The Learning Objectives for Chapter 1 are To define globalization and international business and show how they affect each other To understand why companies engage in international business and why international business growth has accelerated To discuss globalization’s future and the major criticisms of globalization To become familiar with different ways in which a company can accomplish its global objectives To apply social science disciplines to understanding the differences between international and domestic business
This Figure shows the political and legal factors that influence international business operations.
Companies doing business internationally must navigate different philosophies, laws, and attitudes concerning political freedom, property rights, and social responsibility. Managers that understand the differences between countries are in a better position to compete.
The goal of a country’s political system is to integrate the diverse elements of a society. A successful political system unites a society in the face of differing viewpoints. So for example, the peace and prosperity that exists in countries like Sweden and Australia illustrate the success of the political systems in those countries, while the instability and insurrection of Libya’s political system shows its failings.
One standard way to assess a political system is exploring the degree to which it emphasizes individualism versus collectivism. Individualism champions the rights of the individual over those of society. From a business perspective, this suggests that managers have the right to make economic decisions largely free of rules and regulations. You might be aware that countries that have an individualist orientation shape their marketplace with the idea of laissez-faire and support the idea that government should not interfere in business affairs. Under this perspective, individuals are presumed to be self-regulating in promoting economic prosperity and growth, acting fairly and justly to maximize personal performance without threatening the welfare of society. In contrast, collectivism encourages the government to intervene to improve the welfare of the group at the expense of the individual. For business, this means that the ownership of assets, the structure of industries, the conduct of companies, and the actions of managers must improve the welfare of society. Therefore, group members accept the responsibility for making decisions that will benefit everyone. Countries taking a collectivist orientation hold that government will intervene in market situations to ensure that business practices benefit society.
Most countries have competing ideologies. In the United States for example, the Democratic Party competes with the Republican Party to not only describe a vision for the future, but also the means of achieving that future. Most societies today are pluralistic – they have different groups championing different ideologies.
A political spectrum outlines the various forms of political ideology including anarchism, conservatism, secularism, environmentalism, liberalism, feminism, nationalism, socialism, and theocracy. Managers are concerned with the degree of political freedom in a country and its effect on investment choices and operations decisions.
This Figure shows a political spectrum of the various forms of political ideologies. By configuring ideologies along the central axis we can model different political ideologies in relation to each other. The goal of relativity depends on specifying credible ideas to anchor the endpoints of the axis; reasonably set, one can then position alternative ideas. In practice, purely democratic and totalitarian systems are extreme exceptions. Looking around the world, one finds that there are variations of each political ideology. For example, democratic systems range from radical on one side (advocates of extreme political reform) to reactionary (advocates of a return to past conditions). Likewise, totalitarian systems emphasize different degrees of state control; fascism aims to control people’s minds, souls, and daily existence, whereas authoritarianism confines itself to political control of the state. This Figure shows that the majority of political ideologies fall between democracy and totalitarianism.
Understanding the ideals and means of democracy and totalitarianism can help explain the other points on the political spectrum. Democracy calls for participation by citizens in a fair and just decision-making process. Since it supports individualism, companies can make investment and operational decisions based on economic rather than political standards. Under a democracy, commerce and trade is promoted.
A totalitarian system champions the power of a few over the many. Under a totalitarian system, the government maintains control over many aspects of life, the individual is subordinated to the state, and all opposing political and cultural expression is suppressed. Managers operating in a totalitarian state must make decisions based on political rather than economic standards. Typically, local companies are favored over foreign firms forcing multinational companies to make business deals that would not occur in a democratic environment.
Freedom House classifies countries according to their political and civil freedom. A free country has open political competition, respect for civil liberties, independent civic life, and independent media. A partly free country has limited political rights and civil liberties, corruption, weak rules of law, ethnic and religious strife, unfair elections, and censorship. A not free country has few or no political rights and civil liberties.
This Map shows the three types of political freedom identified by Freedom House.
The Third Wave of Democratization refers to the third major surge of democracy in the 20 th century that began in 1974. During this time the number of democratic countries doubled. This steady diffusion of democratic ideology resulted in a situation in which today, some 50 percent of the world’s population lives in a democracy. The rise of democracy was a result of t he failure of totalitarian regimes to deliver economic progress, improved communications technology, and e conomic dividends of increasing political freedom. However, despite these gains, over the last five years, some of the gains in political freedom have declined.
While democracy still retains its appeal worldwide, there are signs that it may actually be in retreat. According to the Economist Intelligence Unit many countries are democracies in name only. The EIU classifies four types of political systems – full democracy, flawed democracy, hybrid regime, and authoritarian regime. Today, 12 percent of the world’s population lives in a full democracy, 37 percent in a flawed democracy, 14 percent in a hybrid regime, and 37 percent in an authoritarian regime. What’s fueling this trend? Several things. One is the growing uncertainty of the relationship between democracy and levels of economic development. A second involves the democracy setbacks in several European countries. Third, the economic problems and in particular the global financial crisis that has plagued the world over the last few years. Finally is the question of just how democracy should be defined and what its standards should be.
This Figure shows the number of electoral democracies over time. Since 2007, there has been a downward trend in the number of democracies and a rise in totalitarian regimes.
This Figure shows the gains and declines in freedom. Notice that early on, freedom exceeds declines, but that more recently, that trend has reversed.
