INTERNATIONAL BUSINESS

UNIT-I

International Business Environment, Trends in International Trade, Needs for Going International,

International Marketing, Economic Growth and its impact on the International Business.

International Business Environment

Concept of International Business:-

Introduction : International business has been playing a crucial role for centuries. In the present day

world it has become indispensable for any country. Its role has increased in significance, both at the

macroeconomic and microeconomic levels. No country developed or developing produces all

commodities to meet its requirements. It needs to import items that are not produced domestically. At

the same time, it tries to export all items that are produced over and above its domestic requirements.

Meaning of International Business : International business means carrying on business activities

beyond national boundaries. These activities normally include transaction of economic resources such

as:

o Goods

o Capital

o Services (comprising technology, skilled labour and transportation, etc.)

o International production.

Production may either involve production of physical goods or provision of services like banking,

finance, insurance, construction, trading and so on. Thus international business includes not only

international trade of goods and services but also foreign investment, especially foreign direct

investment.

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Features of International Business Environment

Cultural and social forces in international business

Many of the additional complexities and problems faced by international marketers stem from

differences in the cultural and social environment which the marketer faces when marketing

internationally. Influences of cultural differences when marketing across national boundaries take on a

heightened importance.

We know how people consume, their needs and wants, and the ways in which these wants are satisfied

are determined by culture. Culture is the human-made part of environment that includes knowledge,

beliefs, morals, laws, customs and other elements acquired by humans in society. Because cultures are

so different between countries, cultural forces and factors take on a particular significance for the

international marketer. We highlight some of the possible areas or aspects of culture where there may

be important differences when marketing in foreign markets:

social organization;

norms and values;

religion;

language;

education;

arts and aesthetics.

Sometimes seemingly relatively small and subtle differences in cultural habits and practices can be

important in marketing products in different cultures. For example, attitudes towards body hair differ

between even relatively geographically proximate European countries. In the UK for instance, most

women shave their under-arm hair, whereas most German women do not. A company like Gillette takes

this difference into account in preparing its marketing plans for the different European countries.

Comparison between domestic and international marketing

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The marketer must understand the implications of these different elements of culture for developing

marketing strategies e.g. there may be very different norms and values pertaining to say gender roles, or

the use of sex in advertising when marketing in a foreign country. Similarly, religious beliefs may have

a significant impact on what is acceptable marketing practice.

It is important to recognize that within any national culture there are often a number of sub-sets of

culture. In the UK there is a distinct cultural difference between the north and south, which affects

purchasing behaviour – in direct and observable ways, but sometimes in quite subtle ways.

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Technological Forces

Technological forces influence organizations in several ways. A technological innovation can have a

sudden and dramatic effect on the environment of a firm. First, technological developments can

significantly alter the demand for an organization's or industry's products or services.

Technological change can decimate existing businesses and even entire industries, since its shifts

demand from one product to another. Moreover, changes in technology can affect a firm's operations as

well its products and services.

These changes might affect processing methods, raw materials, and service delivery. In international

business, one country's use of new technological developments can make another country's products

overpriced and noncompetitive. In general,

Technological trends include not only the glamorous invention that revolutionizes our lives, but

also the gradual painstaking improvements in methods, in materials, in design, in application,

unemployment, and the transportation and commercial base. They diffusion into new industries

and efficiency" (John Argenti).

The rate of technological change varies considerably from one industry to another. In electronics, for

example change is rapid and constant, but in furniture manufacturing, change is slower and more

gradual.

Changing technology can offer major opportunities for improving goal achievements or threaten the

existence of the firm. Therefore, "the key concerns in the technological environment involve

building the organizational capability to

(1) forecast and identify relevant developments - both within and beyond the industry,

(2) assess the impact of these developments on existing operations, and

(3) define opportunities" (Mark C. Baetz and Paul W. Beamish).

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These capabilities should result in the creation of a technological strategy. Technological strategy deals

with "choices in technology, product design and development, sources of technology and R&D

management and funding" (R. Burgeleman and M. Maidique).

Economic Forces

The economic of the host country plays on important role in the decisions of a multinational

organization.

In addition to foreign exchange control policies, the tax structure and the tax policies of the host

country mus be studied an considered. Some of the economic factors to be considered are:

(a) GNP, income levels of the work force and the proportion of disposable income, saving habits of

the population, economic growth trends, trends in industrial development, inflation rate, interest rate

etc.

(b) Any local financial resources available that would be necessary and helpful in further expanding

the facilities of operation.

(c) Any organized labour unions that could create problems in the from of strikes, demand for higher

wages and additional fringe benefits.

(d) Any economic planning agencies that would give the economic trends for the foreseeable future.

India, for example, has five-years plans and sometimes over 10 years and the expected progress over a

number of years in the future.

(e) The infrastructure for support services providing for power and water availability,housing

conditions, transportation and communications.

(f) Stability of local currency and its acceptance outside the host country.

If any of these factors makes the operations economically risky, then some steps can be taken to

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reduce these risks One way would be to go into a joint venture with local citizens. The joint ventures

spread the responsibility and the adverse effects are minimized in case of political changes and policy

changes. Also, they combine the financial and managerial resources of the organization with the needs

and traditional knowledge of the natives and local markets. Some other means of reducing these risks

are:

- Entering into licensing agreements only, which require the transfer on technical knowhow for a fixed

fee or continuous royalty for as long as this technical knowledge is utilized.

- Contracts to manage host country owned installations. This involves leading the managerial talent,

with or without the transfer of technical know-how. This id done again by proper compensation for

such services rendered.

- Turn-key operations. In this case the entire project is undertaken by an organization and consists of

designing, constructing, developing the unit and training personnel to operate the unit and training

personnel to operate the unit to the point where the key can be turned over to the local owners.

Political and Legal Forces

Political-legal forces include the outcomes of elections, legislation, and court judgments, as well as the

decisions rendered by various commissions and agencies. The political sector of the environment

presents actual and potential restriction on the way an organization operates.

Among the most important government actions are: regulation, taxation, expenditure, takeover (creating

a crown corporation, and privatization. The differences among local, national, and international

subsectors of the political environment are often quite dramatic. Political instability in some areas

makes the very form of government subject to revolutionary changes.

In addition the basic system of government and the laws the system promulgates, the political

environment might include such issues as monitoring government policy toward income tax, relative

influence of unions, and policies concerning utilization of natural resources.

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Political activity my also have a significant impact on three additional governmental functions

influencing a firm's external environment:

* Supplier function. Government decisions regarding creation and accessibility of private businesses

to government-owned natural resources and national stockpiles of agricultural products will profoundly

affect the viability of some firm's strategies.

* Customer function. Government demand for products and services can create, sustain, enhance, or

eliminate many market opportunities.

* Competitor function. The government can operate as an almost unbeatable competitor in the

marketplace, Therefore, knowledge of government strategies can help a firm to avoid unfavorable

confrontation with government as a competitor.

In general, the impact of government is far-reaching and increasing.

Trends in International Trade

Meaning of World Trade : World trade helps a country to utilize its natural resources and to export its

surplus production. It is only because of world trade that oil-exporting countries are utilizing their

natural resources and are able to increase the level of economic development of their countries. World

trade helps the country to import technical know-how and thus the importing country can utilize world's

best technology. At the time of natural calamity, a country can import food grains and other goods from

abroad. World trade has helped the developing and least developed countries to import machinery,

capital goods, technical know-how from industrially advanced countries.

Trends in World Trade : Trends in world trade can be analysed in the following manner:

(1)Increase in World's Exports : World's exports have increased significantly. In the year 1950,

world's exports were only 55 billion dollars and in the year 2004, it has increased to 9,153 billion

dollars. It means that in these 54 years world's exports have increased 166 times. It is clear from the

following table:

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The main reason for increase in world's exports is reduction in tariff and non-tariff barriers, multilateral

trade, increase in means of communication, transportation, etc.

(2)Top Exporters in Merchandising World Trade : In the year 2004, the largestexporting country in

world trade is Germany. Its hare in total world's export is 10 per cent. The top five exporting countries

of the world are:

Germany

USA

China

Japan

France

India's ranking in world's export is 30th. Its share in total world's export is just 0.8 per cent. Data

regarding value of exports, percentage in world's exports and their ranking given in the following table:

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(Source: Statistical Outline of India, 2005-06)

(3)Top Importers in Merchandising (Goods) World Trade : In the year 2004, the largest importer

in world trade was U.S.A. Its share in world's imports was 16.1%. India's ranking in world's import is

23rd. India's percentage in world' import is just 1.0% The world's five big importers are:

U.S.A.

Germany

China

France

U.K.

(4)World Trade in Services : Services is another area in which world trade is expanding very fast.

Service sector mainly includes travel, tourism, banking, insurance, telecommunication, business

outsourcing (call centres), IT enabled services, consultancy, media-services, software, advertising,

transportation, etc.

(5)Exports of Developing Countries : Among developing countries, the top five countries in world

trade are:

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Hong Kong

Taiwan

Korea

China

Singapore

Their combined share is 50% of exports of all developing countries.

(6)Composition of World Trade : World Trade in terms of product groups comprise

Foodstuff,

Agricultural raw materials,

Fuels,

Ores and metals

Textiles

Chemicals

Machinery

Transport equipment

Gems and jewellery

Computer software

Leather products etc.

Nowadays trade in services like banking, software, shipping, telecommunication, travel, tourism etc. is

increasing at a faster rate. Presently, World Trade includes engineering goods, capital goods,

technology, computer software, services, chemicals, along with agricultural goods. So composition of

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world trade is changing and share of industrial goods and services is expanding at a faster rate, than

traditional export items.

(7)Growth of Regional Blocs in World Trade : Some of the leading blocs have improved their share

in world trade. The objective of these blocs is to promote free trade and economic cooperation among

different regions of globe.

(8)Shift from Bilateral Trade to Multilateral Trade : Earlier, up to the year 1994, world trade was

mainly bilateral. In bilateral trade, agreement is signed between two nations. With the growth in World

Trade Organisation, there is shift from bilateral to multilateral trade. In multilateral trade, trade

agreements are signed among many nations at a time.

(9)Shift from Restricted Trade to Free Trade : Earlier, various tariff and non-tariff restrictions were

imposed on world trade. These restrictions were

Import quotas,

Custom duties

Discriminatory transport charges

Voluntary import restraints

Licence system

Subsidies

Commercial prohibition etc.

But now as per the directions of WTO, both tariff and non-tariff barriers to international trade have

been reduced. In other worlds, free trade is increasing in the World Trade.

