international management

International Business

Competing in the Global Marketplace

11e

Charles W.L. Hill G. Tomas M. Hult

I n t e r n a t i o n a l B u s i n e s s

C O M P E T I N G I N T H E

G L O B A L M A R K E T P L A C E

I n t e r n a t i o n a l B u s i n e s s

C h a r l e s W. L . H i l l U N I V E R S I T Y O F W A S H I N G T O N

G . T o m a s M . H u l t M I C H I G A N S T A T E U N I V E R S I T Y

1 1 E

C O M P E T I N G I N T H E

G L O B A L M A R K E T P L A C E

F o r J u n e & M i k e H i l l , m y p a r e n t s — C h a r l e s W. L . H i l l

F o r G e r t & M a r g a r e t a H u l t , m y p a r e n t s —

G . T o m a s M . H u l t

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about the AUTHORS C h a r l e s W. L . H i l l U n i v e r s i t y o f W a s h i n g t o n

Charles W. L. Hill is the Hughes M. and Katherine Blake Professor of Strategy and International Business at the Foster School of Business, University of Washington. The Foster School has a Center for International Business Education and Research (CIBER), one of only 17 funded by the U.S. Department of Education. Professor Hill received his PhD from the University of Manchester in the United Kingdom. In addition to the University of Washington, he has served on the facul- ties of the University of Manchester, Texas A&M University, and Michigan State University. Professor Hill has published over 50 articles in peer-reviewed academic journals including the Academy of Management Journal, Academy of Management Review, Strategic Management Journal, and Organization Science. Professor Hill has also published several textbooks including International Business (McGraw-Hill) and Global Business Today (McGraw-Hill). His work is among the most widely cited in international business and strategic management. Professor Hill has taught in the MBA, Executive MBA, Technology Management MBA, Management, and PhD programs at the University of Washington. During his time at the University of Washington he has received over 25 awards for teaching excellence, including the Charles E. Summer Outstanding Teaching Award. Professor Hill works on a private basis with a number of organizations. His clients have included Microsoft, where he has been teaching in-house executive education courses for two decades. He has also consulted for a variety of other large companies (e.g., AT&T Wireless, Boeing, BF Goodrich, Group Health, Hexcel, Microsoft, Philips Healthcare, Philips Medical Systems, Seattle City Light,  Swedish Health Services, Tacoma City Light, Thompson Financial Services, WRQ, and Wizards of the Coast). Professor Hill has served on the advisory board of several start-up companies. For recreation, Professor Hill enjoys mountaineering, rock climbing, skiing, and competitive sailing.

G . T o m a s M . H u l t M i c h i g a n S t a t e U n i v e r s i t y

G. Tomas M. Hult is the John W. Byington Endowed Chair, professor of marketing and international business, and director of the International Business Center in the Eli Broad College of Business at Michigan State University. Professor Hult is an elected Fellow of the Academy of International Business (AIB), one of only about 80 scholars worldwide receiving this honor, and serves as the executive director and foundation president of AIB. He also serves on the U.S. District Export Council and holds board member positions on the International Trade Center of Mid-Michigan and the Sheth Foundation. Several studies have ranked Professor Hult as one of the most cited scholars in the world in business and management. He has served as editor of Journal of the Academy of Marketing Science and has published more than 50 articles in premier business journals, including Journal of International Business Studies, Academy of Management Journal, Strategic Management Journal, Journal of Management,

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Journal of Marketing, Journal of the Academy of Marketing Science, Journal of Retailing, Journal of Operations Management, Decision Sciences, and IEEE.  Professor Hult has also published several books: International Business (2017), Global Business Today (2016), Global Supply Chain Management (2014), Total Global Strategy (2012), and Extending the Supply Chain (2005). He is a regular contributor of op-ed and articles in the popular press (e.g., Time, Fortune, World Economic Forum, The Conversation). Professor Hult is a well-known keynote speaker on international business, international marketing, global supply chain management, global strategy, and marketing strategy. He teaches in doctoral, master’s, and undergraduate programs at Michigan State University, plus he is a visiting professor at Leeds University (United Kingdom) and Uppsala University (Sweden). He also teaches frequently in executive development programs and has developed a large clientele of the world’s top multinational corporations (e.g., ABB, Albertsons, Avon, BG, Bechtel, Bosch, BP, Defense Logistics Agency, Domino’s, FedEx, Ford, FreshDirect, General Motors, GroceryGateway, HSBC, IBM, Michigan Economic Development Corporation, Masco, NASA, Raytheon, Shell, Siemens, State Farm, Steelcase, Tech Data, and Xerox). Tomas Hult is a dual citizen of the United States and Sweden and lives in Okemos, Michigan, with his wife, Laurie, and their children, Daniel and Isabelle. Tennis, golf, and traveling are his favorite recreational activities.

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brief CONTENTS

part one Introduction and Overview Chapter 1 Globalization 2

part two National Differences Chapter 2 National Differences in Political, Economic, and

Legal Systems 38

Chapter 3 National Differences in Economic Development 62

Chapter 4 Differences in Culture 90

Chapter 5 Ethics, Corporate Social Responsibility, and Sustainability 128

part three The Global Trade and Investment Environment Chapter 6 International Trade Theory 160

Chapter 7 Government Policy and International Trade 194

Chapter 8 Foreign Direct Investment 224

Chapter 9 Regional Economic Integration 254

part four The Global Monetary System Chapter 10 The Foreign Exchange Market 286

Chapter 11 The International Monetary System 312

Chapter 12 The Global Capital Market 340

part five The Strategy and Structure of International Business Chapter 13 The Strategy of International Business 362

Chapter 14 The Organization of International Business 392

Chapter 15 Entry Strategy and Strategic Alliances 430

part six International Business Functions Chapter 16 Exporting, Importing, and Countertrade 460

Chapter 17 Global Production and Supply Chain Management 484

Chapter 18 Global Marketing and R&D 516

Chapter 19 Global Human Resource Management 554

Chapter 20 Accounting and Finance in the International Business 582

part seven Integrative Cases Making the Apple iPhone 609

Revolution in Egypt 610

Ghana: An African Dynamo? 612

Walmart Can’t Conquer All Countries 613

Ethics of Exporting Used Batteries 614

The Rise of India’s Drug Industry 615

China Limits Exports of Rare Earth Metals 616

Foreign Retailers in India 618

I Want My Greek TV! 619

The Rise and Fall of the Japanese Yen 619

Currency Trouble in Malawi 620

The IPO of the Industrial and Commercial Bank of China 621

Making Ford Globally Competitive 622

Organizing Siemens for Global Competitiveness 623

JCB Pins Hopes on the Indian Market 624

MD International and Latin America 625

Amazon Kindle Evolution 626

Burberry’s Global Brand 627

MMC China Joint Venture 628

Brazil’s Gol Airlines 629

Glossary 631 Index 643

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THE PROVEN CHOICE FOR INTERNATIONAL BUSINESS

RELEVANT. PRACTICAL. INTEGRATED. It is now about a quarter of a century since work began on the first edition of International Business: Competing in the Global Marketplace. By the third edition the book was the most widely used international business text in the world. Since then its market share has only increased. The success of the book can be attributed to a number of unique features. Specifically, for the eleventh edition we have developed a learning program that

∙ Is comprehensive, state of the art, and timely. ∙ Is theoretically sound and practically relevant. ∙ Focuses on applications of international business

concepts. ∙ Tightly integrates the chapter topics throughout. ∙ Is fully integrated with results-driven technology.

Over the years, and through now eleven editions, Dr. Charles Hill has worked hard to adhere to these goals. The eleventh edition, with Dr. Tomas Hult as a coauthor, follows the same approach. It has not always been easy. An enormous amount has happened over the past years, both in the real world of economics, politics, and business, and in the academic world of theory and empirical research. Often, we have had to significantly rewrite chapters, scrap old examples, bring in new ones, incorporate new theory and evidence into the material, and phase out older theories that are increasingly less relevant to the dynamic world of international business. As noted later, there have been significant changes in this edition—and that will no doubt continue to be the case in the future. In deciding what changes to make, we have been guided not only by our own reading, teaching, and research, but also by the invaluable feedback we received from professors and students around the world, from reviewers, and from the editorial staff at McGraw-Hill. Our thanks go out to all of them.

RELEVANT AND COMPREHENSIVE To be relevant and comprehensive, an international busi- ness package must

∙ Explain how and why the world’s cultures, coun- tries, and regions differ.

∙ Cover economics and politics of international trade and investment.

∙ Tackle international issues related to ethics, cor- porate social responsibility, and sustainability.

∙ Explain the functions and form of the global mon- etary system.

∙ Examine the strategies and structures of interna- tional businesses.

∙ Assess the special roles of an international busi- ness’s various functions.

This text has always endeavored to be relevant, practical, and integrated. Too many other products have paid insuffi- cient attention to some portion of the topics mentioned, be- ing skewed toward a particular portion of international business. Our goal has always been to cover macro and mi- cro issues equally, and in a relevant, practical, and inte- grated manner. We believe that anything short of such a breadth and depth of coverage is a serious deficiency. Many of the students in these international business courses will soon be working in international businesses, and they will be expected to understand the implications of international business for their organization’s strategy, structure, and functions in the context of the global marketplace. We are proud and delighted to have put together this international business learning experience for the leaders of tomorrow. Relevance and comprehensiveness also require cover- age of the major theories. It has always been a goal to in- corporate the insights gleaned from recent academic scholarship into the book. Consistent with this goal, in- sights from the following research, as a sample of theo- retical streams used in the book, have been incorporated:

∙ New trade theory and strategic trade policy. ∙ The work of Nobel Prize–winning economist

Amartya Sen on economic development. ∙ Samuel Huntington’s influential thesis on the

“clash of civilizations.” ∙ Growth theory of economic development champi-

oned by Paul Romer and Gene Grossman. ∙ Empirical work by Jeffrey Sachs and others on

the relationship between international trade and economic growth.

∙ Michael Porter’s theory of the competitive advan- tage of nations.

∙ Robert Reich’s work on national competitive advantage.

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∙ The work of Nobel Prize–winner Douglass North and others on national institutional structures and the protection of property rights.

∙ The market imperfections approach to foreign direct investment that has grown out of Ronald Coase and Oliver Williamson’s work on transac- tion cost economics.

∙ Bartlett and Ghoshal’s research on the transna- tional corporation.

∙ The writings of C. K. Prahalad and Gary Hamel on core competencies, global competition, and global strategic alliances.

∙ Insights for international business strategy that can be derived from the resource-based view of the firm and complementary theories.

∙ Paul Samuelson’s critique of free trade theory. ∙ Conceptual and empirical work on global supply

chain management—logistics, purchasing (sourc- ing), operations, and marketing channels. 

In addition to including leading-edge theory, in light of the fast-changing nature of the international business en- vironment we have made every effort to ensure that this product was as up to date as possible when it went to press. A significant amount has happened in the world since we began revisions of this book. By 2016, almost $4 trillion per day was flowing across national borders. The size of such flows fueled concern about the ability of short-term speculative shifts in global capital markets to destabilize the world economy. The world continued to become more global. Several Asian economies, most notably China and India, contin- ued to grow their economies at a rapid rate. New multi- nationals continued to emerge from developing nations in addition to the world’s established industrial powers. Increasingly, the globalization of the world economy af- fected a wide range of firms of all sizes, from the very large to the very small. And unfortunately, global terror- ism and the attendant geopolitical risks keep emerging in various places globally, many new and inconceivable just a decade ago. These represent a threat to global eco- nomic integration and activity.

What’s New in the Eleventh Edition The most obvious change to the eleventh edition of Inter- national Business is the addition of a coauthor, G. Tomas M. Hult. Professor Hult is the John W. Byington Endowed Chair, professor of marketing and international business, and director of the International Business Center in the Eli Broad College of Business at Michigan State Univer- sity. He is a notable scholar in the area of international business, marketing, and management, and a well-known expert on global supply chain management, global strategy,

and marketing strategy. In addition, he has played a major role in the Academy of International Business, and is cur- rently the executive director and foundation president of the Academy of International Business. I am delighted to have Tomas on the book. Tomas has been a long-term user of the book and has contributed end-of-chapter material to the book for many editions (e.g., he is responsible for the Research Tasks that use Michigan State’s globaledge.msu.edu knowledge re- source). I believe that his skills complement my own. His energy, enthusiasm, and knowledge base helped make an already strong book even better. Tomas has made significant new contributions to all chapters in this edition, including most notably Chapters 4 on culture; Chapter 5 on ethics, corporate social responsibility, and sustainability; Chapters 10 to 12 on the global monetary system; Chapters 13 to 15 on strategy and structure; Chapters 16 to 20 on international business functions; and many of the Part Seven end-of-text integrated cases. The success of the first 10 editions of International Busi- ness was based in part on the incorporation of leading-edge research into the text, the use of the up-to-date examples and statistics to illustrate global trends and enterprise strategy, and the discussion of current events within the context of the appropriate theory. Building on these strengths, our goals for the eleventh edition have focused on the following:

1. Incorporate new insights from scholarly research. 2. Make sure the content covers all appropriate issues. 3. Make sure the text is up to date with current

events, statistics, and examples. 4. Add new and insightful opening and closing cases

in most chapters. 5. Incorporate value-added globalEDGE features in

every chapter. 6. Connect every chapter to a focus on managerial

implications. 7. Add a new section—Part Seven—with integrated

cases.

As part of the overall revision process, changes have been made to every chapter in the book. All statistics have been updated to incorporate the most recently available data, which typically refer to 2014 and 2015. For exam- ple, new examples, cases, and boxes have been added and older examples updated to reflect new developments. Importantly, every chapter of the eleventh edition of International Business  has a new feature spearheaded by  Tomas. Specifically, we incorporated value-added globalEDGE features in every chapter. The Google number- one-ranked globaledge.msu.edu site (for “international business resources”) is used in each chapter to add value to the chapter material and provide up-to-date data and information. This keeps chapter material constantly and

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dynamically updated for teachers who want to infuse globalEDGE material into the chapter topics, and it keeps student abreast of current developments in interna- tional business. In addition to updating all statistics, figures, and maps to incorporate most recently published data, a chapter- by-chapter selection of changes for the eleventh edition include the following:

Chapter 1: Globalization ∙ New opening case: Medical Tourism and the

Globalization of Health Care ∙ New closing case: Building the Boeing 787

Chapter 2: National Differences in Political, Economic, and Legal Systems

∙ New opening case: Corruption in Brazil ∙ Discussion of pseudo democracies added to

section on democracy and totalitarianism. ∙ New Management Focus: Did Walmart Violate

the Foreign Corrupt Practices Act? ∙ New closing case: Putin’s Russia

Chapter 3: National Differences in Economic Development

∙ New opening case: Democracy and Economic Development in Sub-Saharan Africa

∙ Extended discussion of the 2008–2009 global financial crisis

∙ Revised closing case: Political and Economic Reform in Myanmar

Chapter 4: Differences in Culture ∙ New opening case: Best Buy and eBay in China ∙ Deeper treatment of culture, values, and norms ∙ Social media issues inserted into the culture

discussion ∙ Added four basic principles to social stratification ∙ Added depth and coverage of the economic

implications of Buddhism ∙ Updated the Hofstede culture framework with new

research ∙ New closing case: World Expo 2020 in Dubai, UAE

Chapter 5: Ethics, Corporate Social Responsibility, and Sustainability

∙ New opening case: Making Toys Globally ∙ Deeper treatment of corruption ∙ New focus on corporate social responsibility (CSR)

∙ Added Management Focus on Stora Enso to illustrate CSR

∙ New focus on sustainability ∙ Added Management Focus on Umicore to

illustrate global sustainability ∙ New closing case: Bitcoin as an Ethical Dilemma

Chapter 6: International Trade Theory ∙ New opening case: China and Australia Enter into

a Free Trade Agreement  ∙ Revised closing case: Creating the World’s Big-

gest Free Trade Zone

Chapter 7: Government Policy and International Trade

∙ New opening case: U.S. Tariffs on Chinese Solar Panels Benefit Malaysia

∙ New Country Focus: Are the Chinese Illegally Subsidizing Auto Exports?

∙ New closing case: Sugar Subsidies Drive Candy Makers Abroad

Chapter 8: Foreign Direct Investment ∙ New opening case: Volkswagen in Russia ∙ New closing case: Foreign Direct Investment in

Nigeria

Chapter 9: Regional Economic Integration ∙ New opening case: Regional Trade Pacts Give the

Mexican Auto Industry an Edge ∙ Revised closing case: Tomato Wars

Chapter 10: The Foreign Exchange Market ∙ New opening case: Subaru’s Sales Boom Thanks

to the Weaker Yen ∙ New closing case: Embraer and the Wild Ride of

the Brazilian Real

Chapter 11: The International Monetary System

∙ New opening case: The IMF and Ukraine’s Economic Crisis

∙ Revised closing case: The IMF and Iceland’s Economic Recovery

Chapter 12: The Global Capital Market ∙ New opening case: Alibaba’s Record-Setting IPO ∙ Revised closing case: Declining Cross-Border

Capital Flows—Retreat or Reset?

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Chapter 13: The Strategy of International Business

∙ New opening case: IKEA’s Global Strategy ∙ Discussion of the rise of regionalism ∙ Innovative new closing exercise/case focused on

global strategy levers

Chapter 14: The Organization of International Business

∙ New opening case: P&G—Strength in Architecture

∙ New Management Focus: Walmart International ∙ Revised Management Focus: Lincoln Electric

and Culture ∙ New closing case: Koninklijke Philips NV

Chapter 15: Entry Strategy and Strategic Alliances

∙ New opening case: Starbucks’ Foreign Entry Strategy

∙ Revision to Entry Modes section ∙ Revised closing case: General Motors

Corporation

Chapter 16: Exporting, Importing, and Countertrade

∙ New opening case: Exporting Desserts ∙ Added readiness to export and import material ∙ New Management Focus: Ambient Technologies

and the Panama Canal ∙ Added material on globalEDGE Diagnostic

Tools ∙ New closing case: Two Men and a Truck

Chapter 17: Global Production and Supply Chain Management

∙ New opening case: Apple: The Best Supply Chains in the World?

∙ Integration of the supply chain (logistics, purchasing, production, and operations).

∙ New section Strategic Roles for Production Facilities

∙ New section Make-or-Buy Decisions ∙ New section Global Supply Chain Functions ∙ New text for the section Role of Information

Technology

∙ New section Coordination in Global Supply Chains

∙ New section Interorganizational Relationships ∙ New closing case: H&M: The Retail-Clothing

Giant

Chapter 18: Global Marketing and R&D ∙ New opening case: Global Branding of Avengers

and Iron Man ∙ Revised section Globalization of Markets and

Brands ∙ Revised section Configuring the Marketing Mix,

now with a new table with sample measures ∙ New section International Market Research, in-

cluding company examples and six basic steps ∙ Revised positioning of the Product Development

section ∙ New closing case: Domino’s Worldwide

Chapter 19: Global Human Resource Management

∙ New opening case: A Global Team at Mary Kay Inc.

∙ Revised closing case: IBM and Its Human Resources

Chapter 20: Accounting and Finance in the International Business

∙ Revised opening case: Skype Now a Division of Microsoft

∙ Revised closing case: Google and Its Tax Strategy

BEYOND UNCRITICAL PRESENTATION AND SHALLOW EXPLANATION Many issues in international business are complex and thus necessitate considerations of pros and cons. To demonstrate this to students, we have adopted a critical approach that presents the arguments for and against economic theories, government policies, business strate- gies, organizational structures, and so on. Related to this, we have attempted to explain the com- plexities of the many theories and phenomena unique to international business so the student might fully compre- hend the statements of a theory or the reasons a phenom- enon is the way it is. We believe that these theories and phenomena are explained in more depth in this work than they are in the competition, which seem to use the rationale that a shallow explanation is little better than no explanation. In international business, a little knowl- edge is indeed a dangerous thing.

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F O C U S O N M A NAG E R I A L I M P L I C AT I O N S

MAKING ETHICAL DECISIONS INTERNATIONALLY What, then, is the best way for managers in a multinational firm to make sure that ethi-

cal considerations figure into international business decisions? How do managers decide on an ethical course of action when confronted with

decisions pertaining to working conditions, human rights, corruption, and environ- mental pollution? From an ethical perspective, how do managers determine the moral obligations that flow from the power of a multinational? In many cases,

there are no easy answers to these questions—many of the most vexing ethical problems arise because there are very real dilemmas inherent in them and no obvi-

ous correct action. Nevertheless, managers can and should do many things to make sure that basic ethical principles are adhered to and that ethical issues are routinely inserted into international business decisions.

LO 5 -5 Explain how managers can incorporate ethical considerations into their decision making.

Practical and Rich Applications

We have always believed that it is important to show students how the material covered in the text is rele- vant to the actual practice of international business. This is explicit in the later chapters of the book, which focus on the practice of international business, but it is not always obvious in the first half of the book, which considers many macroeconomic and political issues, from international trade theory and for- eign direct investment flows to the IMF and the influence of inflation rates on foreign exchange quotations. Accordingly, at the end of each chapter in Parts Two, Three, and Four—where the focus is on the environment of international business, as opposed to particular firms—there is a section titled Focus on Managerial Implications. In this section, the managerial implications of the material discussed in the chapter are clearly explained.

Another tool that we have used to focus on managerial implications is the Manage- ment Focus box. Most chap- ters have at least one Management Focus. Like the opening cases, the purpose

of these boxes is to illustrate the relevance of chapter material for the practice of international business.

132 Part 3 Part Title

M A NAG E M E N T F O C U S

In mid-2006, news reports surfaced suggesting there were systematic labor abuses at a factory in China that makes the iPhone and iPod for Apple, Inc. According to the reports, workers at Hongfujin Precision Industry were paid as little as $50 a month to work 15-hour shifts making Apple products. There were also reports of forced over- time and poor living conditions for the workers, many of them young women who had migrated from the country- side to work at the plant and lived in company-owned dormitories.

Ethical Issues at Apple new housing for employees and limiting work to 60 hours a week. However, Hongfujin did not immediately withdraw the defamation suit. In an unusually bold move in a country where censorship is still common, China Business News gave its unconditional backing to Wang and Weng. The Shanghai-based news organization issued a statement ar- guing that what the two journalists did “was not a violation of any rules, laws, or journalistic ethics.” The Paris-based Reporters Without Borders also took up the case of Wang

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In addition, each chapter begins with an opening case that sets the stage for the chapter content and familiarizes students with how real international companies con- duct business.

The  Part Seven Integrated Cases  are somewhat longer, allowing a more in-depth study of international companies. These cases can be used as standalone cases, in conjunction with a specific chapter, and also as integrated cases covering relevant and practical material from several chapters. The introduction to the Part Seven section discusses and lays out topics covered in each case.

Credit: ©Federal Reserve Board.

Source: © Frans lemmens/Alamy

National Differences in Economic Development L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO3 -1 Explain what determines the level of economic development of a nation.

LO3-2 Identify the macropolitical and macroeconomic changes occurring worldwide.