What happens in the future? Managers must watch carefully and adapt their operations and decisions accordingly. The Washington Consensus champions democracy, freedom, the rule of law, and human rights. The Beijing Consensus calls for a one-party system in which elected representatives, preapproved by the ruling party, oversee a nominal democratic system whose citizens, though granted the right to vote, cannot participate in decision making. Under the Clash of Civilizations scenario irreconcilable cultural and religious differences between Islam and the West will trigger a backlash against Western political ideals and their crystallization in the ideologically interventionist Washington Consensus.
Political risk represents a very real threat for companies today especially in fast-growing, emerging markets where weak legal systems, makeshift institutions, volatile cities, and fragile regimes complicate the business environment. Moreover, the global credit crisis has aggravated political risk across both developed and developing markets. There are four categories of political risk. Systemic Risks are r isks that impact all firms that operate in the particular political system. Procedural Risk refers to the risk evolving from the daily movement of people, products, and funds from point to point in the global market. Each move creates a procedural transaction between the units involved, whether units of a company or units of a country. Political actions sometimes create frictions that interfere with these transactions. Distributive Risk is a result of the profits generated by foreign companies in the local economy. If the host country questions the distributive justice of the rewards of operating in its market, it may wonder whether, as the business grows more successful, it is receiving its “fair” share of the growing profits. Finally, Catastrophic Risk includes random political developments that adversely affect the operations of every company in a country. Typically, it arises from specific flash points, such as ethnic discord, illegal regime change, civil disorder, or insurrection. It disrupts the business environment in a way that affects every firm in the country. If such disruptions spiral out of control, they devastate companies and nations.
This Table shows the characteristics of political risk.
International managers must be aware of how a country develops, interprets, and enforces its laws. Legal systems vary across counties because of variations in traditions, precedent, usage, custom, and religious precepts. Modern legal systems are composed of constitutional law which preserves an open and just political order , criminal law which safeguards the social order , and civil and commercial laws which promote fairness . There are five types of legal systems. A c ommon law system is based on tradition, precedent, custom, usage, and interpretation by the courts. A civil law system relies on a systematic collection of codes and statues that judges must follow. A theocratic system is based on religious precepts. A customary legal system follows the wisdom of daily experience. Finally, a mixed legal system combines elements of the other systems.
This Map shows the different legal systems being used by countries today.
The retreat of democracy is also changing the legal environment. As countries shift toward totalitarian regimes, the legal system changes to one in which business activity is regulated by the government to support state objectives. Managers must determine what the basis of rule is in a given country – the rule of man or the rule of law. The rule of man is the basis of a totalitarian system, while the rule of law is the basis of democracy.
This Map shows the distribution of the rule of law across the world. Note that the rule of law prevails in wealthier, Westernized countries, but that the rule of man is in place in many emerging economies. In the past, it was common for managers to avoid countries where the rule of man prevailed, but slow growth in countries dominated by the rule of law is forcing managers to reconsider this approach.
Managers doing business abroad face a complex political and legal environment that makes decision- making in the multinational company challenging. Just starting a new business creates several concerns related to registering the new company’s name, choosing the appropriate tax structure, getting licenses and permits, arranging credit, and securing insurance. Some countries facilitate this process, while others do not. Managers must also be aware of how a country’s political and legal environment affects both entering and enforcing contracts. A contract, which is essential to business transactions, is a binding legal agreement that formally exchanges promises, the breach of which triggers legal proceedings. Countries with common law systems tend to encourage precise, detailed contracts, but countries with civil law systems where the civil code deals with many pertinent issues, encourage shorter and less specific contracts. Another area that managers must explore is related to hiring and firing local workers. However, laws and practices in this area vary greatly across the world. Singapore, New Zealand, and the United States are among the countries with the most flexible labor-regulation statutes. China has the most flexibility in hiring and firing plus the greatest discretion in setting employment conditions, but, Angola, Belarus, and Paraguay place rigid restrictions on firing. Finally, how a business is closed down must be explored. Some countries make the process quite difficult. In the United States, for example, the Internal Revenue Service requires completing a series of forms that report, among many others points, changes in the business structure, the sale of assets, payments to subcontractors, and termination of a retirement plan. Other countries like Ireland, Japan, and Canada allow companies to close their doors much more easily. In general we say that there is an inverse relationship between a nation’s wealth and its tendency to regulate business.
In addition to basic operation decisions managers must also consider longer term strategic issues and how the political and legal environment might influence them. A product’s country of origin – where the product was grown, produced, or manufactured – is important for determining import charges. Many countries require companies to ensure that a certain percentage of a good is made locally. These regulations are called local content rules. Today’s slow economic growth have made “buy-local” campaigns very popular. Marketplace behavior can make strategic decisions challenging especially where rule of man prevails. Governments determine what is permissible in all forms of business activities, including sourcing, distributing, advertising, and pricing products. So managers are vulnerable to abrupt changes that could require them to adjust their manufacturing configuration, their supply chain coordination, and their marketing strategy. Product safety and liability is another strategic areas of concern for managers. Local standards may require companies to customize their products. Since these standards often reflect cultural values or social norms, companies must adapt the product to boost its appeal to local consumers. Countries also have legal jurisdiction to stipulate laws that set the criteria for litigation when agents—whether legal residents of the same or of different countries—are unable to resolve a dispute. Typically, in a cross-national dispute, each company petitions its home-country court to claim jurisdiction hoping that this will ensure more favorable treatment. Finally, companies must consider intellectual property rights and protection in a given country.
The protection of intellectual property has become a hot topic in today’s global economy. Product piracy has become common, and many countries feel that others are not doing enough to safeguard the rights of those who own intellectual property. It is difficult for companies to maintain control over their intellectual property because no “global” patent, trademark, or copyright exists. Therefore, managers must be especially vigilant to ensure that product piracy does not occur. Yet, it can be exceedingly difficult to do so. The business of intellectual property theft is huge. Some estimates suggest that international trade in pirated goods is more than $600 billion a year.