Needs for going International

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1. Sales Expansion : The main objective of International business is to increase the sale because in

international business a firm can sell its product in domestic as well as in foreign market. Many

companies look to international markets for growth. Introducing new products internationally can

expand a company's customer base, sales and revenue. For example, after Coca-Cola dominated the

U.S. market, it expanded their business globally starting in 1926 to increase sales and profits.

2. Resource Acquisition : It means getting the resources from other countries because there may be so

many resources of other country which may not be available in home country.

3. Minimize Competitive Risk : Many companies move internationally to minimize the risk of

competitors. They want to go in international market for defensive reasons.

4. Diversification : Many companies want to diversify the sources of sales and supplies, so they may

seek foreign market for this purpose.

5.Growth Many companies look to international markets for growth. Introducing new products

internationally can expand a company's customer base, sales and revenue. For example, after Coca-Cola

dominated the U.S. market, it expanded their business globally starting in 1926 to increase sales and

profits.

Employees Companies go international to find alternative sources of labor. Some companies look to

international countries for lower-cost manufacturing, technology assistance and other services in order

to maintain a competitive advantage

Ideas Companies go international to broaden their work force and obtain new ideas. A work force

comprised of different backgrounds and cultural differences can bring fresh ideas and concepts to help a

company grow. For example, IBM actively recruits individuals from diverse backgrounds because it

believes it's a competitive advantage that drives innovation and benefits customers.

Advantages of International Business

Increased Socio Economic Welfare : International business enhances consumption level, and

economic welfare of the people of the trading countries. For example, the people of China are now

enjoying a variety of products of various countries than before as China has been actively involved in

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international business like Coca Cola, McDonald's range of products, electronic products of Japan and

coffee from Brazil. Thus, the Chinese consumption levels and socio-economic welfare

are enhanced.

Wider Market : International business widens the market and increases the demand for the product in

a single country or customer's tastes market size. Therefore, the companies need not depend on the

preferences of a single country. Due to the enhanced market the Air France, now mostly depends on the

demand for air travel of the customers from countries other than France. This is true in case of most of

the MNCs like Toyota, Honda, Xerox and Coca Cola.

Reduced Effects of Business Cycles : The stages of business cycles vary from country to country.

Therefore, MNCs shift from the country, experiencing a recession to the country experiencing 'boom'

conditions. Thus international business firms can escape from the recessionary conditions.

Reduced Risks : Both commercial and political risks are reduced for the companies engaged in

international business due to spread in different countries. Multinationals, which were operating in to

erstwhile USSR, were affected only partly due to their safer operations in other countries. But the

domestic companies of then USSR collapsed completely.

Large Scale Economies : Multinational companies due to the wider and larger markets produce larger

quantities. Invariably, it provides the benefit of large scale economies like reduced cost of production,

availability of expertise, quality etc

Provides the Opportunity for and Challenge to Domestic Business : International business firms

provide the opportunities to the domestic companies. These opportunities include technology,

management expertise, market intelligence, product developments etc. For example, Japanese firms

operating in US provide these opportunities to US companies. This is more evident in the case of

developing countries like India, African countries and Asian countries

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International Marketing

International marketing (IM) or global marketing refers to marketing carried out by companies

overseas or across national borderlines. This strategy uses an extension of the techniques used in the

home country of a firm.[1] It refers to the firm-level marketing practices across the border including

market identification and targeting, entry mode selection, marketing mix, and strategic decisions to

compete in international markets.[2] According to the American Marketing Association (AMA)

"international marketing is the multinational process of planning and executing the conception,

pricing, promotion and distribution of ideas, goods, and services to create exchanges that satisfy

individual and organizational objectives."[3] In contrast to the definition of marketing only the word

multinational has been added.[3] In simple words international marketing is the application of marketing

principles to across national boundaries. However, there is a crossover between what is commonly

expressed as international marketing and global marketing, which is a similar term.

The intersection is the result of the process of internationalization. Many American and European

authors see international marketing as a simple extension of exporting, whereby the marketing mix 4P's

is simply adapted in some way to take into account differences in consumers and segments. It then

follows that global marketing takes a more standardised approach to world markets and focuses upon

sameness, in other words the similarities in consumers and segments.

Economic Growth & its Impact on International Business

The issues of international trade and economic growth have gained substantial importance with the

introduction of trade liberalization policies in the developing nations across the world. International

trade and its impact on economic growth crucially depend on globalization. As far as the impact of

international trade on economic growth is concerned, the economists and policy makers of the

developed and developing economies are divided into two separate groups.

One group of economists is of the view that international trade has brought about unfavorable changes

in the economic and financial scenarios of the developing countries. According to them, the gains from

trade have gone mostly to the developed nations of the world. Liberalization of trade policies, reduction

of tariffs and globalization have adversely affected the industrial setups of the less developed and

developing economies. As an aftermath of liberalization, majority of the infant industries in these

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nations have closed their operations. Many other industries that used to operate under government

protection found it very difficult to compete with their global counterparts.

The other group of economists, which speaks in favor of globalization and international trade, come

with a brighter view of the international trade and its impact on economic growth of the developing

nations. According to them developing countries, which have followed trade liberalization policies,

have experienced all the favorable effects of globalization and international trade. China and India are

regarded as the trend-setters in this case.

There is no denying that international trade is beneficial for the countries involved in trade, if practiced

properly. International trade opens up the opportunities of global market to the entrepreneurs of the

developing nations. International trade also makes the latest technology readily available to the

businesses operating in these countries. It results in increased competition both in the domestic and

global fronts. To compete with their global counterparts, the domestic entrepreneurs try to be more

efficient and this in turn ensures efficient utilization of available resources. Open trade policies also

bring in a host of related opportunities for the countries that are involved in international trade.

However, even if we take the positive impacts of international trade, it is important to consider that

international trade alone cannot bring about economic growth and prosperity in any country. There are

many other factors like flexible trade policies, favorable macroeconomic scenario and political stability

that need to be there to complement the gains from trade.

There are examples of countries, which have failed to reap the benefits of international trade due to lack

of appropriate policy measures. The economic stagnation in the Ivory Coast during the periods of 1980s

and 1990s was mainly due to absence of commensurate macroeconomic stability that in turn prevented

the positive effects of international trade to trickle down the different layers of society. However,

instances like this cannot stand in the way of international trade activities that are practiced across the

different nations of the world.

In conclusion it can be said that, international trade leads to economic growth provided the policy

measures and economic infrastructure are accommodative enough to cope with the changes in social

and financial scenario that result from it.

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UNIT-II

Political, Legal and Cultural Environment: Impact of economic system and economic reforms. Country

Risk Insurance – Role of OPIC and MIGA; Nature of legal environment; International Protection.

International Political Environment

Political Environment : The influence of political environment on business is enormous. Political

environment includes:

1) Political ideology of government regarding :

a. Foreign investment

b. Foreign trade

c. Tariffs

d. Working of MNCs

e. Price Controls

f. Liberalisation

g. Globalisation

h. Privatisation etc.

(2) Political stability in the country.

Forms of Political System

Democracy

o Parliamentary Democracy

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o Presidential Democracy

Totalitarian System

Secular Totalitarianism

Theocratic Totalitarianism

The political scenario often varies between the two extremes :

Democracy : The purest form of democracy represents direct involvement of citizens in policy making.

This is because, the democratic set-up is "of the people, for the people, and by the people". But with the

growing time and distance barriers over time, it did not remain feasible for all citizens to participate in

the political process, and as a result, democracy turned into a representative democracy where only the

elected representative have a say in political decision. Whatever may be the form of democracy, the

people enjoy fundamental rights of various kinds of freedom and civil liberties.

(i) Parliamentary Democracy : In parliamentary democracy, political decisions are

influenced by widely varying interest groups.

(ii) Presidential Democracy : On the contrary, they are comparatively centralized in

presidential democracy, although the head of the government is an elected

representative.

Totalitarianism : Totalitarianism, at the other extreme, represents monopolization of political power in

the hands of an individual or a group of individuals with virtually no opposition. The policy is simply

the dictates of the ruler. Constitutional guarantee are denied by the citizens.

Types of Political Environment : Political environment is of three types:

(1) Political Environment of Domestic Country : It refers to political environment of the country

in which MNC operates. Usually less developed countries view foreign firms and

foreign capital investment with distrust. On the other hand, different political parties, especially

opposition parties often accuse foreign firms of not providing the latest technology, violating the

rules and seeking favours from the ruling party.

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(2)Political Environment of Foreign Country : It refers to political environment of the country to

which MNC belongs. MNCs are also affected by political ideology of their parent country.

(3)International Political Environment : International political environment is created from the

interaction between the domestic and foreign political environment. International political

environment is changing very fast and these changes affect the domestic, economic and political

environment.

Political Risk : There is no precious definition. However, in Thunell's view, political risk is said to

exist when sudden and unanticipated changes in political set-up in the host country lead to unexpected

discontinuities that bring about changes in the very business environment and corporate performance.

For Example, if a rightist party wins election in the host country and the policy towards foreign

investment turns liberal, it would create a positive impact on the operation of MNCs. On the other hand,

if a left party comes to power in the host country, it will have a negative impact on the operation of

MNCs. It is the negative impact that is normally the focus of attention of transnational investors.

Forms of Political Risks : Some of the forms of political risks are:

Expropriation : Expropriation means seizure of private property by the government. Confiscation is

similar to expropriation, but the difference between two is that while expropriation involves payment of

compensation, confiscation does not involve such payments. International law provides protection to

foreigner's property. It provides for compensation in case of unavoidable seizure. But the process of

compensation is often lengthy and cumbersome. The firm usually requires going-concern value tied to

the present value of lost future cash flows. On the other hand, government prefers depreciated historical

book value, which is lower in the eyes of the firm.

Currency Inconvertibility : Sometimes the host government enacts law prohibiting foreign companies

from taking their money out of the country or from exchanging the host country currency for any other

currency. This is a financial form of political risk.

Credit Risk : Refusal to honour a financial contract with a foreign company or to honour foreign debt

comes under this form of political risk.

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Risk from Ethnic, Religious, or Civil Strife : Political risk arises on account of war and violence and

racial, ethnic, religious or civil strife within a country.

Conflict of Interest : The interest of MNCs is normally different from the interest of the host

government. The former manifests in the maximization of corporate wealth, while the latter is evident

in the welfare of the economy, in general and of the citizens of a constituency, in particular. It is the

conflicting interest that gives rise to political risk.

Corruption : Corruption is endemic in many host countries, as a result of which MNCs have to face

serious problems. Transparency International has surveyed 85 countries and has brought out the

Corruption Perception Index. Many countries rank high on this index.