LO3-3 Describe how transition economies are moving toward market-based systems.

LO3-4 Explain the implications for management practice of national difference in political economy.

part two National Dif ferences

3

part seven cases

Integrative Cases For International Business, eleventh edition, we have included a set of 20 cases as value-added materials at the end of the textbook in addition to the 40 cases—opening case and closing case—that appear in the 20 chapters. These end-of-the-book cases replace what used to be cases included at the end of the core sectional “parts” of the earlier versions of the textbook.

The end-of-the-book cases serve a better and more strategically aligned objective for the core features of International Business, eleventh edition. Specifically, we are able to build on and enhance the market leadership of our International Business textbook

A closing case to each chapter is designed to illustrate the rele- vance of chapter material for the practice of international busi- ness and provide continued in- sight into how real companies handle those issues.

When the global financial crisis hit in 2008, tiny Ice- land suffered more than most. The country’s three big- gest banks had been expanding at a breakneck pace since 2000 when the government privatized the bank- ing sector. With a population of around 320,000, Ice- land was too small for the banking sector’s ambitions, so the banks started to expand into other Scandinavian countries and the UK. They entered local mortgage markets, purchased foreign financial institutions, and opened foreign branches, attracting depositors by offer- ing high interest rates. The expansion was financed by debt, much of it structured as short-term loans that had to be regularly refinanced. By early 2008, the three banks held debts that amounted to almost six times the value of the entire economy of Iceland! So long as they could periodically refinance this debt, it was not a prob- lem. However, in 2008, global financial markets im- ploded following the bankruptcy of Lehman Brothers and the collapse of the U.S. housing market. In the af- termath, financial markets froze. The Icelandic banks found that they could not refinance their debt, and they faced bankruptcy. The Icelandic government lacked the funds to bail out the banks, so it decided to let the big three fail. In quick succession the local stock market plunged 90 percent and unemployment increased ninefold. The krona, Iceland’s currency, plunged on foreign exchange markets, pushing

C L O S I N G C A S E

The IMF and Iceland’s Economic Recovery up the price of imports, and inflation soared to 18 per- cent. Iceland appeared to be in free fall. The economy shrank by almost 7 percent in 2009 and another 4 percent in 2010. To stem the decline, the government secured $10 bil- lion in loans from the International Monetary Fund (IMF) and other countries. The Icelandic government stepped in to help local depositors, seizing the domestic assets of the Icelandic banks and using IMF and other loans to backstop deposit guarantees. Far from imple- menting austerity measures to solve the crisis, the Icelandic government looked for ways to shore up con- sumer spending. For example, the government provided means-tested subsidies to reduce the mortgage interest expenses of borrowers. The idea was to stop domestic consumer spending from imploding and further depressing the economy. With the financial system stabilized, thanks to the IMF and other foreign loans, what happened next is an object lesson in the value of having a floating currency. The fall in the value of the krona helped boost Iceland’s exports, such as fish and aluminum, while depressing de- mand for costly imports, such as automobiles. By 2009 the krona was worth half as much against the U.S. dollar and euro as it was in 2007 before the crisis. Iceland’s exports surged and imports slumped. While the high cost of imports did stoke inflation, booming exports started

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To help students go a step further in expanding their application-level understanding of international business, each chapter incorporates two globalEDGE research tasks designed and written by Tomas Hult, Tunga Kiyak, and the team at Michigan State University’s International Business Center and their globaledge.msu.edu site. The exercises dovetail with the content just covered.

INTEGRATED PROGRESSION OF TOPICS A weakness of many texts is that they lack a tight, inte- grated flow of topics from chapter to chapter. This book explains to students in Chapter 1 how the book’s topics are related to each other. Integration has been achieved by organizing the material so that each chapter builds on the material of the previous ones in a logical fashion.

Part One Chapter 1 provides an overview of the key issues to be addressed and explains the plan of the book. Globaliza- tion of markets and globalization of production is the core focus.

Part Two Chapters 2 through 4 focus on country differences in po- litical economy and culture, and Chapter 5 on ethics, corporate social responsibility, and sustainability issues in international business. Most international business textbooks place this material at a later point, but we be- lieve it is vital to discuss national differences first. After all, many of the central issues in international trade and investment, the global monetary system, international business strategy and structure, and international busi- ness functions arise out of national differences in politi- cal economy and culture.

Part Three Chapters 6 through 9 investigate the political economy of global trade and investment. The purpose of this part is to describe and explain the trade and investment envi- ronment in which international business occurs.

Part Four Chapters 10 through 12 describe and explain the global monetary system, laying out in detail the monetary framework in which international business transactions are conducted.

Part Five In Chapters 13 through 15 attention shifts from the envi- ronment to the firm. In other words, we move from a

macro focus to a micro focus at this stage of the book. We examine strategies and structures that firms adopt to compete effectively in the international business environment.

Part Six In Chapters 16 through 20 the focus narrows further to investigate business functions and related operations. These chapters explain how firms can perform their key functions—exporting, importing, and countertrade; global production; global supply chain management; global marketing; global research and development (R&D); human resource management; accounting; and finance—to compete and succeed in the international business environment. Throughout the book, the relationship of new material to topics discussed in earlier chapters is pointed out to the students to reinforce their understanding of how the material comprises an integrated whole. We deliberately bring a management focus to the macro chapters (Chap- ters 1 through 12). We also integrate macro themes in covering the micro chapters (Chapters 13 through 20). Part Seven with its integrated cases also provides a great learning vehicle to better understand macro and micro issues.

ACCESSIBLE AND INTERESTING The international business arena is fascinating and exciting, and we have tried to communicate our enthusi- asm for it to the student. Learning is easier and better if the subject matter is communicated in an interesting, informative, and accessible manner. One technique we have used to achieve this is weaving interesting anec- dotes into the narrative of the text, that is, stories that illustrate theory. Most chapters also have a Country Focus box that provides background on the political, economic, social, or cultural aspects of countries grappling with an inter- national business issue.

McGRAW-HILL CONNECT INTERNATIONAL BUSINESS

Applied Interactive Application Exercises A variety of interactive assignments within Connect re- quire students to apply what they have learned in a real- world scenario. These online exercises help students assess their understanding of the concepts at a higher level. Exercises include video cases, decision making scenarios/cases from real-world companies, case analy- sis exercises, business models, processes, and problem- solving cases.

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TEACHING SUPPORT Within the Connect International Business’ Instructor Resources you can find a complete package to prepare you for your course.

∙ Instructor’s Manual. The Instructor’s Manual is a comprehensive resource designed to support you in effectively teaching your course. It includes course outlines; chapter overviews and outlines, teaching suggestions, chapter objectives, teaching suggestions for opening cases, lecture outlines, answers to critical discussion questions, teaching suggestions for the closing case, and two student activities; and video notes with discussion questions for each video. The answers to globalEDGE research tasks are included.

∙ Test Bank. Approximately 100 true-false, multiple-choice, and essay questions per chapter are included in the test bank. We’ve aligned our test bank questions with Bloom’s Taxonomy and AACSB guidelines, tagging each question accord- ing to its knowledge and skill areas. Each test bank question also maps to a specific chapter learning objective listed in the text.

∙ PowerPoint Presentations. The PowerPoint pro- gram consists of one set of slides for every chapter which include key text figures, tables, and maps. Quiz questions to keep students on their toes dur- ing classroom presentations are also included, along with instructor notes.

∙ International Business Video Program. McGraw-Hill offers the most comprehensive, diverse, and current video support for the Interna- tional Business classroom. Updated monthly, our video program is the most current on the market. Additionally, video-based application exercises are assignable within Connect.

COURSE DESIGN AND DELIVERY

cesim GlobalChallenge Simulation cesim is an international busi- ness simulation designed to develop student under- standing of the interaction and complexity of various business disciplines and concepts in a rapidly evolving, competitive business environment. The simulation has a particular focus on creating long-term, sustainable, and profitable growth of a global technology company. Student teams make decisions about technology-based product roadmaps and global market and production strategies involving economics, finance, human re- sources, accounting, procurement, production, logis- tics, research and innovation, and marketing. cesim

improves the knowledge retention, business decision- making, and teamwork skills of students.

CREATE Instructors can now tailor their teaching resources to match the way they teach!

With McGraw-Hill Create, www.mcgrawhillcreate.com, instructors can easily rearrange chapters, combine mate- rial from other content sources, and quickly upload and integrate their own content, such as course syllabi or teaching notes. Find the right content in Create by searching through thousands of leading McGraw-Hill textbooks. Arrange the material to fit your teaching style. Order a Create book and receive a complimentary print review copy in three to five business days or a complimentary electronic review copy via e-mail within one hour. Go to www.mcgrawhillcreate.com today and register.

TEGRITY CAMPUS Tegrity makes class time available 24/7 by automati- cally capturing every lecture

in a searchable format for students to review when they study and complete assignments. With a simple one- click start-and-stop process, you capture all computer screens and corresponding audio. Students can replay any part of any class with easy-to-use browser-based viewing on a PC or Mac. Educators know that the more students can see, hear, and experience class resources, the better they learn. In fact, studies prove it. With patented Tegrity “search anything” technology, students instantly recall key class moments for replay online or on iPods and mobile devices. Instructors can help turn all their students’ study time into learning moments immediately supported by their lecture. To learn more about Tegrity, watch a two-minute Flash demo at http:// tegritycampus.mhhe.com.

BLACKBOARD® PARTNERSHIP McGraw-Hill Education and Blackboard have teamed up to simplify your life. Now you and your students can access Connect and Create right from wit hin your Blackboard course—all with one single

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xx

McGRAW-HILL CAMPUS™ McGraw-Hill Campus is a new one-stop teaching and learning experience available to users of any learning man-

agement system. This institutional service allows faculty and students to enjoy single sign-on (SSO) access to all McGraw-Hill Higher Education materials, including the award-winning McGraw-Hill Connect platform, from di- rectly within the institution’s website. With McGraw-Hill Campus, faculty receive instant access to teaching

materials (e.g., eTextbooks, test banks, PowerPoint slides, animations, learning objectives, etc.), allowing them to browse, search, and use any instructor ancillary content in our vast library at no additional cost to instructor or stu- dents. In addition, students enjoy SSO access to a variety of free content (e.g., quizzes, flash cards, narrated presen- tations, etc.) and subscription-based products (e.g., McGraw-Hill Connect). With McGraw-Hill Campus enabled, faculty and students will never need to create another account to access McGraw-Hill products and services. Learn more at www.mhcampus.com.

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CONTENTS

part one Introduction and Overview

C H A P T E R 1 Globalization 2 Opening Case Medical Tourism and the Globalization of Health Care 3

Introduction 4

What Is Globalization? 5 The Globalization of Markets 5 The Globalization of Production 6

Management Focus Vizio and the Market for Flat-Panel TVs 8

The Emergence of Global Institutions 9

Drivers of Globalization 10 Declining Trade and Investment Barriers 10 The Role of Technological Change 12

The Changing Demographics of the Global Economy 14

The Changing World Output and World Trade Picture 15 The Changing Foreign Direct Investment Picture 16

Country Focus India’s Software Sector 16

The Changing Nature of the Multinational Enterprise 18

Management Focus China’s Hisense—an Emerging Multinational 19

The Changing World Order 20 The Global Economy of the Twenty-First Century 21

The Globalization Debate 22 Antiglobalization Protests 22

Country Focus Protesting Globalization in France 23

Globalization, Jobs, and Income 24 Globalization, Labor Policies, and the Environment 26 Globalization and National Sovereignty 28 Globalization and the World’s Poor 28

Managing in the Global Marketplace 30

Chapter Summary 32

Critical Thinking and Discussion Questions 33

Research Task 33

Closing Case Building the Boeing 787 34

Endnotes 35

part two National Differences

C H A P T E R 2 National Differences in Political, Economic, and Legal Systems 38 Opening Case Corruption in Brazil 39

Introduction 40

Political Systems 41 Collectivism and Individualism 41 Democracy and Totalitarianism 43

Country Focus Venezuela under Hugo Chávez, 1999–2013 45

Economic Systems 46 Market Economy 46 Command Economy 47 Mixed Economy 48

Legal Systems 48 Different Legal Systems 49 Differences in Contract Law 50 Property Rights and Corruption 50

Country Focus Corruption in Nigeria 53

Management Focus Did Walmart Violate the Foreign Corrupt Practices Act? 54

The Protection of Intellectual Property 55

Management Focus Starbucks Wins Key Trademark Case in China 56

Product Safety and Product Liability 56

Focus on Managerial Implications: The Macro Environment Influences Market Attractiveness 57

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Chapter Summary 58

Critical Thinking and Discussion Questions 58

Research Task 59

Closing Case Putin’s Russia 59

Endnotes 61

C H A P T E R 3 National Differences in Economic Development 62 Opening Case Democracy and Economic Development in Sub-Saharan Africa 63

Introduction 63

Differences in Economic Development 64 Map 3.1 GNI per Capita, 2013 64 Map 3.2 GNI PPP per Capita, 2013 66 Broader Conceptions of Development: Amartya Sen 66

Map 3.3 Average Annual Growth Rate in GDP, 2004–2013 67

Map 3.4 Human Development Index, 2013 68

Political Economy and Economic Progress 69 Innovation and Entrepreneurship Are the Engines of Growth 69 Innovation and Entrepreneurship Require a Market Economy 69 Innovation and Entrepreneurship Require Strong Property Rights 70 The Required Political System 70

Country Focus Emerging Property Rights in China 71

Economic Progress Begets Democracy 71 Geography, Education, and Economic Development 72

States in Transition 72 The Spread of Democracy 73

Map 3.5 Freedom in the World in 2015 73 The New World Order and Global Terrorism 75 The Spread of Market-Based Systems 76

Map 3.6 Distribution of Economic Freedom, 2015 77

The Nature of Economic Transformation 78 Deregulation 78 Privatization 78

Country Focus India’s Economic Transformation 79

Legal Systems 80

Implications of Changing Political Economy 80

Focus on Managerial Implications: Benefits, Costs, Risks, and Overall Attractiveness of Doing Business Internationally 81

Chapter Summary 86

Critical Thinking and Discussion Questions 86

Research Task 87

Closing Case Political and Economic Reform in Myanmar 87

Endnotes 88

C H A P T E R 4 Differences in Culture 90 Opening Case Best Buy and eBay in China 91

Introduction 92

What Is Culture? 93 Values and Norms 94 Culture, Society, and the Nation-State 95 The Determinants of Culture 96

Social Structure 96 Individuals and Groups 97 Social Stratification 99

Country Focus Using IT to Break India’s Caste System 100

Religious and Ethical Systems 102 Christianity 102

Map 4.1 World Religions 103 Islam 104

Country Focus Islamic Capitalism in Turkey 107

Hinduism 107 Buddhism 109 Confucianism 109

Management Focus DMG-Shanghai 111

Language 111 Spoken Language 112 Unspoken Language 112

Education 113

Culture and Business 114

Cultural Change 117

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Focus on Managerial Implications: Cross-Cultural Literacy and Competitive Advantage 119

Chapter Summary 122

Critical Thinking and Discussion Questions 123

Research Task 123

Closing Case World Expo 2020 in Dubai, UAE 123

Endnotes 125

C H A P T E R 5 Ethics, Corporate Social Responsibility, and Sustainability 128 Opening Case Making Toys Globally 129

Introduction 130

Ethical Issues in International Business 131 Employment Practices 131

Management Focus Ethical Issues at Apple 132

Human Rights 133

Management Focus Unocal in Myanmar 134

Environmental Pollution 135 Corruption 136

Management Focus Corruption at Daimler 137

Ethical Dilemmas 138

The Roots of Unethical Behavior 139 Personal Ethics 139 Decision-Making Processes 140 Organizational Culture 141 Unrealistic Performance Goals 141 Leadership 141 Societal Culture 142

Philosophical Approaches to Ethics 142 Straw Men 142 Utilitarian and Kantian Ethics 144 Rights Theories 145 Justice Theories 146

Focus on Managerial Implications: Making Ethical Decisions Internationally 147

Management Focus Corporate Social Responsibility at Stora Enso 152

Management Focus Sustainability at Umicore 154

Chapter Summary 155

Critical Thinking and Discussion Questions 156

Research Task 157

Closing Case Bitcoin as an Ethical Dilemma 157

Endnotes 158

part three The Global Trade and Investment Environment

C H A P T E R 6 International Trade Theory 160 Opening Case China and Australia Enter into a Free Trade Agreement 161

Introduction 161

An Overview of Trade Theory 162 The Benefits of Trade 162 The Pattern of International Trade 163 Trade Theory and Government Policy 164

Mercantilism 164

Absolute Advantage 165

Country Focus Is China a Neo-mercantilist Nation? 166

Comparative Advantage 168 The Gains from Trade 169 Qualifications and Assumptions 170 Extensions of the Ricardian Model 171

Country Focus Moving U.S. White-Collar Jobs Offshore 174

Heckscher-Ohlin Theory 176 The Leontief Paradox 176

The Product Life-Cycle Theory 177 Product Life-Cycle Theory in the Twenty-First Century 178

New Trade Theory 179 Increasing Product Variety and Reducing Costs 179

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Economies of Scale, First-Mover Advantages, and the Pattern of Trade 180 Implications of New Trade Theory 180

National Competitive Advantage: Porter’s Diamond 181

Factor Endowments 182 Demand Conditions 183 Related and Supporting Industries 183 Firm Strategy, Structure, and Rivalry 183 Evaluating Porter’s Theory 184

Focus on Managerial Implications: Location, First- Mover Advantages, and Government Policy 184

Chapter Summary 186

Critical Thinking and Discussion Questions 187

Research Task 188

Closing Case Creating the World’s Biggest Free Trade Zone 188

Appendix

International Trade and the Balance of Payments 189

Endnotes 192

C H A P T E R 7 Government Policy and International Trade 194 Opening Case U.S. Tariffs on Chinese Solar Panels Benefit Malaysia 195

Introduction 196

Instruments of Trade Policy 196 Tariffs 197 Subsidies 197

Country Focus Are the Chinese Illegally Subsidizing Auto Exports? 198

Import Quotas and Voluntary Export Restraints 199 Local Content Requirements 200 Administrative Policies 201 Antidumping Policies 201

The Case for Government Intervention 201

Management Focus Portecting U.S. Magnesium 202

Political Arguments for Intervention 202

Country Focus Trade in Hormone-Treated Beef 205

Economic Arguments for Intervention 206

The Revised Case for Free Trade 208 Retaliation and Trade War 208 Domestic Politics 208

Development of the World Trading System 208 From Smith to the Great Depression 209 1947–1979: GATT, Trade Liberalization, and Economic Growth 209 1980–1993: Protectionist Trends 210 The Uruguay Round and the World Trade Organization 210 WTO: Experience to Date 211 The Future of the WTO: Unresolved Issues and the Doha Round 212

Country Focus Estimating the Gains from Trade for America 216

Regional and Bilateral Trade Agreements 216

Focus on Managerial Implications: Trade Barriers, Firm Strategy, and Policy Implications 217

Chapter Summary 219

Critical Thinking and Discussion Questions 220

Research Task 220

Closing Case Sugar Subsidies Drive Candy Makers Abroad 221

Endnotes 222

C H A P T E R 8 Foreign Direct Investment 224 Opening Case Volkswagen in Russia 225

Introduction 226

Foreign Direct Investment in the World Economy 226 Trends in FDI 226 The Direction of FDI 227 The Source of FDI 228

Country Focus Foreign Direct Investment in China 229

The Form of FDI: Acquisitions versus Greenfield Investments 230

Theories of Foreign Direct Investment 230 Why Foreign Direct Investment? 230

Management Focus Foreign Direct Investment by Cemex 232

The Pattern of Foreign Direct Investment 234 The Eclectic Paradigm 235

Political Ideology and Foreign Direct Investment 236 The Radical View 236

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The Free Market View 237 Pragmatic Nationalism 237 Shifting Ideology 238

Management Focus DP World and the United States 239

Benefits and Costs of FDI 239 Host-Country Benefits 239 Host-Country Costs 242 Home-Country Benefits 243 Home-Country Costs 243 International Trade Theory and FDI 244

Government Policy Instruments and FDI 244 Home-Country Policies 244 Host-Country Policies 245 International Institutions and the Liberalization of FDI 246

Focus on Managerial Implications: FDI and Government Policy 246

Chapter Summary 249

Critical Thinking and Discussion Questions 250

Research Task 250

Closing Case Foreign Direct Investment in Nigeria 250

Endnotes 252

C H A P T E R 9 Regional Economic Integration 254 Opening Case Regional Trade Pacts Give the Mexican Auto Industry an Edge 255

Introduction 256

Levels of Economic Integration 257

The Case for Regional Integration 259 The Economic Case for Integration 259 The Political Case for Integration 259 Impediments to Integration 260

The Case against Regional Integration 260

Regional Economic Integration in Europe 261 Evolution of the European Union 261

Map 9.1 Member States of the European Union in 2013 262

Political Structure of the European Union 262

Management Focus The European Commission and Intel 263

The Single European Act 264 The Establishment of the Euro 265

Country Focus Creating a Single Market in Financial Services 266

Country Focus The Greek Sovereign Debt Crisis 270

Enlargement of the European Union 271

Regional Economic Integration in the Americas 272 Map 9.2 Economic Integration in the Americas 272 The North American Free Trade Agreement 272 The Andean Community 275 Mercosur 275 Central American Common Market, CAFTA, and CARICOM 276 Free Trade Area of the Americas 277

Regional Economic Integration Elsewhere 277 Association of Southeast Asian Nations 277

Map 9.3 ASEAN Countries 278 Asia-Pacific Economic Cooperation 278

Map 9.4 APEC Members 279 Regional Trade Blocs in Africa 279

Focus on Managerial Implications: Regional Economic Integration Threats 280

Chapter Summary 282

Critical Thinking and Discussion Questions 282

Research Task 283

Closing Case Tomato Wars 283

Endnotes 284

part four The Global Monetary System

C H A P T E R 1 0 The Foreign Exchange Market 286 Opening Case Subaru’s Sales Boom Thanks to the Weaker Yen 287

Introduction 287

The Functions of the Foreign Exchange Market 289 Currency Conversion 289 Insuring against Foreign Exchange Risk 290

Management Focus Volkswagen’s Hedging Strategy 292

The Nature of the Foreign Exchange Market 293

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Economic Theories of Exchange Rate Determination 294 Prices and Exchange Rates 294

Country Focus Quantitative Easing, Inflation, and the Value of the U.S. Dollar 298

Interest Rates and Exchange Rates 300 Investor Psychology and Bandwagon Effects 301 Summary of Exchange Rate Theories 301

Exchange Rate Forecasting 301 The Efficient Market School 302 The Inefficient Market School 302 Approaches to Forecasting 302

Currency Convertibility 303

Focus on Managerial Implications: Foreign Exchange Rate Risk 304

Chapter Summary 307

Critical Thinking and Discussion Questions 308

Research Task 309

Closing Case Embraer and the Wild Ride of the Brazilian Real 309

Endnotes 310

C H A P T E R 1 1 The International Monetary System 312 Opening Case The IMF and Ukraine’s Economic Crisis 313

