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Module I

FOUNDATION OF INTERNATIONALBUSINESS

1.0 Learning Outcomes

� Introduction

� Origin of international business

� Multinational Enterprises

� International Marketing

� International Trade Theories

� The Product Life Cycle Theory

1.1 Introduction

The beverages you drink might be produced in India, but with the collaboration of a USA company, thetea you drink is prepared from the tea powder produced in Sri Lanka. The spares and hard-disk of thecomputer you operate might have been produced in the United States, of America. The perfume youapply might have been produced in France. The television you watch might have been produced withthe Japanese technology; the shoes you wear might have been produced in Taiwan, but remarketed byan Italian company. Your air-travel services might have been provided to you by Air-France and so onso forth.

2 MBA - IV Semester - International Business

Most of you have the experience of browsing internet and visiting different web sites, knowing theproducts and services offered by various companies across the globe. Some of you might have theexperience of even ordering and buying the products through internet. This process gives you theopportunity of transacting in the international business arena without visiting or knowing the variouscountries’ and companies across the globe.

You get all these even without visiting or knowing the country of the company where they are produced.All these activities have become a reality due to the operations and activities of international business.

Thus, international business is the process of focusing on the resources ·of the globe and objectives ofthe organizations on global business opportunities and threats, in order to produce, buy, sell or exchangeof goods/services world-wide.

International trade has been playing a significant role in the functioning of the national economies for along time. Even in ancient times international trade was important for the Egyptians, the Greeks, theRomans, and the Phoenicians and later for Spain, Portugal, Holland and Britain. All the great nations ofthe past that were influential world leaders were also important world traders. Nevertheless the importanceof international trade and finance in determining economic health and standard of living of a country hasnever been a pronounced as it today.

With trade liberalization and globalization, international transactions are all around us. The clothes thatwe wear, the shoes that adorn our feet, the food we eat, the car we drive, the appliances we use anddifferent services that we enjoy come from different countries. Even when we use these items made inour country, it is very likely that they are made of components outsourced from many locations outsidethe country. International trade has expanded the consumption possibility frontiers of people living indifferent countries much beyond their respective production possibility frontiers.

The increased internationalization of economic life is also experienced in terms of capital movementsbetween the countries. People now invest their capital and produce goods and own assets in othercountries on a larger scale than they did earlier.

1.2 Origin of International Business

The origin of international business goes back to human civilization. Historically periods of greateropenness to trade have been characterized by stronger but lopsided global growth. The concept ofinternational business-a broader concept relating to the integration of economies and societies, dates,back to the 19th century. The first phase of globalization began around 1870 and ended with the WorldWar I (1919) driven by the industrial revolution in the UK, Germany and the USA, The import of rawmaterials by colonial empires from their colonies and exporting finished goods to’ their overseaspossessions was the main reason for the sharp increase in the trade during this phase.

The ratio of trade to GDP was as high as 22.1 in 1913, Later various Governments initiated and

3Module 1 - Foundation of Inetrnational Business

imposed a number of barriers to trade to protect their domestic production that led to decline in theratio of trade to GDP to 9,1 during 1930s.The international trade between two world wars has beendescribed as “ a vast game of beggar-my-neighbour.”

Advanced countries experienced a severe setback consequent upon the imposition of trade barriers asthey produced in excess of domestic demand and a decline in the volume of international trade, Addedto this, the breakdown of the gold standard resulted in vacuum in the field of international trade. Thenthe world nations felt the need for international co-operation in global trade and balance of paymentsaffairs, These efforts resulted in the establishment of the International Monetary Fund (IMF) and theInternational Bank for Reconstruction and Development (IBRD-popularly known as the World Bank),

The prolonged recession before the World War II in the West, led to an international consensus afterthe World War II that a different approach towards international trade was required. Consequently, 23countries conducted negotiations in 1947 in order to prevent the protectionist policies and to revive theeconomies from recession aiming at the establishment of the International Trade Organization. Thisattempt of the advanced countries ended with the General Agreement on Trade and Tariffs (GATT) thatprovided a framework for a series of ‘rounds’ of negotiations by which tariffs were reduced. Efforts toconvert the General Agreement on Trade and Tariffs (GATT) into World Trade Organization (WTO)were intensified during 1980s and ultimately GATT was replaced by the WTO on 1’1 January 1995,envisaging trade liberalization. The efforts of IMF, World Bank and WTO along with the efforts ofindividual countries due to economic limitations of the closed economies led to the globalization ofbusiness. Globalization gave fill up to international business particularly during 1990s.

In fact, the term international business was not popular before two decades. The term internationalbusiness has emerged from the term ‘international marketing’, which, in turn, emerged from the term‘international trade.

1.2.1 International Trade

International trade is exchange of capital, goods, and services across international borders or territories.[1]

In most countries, it represents a significant share of gross domestic product (GDP). While internationaltrade has been present throughout much of history (see Silk Road, Amber Road), it’s economic, social,and political importance has been on the rise in recent centuries. Industrialization, advanced transportation,globalization, multinational corporations, and outsourcing are all having a major impact on the internationaltrade system. Increasing international trade is crucial to the continuance of globalization. Internationaltrade is a major source of economic revenue for any nation that is considered a world power. Withoutinternational trade, nations would be limited to the goods and services produced within their ownborders.

International trade is in principle not different from domestic trade as the motivation and the behavior ofparties involved in a trade does not change fundamentally depending on whether trade is across a


border or not. The main difference is that international trade is typically more costly than domestictrade. The reason is that a border typically imposes additional costs such as tariffs, time costs due toborder delays and costs associated with country differences such as language, the legal system or adifferent culture.

International trade uses a variety of currencies, the most important of which are held as foreign reservesby governments and central banks. Here the percentage of global cumulative reserves held for eachcurrency between 1995 and 2005 are shown: the US dollar is the most sought-after currency, with theEuro in strong demand as well.

Another difference between domestic and international trade is that factors of production such ascapital and labor are typically more mobile within a country than across countries. Thus internationaltrade is mostly restricted to trade in goods and services, and only to a lesser extent to trade in capital,labor or other factors of production. Then trade in goods and services can serve as a substitute fortrade in factors of production. Instead of importing the factor of production a country can import goodsthat make intensive use of the factor of production and are thus embodying the respective factor. Anexample is the import of labor-intensive goods by the United States from China. Instead of importingChinese labor the United States is importing goods from China that were produced with Chinese labor.International trade is also a branch of economics, which, together with international finance, forms thelarger branch of international economics.

1.2.2 Features of International Trade

Economists were earlier divided on the issue whether international trade has distinctive featuresnecessitating a separate study. One school felt that there is no significant difference between internationaltrade and inter-regional trade. No doubt, inter-regional trade refers to trade between two countries.Yet, when we consider a large country like India with diverse language and cultural differences and longdistances separating one region from the other, there is very little to distinguish between internationaltrade and inter-regional trade.

The other school of economists strongly felt the need for a separate study of international trade as theexistence of two sovereign states with separate legal, political and currency systems added newdimensions to international trade which are absent in interregional trade.

The differences between international and inter-regional trade is now well recognized. It is sanctionedeven by those who oppose the division that they differ in relative terms, though not absolutely.

The salient features of international trade described below also serve to distinguish it from interregionaltrade.

1. Factor Immobility – Factors of production are more mobile between regions within a countrythan between two countries. There are economic, social and political reasons for this. For


instance, countries follow protective tariff policies immigration policies and industrial policiesthat inhibit free flow of goods, labour and capital respectively between the countries. It is oftensaid that the labour is the most prevent labour going to other countries. Such factors are notpresent for movement between regions within a country.

2. Different Currencies – A critical difference between inter-regional and international trade is theuse of different currencies in foreign trade but a common currency in inter-regional trade. Sointernational trade is limited by the extent of liquidity of foreign exchange while there are nosuch restrictions in inter-regional trade.

3. Issue of balance of payments – The fact that balance of payments should balance between anytwo countries in the long run restricts the volume of demand for goods and services producedin the other nation. If the domestic country cannot export equivalent amount of exports, thenthere is a restriction on the amount of goods and services that it can import also. Such arestriction is absent for interregional trade.

4. Difference in political institutions –Regions within a country are governed by common politicalsystem. While between countries the political ideology may differ. This may result in frictions tointernational trade. For example, if India has bilateral trade connections with Russia it mayaffect our trade relations with USA

5. Different national policies – Countries may pursue various domestic policies with regard totrade, industry, commerce and so on. So trade between regions will not be affecting suchdifference. While those differences matter in international trade. For example, non-tariff barriersregarding environment, child labour, etc. may create problems in the international market.Domestic environmental laws may allow the production process of certain commodities, whilethey may be rejected in the international market.

6. Difference in constitutional policy – The constitution mandates protection of inter-regional tradeby preventing any provincial government from framing policies that obstruct trade betweenregions. On the other hand, there are constitutional provisions that enable the national governmentto frame policies that protect the domestic industries from external competition and therebyreduce free flow of international goods into domestic economy.

1.2.3 Importance of International Trade

International trade is important because it increases economic welfare through higher income andemployment of the trading countries. It helps the countries to benefit from economies of scale due toterritorial division of labour it increases the consumption possibilities of trading countries. The significanceand relevance of international trade has never been as visible or palpable as in the present context of aliberalized and global economy. The effects of trade liberalization is seen and felt in all aspects of life


from what people eat to what movies they see. The consumption possibility frontier has become anelusive and ever receding line. International trade expands the market for production and this leadsterritorial division of labour. The countries reap the advantage of economies of scale resulting fromspecialization.

The increased production leads to higher employment and higher income, higher economic welfare

People in different countries get access to increased volumes of goods and services of higher qualityand this leads to the expansion of consumption possibility frontier

With the growing importance of international trade to country’s economic health it will be instructive tounderstand the theories of international trade which explains the basis for trade between countries.

1.2.4 Current Trends in International Trade

Today’s world trade manifests certain characteristics, an understanding of which will make the study ofinternational trade more meaningful for international policy making. The following salient features areobserved from the analysis of international trade data

1.2.5 Growth in Merchandise Trade

World trade in merchandise has had a perceptible increase in the annual percentage change of 5% inthe last decade. All the regions in the world have experienced a rise in the percentage change inmerchandise trade.

Some regions like Asia, East Asian countries have grown higher than world average growth rate annually.The annual average growth in percentage terms is different across regions.

1.2.6 Commodity composition of Trade

Nearly 75% of the value of trade comes from manufacturers and 25% from primary good includingfood whose share is the largest. Developing countries have competitive advantage in primary productsand their major exports are food and allied items and developed countries mainly export manufacturedgoods and high technology products. Over the years one observes a gradual decline in the relativeshare of food in primary products. The demand for primary products tends to be goods have declined.The primary goods have not enjoyed a price rise similar to the manufactured goods. Hence developingcountries have not been able to experience the gains from trade as developed countries.


World Trade in Services

Trade in services include retail and wholesale trade, restaurants and hotels, transport, storage,communication, financial services, insurance, real estate, business services, personal services, community,social and government services.

World trade in services has grown in importance due to the fact that services account for the largestshare in income and employment in most of the developed countries and for some of the developingcountries like India.

Advantages of International Business & Trade

1. Gains from trade. Pure theories of international trade show forcefully that free trade is mutuallyadvantageous to the trading countries because it allows the countries to reap the benefits of specializationin certain goods for which each country is best suited. It also shows how the gains are shared betweenthe trading partners. Gains from trade depend upon the terms of trade which is the price ratio at whichgoods are exchanged by a country with other countries. Terms of trade again depends upon the size ofthe market, elasticity of export, import demand, tariff policy pursued by the government, and so on.

2. Pattern of trade. International trade theories tell why certain countries are best suited for theproduction of certain commodities than other countries. It tries to explain the pattern of trade—whosells what to whom and why? The earlier theories dealing with the basis for trade, Absolute CostAdvantage by Adam Smith, Comparative Cost Advantage by David Ricardo and the modern theory orFactor Endowment model by Heckscher-Ohlin all focus on finding answers to what decides the patternof trade.

3. Protectionism. Protectionism is a crucial policy issue in international economics. The countries getinvolved in eternal battle between free trade and protectionism. International economics is cruciallyconcerned with the effects of these protective tariff, and quotas on the country’s welfare. Economictheory proves the advantages of free trade formally by using theoretical tools.

4. Balance of payment. The balance of payment shows the record of a country’s economic transactionswith the rest of the world. Apart from international trade in goods and services, there are other economictransactions like capital movements among the countries. The monetary implications of all thesemovements are captured in the balance of payments. Explaining the importance of the balance ofpayment and analyzing its impact on the economy is a major theme in international economics. It alsostudies the implication of the imbalance in balance of payments accounts, the causes that give rise tobalance of payments imbalance and the alternative measures appropriate in handling them.

5. Exchange rate determination. Exchange rate is the price at which one currency is traded foranother currency. This is yet another critical issue discussed under international economics. We knowthat trading countries have different currencies. When relative prices of currencies change drasticallythe effect may be quite different on the countries’ trade outcomes. Hence knowledge of the factors


influencing exchange rate determination becomes very important. Merits and demerits of fixed us.Flexible exchange rates is a standard discussion in this context.

6. International policy co-ordination. International transactions take place between independentcountries which are free to pursue their respective monetary and fiscal policies. However such internalpolicies may affect trade and capital movements between countries in a conflicting manner. For example,when a country’s interest rate is raised by its Central Bank to control domestic inflation, this mayincrease the capital inflow into that country. Even a minor rise in the interest rate may trigger a largecapital inflow into the country and this will affect other countries’ capital inflow. Hence it is necessarythat countries adopt policies in harmony with each other. It is in this regard institutions such as GeneralAgreements on Trade and Tariff (GATT) and WTO have been founded. The fourth part of this bookdeals with WTO, its objective and role in international trade today.

7. International capital movement. Since 1960s international trade has grown along with internationalcapital movements. International capital markets are different from domestic capital markets in tworespects—first one is the currency fluctuations; relative value of the currencies fluctuates frequently.Secondly, special regulation that any country may impose on foreign investment. Even in liberalizedtrade regime, countries impose certain restrictions on foreign capital both with regard to the extent ofinvestment and the nature of investment. Countries choose to allow foreign investment in lines that areessential for domestic economy—for example, infrastructure, energy and industries that will permittransfer of technology, and so on. They use it as an instrument of industrial policy. Capital movementacross countries occurs in various forms.

Models of International Trade

The Ricardian model focuses on comparative advantage and is perhaps the most important concept ininternational trade theory. In a Ricardian model, countries specialize in producing what they producebest. Unlike other models, the Ricardian framework predicts that countries will fully specialize insteadof producing a broad array of goods. Also, the Ricardian model does not directly consider factorendowments, such as the relative amounts of labor and capital within a country.

Assumptions of the Ricardian model (1) Labor is the only primary input to production (labor is consideredto be the ultimate source of value). (2) Constant Marginal Product of Labor (MPL) (Labor productivityis constant, constant returns to scale, and simple technology. (3) Limited amount of labor in the economy(4) Labor is perfectly mobile among sectors but not internationally. (5) Perfect competition (price-takers).

The Ricardian model measures in the short-run, therefore technology differs internationally. This supportsthe fact that countries follow their comparative advantage and allows for specialization.

The Ricardian trade model was studied by Graham, Jones, McKenzie and others. All the theoriesexcluded intermediate goods, or traded input goods such as materials and capital goods. Recently, thetheory was extended to the case that includes traded intermediates. Thus the assumption (1) was

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removed from the theory. McKenzie (1954), Jones (1961) and Samuelson (2001) emphasized thatconsiderable gains from trade would be lost once intermediate goods were excluded from trade. In afamous comment McKenzie pointed that “A moment’s reflection will convince that Lancashire wouldnot be unlikely to produce cotton cloth if the cotton has to be grown in England.”

Heckscher-Ohlin model

The Heckscher-Ohlin model was produced as an alternative to the Ricardian model of basic comparativeadvantage. Despite its greater complexity it did not prove much more accurate in its predictions. Howeverfrom a theoretical point of view it did provide an elegant solution by incorporating the neoclassical pricemechanism into international trade theory.

The theory argues that the pattern of international trade is determined by differences in factor endowments.It predicts that countries will export those goods that make intensive use of locally abundant factors andwill import goods that make intensive use of factors that are locally scarce. Empirical problems with theH-O model, known as the Leontief paradox, were exposed in empirical tests by Wassily Leontief whofound that the United States tended to export labor intensive goods despite having capital abundance.

Core assumptions of the H-O model: (1) Labor and capital flow freely between sectors (2) The productionof shoes is labor intensive and computers is capital intensive (3) The amount of labor and capital in twocountries differ (difference in endowments) (4) free trade (5) technology is the same across countries(long-term) (6) Tastes are the same.

The problem with the H-O theory is that it excludes the trade of capital goods (including materials andfuels). In the H-O theory, labor and capital are fixed entities endowed to each country. In a moderneconomy, capital goods are traded internationally. Gains from trade of intermediate goods areconsiderable, as it was emphasized by Samuelson (2001).

Specific factors model

Global Competitiveness Index (2006-2007): competitiveness is an important determinant for the well-being of states in an international trade environment.

In this model, labour mobility between industries is possible while capital is immobile between industriesin the short-run. Thus, this model can be interpreted as a ‘short run’ version of the Heckscher-Ohlinmodel. The specific factors name refers to the given that in the short-run, specific factors of productionsuch as physical capital are not easily transferable between industries. The theory suggests that if thereis an increase in the price of a good, the owners of the factor of production specific to that good willprofit in real terms. Additionally, owners of opposing specific factors of production (i.e., labour andcapital) are likely to have opposing agendas when lobbying for controls over immigration of labour.Conversely, both owners of capital and labour profit in real terms from an increase in the capitalendowment. This model is ideal for particular industries. This model is ideal for understanding incomedistribution but awkward for discussing the pattern of trade.

Module 1 - Foundation of Inetrnational Business


1.3 International Marketing

International marketing refers to marketing carried out by companies overseas or across nationalborderlines. This strategy uses an extension of the techniques used in the home country of a firm.International marketing is simply the application of marketing principles to more than one country.However, there is a crossover between what is commonly expressed as international marketing andglobal marketing, which is a similar term.

The intersection is the result of the process of internationalization. Many American and European authorssee international marketing as a simple extension of exporting, whereby the marketing mix 4P’s issimply adapted in some way to take into account differences in consumers and segments. It thenfollows that global marketing takes a more standardized approach to world markets and focuses uponsameness, in other words the similarities in consumers and segments. So let’s take a look at somegenerally accepted definitions.

At its simplest level, international marketing involves the firm in making one or more marketing mixdecisions across national boundaries. At its most complex level, it involves the firm in establishingmanufacturing facilities overseas and coordinating marketing strategies across the globe.

So, as with many other elements of marketing, there is no single definition of international marketing,and there could be some confusion about where international marketing begins and global marketingends. These lessons will assume that both terms are interchangeable, and will define international marketingas follows:

International marketing is simply the application of marketing principles to more than one country. Theprocess of globalisation also provide a country to have a hidden attack to another.

International marketing is often not as simple as marketing your product to more than one nation.Companies must consider language barriers, ideals, and customs in the market they are approaching.Tailoring your marketing strategies to attract the specific group of people you are attempting to sell tobe highly important and can serve the number one cause of failure or success.

International Trade to International Marketing

Originally, the producers used to export their products to the nearby countries and gradually extendedthe exports to far-off countries. Gradually, the companies extended the operations beyond trade. Forexample India used to export raw cotton, raw jute and iron ore during the early 1900s. The massiveindustrialization in the country enabled us to export jute products, cotton garments and steel during1960s.

India, during 1980s could create markets for its products, in addition to mere exporting. The exportmarketing efforts include creation of demand for Indian products like textiles, electronics, leather products,tea, coffee etc., arranging for appropriate distribution channels, attractive packaging, productdevelopment, pricing etc. This process is true not only with India, but also with almost all developedand developing economies.

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International Marketing to International Business

The multinational companies which were producing the products in their home countries and marketingthem in various foreign countries before 1980s, started locating their plants ‘and other manufacturingfacilities in foreign/ host countries. Later, they started producing in one foreign country and marketing inother foreign countries. For example Uni Lever established its subsidiary company in .India, i.e., HindustanLever Limited (HLL). HLL produces its products in India and markets them in Bangladesh, Sri Lanka,Nepal etc., Thus, the scope of the international trade is expanded into international marketing andinternational marketing is expanded into international business.

The 1990s and the new millennium clearly indicate rapid internationalization and globalization. Theentire globe is passing at a dramatic pace through the transition period. Today, the international traderis in a position to analyze and interpret the global, social, technical, economic, political and naturalenvironmental factors more clearly. Figure 1.1 presents international business model consisting influencingenvironmental factors, stages, approaches, and modes of entry, goals’ of and advantages of internationalbusiness)

Figure 1: International Business Model



Declining Trade Barriers

Another significant driver of globalization is the declining trade barriers. International trade occurs whenthe goods flow across the countries. Governments used to impose trade barriers’ like quotas and tariffsin order to protect domestic business from the competition of international business. Advanced countriesafter World War II agreed to reduce tariffs in order to encourage free flow of goods. The membercountries of the General Agreement on Trade and tariff (GAIT) in various rounds of ‘negotiationsagreed to reduce the tariff rates. The Uruguay round of negotiations contributed to further reduction oftrade barriers and extension of GAIT to cover manufactured goods and services.

Consequently, the USA reduced the rate of tariffs from 44% in 1913 to 14% in 1950, to 4.8% ill 1990and further t03.9% in 2000. Similarly, Japan reduced the rate of tariff from 30% in 1913 to 5.3% in1990 and to 3.9%in 2000. Thus, most of the advanced countries reduced the tariff rates to 3.9% in2000. The growth of international trade between 1950.and 2007 was about 28-fold. These reductionsin tariff and other trade barriers contributed for the growth of global trade.

Declining Investment Barriers

Global business firms invest capital in order to establish manufacturing and other facilities in foreigncountries. Foreign governments impose barriers on foreign investment in order to protect domesticindustry but various countries have been removing these barriers on foreign direct investment in orderto encourage the growth of global business. Various governments made 1,238 changes in the lawsgoverning foreign direct investment between 1991 and 2007. Out of these amendments, 95% were infavour of foreign direct investment. In addition, bilateral treaties increased from 181 as of 1980 to1,856 as of 2000 among 160 countries. These treaties, which were designed to promote and protectinvestment among countries, enabled the fast growth of globalization of not only trade, but also production.Consequently, the global production increased.

1.4 Multinational Enterprises

A multinational corporation/company is an organization doing business in more than one country.Transnational company produces, markets, invests and operates across the world. MNCs and TNCshave been growing and spreading their operations due to market, financial and other superiorities andthe expansion of international markets.

Growth of Multinational Enterprises

The European Union had l63 out of 500 top MNCs in the world in 2007 followed by USA (162) andJapan (67). Developing countries had around 53 MNCs among the top 500 MNCs in the world in2007. In fact, MNCs of developing countries have been increasing in contrast to that of developedcountries. India had six MNCs among the top 500 MNCs.

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Influences of International Business

Conducting and managing international business operations is a crucial venture due to variations inpolitical, social, cultural and economic factors, from one country to another country. For example, mostof the African consumers prefer less costly products due to their poor economic conditions, whereasthe German consumers prefer high quality and high priced products due to their higher ability to buy.Therefore, the international businessman should produce and export less costly products to most of theAfrican countries and vice versa to most of the European and North American countries. High pricedand high quality Palmolive soaps are marketed in European countries and the economy priced Palmolivesoaps are exported and marketed in developing countries like Ethiopia, Pakistan, Kenya, India,Cambodia etc. Characteristic features of international business include:

• Accurate Information: International business houses need accurate information to make anappropriate decision. Europe was the most opportunistic market for leather goods andparticularly for shoes. Bata based on the accurate data could make appropriate decisions toenter various European countries.

• Timely Information: International business houses need not only accurate but timelyinformation. Coca-Cola could enter the European market based on the timely information,whereas Pepsi entered later. Another example is the timely entrance of Indian software companiesinto the US market compared to those of other countries. Indian software companies alsomade timely decision in the case of Europe.

• Size of the Business: The size of the international business should be large in order to have animpact on the foreign economies. Most of the multinational companies are significantly large insize. In fact, the capital of some of the MNCs is greater than our annual budget and GDPs ofthe some of the African countries.

• Market Segmentation: Most of the international business houses segment their marketsbased on the geographic market segmentation. Daewoo segmented its market as North America,Europe, Africa, Indian sub-continent and Pacific markets.

Stages of international business are

The above stated factors contributed for the significant change in the scenario of international businessand resulted in the variations in the operations of international companies. These variations in the scenariosgenerally categorized into five stages viz., domestic company. Now, we study each scenario in detail.

Stage 1: Domestic Company

Domestic company limits its operations, mission and vision to the national political boundaries. Thiscompany focuses its view on the domestic market opportunities, domestic suppliers, domestic financialcompanies, domestic customers etc.



These companies analyze the national environment of the country; formulate the strategies to exploit theopportunities offered by the environment. The domestic companies’ unstated motto is that, “if it is nothappening in the home country, it is not happening.”

The domestic company never thinks of growing globally. If is grows, beyond its present capacity, thecompany selects the diversification strategy of entering into new domestic markets, new products,technology etc. The domestic company does not select the strategy of expansion/penetrating into theinternational markets.

Stage 2: International Company

Some of the domestic companies, which grow beyond their production and/or domestic marketingcapacities, think of internationalizing their operations. Those companies who decide to exploit theopportunities outside the domestic country are the stage two companies. These companies remainethnocentric or domestic country oriented. These companies believe that the practices adopted indomestic business, the people and products of domestic business are superior to those of other countries.The focus of these companies is domestic but extends the wings to the foreign countries.

These companies select the strategy of locating a’ branch in the foreign markets and extend the samedomestic operations into foreign markets. In other words, these companies extend the domestic product,domestic price, promotion and other business practices to the foreign markets.

Normally internationalization process of most of the global companies starts with this stage two processes.Most of the companies follow this strategy due to limited resources and also to learn from the foreignmarkets gradually before becoming a global company without much risk.

The international company holds the marketing mix constantly and extends the operations to newcountries. Thus, the international company extends the domestic country marketing mix and businessmodel and practices to foreign countries.

Stage 3: Multinational Company

Sooner or later, the international companies learn that the extension strategy (i.e., extending the domesticproduct, price and promotion to foreign markets) will not work. The best example is that Toyotaexported Toyota cars produced for Japan in Japan to the USA in 1957. Toyota was not successful inthe USA. Toyota could not sell these cars in the USA as they were overpriced, underpowered and builtlike tanks. Thus, these cars were not suitable for the US markets. The unsold cars were shipped backto Japan.

Toyota took this failure as a rich learning experience and as a source of invaluable intelligence but not asfailure. Toyota based on this experience designed new models of cars suitable for the US market. Theinternational companies turn into multinational companies when they start responding to the specificneeds of the different country markets regarding product, price and promotion.

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This stage of multinational company is also referred to as multi-domestic. Multi-domestic companyformulates different strategies for different markets; thus, the orientation shifts from ethnocentric topolycentric. Under polycentric orientation the offices/branches/subsidiaries of a multinational companywork like domestic company in each country where they operate with distinct policies and strategiessuitable to the country concerned. Thus, they operate like a domestic company of the country concernedin each of their markets.

Philips of Netherlands was a multi domestic company of this stage during 1960s. 1t used to haveautonomous national organizations and formulate the strategies separately for each country. Its strategydid work effectively until the Japanese companies and Matsushita started competing with this companybased on global strategy. Global strategy was based on focusing the company resources to serve theworld market.

Philips strategy was to work like a domestic company, and produces a number of models of theproduct. Consequently, it increased the cost of production and price of the product. But the Matsushita’sstrategy was to give the value, quality, design and low price to the customer. Philips lost its market shareas Matsushita offered more value to the customer.

Consequently, Philips changed its strategy and created “industry main groups” in Netherlands whichare responsible for formulating a global strategy for producing, marketing and R & D.

Stage 4: Global Company

A global company is the one, which has either global marketing strategy or a global strategy. Globalcompany either produces in home country or in a single country and focuses on marketing these productsglobally, or produces the products globally and focuses on marketing these products domestically.

Harley designs and produces. Super heavy weight motorcycles in the USA and markets .in the globalmarket. Similarly, Dr. Reddy’s Lab designs and produces drugs in India and markets globally. Thus,Harley and Dr. Reddy’s Lab are examples of global marketing focus. Gap procures products in theglobal countries and markets the products through its retail organization in the USA, Thus, Gap is anexample for global sourcing company.

Harley Davidson designs and produces in the USA and gains competitive advantage as Mercedes inGermany. The Gap understands the US consumer and gets competitive advantage.

Stage 5: Transnational Company

Transnational company produces, markets, invests and operates across the world. It is an integratedglobal enterprise that links global resources with global markets at profit. There is no pure transnationalcorporation. However, most of the transnational companies satisfy many of the characteristics of aglobal corporation. For example Coca-Cola Pepsi Cola etc.



Differences between Domestic Business and International Business

Basically, domestic business and international business operate on similar lines. But there are certaindifferences between these two businesses. The significant differences between these two emerge fromforeign exchange, quotas, tariff, regulations of a number of governments, wide variations in culture andthe like. Table presents the differences between domestic business and international business.

Difference between Domestic Business and International Business

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Modes of Entry

When a domestic company plans to engage in international business, the company has to select themode of entry into the foreign country based on all relevant factors like the size of business, influence ofenvironmental factors, attractiveness of the foreign market, market potential Costs and benefits andrisk factors.

• Different modes of entry to foreign markets include

• Direct Exporting

• Indirect Exporting

• Licensing arrangements with foreign companies

• Franchising arrangements with foreign companies

• Contract manufacturing

• Management contracts

• Turn Key projects

• Direct Investment

• Joint Ventures

• Mergers and Acquisitions

Advantages of International Business:

We shall discuss the competitive advantages of international business.

• High Living Standards: Comparative cost theory indicates that the countries which have theadvantage of raw materials, human resources, natural resources and climatic conditions inproducing particular goods can produce the products at low cost and also of high’ quality.Customers in various countries can buy more products with the same amount of money. Inturn, it can also enhance the living standards of the people through enhanced purchasing powerand by consuming high quality products.

• Increased Socio-Economic: Welfare: International business enhances consumption level, andeconomic welfare of the people of the trading countries. For example, the people of China arenow enjoying a variety of products of various countries than before as China has been activelyinvolved in international business like Coca-Cola, McDonald’s range of products, electronicproducts 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 market size.Therefore, the companies need not depend on the demand for the product in a single countryor customer’s tastes and preferences of a single country. Due to the enhanced market the AirFrance, now, mostly depends on the demand for air travel of the customers from countriesother than France. This is true in case of most of the MNCs like Toyota, Honda, Xerox andCoca-Cola.

• Reduced Effects of Business Cycles: The stages of business cycles vary from country tocountry. Therefore, MNCs shift from the country, experiencing a recession to the countryexperiencing ‘boom’ conditions. Thus, international business firms can escape from therecessionary conditions.

• Reduced Risks: Both commercial and political risks are reduced for the companies engagedin international business due to spread in different countries. Multinationals which were operatingin erstwhile USSR were affected only partly due to their safer operations in other countries.But the domestic companies of the then USSR collapsed completely.

• Large-Scale Economies: Multinational companies due to the wider and larger markets producelarger quantities, which provide the benefit of large-scale economies like reduced cost ofproduction, availability of expertise, quality etc.

• Potential Untapped Markets: International business provides the chance of exploring andexploiting the potential markets which are untapped so far. These markets provide the opportunityof selling the product at a higher price than in domestic markets. For example, Bata sells shoesin the UK at £ 100 (Rs. 8,000) whose price is around Rs. 1,200 in India.

• Provides the Opportunity For and Challenge to Domestic Business: International businessfirms provide the opportunities to the domestic companies. These opportunities includetechnology, management expertise, market intelligence, product developments etc. For example,Japanese firms operating in the L provide these opportunities to the LS companies. This ismore evident in the case of developing countries like India, African countries and Asian countries.

• Similarly, the MNCs pose challenges to the domestic business initially. Domestic firms developthemselves to meet these challenges. Thus, the opportunities and challenges help the domesticcompanies to develop. Maruti helped Telco to come up with Tata Indica. Foreign Universitieshelped IMs, ITs and Indian Universities to enhance their curricula.

• Division of Labour and Specialization: As mentioned earlier, international business leads todivision of labour and specialization. Brazil specializes in coffee, Kenya in tea, Japan in.automobiles and electronics, India in textile garments etc.

• Economic Growth of the World: Specialization, division of labour “enhancement of productivity,posing challenges, development to meet them, innovations-and “creations to meet the competitionlead to overall economic growth of the world nations. International business particularly helped

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the Asian countries like Japan, Taiwan, Korea, Philippines, Singapore, Malaysia, and the UnitedArab Emirates.

• Optimum and Proper Utilization of World Resources: International business provides forthe flow of raw materials, natural resources and human resources from the counties where theyare in excess supply to those countries which are in short supply or need most. For example,flow of human resources from India, consumer goods from the UK, France, Italy and Germanyto developing countries. This, in turn, helps in the optimum and proper utilization of worldresources.

• Cultural Transformation: International business benefits are not purely economical orcommercial; they are even social and cultural. These days, we observe that the West is slowlytending towards the East and vice versa. It does mean that the good cultural factors and valuesof the East are acquired by the West and vice versa. Thus, there is a close cultural transformationand integration.

• Knitting the World into a Closely Interactive Traditional Village: International business,ultimately knits the .global economies, societies and countries into a closely interactive andtraditional village where one is for all and all are for one.

Problems of International Business

As is said that, “life is not a bed of roses”, international business is not all that lovely. It has its problems.The important problems include:

Political Factors: Political instability is the major factor that discourages the spread of internationalbusiness. For example, in the Iran-Iraq war, Iraq-Kuwait war, dismantling of erstwhile USSR, CivilWars in Fiji, Malaysia, and Sri Lanka, military coups in Pakistan, Afghanistan, frequent changes ofpolitical parties in power and thereby changes in government policies in India etc., created politicalrisks for the growth of international business. Also, Indo-Pak Summit at Agra in July, 200 1 ended in ano compromise situation, which affected international business. Though there are political problemsbetween India and China, business houses of these two countries have developed opportunities forIndo-China business relations, In fact, these two countries are also working in this direction.

• Huge Foreign Indebtedness: The developing countries with less purchasing power are luredinto a debt trap due to the operations of MNCs in these countries. For example, Mexico,Brazil, Poland, Romania, Kenya, Congo, and Indonesia.

• Exchange Instability: Currencies of countries are depreciated due to imbalances in the balanceof payments, political instability and foreign indebtedness. This, in turn, leads to instability in theexchange rates of domestic currencies in terms of foreign currencies. For example. Zambia,India, Pakistan, Philippines depreciated their currencies many times. This factor discouragesthe growth of international business



• Entry Requirements: Domestic governments’ impose entry requirements to multinationals.For example, An MNC can enter Eritrea only through a joint-venture with a domestic company.However, with the establishment of World Trade Organization (WTO), many entry requirementsby the host governments are dispensed with.

• Tariffs, Quotas and Trade Barriers: Governments of various countries impose tariffs, importand export quotas-and trade barriers .in order to protect domestic business. Further, thesebarriers are imposed based on the political and-diplomatic relations between or amongGovernments. For example, China, Pakistan and the USA (before 1998) imposed tariffs, quotasand barriers on imports from India. But the erstwhile USSR and present Russia liberalizedimports from India.

• Corruption: Corruption has become an international phenomenon. The higher rate bribes andkickbacks discourage the foreign investors to expand their operations.

• Bureaucratic Practices of Government: Bureaucratic attitudes and practices of Governmentdelay sanctions, granting permission and licenses to foreign companies. The best example isIndian Government before 1991.

• Technological Pirating: Copying the original technology, producing imitative products, imitatingother areas of business operations were common in Japan during 1950s and 1960s, in Korea,India etc. This practice invariably alarms the foreign companies against expansion.

• Quality Maintenance: International business firms have to meticulously maintain quality ofthe product based on quality norms of each country. The firms have to face server consequences,if they fail to conform to the country standards. Consumers’ forums/ associations also inspectquality in addition to the government machinery in various foreign countries.

1.5 International Trade Theories

The well known International trade theories can be classified as:

• Theory of Mercantilism

• Theory of Absolute Advantage

• Theory of Absolute Cost Advantage

• Theory of Comparative Advantage

• Theory of Comparative Cost Advantage

• Heckscher-Ohlin Theory

• Leontief Paradox

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• Product Life Cycle Theory

• Porter’s Diamond Model

Common sense suggests that some international trade is beneficial for all. Writing in his famous book,The Wealth of Nations, in 1776, Adam Smith argued that trade is beneficial because of differencesbetween countries in the costs of producing different goods. Like all of his contemporaries, Smith heldto a labour theory of value, according to which the cost of producing a good was given by the labourtime required to produce it. Therefore, the differences in the costs of producing a certain good indifferent countries reflected differences in labour efficiencies in each country. However, rather thaneach country striving to produce all the products which they could, each should concentrate on thoseproducts in which they enjoy a cost advantage over other countries (core competencies of each country)

The result will be that all are better off. To see this, consider a simple numerical example of the kindused by Smith to illustrate this principle. Imagine two countries, A and B, which possess identical labourresources which they divide equally between the two activities, cloth and rice. The following figure’ givethe amount (units) of the two goods which each country is able to produce if all its workers are fullyemployed.

Clearly, A is more efficient at producing rice and B at cloth. Therefore, pays f: to specialize in rice andB in cloth. Hence, A switches all its resources into rice and B into cloth. In that case, situation mayemerge as shown in the following table:

1.5.1 Theory of Mercantilism

The doctrine of mercantilism propagates in the 16th and 17th centuries, advocated that countries shouldsimultaneously encourage exports and discourages imports. Mercantilism was premised on the notionthat .exports are per se good because they earn a country gold, while imports are per se bad because



they result in an outflow of gold. (In those days, gold was the currency normally used to finance trade.)Consequently, a country should strive to reduce its dependence on imports by producing as much as itcould itself. In practical terms, it suggested that the government policy should seek to reduce imports byimposing duties on imports and restricting the amount of foreign goods that are allowed into the country.At the same time, every effort should be made to boost exports by whatever means. If one countrysucceeds in achieving a large export surplus, it can only do so if other countries run an equivalent tradedeficit. It follows that, if all countries pursue such a policy, the result will be conflict among them. Eitherone country will succeed at the expense of the rest or else all will fail to achieve their objective.

