Unit 1-Globalisation- Introduction and Overview

Introduction: National economies Moving from being self contained entities to being part
of interdependent, integrated global economic systems globalisation is
enabling the transition.
World trade has grown faster than world output
Nations have become interdependent An economic slowdown in South east
Asia affects USA and Japan
WTO calls for even lower tariffs
After collapse of communism (end of 1980s)- country after country is
adopting capitalism
Countries opting for free market economies are privatising state owned
enterprises, deregulating markets, increasing competition and welcoming
investment
Lee Hong Koo, Prime Minister of South Korea in the mid 1990s sees it
differently: We didnt realize that the victory of the Cold War was a victory for
market forces above politics
Golden StraitJacket
Globalization - Cross-border exchanges of goods, services, capital and
technologies
Definition:
A shift toward a more integrated and interdependent world economy
- An economic/social and cultural phenomenon?
The movement towards the expansion of economic and social ties between
countries through the spread of corporate institutions and the capitalist
philosophy that leads to the shrinking of the world in economic terms.
Golden Straitjacket (Thomas Friedman- journalist)
citizens able to chose from variety of competing pension options including
foreign-run pension and mutual funds
deregulate economy to promote domestic competition
eliminate government corruption, kickbacks and subsidies
Thomas Friedman - As your country puts on the Golden Straitjacket, two things
tend to happen: your economy grows and your politics shrinks.

Implications: The increasing reliance of economies on each other

The opportunities to be able to buy and sell in any country in the world
The opportunities for labour and capital to locate anywhere in the world
Domestic companies feel threatened
Workers in US are afraid of losing jobs
The growth of global markets in finance
Integration of economies: Made possible by:
Technology
Communication networks
Internet access
Growth of economic cooperation trading blocs (EU, NAFTA, etc.)
Collapse of communism
Movement to free trade
The globalization of markets refers to the merging of historically distinct
and separate national markets into one huge global market place
Tastes and preferences of consumers in different countries are converging
Firms like Coca-cola, starbucks, Mcdonalds sell their pdts worldwide
Attending lectures by a British professor teaching in an American University
via a web-conference in NUS
Size of the company is no limiting factor Internet helps small companies
market their pdts.
Globalization of production refers to the sourcing of goods and services
from locations around the globe to take advantage of national differences in
the cost and quality of factors of production
Cost- reduction is the objective
A typical MNC sources its spares and components from different countries
that the final product loses its country affinity and is a global product

Key Driving Forces of Globalization:-

Emergence of global institutions

As markets globalise institutions are needed to help, manage and regulate and
police the global market place.
GATT
WTO primarily responsible for policing the world trading system.
148 member countries that collectively account for 97% of world trade are
WTO members
IMF and World Bank were created in 1944 by 44 nations that met at Bretton
Woods
Task of IMF to maintain order in the international monetary system
Task of World Bank to promote economic development by extending low
interest loans to cash strapped countries
United Nations Established in the yr 1945 by 51 countries committed to
preserving peace through international cooperation and collective security
Developments in transportation and communications
Transport systems are the means by which people, products and
materials are transferred from one place to another
Communication systems are the means by which information is
transmitted from place to place in the form of ideas, instructions and
images
Improvements in transport technology has shrunk the world
19th century steam engine 20th century jet engine, large ocean-going
vessels move people
Containerisation moves goods fast and cheap over long distances
(ships trucks)
Communication
Faster and more convenient communication
People all over the globe can communicate via telephone, e-mail, fax,
video conferencing, etc
Satellite technology allows for simultaneous communication
Optical fibre systems can transmit large amounts of information and
very high speeds
Internet
Internet has enabled consumers to access information instantly,
conveniently and efficiently
Internet has transferred the way people communicate, do business,
obtain information and purchase goods and services
2) Transnational Companies
TNCs set up operations in different parts of the world because:
Sourcing for new markets
Increased international economies of scale
Production of different parts for products and assembly done in a
variety of countries
Lowering cost of production

Greater employment opportunities

Impact of Globalizations:Economic Impact

Improvements in Standards of Living
Increased Competitions among Nations
Investment and Market
Talent
Widening Gap between the rich and poor
Improvements in Standards of Living
As countries trade and open their doors to foreign investment, they
earn more revenue
As a result, their citizens benefit from a higher standard of living
Free trade allows for a larger variety of foreign goods for the
consumer to choose from
Better quality of life
Increased Competition Among Nations
Investment and Market
Globalisation means more competition as TNCs source for the
cheapest places to lower their cost of production
Governments have to compete with each other to attract these
foreign corporations to invest
When China opened its doors to foreign investment in the
1970s, industrial cities like Suzhou, Wuxi and Dalian were
formed
Investment and Market
Competition for markets and investment is intense
Countries that are better able to offer incentives to investors will
be more successful in attracting investment and markets
This results in further growth for the country when infrastructure
is more developed
Talent
Highly skilled people are in high demand all over the globe
Globalisation allows people to move freely from one country to
another in search of employment
Advanced economies with stable or shrinking populations seek
new talent pools
Emerging economies seek back their best and brightest
E.g. Indias Brain Drain (e.g. Computer)
Widening Income Gap between the Rich and the Poor
Rapid development in developed countries and the spread of poverty
in others
Developed countries experience rapid income growth as they own
most of the manufacturing activities
Dominance of global trade by the rich, northern hemisphere countries
continues

These developed countries and their TNCs are able to attract

investments, skilled labor and resources away from poor areas
However, Developing Countries face trade restrictions put up by
Developed Countries
They are not capable of manufacturing better quality goods that fetch
higher prices
Poorer nations are only attractive for labor-intensive and low-cost
ventures
The rich developed countries prosper with better opportunities while
the poor developing countries face economic uncertainties like
retrenchment
Widening income gap can lead to social problems, increasing tension
between the rich and the poor
Social Impact
Increased Awareness of Foreign Culture
Travel, the Internet, mass media (products of globalization allow you to learn more
Loss of Local Culture
Global (Western) brands dominate consumer markets in developing
countries
Creation of homogenous culture across the world
Spread of pop culture and erosion or loss of local culture
Negative influence of youth
Enforced beliefs
Environmental Degradation:Concerns: Depletion of natural resources by TNCs
Concern over profits vs. protection of the environment
Lack of funds to implement environmental protection
Deforestation and Related Problems
Rainforests cut to make way for development
Rainforests cut down for industries, agriculture, housing,
forestry, cattle ranches
Planting of cash crops
Projects to achieve higher level of economic development
Soil erosion, extinction of flora and fauna, flooding
Loss in tourism
Water pollution
Global Warming
Large amount of greenhouse gases produced by
increased usage of airplanes and ships
Factories and transportation also emit greenhouse gases,
contributing to the increase in world average
temperature.
Environmental Management
Greater awareness
Sustainable development is the key to further growth

Source for alternative energy

Key Issues:
Damage to the environment?
Exploitation of labour?
Monopoly power
Economic degradation
Non-renewable resources
Damage to cultures
Accountability
of Global businesses?
Increased gap between rich and poor fuels potential terrorist reaction
Ethical responsibility of business?
Efforts to remove trade barriers
Unit 2- Regional Economic Integeration:Regional economic integration refers to agreements between countries in a
geographic region to reduce tariff and nontariff barriers to the free flow of goods,
services, and factors of production between each other.
While regional trade agreements are designed to promote free trade, there is some
concern that the world is moving toward a situation in which a number of regional
trade blocks compete against each other.
LEVELS OF ECONOMIC INTEGRATION
There are five levels of economic integration:
Free trade area
Customs union
Common market
Economic union
Political union
An Economic Union involves the free flow of products and factors of
production between member countries and the adoption of a common
external trade policy, but it also requires a common currency, harmonization
of members tax rates, and a common monetary and fiscal policy

 A Political Union occurs when a central political apparatus coordinates the

economic, social, and foreign policy of the member states
THE CASE FOR REGIONAL INTEGRATION
The case for regional integration is both economic and political.
The Economic Case for Integration
The Political Case for Integration
Impediments to Integration
against Regional Economic Integration
Regional economic integration only makes sense when the amount of trade it
creates exceeds the amount it diverts
Trade creation occurs when low cost producers within the free trade area
replace high cost domestic producers
Trade diversion occurs when higher cost suppliers within the free trade area
replace lower cost external suppliers

Case

Economic and Political case for integeration:Economic

Stimulates economic growth in countries
Increases FDI and world production
Countries specialize in those goods and services efficiently produced
Additional gains from free trade beyond the international agreements such as
GATT and WTO
Political
Economic interdependence creates incentives for political cooperation
This reduces potential for violent confrontation
Together, the countries have more economic clout to enhance trade with
other countries or trading blocs
Impediments
Integration is hard to achieve and sustain
Nation may benefit but groups within countries may be hurt
Potential loss of sovereignty and control over domestic issues
Case Against Integration: Economists point out that the benefits of regional integration are determined
by the extent of trade creation, as opposed to trade diversion
Trade creation occurs when high cost domestic producers are
replaced by low cost producers within the free trade area
Trade diversion occurs when lower cost external suppliers are
replaced by higher cost suppliers within the free trade area
EU:
There are two trade blocks in Europe: the European Union (EU) and the European
Free Trade Association. (the EU currently has 25 members; the EFTA has 4). Of the
two, the EU is by far the more significant, not just in terms of membership, but also
in terms of economic and political influence in the world economy.
Evolution of the European Union
Political Structure of the European Union

The Single European Act

The Establishment of the Euro
Enlargement of the European Union
Product of two political factors:
Devastation of WWI and WWII and desire for peace
Desire for European nations to hold their own, politically and
economically, on the world stage
1951 - European Coal and Steel Community.
1957- Treaty of Rome establishes the European Community
1994 - Treaty of Maastricht changes name to the European Union