How do countries decide how and if to protect intellectual property? Well, every country’s policies regarding intellectual property are different and reflect the nation’s legal legacies, economic development, and cultural orientation. The largest share of pirated products is made in countries where the rule of man is dominant. Protection tends to be much better in countries where the rule of law prevails. A country’s economic level of development also plays a role in the protection of intellectual property. Poorer countries typically impose fewer regulations compared to wealthier countries. Similarly, intellectual property rights protection tends to be better in countries where individualism is emphasized, whereas in collectivist societies, protection is much lower. Can protection be improved? Perhaps, but it could take awhile. Over time, countries that become idea creators tend to improve their protection of intellectual property. China for example, has long been known for product piracy, but as it has become an idea lab in recent years, it has been making a better effort to protect intellectual property. In general, c ountries that generate intellectual property are strong advocates of protecting ownership rights.
Case Three: It’s a Knockoff World
Globalization and the Internet have been a boon to product piracy. The number of counterfeit products on the market has grown astronomically since 1982 and is costing companies upwards of $600 billion every year. While you might think that only luxury goods makers need to worry about counterfeit products, in reality, just 4 percent of the counterfeit products available are luxury goods. The rest are ordinary, everyday products. Why has counterfeiting grown so much? The answer is profits. Profit margins on counterfeit goods can be incredibly high, and costs are virtually nil. Keep in mind that the legal side of counterfeiting is just one part of the problem though. There is increasing concern that the practice is leading to health and safety problems as well. Some 10 percent of all drugs sold in the United States today are counterfeit, and that number rises as high as 25 to 50 percent in Africa and South-East Asia.
Companies, governments, and industry associations are fighting back using a variety of weapons including filing lawsuits and using anti-copying technology, threatening trade sanctions, and lobbying international bodies like the World Trade Organization for more legislation.
Despite efforts to limit and control product piracy, counterfeiting is not only continuing, it’s growing - especially in countries like India and China. As demand in these markets for Western products continues to rise, income constraints will encourage greater consumption of pirated goods. Moreover, its seems that counterfeiters have the ability to outwit companies and governments and simply change tactics when necessary.
Has the war on product piracy already been lost? Some think so. The pervasiveness and tenacity of software piracy poses profound questions in general, and in the software industry in particular. Consumers and businesses have grown accustomed to low-priced pirated software and have few ethical qualms about buying pirated goods. Furthermore, the global economic crisis, by reducing consumer income, threatens to push more people to seek low-cost counterfeits. Similarly, many in collectivist cultures believe that software makers should honor the welfare of society, abandon their profit-maximizing business models, and shift their products to open-source software.
Managers study economic environments to estimate how market trends and government policy influence the performance of their companies. A country’s economic policies are a leading indicator of a government’s goals and its planned use of economic tools and market reforms. Managers should study a country’s economic environment to assess its development, explain its performance, and estimate its potential. Managers do this knowing countries differ in different ways, economic and political changes alter market circumstances, that it’s critical to make connections between events and predict the consequences of changes, the challenges of the comeback, and choices of citizens, policymakers, and institutions.
Determining which countries warrant investment is not easy. It’s very difficult to assess the potential of a country because any type of assessment relies on behavioral assumptions as well as more scientific principles. There are some 208 discrete economic environments in the world today. Managers need to narrow them down and identify exactly which countries offer the greatest potential return for the least risk.
This Figure shows the economic factors affecting international business environments. The Figure highlights the importance of applying a systems perspective - linkages among elements mean that change in one element in the economy affects other parts.
So, it’s important for managers to monitor a range of economic issues, but perhaps most important is an assessment of economic freedom, or what a manager has the freedom to do. Economic freedom reflects the absence of government coercion or constraint on the production, distribution, or consumption of goods and services beyond the extent necessary for citizens to protect and maintain liberty. In some countries these freedoms are taken for granted, while in others they are rare. Economic freedom advanced in 2011. As you might expect, it tends to be higher in Western countries and lower in Eastern countries.
This Figure shows economic freedom by region. Notice that most people in the world live in countries with lower degrees of economic freedom.
This Map profiles economic freedom around the world. Notice that the most free countries include Hong Kong, Singapore, Australia, and Canada. The United States is only considered mostly free because of increased government spending, debt, and regulations. North Korea, Cuba, and Venezuela are among the least free economies.
Why is economic freedom important? Countries with economic freedom typically have higher per capita income, standards of living, and social stability as compared to less free countries.
For the last few decades, managers generally assumed that economic freedom would increase. However, the recent global financial crisis combined with a resurgence of government intervention has made this assumption questionable. The notion of free markets is losing support in some countries. Governments are now intervening in markets to implement safeguards to protect against a repeat of the recent financial crisis. This intervention of course then limits economic freedom.
Managers can explore a country’s economic system to understand how the host government regulates the economy, protects property rights, sets fiscal and monetary policies, and enforces antitrust regulation. There are three main types of economic systems: market, command, and mixed economies.
This Figure shows the different types of economic systems.
In market economies private interests own resources, and prices determine supply and demand. While there is generally an attitude of laissez-faire the invisible hand does become more visible at times because of the need to provide public goods and protect society. Market economies maximize economic freedom.
In a command economy, governments plan what goods and services will be produced, the quantity in which they are produced, and the price at which they are sold. Command economies constrain economic freedom.