Divided Government and US Trade Policy

Theory and Evidence

If different parties control the US Congress and White House, the United States may maintain higherimport protection than otherwise. This proposition follows from a distributive politics model in whichCongress can choose to delegate trade policymaking to the President. When the congressional majorityparty faces a President of the other party, the former has an incentive to delegate to but to constrain thePresident by requiring congressional approval of trade proposals by up-or-down vote. This constraintforces the President to provide higher protection in order to assemble a congressional majority. Evidenceconfirms that (i) the institutional constraints placed on the President’s trade policymaking authority arestrengthened in times of divided government and loosened under unified government and (ii) US tradepolicy was significantly more protectionist under divided than under unified government during theperiod 1949-90.

In the mid 16th century, gold and silver was the mainstay of national health and essential for commerce.A country could earn gold and silver by exporting goods and in the same way importing of goodsresulted in the outflow of gold and silver. The main tenet of mercantilism was that it was in the countriesbest interest to maintain a trade surplus, to export more than import. In doing so a country couldaccumulate more gold and silver and, consequently its national wealth and prestige.

1.5.2 Theory of Absolute Advantage

This theory propounded by Adam Smith in 1776, states that a country has an absolute advantage in theproduction of an item when it is more efficient than any other country in producing it. Smith attacked themercantilist assumption and argued that countries differ in their ability to produce goods efficiently. Inhis time, the British, by virtue of their superior manufacturing process, were the world’s most efficienttextile manufacturers. French had the world’s most efficient wine industry due to favourable climate,good soils and accumulated expertise, i.e., the Britain had an absolute advantage in the production oftextiles, while the French had an absolute advantage in the production of wine. The easiest explanationfor trade is the concept of absolute advantage. Mexico exports petroleum to Japan. USA exports

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airplanes to Sweden. These examples illustrate the principle called absolute advantage wherein theexporting company holds superiority in the availability and the cost of certain goods.’

Absolute advantage may come due to factors of climate, quality of land and natural resource endowmentsor difference in labour, capital, technology and entrepreneurship. Some nations have oil and some don’thave. It appears sensible for each country to specialize in the product in .which has an absolute advantageand secure its needs of the product in which it has a disadvantage through trade.

1.5.3 Theory of Absolute Cost Advantage

Adam Smith was a leading advocate of free trade on the ground that it promoted the internationaldivision of labour or territorial specialization. Trade occur; between countries because productionpossibilities of the different countries are different. The factors influencing production possibilities canbe climate, so^ mineral wealth which give certain nations natural advantages in certain production Itcould also differ because of acquired advantages like special skills and technique; in production.

Smith’s concept of cost was based on labour theory of value. The two basis assumptions of the theoryare:

(i) Labour is the only factor of production and it is homogeneous.

(if) The cost of a good depends only upon the amount of labour required to produce it.

Smith’s trading principle was the principle of absolute cost advantage.

In the two-country two-commodity world, international trade and specialist-will be beneficial when anation has an absolute cost advantage in one good and that other nation in the other good. Absolutecost advantage is measured in terms or” labour hour employed in one unit of output. A nation is said tohave absolute advantage in the production of a commodity when it uses lesser labour hour per unit ofoutput than the other nation. A nation will import those goods in which it has absolute cost disadvantageand export those goods in which it has absolute cost advantage.

1.5.4 Theory of Comparative Advantage

Trade based on absolute advantage is easy to understand. But what happens when one country canproduce all products with an absolute advantage? Would trade occur? Can trade still be mutuallyadvantageous to the trading partners?

Here we encounter the doctrine of comparative advantage first introduced b David Ricardo m the early19th century. The doctrine emphasizes relative rather than absolute cost differences. The doctrinedemonstrates that .mutually advantageous trade can occur even when one trading partner has absolute



advantage. It makes sense for a country to specialize in the production’ of those goods that it producesless efficiently from other countries. This theory stresses that comparative advantage arises from differencesin productivity. Ricardo focused on labour productivity and .argued that differences in labour .productivitybetween nations underline the notion of comparative advantage. Thus, whether French .1S mo.re efficientthan British in the production of wine depends on how, productively it uses 1tS resources. ‘ .

1.5.5 Theory of Comparative Cost Advantage

Comparative cost advantage theory of international trade was developed by dr British economists inthe early 19th century. In the year 1817 David Ricar published his ‘Political Economy-and Taxation’ inwhich he presented the La, Comparative cost Advantage. As in the absolute cost advantage theory,this: -also says that international trade is solely due to differences in the productivity a labour in differentcountries. Absolute cost advantage theory can explain only a very small part of world trade such astrade between tropical zone and tempera* zone or between developed countries and developingcountries. Most of the work trade is between developed countries that are similar with respect to theirresource and development which is not explained by absolute cost advantage. The basis for such tradecan be explained by the law of comparative advantage.

Assumptions of the Ricardian Theory

We can begin the analysis by listing the number of assumptions required to build the theory:

1. Each country has a fixed endowment of resources and all units of eac4 particular resource areidentical.

2. The factors of production are perfectly mobile between alternate productions within a country.This assumption implies that the prices factors of production are also the same among alternativeuses.

3. Factors of production are completely immobile between countries.

4. Labour theory of value is employed in the model. The relative value for commodity is measuredsolely by its relative labour content.

5. Countries use fixed technology though there may be different technologies in different countries.

6. The simple model assumes that production is under constant case conditions regardless of thequantity produced. Hence the supply curve for any good is horizontal.

7. There is full employment in the macro-economy.

8. The economy is characterized by perfect competition in the product of the market.

9. There is no governmental intervention in the form of restrictions to for trade.

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10. In the basic model, transport costs are zero.

11. It is a two-country, two-commodity model.

Table 1: Illustration of Comparative Cost Advantage

Table 1 show that country A has absolute cost advantage in the production of both the commodities.This is shown by lesser labour hours required in the production of cloth and wine which is 1 hour perunit of cloth and 3 hours per unit of wine. This is lesser than 2 hours per unit of cloth and 4 hours per unitof wine as required in country B. Even then trade between the two countries can be mutually advantageousso long as the difference in comparative advantage exists between the productions of two commodities.The example shows that country A is twice as productive as country B in cloth production whereas inwine production it is only 4/3 times as productive as the country B. Hence country A has highercomparative advantage in cloth production. Country B has comparative advantage in wine because itsrelative inefficiency is lesser in wine. It is half as productive in cloth while in wine the difference in labourproductivity is only 1/3 minus 1/4, which is much less than 1/2.

International trade is mutually profitable even when one of the countries can produce every commoditymore cheaply than the other. Each country should specialize in the product in which it has a comparativeadvantage that is greatest relative efficiency.

When trade takes place between the two countries, the terms of trade will be within the limits set by theinternal price ratio before trade. For both countries to gain, the terms of trade should be somewherebetween the two countries’ internal price ratios before trade. Country A gains by getting more than oneunit of wine for every 3 units of cloth and country B gains by getting something more than 2 units of clothfor every one unit of wine. The actual terms of trade will depend upon comparative strength of elasticityof demand of each country for the others product.

Illustration with Production Possibility Frontiers

Production Possibility Frontier (PPF) reflects all combination of the two products that the country canproduce under certain conditions. These conditions are:

1. The total resources are finite and known.

2. The resources are fully employed.

3. The technology is given.



4. The production is economically efficient, that is with the least cost combination of inputs.

5. The costs are constant implying opportunity cost is the same at various levels of production.PPF is hence a straight line whose slope is given by opportunity cost of one product in terms ofthe other.

Country A’s resources are given at 18,000 labour hours with price ratio of 1 unit wine: 3 units of cloth.Country A can produce either 18,000 units of cloth and 0 units of wine or 6,000 units of wine and 0units of cloth.

Table 2: Gains from trade with terms of trade

Under the assumed trade price ratio of 1: 2.5 between wine and cloth, the total gain is 400 units of winefor country A and 3,000 units of cloth for country B. The gain for individual countries will differ dependingupon the trade price ratio. However, the point remains that both the countries gain from trade.

Criticisms of the Assumptions of Ricardian Theory

1. Two X Two model. Ricardian theory of comparative advantage is based on the assumptionsof two commodities and two countries. This is not a serious limitation and is made purely forsimplifying the exposition of the theory. The principle behind the theory holds good even whenmore than two countries and more than two commodities are involved. However generalizingthe analysis to cover many countries and many commodities at the same will make the treatmentcumbersome and difficult.

2. Constant costs. Assumption regarding constant cost conditions will lead to completespecialization. When this is relaxed to consider increasing cost conditions, the principle of

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comparative advantage may not lead to complete specialization but to a situation of partialspecialization. In that case countries will specialize in the commodity in which they have acomparative advantage but nevertheless will produce the other commodity also.

3. No transport cost. Absence of transport cost in determining comparative advantage is againnot a crucial assumption. Even when this assumption is relaxed the theory will hold good. Thecosts can be redefined to include transport cost and comparative advantage can be assessedon the basis of such costs. Of course this will reduce the scope for the presence of comparativeadvantage in many commodities for many countries and this explains why every country has alot of non-traded commodities.

4. Trade restrictions. Though in the real world absence of government intervention in the formof protective tariff on quota is hard to find, such restrictions definitely reduce scope for freetrade on the basis of comparative advantage.

5. Labour theory of value. Ricardian theory is basically criticized for one main reason—that itis based on labour theory of value. This limitation has been removed by later theories ofinternational trade. For example, Haberler uses concept of ‘opportunity cost’ and shows howdifference in opportunity cc: production between countries forms the basis of internationaltrade.

6. Emphasis on supply. Ricardian theory clearly shows that free trade res „ in mutual benefit forthe trading countries. However, it does not show the e:\ terms of trade between the twocommodities traded which will determine the e>r of the respective gains from trade. Ricardoemphasizes the supply side factors determinants of basis for trade. It was left to Mill to introducethe demand factor in determining the terms of trade between countries.

7. Changes in tastes and differences. Ricardian theory does not explain possibility of tradeoccurring because of differences in tastes and prefer between people in two countries. Nationscan have commodities with lower the price because of lower domestic demand and not becauseof higher lat. productivity. Here comparative advantage is not because of lower labour cost.

Heckscher-Ohlin Theory (Modem Theory of International Trade)

Swedish economists Eli Heckscher (in 1919) and Bertil Ohlin (in 1933) put forward .theory ofcomparative advantage. According to their theory, the comparative advantage of a country arises fromdifferences in national factor endowment. Factors of endowment mean the extent to which a country isendowed with resources like land, labour and capital. Nations have various factors of endowment anddifferent factors of endowment explain difference in factor of cost. Heckscher-Ohlin theory predictsthat countries will export those goods .that make intensive use of factors that are locally abundant, whileimporting goods that make use of factors that are locally scarce.

Heckscher-Ohlin theory also has a commonsense appeal. For example, the United States has long



been a substantial exporter of agricultural goods reflecting in parts its unusual abundance of arable land.In contrast, China excels in the export of goods produced in labour intensive manufacturing industries,such as textiles and footwear. This reflects China’s relative abundance of low labour cost. The UnitedStates, which lacks abundance of low labour cost, has been a primary importer of these goods. Notethat it is relative, not absolute endowments that are important for example, export of human resourcesfrom India, being a labour abundant country. Similarly, China excels in the export of goods produced inlabour intensive industries.

The Leontief Paradox

Using Heckscher-Ohlin theory, Wassily Leontief (Winner of the Noble Prize in economics in 1973)postulated that since United States was relatively abundant of capital compared to other nations, theUnited States would be an exporter of capital intensive goods and an importer of labour intensivegoods. To his surprise, however, he found that US exports were less capital intensive than US imports.Since this result was at variance with the prediction of the theory, it has become known as the Leontiefparadox.

One possible explanation is that United States has a special advantage in producing new products orgoods made with innovative technologies. Such products may be less capital intensive than productswhose technology has had time to mature and become suitable for mass production. Thus, the UnitedStates must be exporting goods that heavily use skilled labour and innovative entrepreneurship, such ascomputer software, while importing heavy manufacturing products that use large amounts of capital.

One might also argue that United States exports commercial aircraft and imports automobiles notbecause its factor endowments is especially suited to aircraft manufacture and not suited to automobilemanufacture, but because United states is more efficient in producing aircraft than automobiles.

1.6 The Product Life Cycle Theory

Raymond Vernon proposed the product life cycle theory in the mid 1960s. His observation was thatlarge proportions of the new products were developed by US firms and sold in US market, e.g.Televisions, instant cameras, photocopiers, personal computers, etc. Vernon argued that most newproducts were initially produced in the United States. Apparently the pioneering firms believed that it isbetter to keep production facilities close to the market and the firm’s centre of decision making, giventhe risk inherent in introducing new products. Also, the demand for most new products tends to bebased on non price factors.

Vernon argued that early in the life cycle of typical new product, while demand is starting to grow in theUnited States, demand in other advanced countries is limited to the high income groups. Therefore, thelimited initial demand does not necessitate the country to start producing the product but it is requiredto be exported from the United States.

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Over time, the demand for the product increases. As it does, it becomes worthwhile for the country tostart producing the product. In addition, US might set up their production facilities in those countrieswhere the product demand is growing. Consequently, the production within other advanced countriesbegins to limit the potential for exports from the United States. As the market for the product maturesin other advanced countries and the United States, the product becomes more standardized, and pricebecomes the main competitive weapon.

Producers based in other countries, where labour cost is low, might now be able to export the productto the United States.

If the cost pressure becomes intense, the process might not stop here. The cycle by which UnitedStates lost its advantage to other advanced countries may be repeated once more, as developingcountries begin to acquire a production advantage over the advanced countries. Thus, the locus ofglobal production initially switches from the United States to other advanced countries and then fromthose countries to developing countries.

The consequences of these trends for the pattern of world trade is that overtime the United Statesswitches from being an exporter to an importer of the product as production gets concentrated in thelower cost foreign locations.

Table 3: Product Life Cycle theory

Example for Product Life Cycle Theory

Let us take the case of photocopiers, the product was first developed in the early 1960s by Xerox inthe United States and sold initially, Xerox exported photocopy machines from US, primarily to Japanand the advanced countries. As demand began to grow in foreign countries, Xerox entered into jointventures to set up production in Japan (Fuji-xerox), India (Modi-xerox), etc. As a consequence, exportsfrom US declined, and the US users started importing some of their photocopiers from lower-costforeign countries, particularly Japan. This evolution in the pattern of foreign trade is consistent with theproduct life cycle theory.



Mature industries tend to go out of own country and into low-cost assembly locations.

National Competitive Advantage: Porter’s Diamond Model

Michael Porter is a famous Harvard business professor. He conducted a comprehensive study of 100industries in 10 nations to learn why do some nations succeed in international competition? Porterintroduced this model in book: The Competitive Advantage of Nations. He sought to explain why anation achieves success in a particular industry. Why Indians did well in the software industry? Why areJapanese doing well in the automobile industry? Both Heckscher-Ohlin theory and Theory ofComparative Advantage is only partly able to explain.

According to Porter, a nation attains a competitive advantage if its firms are competitive. Firms becomecompetitive through innovation. Innovation can ‘include technical improvements to the product or tothe production process. Porter hypothesizes that four broad attributes of a nation that (Figure 1) shapethe environment in which local firms compete. The quality of this competition promotes or impedes thecreation of global competitive advantage. These four attributes constitute “Diamond”. They are:

Figure 2: Porter’s Diamond Model for the Competitive Advantage of Nations

a) Factor conditions (i.e., the nation’s endowments in factors of production, such as skilled labourand infrastructure necessary to compete in a given industry)

b) Demand conditions (i.e., sophisticated customers in home market)

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c) Related and supporting industries (which are internationally competitive)

d) Firm strategy, structure and rivalry (i.e., conditions governing creation, organization, managementof companies, and the nature of domestic rivalry)

Factor Conditions and Endowments

Factor conditions refer to inputs used as factors of production such as labour, I d, natural resources,capital and infrastructure. Porter classified the factors of production as key (advanced or specialized)factors and non-key (basic) factors.

Porter argues that the key factors of production (or specialized factors) are created, not inherited.Specialized factors of production are skilled labour, capital and infrastructure.

Non-key factors or general use factors, such as unskilled labour and raw materials, can be obtained byany company and, hence, do not generate sustained’ competitive advantage. However, specializedfactors involve heavy, sustained investment. This leads to a competitive advantage, because other firmscannot easily duplicate these factors. For example, development of KPO industry ill India is on accountof key factors like information infrastructure and hugely talented human resources.

The relationship between key and non-key factors’ is complex, Natural resources, climate etc. fallunder non-key factors whereas communication infrastructure, research facilities, etc. are classified askey (advanced) factors Non-key factors provide an initial advantage which is subsequently reinforcedand extended by investment in specialized factors. Conversely, disadvantages’ basic factors can createpressures to invest in advanced factors.

Porter argues that a lack of resources often actually helps ‘countries to become competitive calledSelected Factor Disadvantage (SFD). Abundance generates waste and scarcity generates an innovativemindset. Such countries are forced to innovate to overcome their problem of scarce resources.

a) Switzerland was the first country to experience labour shortages. They abandoned labour-intensive watches and concentrated on innovative/] high-end watches.

b) Japan has high priced land and so its .factory space is at premium. This lead to just-in-timeinventory techniques (Japanese firms can’t have a lot of stock taking up space, so to cope withthe potential of not have goods around when they need it, they innovated traditional inventorytechniques).

Demand Conditions

As per Porter’s model, a sophisticated domestic market is an important element to achieve internationalcompetitiveness. The firms that have demanding’ consumers are likely to sell superior products becausethe market demands high quality. Such consumer enables the firm to better understand the needs anddesires of the customers, for example,



i. Sophisticated and demanding customers helped push Nokia of Finland and Ericsson of Swedento invest hugely in cellular phone technology. On account of this, these two firms are dominantplayers in the global cellular technology.

ii. Japan’s knowledgeable buyers helped stimulate their camera industry to introduce innovativemodels.

Related and Supporting Industries

This is one .of the most pervasive findings of Porter’s study. He says that a set of strong related andsupporting industries is important to the competitiveness of firms. This includes presence of suppliersand related industries. This usually occurs at a regional level as opposed to a national level. Examplesinclude Silicon Valley in US, and Italy (leather-shoes-other leather goods industry). The phenomenonof competitors (and upstream and/or downstream industries) locating in the same area is known asclustering or agglomeration.

When there is a large industry presence in an area, it will increase the Supply of specific factors (i.e.,workers with industry-specific training). At the same time, upstream firms (i.e., those who supplyintermediate inputs) will invest in the area. They will also wish to save on transport costs, tariffs, inter-firm communication costs, inventories, etc. Downstream firms (i.e., those use industry’s product as aninput) will also invest in the area. This causes additional savings. Finally, attracted by the good set ofspecific factors, upstream and downstream firms, producers in related industries (i.e., those who usesimilar inputs or whose goods are purchased by the same set of customers) will also invest. This willtrigger subsequent rounds of investment.

Strategy, Structure and Rivalry

Strategy and structure of the Countries with a short-run outlook (like US) will tend to be more competitivein industries where investment is short-term (like the-computer industry). Countries with a long runoutlook (like Switzerland) w ill tend to be more competitive in industries where investment is long term(like the pharmaceutical industry).

(Individuals base their career decisions on opportunities and prestige. A country will be competitive inan industry whose key personnel hold positions that are considered prestigious. Different nations arecharacterized by different management ideologies. For example, predominance of engineers in topmanagement in Japanese and German firms. This has led to the emphasis on improving the productdesign and manufacturing. Whereas people with finance background are predominant in US leading tocorresponding overemphasis on maximizing short term financial returns in US firms.

Porter argues that the best management styles vary among industries. Some countries may be orientedtoward a particular style of management. Those countries will tend to be more competitive in industriesfor which that style of management is suited. One consequence of dominance of finance in US has beenrelative loss of competitiveness in those engineering based industries (Automobile Industry in US is not

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internationally competent) where manufacturing process and design issues are very important.

Rivalry, as per Porter’s model, there is strong association between vigorous domestic rivalry creationand persistence of competitive advantage. Intense competition spurs innovation resulting in improvedefficiency. Rivalry induce firms to look for ways to improve efficiency, to reduce costs and to innovateFor example, competition is particularly fierce in Japan, where many companies compete vigorously inmost industries.

The Diamond as a System

• Wherever the diamond is favourable, firms are most likely to succeed

• Porter argues that the diamond is a mutually reinforcing system. The effect of on attribute iscontingent on the state of others, i.e., unless there is Inter firm rivalry, favourable demandconditions will not result in competitive advantage.

• The diamond promotes clustering/agglomeration.

Evaluating Porter’s Theory

As per Porter, we should expect his model to predict the pattern of existing International Trade Countriesshould be exporting products from those industries wherever all the attributes of factor are favourable,while importing to those areas where the components are unfavourable.

i. Porter developed this paper based on case studies and these tend to only apply to developedeconomies.

ii. The Porter model does not adequately address the role of MNCs. There seems to be ampleevidence that the diamond is influenced by factors outside the home country.

Implications of Trade Theories

All these trade theories have implications on the business. The implications can be explained as follows:

Strategy for locations is the most of the trade theories emphasize that due to different factors of productiondifferent countries have advantages ·in different productive activities. Hence it makes sense for the firmto disperse the production activities to countries having maximum efficiency. This global web of productiveactivities is used by the firms while going in for .globalization to get the competitive edge. Hence ifdesign can be performed most efficiently in Germany, then this facility should be located there. Similarly,if the manufacturing is done most cheaply in India then the manufacturing facility should be locatedthere. If the firm does not do it then it may find itself at competitive disadvantage relative to firms thatdo.

Policy implementations in the firms are major players on the International trade scene since they doboth import and export. The firms may tend to lobby to increase trade restriction or promote trade.



However the International trade theories claim that free trade is good for the interest of country, althoughit may or may not be in the best interest of that particular firm.

Porter’s theory also contains policy implications. It suggests that it is in the best interest of business fora firm to invest in upgrading advanced factors of production, i.e., to invest in better training and R&D.Infosys is one such firm, which has reaped immense benefit on account of this strategy. Thus, it makesns that the firms lobby with the government to adopt policies which impact all components of Porterdiamond favorably. The government therefore should increase investment in education, infrastructure,and basic research (all advanced factors). The government should also adopt policies which promotestrong competition within domestic markets since this enable the firm to achieve internationalcompetitiveness.

1.7 Review Questions

1. What is International Business and explain its characteristic features.

2. Explain International Marketing, International Trade related to International Business.

3. Explain the various theories associated to International Trade.

4. Explain the various stages of International Business.

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35

Module II

PLANNING AND ORGANISING THE HRDSYSTEM


� Foreign Direct Investment

� Benefits of Documentation

2.1 Foreign Direct Investment (FDI)

A parent business enterprise and its foreign affiliate are the two sides of the FDI relationship. Togetherthey comprise an MNC. The parent enterprise through its foreign direct investment effort seeks toexercise substantial control over the foreign affiliate company. ‘Control’ as defined by the UN, is ownershipof greater than or equal to 10% of ordinary shares or access to voting rights in an incorporated firm.For an unincorporated firm one needs to consider an equivalent criterion.

Foreign direct investment (FDI) in its classic form is defined as a company from one country making aphysical investment into building a factory in another country. It is the establishment of an enterprise bya foreigner. Its definition can be extended to include investments made to acquire lasting interest inenterprises operating outside of the economy of the investor. The FDI relationship consists of a parententerprise and a foreign affiliate which together form an international business or a multinational corporation(MNC). In order to qualify as FDI the investment must afford the parent enterprise control over itsforeign affiliate. The IMF defines control in this case as owning 10% or more of the ordinary shares orvoting power of an incorporated firm or its equivalent for an unincorporated firm; lower ownershipshares are known as portfolio investment.


The foreign direct investor may acquire 10% or more of the voting power of an enterprise in an economythrough any of the following methods:

• by incorporating a wholly owned subsidiary or company

• by acquiring shares in an associated enterprise

• through a merger or an acquisition of an unrelated enterprise

• participating in an equity joint venture with another investor or enterprise

Classification of Foreign Direct Investment

Foreign direct investment may be classified as Inward or Outward. Foreign direct investment, which isinward, is a typical form of what is termed as ‘inward investment’. Here, investment of foreign capitaloccurs in local resources.

The factors propelling the growth of Inward FDI comprises tax breaks, relaxation of existent regulations,loans on low rates of interest and specific grants. The idea behind this is that, the long run gains fromsuch a funding far outweighs the disadvantage of the income loss incurred in the short run. Flow ofInward FDI may face restrictions from factors like restraint on ownership and disparity in the performancestandard. Foreign direct investment, which is outward, is also referred to as “direct investment abroad”.In this case it is the local capital, which is being invested in some foreign resource. Outward FDI mayalso find use in the import and export dealings with a foreign country. Outward FDI flourishes undergovernment backed insurance at risk coverage.

Type of Foreign Direct Investors

A foreign direct investor may be classified in any sector of the economy and could be any one of thefollowing:

• an individual;

• a group of related individuals;

• an incorporated or unincorporated entity;

• a public company or private company;

• a group of related enterprises;

• a government body;

• an estate (law), trust or other societal organization; or

• any combination of the above.

37Module II - Planning and Organising the BRD System

Determinants of Foreign Direct Investment

One of the most important determinants of foreign direct investment is the size as well as the growthprospects of the economy of the country where the foreign direct investment is being made. It is normallyassumed that if the country has a big market, it can grow quickly from an economic point of view andit is concluded that the investors would be able to make the most of their investments in that country.

In case of foreign direct investments that are based on export, the dimensions of the host country areimportant as there are opportunities for bigger economies of scale, as well as spill-over effects. Thepopulation of a country plays an important role in attracting foreign direct investors to a country. In suchcases the investors are lured by the prospects of a huge customer base. Now if the country has a highper capita income or if the citizens have reasonably good spending capabilities then it would offer theforeign direct investors with the scope of excellent performances.

The status of the human resources in a country is also instrumental in attracting direct investment fromoverseas. There are certain countries like China that have taken an active interest in increasing thequality of their workers. They have made it compulsory for every Chinese citizen to receive at least nineyears of education. This has helped in enhancing the standards of the laborers in China.

If a particular country has plenty of natural resources it always finds investors willing to put their moneyin them. A good example would be Saudi Arabia and other oil rich countries that have had overseascompanies investing in them in order to tap the unlimited oil resources at their disposal. Inexpensivelabor force is also an important determinant of attracting foreign direct investment. The BPO revolution,as well as the boom of the Information Technology companies in countries like India has been a proofof the fact that inexpensive labor force has played an important part in attracting overseas directinvestment.

Infrastructural factors like the status of telecommunications and railways play an important part inhaving the foreign direct investors come into a particular country. It has been observed that if theinfrastructural facilities are properly in place in a country then that country receives a substantial amountof foreign direct investment. If a country has extended its arms to overseas investors and is also able toget access to the international markets then it stands a better chance of getting higher amounts of foreigndirect investment. It has been observed in the recent years that a couple of countries have altered theirstance vis-a-vis overseas investment. They have reset their economic policies in order to suit the interestsof the overseas investors.

These companies have increased the transparency of the legal frameworks in place. This has been doneso that the overseas companies can understand the implications of their investment in a particular countryand take the appropriate decisions.

Benefits of FDI

One of the advantages of foreign direct investment is that it helps in the economic development of theparticular country where the investment is being made.


This is especially applicable for the economically developing countries. During the decade of the 90sforeign direct investment was one of the major external sources of financing for most of the countriesthat were growing from an economic perspective. It has also been observed that foreign direct investmenthas helped several countries when they have faced economic hardships. An example of this could beseen in some countries of the East Asian region. It was observed during the financial problems of 1997-98 that the amount of foreign direct investment made in these countries was pretty steady. The otherforms of cash inflows in a country like debt flows and portfolio equity had suffered major setbacks.Similar observations have been made in Latin America in the 1980s and in Mexico in 1994-95.

Foreign direct investment also permits the transfer of technologies. This is done basically in the way ofprovision of capital inputs. The importance of this factor lies in the fact that this transfer of technologiescannot be accomplished by way of trading of goods and services as well as investment of financialresources. It also assists in the promotion of the competition within the local input market of a country.

The countries that get foreign direct investment from another country can also develop the humancapital resources by getting their employees to receive training on the operations of a particular business.The profits that are generated by the foreign direct investments that are made in that country can beused for the purpose of making contributions to the revenues of corporate taxes of the recipient country.

Foreign direct investment helps in the creation of new jobs in a particular country. It also helps inincreasing the salaries of the workers. This enables them to get access to a better lifestyle and morefacilities in life. It has normally been observed that foreign direct investment allows for the developmentof the manufacturing sector of the recipient country. Foreign direct investment can also bring in advancedtechnology and skill set in a country. There is also some scope for new research activities beingundertaken. Foreign direct investment assists in increasing the income that is generated through revenuesrealized through taxation. It also plays a crucial role in the context of rise in the productivity of the hostcountries. In case of countries that make foreign direct investment in other countries this process haspositive impact as well. In case of these countries, their companies get an opportunity to explore newermarkets and thereby generate more income and profits. It also opens up the export window that allowsthese countries the opportunity to cash in on their superior technological resources. It has also beenobserved that as a result of receiving foreign direct investment from other countries, it has been possiblefor the recipient countries to keep their rates of interest at a lower level. It becomes easier for thebusiness entities to borrow finance at lesser rates of interest. The biggest beneficiaries of these facilitiesare the small and medium-sized business enterprises.

Disadvantages of FDI

The disadvantages of foreign direct investment occur mostly in case of matters related to operation,distribution of the profits made on the investment and the personnel. One of the most indirectdisadvantages of foreign direct investment is that the economically backward section of the host countryis always inconvenienced when the stream of foreign direct investment is negatively affected. The situationsin countries like Ireland, Singapore, Chile and China corroborate such an opinion. It is normally the

39

responsibility of the host country to limit the extent of impact that may be made by the foreign directinvestment. They should be making sure that the entities that are making the foreign direct investment intheir country adhere to the environmental, governance and social regulations that have been laid downin the country. The various disadvantages of foreign direct investment are understood where the hostcountry has some sort of national secret – something that is not meant to be disclosed to the rest of theworld. It has been observed that the defense of a country has faced risks as a result of the foreign directinvestment in the country.

At times it has been observed that certain foreign policies are adopted that are not appreciated by theworkers of the recipient country. Foreign direct investment, at times, is also disadvantageous for theones who are making the investment themselves. Foreign direct investment may entail high travel andcommunications expenses. The differences of language and culture that exist between the country of theinvestor and the host country could also pose problems in case of foreign direct investment yet anothermajor disadvantage of foreign direct investment is that there is a chance that a company may lose out onits ownership to an overseas company. This has often caused many companies to approach foreigndirect investment with a certain amount of caution. At times it has been observed that there is considerableinstability in a particular geographical region. This causes a lot of inconvenience to the investor.

The size of the market, as well as, the condition of the host country could be important factors in thecase of the foreign direct investment. In case the host country is not well connected with their moreadvanced neighbors, it poses a lot of challenge for the investors. At times it has been observed that thegovernments of the host country are facing problems with foreign direct investment. It has less controlover the functioning of the company that is functioning as the wholly owned subsidiary of an overseascompany.

This leads to serious issues. The investor does not have to be completely obedient to the economicpolicies of the country where they have invested the money. At times there have been adverse effects offoreign direct investment on the balance of payments of a country. Even in view of the variousdisadvantages of foreign direct investment it may be said that foreign direct investment has played animportant role in shaping the economic fortunes of a number of countries around the world.

Foreign direct investment incentives may take the following forms:

• low corporate tax and income tax rates

• tax holidays

• other types of tax concessions

• preferential tariffs

• special economic zones

• investment financial subsidies

Module II - Planning and Organising the BRD System


• soft loan or loan guarantees

• free land or land subsidies

• relocation & expatriation subsidies

• job training & employment subsidies

• infrastructure subsidies

• R&D support

• derogation from regulations (usually for very large projects)

Foreign Direct Investment Theory

The Eclectic Theory was evolved by John Dunning

The Eclectic Theory was evolved by John Dunning, emeritus professor at the Rutgers University(United States) and University of Reading (United Kingdom). The OLI Paradigm is a mix of 3 varioustheories of foreign direct investment, that concentrating on a various question.

FDI= O + L + I

“O”- Ownership Advantages (or FSA - Firm Specific Advantages).

This firm specific advantage is usually intangible and can be transferred within the multinational enterpriseat low cost (e.g., technology, brand name, benefits of economies of scale). The advantage either givesrise to higher revenues and/or lower costs that can offset the costs of operating at a distance in anabroad location.

A Multinational enterprise operating a plant in a foreign country is faced with additional costs paralleledto a local competitor. The additional costs could be specified:

a) a failure of knowledge about local market conditions

b) legal, institutional, cultural and language diversities

c) the increased costs of communicating and operating at a distance

Consequently, if a foreign firm is to be successful in another country, it must have some kind of anadvantage that vanquishes the costs of operating in an abroad market. Either the firm must be able toearn higher revenues, for the same costs, or have lower costs, for the same revenues, than comparablenative firms. Since merely abroad firms have to pay “costs of foreignness”, they must have other methodsto earn either higher revenues or have lower costs in order to able to stay in business.

Profit = Total revenues - Total costs - Cost of operating at a distance. The Multinational enterprise musthave some separate advantages with its competitors, if it wants to be profitable abroad. Advantages

41

must be particular to the firm and readily transferable between countries and within the firm. Theseadvantages are called ownership or core competencies or firm specific advantages (FSAs).

The firm has a monopoly over its firm specific advantages and can utilize them abroad, resulting in ahigher marginal return or lower marginal cost than its competitors, and thus in more profit.

Exist three basic types of ownership advantages (or Firm Specific Advantages) for a multinationalenterprise, that it can posses. There are:

a) Monopolistic advantages that receive to the Multinational enterprise in the form of privilegedaccess to output and input markets through ownership of scarce natural resources, patentrights, and the like.

b) Technology, knowledge broadly defined so as to contain all forms of innovation activities

c) Economies of large size (advantages of common governance) such as economies of learning,economies of scale and scope, broader access to financial capital throughout the Multinationalenterprise organization, and advantages from international diversification of assets and risks.

“L” - Location Advantages (or Country Specific Advantages - CSA).

The firm must use some foreign factors in connection with its native Firm Specific Advantages (FASs)in order to earn full rents on these FSAs. Therefore the locational advantages of different countries arekey in determining which will become host countries for the Multinational enterprises.

Clearly the relative attractiveness of various locations can change over time so that a host country canto some extent engineer its competitive advantage as a location for foreign direct investment. Thecountry specific advantages (CSAs) can be separate into three classes:

a) E - Economic advantages consist of the quantities and qualities of the factors of production,transport and telecommunications costs, scope and size of the market, and etc.

b) P - Political Advantages include the common and specific government policies that influenceinward Foreign Direct Investment flows, intra-firm trade and international production.

c) S - Social, cultural advantages include psychic distance between the homes and host country,language a cultural diversities, general attitude towards foreigners and the overall position towardsfree enterprise and finally.

“I” - Internalization Advantages (IA).

The Multinational enterprises have several choices of entry mode, ranking from the market (arm’slength transactions) to the hierarchy (wholly owned subsidiary). The Multinational enterprises chooseinternalization where the market does not exist or functions poorly so that transactions expenses of theexternal route are high.



The subsistence of a particular know-how or core ability is an asset that can give rise to economic rentsfor the firm. These rents can be earned by licensing the Firm Specific Advantages to another firm,exporting products using this Firm Specific Advantages as an input, or adjustment subsidiaries abroad.

The 1980’s and 1990’s have seen major changes in the business environment facing organizations.

Within Europe there has been the opening up of markets following on from the development of theSingle European market, and further business opportunities are likely to result from the development ofa single currency. The process of internationalization has been further enhanced by the continuedliberalization of trade through the GATT (General Agreements on Tariffs and Trade) and subsequentlyby the World Trade Organization (WTO). New technology has also played its part in providing greateraccess to information and therefore markets, as well as aiding competitiveness and widening consumerdemand. At the same time the major developed countries in the West have experienced a process ofdeindustrialization with the decline in their manufacturing sectors and a concomitant rise in their servicesector. Whilst many large organizations have been shedding labour the EU predicts that it will be thesmall firm sector which will be the major generator of future employment. It is against this backgroundthat this article sets out to consider the reasons why organizations seek to internationalize, the ways inwhich the internationalization process has taken place and the role of the small firm in internationalizationoperations.

Reasons for Internationalization

There is no single explanation of the factors behind organizations seeking to expand into foreign markets.Transaction costs provide one explanation; the substitution of internal organizations for market exchangepermits the internalization of transaction costs and a subsequent reduction in contracting and monitoring.As Williamson (1985) notes, an advantage of the organization is that intraorganisation activities aremore easily and sensitively enforced than inter-organization activities. Thus because of transaction costs- the costs of using the market organizations may seek to grow both vertically, horizontally or in aconglomerate fashion.

Organizations may also seek to internationalize to achieve economies of scale and economies of scope.Both give unit cost reductions as output increases, the former through the advantages of buying in bulk,having cheaper access to finance etc., while the latter are achieved through changes in average costs asa result of alterations in the mix of production between two or more products. For unrelated productsscope economies can come about through the sharing of inputs in the production process, such asmanagement, administration or storage facilities. For related products there may be cost advantagesthrough complementarily of production, both Ford and Toyota produce different models using commonassembly and production equipment.

Porter (1980) suggests that internationalization is one way by which an organization can attempt tomitigate the effects of increasingly competitive markets, particularly as markets and products mature.An example of such behaviour can be seen in the banking and building society sectors and through thebehaviour of car manufacturers, airlines and coach operators.

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The maturing of markets and the different stages of a products lifecycle can also be preferred asreasons behind the internationalization of companies. Organizations require a portfolio of products,preferably at different stages of their lifecycle, to ensure both current and future earnings. In this respectcompanies may try to acquire elements missing from their own portfolios, especially if they lack starproducts or the potential to develop new products. For example, the takeover of Row tree by Nestle,which, having identified chocolate confectionary as a gap in its existing portfolio, elected to fill it byacquisition rather than entry into a highly competitive market.