Evaluation or Assessment of Political Risk : Assessment of political risk is an important step before a

firm moves abroad. It is because if such risks are very high, the firm would not like to operate in that

country. If the risk is moderate or low, the firm will operate in that country, but with a suitable political-

risk management strategy. But any such strategy cannot be formulated until one assesses the magnitude

of political risk. The ways of assessment may be either qualitative or quantitative.

Management of Political Risk : The political risk management strategy depends upon the type of risk

and the degree of risk the investment carries. It also depends upon the timing of the steps taken. For

example, the strategy will be different if it is adopted prior to investment from that adopted during the

life of the project. Again, it will be different if it is adopted after expropriation of assets. The

management of political risk is divided into three sections:

(A) Management Prior to Investment : Investment will prove a viable venture if political risk is

managed from the very beginning-even before the investment is made in foreign land. At this stage,

there are five ways to manage it.

(1)Increased in Discount Rate : In the first method, the factor of political risk is included in the very

process of capital budgeting and the discount rate is increased. But the problem is that it penalizes the

flows in the earlier years of operation, whereas the risk is more pronounced in the later years.

(2)Reducing the Investment Flow : The risk can be reduced through reducing the investment flow

from the parent to the subsidiary and filling the gap through local borrowing in the host country. In this

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strategy, it is possible that the firm may not get the cheapest fund, but the risk will be reduced. The firm

will have to make a trade-off between higher financing cost and lower political risk.

(3)Agreement with the Host government : If the investing company undergoes an agreement with

the host government over different issues prior to making any investment, the latter shall be bound by

that agreement.

(4)Planned Divestment : Planned divestment is yet another method of reducing work. If the company

plans an orderly shifting of ownership and control of business to the local shareholders and it

implements the plan, the risk of expropriation will be minimal.

(5)Insurance of Risk : Political risk can also be reduced by the insurance of risk.The investing firm

can be insured against political risk. Insurance can be purchased from governmental agencies, private

financial service, organizations or from private property-centred insurers.

(B) Risk Management during the Life Time of the Project : Management of risk during the pre-

investment phase lessens the intensity of risk, but does not eliminate it. So the risk management process

continues even when the project is in operation. There are four ways to handle the risk in this phase.

(1)Joint Venture and Concession Agreement : In a joint venture agreement, the participants are local

shareholders who have political power to pressurize the government to take a decision in their favour or

in favour of the enterprise. In case of concession agreements that are found mainly in mineral

exploration, the government of the host country retains ownership of the property and grants lease to

the producer. The government is interested in earning from the venture and so it does not cancel the

agreement.

(2)Political Support : Risk can also be managed with political support. International companies

sometimes act as a medium through which the host government fulfils its political needs. As long as

political support is provided bythe home country government, the assets of the investing company are

safe.

(3)Structured Operating Environment : The third method is through a structured operating

environment. Political risk can be reduced by creating a linkage of dependency between the operation

of the firm in high risk country and the operation of other units of the same firm in other countries. If

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the unit in a high risk country is dependent on its sister units in other countries for the supply of

technology or raw material , the former is normally not nationalized so long dependency is maintained.

(4)Anticipatory Planning : Anticipatory planning is also useful tool in risk management. It is a fact

that the investing company takes necessary precautions against the political risk prior to the investment

or after the investment. But it is of utmost significance that it should plan the measures to be taken quite

in advance.

(C) Risk Management following Nationalisation : Despite care taken by the international firms for

minimizing the impact of political risk, there are occasions when nationalization takes place. In such

cases, the investing company tries to minimize the effects of such a drastic measure. There are many

ways to do it.

(1)The investing company negotiates with the host government on various issues and shows its

willingness to support the policy and programmes of the latter. Sometimes the investing company

foregoes majority control in order to please the host government.

(2)Political and Economic Pressure : On failure of negotiation with the host government, the

investing company tries to put political and economic pressure.

(3)Arbitration : If nationalization is not reversed through negotiation and political-economic pressure,

the firm goes for arbitration. It involves the help of a neutral third party who mediates and asks for the

payment of compensation.

(4)Approach the Court of Law : When the arbitration fails, the only way out is to approach the court

of law. The international law suggests that the company has, first of all, to seek justice in the host

country itself. If it is not satisfied with the judgement of the court, the company can go to the

international court of justicefor fixation of adequate compensation.

Legal Environment

There are wide variations between countries n the policies and regulations regarding the conduct of the

business. For example, certain trade practices or promotional methods/strategies allowed in some

countries may be regarded as unfair by the laws of some other countries. In many countries there is a lot

of restriction n the use of the media. Radio and Television, in particular are under State monopoly or

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under strict state control in a number of countries. The advent of cable TV however, is creating

problems for regulation.

In most countries, apart from those laws that control investment and related matters, there are a number

of laws that regulate the conduct of the business. These laws cover such matters as standards of product,

packaging, promotion, ethics, ecological factors etc.

Business policies and regulations have much to do with the political system and the characteristics of

the political parties and politicians.

In many countries with a view to protecting consumer interests, regulations have become stronger.

Regulations to protect the purity of the environment and preserve the ecological balance have assumed

great importance in many countries.

Some governments specify certain standards for the products (including packaging) to be marketed in

the country: some even prohibit the marketing of certain products. In most nations promotional

activities are subject to various types of controls. Several European countries restrain the use of

children in commercial advertisement. In a number of countries, including India, the advertisement of

alcoholic liquor is prohibited. Advertisements, including packaging of cigarettes must carry the

statutory warning that cigarette smoking is injurious to health. Similarly, baby foods must not be

promoted as a substitute for breast feedings. In countries like Germany, product comparison

advertisements and the use of superlatives like best or excellent in advertisements is not allowed. In the

United States, the Federal Trade Commission is empowered to require a company to provide sufficient

evidence to substantiate the claim concerning the quality, performance or comparative prices of its

products.

There area host of statutory controls on business in India. Although the controls have been substantially

brought down as a result of the liberalization, a number of controls still prevail.

Many countries today have laws to regulate competition in the public interest. Elimination of unfair

competition and dilution of monopoly power are the important objectives of these regulations.

Certain changes in government policies such as the industrial policy, fiscal policy, tariff policy etc. may

have profound impact on business. Some policy developments create opportunities as well as threats. In

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other words, a development which brightens the prospects of some enterprises may pose a threat to

some others. For example, the industrial policy liberalizations in India have opened up new

opportunities and threats. They have provided a lot of opportunities to a large number of enterprises to

diversify and to make product mix better. But they have also given rise to serious threat to many

existing products by way of increased competition; many seller’s markets have given way to

buyer’s markets. Even products which were seldom advertised have come to be promoted very

heavily. This battle for the market has provided a splendid opportunity for the advertising industry.

The legal systems that exist in different countries across the world may be classified into three

categories, viz, common law, civil law or code law, and theocratic law.

The basis for common law is tradition, past practices, and legal precedents set by the courts through

interpretations of statutes, legal legislation, and past rulings.

Code law, on the other hand, is based on an all-inclusive system of written rules (codes) of law. Under

code law, the legal system is generally divided into three separate codes: commercial, civil, and

criminal. The civil law system, also called a codified legal system, is based on a detailed set of laws that

make up a code. Rules for conducting business transactions are a part of the code.

The theocratic law system is based on religious precepts. The best example of this system is Islamic

law, which is found in Muslim countries. Islamic law, or Shair’a, is based in the following sources:

The Koran, the sacred text; the Sunnah or decisions and sayings of the Prophet Mohammad; the

writings of Islamic scholars, who derive rules by analogy from the principles established in the Koran

ad the Sunnah; and the consensus of Muslim countries’ legal communities.

Human-Cultural Environment

Human-Cultural Environment : Business is an integral part of society and both influence each other.

Human-Cultural Environment: Human cultural environment is studied into four parts:

23

Meaning of Culture : Culture represents the entire set of social norms and responses that dominate the

behavior of persons living in a particular geographic or political boundary. It is a fact that cultural

boundaries may differ from national/political boundaries because individuals with varying cultural

back-grounds may reside in a particular nation.

Culture as noted earlier represents the whole set of social norms and responses that shape the

o Knowledge

o Beliefs

o Morals

24

o Attitude

o Behavior and

o The very way of life of a person or a group of persons.

Culture is not in-born. It is acquired and inculcated.

Elements of Culture : Based on the definition of culture, there are a few basic elements of culture.

These elements are universal, meaning that they from the cultural environment of all societies. But,

what is important is that they perform differently in different societies, leading ultimately to cultural

diversity across different societies. Czinkota et al list these elements as follows:

(1)Language : Language is the medium through which message is conveyed. It may be verbal or non-

verbal. The former includes the use of particular words or how the words are pronounced. When an

international manager gives the instructions to his subordinates, who normally come from the host

country, the instructions must be understood properly by the latter. There is no problem, if the language

spoken in the home country and the host country is similar. But normally it is not.

(2)Religion : Religion is another element of culture. Irrespective of forms, religion believes in a higher

power. It sets the ideals of life and thereby the values and attitude of individuals living in a society.

These values manifests in individual's behavior and performance.

(3)Education : The level of education in a particular culture depends primarily on the literacy rate and

on enrolment in schools and colleges. This element has a close relationship with the availability of

skilled manpower, availability of workers and managers who can be sent to the home country for

training, production of sophisticated products and with the adaptation of imported technology. If the

level of education is high in a particular society, it is easy for multinational firms to operate there. It is

because skilled manpower will be easily available, its training will be east and the firm will be able to

produce sophisticated goods.

(4)Attitude and Values : Values are belief and norms prevalent in a particular society. They determine

largely the attitude and behavior of individuals towards work, status, change and so on. In some

societies, where income and wealth are emphasized upon, people work for more hours ion order to earn

more. On the contrary, in societies where leisure is preferred, people work only for limited hours, just to

25

meet their essential wants necessary for survival. Again the attitude towards social status is an

important factor. Those who believe in higher social status spend even more and to this end they work

more and earn more.

(5)Customs : Customs and manners vary from one society to another. In the United State of America,

silence is taken as negation, while it is not so in Japan.

(6)Social Institutions : Social institutions form an integral part of culture. They are concerned mainly

with the size of the family and social stratification. In the United State of America and the United

Kingdom and most other developed countries, the size of the family is small, comprising of a husband,

wife and children. But in many other countries, especially in developing ones, grand parents too are a

part of the family. In yet another group of countries the family is larger comprising of cousins, aunts

and uncles. In India, the joint family system is still prevalent.