In a mixed economy, both government and private enterprise influence production, consumption, and savings. This type of economy supports socialism and the notion that the partly visible hand of the government commands and controls some factors of production. Therefore, economic freedom in a mixed economy is regulated.
Will free markets prevail or will governments be in control? Many countries today are allowing greater state control. The adoption of state capitalism allows governments to decide how, when, and where assets are valued and resources are allocated. China has been supporting the ideals of state capitalism, and many other countries now see it as an attractive option.
Managers need to assess a country’s level of economic development, performance, and potential. Countries can be classified as developing countries, emerging economies, and developed countries.
One way managers can assess markets is by looking at gross national income or GNI which measures the value of all production in the domestic economy together with the income the country receives from other countries, less similar payments it has made to other countries. Managers can also look at gross national product or GNP. Conceptually, world GNI and world GNP are the same. Gross domestic product or GDP allows managers to assess countries in which the output of multinationals represents a significant share of activity.
It’s important to be careful when using GNI data because it can be misleading. To improve the usefulness of GNI managers should adjust for the growth rate of the economy, the number of people in a country, and the local cost of living.
This Map shows GNI figures for 2009. Notice that high income countries are clustered in just a few regions.
This Map shows GNI per capita adjusted for purchasing power parity or PPP. PPP provides a method of measuring the relative purchasing power of different countries’ currencies for the same basket of goods and services.
In addition to looking at GNI, GNP, and GDP, managers also need to consider sustainability and stability. Green economics allows managers to consider the social and ecological costs of their decisions. The goal should be to create an enabling environment for people to enjoy long, healthy, and happy lives. There is growing criticism of traditional GNI figures as a measure of performance. Research shows that people in rich countries are not significantly happier than people in poor countries. Happynomics focuses on the importance of emotional happiness as a measure of a country’s performance and potential.
Managers can also study other features of an economy including inflation, unemployment, debt, income distribution, poverty, and its balance of payments.
Chronic inflation usually plagues countries where prices have been rising for prolonged periods of time. Deflation occurs when the general price level of goods and services falls. It’s often caused by a reduction in the money supply or a reduction in credit.
The unemployment rate measures the number of workers who want to work but do not have jobs. High unemployment is a warning sign for managers because it symbolizes a government’s ineptitude in managing domestic affairs. Underemployment occurs when people work fewer hours per day than they would prefer or when they work below the level for which they have been trained.
Managers can look at a country’s debt to gauge how much a country borrows from its citizens, foreign organizations, foreign governments, and international institutions. When total debt is high the more uncertain an economy’s performance and potential.
Managers should also look at income distribution to better understand a market’s performance and potential. One trend that is affecting markets across the globe is the growing gap between rich and poor. Managers can estimate inequalities in income distribution using a Gini coefficient. A score of one indicates that one person has all the income. Most countries range between 25 and 60 percent.
Poverty shapes economic environments. While the number of people in extreme poverty in the world has fallen, this figure is misleading because much of the drop has been in a single country, China. Poverty continues to be a problem with as many as 1.2 billion people in poverty. The growth of business and economic progress is dependent on ending poverty. Keep in mind though, that despite being poor, there may still be a market for goods. Some 80 percent of Indians live on less than $2 per day for example, yet there are 700 million cell phone subscribers in the country. The Base of the Pyramid is the largest, but poorest, socioeconomic group in the world who live on less than $2.50 per day. This group may in fact be the future of the global economy prompting the development of frugal engineering which focuses on the needs of poor consumers as a starting point for developing functional, economic products.
A country’s balance of payments is a system of monitoring all of a country’s economic transactions with the rest of the world. It reports the country’s trade and financial transactions with the rest of the world. A current account surplus occurs when exports exceed imports, while a current account deficit occurs when imports exceed exports.
This Table shows the various components of each account in the balance of payments.
This Table shows the countries with the largest current account surpluses and those with the largest current account deficits.
The IMF, which was created in 1945, was formed to promote exchange rate stability and facilitate the international flow of currencies. The IMF monitors the global economy and also the economies of individual nations and provides recommendations as needed. Most recently, the IMF has been involved in the crisis in Greece for example.
Under the Bretton Woods system of par values, the dollar was fixed at $35 per ounce of gold. This became the benchmark against which all other currencies were valued. Under the agreement, currencies could fluctuate within a one percent band of their par value.
The IMF relies on a quota system to generate funds to lend to countries in need. Quotas, which are based on the relative size of a country within the global economy, are important because they influence the voting power of each country. The larger the quota, the higher the voting power. The quota system was reformed in 2010 giving more quota shares to emerging markets. So, while the United States retained its top position, China now holds the number 3 spot, and the BRIC countries are among the largest shareholders in the Fund. Special drawing rights are an international reserve asset given to each country to help increase its reserves. They are also the unit of account in which the IMF keeps its financial records. Currencies making up the SDR basket are the U.S. dollar, the euro, the Japanese yen, and the British pound.
The G20, mindful of the global financial crisis, voted to significantly increase reserves available to the IMF to help countries in distress. Greece has been a beneficiary of IMF funds, but continues to be quite unstable.
In the early 1970s, the United States was in trouble. The country’s large balance-of-trade deficit made it difficult to maintain the fixed exchange rate system prompting then President Richard Nixon to abandon the Bretton Woods system in 1971. A new system, the Smithsonian Agreement was then established, followed by the Jamaica Agreement in 1976.
The IMF requires countries to identify how they base their exchange rate mechanism.
The Table shows different exchange rate arrangements and anchors.