The desire to achieve cost savings is another driver of internationalization. For example, Fiat’s entryinto Eastern Europe and the formation of Ford Europe has enabled both organizations to exploit lowercost areas. However, it should be noted that cost reductions do not always lead to internationalization;they may simply lead to relocation. Boundary changes may also be triggered by changes in themacroeconomic environment such as the upsurge in merger activity that followed the passing of theSingle European Act. Organizations might also seek to internationalize to gain sales, operation, investmentand management synergy.

External factors are also important in altering the boundaries of the organization. The formation oftrading blocs such as the North American Free Trade Agreement (NAFTA) or the European Union(EU) has had a profound effect on the way in which organizations view world markets and planinternational investment or export sales. Worldwide economic cycles also play their part. In times ofrecession, markets become intensely competitive, with organizations looking to more internationalexpansion to reduce their exposure at home. Conversely, when economies move into their boom phases,organizations have sufficient profits to grow internationally.

Labour costs can also provide the stimulus for internationalization. The term “new international divisionof labour” (NIDL) has been used to explain the shift in production from “core” industrialized economiesto less developed countries, as transnational seek cheap, controllable labour on a global scale. Further,there may be push factors which, in industrialized economies, combine to encourage organizations tolook for new locations, such as declining profits and an increasingly militant or rigid labour market.

Finally, technological factors play an important part in widening the markets which an organizationserves. Advances in technology make previously restricted markets profitable to enter. Organizationsmay expand into these markets by locating there or expand their provision in the domestic market andexport goods and services. As Dicken (1998) notes, “technology is without doubt, one of the mostimportant contributory factors underlying the internationalization and globalization of economic activity”.He identifies advances in communications and transport as fundamental “space— shrinking” technologieswhich have facilitated the development of the global organization.

The export process is made more complex by the wide variety of documents that the exporter needs tocomplete to ensure that the order reaches its destination quickly, safely and without problems. Thesedocuments range include those required by the South African authorities (such as bills of entry, foreignexchange documents, export permits, etc.), those required by the importer (such as the proforma andcommercial invoices, certificates of origin and health, and pre-shipment inspection documents), those



required for payment (such as the South African Reserve Bank forms, the letter of credit and the bill oflading) and finally, those required for transportation (such as the bill of lading, the airway bill or thefreight transit order). Documentation requirements for export shipments also vary widely according tothe country of destination and the type of product being shipped. Most exporters rely on an internationalfreight forwarder to handle the export documentation because of the multitude of documentaryrequirements involved in physically exporting goods and it is strongly recommended that you also makeuse of a freight forwarder to help you work your way through the maze of documentation. Click herefor a list of freight forwarders that you can approach to help you.

2.2 The Benefits of Documentation

Documentation is a key means of conveying information from one person or company to another, andalso serves as permanent proof of tasks and actions undertaken throughout the export process.Documentation is not only required for your own business purposes and that of your business partner,but also to satisfy the customs authorities in both countries and to facilitate the transportation of andpayment for goods sold.

One value of documentation is that copies can be made and shared with the parties involved in theexport process (although you should always ensure that you make identical copies from an agreed-upon master - it is no use making changes without the other party’s agreement and then presenting theseas the “latest” copies). If the documentation is complete, accurate, agreed upon by the parties involvedand signed by each of these of these parties (or their representatives), the document will represent alegally binding document.

Function of Export Documentation

Export documentation may serve any or all of the following functions:

• An attestation of facts, such as a certificate of origin

• Evidence of the terms and conditions of a contract if carriage, such as in the case of an airwaybill

• Evidence of ownership or title to goods, such as in the case of a bill of lading

• A promissory note; that is, a promise to pay

• A demand for payment, as with a bill of exchange

• A declaration of liability, such as with a customs bill of entry

• A receipt for goods received.

45

There are five broad categories of documentation you will encounter when exporting. These are:

Documents involving the importer

• The proforma invoice

• The export contract

• The commercial invoice

• The packing list

• Letter of credit

• Certificate of origin

• Certificates of health

• Fumigation certificate

• Pre-shipment inspection certificate

Proforma Invoice

A proforma invoice is little more than a preadvice of what will stand in the commercial invoice oncenegotiations have been completed. Indeed, the proforma invoice and the commercial invoice often lookexactly the same, except that it should state clearly “proforma invoice” on this document, whereas thecommercial invoice will state “invoice” or “commercial invoice”. The proforma invoice serves as anegotiating instrument. The initial proforma invoice often sets the stage for the first round of negotiationsif the exporter and importer have not yet had any real discussions.

What is the difference between a proforma invoice and a quotation?

In reality, there is very little difference in function between the two and the proforma invoice is really aquotation in invoice form; in other words. The difference really comes about in terms of the structureand layout of the proforma invoice/quotation. A quotation appears more like a business letter describinga written offer, while a proforma invoice appears exactly the same as a invoice (except with the words“proforma invoice” written on the document). The proforma invoice essentially serves as a ‘quotation’that sets the road to further negotiations. Some exporters choose to prepare an ‘official’ quotation,while others prefer to use the proforma invoice as their quotation. In fact, the quotation can contain thesame information as a proforma invoice.

The role of the proforma invoice in the negotiation process

Assuming that an importer e-mails you - an exporter - asking you to submit a proforma invoice (or aquotation) for the supply of 100 pumps according to a set standard. You would then prepare and



submit a proforma invoice to the potential importer outlining a description of the product, what the priceis, what the delivery terms will be, what the payment terms will be, as well as any other information thatmay be pertinent to the sale. The importer will most likely reply to your proforma invoice requesting/negotiating different requirements such as a lower price, longer terms of payment, different methods ofpayment, a different delivery schedule and may even request changes to the product specifications.Based on these requests from the importer, you may choose to comply or to refer back to the importer(probably via telephone, fax or e-mail) to discuss or negotiate compromises to these requirements.When you and the importer finally come to an agreement, a second (sometimes even third or fourth)proforma invoice will be exchanged between the two parties. This final proforma invoice - accepted bythe importer - sets the stage for the further processing of the order. You should be aware that theimporter may use the proforma invoice to request foreign exchange within his/her country if his/hercurrency is not freely convertible. The proforma-invoice can also help the importer apply for a letter ofcredit at his/her bank.

In other instances where the exporter and importer have met before and have already discussed andthrashed out an agreement perhaps in a face-to-face meeting, only one final proforma invoice is necessaryto confirm that the two parties are indeed in agreement. Every proforma invoice should be as preciseand as explicit as possible to ensure that both parties understand each other. If the importer is satisfiedwith this final proforma invoice, he/she will request their bank to issue an L/C on the strength of informationstipulated in the proforma invoice. For this reason, it is essential that the proforma invoice be extremelyaccurate, clear and concise. Any errors or misunderstandings will be transferred to the L/C and willcause problems, frustrations and delays down the line. What is more, the proforma invoice is alsoimportant to the importer for the purpose of obtaining an import permit and foreign exchange allocationwithin his country. At the same time, the exporter may use the proforma invoice and acceptance of theorder from the importer to obtain funding to pay for the manufacturer of the goods concerned.


1. What do you mean by Foreign Direct Investment and explain its features.

2. What are determinants of Foreign Direct Investment?

3. What are the disadvantages of Foreign Direct Investment?

4. What is Internationalization and explain the concepts.

* * * *

47

Module III

FINANCIAL ENVIRONMENT OFINTERNATIONAL BUSINESS


� International Finance

� International Financial Environment

� Management of Foreign Exchange Risk

� International Financial Market

� International Financial Institutions

� Government institutions

� Foreign Financial Market & Exchange Determination

� Exchange Rate

3.1 International Finance

International finance, an offshoot of economics, encompasses a detailed understanding of exchangerates and foreign investment and their impact on international trade. Analysis of international projects,overseas investments, cross border capital flows, trade deficits, currency swaps and global financialmarkets are some of its key areas of study. Individual investors usually focus on that part of internationalfinance that deals with global futures and options and the forex market.


There are various global bodies regulating different aspects of international finance. These include:

• IFC: International Finance Corporation is a prominent entity supporting sustainable investmentsin the private sector of developing countries to stimulate their growth. It is the biggest source ofmultilateral loans and equity financing for projects undertaken by the private sector in developingcountries. IFC plays a key role in providing technical assistance to businesses and governmentsof developing countries.

• IMF: International Monetary Fund monitors the balance of payments of its member countries.It is regarded as the lender of last resort for countries facing a financial crisis, such as deficitsand currency crisis. The relief amount is relative to the size of the country’s contribution in theglobal trading system.

• World Bank: It funds the development of projects, mainly in developing countries, that are notfinanced by the private sector.

• WTO: World Trade Organization resolves multilateral and bilateral trade disputes in additionto the negotiation of different trade agreements among its various member nations.

Some of the benefits of international finance are:

• Access to capital markets across the world enables a country to borrow during tough timesand lend during good times.

• It promotes domestic investment and growth through capital import.

• Worldwide cash flows can exert a corrective force against bad government policies.

• It prevents excessive domestic regulation through global financial institutions.

• International finance leads to healthy competition and, hence, a more effective banking system.

• It provides information on the vital areas of investments and leads to effective capital allocation.

• International finance promotes the integration of economies, facilitating the easy flow of capital.The free transfer of funds would eventually result in more equality among countries that are apart of the global financial system.

3.2 International Financial Environment

Investment Decisions

A very important decision which organizations involved in international business must, take is whatprojects are to be financed? and in which nations these are to be financed. These questions which relate

49Module III - Financial Environment of International Business

to the investment decisions are of prime importance from the perspective of parent organization. Ifanswered wrongly then they could create perennial problems for the organization or could lead toheavy losses or could result in complete failure. On the other hand, if these are answered correctly, thenthey could lead to increase in profits for the parent organization or increase in market share of theorganization or could provide a source of competitive edge to the organization. In order to decideabout where to invest and where not to invest, organization looks at a large numbers of factors like thesocio-cultural, economic, political, legal, natural and demographic environment of the host nation. Afteranalyzing the environmental factors the organization develops an idea about the benefits, costs and risksassociated with the investment.

Capital Budgeting

The top management of the organization can take a decision about the investment only when it has adefinite idea about the benefits, costs and risks associated with it. Capital budgeting is a techniquewhich quantifies the benefits, costs and risks involved with an investment or a project. Thus capitalbudgeting allows the top management to easily compare different projects in different nations and makeinformed choices about where to make the investment.

In carrying out capital budgeting the organization involved in international business uses the sametheoretical framework as used by an organization involved in domestic business, i.e., the organizationmakes use of concepts like cash inflows, outflows, discount rate, etc. in order to find out the NetPresent Value (NPV) of the project. If the NPV comes out to be greater than zero, then the organizationcan go for the project.

In spite of the fact that certain similarities exist between the capital budgeting technique followed by anorganization involved in the international business and the technique followed by an organization involvedin the domestic business, there are certain dissimilarities also. Some of the aspects of capital budgetingwhich are specific to foreign project assessment are:

• The cash flows occurring from the projects must be analyzed from the perspective of theparent organization. For example, there is a possibility that two foreign subsidiaries of theorganization may want to set up, each, a new plant for the manufacturing of the same productand for supplying in the same market, on the basis of positive NPV criteria. If this is allowedthen it could create a situation where subsidiaries of the same organization will compete witheach other, and as a result, chances are that the profit from the projects may not materialize asper the expectations. So, in such a situation; the parent organization must reject the proposal ofone of the subsidiaries that will result in a lower positive NPV to it and accept the proposal ofthe subsidiary which will result in a higher positive NPV to it.

• The cash flows occurring to the project are not necessarily the cash flows that will occur to theparent organization. It is often seen that because of the policies, rules and regulations of thehost nation it is not always possible to remit all the cash flows, which are generated from the


project, to the parent organization in the home nation. This situation could arise because of theforeign currency controls exercised by the host nation, which sometimes block the repatriationof cash to the home nation or which heavily taxes the cash flows that are to be repatriated orwhich require that a certain percentage of cash flows generated from the project should bereinvested in the host nation. So, from the perspective of the parent organization the cash flowsthat are not remitted to it are of less value as these cannot be used for the payment of dividendsto the stockholders or for repayment of worldwide debt or for reinvestment in other parts ofthe globe. But from the angle of the project these are cash flows which should be used forcalculating NPV of it.

• The political risk, which refers to the change in the political environment of the host nation thatadversely affects organization’s goals, can substantially reduce the value or expected cashflows of the project. The political risk tends to be more in case of the nations where thegovernment is autocratic, which are passing through a period of social unrest and which areless developed. In case of these nations, the chances are that with the change of governmentthe policies will change and these changes will negativity affect the foreign organization’soperations in the nation. The result of change in policies could be the expropriation of theforeign organization’s assets as happened after the Iranian revolution of 1979 or it could be theincrease in taxes or imposition of additional taxes on the cash flows that are to be repatriatedback.

• The economic risks associated with the foreign investments are more than the domesticinvestments, and mainly relate to increase in the inflation rate in the host nation, depreciation inthe value of the local currency or erratic fluctuations in the exchange rate of the host nationcurrency. All these developments or developments in any of these could drastically affect thecash flows that occur to parent organization-It is seen that many organizations pay considerableattention to political and economic risk analysis while going for investments in foreign projects.Normally, organizations follow two approaches for tackling these risks. One is that they increasethe discount rate is the NPV formula for the nations where the perceived risk is high. Thesecond approach which the organizations follow is that they reduce the future cash flows fromthe project. The logic is that normally foreign investment is not made in a nation where theapparent immediate political and economic risk is high as multinational organizations shy awayfrom making investments in these. But as time elapses, the situation changes and the probabilityof these risks become high, so in order to incorporate these future risks associated with theforeign investments the organizations reduce the future cash flows. For example, Union Carbide,a U.S. Multinational enterprise, has incorporated political risk in its capital budgeting process.

Financing Decisions

Since the organization is able to decide about the foreign project which it will be taking for investment,the next question which arises for it is how to finance the investment? That is the organization has todecide about the source of financing and the structure of financing. In source of financing, the organization

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has to decide that whether it will be using internal sources or external sources for generating the requiredfunds. In structure of financing the organization has to decide about the mix of debt and equity, which itwill be using for financing the project.

Source of Financing

As far as the sources of financing are concerned, the organization has to decide that whether it will beusing internal sources for financing the project or external sources or a combination of the two. If theorganization decides to make use of the internal sources for financing a new project in the host nation,then it has the following options:

• If a subsidiary in the host nation is responsible for the new project then it could make use of thefunds which it gets by selling the product or by providing the service in the host nation.

• The subsidiary can get the funds from the parent organization.

• The subsidiary can also get the required funds from some other subsidiary in the same nation orfrom some other nation.

• The organizations mainly go for utilizing the internal sources of finance

• for one or some of the following reasons:

• To minimize the cost of funding—the cost of generating the required funds internally, if possible,is always less than the cost of getting the same from external sources.

• To make use of organization’s blocked funds—sometimes, the organization finds that its fundsare blocked in some foreign nation X because of the policies of the concerned nation whichdoes not allow repatriation of the funds. So, in this case, the organization can start a newproject in X using the excess funds which are available in its accounts in the nation or if it wantsto fund the project in nation Y then it can do so by finding a bank which has its branches in boththe nations X and Y. Then it can enter into an agreement with the bank, if possible, that the bankshould provide loan in nation Y in nation Y’s currency and should accept the payment in nationX, in the currency of nation X.

• Out of convenience— in certain cases the organization finds that the external market has becomesaturated for it so it cannot raise the required funds from it, therefore, it goes for internalsourcing of funds for financing of the project.

Financial Structure

The financial structure adopted by an’ organization for financing an investment varies from nation tonation and organization to organization. That is there is no standard format available regarding theamount of debt and equity which should be used for financing the projects in all situations, acrossnations, worldwide. According to a study of organizations, in 23 nations, it was found that the average

Module III - Financial Environment of International Business


debt to equity rate was 0.34 in Singapore, 0.55 in the U-S-A. 0.55 in U.K., 0.62 in Germany and 0.76in Italy .

In general it has been seen that the Japanese organizations rely more on debt financing than their U.S.counterparts. The reason for the same could be the government policies or the cultural reasons.

The organization can raise the capital in the debt form either by taking loans from the banks in the homenation or host nation; or by getting the finances from the Eurocurrency market; or by raising it throughbonds.

The international bond market can be divided into foreign bonds and Eurobonds. The foreign bondsare sold outside the borrower’s nation, but are denominated in the currency of the nation in which theyare issued. For example, an Indian organization issuing bonds in U.S. dollars in the U.S.A. The Eurobondsare underwritten by a syndicate of banks and are issued in the nations other than the one in whosecurrency they are denominated. For example, a Japanese organization issuing bonds in US dollars andselling it in nations other than U.S.A.

The main drawback of this approach is that it increases the financial risk. For example, the major causeof the Asian financial crisis of 1997 was the excessive reliance on debt, especially bank debt. Anotherimportant source of external financing available to organization involved in international business is theglobal equity market.

In case of equity market the financer takes an ownership position by way of the stock of shares of theorganization, which it holds. The organization involved in international business can raise the capitalfrom equity market by following the approaches mentioned as under:

1. The organization can get the capital through private placement with a venture capitalist.

2. The organization can also raise the equity capital by listing their stocks on the domestic andforeign exchanges. For example, after the merger of Daimler and Chrysler, the new organizationissued global shares in 21 different markets in eight nations.

3. Another option for raising equity capital is by way of ADRs, GDRs and IDRs.

Management of Global Cash Flows

The efficient management of global cash flows significantly affects the profit line of organizations involvedin international business. In trying to achieve this efficiency objective, the organizations, mainly, concentrateon reducing cash balances, reducing transaction costs and reducing taxes globally.

Reducing Cash Balances

One of the factors which can affect the objective of efficient management of global cash flows is theamount of cash balances that an organization holds for meeting the normal payment requirements andalso to meet the unexpected demand for cash, during a given period of time.

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Normally, the organization invests the excess funds, which are over and above the required cash balances,in long-term financial instruments, such as bonds, certificates of deposit, etc. The period of theseinstruments is generally six months or more and they yield a higher rate of return on the investments. Thecash balances which the organization keep in order to meet the payment requirements cannot be investedin long-term financial instruments as these could be demanded any time during the period for payments.So, these are normally invested by the organization in money market accounts from which they couldbe withdrawn freely at any moment of time. The period of these investments is, mostly, less than orequal to three months and they yield a relatively low rate of interest.

The problem which the organization faces is that if it invests more in long-term financial instruments thenchances are that it may not be able to meet the cash requirements of the period because of limitedliquidity. .On the other hand, if it invests less in long-term financial instruments then the organization willbe having ample amount of liquidity but less return on investments. So, the persistent problem of theorganization involved in international business and having subsidiaries in many nations is that how tominimize the cash balances and at the same time be able to meet all its cash requirements.

Centralized depository is one approach which the organizations follow in .order to reduce’ the cashbalances and maximize the returns on investments. In this approach, the multinational enterprise insteadof allowing the individual subsidiaries to maintain their cash balances hold the cash balances at acentralized depository.

The most important advantage of this approach is that it reduces the required size of cash balance. Inother words, it means that if individual subsidiaries maintain their cash balances then the sum of thesecash balances will always be more than the cash balance which-will be required at the centralizeddepository. So, if the organization follows the centralized depository approach then it can always investmore in high yielding long-term financial instruments then is otherwise possible.

The second advantage of this approach is that it is able to pool a large amount centrally. This largeamount can be invested, on the advice of financial experts at the best, money market accounts. Theresult is a higher return on the short-term investments where the rate of return depends on the size ofamount.

Reducing Transaction Costs

According to the United Nations, nearly, 40 per cent of the international trade takes place betweendifferent subsidiaries of the multinational enterprises. It occurs on account of the fact that the MNEswant to carry out the different value creating activities at the optimal locations globally. This brings intofocus the issue of intra-organization transaction costs, i.e., the costs of changing cash from one currencyinto another and transferring the same to another location. The transaction cost consists of two elements.The first element is the commission which is paid by the organization to the foreign exchange dealers forthe conversion of the currency and the second element is the transfer fee which is paid to the bank formoving the cash from one location to another. The transaction cost is high for an organization if it has



many subsidiaries, and all of them have to make and receive payments from each other. This hightransaction cost could be reduced by following the process of multilateral netting. In multilateral nettingthe organization sets up a central clearing account with the authority to make and receive the necessarypayments to and from the different subsidiaries in order to settle the intra-organization subsidiaryobligations, efficiently and at minimum transaction costs.

Reducing Taxes Globally

It is seen that the corporate tax rate is different in different nations. Moreover, it also varies fromindustry to industry. So, organizations involved in international business try to minimize the total tax paidby them by making use of different approaches for transferring the funds globally. Some of the importantapproaches followed by MNEs for transferring the funds include dividend remittances; royalty paymentsand fees; transfer pricing; fronting loans; and use of tax havens.

Dividend Remittances

One of the most common approaches followed by the organizations for transferring the funds from thesubsidiaries to the parent organization is by way of payment of dividends. This approach becomes lessattractive if the host nation government levies a high tax on dividend payments, or there is an upper limiton the total amount that could be remitted by way of dividends in a year. Additionally, payment by wayof dividends could become unattractive if the income earned by the subsidiary is taxed by both thehome and host nation governments.

The problem of double taxation, i.e., taxes imposed by the home and the host nation, could get mitigatedby way of tax treaties, tax credits and the deferral principle. In general, a tax treaty is a contractbetween the two nations that specifies which income earned by the subsidiary will be taxed by the hostnation and which will be taxed by the home nation. A tax credit lets the organization to reduce the taxwhich is paid to the home nation by the amount which has been already paid as tax to the host nation.Finally, the deferral principle says that the parent organization cannot be taxed on the foreign subsidiaryincome until it actually receives the same.

Royalty Payments and Fees

Sometimes the organization finds that the tax imposed by the host nation on the income earned by thesubsidiary is quite high as compared to the tax imposed by the home nation. So, in order to reduce thehigh tax burden of the host nation the organization tries to deflate the subsidiary income by increasing itsexpenses, substantially, on the payment of royalties and other fees to the parent organization.

The royalty payment is the money paid to the owners of technology, patents or brand names, for the useof the same by the organization. When the organization finds that there is a high tax, in the host nation,on the income that is transferred to the parent organization by way of dividends then it tries to transfersubstantial amount of funds to the parent organization in the form of royalty payments for the use oftechnology, trademark, etc. of it.

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The organization also tries to transfer funds from the subsidiary to the parent organization in the form offee which is paid by the former to the latter for the managerial or technical expertise which the formerreceives from the latter. Generally, the payments made in the form of royalties and fees are treated asexpenses made by the subsidiary, and hence they are tax deductible in the host nation.

Transfer Pricing

A transfer price is the internal price at which the goods and services are transferred between differentunits of the same organization. It refers to the price at which goods/services are transferred from onesubsidiary of the organization to another or from subsidiary to parent organization or vice versa. Normally,it is assumed that the transfer price will be the market based price or it will be slightly less than themarket prize on account of the fact that certain discount will be given to intra-org animation dealings.But the reality is that many organizations manipulate transfer prices in order to avoid or reduce taxliabilities.

For example, organization tries to move funds out of the nation where the tax rate is high by charging ahigh transfer prize for the goods/services which are supplied to the subsidiary based in it; and on theother hand, paying a low transfer price to the goods/services supplied by the subsidiary based in it. Thisway the organization is able to deflate the income which is generated in a high tax nation.

Suppose an organization is having its subsidiaries in two nations X and Y (refer to Table 1). In case ofnation X, the tax rate is 20 per cent, whereas in case of nation Y the tax rate is 40 per cent. Consider thesituation in which the infra-organization transactions. Between the two subsidiaries, takes place at themarket based prices. The subsidiary in national X sells the goods/services to subsidiary in nation Y atRs. 40 lakhs, and hence earns profit of Rs. 5 lakhs, whereas the subsidiary in nation Y sells the goods/services at Rs. 45 lakhs, and also makes a profit of Rs. 5 lakhs. But owning to the different tax rates inX and Y, the net profit for the subsidiaries, after paying the taxes, comes out to be Rs. 4 lakhs and Rs.3 lakhs. respectively- Thus, for the organization as a whole, the total net profit is Rs. 7 lakhs and totaltaxes Rs. 3 lakhs.

Table 1: Transfer Pricing



Now consider another situation in which the organization manipulates transfer prices m order to reducethe total tax and increase the total net profit. In this case, the subsidiary in X sells the goods/services tosubsidiary in Y at a transfer price of Rs. 45 lakhs, whereas He subsidiary in Y also sells it at a price ofRs. 45 lakhs. Thus, the profit for subsidiary in X runs out to be Rs. 10 lakhs, whereas the same is nil inthe case of subsidiary in Y. Thus the organization is able to reallocate its income from a nation where taxrate is high to a nation where the same is low. The result is that the net profit after paying taxes in nationsX and Y stand at Rs. 8 lakhs and nil respectively. Hence, for the organization as a whole the total taxunder manipulated transfer prices is Rs. 2 lakhs and total profit is Rs. 8 lakhs. Therefore, is manipulatingthe transfer prices, the organization is able to reduce its tax by Rs. 1 lakh.

Nowadays manipulating transfer prices arbitrarily is not easy as nations around the world have becomevigilant towards it and feels cheated if the organizations try to use it for avoiding tax liabilities orcircumventing government restrictions on capital flows. Many nations HE trying to rewrite their tax lawsin order to check arbitrary manipulation of transfer prices, for example, in the case of U.S.A., theInternal Revenue Service (IRS) can reallocate the gross income, deductions, credits, etc. betweendifferent units of the organization in order to present tax evasion. In doing so the IRS makes use of thearm’s length price in order to decide about transfer price. The arm’s length price is the market price thatwould be demanded .aid paid by unrelated organizations. The burden of proof lies on the organizationto show that 33$ has done the re-allocation unreasonably.

Fronting Loans

A loan which is given by the parent organization to the subsidiary in the host nation, indirectly, througha commercial bank is known as a fronting loan. In fronting loan the parent organization, suppose basedin the U.S.A., instead of directly giving Joan to its subsidiary’ in China, deposits loan to the subsidiaryin China. The deal is risk free and profitable for the bank as it has 100 per cent collateral in the form ofparent’s deposit and it pays a slightly low interest rate on the deposit than it charges for the amountwhich it has loaned.

In certain cases, the organizations find that there is a high tax on the remittance of dividends to theparent organization and arbitrary manipulation of transfer prices is also not possible. So, organizationstry to transfer funds from the host nation to the parent organization by way of payment of interest to theinternational bank on the loan which it has taken from it. The bank, in turn, gives back the interest,slightly less, to the parent organization on the deposit made by the same. Generally, the host nationgovernment does not restrict or check the interest which is paid to the bank as it doesn’t want to spoilits mutually advantageous relations with the same.

Tax Havens

A tax haven is a nation or jurisdiction with no or very low rate of income tax. Some examples of thesame are the Bahamas, Switzerland, Monaco and Andorra. The organizations involved in internationalbusiness try to reduce or avoid their tax liabilities by setting up their subsidiaries in these locations. Then

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they arbitrarily manipulate transfer prices in order to reallocate income from high tax nation to thesubsidiary situated in tax haven.

Sometimes, organizations headquartered in the nations where the deferral principle is accepted, i.e., theparent organization situated in the nation is not taxed for the income which is generated by its subsidiariesin foreign locations until it receives the same; try to establish subsidiaries in tax havens and channel allfunds to the parent organization through it. The objective is that if funds are required for further foreignoperations then they should be held at the tax haven subsidiary and should be invested from there asand when required. By doing this the organization is able to reduce the tax burden as the funds that areheld at tax haven are not taxed. On the other hand, if these funds would have reached the parentorganization directly, bypassing the tax haven, then these funds would have been taxed by the homenation before investing the same for further foreign operations.

3.3 Management of Foreign Exchange Risk

The management of foreign exchange risk is an important component of international financial managementstrategy of any organization. It involves finding and defining the type of foreign exchange exposure thatthe organization faces and the strategy for managing the same.

Transaction Exposure

It is the extent to which an organization’s paying bills and collecting receivables, from individualtransactions, get affected due to fluctuations in exchange rates. For example, an Indian organizationenters into a contract to import 500 computers from U.S.A. at the rate of $700 per computer. Thedollar/rupee spot exchange rate is $1= Rs.50. The cost of one computer in rupees is Rs.35,000. Theorganization feels that it can sell the computers the day they arrive at Rs. 37,000 per piece. Thus, itexpects to make Rs.2000 as profit. Suppose, the dollar appreciates and the new exchange rate becomes$1 = Rs.55- Therefore, when the computers arrive the organization pays Rs. 38,500 (55 x 700) percomputer to the U.S. exporter. Thus, the fluctuation in the exchange rate turns the deal into an unprofitableone (Rs.2000 per computer profit) into an unprofitable one (Rs, 1500 per Computer Loss) In thiscase, the transaction exposure per computer for the Indian organization b Rs-3500 (Rs.38,500 - Rs.35.000), which is the amount .that the organization has lost one due to change in the exchange rates.

Transition Exposure is the extent to which the reported position of a subsidiary gets affected due tochange in the exchange rate. Suppose, the Indian rupee depreciates from Rs. 50 per dollar to Rs. 55per dollar. Now this change in exchange rate will substantially reduce the dollar value of the Indiansubsidiary of U.S. multinational enterprise. This change is not going to affect the local purchasing powerof rupee, in the short, or deposit in rupee, but this will definitely affect the dealings which will take placein dollars or other foreign currencies.



Economic Exposure

The economic exposure is the extent to which the long-term prices, sales and costs, of m organizationget affected due to change in the exchange rates. For example, in the early 1980s, when the U.S. dollarbecame strong against the Japanese yen then it had a profitable impact against the Japanese exportersas their exports became cheap in U.S. market. On the other hand, when the U.S. dollar started decliningagainst the Japanese yen since the mid-1980s it negatively affected the Japanese exports as they becamecostlier in U.S. markets.

The organizations involved in the international business can manage transaction aid translation exposuresby resorting to number of tactics such as forward exchange contracts; currency swaps; lead and lagstrategies. These strategies basically protect short-term cash flows from fluctuations in exchange rates.

A lead strategy requires collecting foreign exchange receivables early if the foreign currency is expectedto depreciate, and making the payments early if it is expected to appreciate. On the other hand, a lagstrategy requires delaying in collecting the foreign currency receivables if the foreign currency is expectedto appreciate, and delaying in making the payments if n is expected to depreciate.

As far as management of economic exposure is concerned, the same could be achieved by reallocatingthe organization’s value creating activities in different nations. For example, after the mid-1980s whenthe Japanese yen started strengthening against the U.S. dollar, the Japanese exports became uncompetitivein the U.S. markets as the change in exchange are converted Japan from a low-cost manufacturinglocation to a high-cost manufacturing location. Therefore, Japanese auto companies started shiftingtheir manufacturing to U.S. and other overseas locations in order to control the rise in their prices inforeign markets.

3.4 International Financial Market

Euro Dollar Market

Eurocurrency market is an international capital market in which the deposits and leadings take placeoutside the currency of issue and the transactions are not under the general regulations of the monetaryauthorities of the country where they are located.

Origin of Eurocurrency Markets

One of the important facets of the international financial system is the Eurocurrency system. By‘Eurocurrency’ we mean the currency deposited in a bank outside the country of its origin. Example—yen deposited outside Japan is Euroyen; dollar deposited outside United States is Eurodollar. A USdollar deposit in Singapore as well as a US dollar deposit in London is known as Eurodollar. Thus‘Eurocurrency’ is not ‘Euro’ and is not necessarily European currency.

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The origin of Eurocurrency market can be traced back to late 1950’s when the Eastern block countrieswere afraid of depositing dollars in the United States in fear of U.S. confiscation. Hence they depositedtheir money in Europe and the banks which accepted these currencies as deposits became Eurobanks.These deposits are usually borrowed or loaned by major international banks, international corporationsand governments, when they need to acquire or invest additional funds. The market in which borrowingand lending takes place is called Eurocurrency market. These markets operate under a regulatoryregime different from regulations applied to deposits used to execute domestic transactions. It is aparallel market in competition with traditional domestic market.

Initially only dollar was used in this fashion and the market was therefore called Eurodollar market.Subsequently, other leading currencies like the British pound sterling, German mark, Japanese yen, andthe French & Swiss franc began to be used this way and so the market is now appropriately called theEurocurrency market.

Growth of Eurocurrency Markets

The Euro currency deposits have grown from 10 million dollars in the early 1960’s to over 1 trilliondollars in 1990 and further to 9.5 trillion dollars during 1999. In the ten-year period ending 1987 thetotal net deposits have increased from USD 478 billion to USD 2,377 billion. Dollar-denominateddeposits accounts for the largest share of the market which comes to nearly 67% of the totalEurocurrencies deposits. In dollar terms, of roughly USD 1,569 billion, this compares with a total figureof USD 2,377 billion held domestically in the U.S. by commercial banks.

The reasons for the phenomenal growth of the Eurocurrency markets can be attributed to the following:

Restrictive Domestic Regulatory Regime

Ceiling on interest rates on deposits - Until it was abolished in 1986, the Federal Reserve SystemRegulation Q imposed ceilings on the interest rates that U.S. member banks could pay on deposits, tolevels that were often below the rates paid by European banks. As a result short-term dollar depositswere attracted to European banks and became Eurodollars.

Imposition of taxes - The Interest Equalization Tax imposed taxes on U.S. purchases of foreign securities.Also the Foreign Credit Restraint Program limits the volume of bank lending to foreigners. Theseregulations only further encouraged borrowers to invest the Eurocurrency markets.

Capital controls - The European governments also experimented with capital controls in the 1970’s.Both Germany and Switzerland imposed regulations to try to limit the non-resident demand for theircurrencies. These regulations helped to promote the non-dollar segments of the Eurocurrency markets.

The demand for Eurodollars further multiplied when the Bank of England restricted the external use ofsterling in 1957.



Encouraging Nature of Regulation of the Eurocurrency Markets

Yet another reason for the growth of the Eurocurrency markets is that the regulations of the Eurocurrencymarkets are such that there are;

• No reserve requirements

• No interest rates regulations

• No deposit insurance requirements

• No credit allocation regulations

• Less stringent disclosure requirements

• No withholding of taxes.

1. The nature of regulations is such that (a) International corporations could overcome domesticcredit restrictions by borrowing in the Eurocurrency markets; (b) International corporationsoften find it convenient to hold balances abroad for short periods in the currency in whichthey need to make payments.

2. Communist nations prefer to keep their dollars outside U.S. for fear that they might befrozen in political crises. Indeed this is how the Eurocurrency market originated. The rapidgrowth of this market stems in part from the demand for U.S. dollars as an internationalcurrency, in part from the tremendous flows of ‘petrodollars’ into international banks fromthe oil exporting countries during the mid-1970’s and early 1980’s. Eurodollar depositsare not subject to Federal Reserve requirements. Hence deposit rate is typically higherand the borrowing rate is lower compared to U.S. domestic rates.

Features of Eurocurrency Markets

The salient features of Eurocurrency markets are:

1. The Eurocurrency markets are composed of Euro banks which accept/ maintain deposits offoreign currency and the dominant currency USD.

2. The Eurocurrency markets are essentially wholesale markets operating at inter-bank levels.

3. They are highly competitive as there are many Eurodollars markets operating world wide.

4. Euro banks have no central monetary authority and hence there are no regulatory restrictionsimposed by them.

5. Eurocurrency markets operate through Euro banks, which are financial intermediaries, bringingtogether lenders and borrowers.

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Eurocurrency lending operation is standardized and is of high volume. Euro banks dealing withEurocurrencies have lower regulatory costs. They are not subject to interest rate ceilings.

Operations of Eurocurrency Markets

Since Eurocurrencies are in the form of time deposits rather than demand deposits, they are moneysubstitutes or near money rather than money itself. Thus Euro banks are not primarily commercialbanks which are involved in credit creation. They rather operate like domestic savings and loanassociations than like commercial banks. Thus they contribute to international liquidity.

Euro banks are willing to accept deposits denominated in foreign currencies and are able to pay higherinterest rates on these deposits than U.S. banks because they can lend these deposits at still higherrates. In general the spread between lending and borrowing rates on Eurocurrency deposits is smallerthan the U.S. banks.

US Lending/Deposit Rate ED Lending/Deposit Rate

US Lending Rate

ED Lending Rate

ED Deposit Rate

US Deposit Rate

Eurocurrency deposit rate is higher and lending rate lower because Euro banks have lower regulatorycosts, they are not subject to interest rate ceilings. A large percentage of deposits can be lent out. Mostborrowers are well known and safer. Eurocurrency lending is standardized and is of high volume.

Euro banks are banks that accept fixed time Eurocurrency deposits and make loans in Eurocurrency.Euro loan market is extremely competitive and lenders operate on razor thin margins. Euro loans areoften quoted on the basis of London Inter Bank Offer Rate (LIBOR), the rate that London bankscharge each other for short-term Eurocurrency loans. The Eurocurrency loans have floating interestrates with reference to the LIBOR. The interest rates on Eurocurrency loans are often the LIBOR plusfixed margin with LIBOR rate being reset periodically and margin determined by creditworthiness ofborrowers. The volume of Eurocurrency loans is large and requires several Euro banks to form asyndicate. Borrowers are expected to pay syndication fee.

Significance of Eurocurrency Markets

1. In the past the U.S. and the oil exporting countries have been the main lenders while developingcountries have been the net borrowers. The intermediation function that Eurocurrency marketsperformed in recycling hundreds of billions of petrodollars for oil exporting countries to oilimporting countries in the 1970’s resulted in huge international debt problem in developingcountries.



2. The existence of Eurocurrency markets reduces the effect of domestic stabilization efforts ofnational governments. For example, large firms unable to borrow domestically because ofcredit restrictions, often borrow in the Eurocurrency markets, thus frustrating the governmenteffort to restrict credit to fight domestic inflationary pressures. The problem is more serious incountries following fixed exchange rate system.

3. Large and frequent flow of Eurocurrencies from one monetary centre to another causes greaterinstability in foreign exchange rates and domestic interest rate.

4. Eurocurrency markets are largely uncontrolled. As a result worldwide recession could rendersome of the Euro banks insolvent. But for the regulation of the Eurocurrency markets to beeffective there should be greater international cooperation among major countries.

5. On the positive side the Eurocurrency markets have certainly increased competition andefficiency of domestic banking.

6. The intermediation function the Eurocurrency markets have performed transferring deposits ofoil exporting nations to oil importing nations prevented a liquidity crisis in the 1970’s. This otherinternational financial institutions were unable and unwilling to undertake.