Cultural Diversity : In the preceding section, it has been mentioned how the various elements of

culture vary in different societies. In some societies, individualism motivates personal accomplishment,

while in others, the concept of the group is prominent. It is the cultural diversity that shapes the

managers as either risk averse or risk taking leaders. The former are conservative in their decisions,

while the latter are aggressive. Some managers give priority to long-term goals, while the others are

contended with achieving short-term goals. It is the cultural background that makes the two different

from each other. But it is important to know that why such diversity exists. To explain the bases of

diversity, a few of models have been developed.

(1)Hofstede's Study : Hofsede's study surveyed 117000 employees in 88 countries and suggests that

cultural diversity among nations has four dimensions. They are:

(i)Individualism/collectivism

(ii)Masculinity/ femininity

(iii)Power distance

(iv)Uncertainty avoidance

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(2) Kluckhon and Strodtbeck's Study : Similarly, Kluckhon and Strodtbeck identify five problems

that tend to cultural diversity. They are:

(i)Human-Nature relationship

(ii)Orientation towards time

(iii)Beliefs about human nature

(iv)Activity orientation of human being

(v)Inter-human relationship

(3) Fons Trompenaars' Study : Trompenaars' study covers 15,000 managers from 28 countries. It

concludes that cultural diversity is found because of the existence of a few relationship orientations

manifest in form of:

(i) Universalism vis-à-vis particularism

(ii) Neutralism vis-à-vis emotionalism, and

(iii)Achievement vis-à-vis ascription.

Diverse Culture and Competitive Advantage : If an MNC moves to a country with a similar cultural

envirornment, operational problems do not emerge on this count. But this is seldom a case. Generally,

the culture in the parent company's country is found to be different from that in the country where its

subsidiaries exist. This causes serious operational problems and effects the competitive advantage of

the firm, which lies at the very root of every MNC's success.

Cutural Diversity Impeding Competitive Advantage of an MNC :

(i) Poor communication between top managers and subordinates

(ii)Non-responsive attitude leading to inefficiency

(iii)Lack of responsiveness towards innovated product/technology

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(iv)Buying pattern among consumers may not encourage large scale production

(v)Varying concept of human resource management may weaken employer-employee relationship

(vi)Varying culture, limiting the scope for advertisement/sales promotion campaign

Management of Cultural Diversity : Lee outlines a procedure for decision making in different

cultural setups. It is a four step model The successive steps are:

(i)To define the business goal from the home country perspective

(ii)To define the same goal from host country perspective

(iii)To compare the two and note the differences, and

(iv)To eliminate the difference and to find an optimal solution

Role of OPIC and MIGA

OPIC

The Overseas Private Investment Corporation (OPIC) is the U.S.   government ’s development finance

institution. It mobilizes private capital to help solve critical development challenges and, in doing so,

advances U.S.   foreign policy . Because OPIC works with the private sector, it helps U.S. businesses gain

footholds in emerging markets, catalyzing revenues, jobs and growth opportunities both at home and

abroad. OPIC achieves its mission by providing investors with financing, guarantees, political risk

insurance, and support for private equity investment funds.

OPIC supports U.S. foreign policy objectives by encouraging development in regions that have

experienced instability or conflict, yet offer promising growth opportunities, such as the Middle East

and North Africa, sub ‐ Saharan Africa , and Southeast Asia. OPIC’s work contributes to stability and

economic opportunity, which helps mitigate risk to U.S. companies investing abroad, and promotes a

positive developmental effect for the host countries.

OPIC operates on a self‐sustaining basis at no net cost to American taxpayers. It generated net income

of $269 million in Fiscal Year 2011,[1] helping to reduce the federal budget deficit for the

28

34th consecutive year. To date, OPIC has supported nearly $200 billion of investment in more than

4,000 projects, generated $75 billion in U.S. exports and supported more than 276,000 American jobs.

Multilateral Investment Guarantee Agency (MIGA)

The Multilateral Investment Guarantee Agency (MIGA) is an international financial institution which offers

political risk insurance guarantees. Such guarantees help investors protect foreign direct investments against

political and non-commercial risks in developing countries. MIGA is a member of the World Bank Group and is

headquartered in Washington, D.C., United States. It was established in 1988 as an investment insurance facility

to encourage confident investment in developing countries. MIGA's stated mission is "to promote foreign direct

investment into developing countries to support economic growth, reduce poverty, and improve people's

lives". The agency focuses on member countries of the International Development Association and countries

affected by armed conflict. It targets projects that endeavor to create new jobs, develop infrastructure,

generate new tax revenues, and take advantage of natural resources through sustainable policies and

programs.

MIGA is owned and governed by its member states, but has its own executive leadership and staff

which carry out its daily operations. Its shareholders are member governments which provide paid-in

capital and have the right to vote on its matters. It insures long-term debt and equity investments as well

as other assets and contracts with long-term periods. The agency is assessed by an independent

evaluator each year. Its 2011 evaluation recommended that it utilize its recently expanded investing

capacity and closely monitor projects' profitability to better understand their impacts on its financial

performance. MIGA's total investments amounted to $1.1 billion in 2011. It issued $2.1 billion worth of

new investment guarantees in 2011 and held $1.5 million in total assets.

International Protection

WIPO-administered systems of international protection significantly simplify the process for

simultaneously seeking IP protection in a large number of countries. Rather than filing national

applications in many languages, the systems of international protection enable you to file a single

application, in one language, and to pay one application fee. These international filing systems not only

facilitate the process but also, in the case of marks and industrial designs, considerably reduce your

costs for obtaining international protection (in the case of patents, the PCT helps your SME in gaining

29

time to assess the commercial value of your invention before national fees are to be paid in the national

phase). WIPO-administered systems of international protection include three different mechanisms of

protection for specific industrial property rights.

International protection of inventions is provided under the PCT system, the worldwide

system for simplified multiple filing of patent applications. By filing one international patent

application under the PCT, you actually apply for protection of an invention in each of a large

number of member countries (now more than one hundred) throughout the world.

International protection of trademarks is provided under the "Madrid system." The Madrid

system simplifies greatly the procedures for registering a trademark in multiple countries that

are party to the Madrid system. An international registration under the Madrid system produces

the same effects as an application for registration of the mark filed in each of the countries

designated by the applicant and, unless rejected by the office of a designated country within a

certain period, has the same effect in that country as a registration in the Trademark Registry of

that country.

International protection of industrial designs  is provided by the Hague Agreement. This

system gives the owner of an industrial design the possibility to have his design protected in

several countries by simply filing one application with the International Bureau of WIPO, in one

language, with one set of fees in one currency.

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UNIT-III

Commodity Agreements, trading blocks, International trade, trade barriers – tariff and non-tariff, trade

and international investments; types of foreign investments and factor affecting it.

Commodity Agreements

An international commodity agreement is an undertaking by a group of countries to stabilize trade,

supplies, and prices of a commodity for the benefit of participating countries. An agreement usually

involves a consensus on quantities traded, prices, and stock management. A number of international

commodity agreements serve solely as forums for information exchange, analysis, and policy

discussion.

USTR leads United States participation in two commodity trade agreements: the International Tropical

Timber Agreement and the International Coffee Agreement (ICA). Both agreements establish

intergovernmental organizations with governing councils.

Trading Blocks

A trade bloc is a type of intergovernmental agreement, often part of a regional intergovernmental

organization, where regional barriers to trade, (tariffs and non-tariff barriers) are reduced or eliminated

among the participating states.[

31

Regional trade blocs are intergovernmental associations that manage and promote trade activities for

specific regions of the world.

Trade bloc activities have political as well as economic implications. For example, the European Union,

the world’s largest trading block, has “harbored political ambitions extending far beyond the free

trading arrangements sought by other multistage regional economic organizations“ (Gibb and Michalak

1994: 75). Indeed, the ideological foundations that gave birth to the EU were based on ensuring

development and maintaining international stability, i.e., the containment of communist expansion in

post World War II Europe (Hunt 1989). The Maastricht Treaty which gave birth to the EU in 1992

included considerations for joint policies in regard to military defense and citizenship.

The decisions reached by development policy makers on whether regionalism or globalized trade

should be pursued may influence a country’s earnings from trade.

Regionalism differs from globalization in the size and area of markets. From the perspective of

developing countries skeptical of free trade, regional trade blocs offer some form of protection against

an aggressive global market.

Four major trade blocs:-

Some well known trading blocs include the EU (European Union; see Map 1), NAFTA (North

American Free Trade Agreement; see Map 2), MERCOSUR (Mercado Comun del Cono Sur, also

known as Southern Common Markets (SCCM); see Map 3), and ASEAN (Association of Southeast

Asian Nations; see Map 4). The following maps show trade data for 2001 (UNCTAD 2002). The series

of pie charts display the export composition of trade from each country in the bloc.

Interregional Trade

Interregional trade is trade that takes place between two or more regions.

The exports and imports of a region. Measurement and meaning confound the use of the term

interregional trade: first, the measure of gross exports, the out-shipments of goods and services to

producers and consumers outside a region; second, the measure of gross imports, the in-shipments of

goods and services for the use of economic units inside the region. Apropos to both measures is the

32

concept of the region itself. In an economic sense, a region is a collection of local labor market areas or

the commuting areas of central places that are the areas’ trade centers. Further distinctions refer to rural

versus urban and metropolitan regions.

The trading region includes the infrastructure of commerce as well as the export-producing businesses,

their workers and production facilities, and a host of residential activities catering to these businesses

and their workers and households. All are important participants in the initiation and support of

interregional trade, the inevitable result of businesses and workers exercising their particular

competitive advantage through remunerative product specialization. We therefore address the topic by

defining and identifying interregional trade within and between trading regions and, finally, accounting

for the variability and value of interregional trade arising from the product specialization of its export-

producing businesses and industries.

Trade Barriers : Tariff and Non- Tariff

International trade increases the number of goods that domestic consumers can choose from, decreases

the cost of those goods through increased competition, and allows domestic industries to ship their

products abroad. While all of these seem beneficial, free trade isn't widely accepted as completely

beneficial to all parties. This article will examine why this is the case, and look at how countries react to

the variety of factors that attempt to influence trade. (To start with a discussion on trade, see What Is

International Trade? and The Globalization Debate.)

What Is a Tariff?

In simplest terms, a tariff is a tax. It adds to the cost of imported goods and is one of several trade

policies that a country can enact.

Why Are Tariffs and Trade Barriers Used?