What type of arrangement do countries choose? There are three possibilities: hard peg, soft peg, or floating. Countries can adopt a currency in place of their own. Countries that use the dollar as an exchange arrangement with no separate legal tender are practicing dollarization of the currency. Another option for countries with a hard peg is the currency board. A currency board is an organization generally separate from a country ’ s central bank. Its responsibility is to issue domestic currency that is typically anchored to a foreign currency. If it does not have deposits on hand in the foreign currency, it cannot issue more domestic currency. Most countries following a soft peg arrangement use a conventional fixed-peg arrangement, whereby a country pegs its currency to another currency or basket of currencies and allows the exchange rate to vary plus or minus one percent from that value. It’s more similar to the original fixed exchange-rate system used by the IMF. Floating regimes include floating systems that change according to market forces but may be subject to market intervention, or freely floating systems where intervention is rare. Because countries can change their systems, it’s important for managers to monitor exchange regimes in each country.
The EU countries agreed to political and monetary union with the Treaty of Maastricht in 1992. As part of this agreement the countries decided to replace individual currencies with a single currency, the euro. The Growth and Stability Pact provides the criteria that must be met to be part of the EMU. It includes measures of deficits, inflation, debt, interest rates, and exchange rate stability. Today, 17 of the 27 EU countries have adopted the euro, and others are working toward meeting the criteria. The new currency required companies to update their systems, but should also provide greater price transparency, and eliminate foreign exchange costs and risks. During the global financial crisis, investors fled to dollars as a safe-haven currency and only returned to euros when they were willing to incur more risk. Currently, the financial crisis in Greece is threatening the future of the euro. Moreover, instability in Spain, Portugal, and Italy could also be problematic.
In a free float system, currencies are determined by supply and demand without government intervention.
This Figure shows the equilibrium exchange rate in the market and then a movement to a new equilibrium level as the market changes.
Fixed exchange rates do not automatically change in value according to supply and demand. Instead, they are regulated by central banks like the Federal Reserve in the United States and the European Central Bank in the EU. While central banks maintain reserve assets in gold, foreign exchange reserves, and IMF-related assets, the vast majority of reserve assets is foreign exchange. Central banks use these reserves as they intervene in markets by buying and selling currency to influence its price. Keep in mind that governments vary in their intervention policies by country and by administration.
Black markets often exist in countries that strictly regulate and control the convertibility of their currencies.
Fully convertible currencies can be purchased in unlimited amounts by both residents and nonresidents of a country. Hard currencies are usually fully convertible and strong or relatively stable in value compared to other currencies. In contrast, soft currencies aren’t fully convertible. Soft currencies are sometimes called weak currencies. Governments might try to conserve scarce foreign exchange by imposing exchange restrictions. Licensing occurs when a government requires that all foreign exchange transactions be regulated and controlled by it. Governments can also use multiple exchange rate systems to set different rates for different types of transactions. Governments might also demand advance import deposits prior to releasing foreign exchange to pay for imports. Finally, quantity controls can be used to limit the amount of foreign currency that can be used in a specific transaction.
Relative rates of inflation, differences in real rates of inflation, and confidence in the government’s ability to manage the political and economic environment all influence exchange rates. The Big Mac Index can be used to test PPP. The theory suggests that the price of a burger should be the same from country to country after exchange rates. If prices aren’t the same, then the foreign currency is undervalued or overvalued relative to the dollar. Note that if the domestic inflation rate is lower than that in the foreign country, the domestic currency should be stronger than that of the foreign currency.
Interest rate differentials can have an important effect on exchange rates especially in the short term. The Fisher Effect suggests that the nominal interest rate is the real interest rate plus inflation. Because the real interest rate should be the same in every country, the country with the higher interest rate should have higher inflation. According to the International Fisher Effect, the currency of the country with the lower interest rate will strengthen in the future. In other words, interest rate differentials are unbiased predictors of future changes in spot rates. In addition to interest rates and inflation, exchange rates can be affected by confidence and technical factors.
It’s hard to know what will happen to currencies in the future. There are two main approaches to forecasting exchange rates: fundamental forecasting and technical forecasting. Keep in mind that neither approach works well – in fact, all forecasting tends to be imprecise making it difficult for multinationals to develop operating strategies.
Firms can try to monitor certain fundamental factors as a way to gain some insight as to what might happen with currencies in the future. For freely floating exchange rates, the best predictor of future exchange rates are interest rates for short-term movements, inflation rates for medium-term movements, and current account balances for long-term movements. However, since most currencies are managed at least to some degree, there are other factors to consider as well. Firms should consider the institutional setting and whether, for example, the currency floats or is managed, and how intervention is handled. Fundamental analyses can provide insight as to whether the currency is overvalued or undervalued in terms of PPP. Confidence factors can give some indication about market expectations. It’s also important to consider whether there any national or international events or crises that could impact a currency’s value. Finally, technical analyses can provide information about what trends might be emerging.
Why do firms need to bother trying to predict exchange rate changes? Well, they can dramatically affect operating strategies and profits. Exchange rates changes can affect marketing, production, and financial decisions.
Firms also need to protect against foreign exchange risk. Firms face three types of foreign exchange exposure: translation, transaction, and economic.
To protect against exposure, managers need to define and measure it, set up a monitoring and reporting system, assign responsibility for managing it, and formulate hedging strategies. Hedging strategies can be operational or financial. Operational strategies include using local debt to balance local assets and taking advantage of leads and lags for intercompany payments. Financial strategies might include forward contracts to establish a fixed exchange rate for future transactions, or currency options to ensure access to foreign currency at a specific exchange rate.