7. The presence of Eurocurrency markets has promoted competition in U.S. banking. Since 1981international banking facilities have been permitted in the U.S. That is, U.S. banks are nowallowed to accept deposits from abroad and reinvest them overseas and thus compete inEurodollar market. Several States have also passed legislations exempting profits from internationalbanking transactions from State and local taxes. Almost 200 U.S. banks have entered thismarket.

An early factor in the growth of international investment, and the world economy in general, was thedevelopment of the Eurocurrency market. A Eurocurrency is a dollar or other freely traded currencydeposited in a bank outside the country of origin. The Eurocurrency market encompasses those banksthat seek deposits and make loans of foreign currency. The phenomenal growth of Eurocurrency marketsis because of the inherent strength of the Eurocurrency system, the strength emerging from.

• The fierce competition for deposits and loans in the Eurocurrency markets.

• The lower operating cost in Eurocurrency market due to the absence of legal reserve requirementsand other restrictions on Eurocurrency deposits.

• Economies of scale in dealing with very large deposits and loans.

• Risk diversification. Arbitrage is so extensive in the Eurocurrency market.

• That interest rate parity is generally maintained.

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3.5 International Financial Institutions

The most prominent international institutions are the IMF, the World Bank and the WTO:

• The International Monetary Fund (http://www.imf.org/) keeps account of international balanceof payments accounts of member states. The IMF acts as a lender of last resort for membersin financial distress, e.g., currency crisis, problems meeting balance of payment when in deficitand debt default. Membership is based on quotas, or the amount of money a country providesto the fund relative to the size of its role in the international trading system.

• The World Bank (http://www.worldbank.org/) aims to provide funding, take up credit risk oroffer favourable terms to development projects mostly in developing countries that couldn’t beobtained by the private sector. The other multilateral development banks and other internationalfinancial institutions also play specific regional or functional roles.

• The World Trade Organization (http://www.wto.org/) settles trade disputes and negotiatesinternational trade agreements in its rounds of talks (currently the Doha Round).

International Monetary Fund

At the close of the Second World War there was a desire to reform the international monetary systemto one based on mutual co-operation and freely convertible currencies which resulted in the BrettonWoods conference at New Hampshire in 1944, where countries agreed to tie the values of all currenciestogether. The Bretton Woods agreement required that each country fix the value of its currency in termsof gold. The US dollar was the key currency in the system, and USD 1 was defined as being equal invalue to 1/35 ounce of gold. Since every currency had a defined gold value, all currencies were linkedin a system of fixed exchange rates.

Nations belonging to the system were committed to maintaining the parity value of the currency within± per cent of parity. When a country experienced difficulty in maintaining its parity value due to balanceof payments disequilibrium, it could turn to a new institution created at the Bretton Woods Conference,the International Monetary Fund (IMF).

The International Monetary Fund (IMF) was set up under an agreement arrived at the United NationsMonetary and Financial Conference held at Bretton Woods, New Hampshire between July 1-22 1944.The agreement came into force on December 27, 1945 when it was signed by 44 countries. Theinaugural meeting of the IMF was held in March 1946 at Savannah, Georgia. The IMF has itsheadquarters in Washington. India was an original member of the IMF. The IMF commenced its operationin Washington on March 1, 1947 and at present has 184 members.

Objectives of IMF

According to the Agreement, the objectives of the IMF are as given below:



1. To promote international monetary co-operation through a permanent institution that providesthe machinery for consultation and collaboration in international monetary problems.

2. To facilitate the expansion and balanced growth of international trade, and to contribute therebyto the promotion and maintenance of high levels of employment and real income and to thedevelopment of the productive resources of all members as primary objectives of economicpolicy.

3. To promote exchange stability, to maintain orderly exchange arrangements among membersand to avoid competitive exchange depreciation.

4. To assist in the establishment of a multilateral system of payments in respect of current transactionsbetween members and in the elimination of foreign exchange restrictions which hamper thegrowth of world trade.

5. To give confidence to members by making the Funds resources temporarily available to themunder adequate safeguards, thus providing them with opportunity to correct maladjustments intheir balance of payments without resorting to measures which are destructive for national orinternational prosperity.

6. In accordance with the above, to shorten duration and lessen the degree of disequilibrium in theinternational balance of payments of the member-countries.

7. To achieve balanced economic growth especially of the backward countries by securing a risein the level of employment.

8. To reduce disequilibrium in balance of payments by providing assistance to its members eitherby selling or lending foreign currencies to them.

9. To promote investment of capital in backward and under-developed countries through theexport of capital from the richer nations to the poorer nations so that they could develop theireconomic resources for raising their standard of living.

Organization and Management

The IMF, an autonomous organization affiliated with United Nations, has its head office located inWashington. Thirty of the 44 countries represented at the Bretton Woods Conference became “originalmembers” of the Fund by accepting its membership on or before December 31, 1945.

The initial capital of the Fund was USD 8,800 million. Each member of the Fund was assigned asubscription quota based on its national income and its position in international trade. Every membercountry paid 25 per cent of its quota in gold or dollar and the balance in its national currency which waskept within the country itself in the name of the Fund and has periodical reviews of the subscriptionquotas.

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The organizational structure of the Fund has undergone important changes under the Second Amendmentof the Articles of Agreement. The constitution and functions of each of these organs of the Fund are asfollows:

Board of Governors

The highest authority and highest decision-making body of the Fund is the Board of Governors, consistingof one Governor and an alternate Governor for each member country. The member-country appointsthe Governor who will usually be the Finance Minister or the Governor of the Central Bank of thecountry.

The Executive Board

The Board of Governors delegates the executive authority to the Board of Executive Directors. ThisBoard consists of 24 executive directors of whom 6 are appointed, one each by the largest quota-holding countries—USA, UK, Federal Republic of Germany, France, Japan and Saudi Arabia—andothers are elected by different regional groups of member-countries. The Executive Board meets twoor three times each week to consider day-to-day problems.

The chairman of the Board of Executive Directors is the Managing Director, who will be the executivehead and head of the staff of the Fund. He holds office for a term of five years.

The Interim Committee

The Interim Committee of the Board of Governors on the International Monetary System has an advisorybody made up of 24 Fund Governors, Ministers, etc., and the committee normally meets twice ayear—in April or May and at the time of the Annual meeting of the Board of Governors in Septemberor October. The Interim Committee advises and reports to the Board of Governors on issues regardingthe management and adaptation of the International Monetary System—including sudden disturbancesthat might threaten the international monetary system—and proposals to amend the Articles of Agreement.

The Development Committee

The Development Committee (also known as the joint Ministerial committee of the Boards of Governorsof the World Bank and of the IMF on the transfer of real resources to developing countries} comprisingof 24 members (same as the interim committee advises and reports to the Board of Governors of theWorld Bank and of the Fund on all aspects of the transfer of real resources to developing countries.The Managing Director of the Fund and the President of the Bank participate in its work. The Fundoperates through the General Account and the Special Drawing Account. It also administers somespecial Accounts and Trusts.



Functions or Working

The main purposes for which the IMF has been set up are “to provide exchange stability, temporaryassistance to countries falling short of foreign exchange and sponsoring of international measures forcuring fundamental causes of disequilibrium through avoiding competitive exchange depreciation andthrough the conversion of national currencies into one another.” In order to achieve these objectives,the Fund performs the following functions:

Maintaining Exchange Stability

The main arrangement made by the Fund was to ensure stability in the exchange rate and to discouragefluctuations in the exchange rate.

• Each member-country declares par value of its currency in terms of gold as a commondenominator or in terms of U.S. dollars.

• Members agree to keep up the free convertibility of their currencies at not more than 1%above or below its par value.

• Members are allowed to devalue up to 10%, if necessary, by merely informing the Fund.Greater or subsequent change requires the approval of the Governing Body.

• Multiple exchange rates of members are not allowed.

• Members are forbidden to buy or sell gold at prices other than the declared par value.

• The Fund provides financial assistance to member-countries to meet temporary deficits in theirbalance of payments, thereby acting as an international lender of last resort.

Determination of Par Values

The Original Articles allowed the member countries to make adjustments in the par value of theircurrencies for correcting disequilibrium in their balance of payments. A country can make adjustmentsup to 10% by simply informing the IMF. However, for changes more than 10%, but below 20%, theapproval by the two-third members of the Fund was necessary.

The revised Articles of Agreements of the IMF has given the member-countries autonomy regardingexchange arrangements. The exchange rates are allowed to float or change according to the demandand supply conditions in the exchange market and also on the basis of internal price levels. The Articlesrequire the IMF to exercise surveillance to ensure proper working of the international monetary systemto maintain stability of exchange rates.

The IMF provides machinery for international consultations by bringing together representatives of theprincipal countries of the world and affords excellent opportunity for reconciling their conflicting claims.This approach not only has stabilizing influence on world economy but also helps in balanced development

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and growth of world trade and production. To achieve this, the Fund conducts periodic study andresearch relating to urgent and important economic problems of the world.

Financing Facilities

The Fund provides financial support to its members depending upon the nature of the macro-economicand structural problems. In order to help the member-countries to correct disequilibrium in their balanceof payments, the IMF operates various borrowing facilities:

1. Basic Credit Facility. The IMF provides financial assistance to its member-nations to overcometheir temporary difficulties relating to balance of payments. To finance payment deficits, member-nations in exchange for its own currency can purchase SDRs from the Fund. The loan will berepaid when the member repurchases its own currency with other currencies or SDRs. A membercan unconditionally borrow from the Fund in a year equal to 25% of its quota. This unconditionalborrowing right has been called the reserve tranche. In addition, four tranches (each equal to 25%of the quota) are available to a country. Thus, a member-country has the basic credit facility of 5tranches (i.e., 125 % of its quota) from the Fund. However, borrowings by member-countriesfrom the IMF should not be more than 200% of its quota.

2. Standby Arrangements. The member-country was allowed to draw upon the resources of IMF upto specific limits and within an agreed period under standby system brought into force in 1952.The IMF extends to its member-country the facility of drawing funds as and when required. Suchstandby arrangements are negotiated between the IMF and individual members. Once thearrangement has been agreed, the request of a member for accommodation should be allowed byIMF without reconsideration of the member’s position at the time of drawing. The advantageunder the facility was that the countries are assured of the assistance without the Fund imposingstrict exchange and trade controls.

3. Compensatory Financing Facility. IMF established compensatory financing facility in 1953 toprovide additional assistance to the member-countries, particularly primary producing countriesfacing shortfall in export earnings. In 1981, the coverage of the compensatory financing facilitywas extended to payment problem caused by the fluctuations in the cost of cereal inputs.

4. Buffer Stock Facility. The buffer stock financing facility was created in 1969 to help the primaryproducing countries to finance contributions to buffer stock arrangements for the stabilization ofprimary product prices.

5. Extended Fund Facility. Established in September 1974 to assist the member-countries with severebalance of payments problem for long periods, IMF provided additional borrowing facility up to140% of the member’s quota, over and above the basic credit facility. The extended facility waslimited for a period up to 3 years and the rate of interest was low, i.e., from 4% to 6.5%.

6. Supplementary Financing Facility. There was an urgent need for a supplementary facility of a



temporary nature that would enable the Fund to expand its financial assistance to those of itsmembers facing payments imbalances larger in relation to their economies and quotas in the Fund.An agreement was reached in 1977 among 14 willing potential lenders to lend a total of SDR 7.8billion for a supplementary financing facility in the Fund which became operational in May 1979.

7. Trust Fund. Part of the profits earned by selling gold in public auctions at prices much above theprice prevailing in the market has been used to establish a Trust Fund in 1976 for making conditionalloans to the less-developed countries with payments problems.

8. Structural Adjustment Facility (SAF). This facility established in March 1986 provided additionalbalance of payments assistance on concessional terms to the poorer member-countries to undertakestrong macro-economic and structural programmes.

9. Enhanced Structural Adjustment Facility (ESAF). The IMF established this new facility in December1987 from which its poorest member-countries can draw when undertaking strong three-yearmacro-economic and structural programmes. This facility was similar to SAF with regard to interestand repayment.

10. Supplemental Reserve Facility (SRF). This facility approved on December 17, 1997, wascommitted for a period of up to one year and was generally available in two or more branches.The IMF determined the amount of financing available under the SRF by taking into account thefinancing needs of the member; its capacity to repay including in particular the strength of economicprogramme; its outstanding use of IMF credit; and its record in using IMF resources in the pastand compliance with the IMF’s liquidity. Borrowing countries under the SRF are expected torepay within one to one and a half years from the date of each disbursement, though the ExecutiveBoard has authority to extend the period for repayment by up to one year, at which point theborrower will be obliged to pay during the period.

11. Poverty Reduction and Growth Facility (PRGF). An IMF objective of concessional lending wasmodified in 1999 to include an explicit focus on poverty reduction in poor member-countries. TheIMF established the PRGF in place of Enhanced Structural Adjustment Facility (ESAF) to providefinancing based on poverty reduction. The number of PRGF-eligible countries are 80 (reduced to77 in 2000-01) with IMF’s total commitments of SDR 3.3 billion.

Special Drawing Rights (SDRs)

The creation of Special Drawing Rights (SDRs) as an international reserve asset by the Fund was asignificant attempt to reform the international monetary system and to solve the problem of internationalliquidity. In September 1967, in IMF meeting at Rio de Janeiro, an outline for a scheme of SpecialDrawing Rights was pushed forward. The amendment to the IMF Articles of Agreement was submittedto the members in 1968 and the draft amendment was ratified by July 1969. Every member of the IMFhas the right to become a participant of the SDR facility, but every member was not obliged to join thefacility, only members of the IMF can participate in SDR facility.

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SDR or the so-called ‘paper-gold’ takes the form of a credit entry in the name of the participantcountries in the Special Drawing Account of the IMF The newly created SDRs were allocated to theparticipating countries in proportion to their quotas in the IMF. Special Drawing Rights allocated andcredited to a participant’s account was owned by it and they can be freely used by the said country formeeting payments deficits. One distinct characteristic of SDRs was its unconditional use.

Originally one SDR was considered equivalent to 0.88671 gram of gold, equal to the value of one USdollar. Subsequent to the abandonment of the system of par values of currencies and floating of USdollar and other major currencies in 1973, it was decided to determine the value of SDR on the basisof a basket of 16 most widely used currencies of the United States, Britain, Germany, Japan, France,Canada, Italy, the Netherlands, Belgium, Sweden, Australia, Spain, Norway, Austria, Denmark andSouth Africa. Each of these currencies was assigned weight in proportion to its importance in internationaltrade and world financial markets. To facilitate proper valuation of a unit of SDR, the number of currenciesin the basket was reduced from 16 to 5 in January 1981. These currencies included the US dollar, theGerman deutsche mark, the British pound, the French franc and the Japanese yen. From January 1986,the currency composition of the basket of currencies and weightage to be assigned to each currency ofthe basket for the valuation of a unit of SDR was to be revised every five years. The revision of value ofSDR was to be made on the basis of value of exports and balances of currencies held with the IMF bythe member-countries.

The agreed currency weight in SDR basket effective since January 1, 2001 was: US dollar—45%;Euro—29%; Japanese yen—15%; and Pound sterling—11%.

Uses of SDRs

Three principal uses of SDRs are,

1. The IMF designates a participant in the SDR scheme with strong and favourable balance ofpayments and reserve position to provide its currency in exchange of SDRs to another participantwho requires its currency to meet adverse balance of payments.

2. The SDRs are used in all transactions with the IMF

3. The SDRs are used also in the transactions by agreement. The IMF permits the sale of SDRsfor currency by agreement with another participating country in the scheme

Additional uses of SDRs

The Second Amendment has empowered the IMF to employ SDRs in Swap arrangements, forwardoperations, granting and receiving of loans, settlement of financial disputes, security for financial obligationsand granting of donations.

The International Monetary Fund has played a very vital role in the stabilization of exchange system, in



facilitating international payment adjustments and in the promotion of steady expansion of internationaltrade and productive capacities of the member-countries.

Achievements

1. The Fund has been able to promote exchange stability with managed flexibility. It has allowed thevariations in exchange rates by ± 1 per cent

(i) The World Bank

The World Bank Group of international financial institutions was concerned with assisting its member-countries to achieve sustained economic growth. It functions as an intermediary in the transfer of resourcesfrom the more developed to the less developed countries to enable efficient use of capital for economicand social development. There are three affiliates of the World Bank/IBRD—The InternationalDevelopment Association (IDA), the International Finance Corporation (IFC) and Multilateral InvestmentGuarantee Agency (MIGA). The main features of these financial institutions are discussed below,

(ii) International Bank of Reconstruction and Development (IBRD)

The International Monetary Fund (IMF) and the International Bank of Reconstruction and Development(IBRD), popularly known as the World Bank, is the twin institutions set up at the United Nations’Monetary and Financial Conference held at Bretton Woods, New Hampshire, in July 1944. While theIMF was established to provide short-term loans to overcome the balance of payments difficulties, theWorld Bank was aimed at providing long-term loans for the purpose of (i) reconstructing the war-damaged economies, and (if) developing the less developed economics. The IBRD started operationsin June 1946.

Objectives of IBRD

The IBRD was established to promote long-term foreign investment loans on reasonable terms. Thepurposes of the IBRD, as set forth in the Article I of the Agreement’ are as follows:

1. To assist in the reconstruction and development of territories of members by facilitating the investmentof capital for productive purpose including:

• the restoration of economies destroyed or disrupted by war (hence the name Bank forReconstruction);

• the reconversion of productive facilities to peaceful needs; and

• the encouragement of the development of productive facilities and resources in less developingcountries (hence the name Bank for Development).

2. To promote private investment by means of guarantee or participation in loans and other investmentsmade by private investors.

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3. When private capital was not available on reasonable terms, to supplement private investment byproviding on suitable conditions finance for productive purpose out of its own capital funds raisedby it and its other resources.

4. To promote the long-range balanced growth of international trade and the maintenance of equilibriumin balance of payments by encouraging international investment for the development of theproductive resources of members, thereby assisting in raising productivity, the standard of living,and conditions of labour in their territories.

5. To arrange the loans made or guaranteed by it in relation to international loans through otherchannels so that the more useful and urgent projects, large and small alike, will be dealt with first.

6. To conduct its operations with due regard to the effect of international Investment on businessconditions in the territories of members and in the

Organization and Management

The countries which were initially members of the IMF could become the members of the World Bank,but, later on, this restriction to membership was relaxed. Any country can now become a member ofthe Bank if its application is supported by 75% of the existing members, and a member can withdrawfrom the bank by sending a written notice. The Bank can also suspend a member who violates its rules.IBRD was owned by the Governments of 183 countries that have subscribed to its capital. The initialauthorized capital of the World Bank was USD 10,000 million, divided into 1,00,000 shares of USD1,00,000 each. These shares were available only to member-countries. Of each share (a) 2% payablein gold or U.S. dollars; 18% to be paid in the currency of the member-country; and (c) the remaining80% as callable fund, i.e., it was liable to be called if and when needed to meet obligations to lendersfrom whom the Bank has borrowed or to private investors whose loans the Bank has guaranteed.Thus, only 20% of the total capital was called up by the Bank and made available for lending purposes.As on June 2001, the total authorized capital of 183 member-countries was over USD 189.5 billion.

All powers of the Bank are vested in a Board of Governors consisting of one representative appointedby each country and which meets normally once a year. The Governors have delegated most of theirpowers to a Board of Executive Directors which usually meets once a month. There are at present 24Executive Directors— five are appointed by the five nations having the largest capital subscriptions(U.S.A., Japan, Germany, United Kingdom, and France) and 19 arc elected by the Governors of theremaining members for a two-year term. The President of the Bank was the Chairman of the Board ofExecutive Directors. The voting powers of the Executive Directors are proportionate to the capitalsubscriptions of the country or countries which they represent. The Executive Directors are responsiblefor matters of policy and must approve all IBRD loans and IDA credits. The Executive Directors arealso responsible for deciding policy issues that guide the general operations of the Bank and its direction.The day-to-day conduct of the Bank’s operations, including the making of recommendations to theExecutive Directors on loans and questions of policy, is the responsibility of the President.



Lending Activities of IBRD

The Bank lends to its member-countries in any of the following three ways:

(i) Lend directly from own funds. The Bank was authorized to grant loans up to 20 per cent of itssubscribed capital to member-countries—2 per cent of the subscribed capital kept in the form of goldin any way it likes, and the remaining 18 per cent lending only on obtaining the approval of the respectivemember whose currency has to be lent.

(ii) Loans from other sources. To advance loans to member-countries, the Bank may also take loansfrom funds of other countries with approval of the lender country to give loan to another member-country.

(iii) Guarantee of loans. The most significant activity of the Bank was that it may guarantee loans fromprivate investors to its members, and thus encourage private capital investment. But in such cases theBank has to take the approval of both lender and borrower.)

Conditions for Loans

Before the World Bank provides a loan, either directly or indirectly through guarantee, certain conditionsmust be fulfilled. These, conditions, as stated in the Article III of the Articles of Agreements, requirethat:

a) The World Bank lends only to governments or have guarantee of the government in whoseterritory the borrower is located as to the repayment of the principal and the payment of theinterest and other charges.

b) The competent committee of the World Bank reports favourably on the project.

c) The World Bank is satisfied that the borrower is unable to obtain the loan otherwise on reasonableterms.

d) In the opinion of the World Bank, the rate of interest and other charges are reasonable andsuch rate, charges and the schedule for repayment of principal are appropriate to the project.

e) In guaranteeing a loan made by other investors, the World Bank receives suitable compensationfor its risk.

Operations of IBRD

The lending operations of the IBRD, since its inception in 1946, concentrated heavily upon the provisionof capital for infra-structural projects such as roads and railways, generation and distribution of electricity,irrigation projects, ports development, telecommunications, etc. for the first two decades. Since 1970,the emphasis in its lending operations has shifted from infrastructural projects to the financing ofeducational system in developing countries, creation of institutions for financing industrial investment

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and provision of technical assistance for the selection and appraisal of industrial projects and to assist inthe preparation of agricultural projects.

The Bank’s lending policy since 1973 was directed towards the reduction of the massive dimensions ofabsolute poverty. Most of the loans were allocated for rural development projects whose objectivewas to benefit people in the bottom, 40 per cent income group. The Bank in 1975 also announced thatit would try to deal with the problems of urban poor and urban unemployed.

The Bank in 1979 announced that it would increase substantially its assistance for the production andacceleration of oil and natural gas in the developing countries during the early eighties. A new lendingprogramme introduced in 1980 was directed towards structural adjustments by the developing countries.According to this policy the Bank supports programmes of specific policy changes and institutionalreforms in developing countries designed to achieve a more efficient and meaningful use of resources.

Certain modification was approved by the Executive Board in 1981 on repayment terms. They areshifting repayment of new loans for low-income countries, to annuity, extension of grace period throughfiscal year 1991 on new loans to middle-income countries from 3 to 5 years and review of repaymentterms for middle-income countries within three years.

A Special Action Programme (SAP) was started by the Bank in 1983 to provide assistance to themembers for adjusting to the current economic environment. Four major elements of the programmeare—(i) enhanced lending for high priority

operations that support structural adjustment, policy changes, production for export, maximum use ofexisting capacity and the maintenance of crucial infrastructure; (ii) enhanced disbursements under existingand new investment commitments for the timely execution of high priority projects; (Hi] extension ofadvisory services on the design and implementation of appropriate policies which include reviews ofState enterprises, studies to strengthen development orientation and project implementation capabilities,studies to increase the mobilization of domestic resources, reviews of incentives for export diversificationand exploration of ways to strengthen debt management capabilities; and (iv) seeking cooperation ofother donors for fast disbursing assistance in support of programmes of the Bank and IMF.

During the fiscal year 1989 new commitments amounted to USD 16.4 billion as against USD 14.8billion in 1988. Now lending commitments declined by USD 1.2 billion to 15.2 billion in 1990. Totalcommitments during 1990 to 1994 amounted to USD 78 billion, showing an annual average of USD15.6 billion which was higher as compared to the preceding period of five years. Commitments during1994 at USD 14.2 billion were, however, lower by USD 2.8 billion as compared to commitmentsamounting to USD 17.0 billion during 1993. Total disbursements for the period 1990-94 amounted toUSD 60.4 billion. Disbursements during 1994 amounted to USD 10.5 billion as compared to USD12.9 billion in 1993.

During the fiscal year 1995 lending commitments of the IBRD amounted to USD 16.853 million,showing an increase of 18.3 per cent over the previous year, in 1996 it amounted to USD 14,656



million showing a decline of 13 per cent, in 1997 it declined by 0.9 per cent. Gross disbursements bythe IBRD in 1995, 1996 and 1997 amounted to 12,672 million, 13,372 million and 13,998 millionrespectively, showing an increase of .21.3 per cent, 5.5 per cent and 4.7 per cent over the previousyear’s respectively.

New lending by IBRD in fiscal year 2002 at USD 11.5 billion was USD 1 billion above the previousyear’s level. The number of new operations approved was higher than last year at 96. New IBRDlending to Europe and Central Asia reached a record high of USD 4.9 billion, or 43 per cent of totalIBRD commitments, followed by Latin America and the Caribbean with USD 4.2 billion. The East Asiaand Pacific region was third with USD 1 billion.

The prevalent themes correlated to the sector lending, with a major focus on strengthening the financialand private sector regulatory framework and improving public sector governance. Human development,economic management, and urban development were also supported. Public administration was by farthe leading sector for IBRD lending, receiving USD 3.6 billion, over 30 per cent of the total. Thesignificant amount of lending in the public administration sector reflects the Bank’s focus on assisting itsclients to improve development strategies, implement reform policies, and build institutional capacities.Lending to the finance sector was second, representing USD 2.1 billion, about 18 per cent of the total.The share of adjustment lending by IBRD rose to a record high of 64 per cent in fiscal 2002, comparedwith 38 per cent in fiscal 2001, and with 47 per cent and 63 per cent during the East Asian crisis yearsof fiscal 1998 and 1999, respectively. Argentina, Brazil, Jamaica, Tunisia, Turkey and Ukraine areamong the countries where Bank lending sought to alleviate the effects of falling export demand, commodityprices, and capital market access.

3.6 Government Institutions

Governments act in various ways as actors in the GFS: they pass the laws and regulations for financialmarkets and set the tax burden for private players, e.g., banks, funds and exchanges. They also participateactively through discretionary spending. They are closely tied (though in most countries independent of)to central banks that issue government debt, set interest rates and deposit requirements, and intervenein the foreign exchange market.

Private participants

Players acting in the stock-, bond-, foreign exchange-, derivatives- and commodities-markets andinvestment banking are

• Commercial banks

• Hedge funds and Private Equity

• Pension funds

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Legal frameworks and treatises

• Commonwealth of Independent States (CIS)

• Eurozone

• Mercosur

• North American Free Trade Agreement (NAFTA)

Perspectives

There are three primary approaches to viewing and understanding the global financial system.

The liberal view holds that the exchange of currencies should be determined not by state institutions butinstead individual players at a market level. This view has been labelled as the Washington Consensus.This view is challenged by a social democratic front which advocates the tempering of market mechanisms,and instituting economic safeguards in an attempt to ensure financial stability and redistribution. Examplesinclude slowing down the rate of financial transactions, or enforcing regulations on the behaviour ofprivate firms. Outside of this contention of authority and the individual, neoMarxists are highly critical ofthe modern financial system in that it promotes inequality between state players, particularly holding theview that the political North abuses the financial system to exercise control of developing countries’economies.

3.7 Foreign Financial Market & Exchange Determination

Nearly all international business activity requires the transfer of money from one country to anotherTrade transactions must be settled in monetary terms: Buyers in one country pay suppliers in another.Repatriation of dividends, profits, and royalties from overseas investments, contributions of equity andother kinds of financial dealings from such investments also involve the transfer of funds across nationalborders. The transfer of funds poses problems quite different from those associated with the transfer ofgoods and services across national borders. Buyers and sellers are willing to accept and use goods andservices from other countries quite routinely. For example, U.S. consumers are content to drive Japanesecars, such as Toyotas and Hondas, while the Japanese are quite willing to use U.S. operating systemsor other hi-tech products.

This internationalization that applies to product usage is not found when it comes to accepting thecurrency of another country, however. While the U.S. importer is happy to receive Japanese productsand the Japanese importer is glad to accept U.S. products, neither is normally in a position to acceptthe other’s currency. A U.S. importer usually has to pay a Japanese exporter in Japanese yen, while aU.S. exporter will generally want to be paid in U.S. dollars. This is quite logical, since each country hasits own currency, which is legal tender within its borders, and exporters are likely to prefer the currencythat they can use at home for meeting costs and taking profits.



A U.S. importer who must pay a Japanese exporter has to acquire Japanese yen. To do so, he mustexchange his own currency, dollars, into yen. Such an exchange of one currency for another is called aforeign exchange transaction.

For example, a German company invests in an electronics manufacturing facility in Australia. Therefore,it must convert its euros into Australian dollars to meet project costs in Australia. In another example, aU.S. multinational has a plant located in Great Britain. At the end of the financial year, it wants torepatriate its profits to corporate headquarters in the United States. Therefore, it will convert Britishpounds sterling—profits earned by the plant in Great Britain—into U.S. dollars. As another example,suppose a Japanese investor has a large stock holding on Wall Street. After a rally in which his holdingsappreciate substantially, he wants to repatriate his profits to Japan. To do so, he would convert his U.S.dollar profits into Japanese yen.

How do the German company, the U.S. multinational, and the Japanese investor convert the currencyin their possession into the currency they desire? The answer is provided by the foreign exchangemarkets.

The Structure of the Foreign Exchange Markets

The demand for conversion of one currency into another currency give rise to the demand for foreignexchange transactions. The foreign exchange markets of the world serve as the mechanism throughwhich these numerous and complex transactions are completed efficiently and almost instantaneously.

The main intermediaries in the foreign exchange markets are major banks worldwide that deal in foreignexchange. These banks are linked together by a very advanced and sophisticated telecommunicationsnetwork that connects them with major clients and other banks around the world. There is no physicalcontact between the dealers of various banks in the foreign exchange markets, unlike in the stockexchanges or the futures markets, which have specific trading floors or pits.

Some of the larger and more active banks have installed computer terminals called dealing screens intheir trading rooms. Through these terminals, banks can execute trades and receive written confirmationson online printers. Telephone transactions are normally confirmed by an exchange of telex messages ortransaction notes.

Banks that are active in foreign exchange operations set up extremely sophisticated facilities for theirforeign exchange traders; these facilities are located in trading (or dealing) rooms, which are equippedwith instantaneous telecommunication facilities.

A very important feature of modern trading rooms is their access to information about political, economic,and other current events as they unfold. A major source of this information is the British news agencyReuters, which furnishes subscribing banks with a dedicated communication system that provides on-screen information beamed from the central newsroom of the agency. There are also many services,including Reuters and Telerate that provide up-to-the-second information on the prevailing exchange

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rates quoted by banks worldwide. Any changes in exchange rates anywhere in the world can beimmediately brought to the notice of traders.

Exchange trading is an extremely specialized operation that puts enormous pressure on traders becauserates change rapidly and there are chances to make huge profits or incur massive losses. Bankmanagement continually monitors the activity and progress of its dealing rooms, while setting very clearguidelines in order to limit the level of risk the traders can take while trading currencies on behalf of thebank.

To relieve traders from the task of booking orders, trading rooms are supported by backup accountingdepartments that record the transactions made by the traders and that do the necessary computationsto track the trading activity. They also supply the traders with background data and analytical reports tooptimize the traders’ strategy and performance. Such information is fed into electronic trading boardsthat are clearly visible to traders. Generally, this information includes the risk exposure of the bank ineach currency and the current rates for different currencies, as well as a host of other information.

Exchange trading at a bank usually begins every day in the early morning with an in-house conferenceof traders and senior managers to discuss the currency expectations and the strategy for the day. Mosttrading is conducted during local business hours, but the ease of communication made possible by thelatest technology enables banks to continue to trade with banks in other time zones after the localbusiness day is over. Therefore, some major banks have a system of shifts, through which traders comein to trade in markets in different time zones. By using night trading desks, many major banks have beenable to establish 24-hour trading operations.

There are two levels in the foreign exchange markets. One is the customer, or retail, market, in whichindividuals or institutions buy and sell foreign currencies to banks dealing in foreign exchange. Forexample, if IBM wishes to repatriate profits from its German subsidiary to the United States, it canapproach a bank in Frankfurt with an offer to sell its euros in exchange for U.S. dollars. This type oftransaction occurs in what is called the customer market.

Suppose the bank does not have a sufficient amount of U.S. dollars to exchange for the subsidiary’seuros. In this Situation the bank can approach other banks to acquire dollars in exchange for euros orsome other currency. Such sales and purchases are termed inter-bank transactions and collectivelyconstitute the inter-bank market. Inter-bank transactions are both local and international.

The inter-bank market is extremely active. Banks purchase currencies from and sell currencies to oneanother to meet shortages and reduce surpluses that result from transactions with their customers.Transactions in the inter-bank markets are almost always in large sums. Amounts less than US$250,000are not traded in inter-bank markets. Values of inter-bank transactions usually range from US$1 millionto US$10 million per transaction, although deals involving amounts above this range are also known totake place. A large proportion of the transactions in inter-bank markets arise from banks trading currenciesto make profits from movements in exchange rates around the world.



It is important to note that in all this trading activity in foreign exchange markets, billions of dollars ofinternational currency are exchanged without any physical transfer of money. How are the transactionssettled? The answer lies in a system of mutual account maintenance. Banks in one country maintainaccounts at banks in other countries. These accounts are generally denominated in the home currencyof the bank with the account. In banking parlance these are called vostro accounts, which essentiallymeans “your account with us,” or nostro accounts, which means, literally, “our account with you.” Thus,if Citigroup New York has a euro account with Dresdner Bank in Frankfurt, it will term the Dresdneraccount its nostro account. For Dresdner, this will be a vostro account. Similarly, Dresdner Bankwould have a U.S. dollar account with Citibank or another bank in the United States. For Dresdner thiswill be a nostro account, while for the U.S. bank it will be a vostro account. Foreign exchange transactionsare settled by debits or credits to nostro and vostro accounts.

Market Participants

The foreign exchange markets have many different types of participants. These participants differ notonly in the scale of their operations but also in their objectives and methods of functioning.

Individuals

Individuals may participate in foreign exchange markets for personal as well as business needs. Anexample of a personal need would be sending a monetary gift to an overseas relative. To send the gift,the individual would utilize the market to obtain the currency of the relative’s country. Individual businessneeds arise when a person is involved in international business. For example, individual importers usethe foreign exchange markets to obtain the currencies needed to pay their overseas suppliers. Exporters,on the other hand, use the markets to convert the currencies received from their foreign buyers intodomestic or other currencies. Business or leisure travelers also participate in the foreign exchangemarkets by buying and selling foreign and local currencies to meet expenses on their overseas trips.

Institutions

Institutions are very important participants in the foreign exchange markets because of their large andvaried currency requirements. Multinational corporations typically are major participants in the foreignmarkets, continually transferring large sums of currencies across national borders, a process that usuallyrequires the exchange of one currency for another. Financial institutions that have international investmentsare also important foreign exchange market participants. These institutions include pension funds, insurancecompanies, mutual funds, and investment banks. They need to switch their multicurrency investmentsquite often, generating substantial transaction volumes in the foreign exchange markets.

Apart from meeting their basic transaction needs, both the individual and institutional participants usethe foreign exchange markets to reduce the risks they incur because of adverse fluctuations in exchangerates.

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Banks

Banks are the largest and most active participants in the foreign exchange markets. Banks operate inthe foreign exchange markets through their traders. (British banks and many others use the term “exchangedealer” rather than “exchange trader.” These terms can be used interchangeably.) Exchange traders atbanks buy and sell currencies, acting on the requests of their customers and on behalf of the bank itself.

Customer-requested transactions form a very small proportion of trading operations by banks in theforeign exchange markets. To a very large extent, banks treat foreign exchange market operations as anindependent profit center. In fact, some major banks make substantial profits on the strength of theirmarket expertise, information, trading-skills, and ability to hold on to risky investments that would notbe feasible for smaller participants. On occasion, banks can also incur substantial losses. As a result,foreign exchange operations are closely monitored by bank management teams.

Central Banks and Other Official Participants

Central banks enter the foreign exchange markets for a variety of reasons. They can buy substantialamounts of foreign currencies to either build up their foreign exchange reserves or bring down the valueof their own currency, which in their opinion may be overvalued by the markets. They can enter themarkets to sell large amounts of foreign currencies to shore up their own currencies. In the latter part ofthe 1980s, central banks and treasurers of the United States, Japan, and the then West Germanyintervened quite often to correct the imbalances between the values of the yen and deutsche mark (thenthe currency of West Germany; the unified Germany now uses the Euro) versus the U.S. dollar.

The main objective of central banks is not to profit from their foreign exchange operations or to avoidrisks. It is to move their own and other important currencies in line with the values they considerappropriate for the best economic interest of their country.

Central banks of countries that have an official exchange rate for their currency must continually participatein the foreign exchange markets to ensure that their currency is available at the announced rate.

Speculators and Arbitragers

Participation by speculators and arbitragers in the foreign exchange markets is driven by pure profitmotive. These traders seek to profit from the wide fluctuations that occur in foreign exchange markets.

In other words, they do not have any underlying commercial or business transactions that they seek tocover in the foreign exchange market. Typically speculators buy large amounts of a currency when theybelieve it is undervalued and sell it when the price rises. Arbitrage occurs when investors try .to exploitthe differences in exchange rates between different markets. If the exchange rate for the pound ischeaper in London than in New York, they would buy pounds in London and sell them in New York,making a profit. Arbitrage opportunities are now increasingly rare, however, because instantaneouscommunications tend to equalize worldwide rates simultaneously.



A substantial part of the speculative and arbitrage transactions comes from exchange traders ofcommercial banks. Often these transactions represent a conscious effort to maximize profits with clearlydefined profit objectives, loss limits, and risk-taking boundaries. In fact, the overwhelming proportionof foreign exchange market transactions today is driven by speculation.

Foreign Exchange Brokers

Foreign exchange brokers are intermediaries who bring together parties with opposite and matchingrequirements in the foreign exchange markets. They are in simultaneous contact through hotlines withscores of banks, and they attempt to match the buying requirements of some banks with the sellingneeds of others. They do not deal on their own account and are not a party to the actual transactions.For their services they charge an agreed-on fee, which is often called brokerage.