European council
Heads of state and commission
President resolves policy issues and sets policy direction
European Commission
20 Commissioners appointed by members for 4 year terms
Proposing, implementing, and monitoring legislation
European parliament
630 directly elected members
Propose amendments to legislation, veto power over budget and
single-market legislation, appoint commissioners
Court of justice
Council of ministers
The Single Europe Act: This act committed member countries to work toward the establishment of a
single market by December 31, 1992
The act was born out of:
Frustration among members of the European Community regarding the
barriers to the free flow of trade and investment between member
countries
A need to harmonize the wide range of technical and legal standards
for doing business
The Delors Commission proposed that all impediments to the formation of a
single market be eliminated and the Act was enacted in 1987
Objectives:
Remove frontier controls
Mutual recognition of product standards
Open public procurement to non-nationals
Lift barriers to banking and insurance competition
Remove restrictions on foreign exchange transactions
Euro: In December 1991, EC members signed a treaty (the Maastricht Treaty)
that committed them to adopting a common currency by January 1, 1999.14
The euro is now used by 12 of the 25 member states of the European Union;
these 12 states are members of what is often referred to as the euro zone. T

 he 10 countries that joined the EU on May 1, 2004, will adopt the euro when
they fulfill certain economic criteriaa high degree of price stability, a sound
fiscal situation, stable exchange rates, and converged long-term interest
rates.
The current members had to meet the same criteria. Three long-term EU
members, Great Britain, Denmark, and Sweden, are still sitting on the
sidelines.
By mid-2002, all prices and routine economic transactions within the euro
zone were in euros.
Benefits:
Savings from using only one currency
Easy to compare prices, resulting in lower prices
Forces efficiency and slashing costs
Creates liquid pan-Europe capital market
Increases range of investments for individuals and institutions
As of 2004, Euro strong against the dollar and expected to rise
Costs:
Countries lose monetary policy control
European Central Bank controls policy for the Euro zone
EU is not an optimal currency area
Country economies are different
Euro puts the economic cart before the political horse
Strong Euro (2004) makes it harder for Euro zone exporters to sell their
goods
Enlargement of EU: One major issue facing the EU over the past few years has been that of
enlargement
Has become a possibility since the collapse of communism at the end
of the 1980s
By the end of the 1990s 13 countries had applied to become EU
members
In December 2002 the EU formally agreed to accept the applications of 10
countries, which resulted in:
The EU expanding to include 25 states
The addition of 75 million citizens to the EU
Created a single continental economy with a GDP close to 11 trillion
Euros
To qualify for EU membership applicants must:
Privatize state assets
Deregulate markets
Restructure industries
Tame inflation
Enshrine complex EU laws into their own systems
Establish stable democratic governments
Respect human rights

REGIONAL ECONOMIC INTEGRATION IN THE AMERICAS

Regional economic integration is on the rise in the Americas. The North American
Free Trade Agreement (NAFTA) is the most significant attempt.
Other efforts include the Andean group and MERCOSUR.
In addition, there are plans to establish a hemisphere-wide Free Trade Area of the
Americas (FTAA).
The North American Free Trade Agreement

The Andean Community

MERCOSUR
Central American Common Market, CAFTA and CARICOM
Free Trade Area of the Americas

The North American Free Trade Agreement (NAFTA) was ratified by the
governments of the United States, Canada, and Mexico in 1993; it became
law January 1, 1994
The contents of NAFTA includes the following
Over 10 year period: tariffs reduced (99% of goods traded)
Removal of most barriers on cross border flow of services
Removal of restrictions on FDI except in certain sectors
Mexican railway and energy
US airline and radio communications
Canadian culture
Protection of intellectual property rights
Applies national environmental standards
Establishment of commission to police violations

NAFTA Results: Recent surveys indicate that NAFTAs overall impact has been small but
positive
From 1993 to 2004, trade between NAFTAs partners grew by 250
percent
Canadas trade with NAFTA partners increased from 70% to more than
80% of all Canadian foreign trade

Mexicos trade with NAFTA partners increased from 66% to 80% of all
Mexican foreign trade
All countries experienced strong productivity growth
The United States has lost 110,000 jobs per year due to NAFTA
Many economists dispute this figure because more than 2 million jobs
a year were created in the US during the same time period
The most significant impact of NAFTA has not been economic, but political
NAFTA helped create the background for increased political stability in
Mexico
Andean Community: Bolivia, Chile, Ecuador, Colombia, and Peru signed an agreement in 1969 to
create the Andean Pact
The Andean Pact was largely based on the EU model, but was far less
successful at achieving its stated goals
By the mid-1980s, the Andean Pact had all but collapsed and had failed to
achieve any of its stated objectives
Nearly failed. Rejuvenated in 1990 in the Galapagos Declaration
Five current members include Bolivia, Ecuador, Peru, Colombia, and
Venezuela
Objectives included the establishment of a free trade area by 1992, a
customs union by 1994, and common market by 1995
Operates as a customs union currently
Mercosur: Originated in 1988 as a free trade pact between Brazil and Argentina
The pact expanded in March 1990 to include Paraguay and Uruguay
These countries have:
A combined population of 200 million
An average annual growth rate of 3.5% for GDP
MERCOSUR countries have significant trade diversion issues

Other Hemisphere Associations: Central American Common Market

1960s: Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua.
Collapsed in 1969
CARICOM
1973: English-speaking Caribbean countries
19__1: Failed for third time to establish common external tariff
Free Trade Area of the Americas
Talks scheduled for January 2005 did not occur
Two stumbling blocks include intellectual property rights and
reductions in agriculture subsidies
Regional Economic Integration Elsewhere:Various efforts at economic integration are taking place in other parts of the world.
Association of Southeast Asian Nations
Asia Pacific Economic Cooperation

 Regional Trade Blocs in Africa

ASEAN: Created in 1967
Objective to achieve free trade between member countries and achieve
cooperation in their industrial
Brunei, Indonesia, Laos, Malaysia, the Philippines, Myanmar, Singapore,
Thailand, and Vietnam
Progress limited by Asian financial crisis of the 90s
Asia Pacific Economic Cooperation: Founded in 1990 to promote open trade and practical economic cooperation
Promote a sense of community
18 members
50% of worlds GNP
40% of global trade
Despite slow progress, if successful, could become the worlds largest free
trade area
Regional Trade Blocs in Africa
African countries have been experimenting with regional trade blocs for half a
century; there are now 9 trade blocs on the continent
Progress toward the establishment of meaningful trade blocs has been slow
In 2001 Kenya, Uganda, and Tanzania committed themselves to relaunching
the East African Community trade bloc 24 years after it collapsed
The intent is to establish a customs union, regional court, legislative
assembly, and a political federation
Many of these groups have been dormant for years. Significant political
turmoil in several African nations has persistently impeded any
meaningful progress.

Also, deep suspicion of free trade exists in several African countries.

The argument most frequently heard is that because these countries

have less developed and less diversified economies, they need to be
protected by tariff barriers from unfair foreign competition.
Implications for Managers: Opportunities: Creation of single markets
Protected markets, now open
Lower costs doing business in single market
Threats:
Differences in culture and competitive practices make realizing
economies of scale difficult
More price competition
Outside firms shut out of market
EU intervention in mergers and acquisitions
Unit 3- FDI

Foreign direct investment (FDI) occurs when a firm invests directly in new facilities
to produce and/or market in a foreign country
the firm becomes a multinational enterprise
FDI can be in the form of
greenfield investments - the establishment of a wholly new operation in a
foreign country Greenfield operation - mostly in developing nations
Mergers and acquisitions with existing firms in foreign country:
quicker to execute
foreign firms have valuable strategic assets
believe they can increase the efficiency of the acquired firm
more prevalent in developed nations
The flow of FDI - the amount of FDI undertaken over a given time period
Outflows of FDI are the flows of FDI out of a country
Inflows of FDI are the flows of FDI into a country
The stock of FDI - the total accumulated value of foreign-owned assets at a
given time
Both the flow and stock of FDI have increased over the last 30 years
Most FDI is still targeted towards developed nations
United States, Japan, and the EU
but, other destinations are emerging
South, East, and South East Asia especially China
Latin America
India
What are the patterns of FDi: The growth of FDI is a result of
1. A fear of protectionism - want to circumvent trade barriers
2. political and economic changes - deregulation, privatization, fewer
restrictions on FDI
3. new bilateral investment treaties - designed to facilitate investment
4. the globalization of the world economy - many companies now view
the world as their market
5. need to be closer to their customers

Gross fixed capital formation - the total amount of capital invested in

factories, stores, office buildings, and the like
1. the greater the capital investment in an economy, the more favorable
its future prospects are likely to be
So, FDI is an important source of capital investment and a determinant of the
future growth rate of an economy
What is the source of FDI: Since World War II, the U.S. has been the largest source country for FDI
the United Kingdom, the Netherlands, France, Germany, and Japan are
other important source countries
together, these countries account for 60% of all FDI outflows from
1998-2010
Why do firms choose acquisition versus greenfield investments: Most cross-border investment is in the form of mergers and acquisitions
rather than greenfield investments

Firms

between 40-80% of all FDI inflows per annum from 1998 to 2009 were
in the form of mergers and acquisitions
but in developing countries two-thirds of FDI is greenfield
investment because there were fewer target companies
prefer to acquire existing assets because
mergers and acquisitions are quicker to execute than greenfield
investments
it is easier and perhaps less risky for a firm to acquire desired assets
than build them from the ground up
firms believe that they can increase the efficiency of an acquired unit
by transferring capital, technology, or management skills

Why FDI??
Why does FDI occur instead of exporting or licensing?
1. Exporting - producing goods at home and then shipping them to the receiving
country for sale
exports can be limited by transportation costs and trade barriers
FDI may be a response to actual or threatened trade barriers such as
import tariffs or quotas
FDI is more attractive when transportation costs or trade barriers make exporting
unattractive.
Management Focus: Foreign Direct Investment by Cemax explores why
foreign direct investment made more sense for the Mexican cement maker than
exporting. For Cemax, exporting is too costly.
Why Choose FDI?
2. Licensing - granting a foreign entity the right to produce and sell the firms
product in return for a royalty fee on every unit that the foreign entity sells
A firm will favor FDI over licensing when it wishes to maintain control over its
technological know-how, or over its operations and business strategy, or when the
firms capabilities are simply not amenable to licensing.
Internalization theory ( market imperfections theory) - compared to FDI
licensing is less attractive
firm could give away valuable technological know-how to a potential
foreign competitor
does not give a firm the control over manufacturing, marketing, and
strategy in the foreign country
the firms competitive advantage may be based on its management,
marketing, and manufacturing capabilities
What is the Pattern of FDi:Why do firms in the same industry undertake FDI at about the same
time and the same locations?
Knickerbocker - FDI flows are a reflection of strategic rivalry between firms in
the global marketplace
multipoint competition -when two or more enterprises encounter each
other in different regional markets, national markets, or industries