Introduction 313

The Gold Standard 315 Mechanics of the Gold Standard 315 Strength of the Gold Standard 315 The Period between the Wars: 1918–1939 316

The Bretton Woods System 316 The Role of the IMF 317 The Role of the World Bank 318

The Collapse of the Fixed Exchange Rate System 318

The Floating Exchange Rate Regime 320 The Jamaica Agreement 320 Exchange Rates since 1973 320

Country Focus The U.S. Dollar, Oil Prices, and Recycling Petrodollars 323

Fixed versus Floating Exchange Rates 324 The Case for Floating Exchange Rates 324 The Case for Fixed Exchange Rates 325 Who Is Right? 326

Exchange Rate Regimes in Practice 326 Pegged Exchange Rates 327 Currency Boards 327

Crisis Management by the IMF 328 Financial Crises in the Post–Bretton Woods Era 329

Country Focus The Mexican Currency Crisis of 1995 330

Evaluating the IMF’s Policy Prescriptions 331

Focus on Managerial Implications: Currency Management, Business Strategy, and Government Relations 333

Management Focus Airbus and the Euro 335

Chapter Summary 336

Critical Thinking and Discussion Questions 337

Research Task 338

Closing Case The IMF and Iceland’s Economic Recovery 338

Endnotes 339

C H A P T E R 1 2 The Global Capital Market 340 Opening Case Alibaba’s Record-Setting IPO 341

Introduction 341

Benefits of the Global Capital Market 342 Functions of a Generic Capital Market 342 Attractions of the Global Capital Market 343

Management Focus Deutsche Telekom Taps the Global Capital Market 345

Growth of the Global Capital Market 347 Global Capital Market Risks 349

Country Focus Did the Global Capital Markets Fail Mexico? 350

The Eurocurrency Market 351 Genesis and Growth of the Market 351 Attractions of the Eurocurrency Market 352 Drawbacks of the Eurocurrency Market 353

The Global Bond Market 353 Attractions of the Eurobond Market 354

The Global Equity Market 355

Foreign Exchange Risk and the Cost of Capital 356

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Focus on Managerial Implications: Growth of the Global Capital Market 357

Chapter Summary 357

Critical Thinking and Discussion Questions 358

Research Task 358

Closing Case Declining Cross-Border Capital Flows—Retreat or Reset? 359

Endnotes 360

part five The Strategy and Structure of International Business

C H A P T E R 1 3 The Strategy of International Business 362 Opening Case IKEA’s Global Strategy 363

Introduction 364

Strategy and the Firm 364 Value Creation 365 Strategic Positioning 366 The Firm as a Value Chain 367

Global Expansion, Profitability, and Profit Growth 370 Expanding the Market: Leveraging Products and Competencies 371 Location Economies 372 Experience Effects 374 Leveraging Subsidiary Skills 376 Profitability and Profit Growth Summary 376

Management Focus Leveraging Subsidiary Skills at ArcelorMittal 377

Cost Pressures and Pressures for Local Responsiveness 377

Pressures for Cost Reductions 378 Pressures for Local Responsiveness 379

Management Focus Local Responsiveness at MTV Networks 380

Choosing a Strategy 382 Global Standardization Strategy 383 Localization Strategy 384 Transnational Strategy 384 International Strategy 385

Management Focus Evolution of Strategy at Procter & Gamble 386

The Evolution of Strategy 387

Chapter Summary 388

Critical Thinking and Discussion Questions 388

Research Task 389

Closing Case Global Strategy Levers 389

Endnotes 390

C H A P T E R 1 4 The Organization of International Business 392 Opening Case P&G—Strength in Architecture 393

Introduction 393

Organizational Architecture 394

Organizational Structure 396 Vertical Differentiation: Centralization and Decentralization 396

Management Focus Walmart International 398

Horizontal Differentiation: The Design of Structure 398 Integrating Mechanisms 405

Management Focus Dow—(Failed) Early Global Matrix Adopter 406

Control Systems and Incentives 410 Types of Control Systems 410 Incentive Systems 412 Control Systems, Incentives, and Strategy in the International Business 413

Processes 415

Organizational Culture 416 Creating and Maintaining Organizational Culture 416 Organizational Culture and Performance in the International Business 418

Management Focus Lincoln Electric and Culture 419

Synthesis: Strategy and Architecture 420 Localization Strategy 420 International Strategy 421 Global Standardization Strategy 421 Transnational Strategy 421 Environment, Strategy, Architecture, and Performance 422

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Organizational Change 422 Organizational Inertia 423 Implementing Organizational Change 424

Chapter Summary 425

Critical Thinking and Discussion Questions 426

Research Task 426

Closing Case Koninklijke Philips NV 427

Endnotes 428

C H A P T E R 1 5 Entry Strategy and Strategic Alliances 430 Opening Case Starbucks’ Foreign Entry Strategy 431

Introduction 432

Basic Entry Decisions 433 Which Foreign Markets? 433 Timing of Entry 433

Management Focus Tesco’s International Growth Strategy 434

Scale of Entry and Strategic Commitments 436 Market Entry Summary 436

Entry Modes 437 Exporting 437

Management Focus The Jollibee Phenomenon 438

Turnkey Projects 439 Licensing 440 Franchising 441 Joint Ventures 442 Wholly Owned Subsidiaries 443

Selecting an Entry Mode 444 Core Competencies and Entry Mode 444 Pressures for Cost Reductions and Entry Mode 446

Greenfield Venture or Acquisition? 446 Pros and Cons of Acquisitions 446 Pros and Cons of Greenfield Ventures 448 Which Choice? 449

Strategic Alliances 449 The Advantages of Strategic Alliances 450 The Disadvantages of Strategic Alliances 450 Making Alliances Work 451

Chapter Summary 453

Critical Thinking and Discussion Questions 455

Research Task 455

Closing Case General Motors Corporation 455

Endnotes 457

part six International Business Functions

C H A P T E R 1 6 Exporting, Importing, and Countertrade 460 Opening Case Exporting Desserts 461

Introduction 462

The Promise and Pitfalls of Exporting 463

Management Focus Ambient Technologies and the Panama Canal 465

Improving Export Performance 466 International Comparisons 466 Information Sources 466

Management Focus Exporting with a Little Government Help 467

Service Providers 468 Export Strategy 469

Management Focus Export Strategy at 3M 470

globalEDGE Diagnostic Tools 470

Export and Import Financing 471 Lack of Trust 472 Letter of Credit 473 Draft 474 Bill of Lading 474 A Typical International Trade Transaction 475

Export Assistance 476 Export-Import Bank 476 Export Credit Insurance 476

Countertrade 477 The Popularity of Countertrade 478 Types of Countertrade 478 Pros and Cons of Countertrade 479

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Chapter Summary 480

Critical Thinking and Discussion Questions 481

Research Task 481

Closing Case Two Men and a Truck 482

Endnotes 483

C H A P T E R 1 7 Global Production and Supply Chain Management 484 Opening Case Apple: The Best Supply Chains in the World? 485

Introduction 486

Strategy, Production, and Supply Chain Management 486

Where to Produce 489 Country Factors 489

Management Focus Philips in China 490

Technological Factors 491 Production Factors 494 The Hidden Costs of Foreign Locations 497

Management Focus GE Moves Manufacturing from China to the United States 498

Make-or-Buy Decisions 499

Global Supply Chain Functions 502 Global Logistics 502 Global Purchasing 504

Managing a Global Supply Chain 506 Role of Just-in-Time Inventory 506 Role of Information Technology 507 Coordination in Global Supply Chains 507 Interorganizational Relationships 508

Chapter Summary 510

Critical Thinking and Discussion Questions 511

Research Task 512

Closing Case H&M: The Retail-Clothing Giant 512

Endnotes 514

C H A P T E R 1 8 Global Marketing and R&D 516

Opening Case Global Branding of Avengers and Iron Man 517

Introduction 518

Globalization of Markets and Brands 519

Market Segmentation 521

Management Focus Marketing to Black Brazil 522

Product Attributes 523 Cultural Differences 523 Economic Development 523 Product and Technical Standards 524

Distribution Strategy 524 Differences between Countries 524 Choosing a Distribution Strategy 527

Communication Strategy 528 Barriers to International Communication 528 Push versus Pull Strategies 529

Management Focus Unilever—Selling to India’s Poor 530

Global Advertising 531

Management Focus Dove’s Global “Real Beauty” Campaign 533

Pricing Strategy 534 Price Discrimination 534 Strategic Pricing 535 Regulatory Influences on Prices 536

Configuring the Marketing Mix 537

Management Focus Levi Strauss Goes Local 538

International Market Research 540

Product Development 543 The Location of R&D 544 Integrating R&D, Marketing, and Production 545 Cross-Functional Teams 546 Building Global R&D Capabilities 546

Chapter Summary 548

Critical Thinking and Discussion Questions 549

Research Task 550

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Closing Case Domino’s Worldwide 550

Endnotes 552

C H A P T E R 1 9 Global Human Resource Management 554 Opening Case A Global Team at Mary Kay Inc. 555

Introduction 555

Strategic Role of Global HRM 556

Staffing Policy 558 Types of Staffing Policies 558 Expatriate Managers 561

Management Focus Managing Expatriates at Royal Dutch Shell 564

Global Mindset 565

Training and Management Development 556 Training for Expatriate Managers 567 Repatriation of Expatriates 567 Management Development and Strategy 568

Management Focus Monsanto’s Repatriation Program 569

Performance Appraisal 569 Performance Appraisal Problems 569 Guidelines for Performance Appraisal 570

Compensation 570 National Differences in Compensation 570

Management Focus McDonald’s Global Compensation Practices 571

Expatriate Pay 572

International Labor Relations 573 The Concerns of Organized Labor 574 The Strategy of Organized Labor 574 Approaches to Labor Relations 575

Chapter Summary 576

Critical Thinking and Discussion Questions 577

Research Task 577

Closing Case IBM and Its Human Resources 577

Endnotes 579

C H A P T E R 2 0 Accounting and Finance in the International Business 582 Opening Case Skype Now a Division of Microsoft 583

Introduction 583

National Differences in Accounting Standards 583

International Accounting Standards 585

Management Focus Chinese Accounting 587

Accounting Aspects of Control Systems 588 Exchange Rate Changes and Control Systems 588 Transfer Pricing and Control Systems 589 Separation of Subsidiary and Manager Performance 590

Financial Management: The Investment Decision 591 Capital Budgeting 591 Project and Parent Cash Flows 592 Adjusting for Political and Economic Risk 592

Management Focus Black Sea Oil and Gas Ltd. 593

Risk and Capital Budgeting 594

Financial Management: The Financing Decision 594

Financial Management: Global Money Management 595 Minimizing Cash Balances 595 Reducing Transaction Costs 597 Managing the Tax Burden 598 Moving Money across Borders 599

Chapter Summary 603

Critical Thinking and Discussion Questions 604

Research Task 605

Closing Case Google and Its Tax Strategy 605

Endnotes 606

part seven Integrative Cases

Making the Apple iPhone 609

Revolution in Egypt 610

Ghana: An African Dynamo? 612

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Walmart Can’t Conquer All Countries 613

Ethics of Exporting Used Batteries 614

The Rise of India’s Drug Industry 615

China Limits Exports of Rare Earth Metals 616

Foreign Retailers in India 618

I Want My Greek TV! 619

The Rise and Fall of the Japanese Yen 619

Currency Trouble in Malawi 620

The IPO of the Industrial and Commercial Bank of China 621

Making Ford Globally Competitive 622

Organizing Siemens for Global Competitiveness 623

JCB Pins Hopes on the Indian Market 624

MD International and Latin America 625

Amazon Kindle Evolution 626

Burberry’s Global Brand 627

MMC China Joint Venture 628

Brazil’s Gol Airlines 629

Glossary 631

Index 643

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Susan Gouijnstook, Managing Director Michael Ablassmeir, Director Anke Braun Weekes, Senior Brand Manager Gabriela G. Gonzalez, Product Developer Michael Gedatus, Marketing Manager Sam Deffenbaugh, Marketing Coordinator Mary Powers, Content Project Manager (Core)

Yeqing Bao, University of Alabama, Huntsville Jacobus F. Boers, Georgia State University Peter Buckley, Leeds University Ken Chinen, California State University, Sacramento Macgorine A. Cassell, Fairmont State University David Closs, Michigan State University Ping Deng, Maryville University of St. Louis Betty J. Diener, Barry University Abiola O. Fanimokun, Pennsylvania State University, Fayette John Finley, Columbus State University Pat Fox, Marion Technical College David Frayer, Michigan State University Connie Golden, Lakeland Community College Martin Grossman, Bridgewater State University Michael Harris, East Carolina University Kathy Hastings, Greenville Technical College Chip Izard, Richland College Jan Johanson, Uppsala University Candida Johnson, Holyoke Community College Sara B. Kimmel, Mississippi College Tunga Kiyak, Michigan State University

Evan Roberts, Content Project Manager (Assessment) Jennifer Pickel, Senior Buyer Srdjan Savanovic, Designer Lori Hancock, Content Licensing Specialist (Image) DeAnna Dausener, Content Licensing Specialist (Text)

Anthony C. Koh, University of Toledo Laura Kozloski Hart, Barry University Steve Lawton, Oregon State University Ruby Lee, Florida State University Joseph W. Leonard, Miami University Vishakha Maskey, West Liberty University David N. McArthur, Utah Valley University Shelly McCallum, Saint Mary’s University of Minnesota Emily A. Morad, Reading Area Community College Tim Muth, Florida Institute of Technology Sunder Narayanan, New York University Eydis Olsen, Drexel University Daria Panina, Texas A&M University Hoon Park, University of Central Florida Dr. Mahesh Raisinghani, Texas Women’s University Brian Satterlee, Liberty University Dwight Shook, Catawba Valley Community College Michael Volpe, University of Maryland James Whelan, Manhattan College Man Zhang, Bowling Green State University

ACKNOWLEDGMENTS

Numerous people deserve to be thanked for their assistance in preparing this book. First, thank you to all the people at McGraw-Hill Education who have worked with us on this project:

Second, our thanks go to the reviewers who provided good feedback that helped shape this book:

A special thanks to David Closs and David Frayer for allowing us to borrow elements of the sections titled Strategic Roles for Production Facilities; Make-or-Buy Decisions; Global Supply Chain Functions; Coordination in Global Sup- ply Chains; and Interorganizational Relationships for Chapter 17 of this text from Tomas Hult, David Closs, and David Frayer, Global Supply Chain Management, New York: McGraw Hill (2014).

I n t e r n a t i o n a l B u s i n e s s

C O M P E T I N G I N T H E

G L O B A L M A R K E T P L A C E

Credit: ©Federal Reserve Board.

Globalization L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO1 -1 Understand what is meant by the term globalization.

LO1-2 Recognize the main drivers of globalization.

LO1-3 Describe the changing nature of the global economy.

LO1-4 Explain the main arguments in the debate over the impact of globalization.

LO1-5 Understand how the process of globalization is creating opportunities and challenges for business managers.

part one Introduction and Over view

1

Source: © The India Today Group/Getty Images

3

Medical Tourism and the Globalization of Health Care

nearby hospital, he flew to Hyderabad in southern India and had the surgery done for $6,600, a fraction of the $25,000 the procedure would have cost in the United States. Mr. Beeney had his surgery performed at a branch of the Apollo hospital chain. Apollo, which was founded by Dr. Prathap C. Reddy, a surgeon trained at Massachusetts General Hospital, runs a chain of 50 state-of-the-art hospi- tals throughout Asia. Eight of Apollo’s hospitals have the highest level of international accreditation. Apollo’s main hospitals in India are estimated to treat some 50,000 inter- national patients from 55 countries every year, mainly from nations in Southeast Asia and the Persian Gulf, although a growing number are from western Europe and North America. Will demand for American health services soon collapse as work moves offshore to places like India? That seems unlikely. Regulations, personal preferences, and practical considerations mean that the majority of health services will always be performed in the country where the patient resides. For example, the U.S. government–sponsored medical insurance program, Medicare, will not pay for services done outside the country. Moreover, in an interesting countertrend, U.S. medical providers also seem to be benefiting from medical tourism, particularly from China, where health care services are poor and lag far behind U.S. levels. Over the past decade middle-class Chinese have flocked to South Korea for plastic surgery, and to the United States, Singapore, and India for treatment of life-threatening conditions. When Lin Tao was diagnosed with a lethal spinal tumor in 2012, rather than risk treatment in his native Hangzhou, China, he flew to San Francisco and paid $70,000 for treatment at UCSF Medical Center. UCSF Medical Center says that its Chinese population has grown by more than 25 percent in each of the past few years. Similarly, Massachusetts Gen- eral Hospital is expecting its Chinese patients to more than double in 2015 over 2014. As China gets wealthier, ever more Chinese are apparently willing to spend more to get better treatment overseas, and America’s world-class hos- pitals are benefiting from this trend.

Sources: G. Colvin, “Think Your Job Can’t Be Sent to India?,” Fortune, December 13, 2004, p. 80; A. Pollack, “Who’s Reading Your X-Ray,” The New York Times, November 16, 2003, pp. 1, 9; S. Rai, “Low Costs Lure Foreigners to India for Medical Care,” The New York Times, April 7, 2005, p. C6; J. Solomon, “Traveling Cure: India’s New Coup in Out- sourcing,” The Wall Street Journal, April 26, 2004, p. A1; J. Slater, “In- creasing Doses in India,” Far Eastern Economic Review, February 19, 2004, pp. 32–35; U. Kher, “Outsourcing Your Heart,” Time, May 29, 2006, pp. 44–47; Anuradha Raghunathan, “The Reddy Sisters Have India’s Apollo Hospitals Covered in Four Ways,” Forbes Asia, January 8, 2014; Fanfan Wang, “Desperate Chinese Seek Medical Care Abroad,” The Wall Street Journal, September 6, 2014; Apollo Hospital Group, Patients beyond Borders, www.patientsbeyondborders.com/ hospital/apollo-hospitals-group, accessed April 2015.

O P E N I N G C A S E You might think that health care is one of the industries least vulnerable to dislocation from globalization. Like many service businesses, surely health care is delivered where it is purchased? If an American goes to a hospital for an MRI scan, won’t a local radiologist read that scan? If the MRI scan shows that surgery is required, surely the sur- gery will be done at a local hospital in the United States? Until recently, this was true, but we are now witnessing glo- balization in this traditionally most local of industries. Consider the MRI scan: The United States has a short- age of radiologists, the doctors who specialize in reading and interpreting diagnostic medical images, including X-rays, CT scans, MRI scans, and ultrasounds. Demand for radiologists is reportedly growing twice as fast as the rate at which medical schools are graduating radiologists with the skills and qualifications required to read medical im- ages. This imbalance between supply and demand means that radiologists are expensive; an American radiologist can earn as much as $400,000 a year. Back in the early 2000s, an Indian radiologist working at the prestigious Massachusetts General Hospital, Dr. Sanjay Saini, thought he had found a clever way to deal with the shortage and expense—send images over the Internet to India where they could be interpreted by radiologists. This would re- duce the workload on America’s radiologists and cut costs. A radiologist in India might earn one-tenth of his or her U.S. counterpart. Plus, because India is on the opposite side of the globe, the images could be interpreted while it was nighttime in the United States and be ready for the attend- ing physician when he or she arrived for work the follow- ing morning. As for the surgery, here too we are witnessing an out- sourcing trend. Consider Howard Staab, a 53-year-old un- insured self-employed carpenter from North Carolina. Mr. Staab had surgery to repair a leaking heart valve—in India. Mr. Staab flew to New Delhi, had the operation, and after- ward toured the Taj Mahal, the price of which was bundled with that of the surgery. The cost, including airfare, totaled $10,000. If Mr. Staab’s surgery had been performed in the United States, the cost would have been $60,000 and there would have been no visit to the Taj Mahal. Howard Staab is not alone. Driven by a desire to ac- cess low-cost health care, some 150,000 Westerners visit India every year for medical treatments. In general, medical procedures in India cost about 10–20% less than in the United States. The Indian industry generates $2 billion in revenues every year from foreign patients. In another example, after years of living in pain, Robert Beeney, a 64-year-old from San Francisco, was advised to get his hip joint replaced. After doing some research, Mr. Beeney elected instead for joint resurfacing, which was not covered by his insurance. Instead of going to a

4 Part 1 Introduction and Overview

Introduction

Over the past four decades a fundamental shift has been occurring in the world economy. We have been moving away from a world in which national economies were relatively self-contained entities, isolated from each other by barriers to cross-border trade and investment; by distance, time zones, and language; and by national differences in govern- ment regulation, culture, and business systems. We are moving toward a world in which barriers to cross-border trade and investment are declining; perceived distance is shrink- ing due to advances in transportation and telecommunications technology; material cul- ture is starting to look similar the world over; and national economies are merging into an interdependent, integrated global economic system. The process by which this trans- formation is occurring is commonly referred to as globalization. The rise of medical tourism discussed in the opening case is one illustration of the trend toward globalization. Twenty years ago almost all medical procedures were deliv- ered in the country where the patient resided. This is now changing. A global market- place for medical care is developing. MRI images from U.S. patients may be diagnosed by radiologists in India. Wealthy Chinese may go to South Korea for plastic surgery and America for state-of-the-art medical treatment for life-threatening conditions. Some Americans make the trek to India for surgeries that can be done in internationally accred- ited hospitals at a fraction of the cost in the United States. In all of these cases, the motive is to get less expensive or better treatment than is available in the patient’s home nation.  More generally, globalization now has an impact on almost everything we do. The aver- age American, for example, might drive to work in a car that was designed in Germany and assembled in Mexico by Ford from components made in the United States and Japan, which were fabricated from Korean steel and Malaysian rubber. He may have filled the car with gasoline at a Shell service station owned by a British-Dutch multinational company. The gasoline could have been made from oil pumped out of a well off the coast of Africa by a French oil company that transported it to the United States in a ship owned by a Greek ship- ping line. While driving to work, the American might talk to his stockbroker (using a hands-free, in-car speaker) on an Apple iPhone that was designed in California and as- sembled in China using chip sets produced in Japan and Europe, glass made by Corning in Kentucky, and memory chips from South Korea. He could tell the stockbroker to purchase shares in Lenovo, a multinational Chinese PC manufacturer whose operational headquar- ters is in North Carolina, and whose shares are listed on the New York Stock Exchange. This is the world in which we live. It is a world where the volume of goods, services, and investments crossing national borders has expanded faster than world output for more than half a century. It is a world where more than $5 trillion in foreign exchange transac- tions are made every day, where $19 trillion of goods and $4.9 trillion of services were sold across national borders in 2014.1 It is a world in which international institutions such as the World Trade Organization and gatherings of leaders from the world’s most power- ful economies have repeatedly called for even lower barriers to cross-border trade and investment. It is a world where the symbols of material and popular culture are increas- ingly global: from Coca-Cola and Starbucks to Sony PlayStations, Facebook, MTV shows, Disney films, IKEA stores, and Apple iPads and iPhones. It is also a world in which vigorous and vocal groups protest against globalization, which they blame for a list of ills from unemployment in developed nations to environmental degradation and the Americanization of local culture. For businesses, this globalization process has produced many opportunities. Firms can expand their revenues by selling around the world and/or reduce their costs by producing in nations where key inputs, including labor, are cheap. The global expansion of enter- prises has been facilitated by favorable political and economic trends. Since the collapse of communism a quarter of a century ago, the pendulum of public policy in nation after na- tion has swung toward the free market end of the economic spectrum. Regulatory and administrative barriers to doing business in foreign nations have been reduced, while those nations have often transformed their economies, privatizing state-owned enterprises,

Globalization Chapter 1 5

deregulating markets, increasing competition, and welcoming investment by foreign busi- nesses. This has allowed businesses both large and small, from both advanced nations and developing nations, to expand internationally. As globalization unfolds, it is transforming industries and creating anxiety among those who believed their jobs were protected from foreign competition. Historically, while many workers in manufacturing industries worried about the impact foreign com- petition might have on their jobs, workers in service industries felt more secure. Now, this too is changing. Advances in technology, lower transportation costs, and the rise of skilled workers in developing countries imply that many services no longer need to be performed where they are delivered. The opening case described how this is occurring with medical services. The same is true of some accounting services. Today, many indi- vidual U.S. tax returns are compiled in India. Indian accountants, trained in U.S. tax rules, perform work for U.S. accounting firms.2 They access individual tax returns stored on computers in the United States, perform routine calculations, and save their work so that it can be inspected by a U.S. accountant, who then bills clients. As the best-selling author Thomas Friedman has argued, the world is becoming flat.3 People living in devel- oped nations no longer have the playing field tilted in their favor. Increasingly, enterpris- ing individuals based in India, China, or Brazil have the same opportunities to better themselves as those living in western Europe, the United States, or Canada. In this text, we will take a close look at the issues introduced here and many more. We will explore how changes in regulations governing international trade and investment, when coupled with changes in political systems and technology, have dramatically altered the competitive playing field confronting many businesses. We will discuss the resulting opportunities and threats and review the strategies that managers can pursue to exploit the opportunities and counter the threats. We will consider whether globalization benefits or harms national economies. We will look at what economic theory has to say about the outsourcing of manufacturing and service jobs to places such as India and China and look at the benefits and costs of outsourcing, not just to business firms and their employees but also to entire economies. First, though, we need to get a better overview of the nature and process of globalization, and that is the function of this first chapter.