By bringing together various market participants with complementary needs, foreign exchange brokerscontribute significantly to the “perfection of information,” which makes the foreign exchange markets asefficient as they are. Apart from this, brokers also perform another important function. They preservethe confidentiality and anonymity of the participants. In a typical deal, the broker will not reveal theidentity of the other party until the deal is sealed. This achieves a more uniform conduct of business asdeals are decided purely on market considerations and are not influenced by other considerations thatmight be introduced if the parties’ identities became known.

Location of Foreign Exchange Markets

The foreign exchange markets are truly global, working around the clock and throughout the world.The very nature of foreign exchange trading, as well as the revolution in telecommunications, has resultedin a unified market in which distances and even time zones have been compressed. Traditionally, Londonand, later, New York were the main centers of foreign trading. Other centers, however, such as Tokyo,Hong Kong, Singapore, and Frank-fort, have become extremely active. Smaller but significant marketsexist in many European and some Asian countries.

The individual foreign exchange trading centers are closely linked to form one global market. Tradingspills over from one market to another and from one time zone to another. Price levels in one tradingcenter immediately affect those in other centers. As the market closes in one time zone, others open indifferent time zones, taking cues from the activities of the earlier market in setting up trading and pricetrends. A continuous pattern is thus established, giving the impression of one unified market across theworld.

Japan

Because of its geographical position, Japan can be considered the market where the world’s tradingday begins. The Japanese markets, led by Tokyo, are extremely active, with a very high daily turnover.Most of the deals are backed by customer-related requests to finance or settle international commercial

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transactions. Dollar-yen deals predominate in the market, because of the large share of U.S. relatedbusiness in the international transactions of Japan.

Since the deregulation of Japanese foreign exchanges, the element of speculative activity has increasedconsiderably, especially in the Tokyo market. The volume of trading in the market has also increased asthe securities and equity markets of Japan have opened up to foreign investment and some foreigninvestment banks have been allowed to operate in Japan. Brokers are extensively used in the Japanesemarkets, especially in transactions between banks located within the country. The market, however,closes at a set time in the afternoon, thus putting a limit on the volume of transactions that can takeplace. This system has inhibited somewhat the development of the Tokyo market, which would otherwisebe significantly larger.

Singapore and Hong Kong

Singapore and Hong Kong are the next markets to open, about one hour after Tokyo. These marketsare much less regulated, and in pursuit of their aim to become major international financial centers, bothmarkets offer liberal access to overseas banks and commercial establishments. At the same time, thegovernmental authorities have attempted to create a friendly market environment to promote maximumtrading activity. Market activity has increased considerably because several overseas banks, attractedby the incentives offered, have opened branches in both centers. Brokers are heavily involved in localtransactions in Singapore, while international transactions are handled primarily through direct dealsbetween banks. The trading activity of Hong Kong is a mix of direct deals and broker-intermediatedtransactions. Both of these markets have grown tremendously in the past few years.

Bahrain

The Bahrain market in the Middle East emerged as an important center of foreign exchange trading inthe 1970s, as oil-linked commercial transactions grew considerably. Located in the middle of overlappingtime zones, Bahrain is often used by traders in other markets to serve as a link in their global cycle.Bahrain provides a bridge between the closing of the Far Eastern and opening of the European marketsbecause it is open during the time when the markets in those locations are closed.

European Markets

Europe, taken as a whole, is the largest foreign exchange market. Its main centers are London, Frankfurt,and Zurich. European banks have no set closing time for foreign exchange trading and are free to trade24 hours a day, but they generally cease trading in the afternoon. Both direct and brokered deals arecommon in European trading. In the past, some of Europe’s markets, such as that in Paris, have exhibiteda unique feature: rate fixing. Once a day, representatives of the larger banks and the central banks metto fix the exchange rate of the U.S. dollar against local currencies and hence against one another. Thefixed rate represented the balance of offers and bids and was close to what the rate would beinternationally. There was sometimes a small discrepancy, however, which offered an opportunity for



arbitrage. This opportunity, of course, existed for only a very short time, as market pressures quicklyequalized the prices. The fixed rate was important primarily because it was considered to be the legalofficial rate and was often specified in contracts. This practice is less important in the European marketsnow, given that many of the countries are using the same currency (the Euro).

U.S. Markets

The New York market opens next. It is one of the world’s largest markets, and the top foreign exchangetrading firms are headquartered there. The volume of business in New York has increased tremendouslysince deregulation of the banking system and the increasing presence of overseas banks. Both brokeredas well as direct dealing are common in the New York exchange market. The West Coast markets areessentially tied to New York and closely follow the trading patterns that are established there.

Market Volumes

Foreign exchange markets are clearly located in the largest financial markets in the world. Their turnoverexceeds several times that of securities, futures, options, and commodities markets. The actual turnoverfigures, however, are difficult to ascertain, because banks do not publish data on the volume of theirtransactions.

In 1979 one study estimated the daily turnover of the world foreign exchange market to be aboutUS$200 billion.1 A 1986 survey by the Federal Reserve Bank of New York put the daily turnover ofU.S. banks at US$50 billion.2 Today, the estimated turnover is as much as US$ 1.5 trillion per day ona global level. The currencies that predominate in foreign exchange trading activity on a worldwidebasis are the U.S. dollar, the euro, the yen, the Swiss franc, the pound, the Canadian dollar, and theAustralian dollar. Some other currencies of increasing importance in foreign exchange markets are theSwedish krona, the Indian rupee, and the Chinese yuan.

A daily turnover of US$ 1.5 trillion would amount to an annual figure of US$547.5 trillion. The enormityof this figure, which estimates the annual volume of global foreign exchange trading, can be appreciatedif one compares it with the U.S. GNP, which was US$11.71 trillion in 2004.

Uses of the Foreign Exchange Market

The foreign exchange market provides the means by which different categories of individuals andinstitutions acquire foreign exchange to meet different needs, but it is important to understand theeconomic functions performed by the foreign exchange markets and their role in international trade ingoods and services. Two basic functions are the avoidance of risk and the financing of internationaltrade.

International trade transactions, which must be settled monetarily, carry significant risks both to thebuyer and to the seller. If the transaction is invoiced in the currency of the seller, the seller stands to loseif the currency depreciates in the time lag between agreement on the price and the actual date of

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payment. Consider, for example, a British importer of U.S. computers. The importer agrees to buy theshipment of computers for US$150,000, and the current exchange rate is US$1.5 to £1. At this rate,the cost to the British importer is £100,000. Usually, in such instances payments are made after goodsare shipped or received. In this example assume a lag of three months between the signing of thecontract and the actual payment by the British importer.

Suppose that in this period the value of the U.S. dollar appreciates and US$1 becomes equal to £l. Inthis event, the British importer will have to part with £ 150,000 to purchase the US$ 150,000 neededto meet the contractual obligation. As a result, the importer stands to incur a substantial loss: £50,000.Although this is an exaggerated example, the risks are indeed real and can often wipe out the entireprofit from a transaction.

Foreign exchange markets provide mechanisms to reduce this risk and assure a certain minimum return.Foreign exchange markets also provide the financing mechanism for international trade transactions.Financing is required to cover the costs of goods that are in transit. These costs are considerable ifgoods are sent by sea. At the same time, the risks are also high because the parties are in differentcountries, and, in the event of default, the recourse for the party defaulted against is limited. Theseproblems are solved efficiently through the foreign exchange markets, specifically through the use ofinternationally accepted documentation procedures, the most important being letters of credit.

Types of Exposure in Foreign Exchange Markets

There are four major types of risks or exposure that a corporation faces in the course of its internationalbusiness activity: transaction exposure, economic exposure, translation exposure, and tax exposure.

Transaction Exposure

Transaction exposure is the risk that a company’s future cash flows will be disturbed by fluctuations inexchange rates. A company that is expecting inflows of foreign currency will be faced with transactionexposure to the extent that the value of these inflows can be affected by a change in the rate of thecompany’s currency against the preferred currency for conversion. Exchange rates are extremely volatile,and a sharp movement can adversely affect the real value of cash flows in the desired currency. Acorporation can have both inflows and outflows in a currency. Moreover, it can have different amountsof inflows and outflows in different currencies. In this situation, the company nets out its exposure ineach currency by matching a portion of its currency inflows and outflows. The net exposure in eachcurrency is aggregated for all currencies to arrive at a measurement of the total transaction exposure forthe company. The period over which the cash flows are considered for arriving at the figure for transactionexposure depends on the individual methods and views of the company. Organizations use a variety ofmethods to assess the degree to which their net exposed cash flows are at risk. These methods cancenter on the time lag between the initiation and completion of the transaction, the use of currencycorrelations, or statistical projections of exchange-rate volatility. Sophisticated strategies for assessingtransaction exposure often include some element of all of these considerations.



Economic Exposure

Economic exposure is a relatively broader conception of foreign exchange exposure. The prime featureof economic exposure is that it is essentially a long-term, multi-transaction-oriented way of looking atthe foreign exchange exposure of a firm involved in international business. The standard definition ofeconomic exposure is the degree to which fluctuations in exchange rates will affect the net present valueof the future cash flows of a company.

Economic exposure is a particularly serious problem for multinational corporations with operations inseveral different countries. Since currency fluctuations do not follow any set pattern, each operation issubject to a different degree and nature of economic exposure. Measuring the degree of economicexposure is even more difficult than measuring translation exposure. Economic exposure involvesoperational variables, such as costs, prices, sales, and profits, and each of these is also subject tofluctuation in value, independent of the exchange-rate movements. Many techniques are used to measureeconomic exposure. Most of these techniques rely on complex mathematical and statistical models thatattempt to capture all the variables. Use of regression analysis and simulation of cash-flow positionsunder different exchange-rate scenarios are two examples of such techniques.

Managing economic exposure can involve extremely complex strategies and instruments, some of whichare outside the foreign exchange market.

Translation Exposure

Translation exposure is the degree to which the consolidated financial statements and balance sheets ofa company can be affected by exchange-rate fluctuations. It is also known as accounting exposure.

Translation exposure arises when the accounts of a subsidiary are consolidated at the head office at anexchange rate that differs from the rate in effect at the time of the transaction.

Tax Exposure

Tax exposure is the effect that changes in the gains or losses of a company because of exchange-ratefluctuations can have on its tax liability. An unexpected or large gain based solely on exchange-ratefluctuations could upset the tax planning of a multinational by causing an increased tax liability. Gainsand losses from translation exposure generally have an effect on the tax liability of a company at the timethey are actually realized.

Types of Foreign Exchange Markets

There are two main types of foreign exchange transactions that are often characterized as differentmarkets—spot transactions and forward transactions. Often dealers specialize in one of three transactioncategories: cash, tom, or spot.

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The Spot Market

The spot market consists of transactions in foreign exchange that is ordinarily completed on the secondworking day of the deal being made. Within the spot market, there can be three types of transactions:

1. Cash, in which the payment of one currency and delivery of the other currency are completedon the same business day”

2. Tom(short for “tomorrow”), in which the transaction deliveries are completed on the nextworking day

3. Spot exchange, in which the transaction deliveries are completed within the same day of thedeal being struck

Price Quotation in Exchange Markets

The prices of currencies in the spot market can be expressed as direct quotes or indirect quotes. Whenthe price of one currency is expressed as a direct quote, it reflects the number of units of home currencythat are required to buy the foreign currency. A direct quote on the New York market would be US$1.30= •1. An indirect quote is the reverse; the home currency is expressed as a unit, and the price is shownby the number of units of foreign currency that are required to purchase one unit of the home currency.For example, in the New York market an indirect quote would be US$1= •0.77 (to purchase one unitof the home currency, the U.S. dollar, •0.77 are needed).

An important feature of foreign exchange price quotation is the number of decimal used. Since largeamounts are traded, quotes are usually given at least up to the fourth decimal, especially for such majorcurrencies as the pound and the U.S. dollar. Thus, a quote for the pound would be £1 = US$1.7643.

Long and Short Positions

A bank can be in the spot market in three positions:

1. Long, when it buys more than it sells of a currency

2. Short, when it buys less than it sells of a currency

3. Square, when it buys and sells the same amount of currency

Whenever a bank is long or short in a currency, it is exposed to a certain amount of risk. The risk arisesin a long position because the value of the bank’s excess currency could depreciate if that currency fallsin price. Thus, the market value of the assets of a bank would be lower than the cost price. In a shortposition, the bank agrees to sell more currency than it has in its possession. If the price of the currencyin which the bank is short rises, the bank will experience a loss. The bank will have to acquire anddeliver the currency at a higher price than the agreed-on selling price. Both long and short positions can



also result in profits, if the currency in question appreciates or depreciates. Since large losses arepossible, banks must carefully evaluate the amount of exposure they can withstand. Specific limits arelaid down for long and short positions in each currency, as well as aggregate limits for all major currencies.

There are usually two types of trading strategy followed by banks in the spot market. One strategy is todetermine whether the currency is going to appreciate or depreciate and then assume a long or shortposition, allowing the trader to profit from the currency movement. This strategy is often called runninga position, or positions trading. The other strategy is to assume and liquidate long and short positionsvery quickly (often within minutes), as exchange rates fluctuate during the business day. This strategy isknown as in-and-out trading.

The Forward Market

The forward market consists of transactions that require delivery of currency at an agreed -on futuredate. The rate at which this forward transaction will be completed is determined at the time the partiesagree on a contract to buy and sell. The time between the establishment of contracts and the actualexchange of currencies can range from two weeks to more than a year. The more common maturitiesfor forward contracts are one, two, three, and six months. Some forward transactions are termedoutright forwards, to distinguish them from swap transactions.

Forward transactions typically occur when exporters, importers, or others involved in the foreignexchange market must either pay or receive foreign currency amounts at a future date. In such situationsthere is an element of risk for the receiving party if the currency it is going to receive depreciates duringthe intervening period.

For the purposes of a quick example of this concept, assume that the owner of a small business wishedto purchase an amount of softwood lumber from a Canadian company in June 2004. At that time, theCanadian dollar was worth US$0.74. If the purchase had been made in June, the total purchase ofCan$3,000 would have cost the business owner US$2,22O.00 (3,000. x0.74). If for some reason thebusiness owner had waited until November 2004 to purchase the softwood lumber from the Canadiancompany, the Canadian dollar would have risen to US$0.84 by that time. Thus, the same Can$3,000purchase would have cost the business owner US$2,520.00 (or US$300 more than the same productwould have cost in June!). The owner of the small business could have eliminated all or part of this riskby purchasing a forward currency contract over this period of time.

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Table 2: Major Currency Cross Rates as of April 7, 2006

To fix a minimum value on the foreign exchange proceeds, these recipients can lock into a rate inadvance by entering into a forward contract with a bank. Under such a contract, the bank is obligatedto purchase the currency from the exporter at the agreed-on rate, regardless of the rate that prevails onthe day when the foreign currency is actually delivered by the exporter. Banks in turn enter into contractswith other banks to offset these customer contracts, which give rise to inter-bank transactions in theforward market.

The date on which the currencies are to be delivered under a forward contract is fixed in advance andis usually specific. In some customer contracts, however, the banks provide an option to the customersto deliver currencies within a certain time that can range up to 10, 20, or 30 days. The costs of suchcontracts are, naturally, higher than the cost of contracts with specific maturity dates, because bankshave to incur additional costs and efforts to create offsetting contracts in the inter-bank market. Forwardcontracts are popular with customers who are not certain of the dates on which they will have to pay orreceive foreign currency amounts and would therefore like some leeway in executing their contractualobligations.

Foreign Exchange Rates

A foreign exchange rate can be defined as the price of one currency expressed in units of anothercurrency. The price of pounds expressed in terms of U.S. dollars could be 1.8391. Therefore, 1.8391would be the foreign exchange rate of the pound. Many journals and newspapers report foreign exchangerates either daily or periodically. Table 2 shows the major currency cross rates on April 7, 2006 asshown on Yahoo Finance. Notice that you can determine both the direct and the indirect exchange ratesfor each of the currencies listed in the table.



Since it is often confusing to decide whether a rate is an indirect or direct quote, a uniform standard ofexchange-rate quotation was adopted in 1978. Under this standard, the U.S. dollar was to be the unitcurrency and other currencies were expressed as variable amounts relative to the U.S. dollar. Thismethod, where foreign currency prices are quoted as US$ 1, is known as stating the price in Europeanterms. The prices of some currencies, such as the British pound and Australian dollar, however, arequoted in terms of variable units of U.S. dollars per unit of their currency. Such quotations are knownas American terms.

Bid and Offer Rates

Rates in the foreign exchange market are quoted as bid and offer rates. A bid is the rate at which thebank is willing to buy a particular currency, and an offer is the rate at which it is willing to sell thatcurrency. Banks in the market are generally required by convention and practice to quote their bid andoffer prices for particular currencies simultaneously.

When quoting their bid and offer rates for a particularly currency, banks quote a price for buying thecurrency that is lower than the price they charge for selling it. The difference between the buying andselling price is called the bid-offer spread. In a typical spot market transaction a U.S. dollar-poundsterling quote would be 1.8410-1.8420. The quote on the left-hand side would be the bid rate, atwhich the bank would be willing to sell US$1.8410 in exchange for a pound. The quote on the right-hand side would be the offer rate, at which the bank would be willing to buy US$1.8420 for a pound.Notice that the selling rate is higher because the bank is prepared to sell fewer dollars for a pound(US$1.8410) than it is prepared to buy. The use of both American and European terms reverses thebid-offer order. Moreover, a bid quote for one currency is an offer quote for the other currency in thetransaction. To avoid confusion, a useful rule of thumb is to remember that in its quote the bank willalways part with smaller amounts of the currency it is selling than it will receive when it is buying. In theexample, the bank is willing to part with US$1.8410 per unit of pound sterling when selling them, but itwants to receive US$ 1.8420 per unit of pound sterling when it is buying.

In practice, exchange traders quote only the last two decimals of the exchange rate, especially in theinter-bank market. The inter-bank quotations of bid-offer rates feature extremely fine spreads becausetransactions are in huge volumes and the competition is intense.

Cross Rates

Exchange rates are quoted prices of one currency in terms of another currency. In practice, however,prices of all currencies are not always quoted in terms of all other currencies, which is particularly trueof currencies for which there is no active market. For example, rate quotations for Malaysian ringgits interms of Swedish krona are not easily available, but both currencies are quoted against the U.S. dollar.Their rates with reference to the dollar can be compared, and a rate can be determined between thesetwo currencies.

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Premiums and Discounts

The spot price and forward price of a currency are invariably different. When the forward price of thecurrency is higher than the spot price, the currency is said to be at a premium. The difference betweenthe spot price and forward price in this case is called the forward premium. When the forward rate ofa currency is lower than the spot rate, the currency is said to be at a discount. The difference betweenthe spot and forward rate in this case is called the forward discount. Some illustrations of forwardpremiums and discounts are:

Spot rate for U.S. dollar/Can. dollar = Can$1.19 Forward rate for U.S. dollar/Can. dollar = Can$1.29. Notice that in the forward rate, it will require Can$1.29 to buy US$1, while in the spot rate onlyCan$1.19 is required. The U.S. dollar is costlier in the forward quote than in the spot quote and istherefore at a premium against the Canadian dollar. The premium on forward quotes of the U.S. dollaris Can$0.10.

Now, assume the following exchange rates between the U.S. dollar and Canadian dollar:

Spot rate: Can$1.29 = US$1

Forward rate: Can$1.09 = US$1

In this case the spot rate for the U.S. dollar is more expensive, in terms of Canadian dollars, than theforward rate. In other words, the U.S. dollar is cheaper in the forward market; because only Can$1.09 is needed to buy US$ 1 forward, whereas Can$ 1.29 is needed to buy US$ 1 in the spot market.Thus, the U.S. dollar is at a discount of Can$0.20 in the forward market.

It is very important to recognize the type of quotation when considering forward premiums and discounts.When the quotes are indirect, that is, when the home currency is expressed as a unit and the foreigncurrency as variable, forward premiums are subtracted from the spot rate to arrive at the forward rate.Similarly, forward discounts are added to the spot rate to get the forward rate. Following are examplesshowing premiums and discounts.1

Premium:

Spot rate: US$1 = Can$1.29

Forward premium on Can$ = Can$0.010

Forward rate for US$/Can$ = Can$1.28

Discount:

Spot rate: US$1 = Can$1.29

Forward discount on Can$ = Can$0.020

Forward rate for US$/Can$ = Can$1.31



When the exchange rates are quoted as direct rates, that is, when the foreign currency is the unit,premiums are added to the spot rate to arrive at the forward rate; discounts are subtracted.

Consider a situation in which the pound sterling is at a premium:

Spot rate: £1= US$1.78

Forward premium on £ = 0.10

Forward rate for £1/US$ = US$1.88

Consider a situation in which pound sterling is at a discount and direct quotations are used. The forwardrates will be calculated as follows:

Spot: £1= US$1,864

Forward discount: US$0,020

Forward rate: £1 = US$1,844

Notice that the method of arriving at the forward rate is reversed when moving from direct to indirectrates. Remember, however, that the basic rule applicable to all types of quotations is that a currency ata premium will buy more units of the other currency in the forward market than in the spot market, whilethe reverse will be the case when the currency is at a discount. Also, it is important to note that thepremium and discount calculations will be applied at the variable currency, either in a direct or indirectquote. Thus, in the examples above, currencies that are at a premium or discount are the ones that arevariable, that is, whose rates are not expressed as a unit.

Forward premiums and discounts arise when the exchange markets expect the future value of currenciesto be either higher or lower. The amount of premium can and does vary quite often with the length of theforward quote, and banks often quote a series of exchange rates indicating the forward premium ordiscount over a range of forward deliveries. Table 2 illustrates a typical foreign exchange forwardquotation.

In this quotation, the 30-day forward quote shows Canadian dollars at a premium of 10 points, while60-day and 90-day premiums are at 20 and 30 points, respectively. Points here represent values interms of the fourth decimal place of the exchange rate quotation.

3.8 Exchange Rate

One important factor that distinguishes international trade from domestic trade is the existence of differentnational currencies. While the goods and services move from one country to another, in settlement ofthe transaction, money should flow in the reverse direction. An importer in USA, for instance, pays in

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US dollars, which should be received by the Indian exporter in Indian rupees. Foreign exchange marketprovides the mechanism by which currency of one country is converted into currency of another country.The price at which one currency is exchanged for another currency is known as exchange rate. Forinstance, if the foreign exchange market in India quotes the rate of US dollar as Rs. 46, it means onedollar is exchanged for Rs. 46. This is the exchange rate for US dollar in terms of Indian rupee.

The foreign exchange rate is not static. Similar to the price of a share in the equity market, the value ofa currency in the exchange market is also very volatile. There are a number of factors which affect theexchange rate between two currencies. All the transactions in the balance of payments of a currencyresult in either demand for or supply of foreign exchange. For instance, imports and investments madeby residents abroad create demand for foreign exchange. Exports and foreign investments in Indiasupply foreign exchange in the market. Other factors like relative changes in the interest rates in thecountries, changes in inflation rates, political and economic developments affect the exchange rates.However, how far these factors are allowed to influence the exchange rate in the market depends onthe monetary system adopted by the countries concerned.

The country may adopt either (a) fixed exchange rate system, or (b) floating exchange rate system.

When the country adopts fixed exchange rate system, the exchange rate of the currency is kept at thedesired level by the government concerned. The market forces may not be allowed to influence theexchange rates. The exchange rate, therefore, remains at a pre-determined rate, but for small fluctuations.

When the floating rate system is adopted, there is little interference of the government in the exchangerate determined by the market. Exchange rates are allowed to fluctuate freely depending on the marketforces.

In practice, many countries have adopted exchange rate systems which fall in between the two extremesof fixed and fluctuating rates.

Exchange Rate Determination

Some of the instruments available in the foreign exchange market like forward exchange contracts,currency swaps, options, etc., help to a great extent in minimizing the foreign exchange risk. This riskcould be further minimized if an organization involved in international business has an idea about whyexchange rate changes and how it changes. Though there is no one single theory available which explainswhy/how exchange rate changes, but this is for certain that the exchange rate depends on the demandand supply of a currency. For example, if the demand for British pound is more than its supply, then theBritish pound will appreciate. On the other hand, if the supply of U.S. dollars is more than its demandthen the U.S. dollar will depreciate.

The organizations involved in international business are interested in finding out why the demand andsupply of a currency changes so that they could predict the future exchange rates. Though there is noclear cut answer of this question, but most of the exchange rate theories admit that there are three



important factors—the nation’s price inflation, interest rate and market psychology, which influence theexchange rate movements.

Fixed Exchange Rates

Fixed exchange rate refers to a system that permits only very small deviations. Fixed exchange raterefers to maintenance of external value of currency at an officially determined level. In the event of theexchange rate deviating from the official level it will be corrected through official intervention.

Official intervention refers to purchase or sale of foreign exchange from/to the market by the centralbank of the country with a view to regulate the exchange rate. If there is more demand for foreigncurrency with the exchange rate tending to appreciation of the foreign currency beyond the limit fixedby the central bank, it will supply foreign currency in the market by drawing from its reserves. If thesupply of foreign currency in the market is more and thereby the foreign currency tends to depreciate,the central bank absorbs the excess liquidity by purchasing foreign currency from the market.

When International Monetary Fund was instituted, one of its main functions was to specify the par valueof every currency in terms of gold and US dollars. This is the officially pre-determined value. The actualmarket value was allowed to fluctuate around a narrow margin from this level.

When Articles of IMF was amended in the year 1978 the par value system was abolished. Howeversome countries continue to fix their currency value in terms of a single major currency or a basket of fewcurrencies. For example, Pakistan and Egypt have pegged their currencies in terms of U.S. dollar andare allowed to vary only within a narrow band. When currency value is fixed in terms of foreign currencies,then we cannot expect the automatic mechanism to correct the balance of payments imbalance throughexchange rate changes. For example, when there is balance of payments deficit, currency will not beallowed to depreciate spontaneously as a corrective measure. Hence deliberate devaluation will bedone by the Central Bank with a view to reducing imports and increasing exports. On the contrary,revaluation, that is increase in the value of domestic currency in terms of the foreign currency, will bepursued when balance of payments is surplus. This will make domestic exports costlier and importscheaper and finally will reduce the surplus and imbalance will be corrected.

Devaluation or revaluation of the currency will be done by the central bank not frequently. As saidearlier, the changes in exchange rates will be endeavoured to be corrected by official intervention. Onlywhen the forces of demand and supply are so powerful as to render intervention ineffective, the countrywill resort to devaluation or revaluation.

Case for Fixed Exchange Rates

1. Provides a check on domestic inflation. Fixed exchange rate system promotes a strict disciplineneeded in economic policy to prevent a continuing inflation. Policy makers should keep a close watchon domestic inflation rates and if at any time exceeds inflation rate in the world as a whole, contractionarymonetary policies should be undertaken to control domestic inflation. Fixed exchange rate virtually

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forces this type of policy action, and failure to do so will lead to an elimination of country’s internationalreserves. A country with the balance of payments surplus will have to undertake policies in the oppositedirection.

Of course, the merit of the argument that fixed exchange rate enforces discipline should be qualified.Not always such a discipline is desirable. When countries have other objectives apart from price stabilitysuch as higher employment and growth, then contractionary policies may be detrimental. Hence acountry facing balance of payments deficit, for example, may not be willing to sacrifice the other goalsfor the sake of achieving balance of payments balance.

2. Promotes international trade. A long-standing point made by proponents of fixed exchange rate isthat they are conducive for the expansion of world trade. Fixed exchange rate is supposed to reducethe level of risk and uncertainty that may arise due to currency price instability. Hence volume of tradewill increase; this is true for promoting long-term foreign direct investments. If there is stability in thevalue of exchange rate one can make a reasonable estimate on the rate of return and in a fixed exchangerate, the return is not subject to currency value fluctuation.

3. Promotes greater efficiency in resource allocation. Another argument put forward in favour of fixedexchange rate is that under fixed exchange rate system when the currency value is stable, there is noincentive for factor movement between the tradable sector and non-tradable sector. If there exist suchmovement of factors between these sectors, it will only lead to wastage of resources. For example,temporary displacement of labour leads to frictional unemployment.

4. Discretionary policies are more effective. Yet another point in favour of fixed exchange rate system isthat fiscal policy is more effective in influencing the level of national income under fixed exchange ratesystem. For example, under fixed exchange rate system, expansionary fiscal policy where publicexpenditure is greater than public revenue, balance of payments surplus becomes possible; becauseincrease in the public expenditure rises the interest rate and the rise in the interest rate will bring incapital from other countries.

5. Fixed exchange rate reduces currency speculation. Proponents of fixed exchange rate feel that theincentive for currency speculation will be lesser under this system; hence stability that is essential fortrade and investment will be ensured.

Floating/Flexible Exchange Rates

Free or floating rates refer to the system where the exchange rates are determined by the country’sdemand for and supply of foreign exchange hi the market. The rates will vary according to the changesin demand and supply.

Unlike freely floating exchange rate, flexible rates of exchange refer to the system where the rate is fixedbut is subject to frequent adjustments depending upon the market conditions.



Crawling Peg

In the system of crawling peg a country specifies a par value for its currency and permits a smallvariation around the par value such as 2 per cent from parity. Advocates of crawling peg concept pointout that, at least in theory, the existence of the ceiling and floor can provide some discipline on the partof monetary authorities. In addition the fact that the rate is periodically changes implies that the role ofexchange in balance of payments adjustment is maintained.

Managed Floating

One another hybrid arrangement of fixed and flexible exchange rates is managed floating. In generalmanaged floating is characterized by some interference with exchange rate movements, but the interventionis discretionary and not automatic on the part of monetary authorities. In other words, there are noannounced guidelines or rules for intervention, no parity variation.

Inflation

Inflation is the situation in which the prices of goods/services rise on account of the fact that the quantityof money in circulation rises faster than the supply of goods and services. It could occur when theincrease in supply of money is faster than the increase in supply of goods and services. The concept ofinflation in conjunction with the theory of purchasing power parity explains in a better manner how itinfluences the exchange rates.

The purchasing power parity (PPP) theory establishes a relationship between different currencies. ThePPP concept compares the prices of the same basket of goods and services in different nations andthus helps in determining the exchange rate between the currencies of the nations involved.

For example, suppose an identical basket of goods and services costs Rs. 500 in India and $10 in theU.S.A. Then the exchange rate between Indian rupee and U.S. dollar, as per the PPP theory would beequal to Rs. 500/$I0 or Rs.50 per U.S. dollar (i.e. $1 = Rs.50).

Further suppose that the rate of price inflation in India is 5 per cent and in the U.S.A. it is zero per cent.In simple words, it means that the basket of goods and services which costs Rs.500 in India, at the startof year, will cost Rs.525 at the end of the year. On the other hand, the same basket, the cost of whichwas $10 in the U.S.A. at the start of year, will cost the same at the end of year. Therefore, according toPPP theory, the exchange rate, which was at the start of year Rs.50 per dollar (Rs.500/$10), willbecome Rs.52.5 per dollar (Rs. 525/$10) i.e. $1 = Rs. 52.5, at the end of year. Thus, because ofinflation in India the rupee depreciates against dollar, i.e., one can purchase more units of rupees for thesame amount of dollars. To be precise, the percentage depreciation in a currency will be equal to thedifference in the inflation rates in the two nations. As in the aforesaid example, the rate of inflation was5 per cent in India, and zero per cent in the U.S.A. therefore, the Indian rupee depreciates by 5 percent against the U.S. dollar (difference in inflation rates between India and the U.S.A being 5-0 = 5 percent).

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The PPP theory for estimating the exchange rates has been used by the news magazine, The Economist,since 1986. The news magazine uses the price of a Big Mac in different nation for finding out theexchange rates and then comparing this with the actual exchange rates in order to determine whetherthe currency is undervalued or overvalued. The Economist assumes that Big Mac could be used forrepresenting the basket of goods as it is produced in over 120 nations using more or less the samerecipe. According to The Economist, the price of Big Mac in the U.S.A. was $2.49 in 2002, and it wasYuan 10.50 in China. So, the implied exchange rate between the two currencies was Yuan 4.22 perdollar (dividing Yuan 10.50 by $2.49), but the actual exchange rate was Yuan 8.28 per dollar. It meansthat the Yuan was undervalued by 49 per cent against U.S. dollar, in 2002. The main limitation of theBig Mac index lies in the fact that it assumes zero transportation costs and no barrier in trade.

The policies followed by the government of a nation, to a great extent, determines the rate of inflation.If the government policies lead to an increase in the money supply, which is faster than the supply ofgoods and services, then inflation is bound to rise and the currency is likely to depreciate. Normally,when the government of a nation, in order to finance the public expenditure, resorts to the softer optionof printing more money, instead of going for the harder option like taxing people, then it will lead tohigher inflation rate and depreciation of currency. So, an organization involved in international businesscan have a fairly good for about the exchange rate movement, i.e., whether the currency of the nationwill appreciate or depreciate and to some extent its degree also, by having a look at the policies of thenation Argentina, Bolivia and Brazil, are examples of nations the currencies of which depreciate highlyon account of high inflation rates which were the result of the increase in the money supply.

Interest Rates

Apart from the inflation rates, the interest rates also help in understanding the movement of the exchangerate. Generally, it is seen that the interest rates are high in nations in which the inflation rates are high.The reason that the holder of the currency wants to be compensated for the decline in the value of thecurrency.

To understand the relationship more clearly, one must look at the Fisher Effect theory. According to thistheory, the relationship between the nominal interest rate r, the real interest rate R and the inflation ratei, is given as:

(1 + r) = (1 + R) (1 +i)

The nominal interest rate is the actual monetary return on the investment, whereas the real interest rateis the nominal interest rate minus the inflation rate. In a situation where free movement of capital isallowed the real interest rate will be same throughout. For example, if the real interest rate is 5 per centin India and it is 8 per cent in China, then investors would borrow money in India and invest in China.This will lead to more demand for money in India and more supply of money in China. The result will bethat the real interest rate will rise in India and it will fall in China until the rate becomes same in both thenations. (This situation, however, does not occur in reality on account of the governments’ involvementand control over capital movement between nations).



For example, if the real interest rate in India and China is 5 per cent and the inflation rates are 8 and 12per cent, respectively. Then according to the Fisher Effect theory, the nominal rates in India and Chinawill be calculated as follows:

Nominal interest rate in India Ir = (1 + (5/100)) (1 + (8/100)) - 1

Ir = (1.05) (1.08) - 1

= 1.1340 - 1

= 0.1340 or 13.4 per cent

Nominal interest in China will be cr = (1 + (5/100)) (1 + (12/100)) - 1

= (1.05) (1.12) - 1

= 1.1760 - 1

cr = 0.1760 or 17.6 per cent

Thus, if the real interest rate is same between the nations, then the difference in nominal interest ratesoccur due to the difference in the inflation rates. This helps in explaining a very important fact that thenominal interest rate tends to be high in the nations which expect high inflation rates.

Another important theory, known as the International Fisher Effect, says that the difference in theinterest rates is an unbiased predictor of future exchange rate movements. The change in exchange rateshould be proportional to the difference in interest rates, but in opposite direction.

For example, if the interest rate in India is 10 per cent and China is 15 per cent, then the Chinesecurrency Yuan is likely to depreciate by 5 per cent, against Indian rupee, in future.

The explanation of exchange rate movement by International Fisher Effect theory is based on thedifferences in interest rates. These differences in interest rates are due to the differences in inflationrates. The discussion under the purchasing power parity theory explained how inflation rates influencethe exchange rates. Thus, keeping the International Fisher Effect theory and the PPP theory in mind,one can predict that, in the long run, the currency of a nation having high interest rate and inflation rateis likely to depreciate.

Investor Psychology

The empirical evidence suggests that though both the inflation rates and the interest rates are able toexplain the changes in the exchange rate movement over a long period of time, but they have failed, incertain situations, to explain the changes in exchange rates over a short period of time. These changesin short-term exchange rate movements could be better explained on the basis of investor psychology.

The psychology of an investor is influenced by a number of factors and it is nearly impossible to comeout with an exhaustive list of all such factors. One important factor could be the decision taken by an

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individual or an organization, well established in business. For example, when George Soros decided tosell pounds and purchase German marks, in early 1990s, other investors joined him and the ultimateresult was depreciation in the value of pound.

Sometimes, political events could influence the investor psychology. In 2002, the Brazilian currency, thereal, depreciated because of the high poll ratings for a left wing candidate in the run up to presidentialelection. This made the investors feel that the person will not be able to manage the finances and theresult was depreciation in the value of currency.

Or if, sometimes, the confidence of the investors shakes, then this could also influence the exchangerate movement. For example, in 1997, the foreign investors lost confidence in the ability of many SouthKorean firms that they will be able to service their debt payments. The result was that they startedwithdrawing money from South Korea and the Korean won depreciated by more than 50 per cent.

Forecasting Exchange Rate

Many experts are of the view that forecasting exchange rate is a sheer wastage of resource like men,money and time. They feel that the forward exchange rates best forecast the future spot rates and assuch an organization involved in international business should use them and not get too much concernedabout forecasting. However, certain recent studies have shown that the above view does not alwayshold true. This has provided a fillip to the proponents of future exchange rate forecasting who feel thatthe forward exchange rates must be supplemented by the predictions of exchange rate forecastingwhenever an organization involved in international business takes any decision regarding future investmentsor revenues.

Basically, there are two approaches available for forecasting the exchange rates—the fundamentalanalysis approach and the technical analysis approach. In the fundamental analysis approach, a modelis developed for forecasting. This model tries to take into account all the possible factors which caninfluence the exchange rate like the money supply; the inflation rate; the interest rate; the balance ofpayments position; the foreign exchange reserves position; and the monetary and the fiscal policy.Then, after analyzing these factors carefully, the future exchange rate is predicted.

In the technical analysis approach, the exchange rate is forecasted on the basis of the pattern which ithas followed in the past. It is assumed in technical analysis that the past trend, cyclical movements andother movements, will continue in the same pattern in future also. Thus, technical analysis tries to providea value of future exchange rate on the basis of assumption that the conditions which prevailed in the pastwill also continue in the future. Some economists criticize the technical analysis approach on the groundsthat it does not have any logical theoretical base hence; it is as good as fortune telling.

One thing which should always be kept in mind is that forecasting is only an educated guess. Therefore,there is always a probability that it could go wrong as far as the timing of exchange rate movement isconcerned or its direction is concerned or its magnitude is concerned. But it generally aids and helps inbetter decision-making regarding future exchange rates.