With regard to horizontal FDI, market imperfections arise in two

circumstances:
when there are impediments to the free flow of products between
nations which decrease the profitability of exporting relative to FDI and
licensing
when there are impediments to the sale of know-how which increase
the profitability of FDI relative to licensing
Vernon - firms undertake FDI at particular stages in the life cycle of a product

Radical View: Marxist view: MNEs exploit less-developed host countries

Extract profits
Give nothing of value in exchange
Instrument of domination, not development
Keep less-developed countries relatively backward and dependent on
capitalist nations for investment, jobs, and technology
By the end of the 1980s radical view was in retreat
Collapse of communism
Bad economic performance of countries that embraced the radical
view
Strong economic performance of countries who embraced capitalism
rather than the radical view
a growing belief by many of these countries that FDI can be an important
source of technology and jobs and can stimulate economic growth
in retreat almost everywhere
Free Market View and Pragmatic Socialism: Nations specialize in goods and services that they can produce most
efficiently
Resource transfers benefit and strengthen the host country
Positive changes in laws and growth of bilateral agreements attest to
strength of free market view

embraced by advanced and developing nations including the United

States and Britain, but no country has adopted it in its purest form
All countries impose some restrictions on FDI
Theoretical Approaches to FDi: Pragmatic nationalism - FDI has both benefits (inflows of capital, technology,
skills and jobs) and costs (repatriation of profits to the home country and a
negative balance of payments effect)
FDI has benefits and costs
Allow FDI if benefits outweigh costs
Block FDI that harms indigenous industry
Court FDI that is in national interest
Tax breaks
Subsidies
DP World and the United States explores the reaction to the bid by
DP World, a Dubai-based ports operator, to acquire P&O, a British firm
that runs a network of global marine terminals. An acquisition of P&O
would give DP World management of six U.S. ports. While the Bush
administration claimed the acquisition posed no threat to national
security, several prominent U.S. Senators raised concerns about the
acquisition. Ultimately, DP World pulled out of the deal, but stated that
it would look for alternative ways to enter the U.S. market.
India FDI in retail (impact on kirana stores)
Recently, there has been a strong shift toward the free market stance
creating
a surge in FDI worldwide
an increase in the volume of FDI in countries with newly liberalized
regimes
Pattern of FDI: FDI is expensive because a firm must bear the costs of establishing
production facilities in a foreign country or of acquiring a foreign enterprise.
FDI is risky because of the problems associated with doing business in
another culture where the rules of the game may be different.
But, why is it profitable for firms to undertake FDI rather than continuing to
export from home base, or licensing a foreign firm?
Shift to services
location-specific advantages - that arise from using resource endowments or
assets that are tied to a particular location and that a firm finds valuable to
combine with its own unique assets
externalities - knowledge spillovers that occur when companies in the same
industry locate in the same area
How does FDI benefit the Host Country: There are four main benefits of inward FDI for a host country
1. Resource transfer effects - FDI brings capital, technology, and management
resources
2. Employment effects - FDI can bring jobs
3. Balance of payments effects - FDI can help a country to achieve a current
account surplus

4. Effects on competition and economic growth - greenfield investments

increase the level of competition in a market, driving down prices and
improving the welfare of consumers
can lead to increased productivity growth, product and process
innovation, and greater economic growth
Costs of FDI to Host Country: Inward FDI has three main costs:
1. Adverse effects of FDI on competition within the host nation
subsidiaries of foreign MNEs may have greater economic power than
indigenous competitors because they may be part of a larger
international organization
2. Adverse effects on the balance of payments
when a foreign subsidiary imports a substantial number of its inputs
from abroad, there is a debit on the current account of the host
countrys balance of payments
3. Perceived loss of national sovereignty and autonomy
decisions that affect the host country will be made by a foreign parent
that has no real commitment to the host country, and over which the
host countrys government has no real control
FDI Benefit to Home Country: The benefits of FDI for the home country include
1. The effect on the capital account of the home countrys balance of payments
from the inward flow of foreign earnings
2. The employment effects that arise from outward FDI
3. The gains from learning valuable skills from foreign markets that can
subsequently be transferred back to the home country
Costs of FDI to Home Country:1. The home countrys balance of payments can suffer
from the initial capital outflow required to finance the FDI
if the purpose of the FDI is to serve the home market from a low cost
labor location
if the FDI is a substitute for direct exports
2. Employment may also be negatively affected if the FDI is a substitute for
domestic production
But, international trade theory suggests that home country concerns about
the negative economic effects of offshore production (FDI undertaken to serve the
home market) may not be valid
may stimulate economic growth and employment in the home country
by freeing resources to specialize in activities where the home country
has a comparative advantage
How does Government influence FDI: Governments can encourage outward FDI
government-backed insurance programs to cover major types of
foreign investment risk
Governments can restrict outward FDI
limit capital outflows, manipulate tax rules, or outright prohibit FDI
Governments can encourage inward FDI

offer incentives to foreign firms to invest in their countries

gain from the resource-transfer and employment effects of FDI,
and capture FDI away from other potential host countries
Governments can restrict inward FDI
use ownership restraints and performance requirements
The rationale underlying ownership restraints is twofold:
first, foreign firms are often excluded from certain sectors on the
grounds of national security or competition
second, ownership restraints seem to be based on a belief that local
owners can help to maximize the resource transfer and employment
benefits of FDI for the host country
How do International Instituions Influence FDI: Until the 1990s, there was no consistent involvement by multinational
institutions in the governing of FDI
Today, the World Trade Organization is changing this by trying to establish a
universal set of rules designed to promote the liberalization of FDI
What does FDI mean for Managers?
Managers need to consider what trade theory implies about FDI, and the link
between government policy and FDI
The direction of FDI can be explained through the location-specific
advantages argument associated with John Dunning
however, it does not explain why FDI is preferable to exporting or
licensing, must consider internalization theory

A host governments attitude toward FDI is important in decisions about

where to locate foreign production facilities and where to make a foreign
direct investment
firms have the most bargaining power when the host government
values what the firm has to offer, when the firm has multiple
comparable alternatives, and when the firm has a long time to
complete negotiations

Unit 4:- International Trade Theories

Why international trade Theory: International Trade takes place because of the variations in productive factors
in different countries.
The variations of productive factors cause differences in price in different
countries and the price differences are the main cause of international trade
International trade occurs because individuals, businesses and governments
in one country want to buy goods and services produced in another country.
Countries trade with each other to obtain things that are of better quality,
less expensive or simply different from what is produced at home
Instead of trying to produce everything by themselves, countries often
concentrate on producing things that they can produce most efficiently.
International trade is the system by which countries exchange goods and
services
Economic Gains from Trade: Efficient use of productive factors: All countries are not equally endowed
with natural resources
international trade enables a country to produce only those goods in which it
has a comparative advantage or an absolute advantage and import the rest
from other countries
It leads to international specialisation or division of labour, which, in turn,
enables efficient use of the productive factors with minimum wastages.
Equality in commodity and factor prices: International trade leads to an
equality of the prices of internationally traded goods and productive factors in
all the trading regions of the world (if free trade prevails)
The increase that trade can bring to the total amount of goods and services
available to the national population (increased consumption argument)
Mercantilism: not a full-blown trade theory
an economic policy of governmental accumulation of wealth, in the form of
gold bouillon for:
domestic control
investment
international expansion
reflects the era of nation-building and the shifting of European political
power from feudal lords and the church to national sovereigns;
reflects and supports the principal source of wealth trading
The trade-policy implication of this economic policy was the generation of a
national trade surplus, paid for by accumulation of gold reserves.
Some of this gold found its way to overseas investment by the sovereign.
Absolute Advantage: It is the maxim of every prudent master of the family, never attempt to
make at home what it will cost him more to make than buy What is
prudent in the conduct of every family can scarce be folly in that of a great
kingdom If a foreign country can supply us with a commodity cheaper than
we ourselves can make it, better buy it of them

 Adam Smith 1776

Adam Smith argued that the wealth of nations depends upon the
goods and services available to their citizens, rather than the gold
reserves held by the sovereign.
Maximizing this availability depends, first, on putting all resources to use, and
then, on the ability - to obtain goods and services from where they are produced most cheaply
(because of natural or acquired advantages)

Comparitive Advantage: "A country enabled to manufacture commodities with much less
labour that her neighbours may, in return for such commodities,
import a fraction of the corn required for its consumption, even if
corn could be grown with much less labour than in the country from
which it was imported."
David Ricardo

Gains from trade Potential world production is greater with free trade
Trade is a positive sum game in which all countries that participate
realise economic gains
Countries have comparative advantage in goods for which the opportunity
cost of production is relatively low
That is, those that can be produced by giving up relatively little in
production of other goods

Assumptions: A Simple world in which only two goods exist

No transportation costs exist
Exchange rates not considered
Resources are mobile between production of various goods
We have assumed constant returns to scale

 We have assumed that a country has fixed set of resources and free trade
does not alter the available resources
Extension of Ricardian Model: Immobile Resources : Resources cannot be shifted from the production of one
product to another
Diminishing Returns to Specialisation
Dynamic effects and Economic growth: The efficiency of labour and capital
could increase with free trade. The PPF could therefore shift upward
indicating increased efficiency due to the benefits of free trade
Samuelson: In the case of rich countries, free trade relocates production
facilities to low cost developing countries that could result in loss of jobs. The
decrease in the prices of goods does not really offset the loss of jobs
According to Goldman Sachs, countries that have opted for free trade have
also experienced high growth rates
Production Possibility Frontier Under Diminishing Retunrs:-