What Is Globalization?

As used in this text, globalization refers to the shift toward a more integrated and inter- dependent world economy. Globalization has several facets, including the globalization of markets and the globalization of production.

THE GLOBALIZATION OF MARKETS

The globalization of markets refers to the merging of historically distinct and separate national markets into one huge global marketplace. Falling barriers to cross-border trade have made it easier to sell internationally. It has been argued for some time that the tastes and preferences of consumers in different nations are beginning to converge on some global norm, thereby helping create a global market.4 Consumer products such as Citigroup credit cards, Coca-Cola soft drinks, video games, McDonald’s hamburgers, Starbucks coffee, IKEA furniture, and Apple iPhones are frequently held up as prototypical examples of this trend. The firms that produce these products are more than just benefactors of this trend; they are also facilitators of it. By offering the same basic product world- wide, they help create a global market. A company does not have to be the size of these multinational giants to facilitate, and ben- efit from, the globalization of markets. In the United States, for example, according to the In- ternational Trade Administration, more than 295,000 small and medium-size firms with less than 500 employees exported in 2013, accounting for 98 percent of the companies that ex- ported that year. More generally, exports from small and medium-size companies accounted for 33 percent of the value of U.S. exports of manufactured goods in 2013.5 Typical of these is

LO 1 -1 Understand what is meant by the term globalization.

6 Part 1 Introduction and Overview

B&S Aircraft Alloys, a New York company whose exports account for 40 percent of its $8 million annual revenues.6 The situation is similar in several other nations. For example, in Germany, the world’s largest exporter, a staggering 98 percent of small and midsize compa- nies have exposure to international markets, via either exports or international production.7

I N T E R NAT IONA L B U S I N E S S R E S OU RC E S

globalEDGE offers the latest and most comprehensive international business and trade content for a wide range of topics. Whether conducting extensive market research, looking to improve your international knowledge, or simply browsing, you’re sure to find what you need to sharpen your competitive edge in today’s rapidly changing global marketplace. The easy, convenient, and free globalEDGE website’s tagline is “Your Source for Global Business Knowledge.” It was developed and is maintained by a 30-member team in the International Business Center at Michigan State University under the supervision of Tomas Hult, Tunga Kiyak, and Sarah Singer. For example, related to this chapter on globalization, take a look at the always up-to-date “Globalization” resources on the site at globaledge. msu.edu/global-resources/globalization. There is even a quick guide to the world history of globalization to browse!

Despite the global prevalence of Citigroup credit cards, McDonald’s hamburgers, Starbucks coffee, and IKEA stores, it is important not to push too far the view that national markets are giving way to the global market. As we shall see in later chapters, significant differ- ences still exist among national markets along many relevant dimensions, including consumer tastes and preferences, distribution channels, culturally embedded value systems, business systems, and legal regulations. These differences frequently require companies to customize marketing strategies, product features, and operating practices to best match conditions in a particular country. The most global of markets are not typically markets for consumer products—where national differences in tastes and preferences can still be important enough to act as a brake on globalization—but markets for industrial goods and materials that serve univer- sal needs the world over. These include the markets for commodities such as aluminum, oil, and wheat; for industrial products such as microprocessors, DRAMs (computer mem- ory chips), and commercial jet aircraft; for computer software; and for financial assets from U.S. Treasury bills to Eurobonds and futures on the Nikkei index or the euro. That being said, it is increasingly evident that many newer high-technology consumer prod- ucts, such as Apple’s iPhone, are being successfully sold the same way the world over. In many global markets, the same firms frequently confront each other as competitors in nation after nation. Coca-Cola’s rivalry with PepsiCo is a global one, as are the rivalries between Ford and Toyota; Boeing and Airbus; Caterpillar and Komatsu in earthmoving equipment; General Electric and Rolls-Royce in aero engines; and Sony, Nintendo, and Microsoft in video-game consoles. If a firm moves into a nation not currently served by its rivals, many of those rivals are sure to follow to prevent their competitor from gaining an advantage.8 As firms follow each other around the world, they bring with them many of the assets that served them well in other national markets—their products, operating strategies, marketing strategies, and brand names—creating some homogeneity across markets. Thus, greater uniformity replaces diversity. In an increasing number of industries, it is no longer meaningful to talk about “the German market,” “the American market,” “the Brazilian market,” or “the Japanese market”; for many firms there is only the global market.

THE GLOBALIZATION OF PRODUCTION

The globalization of production refers to the sourcing of goods and services from loca- tions around the globe to take advantage of national differences in the cost and quality of

Globalization Chapter 1 7

factors of production (such as labor, energy, land, and capital). By doing this, compa- nies hope to lower their overall cost structure or improve the quality or functionality of their product offering, thereby allowing them to compete more effectively. For example, Boeing has made extensive use of outsourcing to foreign suppliers. Consider Boeing’s 777: eight Japanese suppliers make parts for the fuselage, doors, and wings; a supplier in Singapore makes the doors for the nose landing gear; three suppliers in Italy manufacture wing flaps; and so on.9 In total, some 30 percent of the 777, by value, is built by foreign companies. And, for its most recent jet airliner, the 787, Boeing has pushed this trend even further; some 65 percent of the total value of the aircraft is outsourced to foreign companies, 35 percent of which goes to three major Japanese companies. Part of Boeing’s rationale for outsourcing so much production to foreign suppliers is that these suppliers are the best in the world at their particular activity. A global web of suppliers yields a better final product, which enhances the chances of Boeing winning a greater share of total orders for aircraft than its global rival, Airbus. Boeing also outsources some pro- duction to foreign countries to increase the chance that it will win significant orders from airlines based in that country. For another example of a global web of activities, consider the example of Vizio profiled in the accompanying Management Focus. Early outsourcing efforts were primarily confined to manufacturing activities, such as those undertaken by Boeing, Apple, and Vizio; increasingly, however, companies are tak- ing advantage of modern communications technology, particularly the Internet, to out- source service activities to low-cost producers in other nations. The Internet has allowed hospitals to outsource some radiology work to India, where images from MRI scans and the like are read at night while U.S. physicians sleep; the results are ready for them in the morning (see the opening case). Many software companies, including IBM and Micro- soft, now use Indian engineers to perform test functions on software designed in the United States. The time difference allows Indian engineers to run debugging tests on software written in the United States when U.S. engineers sleep, transmitting the cor- rected code back to the United States over secure Internet connections so it is ready for U.S. engineers to work on the following day. Dispersing value-creation activities in this way can compress the time and lower the costs required to develop new software pro- grams. Other companies, from computer makers to banks, are outsourcing customer ser- vice functions, such as customer call centers, to developing nations where labor is cheaper. In another example from health care, workers in the Philippines transcribe American medical files (such as audio files from doctors seeking approval from insur- ance companies for performing a procedure). Some estimates suggest the outsourcing of many administrative procedures in health care, such as customer service and claims pro- cessing, could reduce health care costs in America by as much as $70 billion.10 Robert Reich, who served as secretary of labor in the Clinton administration, has argued that as a consequence of the trend exemplified by companies such as Boeing, Apple, IBM, and Vizio, in many cases it is becoming irrelevant to talk about American products, Japanese products, German products, or Korean products. Increasingly, according to Reich, the out- sourcing of productive activities to different suppliers results in the creation of products that are global in nature, that is, “global products.”11 But as with the globalization of markets, companies must be careful not to push the globalization of production too far. As we will see in later chapters, substantial impediments still make it difficult for firms to achieve the opti- mal dispersion of their productive activities to locations around the globe. These impedi- ments include formal and informal barriers to trade between countries, barriers to foreign direct investment, transportation costs, issues associated with economic and political risk, and the shear managerial challenge of coordinating a globally dispersed supply chain (which was an issue for Boeing with the 787, as discussed in the closing case). For example, govern- ment regulations ultimately limit the ability of hospitals to outsource the process of interpret- ing MRI scans to developing nations where radiologists are cheaper. Nevertheless, the globalization of markets and production will probably continue. Modern firms are important actors in this trend, their very actions fostering increased globalization. These firms, however, are merely responding in an efficient manner to changing conditions in their operating environment—as well they should.

TEST PREP Use SmartBook to help retain what you have learned. Access your instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

8 Part 3 Part Title

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M A NAG E M E N T F O C U S

Operating sophisticated tooling in environments that must be kept ab- solutely clean, fabrication centers in South Korea, Taiwan, and Japan produce sheets of glass twice as large as king-size beds to exacting specifications. From there, the glass panels travel to Mexican plants located alongside the U.S. border. There, they are cut to size, com- bined with electronic components shipped in from Asia and the United States, assembled into finished flat- panel TVs, and loaded onto trucks bound for retail stores in the United States, where consumers spend more than $35 billion a year on flat- panel TVs. The underlying technology for flat-panel displays was invented in the United States in the late 1960s by RCA. But after RCA and rivals Westinghouse and Xerox opted not to pursue the technology, the Japanese company Sharp made ag- gressive investments in flat-panel displays. By the early 1990s, Sharp was selling the first flat- panel screens, but as the Japanese economy plunged into a decade-long recession, investment leadership shifted to South Korean companies such as Samsung. Then the 1997 Asian crisis hit Korea hard, and Taiwanese companies seized leadership. Today, Chinese companies are elbow- ing their way into the flat-panel display manufacturing business. As production for flat-panel displays migrates its way around the globe to low-cost locations, there are clear winners and losers. U.S. consumers have benefited from the falling prices of flat-panel TVs and are snapping them up. Efficient manufacturers have taken advantage of globally dispersed supply chains to make and sell low- cost, high-quality flat-panel TVs. Foremost among these

Vizio and the Market for Flat-Panel TVs has been the California-based com- pany Vizio, founded by a Taiwanese immigrant. In just 10 years, sales of Vizio flat-panel TVs ballooned from nothing to around $3.1 billion by 2013. The privately held company is the largest provider to the U.S. mar- ket with an 18 to 19 percent share. Vizio, however, has reportedly fewer than 500 employees. Its fo- cus is on final product design, sales, and customer service. Vizio out- sources most of its engineering work, all of its manufacturing, and much of its logistics. For each of its models, Vizio assembles a team of supplier partners strung across the globe. Its 42-inch flat-panel TV, for example, contains a panel from South Korea, electronic compo- nents from China, and processors from the United States, and it is as- sembled in Mexico. Vizio’s manag- ers scour the globe continually for the cheapest manufacturers of flat- panel displays and electronic com-

ponents. They sell most of their TVs to large discount retailers such as Costco and Sam’s Club. Good order visi- bility from retailers, coupled with tight management of global logistics, allows Vizio to turn over its inventory every three weeks, twice as fast as many of its competitors, which allows major cost savings in a business where prices are falling continually.

Sources: D. J. Lynch, “Flat Panel TVs Display Effects of Globalization,” USA Today, May 8, 2007, pp. 1B, 2B; P. Engardio and E. Woyke, “Flat Panels, Thin Margins,” BusinessWeek, February 26, 2007, p. 50; B. Womack, “Flat TV Seller Vizio Hits $600 Million in Sales, Growing,” Orange County Business Journal, September 4, 2007, pp. 1, 64; E. Taub, “Vizio’s Flat Panel Display Sales Are Anything but Flat,” The New York Times Online, May 12, 2009; Greg Tarr, “HIS: Samsung Dusts Vizio in Q4 LCD TV Share in the U.S.,” This Week in Consumer Electronics, April 12, 2012, p. 12.

Vizio’s flat-panel TVs are assembled in Mexico from components produced in many different countries. Source: © Jin Lee/Bloomberg/Getty Images

8

Globalization Chapter 1 9

The Emergence of Global Institutions

As markets globalize and an increasing proportion of business activity transcends national borders, institutions are needed to help manage, regulate, and police the global marketplace and to promote the establishment of multinational treaties to govern the global business system. Over the past half century, a number of important global institu- tions have been created to help perform these functions, including the General Agree- ment on Tariffs and Trade (GATT) and its successor, the World Trade Organization; the International Monetary Fund and its sister institution, the World Bank; and the United Nations. All these institutions were created by voluntary agreement between individual nation-states, and their functions are enshrined in international treaties. The World Trade Organization (WTO)  (like the GATT before it) is primarily respon- sible for policing the world trading system and making sure nation-states adhere to the rules laid down in trade treaties signed by WTO member states. As of 2015, 160 nations that collectively accounted for 98 percent of world trade were WTO members, thereby giving the organization enormous scope and influence. The WTO is also responsible for facilitating the establishment of additional multinational agreements among WTO mem- ber states. Over its entire history, and that of the GATT before it, the WTO has promoted the lowering of barriers to cross-border trade and investment. In doing so, the WTO has been the instrument of its member states, which have sought to create a more open global business system unencumbered by barriers to trade and investment between countries. Without an institution such as the WTO, the globalization of markets and production is unlikely to have proceeded as far as it has. However, as we shall see in this chapter and in Chapter 7 when we look closely at the WTO, critics charge that the organization is usurp- ing the national sovereignty of individual nation-states. The International Monetary Fund (IMF) and the World Bank were both created in 1944 by 44 nations that met at Bretton Woods, New Hampshire. The IMF was estab- lished to maintain order in the international monetary system; the World Bank was set up to promote economic development. In the more than six decades since their creation, both institutions have emerged as significant players in the global economy. The World Bank is the less controversial of the two sister institutions. It has focused on making low- interest loans to cash-strapped governments in poor nations that wish to undertake sig- nificant infrastructure investments (such as building dams or roads). The IMF is often seen as the lender of last resort to nation-states whose economies are in turmoil and whose currencies are losing value against those of other nations. During the past two decades, for example, the IMF has lent money to the governments of trou- bled states, including Argentina, Indonesia, Mexico, Russia, South Korea, Thailand, and Turkey. More recently, the IMF has taken a proactive role in helping countries cope with some of the effects of the 2008–2009 global financial crisis. IMF loans come with strings attached, however; in return for loans, the IMF requires nation-states to adopt specific economic policies aimed at returning their troubled economies to stability and growth. These requirements have sparked controversy. Some critics charge that the IMF’s policy recommendations are often inappropriate; others maintain that by telling national gov- ernments what economic policies they must adopt, the IMF, like the WTO, is usurping the sovereignty of nation-states. We will look at the debate over the role of the IMF in Chapter 11. The United Nations (UN) was established October 24, 1945, by 51 countries commit- ted to preserving peace through international cooperation and collective security. Today, nearly every nation in the world belongs to the United Nations; membership now totals 193 countries. When states become members of the United Nations, they agree to accept the obligations of the UN Charter, an international treaty that establishes basic principles of international relations. According to the charter, the UN has four purposes: to maintain international peace and security, to develop friendly relations among nations, to cooperate in solving international problems and in promoting respect for human rights, and to be a center for harmonizing the actions of nations. Although the UN is perhaps best known for

10 Part 1 Introduction and Overview

its peacekeeping role, one of the organization’s central mandates is the promotion of higher standards of living, full employment, and conditions of economic and social progress and development—all issues that are central to the creation of a vibrant global economy. As much as 70 percent of the work of the UN system is devoted to accomplishing this man- date. To do so, the UN works closely with other international institutions such as the World Bank. Guiding the work is the belief that eradicating poverty and improving the well- being of people everywhere are necessary steps in creating conditions for lasting world peace.12 Another institution in the news is the Group of Twenty (G20). Established in 1999, the G20 comprises the finance ministers and central bank governors of the 19 largest economies in the world, plus representatives from the European Union and the European Central Bank. Collectively, the G20 represents 90 percent of global GDP and 80 percent of international global trade. Originally established to formulate a coordinated policy response to financial crises in developing nations, in 2008 and 2009 it became the forum through which major nations attempted to launch a coordinated policy response to the global financial crisis that started in America and then rapidly spread around the world, ushering in the first serious global economic recession since 1981.

Drivers of Globalization

Two macro factors underlie the trend toward greater globalization.13 The first is the de- cline in barriers to the free flow of goods, services, and capital that has occurred since the end of World War II. The second factor is technological change, particularly the dra- matic developments in recent decades in communication, information processing, and transportation technologies.

DECLINING TRADE AND INVESTMENT BARRIERS

During the 1920s and 1930s, many of the world’s nation-states erected formidable barri- ers to international trade and foreign direct investment. International trade occurs when a firm exports goods or services to consumers in another country. Foreign direct invest- ment (FDI) occurs when a firm invests resources in business activities outside its home country. Many of the barriers to international trade took the form of high tariffs on im- ports of manufactured goods. The typical aim of such tariffs was to protect domestic in- dustries from foreign competition. One consequence, however, was “beggar thy neighbor” retaliatory trade policies, with countries progressively raising trade barriers against each other. Ultimately, this depressed world demand and contributed to the Great Depression of the 1930s. Having learned from this experience, the advanced industrial nations of the West com- mitted themselves after World War II to progressively reducing barriers to the free flow of goods, services, and capital among nations.14 This goal was enshrined in the General Agreement on Tariffs and Trade. Under the umbrella of GATT, eight rounds of negotia- tions among member states worked to lower barriers to the free flow of goods and ser- vices. The most recent negotiations to be completed, known as the Uruguay Round, were finalized in December 1993. The Uruguay Round further reduced trade barriers; ex- tended GATT to cover services as well as manufactured goods; provided enhanced pro- tection for patents, trademarks, and copyrights; and established the World Trade Organization to police the international trading system.15 Table 1.1 summarizes the im- pact of GATT agreements on average tariff rates for manufactured goods. As can be seen, average tariff rates have fallen significantly since 1950 and now stand at about 1.5 percent. Comparable tariff rates in 2014 for China and India were 4.8 and 7.1 percent, respectively. In late 2001, the WTO launched a new round of talks aimed at further liberalizing the global trade and investment framework. For this meeting, it picked the remote location of Doha in the Persian Gulf state of Qatar. At Doha, the member states of the WTO staked

LO 1 -2 Recognize the main drivers of globalization.

Globalization Chapter 1 11

TA B L E 1 . 1

Average Tariff Rates on Manufactured Products as Percentage of Value

Sources: The 1913–1990 data are from “Who Wants to Be a Giant?,” The Economist: A Survey of the Multinationals, June 24, 1995, pp. 3–4. Copyright © The Econo- mist Books, Ltd. The 2014 data are from World Development Indicators 2015, World Bank.

