell the major traded currencies • they profit from foreign-exchange market in several ways • most of their profits come from the spread between the bid and ask prices for foreign exchange • some international banks act as speculators and arbitrageurs in the foreign-exchange market ◦ risky • interbank transactions account for a majority of foreign-exchange transactions • banks and institutional investors in one market are in constant contact with their counterparts in other markets to seek the best currency prices • international banks also play a key role in the retail market for foreign exchange, dealing with individual customers who want to buy or sell large or small amounts of foreign currencies • typically, the price paid by retail customers for foreign exchange is the prevailing wholesale exchange rate plus a premium ◦ the size of the premium is in turn a function of the size of the transaction and the importance of the customer to the bank ◦ clients fall into several categories: ▪ commercial customers – engage in foreign-exchange transactions as part of their normal commercial activities, such as exporting or importing goods and services, paying or receiving dividends and interest from foreign sources, and purchasing or selling foreign assets and investments; some commercial customers may also use the market to hedge, or reduce, their risks due to potential unfavorable changes in foreign-exchange rates for moneys to be paid or received in the future ▪ speculators – deliberately assume exchange rate risks by acquiring positions in a currency, hoping that they can predict changes in the currency's market value ▪ arbitrageurs – attempt to exploit small differences in the price of a currency between markets; they seek to obtain riskless profits by simultaneously buying the currency in the lower-priced market and selling it in the higher-priced market • central banks of countries that allow their currencies to float are free to intervene in the foreign-exchange market to influence the market values of their currencies if they so desire • active markets exist for relatively few pairs of currency other than those involving the U.S. dollar, the euro, the British pound, and the Japanese yen • convertible currencies – currencies that are freely tradable • inconvertible currencies – currencies that are not freely tradable because of domestic laws or the unwillingness of foreigners to hold them Spot and Forward Markets • many international business transactions involve payments to be made in the future ◦ lending activities ◦ purchases on credit • the foreign-exchange market also has a time dimension ◦ spot market – consists of foreign-exchange transactions that are to be consummated immediately ▪ immediately – two days after trade date ◦ forward market – consist of foreign-exchange transactions that are to occur sometime in the future ▪ prices are often published for foreign exchange that will be delivered one, three, and six months in the future ◦ swap transaction – transaction in which
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