Influence of Free trade on PPF

Heckscher Ohlin Theory: Ricardo stressed labor productivity and argued differences in labour
productivity between nations is the basis of trade
Swedish economicsts Eli Heckscher and Bertil Ohlin argued that comparative
advantage arises from differences in factor endowments

 Nations have varying factor endowments and countries will export those
goods that intensely and efficiently makes use of abundant factors available
internally
China abundant availability of low cost labour (hence exports low cost
manufacturing goods)
US is an exporter of agricultural goods due to availability of arable land
Leontief Paradox
Leontief postulated that since US was relatively abundant in capital compared
to other nations, the US would be an exporter of capital intensive goods and
importer of labour intensive goods
Leontief observed that US exports were less capital intensive than labour
intensive Paradox
Possible Explanation: US has a special advantage in producing new pdts with
innovative technology
Production of these products may shift to developing nations because of low
cost labour
US may begin to import these goods and start producing other innovative
products on which it can charge a high price
Ricardos Comparative cost theory gives a suitable answer to the Leontief
Paradox.
Product Life Cycle Theory: Pdts like mass produced automobiles, TV, instant cameras, photo copiers,
PCs) were first developed by US firms and sold in the US mkts
Raymond Vernon , postulated that such innovative products enter maturity
stage, due to increased demand (mass production) they move to low cost
(low labor cost) countries and from here get imported to US. US companies
producing such products also move their production facilities to low labor cost
countries
The demand for most US pdts tend to be on non-price factors.
US thus focuses on developing other new products. They exports these new
products to other developed countries like Japan, European countries where
acceptability is high
Evaluation of PLC theory: PLC theory seems to give an accurate explanation of international trade
Xerox originally exported photocopiers from US to Japan and other
advanced countries
As demand began to grow in these countries Xerox entered into JVs to set up
production in Japan (Fuji-Xerox) and Great Britain (Rank Xerox)
As patents expired, more competitors started entering, US exports of copiers
decreased and US eventually became an importer of copiers
New Trade Theory developed after 1970s
In industries with high fixed costs:
Specialization increases output,
The ability to achieve economies of scale increases through
exporting

 Learning effects are high.

These cost savings come from learning by doing
New Trade Theory Applications: In many industries, world demand will support few competitors
Successful firms may emerge because of
First-mover advantage
First movers capture economies of scale before other entrants and
benefit from a low cost structure (Airbus has first mover advantage
over late entrants like Boeing)
Role of the government becomes significant (Boeing and Airbus
received subsidies from their governments)
learning effects are high. These are cost savings that come from
learning by doing. First movers have this advantage
Some argue that it generates a need for government intervention and
strategic trade policy
National COmpetitve Advantage:-Porters Diamond:Porters 1990 study tried to explain why a nation achieves international success in a
particular industry and identified attributes that promote or impede the creation of
competitive advantage.
The theory attempts to analyze the reasons for a nations success in a
particular industry
Porter studied 100 industries in 10 nations
postulated determinants of competitive advantage of a nation were
based on four major attributes
Factor endowments
Demand conditions
Related and supporting industries
Firm strategy, structure and rivalry

Success occurs where these attributes exist.

More/greater the attribute, the higher chance of success
The diamond is mutually reinforcing
Factor Endowments: Factor endowments:- A nations position in factors of production such as
skilled labor or infrastructure necessary to compete in a given industry
Basic factor endowments : Natural resources
Climate

 Geographic location
Demographics
While basic factors can provide an initial advantage they must be supported
by advanced factors to maintain success
Advanced factor endowments : Are the result of investment by people,
companies, government and are more likely to lead to competitive advantage
Communications skilled labor research
Technology
Education
If a country has no basic factors, it must invest in advanced factors
Demand Condition: Demand:
creates capabilities
creates sophisticated and demanding consumers
Demand impacts quality and innovation
Related and supporting Industries: Creates clusters of supporting industries that are internationally competitive
Must also meet requirements of other parts of the Diamond
Firm Strategy Structure and rivalry: Long term corporate vision is a determinant of success
Management ideology and structure of the firm can either help or hurt you
Presence of domestic rivalry improves a companys competitiveness

Porters theory should predict the pattern of international trade that we

observe in the real world
Countries should be exporting products from those industries where all four
components of the diamond are favorable, while importing in those areas
where the components are not favorable
Implications for business: Location implications:
Disperse production activities to countries where they can be
performed most efficiently
First-mover implications:

 Invest substantial financial resources in building a first-mover, or earlymover advantage

Policy implications:
Promoting free trade is in the best interests of the home-country, not
always in the best interests of the firm, even though, many firms
promote open markets
Unit 5:-The Foreign Exchange Market
The foreign exchange market is simply a market for converting the
currency of one country into that of another country, and an exchange rate
is the rate at which one currency is converted into another.
Second, its used to provide some insurance against foreign exchange risk,
or the adverse consequences of unpredictable changes in exchange rates.
The exchange rate is the rate at which one currency is converted into
another
Events in the foreign exchange market affect firm sales, profits, and strategy
When do firms use foreign exchange market: International companies use the foreign exchange market when
the payments they receive for exports, the income they receive from
foreign investments, or the income they receive from licensing
agreements with foreign firms are in foreign currencies
they must pay a foreign company for its products or services in its
countrys currency
Third, it might be used for short term money market investments. If a
company has a sum of money that it wants to invest for a few months,
it might find that interest rates are higher in foreign locations than at
home.
Fourth, firms that engage in currency speculation where they move
funds from one currency to another in the hopes of making a profit use
the foreign exchange markets.
How can firms hedge against foreign exchange market: The foreign exchange market provides insurance to protect against foreign
exchange risk - the possibility that unpredicted changes in future exchange
rates will have adverse consequences for the firm
A firm that insures itself against foreign exchange risk is hedging
To insure or hedge against a possible adverse foreign exchange rate
movement, firms engage in forward exchanges - two parties agree to
exchange currency and execute the deal at some specific date in the future
Sometimes, companies can be caught off guard when they dont hedge their
currencies. Hedging against adverse exchange rate movements is an
important part of an international firms financial strategy Volkswagen case
Difference between spot rates and forward rates
The spot exchange rate is the rate at which a foreign exchange dealer
converts one currency into another currency on a particular day. Eg - when

youre on a trip to Germany and you change dollars for euros, youll get the
spot rate for the day.
spot rates change continually depending on the supply and demand for
that currency and other currencies
A forward exchange rate is the rate used for hedging in the forward
market
rates for currency exchange are typically quoted for 30, 90, or 180
days into the future
if you know youre going to need 200,000 yen in 30 days to pay for some
components (imports), rather than taking the chance that the rate might
change over the 30 days, you might enter into a forward agreement to buy
the yen now and lockin the rate, and pay for them in 30 days when your
need them.
Currency Swap: A currency swap is the simultaneous purchase and sale of a given amount
of foreign exchange for two different value dates
Swaps are transacted
between international businesses and their banks
between banks
between governments when it is desirable to move out of one currency
into another for a limited period without incurring foreign exchange
rate risk
Nature of foreign exchange market: The foreign exchange market is a global network of banks, brokers, and
foreign exchange dealers connected by electronic communications systems
the most important trading centers are London, New York, Tokyo, and
Singapore
the market is always open and currencies are traded somewhere in the
worldit never sleeps
Do exchange rates differ between markets: High-speed computer linkages between trading centers mean there is no
significant difference between exchange rates and there is a single market
for currencies betwn trading centres
If exchange rates quoted in different markets were not essentially the same,
there would be an opportunity for arbitrage - the process of buying a
currency low and selling it high an d when all dealers do so the gap between
the markets would quickly close.
Most transactions involve dollars on one sideit is a vehicle currency along
with the euro, the Japanese yen, and the British pound
In other words, if you have won, but you need yen, you might first convert
your won into dollars and then the dollars into yen.
How are exchange rates determined: Exchange rates are determined by the demand and supply for different
currencies
The bigger question then becomes what affects the supply and demand for a
currency?

 Three factors impact future exchange rate movements

1. A countrys price inflation
2. A countrys interest rate
3. Market psychology
How do prices influence exchange rates
The law of one price states that in competitive markets free of
transportation costs and barriers to trade, identical products sold in different
countries must sell for the same price when their price is expressed in terms
of the same currency
if you can buy a pair of jeans in New York for $75, then you should be able to
buy the same type of jeans in London for the same price after youve
converted your dollars to pounds.
Purchasing power parity theory (PPP) argues that given relatively
efficient markets (markets in which few impediments to international trade
and investment exist) the price of a basket of goods should be roughly
equivalent in each country
predicts that changes in relative prices will result in a change in
exchange rates
if our basket of goods is a Big Mac, we should be able to buy a Big Mac
in New York, and then take the same amount of money, convert it to
yen, and buy a Big Mac in Japan, or convert the money to pounds, and
buy a Big Mac in London, and so on. If you cant, then you know that
one of the currencies is undervalued or overvalued!

How do interest rates influence exchange rates: The International Fisher Effect states that for any two countries the spot
exchange rate should change in an equal amount but in the opposite
direction to the difference in nominal interest rates between two countries
, in countries where inflation is expected to be high, interest rates will be high
as well, in order to encourage investors to keep their money in the market.
Otherwise, investors would simply shift their money elsewhere.