1913 1950 1990 2014 France 21% 18% 5.9% 1.5%

Germany 20 26 5.9 1.5

Italy 18 25 5.9 1.5

Japan 30 — 5.3 1.3

Holland 5 11 5.9 1.5

Sweden 20 9 4.4 1.5

United Kingdom — 23 5.9 1.5

United States 44 14 4.8 1.5

out an agenda. The talks were scheduled to last three years, but, as of 2015, the talks are effectively stalled due to opposition from several key nations. The Doha agenda includes further tariff reductions for industrial goods, services, and agricultural products; phasing out subsidies to agricultural producers; reducing barriers to cross-border investment; and limiting the use of antidumping laws. If the Doha talks are ever completed, the biggest gain may come from discussion on agricultural products; average agricultural tariff rates are still about 40 percent, and rich nations spend some $300 billion a year in subsidies to support their farm sectors. The world’s poorer nations have the most to gain from any reduction in agricultural tariffs and subsidies; such reforms would give them access to the markets of the developed world.16 In addition to reducing trade barriers, many countries have also been progressively removing restrictions to foreign direct investment. According to the United Nations, some 80 percent of the 1,440 changes made worldwide between 2000 and 2013 in the laws governing foreign direct investment created a more favorable environment for FDI.17 Such trends have been driving both the globalization of markets and the globalization of production. The lowering of barriers to international trade enables firms to view the world, rather than a single country, as their market. The lowering of trade and investment barriers also allows firms to base production at the optimal location for that activity. Thus, a firm might design a product in one country, produce component parts in two other countries, assemble the product in yet another country, and then export the finished product around the world. According to WTO, the volume world trade in merchandised goods has grown consis- tently faster than the growth rate in the world economy since since 1950. As a conse- quence, by 2013 the volume of world trade was 33 times larger than in 1950, whereas the world economy was 9 times larger (these figures are in real terms, adjusted for inflation). This trend has continued into the modern era. Between 2000 and 2013, the volume of world trade has increased 2.9 times whereas the world economy has increased 1.34 times after adjusting for inflation.18 Since the mid-1980s, the value of international trade in services has also grown robustly and now accounts for about 20 percent of the value of all international trade. Increasingly, international trade in services has been driven by ad- vances in communications, which allow corporations to outsource service activities to different locations around the globe. For example, many corporations in the developed world outsource customer service functions, from software testing to customer call cen- ters, to developing nations where labor costs are lower. The fact that the volume of world trade has been growing faster than world GDP implies several things. First, more firms are doing what Boeing does with the 777 and 787: dispersing parts of their production process to different locations around the globe to drive down production costs and increase product quality. Second, the econo- mies of the world’s nation-states are becoming ever more intertwined. As trade

12 Part 1 Introduction and Overview

expands, nations are becoming increasingly dependent on each other for important goods and services. Third, the world has become significantly wealthier since 1990. The implication is that rising trade is the engine that has helped pull the global econ- omy along. Evidence also suggests that foreign direct investment is playing an increasing role in the global economy as firms increase their cross-border investments. The average yearly outflow of FDI increased from $14 billion in 1970 to $1.26 trillion in 2014.19 Even though the 2014 figure was significantly below the peak of $1.9 billion in foreign direct invest- ment recorded in 2007, the long-term trends remain positive. As a result of the strong FDI flow, by 2013 the global stock of FDI was about $25.5 trillion. More than 80,000 parent companies had more than 800,000 affiliates in foreign markets that collectively employed more than 71 million people abroad and generated value accounting for about 11 percent of global GDP. The foreign affiliates of multinationals had $34.5 trillion in global sales, higher than the value of global exports of goods and services, which stood at close to $23.4 trillion.20 The globalization of markets and production and the resulting growth of world trade, foreign direct investment, and imports all imply that firms are finding their home mar- kets under attack from foreign competitors. This is true in China, where U.S. compa- nies such as Apple, General Motors, and Starbucks are expanding their presence. It is true in the United States, where Japanese automobile firms have taken market share away from General Motors and Ford over the past three decades, and it is true in Europe, where the once-dominant Dutch company Philips has seen its market share in the consumer electronics industry taken by Japan’s Panasonic and Sony and Korea’s Samsung and LG. The growing integration of the world economy into a single, huge marketplace is increasing the intensity of competition in a range of manufacturing and service industries. However, declining barriers to cross-border trade and investment cannot be taken for granted. As we shall see in subsequent chapters, demands for “protection” from foreign competitors are still often heard in countries around the world, including the United States. Although a return to the restrictive trade policies of the 1920s and 1930s is un- likely, it is not clear whether the political majority in the industrialized world favors fur- ther reductions in trade barriers. Indeed, the global financial crisis of 2008–2009 and the associated drop in global output that occurred led to more calls for trade barriers to pro- tect jobs at home. If trade barriers decline no further, this may slow the rate of globaliza- tion of both markets and production.

THE ROLE OF TECHNOLOGICAL CHANGE

The lowering of trade barriers made globalization of markets and production a theoretical possibility. Technological change has made it a tangible reality. Since the end of World War II, the world has seen major advances in communication, information processing, and transportation technology, including the explosive emergence of the Internet.

Microprocessors and Telecommunications Perhaps the single most important innovation has been development of the microproces- sor, which enabled the explosive growth of high-power, low-cost computing, vastly in- creasing the amount of information that can be processed by individuals and firms. The microprocessor also underlies many recent advances in telecommunications technology. Over the past 30 years, global communications have been revolutionized by develop- ments in satellite, optical fiber, wireless technologies, and the Internet. These technolo- gies rely on the microprocessor to encode, transmit, and decode the vast amount of information that flows along these electronic highways. The cost of microprocessors con- tinues to fall, while their power increases (a phenomenon known as Moore’s law, which predicts that the power of microprocessor technology doubles and its cost of production falls in half every 18 months).21

Commercial jet travel has reduced the time needed to get from one location to an- other, effectively shrinking the globe. Source: © Glow Images, RF

Globalization Chapter 1 13

The Internet The explosive growth of the Internet since 1994 when the first web browser was in- troduced is the latest expression of this development. In 1990, fewer than 1 million users were connected to the Internet. By 1995, the figure had risen to 50 million. By 2014, the Internet had 2.9 billion users.22 The Internet has developed into the infor- mation backbone of the global economy. In North America alone, e-commerce retail sales reached $300 billion in 2014 (up from almost nothing in 1998), while global e-commerce sales surpassed $1 trillion for the first time in 2012.23 Viewed globally, the Internet has emerged as an equalizer. It rolls back some of the constraints of location, scale, and time zones.24 The Internet makes it much easier for buyers and sellers to find each other, wherever they may be located and whatever their size. It allows businesses, both small and large, to expand their global presence at a lower cost than ever before. Just as important, it enables enterprises to coordinate and control a globally dispersed production system in a way that was not possible 25 years ago.

Transportation Technology In addition to developments in communications technology, several major innovations in transportation technology have occurred since World War II. In economic terms, the most important are probably the development of commercial jet aircraft and super- freighters and the introduction of containerization, which simplifies transshipment from one mode of transport to another. The advent of commercial jet travel, by reducing the time needed to get from one location to another, has effectively shrunk the globe. In terms of travel time, New York is now “closer” to Tokyo than it was to Philadelphia in the colonial days. Containerization has revolutionized the transportation business, significantly lower- ing the costs of shipping goods over long distances. Because the international shipping industry is responsible for carrying about 90 percent of the volume of world trade in goods, this has been an extremely important development.25 Before the advent of con- tainerization, moving goods from one mode of transport to another was very labor in- tensive, lengthy, and costly. It could take days and several hundred longshore workers to unload a ship and reload goods onto trucks and trains. With the advent of widespread containerization in the 1970s and 1980s, the whole process can now be executed by a handful of longshore workers in a couple of days. As a result of the efficiency gains as- sociated with containerization, transportation costs have plummeted, making it much more economical to ship goods around the globe, thereby helping drive the globalization of markets and production. Between 1920 and 1990, the average ocean freight and port charges per ton of U.S. export and import cargo fell from $95 to $29 (in 1990 dollars).26 Today, the typical cost of transporting a 20-foot container from Asia to Europe carrying more than 20 tons of cargo is about the same as the economy airfare for a single pas- senger on the same journey. As a result, in 2012 the shipping cost of a $700 TV set was just $10 and that of a $150 vacuum cleaner just $1.27 The cost of shipping freight per ton-mile on railroads in the United States also fell from 3.04 cents in 1985 to 2.3 cents in 2000, largely as a result of efficiency gains from the widespread use of containers.28 An increased share of cargo now goes by air. Between 1955 and 1999, average air trans- portation revenue per ton-kilometer fell by more than 80 percent.29 Reflecting the falling cost of airfreight, by the early 2000s air shipments accounted for 28 percent of the value of U.S. trade, up from 7 percent in 1965.30

Implications for the Globalization of Production As transportation costs associated with the globalization of production have declined, dispersal of production to geographically separate locations has become more economi- cal. As a result of the technological innovations discussed earlier, the real costs of infor- mation processing and communication have fallen dramatically in the past two decades.

14 Part 1 Introduction and Overview

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These developments make it possible for a firm to create and then manage a globally dispersed production system, further facilitating the globalization of production. A world- wide communications network has become essential for many international businesses. For example, Dell uses the Internet to coordinate and control a globally dispersed produc- tion system to such an extent that it holds only three days’ worth of inventory at its as- sembly locations. Dell’s Internet-based system records orders for computer equipment as they are submitted by customers via the company’s website and then immediately trans- mits the resulting orders for components to various suppliers around the world, which have a real-time look at Dell’s order flow and can adjust their production schedules accordingly. Given the low cost of airfreight, Dell can use air transportation to speed up the delivery of critical components to meet unanticipated demand shifts without delaying the shipment of final product to consumers. Dell has also used modern communications technology to outsource its customer service operations to India. When U.S. customers call Dell with a service inquiry, they are routed to Bangalore in India, where English- speaking service personnel handle the call.

Implications for the Globalization of Markets In addition to the globalization of production, technological innovations have facilitated the globalization of markets. Low-cost global communications networks, including those built on top of the Internet, are helping create electronic global marketplaces. As noted earlier, low-cost transportation has made it more economical to ship products around the world, thereby helping create global markets. In addition, low-cost jet travel has resulted in the mass movement of people between countries. This has reduced the cultural distance between countries and is bringing about some convergence of con- sumer tastes and preferences. At the same time, global communications networks and global media are creating a worldwide culture. U.S. television networks such as CNN, MTV, and HBO are now received in many countries, Hollywood films are shown the world over, while non-U.S. news networks such as the BBC and Al Jazeera also have a global footprint. In any society, the media are primary conveyors of culture; as global media develop, we must expect the evolution of something akin to a global culture. A logical result of this evolution is the emergence of global markets for consumer products. Clear signs of this are apparent. It is now as easy to find a McDonald’s restaurant in Tokyo as it is in New York, to buy an iPad in Rio as it is in Berlin, and to buy Gap jeans in Paris as it is in San Francisco. Despite these trends, we must be careful not to overemphasize their importance. While modern communications and transportation technologies are ushering in the “global village,” significant national differences remain in culture, consumer prefer- ences, and business practices. A firm that ignores differences among countries does so at its peril. We shall stress this point repeatedly throughout this text and elaborate on it in later chapters.

The Changing Demographics of the Global Economy

Hand in hand with the trend toward globalization has been a fairly dramatic change in the demographics of the global economy over the past 30 years. As late as the 1960s, four stylized facts described the demographics of the global economy. The first was U.S. dom- inance in the world economy and world trade picture. The second was U.S. dominance in world foreign direct investment. Related to this, the third fact was the dominance of large, multinational U.S. firms on the international business scene. The fourth was that roughly half the globe—the centrally planned economies of the communist world—was off-limits to Western international businesses. As will be explained here, all four of these qualities either have changed or are now changing rapidly.

LO 1 -3 Describe the changing nature of the global economy.

Globalization Chapter 1 15

THE CHANGING WORLD OUTPUT AND WORLD TRADE PICTURE

In the early 1960s, the United States was still by far the world’s dominant industrial power. In 1960, the United States accounted for 38.3 percent of world output, measured by gross domestic product (GDP). By 2012, the United States accounted for 23.1 percent of world output, still the world’s largest industrial power but down significantly in rela- tive size (see Table 1.2). Nor was the United States the only developed nation to see its relative standing slip. The same occurred to Germany, France, and the United Kingdom— all nations that were among the first to industrialize. This change in the U.S. position was not an absolute decline because the U.S. economy grew significantly between 1960 and 2012 (the economies of Germany, France, and the United Kingdom also grew during this time). Rather, it was a relative decline, reflecting the faster economic growth of several other economies, particularly in Asia. For example, as can be seen from Table 1.2, from 1960 to 2013, China’s share of world output increased from a triv- ial amount to 12.2 percent, making it the world’s second-largest economy. Other coun- tries that markedly increased their share of world output included Japan, Thailand, Malaysia, Taiwan, Brazil, and South Korea. By the end of the 1980s, the U.S. position as the world’s leading trading nation was threatened. Over the past 30 years, U.S. dominance in export markets has waned as Japan, Germany, and a number of newly industrialized countries such as South Korea and China have taken a larger share of world exports. During the 1960s, the United States routinely accounted for 20 percent of world exports of manufactured goods. But as Table 1.2 shows, the U.S. share of world exports of goods and services had slipped to 9.7 percent by 2013, behind that of China. As emerging economies such as China, India, Russia, and Brazil continue to grow, a further relative decline in the share of world output and world exports accounted for by the United States and other long-established developed nations seems likely. By itself, this is not bad. The relative decline of the United States reflects the growing economic development and industrialization of the world economy, as opposed to any absolute de- cline in the health of the U.S. economy. Most forecasts now predict a rapid rise in the share of world output accounted for by developing nations such as China, India, Russia, Indonesia, Thailand, South Korea, Mexico, and Brazil, and a commensurate decline in the share enjoyed by rich industrial- ized countries such as Great Britain, Germany, Japan, and the United States. If current trends continue, the Chinese economy could ultimately be larger than that of the United States on a purchasing power parity basis, while the economy of India will approach that of Germany. The World Bank has estimated that today’s developing nations may account

TA B L E 1 . 2

The Changing Demographics of World Output and Trade

Sources: Output data from World Bank database, April, 2015. Trade data from WTO Statistical Database, 2015.

Share of Share of Share of World Output, World Output, World Exports, Country 1960 (%) 2013 (%) 2013 (%) United States 38.3% 22.2% 9.7%

Germany 8.7 4.9 7.9

France 4.6 3.7 3.5

Italy 3.0 2.2 2.7

United Kingdom 5.3 3.5 3.3

Canada 3.0 2.4 2.3

Japan 3.3 6.5 3.6

China NA 12.2 13.0

16

COUNTRY FOCUS

India’s Software Sector Some 25 years ago, a number of small software enterprises were established in Bangalore, India. Typical of these enter- prises was Infosys Technologies, which was started by seven Indian entrepreneurs with about $1,000 among them. Infosys now has annual revenues of $8.25 billion and some 170,000 employees, but it is just 1 of more than 100 software compa- nies clustered around Bangalore, which has become the epicenter of India’s fast-growing information technology sec- tor. From a standing start in the mid-1980s, by 2014–2015 this sector was generating export sales of almost $100 billion. The growth of the Indian software sector has been based on four factors. First, the country has an abundant supply of engineering talent. Every year, Indian universities graduate some 400,000 engineers. Second, labor costs in the Indian software sector have historically been low. As recently as 2008, the cost to hire an Indian graduate was roughly 12 percent of the cost of hiring an American graduate (how- ever, this gap is narrowing fast with pay in the sector now only 30–40 percent less than in the United States). Third, many Indians are fluent in English, which makes coordina- tion between Western firms and India easier. Fourth, due to time differences, Indians can work while Americans sleep. Initially, Indian software enterprises focused on the low end of the software industry, supplying basic software

development and testing services to Western firms. But as the industry has grown in size and sophistication, Indian firms have moved up the market. Today, the leading Indian companies compete directly with the likes of IBM and EDS for large software development projects, business process outsourcing contracts, and information technology consult- ing services. Over the past 15 years, these markets have boomed, with Indian enterprises capturing a large slice of the pie. One response of Western firms to this emerging competitive threat has been to invest in India to garner the same kind of economic advantages that Indian firms enjoy. IBM, for example, has invested $2 billion in its Indian opera- tions and now has 150,000 employees located there, more than in any other country. Microsoft, too, has made major investments in India, including a research and development (R&D) center in Hyderabad that employs 4,000 people and was located there specifically to tap into talented Indian en- gineers who did not want to move to the United States.

Sources: “America’s Pain, India’s Gain: Outsourcing,” The Economist, January 11, 2003, p. 59; “The World Is Our Oyster,” The Economist, October 7, 2006, pp. 9–10; “IBM and Globalization: Hungry Tiger, Dancing Elephant,” The Economist, April 7, 2007, pp. 67–69; P. Mishra, “New Billing Model May Hit India’s Software Exports,” Live Mint, February 14, 2013; “India’s Outsourcing Business: On the Turn,” The Economist, January 19, 2013.

for more than 60 percent of world economic activity by 2025, while today’s rich nations, which currently account for more than 55 percent of world economic activity, may ac- count for only about 38 percent. Forecasts are not always correct, but these suggest that a shift in the economic geography of the world is now under way, although the magnitude of that shift is not totally evident. For international businesses, the implications of this changing economic geography are clear: Many of tomorrow’s economic opportunities may be found in the developing nations of the world, and many of tomorrow’s most capable competitors will probably also emerge from these regions. A case in point has been the dramatic expansion of India’s software sector, which is profiled in the accompa- nying Country Focus.

THE CHANGING FOREIGN DIRECT INVESTMENT PICTURE

Reflecting the dominance of the United States in the global economy, U.S. firms accounted for 66.3 percent of worldwide foreign direct investment flows in the 1960s. British firms were second, accounting for 10.5 percent, while Japanese firms were a distant eighth, with only 2 percent. The dominance of U.S. firms was so great that books were written about the economic threat posed to Europe by U.S. corporations.31 Several European govern- ments, most notably France, talked of limiting inward investment by U.S. firms. However, as the barriers to the free flow of goods, services, and capital fell, and as other countries increased their shares of world output, non-U.S. firms increasingly began

Globalization Chapter 1 17

to invest across national borders. The motivation for much of this foreign direct invest- ment by non-U.S. firms was the desire to disperse production activities to optimal loca- tions and to build a direct presence in major foreign markets. Thus, beginning in the 1970s, European and Japanese firms began to shift labor-intensive manufacturing opera- tions from their home markets to developing nations where labor costs were lower. In addition, many Japanese firms invested in North America and Europe—often as a hedge against unfavorable currency movements and the possible imposition of trade barriers. For example, Toyota, the Japanese automobile company, rapidly increased its investment in automobile production facilities in the United States and Europe during the late 1980s and 1990s. Toyota executives believed that an increasingly strong Japanese yen would price Japanese automobile exports out of foreign markets; therefore, production in the most important foreign markets, as opposed to exports from Japan, made sense. Toyota also undertook these investments to head off growing political pressures in the United States and Europe to restrict Japanese automobile exports into those markets. One consequence of these developments is illustrated in Figure 1.1, which shows how the stock of foreign direct investment by the world’s six most important national sources— the United States, the United Kingdom, Germany, the Netherlands, France, and Japan— changed between 1980 and 2013. [The stock of foreign direct investment (FDI) refers to the total cumulative value of foreign investments.] Figure 1.1 also shows the stock ac- counted for by firms from developing economies. The share of the total stock accounted for by U.S. firms declined from about 38 percent in 1980 to 24 percent in 2013. Mean- while, the shares accounted for by the world’s developing nations increased markedly. The rise in the share of FDI stock accounted for by developing nations reflects a growing trend for firms from these countries to invest outside their borders. In 2013, firms based in developing nations accounted for 19 percent of the stock of foreign direct investment, up from around 1 percent in 1980. Firms based in Hong Kong, South Korea, Singapore, Taiwan, India, Brazil, and mainland China accounted for much of this investment. Figure 1.2 illustrates two other important trends—the sustained growth in cross-border flows of foreign direct investment that occurred during the 1990s and the increasing importance of developing nations as the destination of foreign direct investment. Throughout the 1990s, the amount of investment directed at both developed and develop- ing nations increased dramatically, a trend that reflects the increasing internationaliza- tion of business corporations. A surge in foreign direct investment from 1998 to 2000 was followed by a slump from 2001 to 2003, associated with a slowdown in global economic activity after the collapse of the financial bubble of the late 1990s and 2000. The growth

19901980 2000 2013

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F I G U R E 1 . 1

Percentage share of total FDI stock, 1980–2013.

18 Part 1 Introduction and Overview

of foreign direct investment resumed in 2004 and continued through 2007, when it hit record levels, only to slow again in 2008 and 2009 as the global financial crisis took hold. However, throughout this time period the growth of foreign direct investment into devel- oping nations remained robust. Among developing nations, the largest recipient has been China, which in 2004–2012 received $60 billion to $100 billion a year in inflows, fol- lowed by the likes of Brazil, Mexico, and India. As we shall see later in this text, the sustained flow of foreign investment into developing nations is an important stimulus for economic growth in those countries, which bodes well for the future of countries such as China, Mexico, and Brazil—all leading beneficiaries of this trend.

THE CHANGING NATURE OF THE MULTINATIONAL ENTERPRISE

A multinational enterprise (MNE) is any business that has productive activities in two or more countries. Since the 1960s, two notable trends in the demographics of the multinational enterprise have been (1) the rise of non-U.S. multinationals and (2) the growth of mini-multinationals.

Non-U.S. Multinationals In the 1960s, global business activity was dominated by large U.S. multinational corpora- tions. With U.S. firms accounting for about two-thirds of foreign direct investment during the 1960s, one would expect most multinationals to be U.S. enterprises. According to the data summarized in Figure 1.3, in 1973, 48.5 percent of the world’s 260 largest multina- tionals were U.S. firms. The second-largest source country was the United Kingdom, with 18.8 percent of the largest multinationals. Japan accounted for 3.5 percent of the world’s largest multinationals at the time. The large number of U.S. multinationals re- flected U.S. economic dominance in the three decades after World War II, while the large number of British multinationals reflected that country’s industrial dominance in the early decades of the twentieth century. By 2012, things had shifted significantly. Some 22 of the world’s 100 largest nonfinan- cial multinationals were U.S. enterprises; 14 were British, 14 French, 10 were German, and 7 were from Japan.32 Although the 1973 data are not strictly comparable with the later data, they illustrate the trend (the 1973 figures are based on the largest 260 firms, whereas the later figures are based on the largest 100 multinationals). The globalization and growth of the world economy has resulted in a relative reduction in the dominance of U.S. firms in the global marketplace.

2,500

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Developed Countries Developing Countries

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F I G U R E 1 . 2

FDI inflows, 1980–2013.

M A NAG E M E N T F O C U S

China’s Hisense—an Emerging Multinational Hisense is rapidly emerging as one of China’s leading multi- nationals. Like many other Chinese corporations, Hisense traces its origins back to a state-owned manufacturer, in this case Qingdao No. 2 Radio Factory, which was established in 1969 with just 10 employees. In the 1970s, the state-owned factory diversified into the manufacture of TV sets; by the 1980s, it was one of China’s leading manufacturers of color TVs, making sets designed by Matsushita under license. In 1992, a 35-year-old engineer named Zhou Houjian was appointed head of the enterprise. In 1994, the shackles of state owner- ship were relaxed when the Hisense Company Ltd. was es- tablished with Zhou as CEO (he is now board chairman). Under Zhou’s leadership, Hisense entered a period of rapid growth, product diversification, and global expan- sion. By 2013, the company had sales of more than $15 billion and had emerged as one of China’s premier makers of TV sets, air conditioners, refrigerators, personal comput- ers, and telecommunications equipment. Hisense sold more than 10 million TV sets, 3 million air conditioners, 4 million CDMA wireless phones, 6 million refrigerators, and 1 million personal computers. International sales accounted for more than 15 percent of total revenue. The company had established overseas manufacturing subsidiaries in Algeria, Hungary, Iran, Pakistan, and South Africa and was growing rapidly in developing markets, where it was taking share away from long-established consumer electronics and appliance makers.

Hisense’s ambitions are grand. It seeks to become a global enterprise with a world-class consumer brand. Al- though it is without question a low-cost manufacturer, Hisense believes its core strength is in rapid product innovation. The company believes that the only way to gain leadership in the highly competitive markets in which it competes is to continuously launch advanced, high-quality, and competitively priced products. To this end, Hisense established its first R&D center in China in the mid-1990s. This was followed by a South African R&D center in 1997 and a European R&D center in 2007. The com- pany also has plans for an R&D center in the United States. By 2008, these R&D centers filed for more than 600 patents. Hisense’s technological prowess is evident in its digital TV business. It introduced set-top boxes in 1999, making it possi- ble to browse the Internet from a TV. In 2002, Hisense intro- duced its first interactive digital TV set, and in 2005 it developed China’s first core digital processing chip for digital TVs, breaking the country’s reliance on foreign chip makers for this core technology. In 2006, Hisense launched an innovative line of multimedia TV sets that integrated digital high-definition technology, network technology, and flat-panel displays.