1. Explain the Financial Environment of International Business.

2. Explain international financial markets.

3. What is Foreign exchange and explain exchange rate of determination?

4. Explain the various sources of Finance for International Business.

5. Explain the concept of International Finance?

* * * *

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Module IV

REGULATION OF INTERNATIONAL BUSINESS


� Institutional Environment of International Business

� Trade Related Investment Measures (TRIMS)

� Goals of MNCs

� Conflict between Multinationals and Government

� International Business Laws

4.1 Institutional Environment of International Business

Economic system is an organization of institutions established to satisfy human needs/wants. There arethree types of economic systems, viz., capitalism, communism and mixed. Economic systems are basedon resource allocation in the system. They are market allocation in case of capitalistic, command/central allocation in case of communistic and mixed allocations in case of mixed economic system. Infact, there are no examples of pure capitalistic or communistic economies. All actual systems are mixedeconomic systems of varied degrees of market allocations and command allocations.

Capitalistic Economic System

Under this system, customer allocates resources. Customers’ choice for product/services decides what


will be produced by whom. This economic system provides for economic democracy, thus giving thecustomer, his choice for products/services.

This system emphasizes the philosophy of individualism believing in private ownership of productionand distribution facilities. The limitation of this economic system made the Governments introduce thewelfare state concept which includes: workmen’s compensation law, provision for social security, labourlegislations for state and housing, agriculture, medical, food, transportation, communication, security,education, water, power supply etc.

The USA, Japan and the UK are the examples of capitalistic countries. Most of the other countries likeIndia, France, Italy and Malaysia have started shifting their economic systems towards this economicsystem.

Mixed Economic System

Under this economic system, major factors of production and distribution are owned, managed andcontrolled by the state. The purpose is to provide the benefits to the public more or less on equity basis.The other factors of mixed economic system are development of strong public sector, agrarian reforms,control over private wealth, regulation of private investment and national self-reliance.

This system does not distribute the existing wealth equally among the people, but advocates the egalitarianprinciple. It believes in full employment, suitable rewards for the workers’ efforts. This is also called‘Fabian socialism.’

As mentioned earlier, there is no pure capitalistic system or communistic economic system. All capitalisticsystems have a command sector and communistic systems have a market sector. The command sectoraccounts for 32 per cent in the USA, 40 per cent in India and 64 per cent in Sweden.

The trend that is taking place in the globe today is the move towards privatization, i.e., move towardsmarket allocation. The UK, France, Holland and India, for example, have reduced their commandsector after 1990.

Communistic Economic System

In this, economic system, private property and property rights to income are abolished. The state ownsall the factors of production and distribution. Communism is also called Marxism. Lenin set up acommunist state .in Russia after the Great October Revolution of 1917. Later, the ideology spread toCzechoslovakia, China, Rumania, Yugoslavia, Poland and Sweden. Most of the East European countriesfollow the Marxist ideologies.

In communistic/command allocation countries, the resource allocation decisions are made by thegovernment planners. The number of automobiles, shoes, shirts, television sets - their size, colour,quality, features etc., motor cycles, and scooters are determined by government planners. Under thissystem, consumers are free to spend their income on what is available.

101Module IV - Regulation of International Business

The major limitations of this system include:

• It reduces individual freedom of choice due to restrictions on items to be produced.

• IT imposes too many restrictions on MNCs and FDI.

• It fails to get total commitment of people to work and country’s welfare.

• It failed to achieve significant economic growth.

• It could not achieve equality - the main plank of Marxism.

• The rules of this system did not set fine example for the executors to follow or implement.

• It has been obsessed with rights of workers.

4.2 Trade Related Investment Measures (TRIMS)

The agreement on Trade Related Investment Measures (TRIMS) requires the investment measures toconform to national treatment and not to impose quantitative restrictions like prescription of minimumlocal procurement by foreign companies or for imports by companies to be matched by exports.

Objective of TRIMS

TRIMS will protect the interests of the foreign investors. The capital and the profits will be protectedand the investee countries will have the obligation to allow the repatriation of capital and profits. Theforeign companies will enjoy the same rights as enjoyed by the local/domestic companies.

This is expected to increase the flow of foreign direct investment. More investment is supposed to leadto greater production and more income. Many rights have been given to the foreign investors. This willprovide unfettered rights to the big corporation and many developing countries having less income thanthe companies will not have any control over the companies.

When Japan and the South East Asian nations started dominating the global scene in international trade,the United States tried to re-establish its supremacy through trade in services; The United States introducedTRIMS in the eighth around (Uruguay Round) of GATT deliberations, though TRIMS was not there inthe original agenda of GATT. The multinational corporations desired to get many concessions from thecountries in which they were investing. They wanted that their capita] should be protected and theyshould enjoy all the privileges extended to the domestic companies by the local governments. TheMNCs wanted equal treatment on par with the local companies in the investment countries.

Features

The salient features of the TRIMS are given below:


i. All restrictions on foreign investments should go.

ii. The foreign investors should be treated on par with the local investors. (iii) There should be nodiscrimination against the foreign investors.

iii. Foreign investors should not be compelled to buy the local materials companies.

iv. Foreign investors should not be compelled to export a part of their production

v. There should be no restriction on the repatriation of capital and profit. In the WTO meetings,most developing countries were disappointed and flexed their muscles too, on the discussionson investment. They are worried that TRIMS may not help their economies.

The Adverse Effects the Growing Powers of the TNCs

Foreign Direct Investment (FDI) by Transnational Corporations (TNCs) has now superseded the globaltrade to become the most important mechanism for international economic integration. There are 65,000TNCs with roughly S.50,000 branches and subsidiaries. The global sales of TNCs are around USD20,000 billion.

Many of these TNCs are bigger than most nations in the world. Fifty biggest TNCs have annual incomeslarger than those of 131 nations.

The WTO agreement has already resulted in ‘multilateralisation of sovereignty’ in many areas of domesticpolicy, thereby reducing the powers of people and national Parliaments. The process of globalizationand liberalization though did not benefit the poor people, has resulted in rapid increases in trade andproduction. The major beneficiaries of this change are the big business houses.

Curbing of Competition

Curbing of competition, particularly the cross-border variety, and lowering of standards and regulationsgoverning interests of labour, consumer and the environment.

Entry and Establishment without Screening

WTO provides for better market access, i.e., the right of any foreign investor to freely establish onprinciples of most favoured nation status. Under the proposed dispute settlement provisions, denial ofmarket access can also be taken up.

It means that even if an investor or a type of investment is not acceptable to a country for any reason,its government will not be able to exercise any option. No country can deny entry to a foreign investorexcept on very few grounds.

National treatment without any discrimination would be the cornerstone both before and after theestablishment. Exceptions sought under ‘Public Order’ are being criticized. Any investor can raise a

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dispute on both pre-establishment and post-establishment discrimination. Any reservation/exceptionshould be narrow, clearly defined and transparent. Issues like balance of payments will be allowed, if atall, for a temporary period only.

Transfer of Money

‘Investors will have the right to transfer all money accrued due to profits, sale proceeds, proceeds fromliquidation, payments for technical and managerial services, royalties from use of trademarks or patentsor other such intellectual properties. This unfettered right to transfer all money is given to the investoreven if the investee-country does not like it.

An unfettered right without any restrictions the investor may have towards the host country, will meandiscrimination against domestic enterprises. This may not be in the interest of the investee-countries.

Movement of Key Personnel

Investors will be allowed free movement of key personnel between one and the other units regardlessof nationality. There would be no restrictions or conditions on the nationality of board members.

It means that an investor can move personnel from one unit to another as it suits them and would notaccept any condition on appointment of board members from the host country.

Investor Protection

TRIMS provide for strong and effective protection for investors against nationalization and expropriation.

This will protect the interests of the investors but the in ves tee-country may not have any control overforeign companies.

Under the current globalization and liberalization process, nationalization or expropriation of foreigninvestor’s assets is an extreme chance, but if a country decides to nationalize all units in one sector fordevelopment policy reasons, e.g., all local and foreign companies are nationalized without anydiscrimination; there would be a case for foreign investors alone.

Dispute Settlement

Provisions for both the investor-State and State-State dispute settlement should be there which shouldalso allow international arbitration or appeal to an international tribunal.

The provisions on dispute settlement are the most crucial for any agreement as they determine the exactspirit and letter of the agreement, and once a dispute is raised, its settlement will interpret the meaningof the agreement and create case law precedents.

The investors can take action against a government in its domestic jurisdiction and vice-versa on theprinciples of non-discrimination; it would mean that a domestic investor will also have the right to takeaction against his government in an international forum. This is ridiculous.

Module IV - Regulation of International Business


No Code of Conduct for the TNCs

The governments of the investee-countries are controlled by the TRIMS but there is no control on theTNCs. There is no code of conduct for them. No action is prescribed against them but all attemptshave been made to protect them.

Multilateral trade negotiations introduced TRIPS in the Uruguay Round of GATT. The industrializedNorth insisted that TRIPS should be included in the final Act. The Agreement on Trade Related Aspectsof Intellectual Property Rights provides for the availability and enforcement of such rights.

The Agreement establishes minimum standards on the following:

i. Copyrights and related rights, including computer programmes and data bases;

ii. Trademarks;

iii. Geographical indications;

iv. Industrial designs;

v. Patents;

vi. Integrated circuits; and

vii. Trade secrets.

This Agreement on TRIPS incorporates the conventions of Paris, Berne, Rome and Washington whichprovide for the protection of such rights. Article 1.1 calls upon the members to provide for full protectionof such rights.

The development of detailed provisions on enforcement in the TRIPS agreement is a major departurefrom the pre-existing conventions on Intellectual Property Rights. The Agreement stipulates specificobligations related to administrative and judicial procedures including provisions on evidence, injunctions,damages, and measures against counterfeiting and penalties in the case of infringement. Any controversyas to compliance with regard to minimum standards should be subject to a multilateral procedure inaccordance with the Dispute Settlement Understanding. Once the violation has been established, theaffected country can apply cross retaliation to the non-complying country. This mechanism provides foran institutionalized, multilateral means to address disputes relating to IPRs. It is aimed at preventingunilateral actions.

The TRIPS (Trade Related Intellectual Property Rights) is certainly an important and controversialissue that adds on considerably to the challenges faced by the Third World countries.

The genetic materials of the South in the form of biodiversity and of the traditional seeds or medicinalplants identified and evolved through generations by farmers and forest dwellers are not patentable,and belong to the domain of the ‘common heritage of mankind’, to be freely shared, even with the

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developed countries. But the genetically modified seeds, plant life or animal life (mainly in the possessionof the developed countries) are to be subject to Intellectual Property protection.

The TRIPS draft agreement in the Uruguay Round of GATT made it compulsory for Southern countriesto adopt IPR regime with standards similar to the Northern countries, and this would put the South ata serious disadvantage in terms of indigenous technological capacity building.

History of Patent Rights

Patents, trademarks and other intellectual (industrial) property rights are not natural human rights. AncientGreece (7th century B.C) granted to cooks a monopoly for one year to exploit new recipes. But a fewcenturies later, Emperor Zeno in Rome (480 AD) rejected the concept of monopoly. The city state ofVenice, the first to establish a patent Jaw in 1474, granted the rights on condition that the patent isworked; otherwise the patent rights were forfeited. The 1791 French patent law said that the monopolyof the inventor was a ‘Natural right’. Not so, said Austria in 1794. It called patents an exception to thenatural right of citizens to have access to inventions.2 There is no definition of ‘patent’ in 1883 Parisconvention. In the joint study by the UNO, UNCTAD and WIPO, the International Bureau of theWIPO provided a description of the patent, as “a legally enforceable right granted by virtue of law to aperson to exclude, for a limited time, others from certain acts in relation to a described inventions; theprivilege is granted by a government authority as a matter of right to the person who is entitled to applyfor it and who fulfils the prescribed conditions.” Thus the patent rights are ‘privileges’ granted by theState to reward inventive work of individuals.

Reasons for the Emergence of IPR Regime

Technology became a major issue in development since 1970. The rate of technological progress wasrapid in 1970s, 1980s, 1990s and later. It had no parallel in history. Information technology simplifiedand solved many issues, problems and concerns of human kind. Computer programmes were evolvedto solve the administrative, healthcare, industrial, transport problems apart from taking up the centerspace in the academic arena.

Internet was thrown open to the public in the early 1990s. Mobile phones revolutionized thecommunication modes. Satellite TV brought entertainment and global news to the drawing rooms.Banking has been completely modified with the emergence of ATMs and anywhere banking. Currenciesare sought to be replaced by credit cards and debit cards. E-commerce is increasing its role. Paperlessoffice will be the reality soon.

Air travel has become cheaper and more frequent. Global distances have shrunk. Sending a letter fromChennai to New York and getting back the reply through Internet have become cheaper than the costof a post card. Hollywood films have become more popular. Almost all these developments had theirroots in the inventions and discoveries from the laboratories and R & D centers of the developedcountries. The developed countries wanted to protect their products, discoveries and inventions. Theydemanded that a powerful intellectual property regime should be established to protect their rights.



The Governments of the First World have invested heavily in the research projects and the benefits arebeing passed on to the private sector.

The multinationals had developed new products and services. The developed countries in general andthe multinationals in particular, were aggressive in promoting their interests and their products.

The multinational/transnational companies wanted to acquire and retain monopoly powers and controlover the new products and services. The new products and services also commanded high prices andbrought in huge profits.

4.3 Goals of MNCs

The fundamental objective of an MNC is to earn profit and this might clash with the host government’sobjective of achieving better quality of life for its citizens. Such conflicts need to be resolved by theMNCs using their own initiative.

Following are the Goals of MNCs, and their subsidiaries:

• Manufacture in those countries where it finds the greatest competitive Advantage

• Buy and sell anywhere in the world to take advantage of the most favorable price to thecompany.

• Take advantage, throughout the world, of changes in labour costs, Productivity, trade agreementsand currency fluctuations.

• Expand or contract, based on worldwide competitive advantages

• Obtain a high and rising return on invested capital.

• Achieve greater sales.

• Hold risks within reasonable limits in relation to profits.

• Maintain and improve technological and oilier company strengths.

• Maintain control of important decisions.

• Encounter fewer barriers in host countries.

Fundamental Goals of Host Governments

Individual countries have different goals they wish to achieve. Their differences are wider than variationsof goals of individual MNCs. However, most countries, developed and less developed, want to

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• Achieve economic growth

• To achieve full employment of people and resources.

• Improve managerial and worker skills.

• Maintain price stability.

• Develop a favorable balance of trade.

• Achieve a more equitable distribution of income among the population.

• Retain a fair share of profits made by MNCs in their country.

• Improve technological development.

• Improve worker productivity.

• Increase local ownership of the means of production.

• Retain hegemony over the economic system.

• Control national security decisions.

• Develop and maintain social and political stability.

• Advance the quality of life of its people.

• Protect the nation’s physical environment.

Defenders and Critics of MNCs

MNCs are criticized, particularly by developing countries, on grounds like low wages, exploitation oflabour, depletion of resources and abuse of human rights. A few grey areas of globalization werebrought out in the previous chapter. Criticisms of globalization are also comments on MNCs as thelatter are the manifestations of globalization. Nevertheless, we prefer to focus on the grey areas ofMNCs separately, as we believe that the multinational companies are the actors, the complete stagebeing the globalization. The stage comprises the director, artists, technicians, supporting staff and thescript.

It may be recollected that the MNCs’ main objective is to earn money. They are operating in anycountry and in any form to earn profit and not to indulge in philanthropic activities. It may also be statedthat the MNCs are not the only entities mat indulge in activities unacceptable to the developing countries.Many of the domestic businesses in the respective developing countries may engage in much moreharmful practices. Why, then, are MNCs singled out? It is because of their clout, the resources theycommand, the deep pockets they carry and the high visibility they exhibit.



Disadvantages Faced by MNCs

Business Risks

MNCs have to bear several serious risks that are not borne by companies whose operations are purelydomestic in nature. Since MNCs conduct business outside the borders of their own countries, they dealwith the currencies of other countries, which render them vulnerable to fluctuations in exchange rates.Violent movements in exchange rates can wipe out the entire profit of a particular business activity.Over the long run, MNCs often have to live with this risk because it is extremely difficult to eliminate it.Over the short run, however, there are market mechanisms such as currency swaps and forward contractsthat allow an MNC to minimize the movement of exchange rates for a particular business transaction.Companies that engage in these forms of financial contracts understand that they are not in the currency-risk business and that it makes sense to minimize this risk when at all possible.

Host-Country Regulations

Operating in different countries subjects MNCs to a myriad of host-country regulations that vary fromcountry to country and, in most cases, are quite different from those of the home country. The MNChas the difficult task of familiarizing itself with these regulations and modifying its operations to ensurethat it does not overstep them. Regulations are often changed, and such changes can have adverseimplications for MNCs. For example, a country may ban the import of a certain raw material or restrictthe availability of bank credit. Such constraints can have serious effects on an MNC’s productionlevels. In many developing countries, national controls are quite pervasive and almost every facet ofprivate business activity is subject to government approval. The MNCs of developed countries are notused to such controls, and their methods of doing business are not geared to work in this type ofenvironment.

Different Legal Systems

MNCs must operate under the different legal systems of different countries. In some countries thelegislative and judicial processes are extremely cumbersome and contain many nuances that are noteasily understood by non-natives. Some legislation can also prohibit the type of business activity theMNC would regard as normal in its home country.

Political Risks

Host countries are sovereign entities and their actions normally do not admit any appeals. There is littlethat an MNC can do if a host country is determined to take actions that are inimical to its interests. Thispolitical risk, as it is known, increases in countries whose governments are unstable and tends to changefrequently.

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Operational Difficulties

Multinationals operates in a wide variety of business environments, which creates substantial operationaldifficulties. Unwritten business practices and market conventions often prevail in host countries. MNCsthat lack familiarity with such conventions find it difficult to conduct business in accordance with them.Often the normal methods of operation of an MNC can be quite contrary to a country’s businesspractices. A typical example is informal credit. In many countries retailers agree to stock goods of amanufacturing company only if they are offered a market-determined period of credit 15 that is notcovered by a written document. The accounting and sales policies of an MNC may not permit sucharrangements. On the other hand, performance of business in that country may not be at all possiblewithout such arrangements. The multinational must therefore adjust its business practices or lose businessentirely.

Cultural Differences

Cultural differences often lead to major problems for MNCs. Many find that their expatriate executivesare not able to turn in optimal performances because they are not able to adjust to the local culture,both personally as well as professionally. On the other hand, local managers of MNCs often havedifficulties in dealing with the home office of an MNC because of culturally based communicationproblems. Inability to understand and respond appropriately to focal cultures has often led MNCproducts to fail. Misunderstanding of local cultures, work ethics, and social norms often leads to problemsbetween MNCs and their local customers, their business associates, government officials, and eventheir own employees.

4.4 Conflict between Multinationals and Government

Every Government supports the development of Multinationals in their country because it gives revenueas well as employment opportunities in the country. Multinationals also supports the Government ofevery country where they are having their operation to a maximum level since it requires the co-operationof the Government to run their business in a particular country. Multinationals also gets the support ofthe various political parties and also their influences to run the business in a particular country. Governmentthough imposes several restrictions over the multinationals it gives freedom and support in variousaspects of the operation of the multinational companies throughout the world.

For Example, in India, the Government provides many tax concessions and subsidies for the multinationalcompany to carry out their activities. The Indian Government provides a good infrastructure to facilitatethe easy operation of the multinational companies. The recently opened multinational companies suchas IBM, Nokia, and Hyundai etc are getting many concessions from the Indian Government. TheGovernment supports the multinationals in all dimensions.

The policy of the Government should support and encourage the multinational companies to remain in



the country. The various environments such as political environment, financial environment, technologicalenvironment, socio cultural environment should be favorable for the multinationals to continue theiroperation in any country. Multinational companies expect the cooperation from the Government fortheir better operation.

Main Features of Relationship between Government and Multinationals

1. The economic relationship between the Government and Multinational companies should bestrong for the existence of multinational companies

2. Government should cooperate in all dimensions for the successful operation of the multinationalcompanies

3. Regulations and Restriction of the Government should not hinder the development of multinationalcompanies

4. The fiscal policy of the Government should motivate the multinational companies

5. Growth of multinational companies gives more contribution to the economic growth of thecountry and it gives immense employment opportunities to the people of the country

Conflict between Multinational and Government

It is not possible in all cases that there exist cooperation between the Government and the multinationalcompanies. In certain cases, there arise few conflicts which can be resolved by bilateral agreement.Conflicts arise due to various aspects which can be discussed in this chapter later. Often the neweconomic and financial policies implemented by the Government will conflict the operation of theMultinational companies which is to be considered as the main problem in International Business. Therelationship between the Government and multinational companies can be strengthened by mutualunderstanding and settlement of the disputes.

The Government conflicts with the multinational companies for a number of reasons. Change of politicalparties and change of Government very often creates the conflict between the Government andMultinational companies in International Business.

Reasons for the conflict between Government and MNC are as follows

1. New Rules and Regulations implemented by the Government affecting the operation of MNC

2. Change of Government, the change of political environment can create conflict between theGovernment and Multinational companies which will affect International business

3. New economic policy of the Government may create conflict between MNC and theGovernment

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4. Changes in legal framework of a country may also create conflict with the Government andMultinational companies

5. Any change in the industrial policy of the Government may conflict with the multinationalcompanies

The above given reasons may create conflicts between the Government and the multinational companiesand resolution of such conflicts will be remedy for the existence of multinational companies.

The various sources of conflict which arises between the Government and Multinational companiesshould be analyzed and the required solutions should be implemented for strengthening the relationshipbetween the Government and multinational companies. International business has its base on thecooperation given by the various Governments. Conflicts between the Government and multinationalcompanies acts as the important barrier for the development of International Business.

Conflict between the Government and multinational companies affects the International Trade betweenvarious nations. As the result of Globalization and liberalization of economic policy, there should becooperation between the Government and multinational companies. Conflict in various areas should beanalyzed and can be resolved by mutual agreements. Conflicts creates unhealthy atmosphere for thedevelopment of International business.

Conflicts arising in various functional areas can be resolved by the formulation and implementationappropriate amendments.

Regulations in International Business

Traditionally trade was regulated through bilateral treaties between two nations. For centuries under thebelief in Mercantilism most nations had high tariffs and many restrictions on international trade. In the19th century, especially in the United Kingdom, a belief in free trade became paramount. This beliefbecame the dominant thinking among western nations since then. In the years since the Second WorldWar, controversial multilateral treaties like the General Agreement on Tariffs and Trade (GATT) andWorld Trade Organization have attempted to create a globally regulated trade structure. These tradeagreements have often resulted in protest and discontent with claims of unfair trade that is not mutuallybeneficial.

Free trade is usually most strongly supported by the most economically powerful nations, though theyoften engage in selective protectionism for those industries which are strategically important such as theprotective tariffs applied to agriculture by the United States and Europe. The Netherlands and theUnited Kingdom were both strong advocates of free trade when they were economically dominant,today the United States, the United Kingdom, Australia and Japan are its greatest proponents. However,many other countries (such as India, China and Russia) are increasingly becoming advocates of freetrade as they become more economically powerful themselves. As tariff levels fall there is also anincreasing willingness to negotiate non tariff measures, including foreign direct investment, procurement



and trade facilitation. The latter looks at the transaction cost associated with meeting trade and customsprocedures.

Traditionally agricultural interests are usually in favour of free trade while manufacturing sectors oftensupport protectionism. This has changed somewhat in recent years, however. In fact, agricultural lobbies,particularly in the United States, Europe and Japan, are chiefly responsible for particular rules in themajor international trade treaties which allow for more protectionist measures in agriculture than formost other goods and services.

During recessions there is often strong domestic pressure to increase tariffs to protect domestic industries.This occurred around the world during the Great Depression. Many economists have attempted toportray tariffs as the underlining reason behind the collapse in world trade that many believe seriouslydeepened the depression.

The regulation of international business is done through the World Trade Organization at the globallevel, and through several other regional arrangements such as MERCOSUR in South America, theNorth American Free Trade Agreement (NAFTA) between the United States, Canada and Mexico,and the European Union between 27 independent states. The 2005 Buenos Aires talks on the plannedestablishment of the Free Trade Area of the Americas (FTAA) failed largely because of oppositionfrom the populations of Latin American nations. Similar agreements such as the Multilateral Agreementon Investment (MAI) have also failed in recent years.

Foreign Exchange Regulation Act, 1973

The Foreign Exchange Regulation Act of 1973 (FERA) in India was repealed on 1 June, 2000. It wasreplaced by the Foreign Exchange Management Act (FEMA), which was passed in the winter sessionof Parliament in 1999. Enacted in 1973, in the backdrop of acute shortage of Foreign Exchange in thecountry, FERA had a controversial 27 year stint during which many bosses of the Indian Corporateworld found themselves at the mercy of the Enforcement Directorate (E.D.). Any offense under FERAwas a criminal offense liable to imprisonment, whereas FEMA seeks to make offenses relating toforeign exchange civil offenses.

FEMA, which has replaced FERA, had become the need of the hour since FERA had becomeincompatible with the pro-liberalization policies of the Government of India. FEMA has brought a newmanagement regime of Foreign Exchange consistent with the emerging frame work of the World TradeOrganization (WTO). It is another matter that enactment of FEMA also brought with it Prevention ofMoney Laundering Act, 2002 which came into effect recently from 1 July, 2005 and the heat of whichis yet to be felt as “Enforcement Directorate” would be investigating the cases under PMLA too.

Unlike other laws where everything is permitted unless specifically prohibited, under FERA nothingwas permitted unless specifically permitted. Hence the tenor and tone of the Act was very drastic. Itprovided for imprisonment of even a very minor offence. Under FERA, a person was presumed guilty

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unless he proved himself innocent whereas under other laws, a person is presumed innocent unless heis proven guilty.

Objectives and Extent of FEMA

The objective of the Act is to consolidate and amend the law relating to foreign exchange with theobjective of facilitating external trade and payments and for promoting the orderly development andmaintenance of foreign exchange market in India.

FEMA extends to the whole of India. It applies to all branches, offices and agencies outside Indiaowned or controlled by a person who is a resident of India and also to any contravention there undercommitted outside India by any person to whom this Act applies.

Except with the general or special permission of the Reserve Bank of India, no person can:-

• deal in or transfer any foreign exchange or foreign security to any person not being an authorizedperson;

• make any payment to or for the credit of any person resident outside India in any manner;

• receive otherwise through an authorized person, any payment by order or on behalf of anyperson resident outside India in any manner;

• reasonable restrictions for current account transactions as may be prescribed.

Any person may sell or draw foreign exchange to or from an authorized person for a capital accounttransaction. The Reserve Bank may, in consultation with the Central Government, specify:-

• any class or classes of capital account transactions which are permissible;

• the limit up to which foreign exchange shall be admissible for such transactions

However, the Reserve Bank cannot impose any restriction on the drawing of foreign exchange forpayments due on account of amortization of loans or for depreciation of direct investments in theordinary course of business.

The Reserve Bank can, by regulations, prohibit, restrict or regulate the following:-

• transfer or issue of any foreign security by a person resident in India;

• transfer or issue of any security by a person resident outside India;

• transfer or issue of any security or foreign security by any branch, office or agency in India ofa person resident outside India;

• any borrowing or lending in foreign exchange in whatever form or by whatever name called;



• any borrowing or tending in rupees in whatever form or by whatever name called between aperson resident in India and a person resident outside India;

• deposits between persons resident in India and persons resident outside India;

• export, import or holding of currency or currency notes;

• transfer of immovable property outside India, other than a lease not exceeding five years, by aperson resident in India;

• acquisition or transfer of immovable property in India, other than a lease not exceeding fiveyears, by a person resident outside India;

• giving of a guarantee or surety in respect of any debt, obligation or other liability incurred

(i) by a person resident in India and owed to a person resident outside India or

(ii) by a person resident outside India.

A person, resident in India may hold, own, transfer or invest in foreign currency, foreign security or anyimmovable property situated outside India if such currency, security or property was acquired, held orowned by such person when he was resident outside India or inherited from a person who was residentoutside India.

A person resident outside India may hold, own, transfer or invest in Indian currency, security or anyimmovable property situated in India if such currency, security or property was acquired, held orowned by such person when he was resident in India or inherited from a person who was resident inIndia.

The Reserve Bank may, by regulation, prohibit, restrict, or regulate establishment in India of a branch,office or other place of business by a person resident outside India, for carrying on any activity relatingto such branch, office or other place of business. Every exporter of goods and services must:

• Furnish to the Reserve Bank or to such other authority a declaration in such form and in suchmanner as may be specified, containing true and correct material particulars, including theamount representing the full export value or, if the full export value of the goods is not ascertainableat the time of export, the value which the exporter, having regard to the prevailing marketconditions, expects to receive on the sale of the goods in a market outside India;

• Furnish to the Reserve Bank such other information as may be required by the Reserve Bankfor the purpose of ensuring the realization of the export proceeds by such exporter.

The Reserve Bank may, for the purpose of ensuring that the full export value of the goods or suchreduced value of the goods as the Reserve Bank determines, having regard to the prevailing market-conditions, is received without any delay, direct any exporter to comply with such requirements as itdeems fit.

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Where any amount of foreign exchange is due or has accrued to any person resident in India, suchperson shall take all reasonable steps to realize and repatriate to India such foreign exchange withinsuch period and in such manner as may be specified by the Reserve Bank.

Section 3: Except as provided in the FEMA Act, rules and RBI permission, no person shall: Deal in/transfer any forex to any person not being an authorized person Make any payment to or for the creditof any nonresident Receive otherwise through an authorized person, any payment by order or on behalfof any nonresident Enter into any financial transaction in India as consideration for or in association withacquisition or creation or transfer of a right to acquire, any asset outside India by any person

Contraventions and Penalties

If any person contravenes any provision of this Act, or contravenes any rule, regulation, notification,direction or order issued in exercise of the powers under this Act, or contravenes any condition subjectto which an authorization is issued by the Reserve Bank, he shall, upon adjudication, be liable to apenalty up to thrice the sum involved in such contravention where such amount is quantifiable, or up totwo lakh rupees where the amount is not quantifiable, and where such contravention is a continuing one,further penalty which may extend to five thousand rupees for every day after the first day during whichthe contravention continues.

Any Adjudicating Authority adjudging any contravention may, if he thinks fit in addition to any penaltywhich he may impose for such contravention direct that any currency, security or any other money orproperty in respect of which the contravention has taken place shall be confiscated to the CentralGovernment and further direct that the foreign exchange holdings, if any, of the persons committing thecontraventions or any part thereof, shall be brought back into India or shall be retained outside India inaccordance with the directions made in this behalf.

“Property” in respect of which contravention has taken place, shall include deposits in a bank, wherethe said property is converted into such deposits, Indian currency, where the said property is convertedinto that currency; and any other property which has resulted out of the conversion of that property.

If any person fails to make full payment of the penalty imposed on him within a period of ninety daysfrom the date on which the notice for payment of such penalty is served on him, he shall be liable to civilimprisonment.

Investigation

The Directorate of Enforcement investigates to prevent leakage of foreign exchange which generallyoccurs through the following malpractices:

• Remittances of Indians abroad otherwise than through normal banking channels, i.e. throughcompensatory payments.



• Acquisition of foreign currency illegally by person in India.

• Non-repatriation of the proceeds of the exported goods.

• Unauthorized maintenance of accounts in foreign countries.

• Under-invoicing of exports and over-invoicing of imports and any other type of invoicemanipulation.

• Siphoning off of foreign exchange against fictitious and bogus imports.

• Illegal acquisition of foreign exchange through Hawala.

• Secreting of commission abroad.

Organizational Set Up and Functions of Enforcement Directorate

Directorate of Enforcement has to detect cases of violation and also perform substantially adjudicatoryfunctions to curb above malpractices.

The Enforcement Directorate, with its Headquarters at New Delhi has seven zonal offices at Bombay,Calcutta, Delhi, Jalandhar, Madras, Ahmedabad and Bangalore. The zonal offices are headed by theDeputy Directors. The Directorate has nine sub-zonal offices at Agra, Srinagar, Jaipur, Varanasi,Trivandrum, Calicut, Hyderabad, Guwahati and Goa, which are headed by the Assistant Directors.The Directorate has also a Unit at Madurai, which is headed by a Chief Enforcement Officer. Besides,there are three Special Directors of Enforcement and one Additional Director of Enforcement.

The main functions of the Directorate are as under:

• To collect and develop intelligence relating to violation of the provisions of Foreign ExchangeRegulation Act and while working out the same, depending upon the circumstances of the case:

• To conduct searches of suspected persons, conveyances and premises for seizing incriminatingmaterials (including Indian and foreign currencies involved) and/or.

• To enquire into and investigate suspected violations of provisions of the Foreign ExchangeManagement Act.

• To adjudicate cases of violations of Foreign Exchange Management Act for levying penaltiesdepartmentally and also for confiscating the amounts involved in contraventions;

• To realize the penalties imposed in departmental adjudication.

Procedural Provisions

For enforcing the provisions of various sections of FEMA, 1999, the officers of Enforcement Directorateof the level of Assistant Director and above will have to undertake the following functions.

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• Collection and development of intelligence/information.

• Keeping surveillance over suspects.

• Searches of persons/vehicles by provisions of Income-tax Act, 1961.

• Searches of premises as per provisions of Income-tax Act, 1961.

• Summoning of persons for giving evidence and producing of documents as per provisions ofIncome-tax Act, 1961.

• Power to examine persons as per provisions of Income-tax Act, 1961.

• Power to call for any information/document as per provisions of Income-tax Act, 1961.

• Power to seize documents etc. as per provisions of Income-tax Act, 1961.

• Custody of documents as per Income-tax Act, 1961.

• Adjudication and appeals - Officers of and above the rank of Deputy Director of Enforcement,are cases of contravention of the provisions of the Act; these proceedings which are quasi-judicial in nature, start with the issuance of show cause notice; in the event of cause shown bythe Notice-not being found satisfactory, further proceedings are held, vis. personal hearing, inwhich the notice has a further right to present his defense, either in person or through anyauthorized representative; on conclusion of these proceedings, the adjudicating authority has toexamine and consider the evidence on record, in its entirety and in case the charges not beingfound proved, the notice is acquitted, and in the event of charges being found substantiated,such penalty, as is considered appropriate as per provisions of section 13 of the Act can beimposed, besides confiscation of amounts involved in these contraventions.

Risk in International Business

Companies doing business across international borders face many of the same risks as would normallybe evident in strictly domestic transactions. For example,

• Buyer insolvency (purchaser cannot pay);

• Non-acceptance (buyer rejects goods as different from the agreed upon specifications);

• Credit risk (allowing the buyer to take possession of goods prior to payment);

• Regulatory risk (e.g., a change in rules that prevents the transaction);

• Intervention (governmental action to prevent a transaction being completed);

• Political risk (change in leadership interfering with transactions or prices);



4.5 International Business Laws

International trade law should be distinguished from the broader field of international economic law.The latter could be said to encompass not only WTO law, but also law governing the internationalmonetary system and currency regulation, as well as the law of international development.

The body of rules for transnational trade in the 21st century derives from medieval commercial lawscalled the lex mercatoria and lex maritima — respectively, “the law for merchants on land” and “the lawfor merchants on sea.” Modern trade law (extending beyond bilateral treaties) began shortly after theSecond World War, with the negotiation of a multilateral treaty to deal with trade in goods: the GeneralAgreement on Tariffs and Trade (GATT).

International trade law is based on theories of economic liberalism developed in Europe and later theUnited States from the 18th century onwards.

World Trade Organization

In 1995, the World Trade Organization, a formal international organization to regulate trade, wasestablished. It is the most important development in the history of international trade law.

The purposes and structure of the organization is governed by the agreement establishing the WorldTrade Organization, also known as the “Marrakesh Agreement”. It does not specify the actual rulesthat govern international trade in specific areas. These are found in separate treaties.

Trade in goods

The GATT has been the backbone of international trade law throughout most of the twentieth century.It contains rules relating to “unfair” trading practices — dumping and subsidies.

Trade and Human Rights

The World Trade Organization Trade Related Intellectual Property Rights (TRIPS) agreement requiredsignatory nations to raise intellectual property rights (also known as intellectual monopoly privileges.This arguably has had a negative impact on access to essential medicines in some nations.

Dispute Settlement

Since there are no international governing judges (2004) the means of dispute resolution is determinedby jurisdiction. Each individual country hears cases that are brought before them. Governments chooseto be party to a dispute. And private citizens determine jurisdiction by the Forum Clause in their contract.

Besides forum, another factor in international disputes is the rate of exchange. With currency fluctuationascending and descending over years, a lack of Commerce Clause can jeopardize trade betweenparties when one party becomes unjustly enriched through natural market fluctuations. By listing the

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rate of exchange expected over the contract life, parties can provide for changes in the market throughreassessment of contract or division of exchange rate fluctuations.

International Trade Negotiations

Negotiations lie at the heart of international diplomacy. Parties (governments, businesses, andnongovernmental organizations) employ the art and science of negotiation to protect and advance theirorganizational and constituent interests. The skillful use of negotiation can advance a party’s interestsand help to avoid a less attractive alternative, e.g., trade wars, litigation, or protracted dispute settlementprocedures under the WTO.

An effective negotiation process can lead to positive outcomes that can result in the promotion ofimportant international objectives including economic development, business interests, environmentalprotection, labor rights, and political stability, all of which can minimize the adverse impacts of povertythat can lead to violence and war.

Even for students and practitioners who may not aspire to the role of negotiator in the heavy stakesarenas of international negotiation, most professionals negotiate frequently in the performance of theirjobs. Whether negotiating for a raise, a vacation, or a promotion with a supervisor or negotiating withpeers and subordinates over work assignments, deadlines, or workplace conflicts, we all negotiate allthe time. No training manual can guarantee success in any particular negotiating setting, but everyonecan improve their negotiating skills to increase the probability of successful outcomes.

A first step in approaching the improvement of your own negotiating technique is to develop an awarenessor mindfulness of when you are engaged in a negotiation of small or large consequence. Many peopleundercut their own self-interest by not paying attention to their own role and participation in day to daynegotiating scenarios.

Depending on the subject matter of a negotiation, different skills must be employed and options exercisedto achieve agreement between or among parties. International negotiations in the broad context oftrade relations may include negotiations over prices, tariffs, and sales or qualitative negotiations overbroad principles related to the environmental, labor, health & safety, or other impacts of trade relatedagreements.