 If there are no restrictions on capital flows, real interest rates must be the
same everywhere, or an arbitrage situation would exist. In other words, if the
real interest in France was 10 percent, but in the U.S., the real interest rate
was just 6 percent, investors would borrow cheap dollars to invest in
France. This would bring the value of the dollar up, and consequently push
the real interest rate in the U.S. up. In other words:
(S1 - S2) /
S2 x 100 = i $ - i
where i $ and i are the respective nominal interest rates in two countries
(say US and Japan), S1 is the spot exchange rate at the beginning of the
period and S2 is the spot exchange rate at the end of the period
How does investor psychology influence exchange rate: The bandwagon effect occurs when expectations on the part of traders turn
into self-fulfilling prophecies - traders can join the bandwagon and move
exchange rates based on group expectations
1992 when George Soros, a well known international financier, made a huge
bet against the British pound. He borrowed billions of pounds, and sold them
for German marks. This helped push down the value of the pound on foreign
exchange markets, and many other investors jumped on the bandwagon and
sold pounds as well. Another situation where bandwagon effects were
important in the Country Focus on the 1997 fall of the Korean Won.
government intervention can prevent the bandwagon from starting,
but is not always effective
Should companies use exchange rate forecasting services: There are two schools of thought
1. The efficient market school argues that forward exchange rates do the
best possible job of forecasting future spot exchange rates, and, therefore,
investing in forecasting services would be a waste of money
An efficient market is one in which prices reflect all available information
if the foreign exchange market is efficient, then forward exchange
rates should be unbiased predictors of future spot rates
Most empirical tests confirm the efficient market hypothesis suggesting that
companies should not waste their money on forecasting services
2. The inefficient market school argues that companies can improve the
foreign exchange markets estimate of future exchange rates by investing in
forecasting services and therefore forecasting service can be valuable.
An inefficient market is one in which prices do not reflect all available
information
in an inefficient market, forward exchange rates will not be the best
possible predictors of future spot exchange rates and it may be
worthwhile for international businesses to invest in forecasting services
However, the track record of forecasting services is not good
How are exchange rates predicted: There are two schools of thought on forecasting
1. Fundamental analysis draws upon economic factors like interest rates,
monetary policy, inflation rates, or balance of payments information to
predict exchange rates

2. Technical analysis charts trends with the assumption that past trends and
waves are reasonable predictors of future trends and waves
Are all currencies freely convertible:Up until now, weve assumed that a currency can always be converted to another
currency. But, sometimes currencies cant be changed easily.
A currency is freely convertible when a government of a country allows
both residents and non-residents to purchase unlimited amounts of foreign
currency with the domestic currency
A currency is externally convertible when non-residents can convert their
holdings of domestic currency into a foreign currency, but when the ability of
residents to convert currency is limited in some way
A currency is nonconvertible when both residents and non-residents are
prohibited from converting their holdings of domestic currency into a foreign
currency
Most countries today practice free convertibility, although many countries
impose some restrictions on the amount of money that can be converted the
domestic currency is rapidly losing value perhaps because of hyperinflation or
other economic concerns
Countries limit convertibility to preserve foreign exchange reserves and
prevent capital flight - when residents and nonresidents rush to convert
their holdings of domestic currency into a foreign currency
When a countrys currency is nonconvertible, firms may turn to
countertrade - barter like agreements by which goods and services can be
traded for other goods and services
What do exchange rates mean for managers:Managers shld understand the influence of exchange rates on the
profitability of trade and investment deals because an adverse shift in the
value of a currency can make a deal that appeared profitable, a bad choice.
Managers need to consider three types of foreign exchange risk
1. Transaction exposure - the extent to which the income from individual
transactions is affected by fluctuations in foreign exchange values
includes obligations for the purchase or sale of goods and services at
previously agreed prices and the borrowing or lending of funds in
foreign currencies imports become costlier if currency depreciates
2. Translation exposure - the impact of currency exchange rate changes on
the reported financial statements of a company
concerned with the present measurement of past events - Many
American companies with operations in Europe were able to benefit
from translation exposure between 2002 and 2004, when the rising
euro increased dollar profits.
gains or losses are paper losses they are unrealized
3. Economic exposure - the extent to which a firms future international
earning power is affected by changes in exchange rates
concerned with the long-term effect of changes in exchange rates on
future prices, sales, and costs

 This is concerned with the long-term effect of changes in exchanges rates on

future prices, sales, and costs.
Many American firms were affected by this type of exposure in the 1990s
when the rise in the dollar made it difficult to be globally competitive,
Hpw can mangers minimize exchange rate risk: To minimize transaction and translation exposure, managers should
1. Buy forward
2. Use swaps
3. Lead and lag payables and receivables
lead strategy - attempt to collect foreign currency receivables early
when a foreign currency is expected to depreciate and pay foreign
currency payables before they are due when a currency is expected to
appreciate
lag strategy - delay collection of foreign currency receivables if that
currency is expected to appreciate and delay payables if the currency
is expected to depreciate
Lead and lag strategies can be difficult to implement
To reduce economic exposure, managers should
1. Distribute productive assets to various locations so the firms long-term
financial well-being is not severely affected by changes in exchange rates
2. Ensure assets are not too concentrated in countries where likely rises in
currency values will lead to damaging increases in the foreign prices of the
goods and services the firm produces
In general, managers should
1. Have central control of exposure to protect resources efficiently and ensure
that each subunit adopts the correct mix of tactics and strategies
2. Distinguish between transaction and translation exposure on the one hand,
and economic exposure on the other hand
3. Attempt to forecast future exchange rates
4. Establish good reporting systems so the central finance function can regularly
monitor the firms exposure position
5. Produce monthly foreign exchange exposure reports
Unit -6-Political economy of international trade
Free trade occurs when governments do not attempt to restrict what its
citizens can buy from another country or what they can sell to another
country
While many nations are nominally committed to free trade, they tend to
intervene in international trade to protect the interests of politically important
groups
The main instruments of trade policy are:
Tariffs
Subsides
Import Quotas
Voluntary Export Restraints
Local Content Requirements

 Administrative Polices
Antidumping Policies
Tariffs are taxes levied on imports that effectively raise the cost of imported
products relative to domestic products
Specific tariffs are levied as a fixed charge for each unit of a good imported
Ad valorem tariffs are levied as a proportion of the value of the imported
good
Tariffs increase government revenues, provide protection to domestic
producers against foreign competitors by increasing the cost of imported
foreign goods, and force consumers to pay more for certain imports
So, tariffs are unambiguously pro-producer and anti-consumer, and tariffs
reduce the overall efficiency of the world economy
Subsidies are government payments to domestic producers
Consumers typically absorb the costs of subsidies
Subsidies help domestic producers in two ways:
they help them compete against low-cost foreign imports
they help them gain export markets
Import Quotas and voluntary export restraints: Import quotas directly restrict the quantity of some good that may be
imported into a country
Tariff rate quotas are a hybrid of a quota and a tariff where a lower tariff is
applied to imports within the quota than to those over the quota
Voluntary export restraints are quotas on trade imposed by the exporting
country, typically at the request of the importing countrys government
A quota rent is the extra profit that producers make when supply is artificially
limited by an import quota
Import quotas and voluntary export restraints benefit domestic producers by
limiting import competition, but they raise the prices of imported goods
Local Content Requirements: A local content requirement demands that some specific fraction of a good be
produced domestically
Local content requirements benefit domestic producers, but consumers face
higher prices
Administrative trade polices are bureaucratic rules that are designed to
make it difficult for imports to enter a country
These polices hurt consumers by denying access to possibly superior foreign
products
Antidumping policies: Dumping refers to selling goods in a foreign market below their costs of
production, or selling goods in a foreign market below their fair market
value
Dumping enables firms to unload excess production in foreign markets

 Some dumping may be predatory behavior, with producers using substantial

profits from their home markets to subsidize prices in a foreign market with a
view to driving indigenous competitors out of that market, and later raising
prices and earning substantial profits
Antidumping polices (or countervailing duties) are designed to punish foreign
firms that engage in dumping and protect domestic producers from unfair
foreign competition
Case of government intervention:Arguments for government intervention:
Political arguments are concerned with protecting the interests of certain
groups within a nation (normally producers), often at the expense of other
groups (normally consumers)
Economic arguments are typically concerned with boosting the overall wealth
of a nation (to the benefit of all, both producers and consumers)
Political arguments for free trade:Political arguments for government intervention include:
protecting jobs
protecting industries deemed important for national security
retaliating to unfair foreign competition
protecting consumers from dangerous products
furthering the goals of foreign policy
protecting the human rights of individuals in exporting countries
Protecting jobs and industries is the most common political reason for
trade restrictions
Usually this results from political pressures by unions or industries that are
"threatened" by more efficient foreign producers, and have more political
clout than the consumers that will eventually pay the costs
Industries such as aerospace or electronics are often protected because they
are deemed important for national security
Retaliation: When governments take, or threaten to take, specific actions, other countries
may remove trade barriers
If threatened governments dont back down, tensions can escalate and new
trade barriers may be enacted
Protecting consumers
Governments may intervene in markets to protect consumers
Furthering Policy Objectives: Foreign policy objectives can be supported through trade policy
Preferential trade terms can be granted to countries that a government wants
to build strong relations with
Trade policy can also be used to punish rogue states that do not abide by
international laws or norms
However, it might cause other countries to undermine unilateral trade
sanctions

 The Helms-Burton Act and the DAmato Act, have been passed to protect
American companies from such actions
Protecting Human Rights: Trade policy can be used to improve the human rights policies of trading
partners
However, unless a large number of countries choose to take such action, it is
unlikely to be successful
Some critics have argued that the best way to change the internal human
rights of a country is to engage it in international trade
The decision to grant China MFN status in 1999 was based on this philosophy
Economic Arguments for Interventions:Economic arguments for intervention include:
the infant industry argument
strategic trade policy
The infant industry argument suggests that an industry should be
protected until it can develop and be viable and competitive internationally
The infant industry argument has been accepted as a justification for
temporary trade restrictions under the WTO
However, it can be difficult to gauge when an industry has grown up
Critics argue that if a country has the potential to develop a viable
competitive position its firms should be capable of raising necessary funds
without additional support from the government
Strategic trade policy suggests that in cases where there may be
important first mover advantages, governments can help firms from their
countries attain these advantages
Strategic trade policy also suggests that governments can help firms
overcome barriers to entry into industries where foreign firms have an initial
advantage
Revised case for Free trade:Restrictions on trade may be inappropriate in the cases of:
Retaliation and Trade War
Domestic Politics
Retaliation and trade war: Paul Krugman argues that strategic trade policies aimed at establishing
domestic firms in a dominant position in a global industry are beggar-thyneighbor policies that boost national income at the expense of other
countries
Countries that attempt to use such policies will probably provoke retaliation
Domestic policies
Krugman argues that since special interest groups can influence
governments, strategic trade policy is almost certain to be captured by such
groups who will distort it to their own ends