Sources: Harold L. Sirkin, “Someone May Be Gaining on Us,” Barron’s, February 5, 2007, p. 53; “Hisense Plans to Grab More International Sales,” Sino Cast China IT Watch, November 30, 2006; “Hisense’s Wonder Chip,” Financial Times Information Limited—Asian Intelli- gence Wire, October 30, 2006; Hisense’s website, www.hisense.com.

F I G U R E 1 . 3

National share of largest multinationals, 1973 and 2012.

60

50

40

30

20

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0 United States

Japan United Kingdom

France Germany Other

1973 2012

19

20 Part 1 Introduction and Overview

According to UN data, the ranks of the world’s largest 100 multinationals are still dominated by firms from developed economies.33 However, eight firms from developing economies had entered the UN’s list of the 100 largest multinationals by 2012. The larg- est was Hutchison Whampoa of Hong Kong, China, which ranked 26th.34 Firms from developing nations can be expected to emerge as important competitors in global mar- kets, further shifting the axis of the world economy away from North America and west- ern Europe and threatening the long dominance of Western companies. One such rising competitor, Hisense, one of China’s premier manufacturers of consumer appliances and telecommunications equipment, is profiled in the accompanying Management Focus.

The Rise of Mini-Multinationals Another trend in international business has been the growth of medium-size and small multinationals (mini-multinationals).35 When people think of international businesses, they tend to think of firms such as ExxonMobil, General Motors, Ford, Panasonic, Procter & Gamble, Sony, and Unilever—large, complex multinational corporations with operations that span the globe. Although most international trade and investment are still conducted by large firms, many medium-size and small businesses are becoming in- creasingly involved in international trade and investment. The rise of the Internet is low- ering the barriers that small firms face in building international sales. Consider Lubricating Systems Inc. of Kent, Washington. Lubricating Systems, which manufactures lubricating fluids for machine tools, employs 25 people and generates sales of $6.5 million. It’s hardly a large, complex multinational, yet more than $2 million of the company’s sales are generated by exports to a score of countries, including Japan, Israel, and the United Arab Emirates. Lubricating Systems has also set up a joint venture with a German company to serve the European market.36 Consider also Lixi Inc., a small U.S. manufacturer of industrial X-ray equipment; 70 percent of Lixi’s $4.5 million in revenues comes from exports to Japan.37 Or take G. W. Barth, a manufacturer of cocoa-bean roast- ing machinery based in Ludwigsburg, Germany. Employing just 65 people, this small company has captured 70 percent of the global market for cocoa-bean roasting ma- chines.38 International business is conducted not just by large firms but also by medium- size and small enterprises.

THE CHANGING WORLD ORDER

Between 1989 and 1991, a series of democratic revolutions swept the communist world. For reasons that are explored in more detail in Chapter 3, in country after country throughout eastern Europe and eventually in the Soviet Union itself, Communist Party governments collapsed. The Soviet Union receded into history, having been replaced by 15 independent republics. Czechoslovakia divided itself into two states, while Yugoslavia dissolved into a bloody civil war, now thankfully over, among its five successor states. Many of the former communist nations of Europe and Asia seem to share a commit- ment to democratic politics and free market economics. For half a century, these coun- tries were essentially closed to Western international businesses. Now, they present a host of export and investment opportunities. Two decades later, the economies of many of the former communist states are still relatively undeveloped, and their continued commit- ment to democracy and market-based economic systems cannot be taken for granted. Disturbing signs of growing unrest and totalitarian tendencies continue to be seen in several eastern European and central Asian states, including Russia, which has shown signs of shifting back toward greater state involvement in economic activity and authori- tarian government.39 Thus, the risks involved in doing business in such countries are high, but so may be the returns. In addition to these changes, quieter revolutions have been occurring in China, other states in Southeast Asia, and Latin America. Their implications for international busi- nesses may be just as profound as the collapse of communism in eastern Europe. China suppressed its own pro-democracy movement in the bloody Tiananmen Square massacre

Globalization Chapter 1 21

of 1989. Despite this, China continues to move progressively toward greater free market reforms. If what is occurring in China continues for two more decades, China may move from third-world to industrial superpower status even more rapidly than Japan did. If China’s GDP per capita grows by an average of 6 to 7 percent, which is slower than the 8 to 10 percent growth rate achieved during the past decade, then by 2030 this nation of 1.3 billion people could boast an average GDP per capita of about $23,000, roughly the same as that of Chile or Poland today. The potential consequences for international business are enormous. On the one hand, China represents a huge and largely untapped market. Reflecting this, between 1983 and 2014, annual foreign direct investment in China increased from less than $2 billion to $110 billion annually. On the other hand, China’s new firms are proving to be very capable competitors, and they could take global market share away from Western and Japanese enterprises (e.g., see the Management Focus about Hisense). Thus, the changes in China are creating both opportunities and threats for established international businesses. As for Latin America, both democracy and free market reforms have been evident there too. For decades, most Latin American countries were ruled by dictators, many of whom seemed to view Western international businesses as instruments of imperialist domination. Accordingly, they restricted direct investment by foreign firms. In addi- tion, the poorly managed economies of Latin America were characterized by low growth, high debt, and hyperinflation—all of which discouraged investment by inter- national businesses. In the past two decades, much of this has changed. Throughout most of Latin America, debt and inflation are down, governments have sold state- owned enterprises to private investors, foreign investment is welcomed, and the re- gion’s economies have expanded. Brazil, Mexico, and Chile have led the way. These changes have increased the attractiveness of Latin America, both as a market for exports and as a site for foreign direct investment. At the same time, given the long his- tory of economic mismanagement in Latin America, there is no guarantee that these favorable trends will continue. Indeed, Bolivia, Ecuador, and most notably Venezuela have seen shifts back toward greater state involvement in industry in the past few years, and foreign investment is now less welcome than it was during the 1990s. In these nations, the government has seized control of oil and gas fields from foreign investors and has limited the rights of foreign energy companies to extract oil and gas from their nations. Thus, as in the case of eastern Europe, substantial opportunities are accompa- nied by substantial risks.

THE GLOBAL ECONOMY OF THE TWENTY-FIRST CENTURY

As discussed, the past quarter century has seen rapid changes in the global economy. Barriers to the free flow of goods, services, and capital have been coming down. As their economies advance, more nations are joining the ranks of the developed world. A genera- tion ago, South Korea and Taiwan were viewed as second-tier developing nations. Now they boast large economies, and their firms are major players in many global industries, from shipbuilding and steel to electronics and chemicals. The move toward a global econ- omy has been further strengthened by the widespread adoption of liberal economic poli- cies by countries that had firmly opposed them for two generations or more. In short, current trends indicate the world is moving toward an economic system that is more fa- vorable for international business. But it is always hazardous to use established trends to predict the future. The world may be moving toward a more global economic system, but globalization is not inevita- ble. Countries may pull back from the recent commitment to liberal economic ideology if their experiences do not match their expectations. There are clear signs, for example, of a retreat from liberal economic ideology in Russia. If Russia’s hesitation were to become more permanent and widespread, the liberal vision of a more prosperous global economy based on free market principles might not occur as quickly as many hope. Clearly, this would be a tougher world for international businesses.

22 Part 1 Introduction and Overview

Also, greater globalization brings with it risks of its own. This was starkly demon- strated in 1997 and 1998 when a financial crisis in Thailand spread first to other East Asian nations and then to Russia and Brazil. Ultimately, the crisis threatened to plunge the economies of the developed world, including the United States, into a recession. We explore the causes and consequences of this and other similar global financial crises in Chapter 11. Even from a purely economic perspective, globalization is not all good. The opportunities for doing business in a global economy may be significantly en- hanced, but as we saw in 1997–1998, the risks associated with global financial contagion are also greater. Indeed, during 2008–2009, a crisis that started in the financial sector of America, where banks had been too liberal in their lending policies to homeowners, swept around the world and plunged the global economy into its deepest recession since the early 1980s, illustrating once more that in an interconnected world a severe crisis in one region can affect the entire globe. Still, as explained later in this text, firms can exploit the opportunities associated with globalization while reducing the risks through appropriate hedging strategies.

The Globalization Debate

Is the shift toward a more integrated and interdependent global economy a good thing? Many influential economists, politicians, and business leaders seem to think so.40 They argue that falling barriers to international trade and investment are the twin engines driv- ing the global economy toward greater prosperity. They say increased international trade and cross-border investment will result in lower prices for goods and services. They be- lieve that globalization stimulates economic growth, raises the incomes of consumers, and helps create jobs in all countries that participate in the global trading system. The arguments of those who support globalization are covered in detail in Chapters 6, 7, and 8. As we shall see, there are good theoretical reasons for believing that declining barriers to international trade and investment do stimulate economic growth, create jobs, and raise income levels. Moreover, as described in Chapters 6, 7, and 8, empirical evidence lends support to the predictions of this theory. However, despite the existence of a com- pelling body of theory and evidence, globalization has its critics.41 Some of these critics are vocal and active, taking to the streets to demonstrate their opposition to globalization. Here, we look at the nature of protests against globalization and briefly review the main themes of the debate concerning the merits of globalization. In later chapters, we elabo- rate on many of these points.

ANTIGLOBALIZATION PROTESTS

Popular demonstrations against globalization date to December 1999, when more than 40,000 protesters blocked the streets of Seattle in an attempt to shut down a World Trade Organization meeting being held in the city. The demonstrators were protesting against a wide range of issues, including job losses in industries under attack from foreign competi- tors, downward pressure on the wage rates of unskilled workers, environmental degrada- tion, and the cultural imperialism of global media and multinational enterprises, which was seen as being dominated by what some protesters called the “culturally impover- ished” interests and values of the United States. All of these ills, the demonstrators claimed, could be laid at the feet of globalization. The World Trade Organization was meeting to try to launch a new round of talks to cut barriers to cross-border trade and investment. As such, it was seen as a promoter of globalization and a target for the pro- testers. The protests turned violent, transforming the normally placid streets of Seattle into a running battle between “anarchists” and Seattle’s bemused and poorly prepared police department. Pictures of brick-throwing protesters and armored police wielding their batons were duly recorded by the global media, which then circulated the images around the world. Meanwhile, the WTO meeting failed to reach agreement, and although

LO 1 - 4 Explain the main arguments in the debate over the impact of globalization.

TEST PREP Use SmartBook to help retain what you have learned. Access your instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

23

COUNTRY FOCUS

One night in August 1999, 10 men under the leadership of local sheep farmer and rural activist José Bové crept into the town of Millau in central France and vandalized a McDonald’s restaurant under construction, causing an esti- mated $150,000 in damage. These were no ordinary vandals, however, at least according to their supporters, for the “symbolic dismantling” of the McDonald’s outlet had noble aims, or so it was claimed. The attack was ini- tially presented as a protest against unfair American trade policies. The European Union had banned imports of hormone-treated beef from the United States, primarily be- cause of fears that it might lead to health problems (although EU scientists had concluded there was no evi- dence of this). After a careful review, the World Trade Or- ganization stated the EU ban was not allowed under trading rules that the EU and United States were party to and that the EU would have to lift it or face retaliation. The EU refused to comply, so the U.S. government imposed a 100 percent tariff on imports of certain EU products, includ- ing French staples such as foie gras, mustard, and Roquefort cheese. On farms near Millau, Bové and others raised sheep whose milk was used to make Roquefort. They felt incensed by the American tariff and decided to vent their frustrations on McDonald’s. Bové and his compatriots were arrested and charged. About the same time in the Languedoc region of France, California winemaker Robert Mondavi had reached agree- ment with the mayor and council of the village of Aniane and regional authorities to turn 125 acres of wooded hill- side belonging to the village into a vineyard. Mondavi planned to invest $7 million in the project and hoped to produce top-quality wine that would sell in Europe and the United States for $60 a bottle. However, local environmen- talists objected to the plan, which they claimed would de- stroy the area’s unique ecological heritage. José Bové, basking in sudden fame, offered his support to the oppo- nents, and the protests started. In May 2001, the socialist

mayor who had approved the project was defeated in lo- cal elections in which the Mondavi project had become the major issue. He was replaced by a communist, Manuel Diaz, who denounced the project as a capitalist plot de- signed to enrich wealthy U.S. shareholders at the cost of his villagers and the environment. Following Diaz’s victory, Mondavi announced he would pull out of the project. A spokesperson noted, “It’s a huge waste, but there are clearly personal and political interests at play here that go way beyond us.” So, are the French opposed to foreign investment? The experience of McDonald’s and Mondavi seems to suggest so, as does the associated news coverage, but look closer and a different reality seems to emerge. Today McDonald’s has more than 1,200 restaurants in France. McDonald’s employs 69,000 workers in the country. France is the most profitable market for McDonald’s after the United States. In short, 15 years after the protests, France is a major success story for McDonald’s. Moreover, France has long been one of the most favored locations for inward foreign direct in- vestment, receiving more than $660 billion of foreign in- vestment between 2000 and 2013, which makes it one of the top destinations for foreign investment in Europe. American companies have always accounted for a signifi- cant percentage of this investment. French enterprises have also been significant foreign investors; some 1,100 French multinationals have about $1.1 trillion of assets in other nations. For all of the populist opposition to global- ization, French corporations and consumers appear to be embracing it.

Sources: “Behind the Bluster,” The Economist, May 26, 2001; “The French Farmers’ Anti-global Hero,” The Economist, July 8, 2000; C. Trueheart, “France’s Golden Arch Enemy?” Toronto Star, July 1, 2000; J. Henley, “Grapes of Wrath Scare Off U.S. Firm,” The Econo- mist, May 18, 2001, p. 11; United Nations, World Investment Report, 2014 (New York and Geneva: United Nations, 2011); Rob Wile, “The True Story of How McDonald’s Conquered France,” Business Insider, August 22, 2014.

Protesting Globalization in France

the protests outside the meeting halls had little to do with that failure, the impression took hold that the demonstrators had succeeded in derailing the meetings. Emboldened by the experience in Seattle, antiglobalization protesters now often turn up at major meetings of global institutions. Smaller-scale protests have occurred in sev- eral countries, such as France, where antiglobalization activists destroyed a McDonald’s restaurant in 1999 to protest the impoverishment of French culture by American imperialism

24 Part 1 Introduction and Overview

(see the accompanying Country Focus for details). While violent protests may give the antiglobalization effort a bad name, it is clear from the scale of the demonstrations that support for the cause goes beyond a core of anarchists. Large segments of the population in many countries believe that globalization has detrimental effects on living standards, wage rates, and the environment. The media have often fed on this fear. For example, former CNN news anchor Lou Dobbs ran TV shows that were highly critical of the trend by American companies to take advantage of globalization and “export jobs” overseas. As the world slipped into a recession in 2008, Dobbs stepped up his antiglobalization rhetoric (Dobbs left CNN in 2009). Both theory and evidence suggest that many of these fears are exaggerated; both poli- ticians and businesspeople need to do more to counter these fears. Many protests against globalization are tapping into a general sense of loss at the passing of a world in which barriers of time and distance, and significant differences in economic institutions, politi- cal institutions, and the level of development of different nations, produced a world rich in the diversity of human cultures. However, while the rich citizens of the developed world may have the luxury of mourning the fact that they can now see McDonald’s restaurants and Starbucks coffeehouses on their vacations to exotic locations such as Thailand, fewer complaints are heard from the citizens of those countries, who welcome the higher living standards that progress brings.

GLOBALIZATION, JOBS, AND INCOME

One concern frequently voiced by globalization opponents is that falling barriers to inter- national trade destroy manufacturing jobs in wealthy advanced economies such as the United States and western Europe. Critics argue that falling trade barriers allow firms to move manufacturing activities to countries where wage rates are much lower.42 Indeed, due to the entry of China, India, and states from eastern Europe into the global trading system, along with global population growth, estimates suggest that the pool of global labor may have quadrupled between 1985 and 2005, with most of the increase occurring after 1990.43 Other things being equal, we might conclude that this enormous expansion in the global labor force, when coupled with expanding international trade, would have depressed wages in developed nations. This fear is often supported by anecdotes. For example, D. L. Bartlett and J. B. Steele, two journalists for the Philadelphia Inquirer who gained notoriety for their attacks on free trade, cite the case of Harwood Industries, a U.S. clothing manufacturer that closed its U.S. operations, where it paid workers $9 per hour, and shifted manufacturing to Honduras, where textile workers received 48 cents per hour.44 Because of moves such as this, argue Bartlett and Steele, the wage rates of poorer Americans have fallen signifi- cantly over the past quarter of a century. In the past few years, the same fears have been applied to services, which have in- creasingly been outsourced to nations with lower labor costs. The popular feeling is that when corporations such as Dell, IBM, or Citigroup outsource service activities to lower- cost foreign suppliers—as all three have done—they are “exporting jobs” to low-wage nations and contributing to higher unemployment and lower living standards in their home nations (in this case, the United States). Some U.S. lawmakers have responded by calling for legal barriers to job outsourcing. Supporters of globalization reply that critics of these trends miss the essential point about free trade—the benefits outweigh the costs.45 They argue that free trade will result in countries specializing in the production of those goods and services that they can pro- duce most efficiently, while importing goods and services that they cannot produce as efficiently. When a country embraces free trade, there is always some dislocation—lost textile jobs at Harwood Industries or lost call-center jobs at Dell—but the whole econ- omy is better off as a result. According to this view, it makes little sense for the United States to produce textiles at home when they can be produced at a lower cost in Honduras or China. Importing textiles from China leads to lower prices for clothes in the United States, which enables consumers to spend more of their money on other items. At the

Globalization Chapter 1 25

same time, the increased income generated in China from textile exports increases in- come levels in that country, which helps the Chinese purchase more products produced in the United States, such as pharmaceuticals from Amgen, Boeing jets, microprocessors made by Intel, Microsoft software, and Cisco routers. The same argument can be made to support the outsourcing of services to low-wage countries. By outsourcing its customer service call centers to India, Dell can reduce its cost structure, and thereby its prices for PCs. U.S. consumers benefit from this develop- ment. As prices for PCs fall, Americans can spend more of their money on other goods and services. Moreover, the increase in income levels in India allows Indians to purchase more U.S. goods and services, which helps create jobs in the United States. In this man- ner, supporters of globalization argue that free trade benefits all countries that adhere to a free trade regime. If the critics of globalization are correct, three things must be shown. First, the share of national income received by labor, as opposed to the share received by the owners of capital (e.g., stockholders and bondholders), should have declined in advanced nations as a result of downward pressure on wage rates. Second, even though labor’s share of the economic pie may have declined, this does not mean lower living standards if the size of the total pie has increased sufficiently to offset the decline in labor’s share—in other words, if economic growth and rising living standards in advanced economies have offset declines in labor’s share (this is the position argued by supporters of globalization). Third, the decline in labor’s share of national income must be due to moving production to low- wage countries, as opposed to improvement in production technology and productivity. Several studies shed light on these issues.46 First, the data suggest that over the past two decades, the share of labor in national income has declined. However, detailed analysis sug- gests the share of national income enjoyed by skilled labor has actually increased, suggest- ing that the fall in labor’s share has been due to a fall in the share taken by unskilled labor. A study by the IMF suggested the earnings gap between workers in skilled and unskilled sectors has widened by 25 percent over the past two decades.47 Another study that focused on U.S. data found that exposure to competition from imports led to a decline in real wages for workers who performed unskilled tasks, while having no discernible impact on wages in skilled occupations. The same study found that skilled and unskilled workers in sectors where exports grew saw an increase in their real wages.48 These figures suggest that un- skilled labor in sectors that have been exposed to more efficient foreign competition prob- ably has seen its share of national income decline over the past three decades. However, this does not mean that the living standards of unskilled workers in devel- oped nations have declined. It is possible that economic growth in developed nations has offset the fall in the share of national income enjoyed by unskilled workers, raising their living standards. Evidence suggests that real labor compensation has expanded in most developed nations since the 1980s, including the United States. Several studies by the Organisation for Economic Co-operation and Development (OECD), whose members in- clude the 34 richest economies in the world, conclude that while the gap between the poorest and richest segments of society in OECD countries has widened, in most coun- tries real income levels have increased for all, including the poorest segment. In one study the OECD found that between 1985 and 2008, real household income (adjusted for inflation) increased by 1.7 percent annually among its member states. The real income level of the poorest 10 percent of the population increased at 1.4 percent on average, while that of the richest 10 percent increased by 2 percent annually (i.e., while everyone got richer, the gap between the most affluent and the poorest sectors of society widened). The differential in growth rates was more extreme in the United States than most other countries. The study found that the real income of the poorest 10 percent of the population grew by just 0.5 percent a year in the United States between 1985 and 2008, while that of the richest 10 percent grew by 1.9 percent annually.49 As noted earlier, globalization critics argue that the decline in unskilled wage rates is due to the migration of low-wage manufacturing jobs offshore and a corresponding re- duction in demand for unskilled workers. However, supporters of globalization see a

26 Part 1 Introduction and Overview

more complex picture. They maintain that the weak growth rate in real wage rates for unskilled workers owes far more to a technology-induced shift within advanced econo- mies away from jobs where the only qualification was a willingness to turn up for work every day and toward jobs that require significant education and skills. They point out that many advanced economies report a shortage of highly skilled workers and an excess supply of unskilled workers. Thus, growing income inequality is a result of the wages for skilled workers being bid up by the labor market and the wages for unskilled workers be- ing discounted. In fact, evidence suggests that technological change has had a bigger impact than globalization on the declining share of national income enjoyed by labor.50 This suggests that a solution to the problem of slow real income growth among the un- skilled is to be found not in limiting free trade and globalization, but in increasing soci- ety’s investment in education to reduce the supply of unskilled workers.51 Finally, it is worth noting that the wage gap between developing and developed nations is closing as developing nations experience rapid economic growth. For example, one estimate suggests that wages in China will approach Western levels in two decades.52 To the extent that this is the case, any migration of unskilled jobs to low-wage countries is a temporary phenomenon representing a structural adjustment on the way to a more tightly integrated global economy.