The purpose of this manual is to provide the reader and practitioner with the following analytical andpractical skills:

• Problem identification and development of negotiation goals and strategies

• Identification of parties (stakeholders) and their respective interests and priorities

• Development of multiple options (solutions) that will maximize the probability of positive outcomesfor all parties to the process



• Development of specific skills in the following areas:

• Negotiation strategy

• Pre-negotiation research and planning

• Negotiation skills and technique to be employed throughout the negotiation process

• Crafting and drafting durable agreements with an emphasis on successful implementation of theagreement

This manual includes various examples and simulations designed to assist the student and practitioner inhow to adapt the theory of principled negotiation to effective practice and success in the negotiationprocess.

While the focus of this manual revolves around trade-related negotiations in the international arena, theapplications of these analytical and skills sets may assist those engaged in a multitude of different negotiationscenarios.

It is the strong belief of the authors that practice is at the core of an effective negotiation technique. Webelieve that the use of simulation exercises can be of great benefit to the student of international negotiation.As in the practice of any discipline in politics, art, or sports, the most successful players are those whohave learned from repetition of methodical practice. One can gain only a certain level of understandingby acquiring a theoretical knowledge of any discipline. The true practitioner perfects his/her skill andexpertise through the repetitive drilling that gives meaning to the axiom that “practice makes perfect”.

We share this manual with all interested students and practitioners with the confidence that through thedevelopment and practice of the art and science of interest-based negotiations, the world can be madea better, healthier, and safer place to live.

We welcome your comments and feedback, stories of your successes and failures alike. By developinga repository of information we expect that this manual will benefit from revisions, refinements, and thecollective inputs of those in the growing community of international negotiators.

The Role and Development of Negotiations in Commercial Diplomacy before exploring the other elementsof interest-based negotiations, it is essential to describe the range of negotiations that occur in theinternational and trade arenas.

There are profound differences in the subject matter negotiated in international trade and investment inthe character of the negotiations, as well as in the level and formality of various levels of negotiations.These differences have important implications for the optimal choice of negotiating strategies.

Most international transactions that involve trade and investment are negotiated between private parties:between buyer and seller, importer and exporter, employer and employee, contractor and subcontractor.

This addresses the negotiation of policy measures that affect international trade and investment. The

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negotiation of trade-related policy issues primarily centers on the reconciliation of trade-based economicobjectives and broader public policy objectives such as health, safety, and the social welfare ofdisadvantaged groups in society. These different interests of society are reconciled through a complexnegotiating process that takes place within and between domestic stakeholder groups such as businesses,unions, civic groups and government agencies, and ultimately between national governments. The specialcharacter of commercial diplomacy is that it encompasses both private stakeholders and governments,that it addresses both private commercial interests and public policy interests, and that the outcome isarbitrated through both economic markets and political markets. Negotiations in commercial diplomacycover business issues, policy issues, broad economic issues and political issues, as well as legal issues.

Negotiations in commercial diplomacy potentially involve a wide range of stakeholders – the groupswho represent the commercial interests, policy interests, political interests, economic interests, legalinterests and institutional/bureaucratic interests affected by trade and investment policy decisions. Eachof these groups seeks to influence the policy outcome through negotiations. The most visible negotiationscarried out in the trade policy arena are the negotiations carried out between governments, eitherbilaterally or multilaterally. Such government to government negotiations, however, are preceded byintense negotiations within the individual countries on the country’s negotiating position. These internalnegotiations often start within the individual firms, industry associations, government agencies, legislativecommittees, and non-governmental organizations that have a stake, and are followed by the negotiationand formation of policy oriented coalitions among stakeholders for the purpose of influencing the policyoutcome. The negotiations to form these coalitions can cross national borders, and involve businessleaders, academics, politicians, bureaucrats, and leaders of civil society from many different countries.Coalitions that cross national borders seek to influence the respective governments in parallel. Privatestakeholders, whether acting on their own or as representatives of a coalition, negotiate with the variousgovernment agencies and politicians involved in the decision making process and ultimately thesegovernment agencies and politicians negotiate with each other to arrive at a negotiating position for theircountry. Often these internal negotiations are much tougher and take a lot more time than the morevisible government to government negotiations.

Each of the stakeholder groups involved in the trade policy advocacy, decision-making and negotiatingprocess brings their own motivations and interests to bear on the negotiations. As we shall exploremore fully later, these interests and motivations are the key to a structured approach to negotiations thathas the highest prospects for a satisfactory outcome. The interests and motivations that influence thepositions of many stakeholders in the private sector are fairly straightforward, and not too difficult toanalyze. The interests and motivations of governments are often much more difficult to identify becausegovernments represent all the various interests of society. Nevertheless, there is a great deal of consistencyacross governments with respect to the principal interests represented by government agencies anddepartments responsible for particular areas of government policy. The successful negotiator will preparehim or her by carefully analyzing the interests and political influence of each of the principal stakeholdergroups.

Most negotiations in commercial diplomacy are over the impact of specific policy measures on particular



products or industries. The negotiation of such trade or investment related policy issues typically startas a negotiation between an affected enterprise or industry and the government responsible for thetargeted policy measure. If the issue is not resolved at that level, the home government of the affectedenterprise or industry may step into the dispute by initiating government to government negotiations.These kinds of negotiations usually go through a number of different phases that call for different negotiatingattitudes and tactics.

The first contact is usually best approached as an informal information gathering effort. After all, theenterprise managers may be ill informed about the specific regulations or laws at issue, or the administrativeguidelines followed by the responsible officials. Conversely, the officials involved may be ill informedabout the production methods or business practices covered by the regulations.

Once the facts have been clarified, and a policy issue has been identified, the negotiation should moveinto a problem-solving phase. A problem-solving approach, which suspends value judgments aboutwho is right or wrong, encourages flexibility by the negotiating partners, maximizing the chances that anamicable resolution can be found that simultaneously preserves the policy objectives of the governmentand the commercial objectives of the enterprises involved in the negotiation. The best tactics to use inthis type of a “win-win negotiation” will be explored later. Of course, some policy issues raised byexporters or investors are without merit, while other policy actions taken by governments are not verydefensible. In these situations, sometimes the best resolution is a graceful withdrawal before issues offace and prestige make such a withdrawal difficult.

If efforts to resolve the issue through a problem solving approach fail, the negotiations may move into athird, more formal stage of negotiation, during which the negotiators may increase the political and legalpressure on the other side. There is an increased risk at this stage that the negotiation may turn into azero sum game type of negotiation, in which one side or the other has to lose in order to secure aresolution of the issue. As we shall see later, zero sum type of negotiations are more difficult to conclude,and a successful negotiator will keep emphasizing the potential for a win-win outcome.

A negotiation that remains deadlocked may be referred to a dispute settlement process. Many tradeand investment agreements identify a process for settling disputes that cannot be resolved throughnegotiations. Some forms of dispute settlement, such as arbitration and mediation, are a structured andassisted form of negotiation.

While most day-to-day negotiations between governments on international commercial issues focus onspecific commercial problems created by specific policy measures, the negotiations that get the mostattention are comprehensive government to government negotiations that cover a wide range of productsand policy issues. Examples are bilateral free trade negotiations aimed at removing most barriers totrade and investment between countries, or the multilateral rounds of trade negotiations carried outunder the auspices of the world trade negotiations. These negotiations typically address both the reductionand elimination of a wide range of trade barriers and the negotiation of trade rules. These negotiationsby their very character have to be approached as win-win negotiations, because no deal is possible

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without each party agreeing that the proposed agreement is in its interest. Rules-based negotiations, inparticular, have to start from the identification of common interests that might be advanced through theadoption of the rule.

Another type of negotiation in commercial diplomacy is one in which one government seeks to eliminate,or at a minimum to moderate, a restrictive trade policy action by another government. On its face, thiskind of negotiation is set up as a zero sum game type of negotiation, and it takes extraordinary skill toconvert it into a win-win negotiation. Assuming that the proposed measure has some degree of merit inlight of the economic circumstances faced by the country involved, the trick is to show that negotiationscan lead to a more balanced consideration of the interests of all parties involved.

Another type of negotiation might be one between a stakeholder left out of an agreement and theparties to a negotiated agreement. The aggrieved stakeholder could be a country adversely affected bya bilateral agreement between two other countries, or a non-governmental organization that believes itspolicy interests have not been adequately considered by the government and business representativesthat worked out the deal. Commercial diplomats representing parties not invited to the negotiating tableneed to consider what tactics might get them invited to the table. Ultimately, this means, that they needto consider how they might identify and mobilize potential allies with the necessary political influence.

Each of the various types of negotiations calls for a different negotiating style, and different negotiatingskills. Negotiations aimed at defining common interests – whether that involves the negotiation of acoalition, the negotiation of a common course of action or the negotiation of common principles orrules, requires a soft sales approach that emphasizes common interests and engenders a great deal ofmutual trust among negotiators on the genuine commitment of the negotiating partners to the advocatedgoals. Negotiations over tariffs and quotas require a more hard-nosed approach that demonstrates toall stakeholders that the negotiated outcome was the best that could be achieved under the circumstances.Problem solving negotiations fall somewhere in between. Each side to the negotiations must defend itsinterests, but also has to be able to demonstrate that both sides can gain from both the policy and thecommercial aspects of an agreement.

Understanding the nature of the parties and the subject matter of the negotiation is critical to the processof planning and preparation for a formal negotiation session.

Terminology and descriptions of the various types of parties and form of negotiation follow:

1. Inter-governmental negotiations – between governments the government of Pakistan negotiateswith the government of India

2. Intra-governmental negotiations – within and among one government, usually betweengovernment agencies, political parties, or with constituent groups.

3. Commercial negotiations – between businesses, companies, corporations. This may includebusiness negotiations related to contracts, sales agreements, investments, joint ventures, etc.Or, may involve negotiations within a business or trade association.



4. Internal business negotiations – Within the business organization, company or corporation.Examples: management –labor negotiations, human resources, inter-departmental, unionnegotiations, etc.

5. Nongovernmental Organizations (NGOs)-business associations, trade associations,environmental, labor, human rights, development, etc.)

Intra-group (within the NGO)

a) Inter-group – between and among other NGOs

b) NGO-business organization

c) NGO-governmental organization

d) NGO-international governmental body (WTO, UN, WHO, ASEAN, etc)

Differences in Players, Resources, Styles, and Motivations

With each identified type of negotiation and potential interest group involvement there will emergedifferent negotiating styles, techniques, and cultures.

It stands to reason that groups of like-function (government to government) will employ more similarnegotiating styles and protocols than groups that cross functional, experiential, and interest-based linesof demarcation.

As groups cross from negotiations with familiar counterparts to dissimilar counterparts, the cadence ofthe negotiating dance will more likely be dissonant. In other words, people feel more comfortablenegotiating with counterparts performing a similar role and dealing with like subject matter than withthose representing different subject, professional, and cultural differences.

It is one thing to acknowledge the differences inherent in a cross-over in negotiating with a group ofdifferent interest and professional focus—it is quite another to adapt one’s negotiating style and techniqueto accommodate or at least function with negotiators of diverse interest groups.

As discussed, supra, a diplomatic culture exists among officials representing various governments.While language, background, and cultural differences may exist, the diplomatic culture plays uponcommon experience, educational training, and acceptance of protocols developed over decades sothat negotiators can work with one another in an atmosphere that is predictable and based upon certainaccepted norms, routines, and behaviors.

While the subject of a trade dispute may not change, the parties to negotiations may vary fromgovernmental representatives meeting with each other one day and those same representatives meetingwith a cast of business or NGO representatives the next. While the differences should not be ignored,they can perhaps be minimized by planning and charting the divergent interests, histories, goals, andobjectives.

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1. Explain about Institutional Environment of International Business?

2. What is TRIMS? Briefly explain its objectives?

3. What kind of Conflict between Multinational and Government will occur? Explain.

4. What is the use of WTO?

* * * *



Module V

STRATEGY AND MANAGEMENT OFINTERNATIONAL BUSINESS


� Introduction

� Nature of International Strategic Management

� International Business Strategy

� Global Competitive Strategy

� Global Marketing Strategy

� Production Management Strategy

� Organization of Human Resources in MNES

� International Finance Management

5.1 Introduction

International Strategic Management (ISM) is an ongoing management planning process aimed atdeveloping strategies to allow an organization to expand abroad and compete internationally. Strategicplanning is used in the process of developing a particular international strategy.

127Module V - Strategy and Management of International Business

An organization must be able to determine what products or services they intend to sell, where and howthe organization will make these products or services, where they will sell them, and how the organizationwill acquire the necessary resources for these tasks. Even more importantly an organization must havea strategy on how it expects to outperform its competitors.

When an organization moves from being a domestic entity to an international organization it must considerthe possible broad complexities that accompany such a decision. In a domestic country, an organizationmust only consider one national government, a single currency and accounting system, one political andlegal system, and usually a similar culture. Entering into one or more foreign countries can involvemultiple governments, currencies, accounting systems, legal systems, and a large variety of languagesand cultures. This can create numerous barriers to entry for an organization looking to expandinternationally.

5.2 Nature of International Strategic Management

Strategic management is concerned with the process of formulating, implementing, and evaluating strategiesto achieve a firm’s objectives. In concept, strategic management process in an MNC is similar to that inany other form of organization, the main complicating factors being the numerous country and regionalenvironments it has to analyze and understand before considering the various strategic options. Moretime and efforts are required to identify and evaluate external trends and events in MNC’s Geographicdistances, cultural and national differences, and variations in business practices, often make communicationbetween home offices and overseas operations difficult. Strategy implementation can be more difficultbecause different cultures have different norms, values and work ethics.

Strategic management is critical to international business. An MNC needs to keep tract of its increasinglydiversified operations in a continuously changing international environment. This need is particularlyobvious when one considers the amount of FDI that has taken place in recent years. FDI has outgrowntrade across the globe and this development necessitates the need to coordinate and integrate diverseoperation with a united goal. There are examples of firms that are precisely doing this classic examplesbeing Tata group. Also take the case of Ford Motor, which has re-entered the market in Thailand anddespite a shrinking demand for automobiles there, is beginning to build a strong sales force to garnermarket share. The firm’s strategic plan is based on offering the right combinations of price and financingto a carefully identified market segment. In particular, Ford is working to bring down the monthlypayments so that customers can afford a new vehicle. This is the same approach that Ford used inMexico, where the current crisis of 1994 resulted in serious problems for many multinationals.

Toyota is another multinational company which has benefited vastly from strategic management. Thecompany is going beyond the automotive market. IN the process, Toyota is assessing environmentalopportunities and threats and examine to internal strengths and weaknesses so that the firm’s strategicthrust can exploit its strength and sidestep any shortcomings.


International Strategic Management Process

Strategic Orientation

Before describing strategic management process of international business, it is useful to understandtheir strategic predisposition towards doings things in a particular way. The predisposition helps todetermine specific decisions the firm will implement. There are four such predispositions: ethnocentric,polycentric, regiocentric and geocentric.

Ethnocentric Disposition

An MNC with an ethnocentric orientation will rely on the values and interests of the parent country informulating and implementing the strategic plan. Primary emphasis is on profitability and the firm will tryto run its operations overseas in the same way they are run at home.

Polycentric Disposition

An MNC with a polycentric predisposition will tailor its strategic plan to meet the needs of the hostcountry culture. If the firm operates in more than one country, an overall plan will be adopted to meetspecific needs of the host country. Each subsidiary will decide on the objective it wants to pursuedepending on local needs. Profits will be ploughed back to the host country for expansion and thegrowth of the business operations

Regiocentric Predisposition

An MNC with a regiocentric predisposition will be interested in both profit as well as public acceptance– an acceptance of both ethnocentric and polycentric orientations. The firm will use such a strategy thatallows it to address to both local and regional needs. For example an MNC doing business in the EUwill be interested in all its member countries.

Geocentric

An MNC with a geocentric approach will view operations from a global perspective. They offer globalproducts with local variations and their employees belong to different parts of the globe. They hire thebest people, notwithstanding their region or relation.

The predisposition of an international business greatly influences its strategic management process.Some MNC for example are more interested in profit and or growth than they are in developing acomprehensive corporate strategy that exploits their potential. Others are more interested in large scalemanufacturing that will allow them to compete on price across the country or region, as opposed todeveloping high degree responsiveness to local demand by tailoring a product need local needs. Someprefer to sell in countries where the cultures are similar to their own so that the same basic marketingorientation can be used throughout the regions. These orientations or predepositions greatly influencecorporate strategy.

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Steps in Strategic Management Process

Strategic Management process is necessary both at the headquarters of an MNC as well as at each ofthe subsidiaries. The global strategic management process duplicates the process followed in domesticcompanies; however, the variables and therefore, the process itself are far more complex in internationalbusiness because of the difficulty in obtaining accurate and timely information; the diversity of geographiclocations and the differences in political, legal, cultural and economic forces. Typically, the strategicmanagement process of an international business comprises four major steps viz.

1) Scanning of global environment

2) Formulation of strategies

3) Implementation of strategies

4) Evaluation and control of strategies

Competitive Advantage and International Business

While reviewing the opportunities in the international environment, a firm has to make crucial decisionsabout the entry mode it is likely to follow as entry mode decisions critically affect issues of control of theinternational venture. Internal focus firms with limited experience in working with external constituentsare likely to prefer higher control over their international ventures. An operating strategy firms implementinternationally is closely linked with a firm’s control preferences. Certain international strategies, likethat of global integration, are likely to work better with high control of subsidiaries. On the other hand,multifocal strategies are likely to be successful when the subsidiary shares control with local partners.

As the preceding paragraphs indicate, we take a path dependence approach in our analysis. “Pathdependence,” according to Antonelli, “defines the set of dynamic processes where small events havelong-lasting consequences that economic action at each moment can modify yet only to a limited extent.The trajectory of a path dependent process however cannot be fully anticipated on the basis of theoriginal events” We take the position that preexisting or initial conditions do impact subsequent actions,and our research propositions have been developed to test whether there are specific relationshipsamong competitive orientations, control preferences, pursuance of strategies, and subsequentperformance. We agree with Antonelli (1997) that path dependence defines the set of dynamic processeswhere small events have long-lasting consequences.

Theoretical Background

Dunning (1995) makes a strong case for reappraising the existing system of market-based capitalismby suggesting that competitive market forces do not provide a complete explanation of economicdevelopment, nor do such forces necessarily ensure growth and dynamism in an uncertain world. Asecond and more insightful observation is that the traditional view of ownership and control of resourcesand competencies, the basic edifice of transaction cost analysis, is not necessarily the most efficient

Module V - Strategy and Management of International Business


means of wealth generation. The traditional view holds that wealth creation is best achieved throughcompetition, rather than through cooperation. In examining international business strategy, we focus ontwo types of strategies: (1) the mode of international entry firms choose to undertake, and (2) theinternational strategy firms choose to implement in order to fulfill their long-term business objectives.

The Conceptual Model

We look at three specific orientations a firm may have. These orientations are internal focus, externalfocus, and dual focus. We will examine two aspects of international business strategy. The first is themode of entry into international markets, which we define as the degree of control a firm exercises in itsforeign operations. For reasons of parsimony, we suggest that control can be classified as joint controland high control. Also for the purpose of this analysis, we examine three broad forms of internationalbusiness strategy. The first is a strategy of global standardization, the second is one of marketcustomization, and the third is a combination of the first two strategies called transnational strategy.

Competitive Advantage

Three Types of Competitive Advantage

We reason that competitive advantage, defined in terms of external relationships and internal capabilities,drives international strategy. We suggest that the nature and texture of competitive advantage developedby a firm would influence it to prefer certain types of entry modes and follow particular internationalstrategies over others. Competitive advantage can be categorized into three types.

Internal Focus Firms. In developing their competitive advantage, some firms may choose to be moreinternally focused with the aim of maximizing economic rents from valuable, rare, inimitable, and non-substitutable resources. Most scholars of the resource-based view agree on the need to create uniqueand inimitable resources to differentiate a firm from its rivals, and to maintain sustained competitiveadvantage.

External Focus Firms. For over a decade, inter-organizational arrangements based on certain relationalattributes have become an important part of the strategy literature. The focus is on how traditionaladversarial relationships between buyers and suppliers may be giving way to new forms of obligationcontracting involving closer cooperation between buyers and their dependent suppliers. The primaryfocus of some firms in developing their competitive advantage is essentially relational based on suchfactors as trust and commitment.

Dual Focus Firms. Commenting on changing environmental conditions, Moore (1993) suggests thatin today’s intensely competitive world, success is possible through being a part of a complex businessecosystem. Brandenburger & Nalebuff (1993) mention that competitive success comes from a win-win strategy, not from the old win-lose (zero sun game) with other firms. This is a process firms cansuccessfully use with its competitors and its suppliers, and it includes sharing proprietary skills andtechnology with outsiders to enhance the overall competitive abilities of a given firm. Some scholars

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have come to the conclusion that economic ecosystems and mini ecologies provide a powerfulexplanation of firm behavior. Obviously such firms have well developed external relationships tosuccessfully maintain interdependencies, and also possess valuable assets and resources that theyexchange and leverage in the network.

5.3 International Business Strategy

5.3.1 Entry Mode and Control

In our analysis, we examine entry mode control that ranges from shared control to high control (Palenzuela& Bobillo, 1999). Researchers have pointed out that joint ventures are usually associated with someform of shared control, while wholly owned subsidiaries are typically associated with high control (Hill,Hwang & Kim, 1990; and Kobrin, 1989).

5.3.2 Two levels of Control

Shared control typically, control is shared through equity arrangement between the partners; there arealso instances where non-equity control can be exercised. Work by Sohn (1994) indicates that the clanconcept of social knowledge could be a more effective control mechanism compared to the moretraditional form of control through equity ownership. He suggests that firms with a high level of socialknowledge may maintain control in spite of low levels of equity.

High Control - High control is preferred on the assumption that the objectives of the multinational andlocal partners will conflict. Multinationals prefer owned subsidiaries with high control as joint ventures(with shared control) are considered to be more costly to operate in terms of cost and efficiency.Moreover, high control in the form of wholly owned or majority owned subsidiaries continues to be atrend in industries typified by high technology and high firm-specific capabilities.

5.3.3 International Strategy

Global Integration Strategy: A strategy of global integration involves high resource commitment andhigh coordination, and requires a high degree of control to achieve it. Without control, a firm finds itmore difficult to coordinate actions, carry out strategies, revise strategies, and resolve disputes thatarise when two parties to a contract pursue their own interests (Davidson, 1982). A global strategyrequires well developed internal capabilities which can be leveraged worldwide through high coordinationand control. If a firm wishes to minimize risks that arise when dealing with external elements, it willprefer a global strategy resulting in maximizing internal linkages and coordination. It is also a strategy



that is characterized by standardized needs, standardized practices and processes, and standardizedcustomer services.

5.3.4 Multifocal Strategy

This is a strategy that is followed to satisfy strong local needs, and is “negotiated to satisfy host governmentor local market requirements”. It can be viewed as a tradeoff between high control and flexibility torespond to local requirements. Such a strategy of flexibility is undertaken with reduced resourcecommitment but a higher degree of shared control resulting in diffused interests between the entrant andits partners. It involves working with others in implementing joint strategies and it increases the entrant’sexposure and dependency. Multifocal strategies are usually associated with customizing products basedon local knowledge, adapting to local markets, and providing localized service.

5.3.5 Transnational Strategy

This strategy, which combines the key aspects of global integration and multifocal strategies, is when afirm is able to meet local requirements along with a high degree of global integration. It is a complexstrategy of being able to combine high customization with high standardization. It is the ability to formsuperior external networks and simultaneously leveraging internal resources optimally. It is the ability toextend control without necessarily extending hierarchies and having the flexibility to respond in a multitudeof ways to changing environments. Such firms are able to produce a base product due to well developedinternal capabilities, and adapt their products through network relationships. Such firms have truetransnational capabilities and are able to respond most effectively to the dual pressures of global integrationand local responsiveness. More importantly, such firms are able to standardize some links of the valueadded chain and meet the pressures of global integration, and decline others to fulfill pressures of localresponsiveness.

The transnational concept is an integrated framework of resources of technology, financial resources,creative ideas, and people that cannot be explained in simple centralization versus decentralizationterms. A transnational strategy leads to reciprocal interdependence among a firm’s operations requiringcomplex coordination and control mechanisms. Such an organizational arrangement of integrated varietyhas great strategic potential because it would be best able to respond to variations in environments aswell as to a great variety of linkages. The three international strategies that we consider in our model areglobal integration, multifocal, and transnational.

Competitive Advantage and International Strategy

We have pointed out earlier that there is considerable fragmentation in the discipline of internationalbusiness strategy. Our aim in developing the conceptual model is not only to better understand the

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influence of competitive advantage on international business strategy, but also to integrate parts of thediscipline by examining the relationship among competitive advantage, entry mode, international strategy,and performance.

We categorize the competitive advantage that firms have into three distinct groups of firms: (1) internalfocus; (2) external focus; and (3) dual focus. Based on the nature and type of competitive advantage,the choice of international entry that we specifically explore ranges from (1) shared control typical injoint ventures; (2) to high control typical in owned subsidiaries. The three international strategies in ourconceptual model are: (1) a global strategy to address forces of global integration; (2) multifocal strategyto address pressures of local responsiveness; and (3) a transnational strategy that combine aspectsglobal integration along aspects with high local responsiveness.

Propositions

Based on the discussion and arguments made so far, the following associations among competitiveadvantage, entry mode, and international strategy should be most salient. One, internal focus firmsshould be most closely associated with a high control entry mode and a global strategy. Two, externalfocus firms should be most closely associated with a shared control entry mode and a multifocal strategy.Finally, dual focus firms should be to handle both joint control and high control arrangements. In thecase of internal- or external focus firms, there are restrictions on what mode of entry and strategy areappropriate. Figure 1 presents the path dependent nature of our assertions and propositions.

Competitive Advantage, Entry Mode, and Performance

Internal focus firms are likely to prefer high control over operations in order to protect their assets andother firm-specific resources, and am likely to prefer wholly (or majority) owned subsidiaries as preferredentry mode, and for these reasons unlikely to choose joint ventures. Such firms would do this in orderto internalize operations and maximize returns on firm-specific attributes. However, these firms arelikely to perform poorly in joint venture arrangements as they do not have the capability to meaningfullyshare control. We propose the following relationship:

Proposition 1a: Internal focus firms have a greater likelihood of choosing wholly owned or majorityowned subsidiaries as the preferred entry mode.

Proposition 1b: For internal focus firms, use of wholly owned or majority owned subsidiaries is likely toresult in higher performance than the use of joint ventures.

As opposed to internal focus firms, external focus firms are able to share control more easily as theyhave well developed relational skills. External focus firms will be able to form relatively successful jointventures, and may be prepared to enter less favorable locations because it has the capability to manageits external environment in a superior manner. External focus firms are unlikely to choose wholly ormajority owned subsidiaries as they have limited internal assets to leverage, and are likely to performpoorly as wholly or majority owned subsidiaries which leads to the following propositions:



Proposition 2a: External focus firms will have a greater likelihood of choosing joint ventures as thepreferred entry mode.

Proposition 2b: For external focus firms, use of joint ventures is likely to result in higher performancethan the use of wholly owned or majority owned subsidiaries.

Competitive Advantage, International Strategy, and Performance

Internal focus firms would prefer to leverage their firm-specific capabilities in international operations.To do this it would need to integrate various overseas units to generate scale economies; however, thisis possible through high resource commitment and high internal coordination. Such coordination isrequired for plant loading, worldwide logistics, and transfer pricing. It is important to note that highvolumes and scale economies can be achieved through a high degree of standardization. These, in turn,constitute the basic components of a global integration strategy. For internal focus firms, not only is aglobal integration strategy appropriate, but because of the inherent strengths such firms have to supportsuch a strategy, performance will be enhanced. We, therefore, propose the following:

Proposition 3a: Internal focus firms are more likely to follow a strategy of global integration.

Proposition 3b: For internal focus firms the use of a global integration strategy is likely to result in higherperformance than the use of a multifocal strategy.

According to Hill, Hwang & Kim (1990), when risks are high due to political instability, concerns overexpropriation, and host government mandates, firms prefer to limit their exposure not only throughshared control, but also through joint strategies to spread the uncertainty. Such arrangements, whichare multifocal in nature, entail a higher degree of risk as it involves working with others in implementingjoint strategies as it increases a firm’s exposure and dependency upon other firms. External focus firms,with their strong relational skills, can use diffused interests to their advantage by focusing on customizedproducts that require local knowledge, adapting to local markets, and providing localized service (Roth& Morrison, 1990). On account of external focus firms ability to share control, manage risk, work withothers, and follow multiple objectives, we propose:

Proposition 4a: External focus firms are more likely to follow a multifocal strategy.

Proposition 4b: For external focus firms the use of a multifocal strategy is likely to result in higherperformance than the use of a global integration strategy.

Entry Mode and International Strategy

This important aspect of international management, the relationship between entry mode and internationalstrategy, continues to remain underdeveloped in the international business literature. Based on thearguments associated with the propositions discussed so far, we suggest that there is a strong associationbetween high control and a global integration strategy, and between shared control and a multifocalstrategy which leads to the following propositions?

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Proposition 5a: Firms that enter through a wholly owned or majority owned process are more likely tofollow a global strategy.

Proposition 5b: Firms that enter through a joint venture process are more likely to follow a multifocalstrategy.

Transnational Strategies

Dual focus firms are able to simultaneously form superior networks and leverage their resources optimally,a capability not possible for external focus or internal focus firms. Dual focus firms are, in effect, able toextend control without necessarily extending hierarchies, and thus be able to respond in a variety ofways to their changing environments. Dual focus firms are able to develop true transnational capabilities(Bartlett & Ghoshal, 1989), and are able to respond more effectively to pressures of global integrationand local responsiveness. In essence, dual focus firms have the capabilities to formulate and implementtransnational strategies which leads us to propose the following:

Proposition 6a: Dual focus firms that follow a transnational strategy are more likely to have higherperformance than the use of a transnational strategy by internal focus or external focus firms.

We argue that dual focus firms following a strategy of global integration will outperform internal focusfirms that follow a strategy of global integration for a number of reasons. Dual focus firms will be able toleverage their resources through external networks and alliances more effectively than internal focusfirms. Such leveraging will allow higher levels of exchange of skills and resources, which include developingmore effective downstream distributors and other channel related infrastructure. While dual focus firmscan match the internal capabilities of internal focus firms, they have the importance of relational skills toform linkages and networks. Based on this, we suggest:

Proposition 6b: Dual focus firms that follow a global integration strategy are likely to outperform internalfocus firms that follow a global strategy.

For similar kinds of reasons that suggest that dual focus firms have important advantages over internalfocus firms, dual focus firms have important advantages over external focus firms. While both dualfocus and external focus firms are matched on external relationships, dual focus firms have superiorinternal capabilities that allow them to produce better goods and leverage their internal resources better.Dual focus firms have superior upstream and manufacturing strengths, and have matching relationalskills compared to external focus firms. Thus, in following a multifocal strategy, dual focuses firms willperform equally well on relational capabilities, but will outperform on account of superior internalcapabilities. Based on this, we make the following proposition:

Proposition 6c: Dual focus firms that follow a multifocal strategy are likely to outperform external focusfirms that follow a multifocal strategy.

The conceptual model we have developed has addressed the original objectives that we have mentionedat the beginning of this paper. We have defined competitiveness in very specific terms, and thus have



avoided the generalities that are occasionally used. Statements like core capabilities and core competencieshave little value unless very specific concepts and definitions are provided by which these terms can bemeasured and important interrelationships be identified. We have also extended the concept of competitiveadvantage to include both an internal as well as an external perspective; an extension we believe bettercaptures this complex phenomenon. Our conceptual model attempts to logically address the overallrelationship through three major constructs, namely competitive advantage, strategy, and performance.We have also integrated the two important aspects of international management—entry mode andinternational strategy—two streams that have typically been researched separately. Our propositionsspecifically address the relationships of the constructs that we have highlighted. We outline the threedifferent categories of competitive advantage with the two types of entry, and the three internationalstrategies. Internal focus firms, we argue are driven by high control, and a need to leverage their welldeveloped internal capabilities through volume and standardization. External focus firm prefer to sharecontrol on account of strong of relational skills, and prefer to use their skills to adapt to market needsthrough local partners. In the case of dual focus firms, the mediation effect of entry mode is relativelyless important as such firms have the skills to manage a wide variety of control mechanisms andorganizational arrangements successfully. Dual focus firms are also able to execute a range of strategiesmore successfully when compared to other types of firms

International Financial Management

Financial management entails planning for the future of a person or a business enterprise to ensure apositive cash flow. It includes the administration and maintenance of financial assets. Besides, financialmanagement covers the process of identifying and managing risks.

The primary concern of financial management is the assessment rather than the techniques of financialquantification. A financial manager looks at the available data to judge the performance of enterprises.Managerial finance is an interdisciplinary approach that borrows from both managerial accounting andcorporate finance.

Some experts refer to financial management as the science of money management. The primary usageof this term is in the world of financing business activities. However, financial management is importantat all levels of human existence because every entity needs to look after its finances.

Financial Management Levels

Broadly speaking, the process of financial management takes place at two levels. At the individual level,financial management involves tailoring expenses according to the financial resources of an individual.Individuals with surplus cash or access to funding invest their money to make up for the impact oftaxation and inflation. Else, they spend it on discretionary items. They need to be able to take thefinancial decisions that are intended to benefit them in the long run and help them achieve their financialgoals.

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From an organizational point of view, the process of financial management is associated with financialplanning and financial control. Financial planning seeks to quantify various financial resources availableand plan the size and timing of expenditures. Financial control refers to monitoring cash flow. Inflow isthe amount of money coming into a particular company, while outflow is a record of the expenditurebeing made by the company. Managing this movement of funds in relation to the budget is essential fora business.

At the corporate level, the main aim of the process of managing finances is to achieve the various goalsa company sets at a given point of time. Businesses also seek to generate substantial amounts of profits,following a particular set of financial processes.

Financial managers aim to boost the levels of resources at their disposal. Besides, they control thefunctioning on money put in by external investors. Providing investors with sufficient amount of returnson their investments is one of the goals that every company tries to achieve. Efficient financial managementensures that this becomes possible.

Strong financial management in the business arena requires managers to be able to:

1. Interpret financial reports including income statements, Profits and Loss or P&L, cash flowstatements and balance sheet statements

2. Improve the allocation of working capital within business operations

3. Review and fine tune financial budgeting, and revenue and cost forecasting

4. Look at the funding options for business expansion, including both long and short term financing

5. Review the financial health of the company or business unit using ratio analyses, such as thegearing ratio, profit per employee and weighted cost of capital

6. Understand the various techniques using in project and asset valuations

7. Apply critical financial decision making techniques to assess whether to proceed with aninvestment

8. Understand valuations frameworks for businesses, portfolios and intangible assets.

5.4 Global Competitive Strategy

Global Financial System

The global financial system (GFS) is a financial system consisting of institutions and regulators that acton the international level, as opposed to those that act on a national or regional level. The main playersare the global institutions, such as International Monetary Fund and Bank for International Settlements,



national agencies and government departments, e.g., central banks and finance ministries, and privateinstitutions acting on the global scale, e.g., banks and hedge funds.

Deficiencies and reform of the GFS have been hotly discussed in recent years. The history of financialinstitutions must be differentiated from economic history and history of money. In Europe, it may havestarted with the first commodity exchange, the Bruges Bourse in 1309 and the first financiers and banksin the 1400–1600s in central and western Europe. The first global financiers the Fuggers (1487) inGermany; the first stock company in England (Russia Company 1553); the first foreign exchange market(The Royal Exchange 1566, England); the first stock exchange (the Amsterdam Stock Exchange 1602).

Milestones in the history of financial institutions are the Gold Standard (1871–1932), the founding ofInternational Monetary Fund (IMF), World Bank at Bretton Woods, and the abolishment of fixedexchange rates in 1973.

Global Competitive Strategy

Globalization has fundamentally changed the game of business. Strategic frameworks developed forthe analysis of purely domestic business necessarily fall short in the international business context.Managers and business students require new approaches to understand and cope with these far-reachingchanges. We must learn to think globally in order to succeed. Global Competitive Strategy shows howwe can do this by providing a unique set of strategic tools for international business. Such tools includethe ‘star analysis’ that allows strategy makers to integrate geographic information with market informationabout the global business environment. Also introduced is the ‘global value connection’ that showsmanagers how to account for the gains from trade and the costs of trade.

Global Competitive Strategy is a great work. With its focus on the tremendous increase in globalcompetition and the variety of global markets.

Managers face competitive challenges in the best of times, but globalization raises the level of thosechallenges exponentially. Using the best from modern research, world-class economist Daniel Spulberunravels these managerial challenges and offers keys to competing successfully in the global market.

5.5 Global Marketing Strategy

The Oxford University Press defines global marketing as “marketing on a worldwide scale reconcilingor taking commercial advantage of global operational differences, similarities and opportunities in orderto meet global objectives.”

(i) Worldwide Competition

One of the product categories in which global competition has been easy to track in U.S.is automotivesales. Three decades ago, there were only the big three: General Motors, Ford, and Chrysler. Now,

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Toyota, Honda, and Volkswagen are among the most popular manufacturers. Companies are on aglobal playing field whether they had planned to be global marketers or not.

(ii) Evolution to global marketing

Global marketing is not a revolutionary shift, it is an evolutionary process. While the following does notapply to all companies, it does apply to most companies that begin as domestic-only companies.

(iii) International Marketing

If the exporting departments are becoming successful but the costs of doing business from headquartersplus time differences, language barriers, and cultural ignorance are hindering the company’scompetitiveness in the foreign market, then offices could be built in the foreign countries. Sometimescompanies buy firms in the foreign countries to take advantage of relationships, storefronts, factories,and personnel already in place. These offices still report to headquarters in the home market but mostof the marketing mix decisions are made in the individual countries since that staff is the mostknowledgeable about the target markets. Local product development is based on the needs of localcustomers. These marketers are considered polycentric because they acknowledge that each market/country has different needs.

(iv) Multinational Marketing

At the multi-national stage, the company is marketing its products and services in many countriesaround the world and wants to benefit from economies of scale. Consolidation of research, development,production, and marketing on a regional level is the next step. An example of a region is WesternEurope with the US. But, at the multi-national stage, consolidation, and thus product planning, does nottake place across regions; a regiocentric approach.