Tariffs are often created to protect infant industries and developing economies, but are also used by

more advanced economies with developed industries. Here are five of the top reasons tariffs are used:

1. Protecting Domestic Employment

The levying of tariffs is often highly politicized. The possibility of increased competition from

imported goods can threaten domestic industries. These domestic companies may fire workers

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or shift production abroad to cut costs, which means higher unemployment and a less happy

electorate. The unemployment argument often shifts to domestic industries complaining about

cheap foreign labor, and how poor working conditions and lack of regulation allow foreign

companies to produce goods more cheaply. In economics, however, countries will continue to

produce goods until they no longer have a comparative advantage (not to be confused with an

absolute advantage).

2. Protecting Consumers

A government may levy a tariff on products that it feels could endanger its population. For

example, South Korea may place a tariff on imported beef from the United States if it thinks that

the goods could be tainted with disease.

3. Infant Industries

The use of tariffs to protect infant industries can be seen by the Import Substitution

Industrialization (ISI) strategy employed by many developing nations. The government of a

developing economy will levy tariffs on imported goods in industries in which it wants to foster

growth. This increases the prices of imported goods and creates a domestic market for

domestically produced goods, while protecting those industries from being forced out by more

competitive pricing. It decreases unemployment and allows developing countries to shift from

agricultural products to finished goods.

Criticisms of this sort of protectionist strategy revolve around the cost of subsidizing the

development of infant industries. If an industry develops without competition, it could wind up

producing lower quality goods, and the subsidies required to keep the state-backed industry

afloat could sap economic growth.

4. National Security

Barriers are also employed by developed countries to protect certain industries that are deemed

strategically important, such as those supporting national security. Defense industries are often

viewed as vital to state interests, and often enjoy significant levels of protection. For example,

while both Western Europe and the United States are industrialized, both are very protective of

defense-oriented companies.

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5. Retaliation

Countries may also set tariffs as a retaliation technique if they think that a trading partner has

not played by the rules. For example, if France believes that the United States has allowed its

wine producers to call its domestically produced sparkling wines "Champagne" (a name specific

to the Champagne region of France) for too long, it may levy a tariff on imported meat from the

United States. If the U.S. agrees to crack down on the improper labeling, France is likely to stop

its retaliation. Retaliation can also be employed if a trading partner goes against the

government's foreign policy objectives.

Types of Tariffs and Trade Barriers

There are several types of tariffs and barriers that a government can employ:

Specific tariffs

Ad valorem tariffs

Licenses

Import quotas

Voluntary export restraints

Local content requirements

Specific Tariffs

A fixed fee levied on one unit of an imported good is referred to as a specific tariff. This tariff can vary

according to the type of good imported. For example, a country could levy a $15 tariff on each pair of

shoes imported, but levy a $300 tariff on each computer imported.

Ad Valorem Tariffs

The phrase ad valorem is Latin for "according to value", and this type of tariff is levied on a good based

on a percentage of that good's value. An example of an ad valorem tariff would be a 15% tariff levied

by Japan on U.S. automobiles. The 15% is a price increase on the value of the automobile, so a $10,000

vehicle now costs $11,500 to Japanese consumers. This price increase protects domestic producers from

35

being undercut, but also keeps prices artificially high for Japanese car shoppers.

Non-tariff barriers to trade include:

Licenses

A license is granted to a business by the government, and allows the business to import a certain type of

good into the country. For example, there could be a restriction on imported cheese, and licenses would

be granted to certain companies allowing them to act as importers. This creates a restriction on

competition, and increases prices faced by consumers.

Import Quotas

An import quota is a restriction placed on the amount of a particular good that can be imported. This

sort of barrier is often associated with the issuance of licenses. For example, a country may place a

quota on the volume of imported citrus fruit that is allowed.

Voluntary Export Restraints (VER)

This type of trade barrier is "voluntary" in that it is created by the exporting country rather than the

importing one. A voluntary export restraint is usually levied at the behest of the importing country, and

could be accompanied by a reciprocal VER. For example, Brazil could place a VER on the exportation

of sugar to Canada, based on a request by Canada. Canada could then place a VER on the exportation

of coal to Brazil. This increases the price of both coal and sugar, but protects the domestic industries.

Local Content Requirement

Instead of placing a quota on the number of goods that can be imported, the government can require

that a certain percentage of a good be made domestically. The restriction can be a percentage of the

good itself, or a percentage of the value of the good. For example, a restriction on the import of

computers might say that 25% of the pieces used to make the computer are made domestically, or can

say that 15% of the value of the good must come from domestically produced components.

Trade and International Investment

The strategy of selecting globally-based investment instruments as part of an investment portfolio.

International investing includes such investment vehicles as mutual funds, American Depository

36

Receipts, exchange-traded funds (ETFs) or direct investments in foreign markets. People often invest

internationally for diversification, to spread the investment risk among foreign companies and markets;

and for growth, to take advantage of emerging markets.

Why International?

Most investors tend to invest in what they know. This isn't necessarily a bad thing as it's important to

have a good understanding of your investments; however, it becomes detrimental when the blinders are

put on and people refrain from learning about other investments. International investing, in particular, is

a strategy sometimes overlooked by investors as a means of diversification.

With all the volatility found in stock markets, it's difficult enough to pick winning stocks let alone

winning economies. This is where diversification through international investing can help. Every year,

the economic performance of a country will fluctuate and this undoubtedly affects the stock market. By

buying securities in different markets as opposed to purchasing only U.S. stocks and bonds, you can

reduce the impact of country or region-specific economic problems. (For more information, see Can

You "Learn" The Stock Market?)

Take a look at the following chart:

YearJapan

Nikkei

U.S. S&P

500

Canada S&P TSX

Composite

London FTSE

100

1993 18.8% 9.7% 30% 24.3%

1994 -7.8% -2.3% -11.8% -14.3%

1995 11.6% 35.8% 23.7% 25.7%

1996 -11.9% 23.6% 23% 13.7%

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1997 -12% 24.7% 9.7% 27.7%

1998 -12.8% 30.5% 0.4% 8%

1999 35% 9% 26% 6.3%

2000 -29% -2% 9.9% 0.5%

2001 -27.8% -17.3% -17.9% -18%

2002 -16.6% -19.6% -11.5% -30.9%

2003 22.53% 22.38% 21.97% 11.66%

2004 6.13% 9.48% 11.70% 6.87%

2005 40.86% 3.84% 23.29% 15.92%

2006 4.87% 11.78% 12.23% 8.86%

2007 -10.44% 4.37% 10.10% 3.02%

2008 -40.51% -37.58% -37.31% -31.96%

2009 17.59% 19.67% 26.19% 17.87%

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2010 -3.64% 11.00% 13.21% 8.12%

2011* -16.67% -2.82% -11.09% -9.27%

* As of December 2011

This chart outlines the percentage returns on the indexes of international exchanges. With careful

inspection, we can see that the magnitude and direction of returns for these four indexes don't always

coincide. There are years when one index is up while another is down, and other times when an index

rises by nearly 36% while others rise only by 12%. By participating in these other markets, that is,

through purchasing securities from other countries, an investor can, with the added benefit of higher

returns in foreign exchanges, add some protection against a national downturn in the U.S. economy.

Different Types of International Investments

There are numerous ways in which the ordinary investor can invest in foreign markets without having

too much trouble. Here are a few of the major types offered by most brokerages.

American Depositary Receipts (ADRs)

American depositary receipts are used by foreign countries unable to list on the NYSE or Nasdaq,

which have domestic country regulations. ADRs mimic their domestic stocks very closely, and offer

you a way of investing internationally without actually buying stock from a foreign exchange. One

ADR found on the NYSE is Nokia (NYSE:NOK). This company tracks its parent stock on the Helsinki

Exchange almost identically, allowing investors the convenience of international diversification without

actually leaving American exchanges.

Exchange-Traded Funds (ETFs)

These investments offer a wide variety of international flavors. You can buy ETFs that track most of

the major foreign indexes, and they allow investors to obtain a return based on a specific foreign market

39

without having too great of an exposure. Also, because they trade and work like any other ETF, they

aren't expensive to trade and are relatively liquid.

International Funds

International stock funds are comparable to international ETFs as they also provide for diversification

but have same drawbacks and benefits that are associated with regular funds and ETFs. One thing to

remember is that in these international funds, a hired professional portfolio manager is in charge and

decides what to place in the portfolio. Be sure you do your research before buying such a fund to make

sure that these investments and the trading strategy of the fund are in line with your preferences.

Foreign Securities

Many brokerage firms will offer investors the ability to buy investments from different countries

directly from the brokerage's international trading desk. So, if you wanted to buy a stock in a company

that doesn't trade on American markets, you can inquire with your brokerage to see if it will facilitate

the trade for you through one of the brokerage's affiliated international companies that has a

membership on the foreign exchange or market. Because these trades are typically more expensive and

less liquid than regular domestic trades, you should carefully check out all of the other alternatives

before you decide to do it this way.

Eurobonds

Not recommended for the beginner investor, these are bonds issued in foreign markets by domestic

companies. An example of this would be if Sony were to issue a bond that matures in yen for American

investors. Eurobonds don't always offer higher yields than domestic bonds, and they are only as secure

as the company issuing them, but they are a way you can participate in a foreign fixed-income market.

One of the main reasons that beginner investors should be wary of these bonds is that they pay a foreign

currency that the investor will probably have to exchange.

International investment or capital flows fall into four principal categories: commercial loans, official

flows, foreign direct investment (FDI), and foreign portfolio investment (FPI).

Commercial loans, which primarily take the form of bank loans issued to foreign businesses or

governments.

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Official flows, which refer generally to the forms of development assistance that developed nations give

to developing ones.

Foreign direct investment (FDI) pertains to international investment in which the investor obtains a

lasting interest in an enterprise in another country. Most concretely, it may take the form of buying or

constructing a factory in a foreign country or adding improvements to such a facility, in the form of

property, plants, or equipment.

FDI is calculated to include all kinds of capital contributions, such as the purchases of stocks, as well as

the reinvestment of earnings by a wholly owned company incorporated abroad (subsidiary), and the

lending of funds to a foreign subsidiary or branch. The reinvestment of earnings and transfer of assets

between a parent company and its subsidiary often constitutes a significant part of FDI calculations.

According to the United Nations Conference on Trade and Development (UNCTAD), the global

expansion of FDI is currently being driven by over 65,000 transnational corporations with more than

850,000 foreign affiliates.

An investor’s earnings on FDI take the form of profits such as dividends, retained earnings,

management fees and royalty payments.

Foreign portfolio investment (FPI), on the otherhand is a category of investment instruments that is

more easily traded, may be less permanent, and do not represent a controlling stake in an enterprise.

These include investments via equity instruments (stocks) or debt (bonds) of a foreign enterprise which

does not necessarily represent a long-term interest.