GLOBALIZATION, LABOR POLICIES, AND THE ENVIRONMENT

A second source of concern is that free trade encourages firms from advanced nations to move manufacturing facilities to less developed countries that lack adequate regulations to protect labor and the environment from abuse by the unscrupulous.53 Globalization critics often argue that adhering to labor and environmental regulations significantly in- creases the costs of manufacturing enterprises and puts them at a competitive disadvan- tage in the global marketplace vis-à-vis firms based in developing nations that do not have to comply with such regulations. Firms deal with this cost disadvantage, the theory goes, by moving their production facilities to nations that do not have such burdensome regulations or that fail to enforce the regulations they have. If this were the case, we might expect free trade to lead to an increase in pollution and result in firms from advanced nations exploiting the labor of less developed nations.54 This argument was used repeatedly by those who opposed the 1994 formation of the North American Free Trade Agreement (NAFTA) among Canada, Mexico, and the United States. They painted a picture of U.S. manufacturing firms moving to Mexico in droves so that they would be free to pollute the environment, employ child labor, and ig- nore workplace safety and health issues, all in the name of higher profits.55 Supporters of free trade and greater globalization express doubts about this scenario. They argue that tougher environmental regulations and stricter labor standards go hand in hand with economic progress.56 In general, as countries get richer, they enact tougher environmental and labor regulations.57 Because free trade enables developing countries to increase their economic growth rates and become richer, this should lead to tougher envi- ronmental and labor laws. In this view, the critics of free trade have got it backward— free trade does not lead to more pollution and labor exploitation; it leads to less. By creating wealth and incentives for enterprises to produce technological innovations, the free market system and free trade could make it easier for the world to cope with pollu- tion and population growth. Indeed, while pollution levels are rising in the world’s poorer countries, they have been falling in developed nations. In the United States, for example, the concentration of carbon monoxide and sulfur dioxide pollutants in the atmosphere decreased by 60 percent between 1978 and 1997, while lead concentrations decreased by 98 percent—and these reductions have occurred against a background of sustained eco- nomic expansion.58 A number of econometric studies have found consistent evidence of a hump-shaped relationship between income levels and pollution levels (see Figure 1.4).59 As an economy grows and income levels rise, initially pollution levels also rise. However, past some

Globalization Chapter 1 27

point, rising income levels lead to demands for greater environmental protection, and pol- lution levels then fall. A seminal study by Grossman and Krueger found that the turning point generally occurred before per capita income levels reached $8,000.60 While the hump-shaped relationship depicted in Figure 1.4 seems to hold across a wide range of pollutants—from sulfur dioxide to lead concentrations and water quality— carbon dioxide emissions are an important exception, rising steadily with higher-income levels. Given that carbon dioxide is a heat-trapping gas, and given that there is good evi- dence that increased atmospheric carbon dioxide concentrations are a cause of global warming, this should be of serious concern. The solution to the problem, however, is probably not to roll back the trade liberalization efforts that have fostered economic growth and globalization, but to get the nations of the world to agree to policies designed to limit carbon emissions.61 Although UN-sponsored talks have had this as a central aim since the 1992 Earth Summit in Rio de Janeiro, there has been little success in moving toward the ambitious goals for reducing carbon emissions laid down in the Earth Summit and subsequent talks in Kyoto, Japan, in 1997 and in Copenhagen in 2009. In part, this is because the largest emitters of carbon dioxide, the United States and China, have failed to reach agreements about how to proceed. China, a country whose carbon emissions are increasing at a rapid rate, has shown little appetite to adopt tighter pollution controls. As for the United States, political divisions in Congress and a culture of denial have made it difficult for the country to even acknowledge, never mind move forward with, legislation designed to tackle climate change. On the other hand, in late 2014 America and China struck a historic deal under which both countries agreed to potentially significant reduc- tions in carbon emissions. If this agreement holds, progress may be made on this impor- tant issue. Notwithstanding this, supporters of free trade point out that it is possible to tie free trade agreements to the implementation of tougher environmental and labor laws in less developed countries. NAFTA, for example, was passed only after side agreements had been negotiated that committed Mexico to tougher enforcement of environmental protec- tion regulations. Thus, supporters of free trade argue that factories based in Mexico are now cleaner than they would have been without the passage of NAFTA.62 They also argue that business firms are not the amoral organizations that critics sug- gest. While there may be some rotten apples, most business enterprises are staffed by managers who are committed to behave in an ethical manner and would be unlikely to move production offshore just so they could pump more pollution into the atmosphere or exploit labor. Furthermore, the relationship between pollution, labor exploitation, and

P o

llu ti

o n

L e

ve ls

$8,000 Income per Capita

Other Pollutants

Carbon Dioxide Emissions

F I G U R E 1 . 4

Income levels and environmental pollution.

28 Part 1 Introduction and Overview

production costs may not be that suggested by critics. In general, a well-treated labor force is productive, and it is productivity rather than base wage rates that often has the greatest influence on costs. The vision of greedy managers who shift production to low- wage countries to exploit their labor force may be misplaced.

GLOBALIZATION AND NATIONAL SOVEREIGNTY

Another concern voiced by critics of globalization is that today’s increasingly interdepen- dent global economy shifts economic power away from national governments and toward supranational organizations such as the World Trade Organization, the European Union, and the United Nations. As perceived by critics, unelected bureaucrats now impose poli- cies on the democratically elected governments of nation-states, thereby undermining the sovereignty of those states and limiting the nation’s ability to control its own destiny.63 The World Trade Organization is a favorite target of those who attack the headlong rush toward a global economy. As noted earlier, the WTO was founded in 1995 to police the world trading system established by the General Agreement on Tariffs and Trade. The WTO arbitrates trade disputes between the 160 states that are signatories to the GATT. The arbitration panel can issue a ruling instructing a member state to change trade poli- cies that violate GATT regulations. If the violator refuses to comply with the ruling, the WTO allows other states to impose appropriate trade sanctions on the transgressor. As a result, according to one prominent critic, U.S. environmentalist, consumer rights advo- cate, and sometime presidential candidate Ralph Nader:

Under the new system, many decisions that affect billions of people are no longer made by local or national governments but instead, if challenged by any WTO member nation, would be deferred to a group of unelected bureaucrats sitting behind closed doors in Geneva (which is where the headquarters of the WTO are located). The bureaucrats can decide whether or not people in California can prevent the destruction of the last virgin forests or determine if carcinogenic pesticides can be banned from their foods; or whether European countries have the right to ban dangerous biotech hormones in meat…. At risk is the very basis of democracy and accountable decision making.64

In contrast to Nader, many economists and politicians maintain that the power of supra- national organizations such as the WTO is limited to what nation-states collectively agree to grant. They argue that bodies such as the United Nations and the WTO exist to serve the collective interests of member states, not to subvert those interests. Supporters of su- pranational organizations point out that the power of these bodies rests largely on their ability to persuade member states to follow a certain action. If these bodies fail to serve the collective interests of member states, those states will withdraw their support and the supranational organization will quickly collapse. In this view, real power still resides with individual nation-states, not supranational organizations.

GLOBALIZATION AND THE WORLD’S POOR

Critics of globalization argue that despite the supposed benefits associated with free trade and investment, over the past 100 years or so the gap between the rich and poor nations of the world has gotten wider. In 1870, the average income per capita in the world’s 17 richest nations was 2.4 times that of all other countries. In 1990, the same group was 4.5 times as rich as the rest. In 2013, the 34 member states of the Organisa- tion for Economic Co-operation and Development (OECD), which includes most of the world’s rich economies, had an average gross national income (GNI) per person of $38,896, whereas the world’s 40 least developed countries had a GNI of just $888 per capital—implying that income per capita in the world’s 34 richest nations was 45 times that in the world’s 40 poorest.65  While recent history has shown that some of the world’s poorer nations are capable of rapid periods of economic growth—witness the transformation that has occurred in some Southeast Asian nations such as South Korea, Thailand, and Malaysia—there appear to

Globalization Chapter 1 29

be strong forces for stagnation among the world’s poorest nations. A quarter of the coun- tries with a GDP per capita of less than $1,000 in 1960 had growth rates of less than zero from 1960 to 1995, and a third had growth rates of less than 0.05 percent.66 Critics argue that if globalization is such a positive development, this divergence between the rich and poor should not have occurred. Although the reasons for economic stagnation vary, several factors stand out, none of which has anything to do with free trade or globalization.67 Many of the world’s poorest countries have suffered from totalitarian governments, economic policies that destroyed wealth rather than facilitated its creation, endemic corruption, scant protection for prop- erty rights, and prolonged civil war. A combination of such factors helps explain why countries such as Afghanistan, Cuba, Haiti, Iraq, Libya, Nigeria, Sudan, Syria, North Korea, and Zimbabwe have failed to improve the economic lot of their citizens during recent decades. A complicating factor is the rapidly expanding populations in many of these countries. Without a major change in government, population growth may exacer- bate their problems. Promoters of free trade argue that the best way for these countries to improve their lot is to lower their barriers to free trade and investment and to implement economic policies based on free market economics.68 Many of the world’s poorer nations are being held back by large debt burdens. Of par- ticular concern are the 40 or so “highly indebted poorer countries” (HIPCs), which are home to some 700 million people. Among these countries, the average government debt burden has been as high as 85 percent of the value of the economy, as measured by gross domestic product, and the annual costs of serving government debt consumed 15 percent of the country’s export earnings.69 Servicing such a heavy debt load leaves the govern- ments of these countries with little left to invest in important public infrastructure proj- ects, such as education, health care, roads, and power. The result is the HIPCs are trapped in a cycle of poverty and debt that inhibits economic development. Free trade alone, some argue, is a necessary but not sufficient prerequisite to help these countries bootstrap themselves out of poverty. Instead, large-scale debt relief is needed for the world’s poor- est nations to give them the opportunity to restructure their economies and start the long climb toward prosperity. Supporters of debt relief also argue that new democratic govern- ments in poor nations should not be forced to honor debts that were incurred and mis- managed long ago by their corrupt and dictatorial predecessors. In the late 1990s, a debt relief movement began to gain ground among the political establishment in the world’s richer nations.70 Fueled by high-profile endorsements from Irish rock star Bono (who has been a tireless and increasingly effective advocate for debt relief), the Dalai Lama, and influential Harvard economist Jeffrey Sachs, the debt relief movement was instrumental in persuading the United States to enact legislation in 2000 that provided $435 million in debt relief for HIPCs. More important perhaps, the United States also backed an IMF plan to sell some of its gold reserves and use the proceeds to help with debt relief. The IMF and World Bank have now picked up the banner and have embarked on a systematic debt relief program.  For such a program to have a lasting effect, however, debt relief must be matched by wise investment in public projects that boost economic growth (such as education) and by the adoption of economic policies that facilitate investment and trade. Consistent with this, in June 2005, the finance ministers from several of the world’s richest economies (including the United States) agreed to provide enough funds to the World Bank and IMF to allow them to cancel a further $55 billion in debt owed by the HIPCs. The goal was to enable the HIPCs to redirect resources from debt payments to health and education pro- grams, and for alleviating poverty.  The richest nations of the world also can help by reducing barriers to the importation of products from the world’s poorest nations, particularly tariffs on imports of agricul- tural products and textiles. High-tariff barriers and other impediments to trade make it difficult for poor countries to export more of their agricultural production. The World Trade Organization has estimated that if the developed nations of the world eradicated subsidies to their agricultural producers and removed tariff barriers to trade in agriculture,

30 Part 1 Introduction and Overview

this would raise global economic welfare by $128 billion, with $30 billion of that going to poor nations, many of which are highly indebted. The faster growth associated with expanded trade in agriculture could significantly reduce the number of people living in poverty according to the WTO.71 Despite the large gap between the rich and poor nations, there is some evidence that progress is being made. In 2000 the United Nations adopted what were known as the Millennium Goals. These were eight economic and human development goals for the world. One of these goals was to cut in half the number of people living in extreme poverty, defined as less than $1.25 a day, between 1995 and 2015. This goal was actu- ally achieved in 2010, five years ahead of schedule. Some 1.2 billion people were pulled out of poverty, the majority in China and India, two countries that have been rapidly integrated into the global economy. This represents the greatest reduction in extreme poverty in human history. It’s hard to escape the conclusion that globalization and lower barriers to cross-border trade and investment were major factors behind this remarkable achievement.

Managing in the Global Marketplace

Much of this text is concerned with the challenges of managing in an international business. An international business is any firm that engages in international trade or investment. A firm does not have to become a multinational enterprise, investing di- rectly in operations in other countries, to engage in international business, although multinational enterprises are international businesses. All a firm has to do is export or import products from other countries. As the world shifts toward a truly integrated global economy, more firms—both large and small—are becoming international busi- nesses. What does this shift toward a global economy mean for managers within an international business? As their organizations increasingly engage in cross-border trade and investment, man- agers need to recognize that the task of managing an international business differs from that of managing a purely domestic business in many ways. At the most fundamental level, the differences arise from the simple fact that countries are different. Countries dif- fer in their cultures, political systems, economic systems, legal systems, and levels of economic development. Despite all the talk about the emerging global village, and de- spite the trend toward globalization of markets and production, as we shall see in this text, many of these differences are very profound and enduring. Differences among countries require that an international business vary its practices country by country. Marketing a product in Brazil may require a different approach from marketing the product in Germany; managing U.S. workers might require different skills from managing Japanese workers; maintaining close relations with a particular level of government may be very important in Mexico and irrelevant in Great Britain; the busi- ness strategy pursued in Canada might not work in South Korea; and so on. Managers in an international business must not only be sensitive to these differences but also adopt the appropriate policies and strategies for coping with them. Much of this text is devoted to explaining the sources of these differences and the methods for successfully coping with them. A further way in which international business differs from domestic business is the greater complexity of managing an international business. In addition to the problems that arise from the differences between countries, a manager in an international busi- ness is confronted with a range of other issues that the manager in a domestic business never confronts. The managers of an international business must decide where in the world to site production activities to minimize costs and to maximize value added. They must decide whether it is ethical to adhere to the lower labor and environmental standards found in many less developed nations. Then they must decide how best to coordinate and control globally dispersed production activities (which, as we shall see

LO 1 -5 Understand how the process of globalization is creating opportunities and challenges for business managers.

TEST PREP Use SmartBook to help retain what you have learned. Access your instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

Globalization Chapter 1 31

later in the text, is not a trivial problem). The managers in an international business also must decide which foreign markets to enter and which to avoid. They must choose the appropriate mode for entering a particular foreign country. Is it best to export its product to the foreign country? Should the firm allow a local company to produce its product under license in that country? Should the firm enter into a joint venture with a local firm to produce its product in that country? Or should the firm set up a wholly owned subsid- iary to serve the market in that country? As we shall see, the choice of entry mode is critical because it has major implications for the long-term health of the firm. Conducting business transactions across national borders requires understanding the rules governing the international trading and investment system. Managers in an international busi- ness must also deal with government restrictions on international trade and investment. They must find ways to work within the limits imposed by specific governmental interventions. As this text explains, even though many governments are nominally committed to free trade, they often intervene to regulate cross-border trade and investment. Managers within interna- tional businesses must develop strategies and policies for dealing with such interventions. Cross-border transactions also require that money be converted from the firm’s home currency into a foreign currency and vice versa. Because currency exchange rates vary in response to changing economic conditions, managers in an international business must develop policies for dealing with exchange rate movements. A firm that adopts the wrong policy can lose large amounts of money, whereas one that adopts the right policy can in- crease the profitability of its international transactions. In sum, managing an international business is different from managing a purely do- mestic business for at least four reasons: (1) countries are different, (2) the range of prob- lems confronted by a manager in an international business is wider and the problems themselves more complex than those confronted by a manager in a domestic business, (3) an international business must find ways to work within the limits imposed by govern- ment intervention in the international trade and investment system, and (4) international transactions involve converting money into different currencies. In this text, we examine all these issues in depth, paying close attention to the different strategies and policies that managers pursue to deal with the various challenges created when a firm becomes an international business. Chapters 2, 3, and 4 explore how countries differ from each other with regard to their political, economic, legal, and cultural institutions. Chapter 5 takes a detailed look at the ethical issues that arise in international business. Chap- ters 6 through 9 look at the international trade and investment environment within which in- ternational businesses must operate. Chapters 10 through  12  review the international monetary system. These chapters focus on the nature of the foreign exchange market and the emerging global monetary system. Chapters 13 through 15 explore the organization and strategy of international businesses. Chapters 16 through 20 look at the management of vari- ous functional operations within an international business, including production, marketing, and human relations. By the time you complete this text, you should have a good grasp of the issues that managers working within international business have to grapple with on a daily basis, and you should be familiar with the range of strategies and operating policies available to compete more effectively in today’s rapidly emerging global economy.

TEST PREP Use SmartBook to help retain what you have learned. Access your instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

globalization, p. 5 globalization of markets, p. 5 globalization of production, p. 6 factors of production, p. 7 General Agreement on Tariffs and

Trade (GATT), p. 9 World Trade Organization

(WTO), p. 9

International Monetary Fund (IMF), p. 9

World Bank, p. 9 United Nations, p. 9 Group of Twenty (G20), p. 10 international trade, p. 10 foreign direct investment

(FDI), p. 10

Moore’s law, p. 12 stock of foreign direct

investment (FDI), p. 17 multinational enterprise

(MNE), p. 18 international business, p. 30

Key Terms

C H A P T E R S U M M A R Y

This chapter has shown how the world economy is becoming more global and reviewed the main drivers of globalization, arguing that they seem to be thrusting nation-states toward a more tightly integrated global economy. It looked at how the nature of international business is changing in response to the changing global economy, discussed concerns raised by rapid globaliza- tion, and reviewed implications of rapid globalization for individual managers. The chapter made the follow- ing points:

1. Over the past three decades, we have witnessed the globalization of markets and production.

2. The globalization of markets implies that na- tional markets are merging into one huge marketplace. However, it is important not to push this view too far.

3. The globalization of production implies that firms are basing individual productive activities at the optimal world locations for the particular activities. As a consequence, it is increasingly irrelevant to talk about American products, Japanese products, or German products because these are being replaced by “global” products.

4. Two factors seem to underlie the trend toward globalization: declining trade barriers and changes in communication, information, and transportation technologies.

5. Since the end of World War II, barriers to the free flow of goods, services, and capital have been lowered significantly. More than anything else, this has facilitated the trend toward the glo- balization of production and has enabled firms to view the world as a single market.

6. As a consequence of the globalization of produc- tion and markets, in the last decade world trade has grown faster than world output, foreign direct investment has surged, imports have penetrated more deeply into the world’s indus- trial nations, and competitive pressures have increased in industry after industry.

7. The development of the microprocessor and re- lated developments in communication and infor- mation processing technology have helped firms link their worldwide operations into sophisti- cated information networks. Jet air travel, by shrinking travel time, has also helped link the worldwide operations of international businesses.

These changes have enabled firms to achieve tight coordination of their worldwide operations and to view the world as a single market.

8. In the 1960s, the U.S. economy was dominant in the world, U.S. firms accounted for most of the foreign direct investment in the world economy, U.S. firms dominated the list of large multinationals, and roughly half the world—the centrally planned economies of the communist world—was closed to Western businesses.

9. By the 2000s, the U.S. share of world output had been cut in half, with major shares now being accounted for by western European and South- east Asian economies. The U.S. share of world- wide foreign direct investment had also fallen by about two-thirds. U.S. multinationals were now facing competition from a large number of Japanese and European multinationals. In addi- tion, the emergence of mini-multinationals was noted.

10. One of the most dramatic developments of the past 30 years has been the collapse of commu- nism in eastern Europe, which has created enor- mous opportunities for international businesses. In addition, the move toward free market econo- mies in China and Latin America is creating opportunities (and threats) for Western interna- tional businesses.

11. The benefits and costs of the emerging global economy are being hotly debated among busi- nesspeople, economists, and politicians. The debate focuses on the impact of globalization on jobs, wages, the environment, working condi- tions, national sovereignty, and extreme poverty in the world’s poorest nations.

12. Managing an international business is different from managing a domestic business for at least four reasons: (a) countries are different, (b) the range of problems confronted by a manager in an international business is wider and the problems themselves more complex than those confronted by a manager in a domestic business, (c) manag- ers in an international business must find ways to work within the limits imposed by govern- ments’ intervention in the international trade and investment system, and (d) international transactions involve converting money into different currencies.

32 Part 1 Introduction and Overview

Globalization Chapter 1 33

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises:

1. As the drivers of globalization continue to pressure both the globalization of markets and the globalization of production, we continue to see the impact of greater globalization on worldwide trade patterns. HSBC, a large global bank, analyzes these pressures and trends to identify opportunities across markets and sec- tors, through its trade forecasts. Visit the HSBC Global Connections site and use the trade forecast tool to identify which export routes are forecasted to see the greatest growth over the next 15 to 20 years. What patterns do you see? What types of countries dominate these routes?

2. You are working for a company that is consider- ing investing in a foreign country. Investing in countries with different traditions is an impor- tant element of your company’s long-term strate- gic goals. As such, management has requested a report regarding the attractiveness of alternative countries based on the potential return of FDI. Accordingly, the ranking of the top 25 countries in terms of FDI attractiveness is a crucial ingre- dient for your report. A colleague mentioned a potentially useful tool called the Foreign Direct Investment (FDI) Confidence Index. The FDI Confidence Index is a regular survey of global executives conducted by A.T. Kearney. Find this index, and provide additional information re- garding how the index is constructed.

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. Describe the shifts in the world economy over the past 30 years. What are the implications of these shifts for international businesses based in Great Britain? North America? Hong Kong?

2. “The study of international business is fine if you are going to work in a large multinational enterprise, but it has no relevance for individuals who are going to work in small firms.” Evaluate this statement.

3. How have changes in technology contributed to the globalization of markets and production? Would the globalization of production and mar- kets have been possible without these technologi- cal changes?

4. “Ultimately, the study of international business is no different from the study of domestic business. Thus, there is no point in having a separate course on international business.” Evaluate this statement.

5. How does the Internet affect international busi- ness activity and the globalization of the world economy?

6. If current trends continue, China may be the world’s largest economy by 2030. Discuss the possible implications of such a development for

(a) the world trading system, (b) the world mone- tary system, (c) the business strategy of today’s European and U.S.-based global corporations, and (d) global commodity prices.

7. Reread the Management Focus on Vizio and answer the following questions: a. Why is the manufacturing of flat-panel TVs

migrating to different locations around the world?

b. Who benefits from the globalization of the flat-panel display industry? Who are the losers?

c. What would happen if the U.S. government required that flat-panel displays sold in the United States had to also be made in the United States? On balance, would this be a good or a bad thing?

d. What does the example of Vizio tell you about the future of production in an increas- ingly integrated global economy? What does it tell you about the strategies that enter- prises must adopt to thrive in highly com- petitive global markets?