The dollar, the euro, the yen, and the yuan will all play a role in the global economy in the future. At this point it is difficult to say just what will happen though. The dollar will probably maintain its position as a benchmark currency in the world, especially given that the euro continues to be a question mark given the problems in Greece and some of the other unstable EU countries like Spain, Portugal, Ireland, and Italy. The Japanese yen will probably not have as much power as the dollar or the euro, but remains one of the most widely traded currencies in the world. However, the yuan could become a major currency. While it’s still not floating freely, it’s going through a significant liberalization process, and could become influential in the future. Similarly, the Brazilian real is emerging as a key currency in Latin America.
Enu business risk pel 050812
Go Global !Global Economic Environment :Sources of Business Risk By Stephen Ong Edinburgh Napier University Business School firstname.lastname@example.org Visiting Professor, College of Management, Shenzhen University 5 August 2012
Learning Objectives To assess a range of political, economic and legal risks faced by companies operating globally To evaluate the main measures taken to offset these risks To analyse three different types of exposure to foreign exchange risk
Introduction Political and Legal Factors Influencing International Business Operations
The Political EnvironmentEvery country has its own political and legal environmentCompanies must determine where, when, and how to adjust their business practices without undermining the basis for success
The Political Environment Managers evaluate, monitor, and forecast political environments A country’s political system refers to the structural dimensions and power dynamics of its government that specify institutions, organizations, and interest groups, and define the norms that govern political activities
Individualism vs. Collectivism Individualism primacy of the rights and role of the individual Collectivism primacy of the rights and role of the community
Political Ideology A political ideology stipulates how society ought to function and outlines the methods by which it will do so Most modern societies are pluralistic different groups champion competing political ideologies Democrats vs. Republicans in the United States Democratic Party vs. Liberal Party in Japan
Spectrum Analysis A political spectrum outlines the various forms of political ideology Political freedom measures the degree to which fair and competitive elections occur the extent to which individual and group freedoms are guaranteed the legitimacy ascribed to the general rule of law the freedom of the press
Democracy In a democracy all citizens are politically and legally equal all are equally entitled to freedom of thought, opinion, belief, speech, and association all equally command sovereign power over public officials Prominent types of democracy include Representative Multiparty Parliamentary Social
Totalitarianism A totalitarian system subordinates the individual to the interests of the collective dissent is eliminated through indoctrination, persecution, surveillance, propaganda, censorship, and violence Prominent types of totalitarianism include Authoritarianism Fascism Secular Theocratic
The Standard of FreedomFreedom House assesses political and civil freedom around the worldFreedom House recognizes three types of political systems Free Partly free Not free
The Standard of Freedom Map of Political Freedom, 2010
Trends in Political Ideologies :Third Wave of Democratization Third Wave of Democratization number of democracies doubled in two decades Engines of Democracy 1. The failure of totalitarian regimes to deliver economic progress 2. Improved communications technology 3. Economic dividends of increasing political freedom
Democracy:Recession and Retreat Democracy’s retreat just 26 of the world’s democracies are full democracies Engines of totalitarianism Economic development Inconsistencies Economics problems Standards of democracy
Democracy:Recession and Retreat Freedom in the World: Number of Electoral Democracies
Democracy:Recession and Retreat Freedom in the World: Gains and Declines
Political Ideology and the MNEWhat will the political map look like in the future? The Washington Consensus The Beijing Consensus The Clash of Civilisations
Political RiskPolitical risk refers to the risk that political decisions or events in a country negatively affect the profitability or sustainability of an investmentTypes: Systemic Procedural Distributive Catastrophic
Classifying Political Risk Characteristics of Political Risk
The Legal EnvironmentThe legal system is the mechanism for creating, interpreting, and enforcing the laws in a specified jurisdictionTypes: Common law Civil law Theocratic law Customary law Mixed systems
The Legal Environment The Wide World of Legal Systems
Trends in Legal Systems What is the basis of rule in a country? The rule of man legal rights derive from the individual who commands the power to impose them associated with a totalitarian system The rule of law systematic and objective laws applied by public officials who are held accountable for their administration associated with a democratic system
Trends in Legal Systems The Worldwide Distribution of the Rule of Law
Operational ConcernsOperational issues Starting a business Entering and enforcing contracts Hiring and firing local workers Closing down the businessIn general rich countries regulate less poor countries regulate more
Strategic ConcernsStrategic issuesCountry of origin and local contentMarketplace behaviorProduct safety and liabilityLegal jurisdictionIntellectual property
Intellectual Property:Rights and Protection Intellectual property refers to creative ideas, expertise, or intangible insights that grant its owner a competitive advantage Intellectual property rights refer to the right to control and derive the benefits from writing, inventions, processes, and identifiers no “global” patent, trademark or copyright exists
Intellectual Property:Rights and Protection Attitudes towards intellectual property Legal legacies rule of man versus rule of law Wealth, poverty, and protection levels of economic development Cultural orientation individualism versus collectivism
Patent Litigation Creative wins MP3 player patent One of Apples main rivals, Creative Technology, has been awarded a patent in the US for the interface used on many digital music players. "The first portable media player based upon the user interface covered in our Zen Patent was our Nomad Jukebox MP3 player," said Creative CEO Sim Wong Hoo."The Apple iPod was only announced in October 2001, 13 months after we had been shipping the Nomad Jukebox based upon the user interface covered by our Zen Patent."In its press release, Creative said Apple had filed for a patent for a user interface in a multimedia player in late 2002, but its application had been recently rejected. On 24 August 2006, Apple and Creative announced a broad settlement to end their legal disputes. Apple will pay Creative US$100 million for a paid-up license, to use Creatives awarded patent in all Apple products. As part of the agreement, Apple will recoup part of its payment, if Creative is successful in licensing the patent. Source: bbc.co.uk 30th August 2005