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Stocks:

dividend payments

holder owns a part of a company

possible voting rights

open-ended holding period

Bonds:

interest payments

ownership of bond rights only

no voting rights

specific holding period

While FDI tends to be commonly undertaken by multinational corporations, FPI comes from my

diverse sources such as a small company’s pension or through mutual funds held by individuals.

The returns that an investor acquires on FPI usually take the form of interest payments or dividends.

Investments in FPI that are made for less than one year are distinguished as short-term portfolio flows.

FPI flows tend to be more difficult to calculate definitively, because they comprise so many different

instruments, and also because reporting is often poor. Estimates on FPI totals generally vary from levels

equaling half of FDI totals, to roughly one-third more than FDI totals.

The difference between FDI and FPI can sometimes be difficult to discern, given that they may overlap,

especially in regard to investment in stock. Ordinarily, the threshold for FDI is ownership of “10

percent or more of the ordinary shares or voting power” of a business entity (IMF Balance of Payments

Manual, 1993).

Calculating Investment: Calculations of FDI and FPI are typically measured as either a “flow,” referring

42

to the amount of investment made in one year, or as “stock,” measuring the total accumulated

investment at the end of that year.

Until the 1980s, commercial loans from banks were the largest source of foreign investment in

developing countries. However, since that time, the levels of lending through commercial loans have

remained relatively constant, while the levels of global FDI and FPI have increased dramatically. Over

the period 1991-1998, FDI and FPI comprised 90 percent of the total capital flows to developing

countries. Over the period of 1996-2006, FDI and FPI outflows from the United States more than

doubled (International Monetary Fund, 2007). Global FDI flows decreased significantly from 2007-

2009 due to the Financial Crisis and finally started rising again in 2010.

Similarly, when viewed against the tremendous and growing volume of FDI and FPI, the funds

provided in the past by governments through official development assistance, or lending by commercial

banks the World Bank or IMF, are diminishing in importance with each passing year. Therefore, when

one talks about the recent phenomenon of globalization, one is referring in large part to the effects of

FDI and FPI, and these two instruments will therefore be the primary focus of this Issue in Depth.

Conclusion

Aside from allocating assets amongst different securities and industries, international investing is a

good alternative for diversification. It reduces the impact investors experience from the downturn of a

specific economy and helps to increase returns on portfolios concentrated in domestic markets that are

no longer growing at a rapid rate. Furthermore, the availability for international products has increased

dramatically with the globalization of equity markets, so even the average investor can take advantage

of the benefits without paying too much. Before you decide upon diversifying internationally, be sure

you research your investment closely so that you can make an informed decision.

Factors affecting Foreign Investment

Factors Affecting Foreign investment Decision

(1) Stable, predictable macro economic policy.

(2) An effective and honest government.

(3) A large and growing market.

43

(4) Freedom of activity in the market.

(5) Minimal government regulation.

(6) Property rights at1d protection.

(7) Reliable 'infrastructure:

(8) Availability of high-quality factors of production.

(9) A strong local currency.

(10) The ability to remit profits, dividends and interest.

(11) A fayourable tax climate.

(12) Freedom to operate between markets

UNIT-IV

International finance environment; main exchange rate regimes; International monetary system and

IMF; European monetary system and the ‘Euro’; World bank (IBRD, IDA & IFC); Euro Markets and

their working.

International Finance Environment

An international financial environment represents the conditions for activity in the economy or in the

financial markets around the world. It can be influenced by something major, such as the credit

worthiness of one country's debt. Governments, corporations, and other investors around the world

participate in purchasing the debt of other nations as profit opportunities arise. A downgrade of a

country's debt by a rating's agency could damage the value of that country's debt and suggest that a

default might be imminent. These conditions have the potential to trigger a sell-off, which is when there

are more sellers than buyers of risky debt in the markets.

A brief definition of the global financial system (GFS) is: The financial system consisting of

institutions, their customers, and financial regulators that act on a global level.

The WHO defines it as "...various official and legal arrangements that govern international financial

flows in the form of loan investment, payments for goods and services, interest and profit remittances.

The main elements are the surveillance and monitoring of economic and financial stability, and

44

provision of multilateral finance to countries with balance of payments difficulties. The organization at

the centre of the system is the International Monetary Fund (IMF), which has the mandate to ensure its

effective running.".

The Financial Times lexicon defines it as:"..interplay of financial companies, regulators and

institutions operating on a supranational level. The global financial system can be divided into

regulated entities (international banks and insurance companies), regulators, supervisors and

institutions like the European Central Bank or the International Monetary Fund.The system also

includes the lightly regulated or non-regulated bodies - this is known as the “shadow banking” system.

Mainly, this covers hedge funds, private equity and bank sponsored entities such as off-balance-sheet

vehicles that banks use to invest in the financial markets."[2].

The term global is often used synonymously with the terms "international" or "multinational".

Economists do not have a standard definition for a global versus a multinational company. [3].

Main Exchange Rate Regims

An exchange-rate regime is the way an authority manages its currency in relation to other currencies

and the foreign exchange market. It is closely related to monetary policy and the two are generally

dependent on many of the same factors.

The basic types are a floating exchange rate, where the market dictates movements in the exchange rate;

a pegged float, where a central bank keeps the rate from deviating too far from a target band or value;

and a fixed exchange rate , which ties the currency to another currency, mostly more widespread

currencies such as the U.S. dollar or the euro or a basket of currencies.

Types

Float

Floating rates are the most common exchange rate regime today. For example, the dollar, euro, yen, and

British pound all are floating currencies. However, since central banks frequently intervene to avoid

excessive appreciation or depreciation, these regimes are often called managed float or a dirty float.

45

Pegged float

Pegged floating currencies are pegged to some band or value, either fixed or periodically adjusted.

Pegged floats are:

Crawling bands

The rate is allowed to fluctuate in a band around a central value, which is adjusted periodically. This is

done at a preannounced rate or in a controlled way following economic indicators.

Fixed

Fixed rates are those that have direct convertibility towards another currency. In case of a separate

currency, also known as a currency board arrangement, the domestic currency is backed one to one by

foreign reserves. A pegged currency with very small bands (< 1%) and countries that have adopted

another country's currency and abandoned its own also fall under this category.

Dollarization

Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of

the domestic currency. The term is not only applied to usage of the United States dollar, but generally

to the use of any foreign currency as the national currency. Zimbabwe is a good example of

dollarization since the collapse of the Zimbabwean dollar.

International Monetary System

International monetary systems are sets of internationally agreed rules, conventions and supporting

institutions, that facilitate international trade, cross border investment and generally the reallocation of

capital between nation states. They provide means of payment acceptable between buyers and sellers of

different nationality, including deferred payment. To operate successfully, they need to inspire

confidence, to provide sufficient liquidity for fluctuating levels of trade and to provide means by which

global imbalances can be corrected. The systems can grow organically as the collective result of

numerous individual agreements between international economic factors spread over several decades.

Alternatively, they can arise from a single architectural vision as happened at Bretton Woods in 1944.

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IMF

The International Monetary Fund (IMF) is an organization of 188 countries, working to foster global

monetary cooperation, secure financial stability, facilitate international trade, promote high employment

and sustainable economic growth, and reduce poverty around the world.

The International Monetary Fund (IMF) is an international organization that was initiated in 1944 at

the Bretton Woods Conference and formally created in 1945 by 29 member countries. The IMF's stated

goal was to stabilize exchange rates and assist the reconstruction of the world’s international payment

system post-World War II. Countries contribute money to a pool through a quota system from which

countries with payment imbalances can borrow funds temporarily. Through this activity and others such

as surveillance of its members' economies and policies, the IMF works to improve the economies of its

member countries.[1] The IMF describes itself as “an organization of 188 countries, working to foster

global monetary cooperation, secure financial stability, facilitate international trade, promote high

employment and sustainable economic growth, and reduce poverty around the world.” [2] The

organization's stated objectives are to promote international economic cooperation, international trade,

employment, and exchange rate stability, including by making financial resources available to member

countries to meet balance of payments needs.[3] Its headquarters are in Washington, D.C., United States.

Functions

The IMF works to foster global growth and economic stability. It provides policy advice and financing

to members in economic difficulties and also works with developing nations to help them achieve

macroeconomic stability and reduce poverty.[42] The rationale for this is that private international capital

markets function imperfectly and many countries have limited access to financial markets. Such market

imperfections, together with balance of payments financing, provide the justification for official

financing, without which many countries could only correct large external payment imbalances through

measures with adverse effects on both national and international economic prosperity. [43] The IMF can

provide other sources of financing to countries in need that would not be available in the absence of an

economic stabilization program supported by the Fund.

Upon initial IMF formation, its two primary functions were: to oversee the fixed exchange rate

arrangements between countries,[44] thus helping national governments manage their exchange rates and

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allowing these governments to prioritize economic growth,[45] and to provide short-term capital to aid

balance-of-payments.[44] This assistance was meant to prevent the spread of international economic

crises. The Fund was also intended to help mend the pieces of the international economy post the Great

Depression and World War II.[46]

The IMF’s role was fundamentally altered after the floating exchange rates post 1971. It shifted to

examining the economic policies of countries with IMF loan agreements to determine if a shortage of

capital was due to economic fluctuations or economic policy. The IMF also researched what types of

government policy would ensure economic recovery.[47] The new challenge is to promote and

implement policy that reduces the frequency of crises among the emerging market countries, especially

the middle-income countries that are open to massive capital outflows.[48] Rather than maintaining a

position of oversight of only exchange rates, their function became one of “surveillance” of the overall

macroeconomic performance of its member countries. Their role became a lot more active because the

IMF now manages economic policy instead of just exchange rates.

In addition, the IMF negotiates conditions on lending and loans under their policy of conditionality,[44]

which was established in the 1950s.[46] Low-income countries can borrow on concessional terms, which

means there is a period of time with no interest rates, through the Extended Credit Facility (ECF), the

Standby Credit Facility (SCF) and the Rapid Credit Facility (RCF). Nonconcessional loans, which

include interest rates, are provided mainly through Stand-By Arrangements (SBA), the Flexible Credit

Line (FCL), the Precautionary and Liquidity Line (PLL), and the Extended Fund Facility. The IMF

provides emergency assistance via the newly introduced Rapid Financing Instrument (RFI) to all its

members facing urgent balance of payments needs.[49]

European Monetary System and Euro

The European Monetary System (EMS) was the forerunner of Economic and Monetary Union (EMU),

which led to the establishment of the Euro. It was a way of creating an area of currency stability

throughout the European Community by encouraging countries to co-ordinate their monetary policies.