(v) Global Marketing

When a company becomes a global marketer, it views the world as one market and creates productsthat will only require weeks to fit into any regional marketplace. Marketing decisions are made byconsulting with marketers in all the countries that will be affected. The goal is to sell the same thing thesame way everywhere.

(vi) Elements of the global marketing mix

The “Four P’s” of marketing: product, price, placement, and promotion are all affected as a companymoves through the five evolutionary phases to become a global company. Ultimately, at the globalmarketing level, a company trying to speak with one voice is faced with many challenges when creatinga worldwide marketing plan. Unless a company holds the same position against its competition in allmarkets (market leader, low cost, etc.) it is impossible to launch identical marketing plans worldwide.



(vii) Product

A global company is one that can create a single product and only have to tweak elements for differentmarkets. For example, Coca-Cola uses two formulas (one with sugar, one with corn syrup) for allmarkets. The product packaging in every country incorporates the contour bottle design and the dynamicribbon in some way, shapes, or form. However, the bottle or can also includes the country’s nativelanguage and is the same size as other beverage bottles or cans in that country.

(viii) Pricing

Price will always vary from market to market. Price is affected by many variables: cost of productdevelopment (produced locally or imported), cost of ingredients, cost of delivery (transportation, tariffs,etc.), and much more. Additionally, the product’s position in relation to the competition influences theultimate profit margin. Whether this product is considered the high-end, expensive choice, the economical,low-cost choice, or something in-between helps determine the price point.

(ix) Placement

How the product is distributed is also a country-by-country decision influenced by how the competitionis being offered to the target market. Using Coca-Cola as an example again, not all cultures use vendingmachines. In the United States, beverages are sold by the pallet via warehouse stores. In India, this isnot an option. Placement decisions must also consider the product’s position in the market place. Forexample, a high-end product would not want to be distributed via a “dollar store” in the United States.Conversely, a product promoted as the low-cost option in France would find limited success in a priceyboutique.

(x) Promotion

After product research, development and creation, promotion (specifically advertising) is generally thelargest line item in a global company’s marketing budget. At this stage of a company’s development,integrated marketing is the goal. The global corporation seeks to reduce costs, minimize redundanciesin personnel and work, maximize speed of implementation, and to speak with one voice. If the goal ofa global company is to send the same message worldwide, then delivering that message in a relevant,engaging, and cost-effective way is the challenge.

Effective global advertising techniques do exist. The key is testing advertising ideas using a marketingresearch system proven to provide results that can be compared across countries. The ability to identifywhich elements or moments of an ad are contributing to that success is how economies of scale aremaximized. Market research measures such as Flow of Attention, Flow of Emotion and brandingmoments provide insights into what is working in an ad in any country because the measures are basedon visual, not verbal, elements of the ad.

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Global Marketing Advantages and Disadvantages

Advantages

• Economies of scale in production and distribution

• Lower marketing costs

• Power and scope

• Consistency in brand image

• Ability to leverage good ideas quickly and efficiently

• Uniformity of marketing practices

• Helps to establish relationships outside of the “political arena”

• Helps to encourage ancillary industries to be set up to cater for the needs of the global player

Global Marketing Strategy

Other marketing activities also need to be examined carefully for their globalization potential. DellComputer is a good example of a company which has replicated its direct selling practices across theworld. In 1998, Dell generated approximately 31% of its sales in overseas markets. Dell’s sales personsdirectly target large international accounts. Retail customers can dial toll free one of its call centres inEurope and Asia. A truly global marketing strategy would aim to standardize some elements of themarketing mix across the world, while customizing others. The correct approach would be to identifythe various value chain activities within the marketing function and decide which of these can be performedon a global basis and which can be localized.

Typically, marketing includes the following activities: -

• Market research.

• Concept & idea generation.

• Product design.

• Prototype development & test marketing

• Positioning

• Choice of brand name

• Selection of packaging material, size and labeling

• Choice of advertising agency



• Development of the advertising script

• Execution of advertisements

• Recruitment and posting of sales force

• Pricing

• Promotion

• Selection and management of distribution channels.

Some of these activities are amenable to a uniform global approach. Others involve a great degree ofcustomization. Within a given activity, parts can be globalized and others performed locally.

Product Development

Product design & development is an activity where the potential to globalize needs to be examinedcarefully. A globally standardized product can be made efficiently at a low cost but may end up pleasingfew customers. On the other hand, customized products targeted at different markets across the worldmay be too expensive. The trick, as in the case of other value chain activities is to identify thoseelements of the product which can be standardized across markets and those which need to be customized.

Japanese companies such as Sony and Matsushita have been quite successful in marketing standardizedversions of their consumer electronics products. These companies had limited resources during theirearly days of globalization and identified features which were universally popular among customersacross the world. Global economies of scale helped them to price their products competitively. At thesame time, these companies laid great emphasis on quality. As a result, as their products, even withoutfrills, began to appeal to customers. Many of Sony’s consumer electronics products are highlystandardized except for the parts that meet national electrical standards.

Canon offers the interesting example of a Japanese company that took into account global considerationswhile developing a new product. In its domestic market, customer requirements were quite different.Photocopiers in Japan were expected to copy all sizes of paper. Canon felt that the designing aroundthe requirements of the US, the largest market for photocopiers in the world made sense. In the process,the company deliberately overlooked some of the features required by the Japanese market, to keep itsdevelopment costs under control.

In the case of industrial products, standardization may become unavoidable if global customers coordinateglobally their purchases. This seems to be true in the PC industry and companies such as Dell are takingfull advantage of this trend. This is likely to accentuate further, as companies increasingly feel thecompelling need to coordinate their corporate information systems on a global scale. MNCs oftenchoose to replicate the computer system in their headquarters to minimize the costs involved in writingnew programs and training staff.

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In industries characterized by high product development costs and great risk of technologicalobsolescence, there is a great motivation for developing globally standardized products and services.By serving large markets, costs can be quickly recovered. Even in the food industry, where tastes arelargely local, companies are looking for opportunities to standardize. Even if identical offerings cannotbe made in different markets, companies are developing a core product with minor customization, suchas a different blend of coffee, to appeal to local tastes.

In a globalized economy, there is pressure on companies to improve efficiencies by offering standardproducts to the extent possible. There are pitfalls however to be avoided. Customer preferences varyacross countries. Let us say all these are carefully taken note of and some ‘average’ preference arrivedat. Based on this, if a company develops a new product, it may well and up pleasing no one. As KenichiOhmae has remarked in his book, ‘The Borderless World’: “When it comes to product strategy, managingin a borderless economy doesn’t mean managing by averages. It doesn’t mean that all tastes run togetherinto one amorphous mass of universal appeal. And it doesn’t mean that the appeal of operating globallyremoves the obligation to localize products. The lure of a universal product is a false allure.”

Some products of course tend to be more global than the others. These include cameras, watches,pocket calculators, premium priced fashion goods and luxury automobiles. In the case of many industrialproducts, purchase decisions are normally taken on the basis of performance characteristics. Considerablescope exists for standardization that can cut costs. However, even for these products, local customizationmay be required in engineering, installation, sales, service and financing schemes. In the case of financialservices, institutional products tend to be more global than the retail ones.

Consider a product like cars. Traditionally, car manufacturers have developed hundreds of models tomeet the needs of different markets without exploring the possibilities that exist for standardization.Proliferation of models has resulted in unused capacities and inefficiencies. In the global automobileindustry today, substantial excess capacity exists. Under these circumstances, car manufacturers arelooking for ways to cut costs. One approach has been to select common platforms and build models ofdifferent shapes around these platforms. The idea here is that the basic functionality of a car can beextended globally while features and shape are customized to appeal to different consumer tastes invarious parts of the world. Ford and Toyota have made a lot of progress in standardizing the platforms.Other automobile companies are also laying a lot of emphasis in this regard.

Market Research

Now, let us move on to another important marketing activity, market research. Some elements canprobably be standardized. For example, the sample to population ratio can be controlled globally. Theinformation to be collected for each product category can also be standardized. However, questionshave to be tailored taking into account the sensitivity of both the local government and the local people.In particular, personal and embarrassing questions have to be avoided in certain countries. The actualtask of administering the questionnaire and collecting data has of course to be performed locally.



Even if questionnaires have to be customized to suit local requirements, a global approach to marketingresearch efforts can help in improving efficiency. For example, clusters of countries might need thesame questionnaire. Global coordination is also necessary to facilitate sharing and transfer of knowledge.The global head of market research has the important job of ensuring that each country is aware of notonly the research activities it is carrying out but also of the activities being conducted in other countries.A systematic process of collecting inputs relating to research methodology and data from different partsof the world can help in the formulation and implementation of a globally coordinated market researchstrategy.

Advertising

Advertising is obviously a critical marketing activity. Consider the choice of advertising agency. A totallydecentralized approach would mean selection of different agencies by different subsidiaries. Whilelocal agencies may feel they are in the best position to understand the needs of the local markets, noglobal company can afford such an uncoordinated approach towards advertising.

Nestle had been employing over a hundred different agencies. As the company looked for globalbranding opportunities, coordinating the activities of so many agencies became a major problem. Nestledecided in favour of retaining only a few agencies – Mc Cann Ericsson, Lintas, Ogilvy & Mather, JWT,Publicis / FCB and Dentsu. Peter Letmathe, Nestle CEO explains the role of an advertising agency inthe company’s globalization efforts: “ To us, the most important thing is to have dedicated teams. McCann for instance has 10 people working only with Nestle. I see them as an extended arm of mycommunications team. They visit every six weeks to tell us what they are doing around the world.”

Nestle subsidiaries have encouraged their local agencies to tie up with the company’s global agencies.The rationalization of worldwide communications efforts has helped Nestle achieve efficiencies in thecase of products such as coffee, ice creams and chocolates. While Nestle has also made attempts totransfer advertising expertise across countries, there are obvious limits. Letmathe himself has articulatedsome of the difficulties involved in using the same advertisement across different countries: “Sometimeago, Chile produced an outstanding Nescafe commercial. In a little house by a lake, a man gets up earlyand tries to wake his son (who prefers to stay in bed) to go fishing. We see the disappointed fathersitting in the morning mist at the lake. Then the son reconsiders the decision, get up and makes a cup ofcoffee and brings it to his father for a moment of spontaneous renewal. Their whole relationship is builtup through coffee. Now, the same commercial, projected in a different market can bring completelydifferent connotations. In Paris, you might even provoke ecological feelings that look almost like anenvironmental statement. The same images are perceived totally differently.”

Pricing

When it comes to pricing, both global and local approaches can be used depending on the specificsituation. Consider the virtual bookstore Amazon. Com. The store sells books which are essentiallybranded products. Customers typically have a distinct preference for a particular book. For

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Amazon.com, global pricing probably makes sense. On the other hand in the car industry, inspite ofclaiming to be global, pricing has to take into account local factors. Companies such as Ford andGeneral Motors are realizing that the Indian customers are unwilling to pay Rs. 7 –8 lakhs (based on anexchange rate of Rs. 43/$) for the same models which cost $ 15 – 18,000 in the US and WesternEurope. This is putting pressure on them to look for ways to cut costs, indigenise and offer cheapermodels. Sometimes global pricing becomes difficult because of different levels of competition in differentmarkets. Even a company like GE which follows global pricing for its jet engines makes suitableadjustments for local competition. Using a uniform price relative to competitors appears to make sensein many cases as it protects market share while maintaining a consistent positioning.

Positioning

A global positioning of products helps in improving the efficiency and effectiveness of marketing programs.On the other hand, differing usage patterns, buying motives and competitive pressures across countriesnecessitate the need for positioning products uniquely to suit the needs of individual markets. Whereverpossible, a global positioning need to be used as it ensures that money is wisely spent on building thesame set of qualities and features into products. Global positioning can also reduce advertising costs.However, as mentioned earlier, uniform positioning without taking into account the sensitivities of localmarkets can result in product failures. Sometimes, local positioning has to take into account marketrealities. For a long time, Citibank has been serving the premium segment in India. To open a SavingsBank account, the minimum deposit required is Rs. 3 lakhs. While this may sound reasonable in dollarterms ($ 7500) it is obviously beyond the reach of the Indian middle class. Citibank has probablyrealized that targeting the mass market would be a Herculean task in a vast, predominantly rural countrylike India where the Government also has imposed several restrictions on the expansion of foreignbanks. Hence its decision to restrict itself to India’s major cities and target wealthy individuals and bluechip corporate. Citibank’s up market positioning needs to be viewed in this context. Now, Citi seemsto have realized the need for offering products and services for the mass market.

Global positioning of products often evolves over time. Ford offers some useful insights. Ford’s firstglobal product, the Escort was launched individually in different countries. Each country not only cameup with its own positioning but also developed its own advertising message using local agencies. Insome countries, the product was positioned as a limousine and in others as a sports car. Compared tothe Escort, Ford’s new compact, Focus is a classic example of global positioning. The Focus is beinglaunched across markets as a car with a lot of design flair, plenty of space, great fuel efficiency andengineering features to promote safety. Ford has employed only one advertising agency for the launchof the Escort.

Nestle uses positioning documents for the worldwide brands as well as important regional brands.These documents are prepared by the respective Strategic Business Units in consultation with marketingpersonnel from different parts of the world and approved by the general management. In the late1990s, roughly 40% of Nestle’s total sales were generated by products covered by the Nestle corporate



brand. For some products such as pet foods, Nestle has chosen to keep the brands as distant aspossible from the Nestle brand name. In the case of mineral water also, Nestle does not use its corporatename. Letmathe explains: “We felt that people buying water are looking for the purity of the sourcewhereas our seal is that of a manufacturer. So we set up a special institute, Perrier – Vittel, which putsits own guarantee on mineral water.”

Selling

If a customer in Portugal makes a local call, it is automatically forwarded to the call center in Francewhere a Portuguese speaking sales representative answers the customer’s questions. To be closer tooverseas customers in Europe and Asia, Dell has a plant in Limerick, Ireland and another in Penang,Malaysia. Dell has attempted to configure its factories similar to its Austin plant, in the US. The plant atIreland, is for example very close to the plants of its suppliers such as Intel (microprocessors), Maxtor(Computer hard drive) and Selectron (Computer motherboard). Such arrangements facilitate the smoothexecution of Dell’s direct selling; build to order, just in time model.

5.6 Production Management Strategy

Production Management

Production systems play a very important role in achieving organizational excellence. But the lack ofproper planning, co-ordination and control often affects the capabilities of these systems because ofwhich these systems are not utilized fully and effectively leading to many undesirable situations forcingmany organizations to become less competitive. A number of organizations worldwide have achievedand sustained excellence by effective production management.

Effective production management involves understanding of the characteristics of various types ofproduction systems, identification of the dynamics of the different phases of the management process,realizing the potential of different analytical tools, learning the nuances of the implementation of thesetools, visualizing the impact of various uncertain situations and developing the ability to react undervarious scenarios to achieve consistently excellent business results. There are evidences to show how anumber of organizations achieved world class status by effective management of their production systems.These organizations achieved superior quality, higher productivity, perfect delivery performance, overallcustomer satisfaction and enterprise excellence all with lower cost.

Production management, alternatively referred to as manufacturing management, is required fortransforming raw materials and partly, fabricated materials into finished products. Production managementdoes not imply management of productive process alone, but it covers all their activities which go intothe making of production. To make production a concrete reality, one, must pay heed to the factors ofproduction like land, labour, capital and organization, or to speak in the language of business, materials,men, money, machines and methods. Production management thus calls for the work of planning andcontrol pertaining to each of these factors of production.

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Production management does not involve a mechanical assemblage of relevant factors. In contrast tomere transformation of raw materials into finished products, it aims at transmuting and permuting resourcesof higher productivity so that the greatest outputs are obtained from the least inputs. With its end inviews, production management embraces the productive process too and involves planning, directingand controlling operations till their successful completion. Quality, quantity, cost and time of productionhas an important bearing on productivity of the manufacturing enterprise. Accordingly, it is the task ofproduction management to see that effective utilization of resources is made, time is shortened, wastesand scrapings are avoided, and harmonious working is made to prevail in the plant.

For effective managerial performance, the work of production department is required to be organizedon sound lines. All the principles and practices of organizing are to be applied in building a soundstructure for improving the result of production management. Successful production management is notpracticable without the existence of an appropriate organization structure. Consequently, managerialefforts are to be directed in designing an organization structure that conforms to the needs of theproduct, size of the enterprise and availability of production facilities. Organizing for production may beconceived in broader sense to include some aspects of works engineering or works organization likeplant layout and factory building.

The problems of production management differ from case to case and are mainly related to the systemof production. There are several systems of production which determine the magnitude of productionwork and the problems to be tackled in manufacturing operations. Hence, a familiarity with the differentsystems of production is required for understanding the intricacies of production management. Of course,the system of production is dictated in a particular case by the volume of sales and the nature ofproduct. The quantity to be produced is nothing but an answer to the question of ‘what can be sold”. Inthe ultimate analysis, therefore, sales are the regulator of a system of production.

The management of transformation process of inputs into output is the essence of production management.In present competitive world the production process in every enterprise needs some effective andscientific planning as well as proper control. Thus production management can be defined as“Management which by scientific planning and regulation sets into motion the part of an enterprise towhich it has been entrusted the task of actual transformation of inputs into output”. In the words of Mr.E.L. Brech, “Production Management then becomes the process of effectively planning and regulatingthe operations of that part of an enterprise which is responsible for the actual transformation of materialsinto finished products”.

This definition appears to be incomplete as it does not include the human factors involved in a productionprocess. It lays stress only on the materialistic features. In broader sense, production managementactually deals with decision making related to production processes, so that the resulting goods andservices are produced in accordance with the quantitative specifications and demand schedule withminimum cost. To attain these objectives the two main activities of Production Management are theDesign and Control of production systems.



In production management effective planning and control are essential. In the absence of effectiveplanning and regulation of any production activity the goals cannot be achieved, the customers may notbe satisfied and ultimately certain activities may be closed which may lead to social evils.

Measurement of Work

In an engineering sense efficiency can be simply stated as the ratio of useful energy obtained to energyapplied. We can all understand that. Put succinctly, that is what is really meant by efficiency of production,but the difficulty is to see the relationship between input and output of production, or to measureperformance. Which brings us right to the heart of the problem of efficiency of production: how tomeasure performances. There is usually some difficulty about measuring the comparative performanceof several departments in a Company or different companies. If two factories are turning out the sameproduct which is measured in tons or feet, then overall cost per ton or per foot is a measure of performancewhich can be obtained readily and used for comparison. But how does one compare the costs orefficiency of two factories or department s making dissimilar products? Cost per ton or unit is no good.As between two different firms, only the percentage net profit is any measure, and that is affected by thetype of market and selling cost which are not production costs. And between different departments inthe same firm there would seem to be, at first sight, no measure of efficiency on a common and thereforecomparable basis.

If, however, the amount of “effort” (or cost-material, labour and overhead services) which should havebeen sued to make a given quantity of a product is known and also the amount actually used, thensurely the correct amount as a proportion of the actual amount is a measure of performance of efficiency.It is in reality an efficiency formula again, output over input. The real value of output, in effort, hours ors.d., is the amount of cost which goes out of the factory or department in a useful form, i.e., it does notinclude all wastage and excess costs, avoidable, and of no benefit to customer or company. And inputis the total of all effort and costs absorbed. Including excess costs.

Organization of Production Planning Department

The work of a Production Planning Department generally falls into three sections, dealing with threestages of the sequence of operations. They are;

i. Compiling and recording facts.

ii. Developing plans.

iii. Putting plans into operation and controlling results. In the first stage and section, information isgathered together, recorded and filed in a way which is suitable for use by planners, and so thatreference to it is easy and rapid. The information is of three kinds, relating to:

a) Customers’ orders and requirements;

b) Stocks of materials and components;

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c) Plant available, capacities, operations and times. Unless the organization is of such a size that eachkind of information is dealt with in a separate section, it is advisable for all of it to be handled by onesection under the supervision of a person skill din the work. Its organization is mainly a problem of filingand entering-up figures or records form vouchers, i.e., transferring information and striking balances. Itcan usually be staffed with Juniors, female, or relatively unskilled labour, but must be carefully supervisedand checked by very reliable people. The absolute accuracy and therefore double checking required inbanks is not essential, but inaccuracies can be troublesome and costly.

The second stage and section comprises the vital part of planning. It is her that the effectiveness orindifference of results is ensured. And where the ability to scheme, think ahead and take all factors intoaccount is so essential. It is a job mainly done on paper, juggling as it were with figures and charts. Salesbudgets must be broken down into or integrated with long-term production plans, factory anddepartmental plans formulated, and weekly or daily or even hour-by-hour loads prepared. In smallfactories a few simple charts or schedules suffice, but in very large organizations a vast amount ofdetailed information, in the form of masses of figures, flows into the section, and must be rapidly andregularly collated and reissue for action. Extreme tidiness is essential, and if those concerned are not tobe bogged down by a continuous stream of insistent inquiries demanding attention, much of the workmust so be organized as to be dealt with in a routine manner by juniors.

The third stage consists of translating the plans into instructions and can be mainly of a clerical nature. Inpractice, however, it is at this stage that a certain amount of decentralization is advisable, and the hour-by-hour machine or operation loading and the actual issue of jobs to operators is done either in oradjacent to the Forman’s office, or in a shop office. Progress work, that is, checking performanceagainst plans and reporting results (with recommendations for corrective action and requests for urgentactions) to foremen or other supervisors, which is really an aspect of control, is frequently carried outform the same of and even by the same persons.

The complexity of an organization structure for production planning depe4nds on the type of industry ormanufacture rather than its scale. In mass-production and continuous-process manufacture, productionplanning consists of balancing the flow of materials (or components) from outside or componentmanufacturing departments, with consumption by the factory or assembly departments. Particularly isthis so in the automobile or similar industries, where a good deal of preliminary work on materials insubcontracted, no large stocks of materials are kept (or could be for the immense consumption rate)and a small interruption to production affects a large part of the factory and is very expensive. In thosefactories engaged on batch production of partly standardized products there is the added complexity ofsetting-up (time and cost), varying batch sizes, and the synchronization of finishing dates for parts andsub assemblies when batches vary so much. It is predominantly a question of continual adjustment inorder to maintain balanced loads on departments and to correct for unforeseen delays. When theproduct is designed to customers’ requirements, the total process time is increased by the time requiredfor design or preparation for each order, and consequently the period over which planning must extendis greater, making the problem more complex. Production planning is most complex when the product



is mainly to customers’ requirements, but is designed to incorporate many standard parts kept in stock.When the number of orders exceeds something like 50 per week, the amount of information to behandled becomes large and the department correspondingly.

Production Planning Methods

The purpose of production order is to provide information about various operations involved in aproduction process. Once a production order is formulated, there arises the necessity to determine thatwhen and where each operation is to be done. The reasons in that the operations described in aproduction order may be executed in several ways to get the final product and one may like to use aproduction strategy which makes most effective use of an, machine and material in the system. The beststrategy is planned through the methods of Routing and Scheduling. Thus scheduling and routing is thefinal stage in production planning and have the following objectives:

i. to prescribe where and by whom each operation necessary to manufacture a product is to beexecuted. This is known as routing.

ii. the establishment of times at which to begin and/or complete each even or operation. This istermed as scheduling.

Plant Layout

Layout problems are fundamental to every type of organization/enterprise and are experienced in allkinds of undertakings. Housewife must arrange her kitchen, retailer must arrange his counters anddisplay the items in such a manner which facilitates movement and attract the attention of customers,office management positions the desks, tables and other equipment in such a way that it facilitates theflow of work. The manufacturing organizations must arrange their facilities, not only the departmentwithin the factory but also the plant, stores and services so as to achieve smooth flow of products. Theadequacy of layout affects the efficiency of subsequent operations. It is an important perquisite forefficient operations and also has a great deal in common with many of the problems. The simplest ofsituations with comparatively fewer items to arrange have many alternatives available. Import the layoutdecisions were based merely on intuition, experience, judgment and some sort of improvisation butwith increase in the complexities of organizations the layout problems are solved scientifically.

Once a decision about location of the plant has been taken, next important problem before themanagement is to plan suitable layout for the plant. Efficiency and performance of good machines andsturdy building depend to a great extent on the layout of a plant. Plat layout is the method of allocatingmachines and equipment, various production processes and other necessary services involved intransformation process of a product with the available space of the factory so as to perform variousoperations in the most efficient and convenient manner providing output of high quality and minimumcost.

In the words of James Lundy, “layout identically involves the location of space and the arrangement of

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equipment in such a manner that overall operating costs are minimized.” Alternately, plant layout is aneffort to arrange machines and equipment, and other services within a predesigned building ensuringsteady, smooth and economical flow of material.

Planning the layout of a plant is a continuous process as there are always chances of making improvementsover the existing arrangement especially with shifts in the policies of management of techniques ofproduction.

The disposition of the various parts of a plant along with all the equipment used is known as plantlayout. It should be so designed that the plant functions most effectively. Layout problems are commonto all kinds of organization. A retailer must arrange his counter, display of items etc., office managementmust position desks, tables etc. in such a way that it facilitates the flow of work. A manufacturingorganization must position its machinery and other equipment so as to achieve smooth flow of productsthrough their factories.

A good layout results in comforts convenience, safety, efficiency, Compactness and profits. A poorlayout results in congestion, waste, frustration and inefficiency. Thus after plant location the properdesign of plant layout is most significant for smooth functioning and success of the organization.

Plant Layout Tools and Techniques

I. Process charts

i. Operations Process Charts

ii. Flow process Chart

II. Process Flow Diagrams

III. Machine data cards

IV. Visualization of Layout

i. Two-dimensional plan or Templates

ii. Three-dimensional Plan or machine models

Plant Location

The performance of an enterprise is considerably affected by its location. The location of an industry isas important as the choice is for the location of a business or a shop in a city or locality. Unscientific andunplanned industrialization is harmful not only to the industrial unit but also to the social and economicstructure of the country as a whole.

Nearly sixty years before, much importance was not given to the selection of appropriate location andthe decisions in this regard were mainly governed by the individual preferences of the entrepreneurs and



social customs. This resulted in failure of any organization which otherwise could have been successful.Government also with the objective of establishing socialistic pattern of society became instrument all inthe selection of site for various industries in undeveloped areas by providing various investment benefitsand other incentives. All this encouraged a large number of industrialists to follow a more scientific alogical approach towards the selection of site for establishing their industries.

The degree of significance for the selection of location for any enterprise mainly depends on its size andnature. Sometimes, the nature of the product itself suggests some suitable location. A small scale industrymainly selects the site where in accordance with its capacity the local market for the product is available.It can easily shift to other place when there is any change in the market. But for large scales industriesrequiring huge amount of investment there are many considerations other than the local demand in to theselection of proper plant location. These plants cannot be easily shifted to other place and an error ofjudgment in the selection of site can be very expensive to the organization.

Production Methods

One activity of the administrative side of production is concerned with finding and stating the one bestway to do all jobs. No longer is this left to the skilled and interested operator, proceeding by trial anderror, successive operators making the same, or sometimes a different result. As more machines, toolsand equipment, some of them highly specialized, have been designed and become available, and newmaterials and process materials and process developed, it has become increasingly a skilled technicaljob to keep abreast of developments and always to know the up-to-date or best way to do a job. Itwould be quite impossible today for the craftsman at the bench or machine to keep him so informed anddo a job of producing. Skilled men are still required, but increasingly today they become setters,minders, or maintenance men.

The old type of foreman is apt to think that the appointment of a production engineer, process engineer,or chemist, reduces his usefulness, his value to the Company, or his status. It does nothing of the kind,of course. It is true that, before the development of production engineering, and the use of chemists inthe works as well as in the analytical laboratory, the Work Manger and his foreman supplied theproduction “know-how”, and decided how a job should be done. But it is now recognized that thetraining and supervising of person is a much more complex job than it once was, and to relive a foremanof a large amount of administrative work makes a higher general performance possible and his jobmore valuable, not less. It is essential to separate planning form doing, administration from execution.

When a new material is developed or a new product designed, the method of production is obviouslyeither known or worked out. But form then onwards all is change. Better method of production is beingdiscovered continually. Furthermore, in many factories, particularly those engaged in engineering, thedetailed method of production for each part to be manufactured, the machines to be used and equipmentrequired, is decided subsequent to design. The task of deciding the best method of production, ofsaying how a job shall be produced, and of finding new and better ways of doing so, should be theresponsibility of a Method of Production Engineering Department. Similarly, in a company where the

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technical knowledge is supplied by chemists, production method would be the responsibility of theworks laboratory.

In deciding the one best way of doing a job, the production engineer or chemist must have regard forthe costs of production, and therefore for the time to do the job. He must have regard for the costs ofproduction, and therefore for the time to do the job. He must have some say also in new tools orequipment required. These are the three divisions into which the activities of the production or methodsengineer usually fall that is to say, work study or methods, work measurement or time study and tooldesign.

These three aspects all call for close collaboration with the designer and works departments. Thedesign of jigs and tools might be thought to be a logical development of the Design or Drawing Officework and in some works it is done in the Drawing Office. But it cannot be effectively developed withoutdetailed study of methods and work being done in the factory, and, as will be shown later, this studyforms the basis of standards for time, and hence for payment by results, production planning and costs.This study work calls for a specialized technique and training quite different form Drawing Office work.The outlook required is different too. It is more successful in practice if it is recognized as a separateactivity, and combined with the design of tools and equipment. To avoid it becoming too remote from orindependent of the Drawing Office, Design Department, or Technical Department, new drawings, designs,or technical developments should always be referred to, and discussed with, the production engineersbefore final issue.

The development of production engineering as a special skill and the extensive use of specially designedtools and equipment have contributed largely to the very much greater output per man-hour. There is nodoubt that it is through such development, adding horse-power to man-power, and taking out themanual efforts from jobs, that the way lies to reduce man-hour requirements.

Because production engineers tend to get machine or gadget minded, they are apt to forget or neglectthe human factor. Machines cannot yet operate without human agency, and men should not be madeinto robots. The foremen may have something to say if the division of labour, for example, is carried toofar, or if new methods are forced on them without consultant. Continued and close co-operation betweenthe production engineers and works departments is absolutely essential.

The function of the production Engineering or Methods Department is to determine, in collaborationwith the Design and Works Departments, the most effective, economical and suitable method ofproduction, today down standards for material and time, and to design special tools and equipmentrequired.

Production Planning

Planning may be defined as “Any information which either specifies or guides the taking of futureactions by its members geared towards overcoming existing or anticipated problems”. Billy E. Goetzhas rightly remarked planning as “fundamentally choosing”, and “a planning problem arises when an

Module V - Strategy and Management of International BusinessModule V - Strategy and Management of International Business


alternative course of action is discovered”. So, in simplest way, we may define production planning asplanning of production. But production planning requires a careful and elaborate study of co-ordinatingand related activities which are necessarily performed by different departments. Messrs. Bethol, Smithand others in their book ‘Industrial Organization and Management’ have defined the production planningas “It is a series of related and co-ordinated activities performed by not one but a number of differentdepartmental groups, each activity being designed to systematize in advance the manufacturing effortsin its area”.

Conclusively, production planning may be defined in the words that “It is the predetermination ofmanufacturing requirements such as available materials, money men, order, priority, production processetc. within the scope of Industrial unit for efficient production of goods to cope with its sale requirements.Production planning mainly depends on the type of manufacturing plants which can be divided into twocategories: (a) Continuous type of manufacturing plants such as rayon, yarn, shoes, paper plants etc.and (b) Intermitted type of manufacturing plants such as Engineering type of plants and also repetitivetype of industries-automobiles, typewriters etc.

Planning in the continuous type of plant is somewhat easy as we have only to decide what and when andnot to decide how and where. In intermittent type of plant. Planning becomes difficult by the entry of anumber of complex factors into picture. The same machine is engaged for production of different partsat different times, the machine is kept busy to meet the requirements for various parts to the customer’sbest satisfaction. In the repetitive type of plant such as automobiles the process appears to be continuousbut we have depend on so many parts meeting the schedule before we can move on to the next; thusplanning becomes complex. For example, in an automobile plant, a sub-assembly process cannot besaid to be complete unless all the various parts whether manufactured on the plant or sub-contractedform outside are available as complete.

5.7 Organization of Human Resources in MNCs

The organizational activities undertaken by a Human Resources Department of International organizationto effectively utilize its Human Resources.

• Staffing

• Selection

• Management development

The roles of the managers in transnational corporations are categorized as given below:

• Top-level corporate management

• Global business managers

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• Worldwide functional managers

• Country (subsidiary) managers

The role of the Global business managers are having the following functions

• Cross-border coordination

• Need not to be located in the home country

• Worldwide product strategist

• Asset and resource configuration

Worldwide functional managers and their role in Human Resources Management

• Cross-pollinator of best practices

• Developing and diffusing knowledge specialized by function – tech, marketing, manufacturing,etc.

• Worldwide intelligence scanner

The roles of country managers are discussed as given below:

• Frontline implementer of corporate strategy

• Bicultural interpreter

• National defender and advocate (ensuring the needs and opportunities that exist in the localenvironment are well understood and incorporated into the decision-making process).

Top-level corporate management has the following functions

• Ensuring continual renewal

• Reducing internal bureaucracy, forcing adaptation and learning, etc.

• Providing purpose and direction

• Facilitating cross-organizational flows (resources, goods, and information).

Staffing country managers are play a vital role and has the following role

• Geocentric approach

• Staffing policy - the selection of employees who have the skills required to perform a particularjob.



Types of approach of staffing in International Human Resources

1. Ethnocentric approach

2. Polycentric approach

Factors associated with employee willingness of the international organization to take expat assignments

• Organization relocation support activities

• Career planning support, selection practices, lead time, training support, mentor support,compensation, family assistance, repatriation support

Employee personal characteristics in International Human Resources

• Age, sex, marital status and children, international experience

• Employee job and relocation attitudes

• International interests, ethnocentrism, career focus, , organizational commitment, readiness forrelocation

• Spouse characteristics and attitudes

• Spouse employment status

5.8 International Finance Management

The Management of finances is a very important operation in the affairs of any organization. Whether itis involved in domestic business or international business. But the financial management aspect is morecomplex or complicated in the case of international business as compared to domestic business onaccount of the differences in currencies; differences in tax policies; differences in economic and politicalconditions; differences in movement of and restrictions on capital; foreign exchange risk; etc. whichaccompany the former. Thus, international financial management requires a thorough understanding ofthese factors and their effective management for the organization’s benefits.

In brief, we can define international financial management as the process that encompasses the followingactivities. The investment decision, the financing decisions, the management of global cash flows andthe management of foreign exchange risk. The organization involved in international business can gain acompetitive edge by managing their International finances effectively and efficiently. For example, certainorganization reduced their cost of raising capital, in 2001 by issuing foreign bonds in Japan instead ofU.S.A. as the interest rates were low in Japan, so debt was available at a cheaper rate or FMC, aChicago based producer of chemicals and farm equipment which generates 40 percent of its salesoutside the home nation, offers its customers stable long term prices for three or more years andprovide them the option of paying in several currencies as per their convenience.

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Investment Decisions

A very important decision which organization involved in international business must take is what projectsare to be financed? and in which national these are to be financed. These questions which relate to theinvestment decisions are of prime importance from the perspective of parent organization. If answeredwrongly then they could create perennial problems for the organization or could lead to heavy losses orcould result in complete failure. On the other hand, if these are answered correctly, then they could leadto increase in profits for the parent organization or increase in market share of the organization or couldprovide a source of competitive edge to the organization. In order to decide about where to invest andwhere not to invest, organization looks at a large numbers of factors like the socio-cultural, economic,political, legal natural and demographic environment of the host nation.

Capital Budgeting

The top management of the organization can take a decision about the investment only when it has adefinite idea about the benefits, costs and risks associated with it. Capital budgeting is a techniquewhich quantifies the benefits, costs and risks involved with an investment or a project. Thus capitalbudgeting allows the top management to easily compare different projects in different nations and makeinformed choices about where to make the investment.

In carrying out capital budgeting the organization involved in international business uses the sametheoretical framework as used by an organization involved in domestic business i.e. the organizationmakes use of concepts like cash inflows, cash outflows, discount rate, etc. In order to find out the NetPresent Value of the project. If the NPV comes out to be greater than zero, then the organization can gofor the project.

In spite of the fact that certain similarities exist between the capital budgeting technique followed by anorganization involved in international business and the technique followed by an organization involved inthe domestic business, there are certain dissimilarities also. Some of the aspects of capital budgetingwhich are specific to foreign project assessment are:

The cash flows occurring from the project must be analyzed from the perspective of the parent organization.

The cash flows occurring to the project are not necessarily the cash flows that will occur to the parentorganization. It is often seen that because of the policies, rules and regulations of the host nation it is notalways possible to remit all the cash flows, which are generated from the project, to the parent organizationin the home nation.

The political risk which refers to the change in the political environment of the host nation that adverselyaffects organization’s goals can substantially reduce the value or expected cash flows of the project.The political risk tends to be more in case of the nations where the government is autocratic, which arepassing through a period of social unrest and which are less developed.



The economic risk associated with the foreign investments are more than the domestic investments, andmainly relate to increase in the inflation rate in the host nation, depreciation in the value of the localcurrency or erratic fluctuations in the exchange rate of the host nation currency. All these developmentsor developments in any of these could drastically affect the cash flows that occur to present organization.

Financing Decisions

Once the organization is able to decide about the foreign project which it will be taking for investment,the next question which arises for it is how to finance the investment? That is the organization has todecide about the source of financing and the structure of financing. In source or external sources forgenerating the required funds. In structure of financing the organization has to decide about the mix ofdebt and equity, which it will be using for financing the project.

Source of Financing

As far as the sources of financing are concerned, the organization has to decide that whether it will beusing internal sources for financing the project or external sources or a combination or the two. If theorganization decides to make use of the internal sources for financing a new project in the host nation,then it has the following options;

If a subsidiary in the host nation is responsible for the new project then it could make use of the fundswhich it gets by selling the product or by providing the service in the host nation. The subsidiary can getthe funds from the parent organization. The subsidiary can also get the required funds from some othersubsidiary in the same nation or from some other nation.

Financial Structure

The financial structure adopted by an organization for financing an investment varies from nation tonation and organization and organization. That is there is no standard format available regarding theamount of debt and equity which should be used for financing the projects in all situations acrossnations, worldwide.


1. What is International Strategic Management?

2. Explain the process of International Strategic Management?

3. What is Global Competitive Advantage?

4. Explain Global Marketing and its advantages and disadvantages?

5. Explain International Finance Management and its functions.

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