Apple pays US$100m for use of Patent Automatic hierarchical categorization of music by metadata Patent number : 6928433 Filing date: Jan 5, 2001 Issue date: Aug 9, 2005 Application number : 9/755,723 A method, performed by software executing on the processor of a portable music playback device, that automatically files tracks according to hierarchical structure of categories to organize tracks in a logical order. A user interface is utilized to change the hierarchy, view track names, and... Inventors: Ron Goodman, Howard N. Egan Assignee: Creative Technology LTD Source: bbc.co.uk 30th August 2005
SPOT theDIFFERENCEPINK CREAF NASDAQMarket Cap : AAPLUS$0.150 B Market Cap : US$308.8 B
Big Money, Big Risks Product piracy refers to the illegal imitating, copying, or counterfeiting of registered products The cost of piracy is $600 billion per year Intellectual property theft has grown 10,000% since 1982 Profit margins for counterfeiters are high gross margins of 500-5,000% are common Problems for all products – luxury and ordinary Poses health and safety concerns
Waging a Mulitfront War Companies, governments, and industry associations are fighting back lawsuits and anti-copying technology government sanctions against countries that do not police piracy pressure on transnational bodies to enact and enforce anti-piracy laws WIPO TRIPS
The Bandits Are Everywhere Despite these efforts, piracy continues to rise especially in China and India demand for pirated goods is increasing Crafty pirates staying one step ahead
Is Piracy Inevitable? Has the war on piracy already been lost? Ethical issues regarding the use of pirated products Effect of consumer income on demand for pirated goods Cultural differences on low- priced software is it a right?
Economic Risks Managers assess a country’s economic environment knowing Countries differ in different ways Economic and political changes alter market circumstances It is important to understand connections, change, and consequences The challenges of the comeback Choices of citizens, policymakers, and institutions
International Economic Analysis A universal assessment of economic environments is difficult because it is difficult to stipulate a definitive set of indicators to estimate the performance and potential of a country’s economy today’s set of perfect measures may prove imperfect tomorrow interdependencies complicate interpreting the relationship among elements of the economic environment
International EconomicAnalysis Economic Factors Affecting International Business Operations
Economic Freedom Economic freedom – people have the right to work, produce, consume, save, and invest the way they prefer measured across business freedom, monetary freedom, fiscal freedom, investment freedom, freedom from corruption, property rights, trade freedom, government size, financial freedom, and labor freedom
Economic Freedom Economic Freedom by Region, with Population
Value of Economic Freedom Economic freedom affects Growth rates Productivity Income levels Inflation Employment Life expectancy Literacy Political openness Environmental sustainability
Trends in Economic FreedomThe trend toward increased economic freedom is no longer certain Questions about the legitimacy of free markets The benefits of more state control
Types of Economic Systems An economic system refers to the mechanism that deals with the production, distribution, and consumption of goods and services Types Market economy Command economy Mixed economy
Types of Economic Systems Types of Economic Systems
Market Economy In a market economy individuals rather than governments make most economic decisions Capitalism private ownership of capital Laissez-faire governmental noninterference in economic affairs
Command Economy In a command economy the visible hand of the state supersedes the invisible hand of individuals Government owns and controls resources determines prices Communism
Mixed EconomyMost economies are mixed economies fall between market and command economiesSocialism regulate economic activity with a focus on social equality and a fair distribution of wealth
State Capitalism: Detour or Destination?State capitalism refers to a system in which the government explicitly manipulates market outcomes for political purposes promote certain industries to encourage economic development develop national companies into global leaders foreign companies restricted from strategic industries
Economic Development, Performance, and Potential Broad classes of countries include developing countries largest number of countries low per capita income emerging economies fast growing, relatively prosperous BRICs – Brazil, Russia, India, and China developed countries high per capita income and standard of living like the U.S., Japan, France, Australia
Gross National Income Gross national income (GNI) the broadest measure of economic activity for a country Gross national product (GNP) the total value of all final goods and services produced within a nation in a particular year Gross domestic product (GDP) the total market value of goods and services produced by workers and capital within a nation’s borders
Improving Analysis GNI data should be adjusted for the growth rate of the economy the number of people in a country the local cost of living
Features of an EconomyManagers should also consider Inflation Unemployment Debt Income distribution Poverty Balance of payments
InflationInflation a measure of the increase in the cost of livingDeflation when prices for products go down not upReflation increase the money supply and reduce taxes to accelerate economic
UnemploymentUnemployment rate share of unemployed workers seeking employment for pay relative to the total civilian labor forceMisery index the sum of a country’s inflation and unemployment rates
Debt Debt the total of a government’s financial obligations internal debt external debt Growing public debt signals tax increases reduced growth rising inflation increasing austerity
Income DistributionIncome distribution estimates the proportion of the population that earns various levels of incomeGini coefficient measures the extent to which the distribution of resources deviates from a perfectly equal distribution
Poverty Poverty the state of having little or no money and few or no material possessions extreme poverty less than $1.25 per day moderate poverty less than $2.00 per day Today the world population is 80% poor, 10% middle income, and 10% rich Base of the Pyramid Frugal engineering