It used an Exchange Rate Mechanism (ERM) to create stable exchange rates in order to improve trade

between EU member states and thus help the development of the single market. Stable money had been

a key part of international economic calculations since World War II. However, by the 1980s, opinion

about it was much more divided. As a result, not all countries took part in the EMS straight away, and

48

there were deeper splits in the years to come over the role of the EU in setting monetary policy as the

EMS was replaced with the Euro.

History

The EMS was launched in 1979 to help lead to the ultimate goal of EMU that had been set out in the

Werner Report (1970). Since World War II, attempts had been made to maintain currency stability

amongst major currencies through a system of fixed exchange rates called the Bretton Woods System.

This collapsed in the early 1970s. However, European leaders were keen to maintain the principle of

stable exchange rates rather than moving to the policy of floating exchange rates that was gaining

popularity in the USA. This led them to create the EMS. It was not an entirely successful move

because, firstly, it posed many technical difficulties in setting the correct rate for all member states, and

secondly, some members were less committed to it than others. Britain didn't join the ERM until 1990

and was forced to leave it in 1992 because it could not keep within the exchange rate limits. The

project, however, continued: under the Maastricht Treaty (1992), the EMS became part of the wider

project for EMU that was developed during the 1990s. When the Euro came into being in 1999, the

EMS was effectively wound up, although the ERM remained in operation.

How did the European Monetary System work?

The most important part of the EMS was the Exchange Rate Mechanism. This committed all member

states' governments to keep their currency exchange rates within bands. This meant that no country's

exchange rate could fluctuate more than 2.25% from a central point. This was designed to help create

stable commerce without the fear that sudden changes in the values of currencies would dampen trade

and encourage the development of trading barriers between member states.

It also created a European Currency Unit (ECU) to be used as a unit of account. Although not a real

currency, the ECU became the basis for the idea of creating a single currency - an idea that was realised

with the launch of the Euro in 1999.

World Bank

The World Bank is an international financial institution that provides loans [3] to developing countries

for capital programs.

49

The World Bank's official goal is the reduction of poverty. According to the World Bank's Articles of

Agreement (as amended effective 16 February 1989), all of its decisions must be guided by a

commitment to promote foreign investment, international trade, and facilitate capital investment.[4]

The World Bank differs from the World Bank Group, in that the World Bank comprises only two

institutions: the International Bank for Reconstruction and Development (IBRD) and the International

Development Association (IDA), whereas the latter incorporates these two in addition to three more: [5]

International Finance Corporation (IFC), Multilateral Investment Guarantee Agency (MIGA), and

International Centre for Settlement of Investment Disputes (ICSID).

International Bank for Reconstruction and Development

The International Bank for Reconstruction and Development (IBRD) aims to reduce poverty in middle-

income countries and creditworthy poorer countries by promoting sustainable development through

loans, guarantees, risk management products, and analytical and advisory services. Established in 1944

as the original institution of the World Bank Group, IBRD is structured like a cooperative that is owned

and operated for the benefit of its 188 member countries.

IBRD raises most of its funds on the world's financial markets and has become one of the most

established borrowers since issuing its first bond in 1947. The income that IBRD has generated over the

years has allowed it to fund development activities and to ensure its financial strength, which enables it

to borrow at low cost and offer clients good borrowing terms.

The oldest of the World Bank agencies - the International Bank for Reconstruction and Development

(IBRD) - was set up in 1944 at a conference convened in the town of Bretton Woods, New Hampshire,

at the end of the Second World War with the original intention of providing low interest loans to

Europe and Japan to help rebuild their infrastructure after the devastation of the war. This plan was

scuppered when these countries opted instead to take money from the United States Marshall Plan,

50

which provided grants (money that does not have to be repaid), for the same purpose. Over the next

few decades the IBRD rewrote its original mandate to provide cheap loans to the Third World instead.

The two men who shaped the institution were probably John Maynard Keynes, the brains behind the

Bretton Woods conference (also the architect of the Gross National Product economic indicator) and

Robert McNamara, who headed up the World Bank in the 1970s, after he left his job at the Pentagon

spearheading the Vietnam War for the United States. Today the IBRD's policies are dictated by the

member countries who run the institution. Although almost every country in the world is a member, the

agency is ruled on the principal "one dollar, one vote" and so it is controlled by the US, the UK, Japan,

Germany, France, Canada, and Italy -- the "Group of 7," which holds over 40% of the votes on their

boards

In fiscal 1999, the IBRD loaned out US$22.2 billion, up from US$21 billion dollars the previous year,

making it the biggest source of development capital for Third World countries and the former Soviet

bloc. Many of these loans are for major industrial development projects like dam building, power plants

and mining for non-renewable resources like gold and copper. In addition the IBRD dispenses loans for

social matters such as education and health but these loans are often linked to strict economic policies

such as Structural Adjustment Programs that have often exacerbated local problems. Finally because

these loans are often designed in Washington by the Bank's own staff, they often reflect theoretical

models that have little relevance in the borrowing countries.

A leaked May 1999 draft Bank review of structural and sectoral adjustment loans severely criticized

their treatment of environmental and social issues. The review assessed 54 such loans approved

between July 1997 and December 1998 and found that only 20% contained a environmental goals or

conditionalities - down from 60% in 1994. Furthermore, according to the document, ''the majority of

loans do not address poverty directly, the likely economic impact of proposed operations on the poor,

or ways to mitigate negative effects of reform.''

Although most projects did achieve their short-term physical objectives, according to the report, only

44% were likely to be sustained after completion - largely because staff appraisals underestimated the

projects' recurrent costs, which would have to be borne by the agency's borrowers.

The IBRD makes loans to countries at the best possible market rates because its bonds have the highest

51

possible credit rating on Wall Street. The agency has this high rating because almost all its borrowers

pay their loans back on time, although the way many borrowers do this is by taking out fresh loans. In

fact the Bank often receives more money in debt repayments than it makes in loans. Contrary to public

opinion, the agency is not even a non-profit organization: the Bank routinely makes a billion dollars in

profits every year on the loans it makes.

IBRD has three major sister agencies - the International Development Agency (IDA), the International

Finance Corporation (IFC) and the Multilateral Investment Guarantee Agency. These four and the

much smaller International Center for the Settlement of Investment Disputes (ICSID) make up the

World Bank group. Unlike the IBRD the IDA makes loans at almost no interest over much longer

periods of time (a 0.5% handling fee is charged) to the poorest countries. This agency loaned out

US$6.8 billion dollars in fiscal 1999, down from the US$7.5 billion dollars that it loaned out in 1998.

The IFC and MIGA do not make loans to countries. Instead the IFC makes loans to private

corporations that have projects in the Third World and former Soviet bloc. This includes major

multinational corporations like Shell and Coca-Cola. MIGA provides political risk insurance to

companies that are worried that their assets may be seized by local governments or destroyed in war or

other civil disturbances.

The region that received the most loans from IBRD and IDA was East Asia and the Pacific, struggling

to recover from the financial crisis of 1997-98, with US$9.8 billion, followed by Latin America and the

Caribbean with US$7.7 billion. The region suffered ripple effects from the East Asian meltdown as

well as the ravages of Hurricane Mitch, which struck Central America in October, 1998. Europe and

Central Asia came third, with US$5.3 billion in new commitments, followed by South Asia US$2.6

billion, sub- Saharan Africa with US$2.1 billion and the Middle East and North Africa with US$1.6

billion.

Argentina is the Bank's largest borrower with US$3.2 billion in commitments from the Bank in fiscal

1999, followed by Indonesia, with US$2.7 billion in commitments, China with US$2.1 billion, South

Korea with US$2 billion, Russia with US$1.9 billion, Brazil with US$1.7 billion, Thailand with

US$1.3 billion, India with US$1.1 billion, Bangladesh US$1 billion, and Mexico with US$950 million.

Financing designed to support over-arching policy themes such as privatization of state enterprises and

52

commercialization of services dominated the new commitments, with loans for 'multi- sector' projects

and policy reforms amounting to US$10.3. Some US$4.5 billion went to transportation, industrial, oil

and gas, energy and mining projects, with another US$2.8 billion for agriculture, US$753 million for

water and sanitation and US$647 million dollars for urban development. Population, health and

nutrition projects accounted for another US$1.1 billion dollars. Education garnered US$1.3 billion and

US$2.7 billion were earmarked for social programs. Environmental lending amounted to US$540

million.

IFC

The International Finance Corporation (IFC) is an international financial institution which offers

investment, advisory, and asset management services to encourage private sector development in

developing countries. The IFC is a member of the World Bank Group and is headquartered in

Washington, D.C., United States. It was established in 1956 as the private sector arm of the World

Bank Group to advance economic development by investing in strictly for-profit and commercial

projects which reduce poverty and promote development. The IFC's stated aim is to create opportunities

for people to escape poverty and achieve better living standards by mobilizing financial resources for

private enterprise, promoting accessible and competitive markets, supporting businesses and other

private sector entities, and creating jobs and delivering necessary services to those who are poverty-

stricken or otherwise vulnerable. Since 2009, the IFC has focused on a set of development goals which

its projects are expected to target. Its goals are to increase sustainable agriculture opportunities,

improve health and education, increase access to financing for microfinance and business clients,

advance infrastructure, help small businesses grow revenues, and invest in climate health.

53

The IFC is owned and governed by its member countries, but has its own executive leadership and staff

which conduct its normal business operations. It is a corporation whose shareholders are member

governments which provide paid-in capital and which have the right to vote on its matters. Originally

more financially integrated with the World Bank Group, the IFC was established separately and

eventually became authorized to operate as a financially autonomous entity and make independent

investment decisions. It offers an array of debt and equity financing services and helps companies face

their risk exposures, while refraining from participating in a management capacity. The corporation also

offers advice to companies on making decisions, evaluating their impact on the environment and

society, and being responsible. It advises governments on building infrastructure and partnerships to

further support private sector development.

The corporation is assessed by an independent evaluator each year. In 2011, its evaluation report

recognized that its investments performed well and reduced poverty, but recommended that the

corporation define poverty and expected outcomes more explicitly to better-understand its effectiveness

and approach poverty reduction more strategically. The corporation's total investments in 2011

amounted to $18.66 billion. It committed $820 million to advisory services for 642 projects in 2011,

and held $24.5 billion worth of liquid assets. The IFC is in good financial standing and received the

highest ratings from two independent credit rating agencies in 2010 and 2011.

Euro Markets and their working

Euromarkets

These can broadly be classified as Eurocurrency and Eurobond markets. We want to focus on how

MNCs can use these international markets to meet their financing requirements.