From Smith to the great depression: Until the Great Depression of the 1930s, most countries had some degree of
protectionism
The Smoot-Hawley tariff was enacted in 1930 in the U.S creating significant
import tariffs on foreign goods
Other nations took similar steps and as the depression deepened, world trade
fell further
1947-79: GATT, Trade Liberalization, And Economic Growth: After WWII, the U.S. and other nations realized the value of freer trade, and
established the General Agreement on Tariffs and Trade (GATT)
The approach of GATT (a multilateral agreement to liberalize trade) was to
gradually eliminate barriers to trade
1980-1993: Protectionist Trends
In the 1980s and early 1990s, the world trading system was strained
Japans economic strength and huge trade surplus stressed what had been
more equal trading patterns, and Japans perceived protectionist (neomercantilist) policies created intense political pressures in other countries
Persistent trade deficits by the U.S., the worlds largest economy, caused
significant economic problems for some industries and political problems for
the government
Many countries found that although limited by GATT from utilizing tariffs,
there were many other more subtle forms of intervention that had the same
effects and did not technically violate GATT

The Uruguay Round And The World Trade Organization

The Uruguay Round of GATT negotiations began in 1986
The talks focused on several areas:
Services and Intellectual Property
-going beyond manufactured goods to address trade issues related to
services and intellectual property, and agriculture
The World Trade Organization
-it was hoped that enforcement mechanisms would make the WTO a more
effective policeman of the global trade rules
The WTO encompassed GATT along with two sisters organizations, the
General Agreement on Trade in Services (GATS) and the Agreement on Trade
Related Aspects of Intellectual Property Rights (TRIPS)

WTO: Experience To Date

Since its establishment, the WTO has emerged as an effective advocate and
facilitator of future trade deals, particularly in such areas as services
So far, the WTOs policing and enforcement mechanisms are having a
positive effect
Most countries have adopted WTO recommendations for trade disputes

 In 1997, 68 countries that account for more than 90% of world

telecommunications revenues pledged to open their markets to foreign
competition and to abide by common rules for fair competition in
telecommunications
102 countries pledged to open to varying degrees their banking, securities,
and insurance sectors to foreign competition
The agreement covers not just cross-border trade, but also foreign direct
investment
The 1999 meeting of the WTO in Seattle was important not only for what
happened between the member countries, but also for what occurred outside
the building
Inside, members failed to agree on how to work toward the reduction of
barriers to cross-border trade in agricultural products and cross-border trade
and investment in services
Outside, the WTO became a magnet for various groups protesting free trade

The Future Of The WTO: Unresolved Issues And The Doha Round
The current agenda of the WTO focuses on:
the rise of anti-dumping policies
the high level of protectionism in agriculture
the lack of strong protection for intellectual property rights in many nations
continued high tariffs on nonagricultural goods and services in many nations
The WTO is encouraging members to strengthen the regulations governing
the imposition of antidumping duties
The WTO is concerned with the high level of tariffs and subsidies in the
agricultural sector of many economies
TRIPS obliges WTO members to grant and enforce patents lasting at least 20
years and copyrights lasting 50 years
The WTO would like to bring down tariff rates on nonagricultural goods and
services, and reduce the scope for the selective use of high tariff rates
The WTO launched a new round of talks at Doha, Qatar in 2001
The agenda includes:
cutting tariffs on industrial goods and services
phasing out subsidies to agricultural producers
reducing barriers to cross-border investment
limiting the use of anti-dumping laws

Ubit 6:- national deifferebce-political

Political economy of a nation - how the political, economic, and legal systems
of a country are interdependent

they interact and influence each other

they affect the level of economic well-being in the nation
Political system - the system of government in a nation
Political systems have two dimensions: the degree of collectivism versus
individualism, and the degree of democracy versus totalitarianism.
These dimensions are interrelated; systems that emphasize collectivism tend
towards totalitarianism, while systems that place a high value on
individualism tend to be democratic.
It is possible to have democratic societies that emphasize a mix of
collectivism and individualism.
It is possible to have totalitarian societies that are not collectivist.
The Opening Case: The Polish Surprise explores how Poland has
successfully weathered the recent global financial and economic crisis. After
decades of Communist rule, the country embraced democracy and market
based economic ideals. In addition, Poland implemented privatization
policies and welcomed FDI.

Collectivism stresses the primacy of collective goals over individual goals

can be traced to the Greek philosopher, Plato (427-347 BC)
The needs of society as a whole are generally viewed as being more
important than individual freedoms
Today, collectivism is equated with socialists (Karl Marx 1818-1883)
advocate state ownership of the basic means of production,
distribution, and exchange
manage to benefit society as a whole, rather than individual capitalists
Socialism: In the early 20th century, socialism split into
1. Communism socialism can only be achieved through violent revolution and
totalitarian dictatorship.
This system reached its high point in the 70s
in retreat worldwide by mid-1990s
Communism was swept out of Eastern Europe by a bloodless revolution
of 1989
China freedom in economic but not political space
1. Social democrats socialism is achieved through democratic means eg.
India & Brazil, some European nations in the past
In many countries state ownership of means of production lead to
inefficiency and ran counter to public good
retreating as many countries move toward free market economies
Eg. India (free mkt economy since 1990) state-owned enterprises
have been privatized
Individualism: Individualism refers to philosophy that an individual should have freedom in
his own economic and political pursuits
The welfare of the society is best served by letting people pursue their own
economic-self interest.

 Individual, economic and political freedoms are the ground rules on which a
society should be based.
can be traced to Greek philosopher, Aristotle (384-322 BC)
individual diversity and private ownership are desirable- public
ownership receives little care as against indivl ownership
implies democratic political systems and free market economies
Individualism was refined in the work of number of British followers like
David Hume, Adam Smith and JS Mill.
In recent times Nobel prize winning economists like Milton Friedman,
James Buchanan have championed this philosophy.
Democracy
Democracy - a political system in which government is by the people,
exercised either directly or through elected representatives
usually associated with individualism
pure democracy is based on the belief that citizens should be directly
involved in decision making
most modern democratic states practice representative democracy
where citizens periodically elect individuals to represent them
The safeguards of democracy are 1. an individuals right to
expression, opinion and organisation
2. free media
3. Regular elections in which individuals are allowed to
vote 4. universal adult suffrage
5. limited terms for elected representatives
5. a fair court system that is independent from the political system
6. a
non-political state bureaucracy 8. a nonpolitical police force and armed service
9. relatively free access to state information
Totalitarianism - form of government in which one person or political party
exercises absolute control over all spheres of human life and prohibits
opposing political parties
Totalitarianism denies its citizens all of the constitutional guarantees asserted
by representative democracies.
Communist: a version of collectivism that believes that socialism can be
achieved through collective dictatorship China, Vietnam, Laos, Cambodia,
North Korea
Theocratic: Found in States where political power is monopolized by a
party, group or individuals that governs according to religious principles

Tribal totalitarianism found in states where a political party that

represents the interests of a particular tribe monopolizes power
This system was observed in African countries like Zimbabwe, Tanzania,
Uganda and Kenya.
Right wing totalitarianism: It permits individual economic freedom but
restricts political freedom. Most nations that adopted this system had a
hostility towards socialist or communist ideas
Eg. Fascist regimes of Germany, until early 1980s right-wing dictatorships
were common throughout Latin America. Also in Several Asian countries.

 , China has seen a move toward greater individual freedom in the economic
sphere, but the government is still a totalitarian dictatorship.
Political ideology and economic systems:Political ideology and economic systems are connected
countries that stress individual goals are likely to have market based
economies
in countries where state-ownership is common, collective goals are
dominant
Democracy and individualism go hand in hand, as do the communist version
of collectivism and totalitarianism.
Tribal Totalitarianism: This system was observed in African countries like
Zimbabwe, Tanzania, Uganda and Kenya.
It occurs when a political party that represents a particular tribe monopolizes
power.
Economic system: There are three types of economic systems
1. Market economies - all productive activities are privately owned and
production is determined by the interaction of supply and demand
government encourages free and fair competition between private
producers
Production is determined by the interaction of supply and demand and
signaled to producers through the price system.
For a market to work in this manner there must be no restrictions on supply. A
restriction on supply occurs when a market is monopolized by a single firm. In
such circumstances, rather than increase output in response to increased
demand, a monopolist might restrict output and let prices rise.
Command economies - government plans the goods and services that a
country produces, the quantity that is produced, and the prices at which they
are sold
all businesses are state-owned, and governments allocate resources
for the good of society
because there is little incentive to control costs and be efficient,
command economies tend to stagnate
Consistent with the collectivist ideology, the objective of a command
economy is for government to allocate resources for the good of
society. In addition, in a pure command economy, all businesses are
state owned.
3. Mixed economies - certain sectors of the economy are left to private
ownership and free market mechanisms while other sectors have significant
state ownership and government planning
governments tend to own firms that are considered important to
national security
India has a mixed economy.
Mixed economies were once very common throughout much of the world,
although they are becoming much less so. There was a time not too long ago

when Great Britain, France, and Sweden were mixed economies, but
extensive privatization has reduced state ownership of businesses in all
three.
Legal system - the rules that regulate behavior along with the processes by
which the laws are enforced and through which redress for grievances is
obtained
the system in a country is influenced by the prevailing political system
Legal systems are important for business because they
define how business transactions are executed
identify the rights and obligations of parties involved in business
transactions
A countrys laws regulate business practice, define the manner in
which business transactions are to be executed, and set down the
rights and obligations of those involved in business transactions.
Differences in legal system can affect the attractiveness of a country
as an investment site
Totalitarian states generally restrict private enterprise and the governments with a
political philosophy of individualism tend to be pro-private enterprise and proconsumer
There are three types of legal systems
1. Common law - Common law evolved in England over hundreds of years.
based on tradition, precedent, and custom
Tradition refers to a countrys legal history
Precedent to cases that have come before the court in the past
Customs to the ways in which laws are applied in specific situations
It is now found in most of Great Britains former colonies, including the US
When law courts interpret common law, they do so with regard to these
characteristics. This gives a common law system a degree of flexibility that other
systems lack because it allows the judge to interpret the law.
2. Civic law - based on detailed set of laws organized into codes. More than 80
countries, including Japan, France, Russia, operate within a civil law system A civil
law system tends to be less adversarial than a common law system, since the
judges rely upon detailed legal codes rather than tradition, precedent and custom
which they interpret. Judges under a civil law system have less flexibility than those
under a common law system.
Theocratic law - law is based on religious teachings Islamic law, Hindu law
Islamic Law: Legal system in many Middle Eastern countries
Based on the sharia - a comprehensive code governing Muslim conduct in all
areas of life
Koran and Sunnah- Holy Book
Based on life, sayings, and practices of Muhammad
Identifies forbidden practices haram