Balance of PaymentsBalance of payments reports a country’s trade and financial transactions with the rest of the worldCurrent account tracks merchandise tradeCapital account tracks loans given to foreigners and loans received by citizens
Balance of Payments Components of a Country’s Balance of Payments
Balance of Payments (2011) Current Account Balances: The Top and Bottom Five
Foreign Exchange & TheInternational Monetary Fund The goals of the International Monetary Fund (IMF) (1945) are to ensure stability in the international monetary system promote international monetary cooperation and exchange-rate stability facilitate the balanced growth of international trade provide resources to help members in balance- of-payments difficulties or to assist with poverty reduction
The International Monetary FundThe Bretton Woods Agreement established a par value, or benchmark value, for each currency initially quoted in terms of gold and the U.S. dollar ($35/oz)The dollar became the world benchmark for trading currencies and continues in that role today
The IMF TodayThe Quota System every member contributes a quotaAssistance Programs the IMF lends money to ease balance-of- payments difficultiesSpecial drawing rights (SDRs) the IMF’s unit of account
The Global Financial Crisis and the IMFThe global crisis in 2008-2009 raised concerns over global liquidity prompted the G20 to inject huge amounts of cash into the IMFGreece’s 2010-2011 financial crisis required assistance from the IMF and the EU the IMF required Greece to adopt very unpopular austerity measures
Evolution to Floating ExchangeRatesThe Smithsonian Agreement (1971) 8% devaluation of the dollar revaluation of other currencies widening of exchange rate flexibilityThe Jamaica Agreement (1976) provided greater exchange rate flexibility eliminated the use of par values
Exchange Rate ArrangementsUnder the Jamaica Agreement countries selected and maintained their own exchange rate arrangementsThe IMF monitors the exchange rate policies of countries to see if they are acting openly and responsibly
Exchange Rate Arrangements Exchange Rate Arrangements and Anchors
Three Choices:Hard Peg, Soft Peg, or Floating The IMF classifies currencies into three categories Hard peg 12.2% of total value is locked into something and does not change dollarization currency boards Soft peg 45.7% of total more flexible than hard peg Floating 42.1% of total floating or freely floating
The Euro The European Monetary System (EMS) (1992) established to create exchange rate stability within the European Community European Monetary Union (EMU) outlined the criteria for euro applicants (17/27) the U.K., Sweden, and Denmark opted not to adopt the euro The European Central Bank (ECB) sets monetary policy for the adopters of the euro
Determining Exchange RatesCurrency in a floating rate world demand for a country’s currency is a function of the demand for that country’s goods and services and financial assets
Determining Exchange Rates The Equilibrium Exchange Rate and How it Moves
Determining Exchange Rates Currency in a fixed rate or managed floating rate world Role of central banks reserve assets intervening in the market attitudes toward intervention The Bank for International Settlements (BIS) the central banks’ bank coordinates central bank intervention
Black MarketsA black market closely approximates a price based on supply and demand for a currency instead of a government controlled price
Foreign ExchangeConvertibility and Controls Hard currencies U.S. dollar, euro, British pound, Japanese yen Soft currencies developing countries Countries can control convertibility through licenses multiple exchange rate systems advance import deposits quantity controls
Exchange Rates and Purchasing Power ParityPurchasing power parity (PPP) a change in relative inflation between two countries must cause a change in exchange rates to keep the prices of goods in the countries fairly similarThe Big Mac Index
Exchange Rates and InterestRatesThe Fisher Effect links inflation and interest ratesThe International Fisher Effect (IFE) links interest rates and exchange ratesOther Factors in Exchange Rate Determination Confidence (speculation) information(speculation) trade flows
Fundamental and Technical Forecasting Forecasting exchange rates Fundamental forecasting uses trends in economic variables to predict future rates Technical forecasting uses past trends in exchange rates to spot future trends Biases can skew forecasts Timing, direction, and magnitude of exchange rate movements are important to consider
Business Implications of ExchangeRate Changes Marketing Decisions when the value of a country’s currency rises, exporting becomes more difficult as the product becomes more expensive in foreign markets Production Decisions might locate production in a weak currency country because the initial investment is cheap and it will make a good base for exports Financial Decisions currency rates influence sourcing, cross-border remittance of funds, and the reporting of financial results
Foreign Exchange Risk Management Types of foreign exchange exposure Translation exposed accounts either gain or lose value in dollars when the exchange rate changes Transaction when a transaction is denominated in a foreign currency and the settlement results in a cash flow gain or loss Economic or operating the potential for change in expected cash flows that arises from the pricing of products, the sourcing and cost of inputs, and the location of investments
Foreign Exchange Risk Management Exposure Management Strategy Defining and measuring exposure Creating a reporting system Adopt a policy assigning responsibility for minimizing or hedging exposure Formulating hedging strategies Operational leads and lags strategy Financial forward contracts and currency options
The Future: The Dollar, TheEuro, The Yen, The Yuan Europe the euro should take market share away from the dollar as the prime reserve asset assuming the problems in PIIGS, ie Greece and other countries are controlled ??? Asia China is moving forward to establish the yuan as a major world currency ??? Latin America emerging market currencies should strengthen as commodity prices recover ???
Conclusion“A monetary system that functions poorly may … subject economies to disruptive shocks.” Robert Solomon
Casestudy : IKEA1. Read and prepare the Casestudy on IKEA (Johnson, Whittington & Scholes (2011)) for discussion and presentation next week.2. Identify and evaluate the challenges facing IKEA during the global recession, by conducting External Environment, Industry, Competitor analysis and SWOT.
Core Reading Juleff, L, Chalmers, A.. and Harte, P. (2008) Business Economics in a Global Environment, Napier University Edinburgh Daniels, J.D., Radebaugh, L.H. and Sullivan, D.P. (2012) International Business: Environments and Operations. 14th edition, Pearson