Euromarkets (occasionally called ‘xenomarkets’) are markets on which banks deal in a currency other

than their own. For example, eurodollars are dollars held by banks outside the United States. The prefix

‘euro’ refers to the fact that such deposits first appeared in Europe in around 1955. The origins of the

eurodollar are traceable partly to the Cold War, when the USSR (in particular) desperately needed

international liquidity – dollars -  but did not want to hold them in the United States. The rise of the

dollar as an international currency encouraged companies world-wide to hold dollar cash reserves, and

banks to ask for dollars on deposit. Some countries decided that such deposits did not need to be so

54

closely regulated as deposits in the national currency because they did not affect the internal money

supply. This produced a very liberal loan market, particularly in comparison with the prevailing heavy

post-war regulation. On top of that, America’s Q regulation (put in place by the 1933 Glass Steagall

Act) set a ceiling on the interest rates payable on bank deposits and so savers looked for more attractive

rates elsewhere. Similarly, eurobonds benefited from an equalisation tax imposed in 1963 on interest

payable on foreign issues placed in the USA.

London played a key role in the development of euromarkets. Eurodollar loans, still negligible in 1958,

rose to 25 billion dollars in 1968 and 130 billion in 1973. At that time London accounted for almost

80% of the market, which was still largely controlled by London branches of foreign banks – mostly

American, but also some French, Japanese and German. By 1975 there were 243 such subsidiaries in

London.

While the main incentive for the development of euromarkets was the avoidance of national

regulations, their development also helped to weaken those same regulations by providing both

borrowers and lenders with alternatives to nationally regulated solutions. The logical outcome of

euromarkets was the liberalisation of capital movements. They undoubtedly represented one nail in the

coffin of the Bretton Woods fixed exchange rate scheme, which assumed that central banks were

capable of controlling exchange rates; this they could only do if they could control capital flows, at

least in the short term.

At present, the term ‘euromarket’ is less often employed, since lending in a currency other than that of

the borrower or lender has now become commonplace.

Eurocurrency market

Definition and background

The Eurocurrency market consists of banks (called Eurobanks) that accept deposits and make loans in

foreign currencies. A Eurocurrency is a freely convertible currency deposited in a bank located in a

country which is not the native country of the currency. The deposit can be placed in a foreign bank or

in the foreign branch of a domestic US bank.

55

In the Eurocurrency market, investors hold short-term claims on commercial banks which intermediate

to transform these deposits into long-term claims on final borrowers.

The Eurocurrency market is dominated by US $ or the Eurodollar. Occasionally, during weak dollar

periods (latter part of 1970s and 1980s), the EuroSwiss franc and the EuroDM markets increased in

importance. The Eurodollar market originated post WWII in France and England thanks to the fear of

Soviet Bloc countries that dollar deposits held in the US may be attached by US citizens with claims

against communist governments!

Thriving on government regulation

By using Euromarkets, banks and financiers are able to circumvent / avoid certain regulatory costs and

restrictions. Some examples are:

a) Reserve requirements

b) Requirement to pay FDIC fees

c) Rules or regulations that restrict competition among banks

Continuing government regulations and taxes provide opportunities to engage in Eurocurrency

transactions. However, ongoing erosion of domestic regulations have rendered the cost and return

differentials much less significant than before. As a result, the domestic money market and

Eurocurrency markets are closely integrated for most major currencies, effectively creating a single

worldwide money market for each participating currency.

Illustration I

German firm sells medical equipment to institutional buyer in the US. It receives a US$ check drawn

on Citicorp, NY. Initially this check is deposited in a checking account for dollar working capital use.

But to earn a higher return (or rate of interest) on the $ 1 million the German firm decides to place the

funds in a time deposit with a bank in London, UK.

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One million Eurodollars have thus been created by substituting a dollar account in a London bank for

the dollar account held in NY. Notice that no US $ left NY but ownership of the US deposit has moved

from a foreign corporation to a foreign bank. The London bank would not like to leave the funds idle in

NY account. If a government or commercial borrower is unavailable, the London bank will place the $

1 million in the London interbank market. The interest rate at which such interbank loans are made is

called the London interbank offer rate (LIBOR).

This example demonstrates that the Eurocurrency market is a chain of deposits and a chain of

borrowers and lenders. The majority of Eurocurrency transactions involve transferring control of

deposits from one Eurobank to another Eurobank. Loans to non-Eurobank borrowers account for less

than half of all Eurocurrency loans.

The Eurocurrency market operates like any other financial market, but for the absence of government

regulations on loans that can be made and interest rates that can be charged.

Eurocurrency loans

Eurocurrency loans are made on a floating – rate basis.

Interest rates on loans to governments, corporations and nonprime banks are set at a fixed margin above

LIBOR for a given period and currency.

Example

If the margin is 75 basis points (b.p.) and the current LIBOR is 6%, the borrower is charged 6.75% for

the relevant period. LIBOR is the underlying variable rate of interest, usually set for a 6 month period.

The margin or spread between the lending bank’s cost of funds and the interest charged by the borrower

is based on the borrower’s perceived creditworthiness / riskiness. The spreads can range from 15 b.p.

to more than 300 b.p., the median of the range varying from 100 to 200 b.p.

The maturity of the Eurocurrency loan can range from 3 to 10 years. Eurocurrency loans are made by

bank syndicates. The bank originating the loan becomes the lead bank managing the syndicate, inviting

one or two other banks to be co-managers of the loan. The borrower is charged a one-time syndication

57

fee ranging from 0.25 % to 2 % of the loan value according to the size and type of the Eurocurrency

loan.

The drawdown [period over which the borrower may use the loan] of the loan and the repayment period

vary in accordance with the borrower’s needs. A commitment fee of about 0.5 % per annum is paid on

the unused balance, and prepayments in advance of the agreed upon schedule are permitted but are

sometimes subject to a penalty fee.

i) EAC of Eurocurrency loan

A corporate borrower has arranged a DM 500 million, five-year EuroDM loan with a bank syndicate

led by two managing banks. The upfront syndication fee is 2 %.

Net proceeds to the borrower = $ 500 mn – 0.02 (US $ 500 mn) = DM 490 mn.

The interest rate on the EuroDM loan is LIBOR + 1.75 %, with LIBOR reset every 6 months. If the

initial LIBOR6 rate for DM is 6 %, the first semiannual debt service payment is:

[(0.06 + 0.0175) / 2] * DM 500 mn = DM 19.3750 mn

Therefore the borrower’s effective annual rate (EAC) for the first six months is:

[DM 19.3750 mn / DM 490 mn] * 2 * 100 = 7.9082 %

This EAC changes in every reset period (in this case 6 months) with LIBOR6.

ii) Multicurrency loans

Though most Eurocurrency loans are Eurodollar loans, these often come with a multicurrency clause.

This clause gives the borrower the right (subject to availability) to switch from one currency to another

on any rollover (or reset) date. This option allows the borrower to match currencies with cash inflows

and outflows (which is an effective way of managing exposure to currency risk, and thus an effective

risk-management technique). The option also allows borrowers to take advantage of its own

expectations regarding currency changes and search for funds with the lowest effective cost.

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iii) Interest rates

Interest rates in national and Eurocurrency markets are closely linked through arbitrage.

US $ credit markets Sterling credit markets

US lending rate UK lending rate

Eurodollar lending rate Eurosterling lending rate

Eurodollar deposit rate Eurosterling deposit rate

US deposit rate UK deposit rate

The difference between the Euro$ deposit rate and the Eurosterling deposit rate is given by the forward

discount or premium (which approximates the expected change in the dollar/pound exchange rate).

Eurobond markets

Eurobonds are bonds sold outside the country whose currency they are dominated in. They are similar

in many ways to public debt sold in domestic capital markets. However, the Eurobond market is

entirely free of official regulation and is self-regulated by the Association of International Bond

Dealers.

Borrowers in the Eurobond market are typically well known and have impeccable credit ratings (for

example, developed countries, international institutions, and large MNCs). The Eurobond market has

grown rapidly in the last two decades, and it exceeds the Eurocurrency market in size.

i)Currency denomination

About 75 % of Eurobonds are dollar denominated. The most important nondollar currencies for

Eurobond issues are DM and FF (now rapidly replaced by the euro), the JY and the BP [The Swiss

central bank ban has led to the absence of SF Eurobonds].

ii)Fixed – rate Eurobonds

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Fixed-rate Eurobonds pay coupons once a year, unlike the semiannual coupon, domestic bonds in the

US market. Borrowers compare the all-in cost, that is, the effective interest rate, on Eurobonds and

domestic bonds.

This interest rate is calculated as the discount rate that equates the present value of the future interest

and principal payments to the net proceeds received by the issuer, or as the IRR of the bond.

iii) Comparing Eurobond issue with a US domestic issue

To compare a Eurobond issue with a US domestic issue, therefore, the all-in cost of funds on an annual

basis must be converted to a semiannual basis or vice versa. Thus,

Semiannual yield = [1 + Annual yield]^0.5 – 1, and (1)

Annual yield = [1 + Semiannual yield]^2 – 1. (2)

Illustration II

P & G plans to issue a 5-year bond with a face value of $ 100 million. Its investment banker estimates

that a Eurobond issue would have to bear a 7.5 % coupon and that fees and other expenses will total $

738,000 providing net proceeds to P & G of $ 99,262,000.

Exhibit 1 shows the cashflows associated with the Eurobond issue. The all-in cost (IRR) of this issue,

which is an annual rate, is shown as 7.68 %. As a cross – check, the third column shows that the PV of

the cashflows, using a discount rate of 7.68 %, sum to P & G ‘s net proceeds of $ 99,262,000.

Alternatively, P & G can issue a $ 100 million, 5-year bond in the US market with a coupon of 7.4 %.

With estimated issuance costs of $ 974,000, P & G will receive net proceeds of $ 99,026,000.

Exhibit 2 shows the cashflows associated with this issue and its all-in cost (IRR) of 3.82 %. Note that

the cashflows are semiannual, as is the all-in cost. Again, the third column does a cross-check to

confirm the 3.82 % all-in cost.

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According to Equation (1) above, the equivalent semiannual all-in cost for the Eurobond issue is

(1.0768)^0.5 – 1 = 3.77 %. Thus, the all-in cost of the Eurobond is lower, making it preferable if all

other terms and conditions on the two bonds are the same.

Alternatively, using Equation (2) above, we can convert the US bond yield to its annual equivalent and

compare that figure to the Eurobond yield of 7.68 %. This computation would have yielded an

annualized all-in cost of the US bond issue equal to (1.0382)^2 – 1 = 7.78 %. As before, the Eurobnd

issue is preferable because its all-in cost is 10 basis points lower.

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