Any Westerner doing business in Malaysia in the Middle East

should have, at minimum, a rudimentary understanding of
Islamic law and its implications for commercial activities.
Brewers, for example, must refrain from advertising beer on
billboards or in local-language newspapers.
To the devout muslim acceptance of interest payment is seen as
a grave sin

How are contracts enforced in different legal system: Contract - document that specifies the conditions under which an exchange is
to occur and details the rights and obligations of the parties involved
Contract law is the body of law that governs contract enforcement
under a common law system, contracts tend to be very detailed with
all contingencies spelled out
under a civil law system, contracts tend to be much shorter and less
specific because many issues are already covered in the civil code
This suggests that it is more expensive to draw up contracts in a
common law jurisdiction, and that resolving contract disputes can be a
very adversarial process in common law systems.

Which country law should be applied in dispute: The United Nations Convention on Contracts for the International Sale of
Goods (CIGS)
establishes a uniform set of rules governing certain aspects of the
making and performance of everyday commercial contracts between
buyers and sellers who have their places of business in different
nations
Ratified by the U.S. and about 70 countries
By adopting CIGS, a nation signals to other adopters that it will treat
the conventions rules as part of the law
Thus if a country has ratified CIGS, it applies, unless parties concerned
have opted out of it
but, many larger trading nations including Japan and the U.K. have not
agreed to the provisions of CIGS and opt for arbitration instead
When firms do not opt for CIGS, they opt for arbitration by a recognised
arbitration court to settle disputes
How are property rights and corruption related:Property rights - the legal rights over the use to which a resource is put and over
the use made of any income that may be derived from that resource
Resources include land, buildings, equipment, capital, mineral rights,
businesses, and intellectual property (such as patents, copyrights and
trademarks
Countries differ significantly in the extent to which their legal system protects
property rights. (The law and its enforcement)
Property rights can be violated in two ways- private and public action
Private action : theft, piracy, blackmail by private groups

Russia in the chaotic period following collapse of communism successful

corporate had to pay protection money to mafia
In the United States the Foreign Corrupt Practices Act was passed during
the 1970s following revelations that U.S. companies had bribed government
officials in foreign countries in an attempt to win lucrative contracts.
The Foreign Corrupt Practices Act makes it illegal for U.S. companies to bribe
foreign government officials to obtain or maintain business over which that
foreign official has authority
Requires publicly held companies to institute internal accounting
controls that would record all transactions
However the law uses languages that allows for exceptions known as facilitating or
expediting payments to Facilitate or expedite routine government action
The law distinguishes payment made to maintain business and facilitate
performance
Property rights:Public action - legally - ex. excessive taxation, requiring expensive licenses or
permits from property holders taking assets into state ownership without
compensation
illegally - corruption- taking bribes or blackmailing
Corruption Ferdinand Marcos of Philippines, President Suharto in Indonesia
high levels of corruption reduce foreign direct investment, the level of international
trade, and the economic growth rate in a country
Intellectual Property: Intellectual property - property that is the product of intellectual activity
computer software, new drugs
Intellectual property must be registered in each country where business is
conducted
Can be protected using
1. Patents exclusive rights for a defined period to the manufacture, use, or
sale of that invention
2. Copyrights the exclusive legal rights of authors, composers, playwrights,
artists, and publishers to publish and disperse their work as they see fit
3. Trademarks design and names by which merchants or manufacturers
designate and differentiate their products
Infringement of IPR: Counterfeitingunauthorized copying and production of a product
Associative counterfeit/imitationproduct name differs slightly from a wellknown brand
Piracyunauthorized publication or reproduction of copyrighted work
How can ipr be protected: Many countries participate in international conventions designed for mutual
recognition and protection of intellectual property rights
World Intellectual Property Organization

 Paris Convention for the Protection of Industrial Property

To avoid piracy, firms can
stay away from countries where intellectual property laws are lax
file lawsuits
lobby governments for international property rights agreements and
enforcement
Product safety and liability: Product safety laws set certain standards to which a product must adhere
Product liability involves holding a firm and its officers responsible when a
product causes injury, death, or damage
There are both civil and criminal product liability laws. Civil laws call for
payment and monetary damages. Criminal liability laws result in fines or
imprisonment. Both civil and criminal liability laws are probably more
extensive in the United States than in any other country
liability laws tend to be less extensive in less developed nations
Why is it important: Country differences in product safety and liability laws raise an important
ethical issue for firms doing business abroad. When product safety laws are
tougher in a firms home country than in a foreign country and/or when
liability laws are more lax, should a firm doing business in that foreign
country follow the more relaxed local standards or should it adhere to the
standards of its home country?
Does the high cost of liability insurance in the U.S. make
American companies less competitive
Is it ethical to follow host country standards when product
safety laws are stricter in a firms home country than in a
foreign country?
Is it ethical to follow host country standards when liability laws
are more lax in the host country?
How Can Managers Determine A Markets Overall Attractiveness?
The overall attractiveness of a country as a potential market and/or
investment site for an international business depends on balancing the
benefits, costs, and risks associated with doing business in that country
Other things being equal, more attractive countries have democratic
political institutions, market based economies, and strong legal
systems that protect property rights and limit corruption
The International Monetary System
The international monetary system refers to the institutional
arrangements that countries adopt to govern exchange rates. There are
international agreements that govern exchange rates
A floating exchange rate system exists when a country allows the foreign
exchange market to determine the relative value of a currency US, EU,
Japan and UK

 a dirty float exists when a country tries to hold the value of its
currency within some range of a reference currency- China- Yuan is
allowed to float against a basket of currencies within tight limits
A fixed exchange rate system exists when countries fix their currencies
against each other
European Monetary System (EMS)
A pegged exchange rate system exists when a country fixes the value of
its currency relative to a reference currency Mexico, Lativia and many
countries had pegged their currency with reference to US dollar
The gold standard refers to a system in which countries peg currencies to
gold and guarantee their convertibility
the gold standard dates back to ancient times when gold coins were a
medium of exchange, unit of account, and store of value
payment for imports was made in gold or silver - possible becos
transactions were less
Post industrialisation gold standard was established
payment was made in paper currency which was linked to gold at a
fixed rate
in the 1880s, most nations followed the gold standard
$1 = 23.2 grains of fine (pure) gold
the gold par value refers to the amount of a currency needed to
purchase one ounce of gold
Under the gold standard, each currency was linked to a fixed amount of gold.
The exchange rate between currencies then, was based on the gold par
value, or the amount of a currency needed to purchase one ounce of gold.
In other words, if you had dollars, and needed francs, you would convert your
dollars to gold at the rate of 23.22 grains of gold per dollar, and then convert
the gold to francs at the franc/gold rate.
Why did gold standard make sense?
The great strength of the gold standard was that it contained a powerful
mechanism for achieving balance-of-trade equilibrium for all countries when the income a countrys residents earn from its exports is equal to the
money its residents pay for imports
Eg. Well, if Japan has a trade surplus with the U.S., or exports more to the
U.S. than it imports, dollars flow out of the U.S. to pay for the imports. After
the Japanese exporters cash the dollars in for yen at the Japanese bank, the
Japanese bank will trade them for gold with the U.S. The outflow of gold from
the U.S. will reduce the U.S money supply and increase Japans money supply
causing higher prices in Japan and lower prices in the U.S.
The gold standard worked well from the 1870s until 1914
but, many governments financed their World War I expenditures by
printing money and so, created inflation
Then, in an effort to encourage exports and domestic employment,
countries started to devalue their currencies.
People lost confidence in the system

 demanded gold for their currency putting pressure on countries' gold

reserves, and forcing them to suspend gold convertibility
By 1939, the gold standard was dead
What was Bretton woods system
The great strength of the gold standard was that it contained a powerful
mechanism for achieving balance-of-trade equilibrium for all countries when the income a countrys residents earn from its exports is equal to the
money its residents pay for imports
Eg. Well, if Japan has a trade surplus with the U.S., or exports more to the
U.S. than it imports, dollars flow out of the U.S. to pay for the imports. After
the Japanese exporters cash the dollars in for yen at the Japanese bank, the
Japanese bank will trade them for gold with the U.S. The outflow of gold from
the U.S. will reduce the U.S money supply and increase Japans money supply
causing higher prices in Japan and lower prices in the U.S.
The gold standard worked well from the 1870s until 1914
but, many governments financed their World War I expenditures by
printing money and so, created inflation
Then, in an effort to encourage exports and domestic employment,
countries started to devalue their currencies.
People lost confidence in the system
demanded gold for their currency putting pressure on countries' gold
reserves, and forcing them to suspend gold convertibility
By 1939, the gold standard was dead
What Institutions Were Established At Bretton Woods?
The Bretton Woods agreement also established two multinational institutions
IMF
1. The International Monetary Fund (IMF) to maintain order in the
international monetary system through a combination of discipline and
flexibility
requiring fixed exchange rates stopped competitive devaluations and
brought stability to the world trade environment
fixed exchange rates imposed monetary discipline on countries,
limiting price inflation
in cases of fundamental disequilibrium, devaluations were permitted
the IMF lent foreign currencies to members during short periods of
balance-of-payments deficit, when a rapid tightening of monetary or
fiscal policy would hurt domestic employment
a rigid policy of fixed exchange rates would be too inflexible in a more
global world - the IMF created a fund using contributions from
members that gave it the ability to lend foreign currencies to members
to tide them over during short term balance of payments deficits
2. World bank to promote general economic development
3. The World Bank to promote general economic development - also called the
International Bank for Reconstruction and Development (IBRD) initially designed to lend money to help rebuild Europe, but shifted its role to
helping Third World nations after the Marshall Plan was implemented.

 Countries can borrow from the World Bank in two ways

under the IBRD scheme, money is raised through bond sales in the
international capital market
1. borrowers pay a market rate of interest - the bank's cost of
funds plus a margin for expenses.
through the International Development Agency, an arm of the bank
created in 1960 - raises money through subscriptions from wealthy
members like the U.S.
4. IDA loans go only to the poorest countries which have 50 years to repay at a
1 percent per year rate of interest.
Why Did The Fixed Exchange Rate System Collapse?
Bretton Woods worked well until the late 1960s
It collapsed when huge increases in welfare programs and the Vietnam War
were financed by increasing the money supply and causing significant
inflation- This led to a deterioration of the U.S. foreign trade position, and
speculation that the dollar would have to be devalued.
under the Bretton Woods system, devaluing the dollar meant that all other
currencies would have to be revalueda prospect that wasnt appealing to
other countries that would see the price of their products rise relative to
American products!
In 1971, President Nixon announced that the dollar would no longer be
convertible to gold, and that a 10 percent tariff on all imports would be
implemented unless countries agreed to revalue their currencies.
The dollar was eventually devalued by about 8 percent, but problems
continued to persist. The U.S. continued to expand its money supply, run
high trade deficits, and experience high inflation.
The Bretton Woods system was only viable when the U.S. inflation rate was
low, and the U.S. did not run a balance of payments deficit, and so it
collapsed, and currencies began to float against each other.
Other countries increased the value of their currencies relative to the U.S.
dollar in response to speculation the dollar would be devalued
However, because the system relied on an economically well managed U.S.,
when the U.S. began to print money, run high trade deficits, and experience
high inflation, the system was strained to the breaking point the U.S. dollar
came under speculative attack
What Was The Jamaica Agreement?
After the collapse of Bretton Woods, IMF members got together in 1976 in
Jamaica to formalize the new floating exchange rate system.
Under the Jamaica Agreement,
floating rates were deemed acceptable
gold was abandoned as a reserve asset,
IMF quotas, or the amounts that countries contributed to the IMF, were
increased.
The rules that were agreed on then, are still in place today
What Has Happened To Exchange Rates Since 1973?

 Since 1973, exchange rates have been more volatile and less predictable
than they were between 1945 and 1973 because of
the 1971 oil crisis
the loss of confidence in the dollar after U.S. inflation in 1977-78
the 1979 oil crisis
the rise in the dollar between 1980 and 1985
the partial collapse of the European Monetary System in 1992
the 1997 Asian currency crisis that saw various Asian currencies lose
between 50 and 80 percent of their value!

Which Is Better Fixed Rates Or Floating Rates?

Floating exchange rates provide
1. Monetary policy autonomy
removing the obligation to maintain exchange rate parity restores
monetary control to a government - the government could choose to
expand the money supply to encourage people to buy more (stimulate
dd, I and employment) without worrying about maintaining parity.
2. Automatic trade balance adjustments - For example, if a country is running a
trade deficit, buying more than it sells, the outflow of money will eventually
lead to a depreciation of its currency. This depreciation will make its goods
cheaper in foreign markets, and imports more expensive, and the trade
deficit should eventually correct itself.
3. Under the Bretton Woods System Devaluation is possible only with the
permission of IMF
But, a fixed exchange rate system
1. Provides monetary discipline
ensures that governments do not expand their money supplies at
inflationary rates
2. Minimizes speculation

3.

speculation that occurs with floating exchange rate regimes can cause
currency fluctuations. the dollar fluctuated sharply in the 1980s, and
critics of floating regimes argue that this was the result of speculation
not comparative inflation rates or trade deficits.
For companies, this uncertainty makes planning more challenging
Reduces uncertainty
promotes growth of international trade and investment
the lack of connection between trade balances and exchange rates.
Finally, advocates of floating exchange rates argue that floating rates help
adjust trade imbalances
Critics claim trade deficits reflect the balance between savings and
investment in a country.

Who Is Right?
There is no real agreement as to which system is better
A fixed exchange rate regime modeled along the lines of the Bretton Woods
system will not work
But a different kind of fixed exchange rate system might be more enduring
and might foster the kind of stability that would facilitate more rapid growth
in international trade and investment
What Type of Exchange Rate System Is In Practice Today?
Various exchange rate regimes are followed today
14% of IMF members follow a free float policy
26% of IMF members follow a managed float system
28% of IMF members have no legal tender of their own
the remaining countries use less flexible systems such as pegged
arrangements, or adjustable pegs

What Is A Pegged Rate System?

A country following a pegged exchange rate system, pegs the value of its
currency to that of another major currency
popular among the worlds smaller nations
adopting a pegged exchange rate regime can moderate inflationary
pressures in a country

What Is A Currency Board?

Countries using a currency board commit to converting their domestic
currency on demand into another currency at a fixed exchange rate
the currency board holds reserves of foreign currency equal at the
fixed exchange rate to at least 100% of the domestic currency issued
the currency board can issue additional domestic notes and coins only
when there are foreign exchange reserves to back them
What Is The Role Of The IMF Today?
IMF was originally established to help maintain the exchange rate system
that was set at Bretton Woods.
Today, the IMF focuses on lending money to countries in financial crisis - For
example, the IMF lent money to several Asian countries in 1997.
A currency crisis occurs when a speculative attack on the exchange
value of a currency results in a sharp depreciation in the value of the
currency, or forces authorities to expend large volumes of international
currency reserves and sharply increase interest rates in order to
defend prevailing exchange rates
A banking crisis refers to a situation in which a loss of confidence in
the banking system leads to a run on the banks, as individuals and
companies withdraw their deposits
A foreign debt crisis is a situation in which a country cannot service
its foreign debt obligations, whether private sector or government debt
What Was The Mexican Currency Crisis Of 1995?
The Mexican currency crisis of 1995 was a result of - high Mexican debts, a
pegged exchange rate that did not allow for a natural adjustment of prices
Mexicos pegged currency was the result of its 1982 financial crisis that had
required an IMF bailout. The IMF believed that the peg was necessary to limit
growth in the money supply and to contain inflation.
However, by the mid-1980s, producer prices had risen significantly in Mexico
without a corresponding adjustment in the exchange rate - Mexicos trade
deficit was $17 billion, and investors, reassured by the governments pledge
to maintain the peg, poured money into the country.
Eventually though, currency traders concluded that a devaluation of the peso
was necessary, and began to dump the currency.
The government, after initially trying to maintain the exchange rate, suddenly
devalued the peso, which combined with other selling, added up to a 40
percent drop in value!
At this point, the IMF stepped in to provide assistance and help the country
get back on track.
To keep Mexico from defaulting on its debt, the IMF created a $50 billion aid
package
required tight monetary policy and cuts in public spending
What Was The Asian Currency Crisis?
The 1997 Southeast Asian financial crisis was caused by events that took
place in the previous decade including

1. An investment boom - fueled by huge increases in exports fueling a

boom in commercial and residential property, industrial assets, and
infrastructure.
2. Excess capacity - investments were based on projections of future
demand conditions, resulting in excess capacity
3. High debt - investments were supported by dollar-based debts
4. Expanding imports caused current account deficits
By mid-1997, several key Thai financial institutions were on the verge of
default - They had made loans to companies that werent being repaid,
making it difficult to meet their own debt obligations.
The value of the baht dropped by 55 percent!
speculation against the baht and short selling began
Initially, the Thai government tried to defend its currency, but then
more or less gave up, and allowed the baht to float against the dollar.
Thailand abandoned the baht peg and allowed the currency to float
The IMF provided a $17 billion bailout loan package
required higher taxes, public spending cuts, privatization of stateowned businesses, and higher interest rates
Speculation caused other Asian currencies including the Malaysian Ringgit,
the Indonesian Rupaih and the Singapore Dollar to fall
These devaluations were mainly driven by
excess investment, high borrowings, much of it in dollar denominated
debt, and a deteriorating balance of payments position
The IMF provided a $37 billion aid package for Indonesia
required public spending cuts, closure of troubled banks, a balanced
budget, and an end to crony capitalism
The IMF provided a $55 billion aid package to South Korea
required a more open banking system and economy, and restraint by
chaebol
How Has The IMF Done?
By 2008, the IMF was committing loans to 65 countries in economic and
currency crisis
All IMF loan packages require a combination of tight macroeconomic policy
and tight monetary policy
However, critics worry
the one-size-fits-all approach to macroeconomic policy is
inappropriate for many countries
the IMF is exacerbating moral hazard - when people behave
recklessly because they know they will be saved if things go wrong
the IMF has become too powerful for an institution without any real
mechanism for accountability
But, as with many debates about international economics, it is not clear who
is right
What Does The Monetary System Mean For Managers?
Managers need to understand how the international monetary system affects

1. Currency management - the current system is a managed float government intervention can influence exchange rates
speculation can also create volatile movements in exchange rates
while exchange rate movements can be difficult to predict, they can
have a significant impact on business.
2. Business strategy - exchange rate movements can have a major impact on
the competitive position of businesses
need strategic flexibility to avoid economic exposure
Some foreign suppliers decided that rather than risk trying to pass the
effects of the declining dollar on to consumers in the form of higher
prices, theyd simply accept a smaller profit margin instead.
3. Corporate-government relations - businesses can influence government
policy towards the international monetary system
companies should promote a system that facilitates international
growth and development
Exporters in the U.S. for example, have lobbied for devaluations in the
dollar to make exports more attractive in foreign markets.