34 Part 1 Introduction and Overview

Executives at the Boeing Corporation, America’s largest exporter, like to say that building a large commercial jet aircraft like the 747 or 787 involves bringing together more than a million parts in flying formation. Forty-five years ago, when the early models of Boeing’s venerable 737 and 747 jets were rolling off the company’s Seattle area pro- duction lines, foreign suppliers accounted for only 5 per- cent of those parts on average. Boeing was vertically integrated and manufactured many of the major compo- nents that went into the planes. The largest parts produced by outside suppliers were the jet engines, where two of the three suppliers were American companies. The lone for- eign engine manufacturer was the British company Rolls-Royce. Fast-forward to the modern era, and things look very different. In the case of its latest aircraft, the super efficient 787 Dreamliner, 50 outside suppliers spread around the world account for 65 percent of the value of the aircraft. Italian firm Alenia Aeronautica makes the center fuselage and horizontal stabilizer. Kawasaki of Japan makes part of the forward fuselage and the fixed trailing edge of the wing. French firm Messier-Dowty makes the aircraft’s landing gear. German firm Diehl Luftahrt Elektronik supplies the main cabin lighting. Sweden’s Saab Aerostructures makes the access doors. Japanese company Jamco makes parts for the lavatories, flight deck interiors, and galleys. Mitsubishi Heavy In- dustries of Japan makes the wings. KAA of Korea makes the wing tips. And so on. Why the change? One reason is that 80 percent of Boeing’s customers are foreign airlines, and to sell into those nations, it often helps to be giving business to those nations. The trend started in 1974 when Mitsubishi of Japan was given contracts to produce inboard wing flaps for the 747. The Japanese reciprocated by placing big orders for Boeing jets. A second rationale was to disperse component part production to those suppliers who are the best in the world at their particular activity. Over the years, for example, Mitsubishi has acquired considerable expertise in the manufacture of wings, so it was logical for Boeing to use Mitsubishi to make the wings for the 787. Similarly, the 787 is the first com- mercial jet aircraft to be made almost entirely out of car- bon fiber, so Boeing tapped Japan’s Toray Industries, a world-class expert in sturdy but light carbon-fiber com- posites, to supply materials for the fuselage. A third rea- son for the extensive outsourcing on the 787 was that

Boeing wanted to unburden itself of some of the risks and costs associated with developing production facili- ties for the 787. By outsourcing, it pushed some of those risks and costs onto suppliers, who had to undertake major investments in capacity to ramp up to produce for the 787. So what did Boeing retain for itself? Engineering de- sign, marketing and sales, and final assembly are done at its Everett plant north of Seattle, all activities where Boe- ing maintains it is the best in the world. Of major compo- nent parts, Boeing made only the tail fin and wing to body fairing (which attaches the wings to the fuselage of the plane). Everything else was outsourced. As the 787 moved through development in the 2000s, however, it became clear that Boeing had pushed the out- sourcing paradigm too far. Coordinating a globally dis- persed production system this extensive turned out to be very challenging. Parts turned up late, some parts didn’t “snap together” the way Boeing had envisioned, and sev- eral suppliers ran into engineering problems that slowed down the entire production process. As a consequence, the date for delivery of the first jet was pushed back more than four years, and Boeing had to take millions of dol- lars in penalties for late deliveries. The problems at one supplier, Vought Aircraft in North Carolina, were so se- vere that Boeing ultimately agreed to acquire the com- pany and bring its production in-house. Vought was co-owned by Alenia of Italy and made parts of the main fuselage. There are now signs that Boeing is rethinking some of its global outsourcing policy. For its next jet, a new version of its popular wide-bodied 777 jet, the 777X, which will use the same carbon-fiber technology as the 787, Boeing will bring wing production back in-house. Mitsubishi and Kawasaki of Japan produce much of the wing structure for the 787, and for the original ver- sion of the 777. However, recently Japan’s airlines have been placing large orders with Airbus, breaking with their traditional allegiance to Boeing. This seems to have given Boeing an opening to bring wing produc- tion back in-house. Boeing executives also note that Boeing has lost much of its expertise in wing produc- tion over the last 20 years due to outsourcing, and bringing it back in-house for new carbon-fiber wings might enable Boeing to regain these important core skills and strengthen the company’s competitive position.

C L O S I N G C A S E

Building the Boeing 787

Globalization Chapter 1 35

Sources: K. Epstein and J. Crown, “Globalization Bites Boeing,” Bloomberg Businessweek, March 12, 2008; H. Mallick, “Out of Control Outsourcing Ruined Boeing’s Beautiful Dreamliner,” The Star, February 25, 2013; P. Kavilanz, “Dreamliner: Where in the World Its Parts Come From,” CNN Money, January 18, 2013; S. Dubois, “Boeing’s Dreamliner Mess: Simply Inevitable?,” CNN Money, January 22, 2013; A. Scott and T. Kelly, “Boeing’s Loss of a $9.5 Billion Deal Could Bring Jobs Back to the U.S.,” Business Insider, October 14, 2013.

C a s e D i s c u s s i o n Q u e s t i o n s

1. What are the benefits to Boeing of outsourcing manufacturing of components of the Boeing 787 to firms based in other countries?

2. What are the potential costs and risks to Boeing of outsourcing? 

3. In addition to foreign subcontractors and Boeing, who else benefits from Boeing’s decision to outsource component part manu- facturing assembly to other nations? Who are the potential losers?

4. If Boeing’s management decided to keep all production in America, what do you think the effect would be on the company, its employees, and the communities that depend on it? 

5. On balance, do you think that the kind of outsourcing undertaken by Boeing is a good thing or a bad thing for the American econ- omy? Explain your reasoning.

1. Figures from World Trade Organization, Statistics Database, 2013.

2. Thomas L. Friedman, The World Is Flat (New York: Farrar, Straus and Giroux, 2005).

3. Ibid. 4. T. Levitt, “The Globalization of Markets,” Harvard Business

Review, May–June 1983, pp. 92–102. 5. U.S. Department of Commerce, Internal Trade Administration,

“Profile of U.S. Exporting and Importing Companies, 2012–2013,” April 2015. 

6. C. M. Draffen, “Going Global: Export Market Proves Profitable for Region’s Small Businesses,” Newsday, March 19, 2001, p. C18.

7. B. Benoit and R. Milne, “Germany’s Best Kept Secret, How Its Exporters Are Betting the World,” Financial Times, May 19, 2006, p. 11.

8. See F. T. Knickerbocker, Oligopolistic Reaction and Multina- tional Enterprise (Boston: Harvard Business School Press, 1973); R. E. Caves, “Japanese Investment in the U.S.: Lessons for the Economic Analysis of Foreign Investment,” The World Economy 16 (1993), pp. 279–300.

9. I. Metthee, “Playing a Large Part,” Seattle Post-Intelligencer, April 9, 1994, p. 13.

10. “Operating Profit,” The Economist, August 16, 2008, pp. 74–76.

11. R. B. Reich, The Work of Nations (New York: Knopf, 1991).

12. United Nations, “The UN in Brief,” www.un.org/Overview/ brief.html.

13. J. A. Frankel, “Globalization of the Economy,” National Bureau of Economic Research, working paper no. 7858, 2000.

14. J. Bhagwati, Protectionism (Cambridge, MA: MIT Press, 1989). 15. F. Williams, “Trade Round Like This May Never Be Seen

Again,” Financial Times, April 15, 1994, p. 8. 16. W. Vieth, “Major Concessions Lead to Success for WTO

Talks,” Los Angeles Times, November 14, 2001, p. A1; “Seeds Sown for Future Growth,” The Economist, November 17, 2001, pp. 65–66.

17. United Nations, World Investment Report, 2014 (New York and Geneva: United Nations, 2014).

18. World Trade Organization, International Trade Statistics 2014  (Geneva: WTO, 2014).

19. United Nations Conference on Trade and Investment, “Global FDI Flows Declined in 2014,” Global Investment Trends Monitor, January 29, 2015.

20. United Nations, World Investment Report, 2014. 21. Moore’s law is named after Intel founder Gordon Moore. 22. Data compiled from various sources and listed at

www.internetworldstats.com/stats.htm. 23. From www.census.gov/mrts/www/ecomm.html. See also

S. Fiegerman, “Ecommerce Is Now a Trillion Dollar Industry,” Mashable Business, February 5, 2013.

E n d n o t e s

36 Part 1 Introduction and Overview

24. For a counterpoint, see “Geography and the Net: Putting It in Its Place,” The Economist, August 11, 2001, pp. 18–20.

25. International Chamber of Shipping, Key Facts, www.ics- shipping.org/shipping-facts/key-facts.

26. Frankel, “Globalization of the Economy.” 27. R. Wile, “Here’s What It Costs to Ship 7 Everyday Goods

across the Ocean,” Business Insider, September 19, 2012. 28. Data from Bureau of Transportation Statistics, 2001. 29. John G. Fernald and Victoria Greenfield, “The Fall and Rise

of the Global Economy,” Chicago Fed Letter, April 2001, Number 164.

30. Data located at www.bts.gov/publications/us_international_ trade_and_freight_transportation_trends/2003/index.html.

31. N. Hood and J. Young, The Economics of the Multinational Enterprise (New York: Longman, 1973).

32. United Nations, World Investment Report, 2014. 33. Ibid. 34. Ibid. 35. S. Chetty, “Explosive International Growth and Problems of

Success among Small and Medium Sized Firms,” International Small Business Journal, February 2003, pp. 5–28.

36. R. A. Mosbacher, “Opening Up Export Doors for Smaller Firms,” Seattle Times, July 24, 1991, p. A7.

37. “Small Companies Learn How to Sell to the Japanese,” Seattle Times, March 19, 1992.

38. W. J. Holstein, “Why Johann Can Export, but Johnny Can’t,” BusinessWeek, November 3, 1991, www.businessweek.com/ stories/1991-11-03/why-johann-can-export-but-johnny-cant.

39. N. Buckley and A. Ostrovsky, “Back to Business—How Putin’s Allies Are Turning Russia into a Corporate State,” Financial Times, June 19, 2006, p. 11.

40. J. E. Stiglitz, Globalization and Its Discontents (New York: W. W. Norton, 2003); J. Bhagwati, In Defense of Globalization (New York: Oxford University Press, 2004); Friedman, The World Is Flat.

41. See, for example, Ravi Batra, The Myth of Free Trade (New York: Touchstone Books, 1993); William Greider, One World, Ready or Not: The Manic Logic of Global Capitalism (New York: Simon & Schuster, 1997); D. Radrik, Has Globalization Gone Too Far? (Washington, DC: Institution for International Economics, 1997).

42. E. Goldsmith, “The Winners and the Losers,” in The Case against the Global Economy, ed. J. Mander and E. Goldsmith (San Francisco: Sierra Club, 1996); Lou Dobbs, Exporting America (New York: Time Warner Books, 2004).

43. For an excellent summary, see “The Globalization of Labor,” Chapter 5, in IMF, World Economic Outlook 2007 ( Washington, DC: IMF, April 2007). Also see R. Freeman, “Labor Market Imbalances,” Harvard University working paper, www.bos.frb.org/economic/conf/conf51/conf51d.pdf.

44. D. L. Bartlett and J. B. Steele, “America: Who Stole the Dream,” Philadelphia Inquirer, September 9, 1996.

45. For example, see Paul Krugman, Pop Internationalism ( Cambridge, MA: MIT Press, 1996).

46. For example, see B. Milanovic and L. Squire, “Does Tariff Liberalization Increase Wage Inequality?,” National Bureau of Economic Research, working paper no. 11046, January 2005; B. Milanovic, “Can We Discern the Effect of Globalization on Income Distribution?,” World Bank Economic Review 19 (2005), pp. 21–44. Also see the summary in Thomas Piketty, “The Globalization of Labor,” in Capital in the Twenty First Century (Cambridge, MA: Harvard University Press, 2014). 

47. See Piketty, “The Globalization of Labor.” 48. A. Ebenstein, A. Harrison, M. McMillam, and S. Phillips,

“ Estimating the Impact of Trade and Offshoring on American Workers Using the Current Population Survey,” Review of Economics and Statistics 67 (October 2014), pp. 581–95. 

49. M. Forster and M. Pearson, “Income Distribution and Poverty in the OECD Area,” OECD Economic Studies 34 (2002); Moffett, “Income Inequality Increases”; OECD, “Growing Income Inequality in OECD Countries,” OECD Forum, May 2, 2011.

50. See Piketty, “The Globalization of Labor.” 51. See Krugman, Pop Internationalism; D. Belman and T. M. Lee,

“International Trade and the Performance of U.S. Labor Markets,” in U.S. Trade Policy and Global Growth, ed. R. A. Blecker (New York: Economic Policy Institute, 1996).

52. Freeman, “Labor Market Imbalances.” 53. E. Goldsmith, “Global Trade and the Environment,” in The

Case against the Global Economy, eds. J. Mander and E. Goldsmith (San Francisco: Sierra Club, 1996). 

54. P. Choate, Jobs at Risk: Vulnerable U.S. Industries and Jobs under NAFTA (Washington, DC: Manufacturing Policy Project, 1993).

55. Ibid. 56. B. Lomborg, The Skeptical Environmentalist (Cambridge, UK:

Cambridge University Press, 2001). 57. H. Nordstrom and S. Vaughan, Trade and the Environment,

World Trade Organization Special Studies No. 4 (Geneva: WTO, 1999).

58. Figures are from “Freedom’s Journey: A Survey of the 20th Century. Our Durable Planet,” The Economist, September 11, 1999, p. 30.

59. For an exhaustive review of the empirical literature, see B. R. Copeland and M. Scott Taylor, “Trade, Growth and the Environment,” Journal of Economic Literature, March 2004, pp. 7–77.

60. G. M. Grossman and A. B. Krueger, “Economic Growth and the Environment,” Quarterly Journal of Economics 110 (1995), pp. 353–78.

61. For an economic perspective on climate change see William Nordhouse, The Climate Casino (Yale University Press, Princeton, NJ, 2013).

62. Krugman, Pop Internationalism. 63. R. Kuttner, “Managed Trade and Economic Sovereignty,” in

U.S. Trade Policy and Global Growth, ed. R. A. Blecker (New York: Economic Policy Institute, 1996).

64. Ralph Nader and Lori Wallach, “GATT, NAFTA, and the Subversion of the Democratic Process,” in U.S. Trade Policy and Global Growth, ed. R. A. Blecker (New York: Economic Policy Institute, 1996), pp. 93–94.

Globalization Chapter 1 37

65. Lant Pritchett, “Divergence, Big Time,” Journal of Economic Perspectives 11, no. 3 (Summer 1997), pp. 3–18. The data are from the World Bank’s World Development Indicators, 2015. 

66. Ibid. 67. W. Easterly, “How Did Heavily Indebted Poor Countries Be-

come Heavily Indebted?” World Development, October 2002, pp. 1677–96; and J. Sachs, The End of Poverty (New York, Penguin Books, 2006).

68. See D. Ben-David, H. Nordstrom, and L. A. Winters, Trade, Income Disparity and Poverty: World Trade Organization Special Studies No. 5 (Geneva: WTO, 1999).

69. William Easterly, “Debt Relief,” Foreign Policy, November– December 2001, pp. 20–26.

70. Jeffrey Sachs, “Sachs on Development: Helping the World’s Poorest,” The Economist, August 14, 1999, pp. 17–20.

71. World Trade Organization, Annual Report 2003 (Geneva: WTO, 2004).

Credit: ©Federal Reserve Board.

Source: © Evaristo Sa/AFP/Getty Images

National Differences in Political, Economic, and Legal Systems L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO2-1 Understand how the political systems of countries differ.

LO2-2 Understand how the economic systems of countries differ.

LO2-3 Understand how the legal systems of countries differ.

LO2-4 Explain the implications for management practice of national differences in political economy.

part two National Dif ferences

2

39

This time it involved the state-owned oil company, Petro- bras. Under a scheme that seems to have been operating since 1997, construction firms wanting to do business with Petrobras agreed to pay bribes to the company’s execu- tives. Many of these executives were themselves political appointees. The executives would inflate the value of con- tracts they awarded, adding a 3 percent “fee,” which was effectively a kickback. The 3 percent fee was shared among Petrobras executives, construction industry execu- tives, and politicians. The construction companies estab- lished shell companies to make payments and launder the money. According to prosecutors investigating the case, the total value of bribes may have exceeded $3.7 billion.   As of early 2015, 4 former Petrobras officials and at least 23 construction company executives have been charged with crimes that include corruption and money laundering. In addition, Brazil’s Supreme Court has given prosecutors the go-ahead to investigate 48 current or for- mer members of Congress, including the former Brazilian president, Fernando Collor de Mello. The current Brazilian president, Dilma Rousseff, has also been tainted by the scandal. She was chair of Petrobras during the time this was occurring. She is also a member of the governing Workers’ Party, several members of which seem to have been among the major beneficiaries of the kickback scan- dal. Although there is no evidence that Rousseff knew of the bribes, or profited from them, her ability to govern ef- fectively has been severely damaged by association. The scandal has so rocked Brazil that it has pushed the country close to a recession. If there is a bright spot in all of this, it is that the scandals are coming to light. Backed by Supreme Court rulings and public outrage, corrupted politicians, government officials, and business executives are being prosecuted. In the past, that was far less likely to occur.

Sources: Will Conners and Luciana Magalhaes, “Brazil Cracks Open Vast Bribery Scandal,” The Wall Street Journal, April 7, 2015; Marc Margolis, “In Brazil’s Trial of the Century, Lula’s Reputation Is at Stake,” Newsweek, July 27, 2012; “The Big Oily,” The Economist, January 3, 2015. 

O P E N I N G C A S E Brazil is the seventh-largest economy in the world with a gross domestic product of $2.25 trillion. The country has a democratic government and an economy characterized by moderately free markets, although the country’s largest oil producer (Petrobras) and one of its top banks (Banco do Brazil) are both state owned. Many economists, however, have long felt that the country has never quite lived up to its considerable economic potential. A major reason for this has been an endemically high level of corruption that favors those with political connections, and discourages investment by more ethical businesses. Transparency International, a nongovernmental orga- nization that evaluates countries based on perceptions of how corrupt they are, ranks Brazil 69 out of the 175 coun- tries it looks at. The problems it identifies in Brazil include public officials who demand bribes in return for awarding government contracts, and “influence peddling,” where elected officials use their position in government to ob- tain favors or preferential treatment. Consistent with this, according to a study by the World Economic Forum, Brazil ranks 135th out of 144 countries in the proper use of pub- lic funds. Over the last decade, several corruption scandals have come to light that serve to emphasize Brazil’s corruption problem. In 2005, a scandal known as the mensalao (the monthly payoff scandal) broke. The scandal started when a midlevel postal official was caught on film pocketing a modest bribe in exchange for promises to favor certain businesses in landing government contracts. Further in- vestigation uncovered a web of influence peddling in which fat monthly payments were given to lawmakers will- ing to back government initiatives in National Congress. After a lengthy investigation, in late 2012 some 25 politi- cians and business executives were found guilty of crimes that included bribery, money laundering, and corruption. The public uproar surrounding the mensalao scandal was just starting to die down when in March 2014 another corruption scandal captured the attention of Brazilians.

Corruption in Brazil

40 Part 2 National Differences

Introduction

International business is much more complicated than domestic business because coun- tries differ in many ways. Countries have different political, economic, and legal systems. They vary significantly in their level of economic development and future economic growth trajectory. Cultural practices can vary dramatically, as can the education and skill levels of the population. All these differences can and do have major implications for the practice of international business. They have a profound impact on the benefits, costs, and risks associated with doing business in different countries; the way in which opera- tions in different countries should be managed; and the strategy international firms should pursue in different countries. The main function of this chapter and the next two is to develop an awareness of and appreciation for the significance of country differences in political systems, economic systems, legal systems, economic development, and soci- etal culture. Another function of the three chapters is to describe how the political, eco- nomic, legal, and cultural systems of many of the world’s nation-states are evolving and to draw out the implications of these changes for the practice of international business. This chapter focuses on how the political, economic, and legal systems of countries dif- fer. Collectively, we refer to these systems as constituting the political economy of a coun- try. We use the term political economy to stress that the political, economic, and legal systems of a country are interdependent; they interact with and influence each other, and in doing so, they affect the level of economic well-being. In Chapter 3, we build on the con- cepts discussed here to explore in detail how differences in political, economic, and legal systems influence the economic development of a nation-state and its likely future growth trajectory. In Chapter 4, we look at differences in societal culture and at how these differ- ences influence the practice of international business. Moreover, as we will see in Chapter 4, societal culture has an influence on the political, economic, and legal systems in a nation, and thus its level of economic well-being. We also discuss how the converse may occur— how political, economic, and legal systems may also shape societal culture. The opening case illustrates some of the issues discussed in this chapter. Between 1964 and 1985 Brazil was ruled by a military dictatorship. The dictatorship was brought down by poor economic management which led to rampant inflation. Since then, Brazil has become a democratic state with moderately free markets. Under democratic and mar- ket reforms, Brazil’s economy has grown more rapidly, but many feel that the country is still held back by a legal system that favors the wealthy, and endemic corruption that reaches up to the highest levels of government and business. On the other hand, stronger legal sanctions, and greater legal activism, seem to be bringing corruption to light. Cor- rupt politicians, government employees, and business executives are being prosecuted, which raises the possibility that the rule of law will become more firmly established go- ing forward. If this does happen, a strong legal system, together with continued economic and political reforms, could finally unleash Brazil’s considerable economic potential.

G E T I N S I G H T S B Y C O U N T R Y

The “Get Insights by Country” section of globalEDGE (globaledge.msu.edu/global-insights/by/ country) is your source for information and statistical data for nearly every country around the world (more than 200 countries). As related to Chapter 2 of the text, globalEDGE has a wealth of information and data on national differences in political economy. These differences are available across a dozen menu categories in the country sections (e.g., economy, history, gov- ernment, culture, risk). The “Executive Memos” on each country page are also great for abbrevi- ated fingertip access to current information. At a minimum, we suggest that you take a look at the country pages of the United Kingdom and Sweden because the authors of this text are from those countries—have you figured out who is from the UK and who is from Sweden yet?

National Differences in Political, Economic, and Legal Systems Chapter 2 41

Political Systems

The political system of a country shapes its economic and legal systems.1 As such, we need to understand the nature of different political systems before discussing economic and legal systems. By political system, we mean the system of government in a nation. Political systems can be assessed according to two dimensions. The first is the degree to which they emphasize collectivism as opposed to individualism. The second is the degree to which they are democratic or totalitarian. These dimensions are interrelated; systems that emphasize collectivism tend to lean toward totalitarianism, whereas those that place a high value on individualism tend to be democratic. However, a large gray area exists in the middle. It is possible to have democratic societies that emphasize a mix of collectivism and individualism. Similarly, it is possible to have totalitarian societies that are not collectivist.

COLLECTIVISM AND INDIVIDUALISM

Collectivism refers to a political system that stresses the primacy of collective goals over individual goals.2 When collectivism is emphasized, the needs of society as a whole are generally viewed as being more important than individual freedoms. In such circumstances, an individual’s right to do something may be restricted on the grounds that it runs counter to “the good of society” or to “the common good.” Advocacy of collectivism can be traced to the ancient Greek philosopher Plato (427–347 B.C.), who, in The Republic, argued that individual rights should be sacrificed for the good of the majority and that property should be owned in common. Plato did not equate collectiv- ism with equality; he believed that society should be stratified into classes, with those best suited to rule (which for Plato, naturally, were philosophers and soldiers) adminis- tering society for the benefit of all. In modern times, the collectivist mantle has been picked up by socialists.

Socialism Modern socialists trace their intellectual roots to Karl Marx (1818–1883), although socialist thought clearly predates Marx (elements of it can be traced to Plato). Marx argued that the few benefit at the expense of the many in a capitalist society where indi- vidual freedoms are not restricted. While successful capitalists accumulate considerable wealth, Marx postulated that the wages earned by the majority of workers in a capitalist society would be forced down to subsistence levels. He argued that capitalists expropriate for their own use the value created by workers, while paying workers only subsistence wages in return. According to Marx, the pay of workers does not reflect the full value of their labor. To correct this perceived wrong, Marx advocated state ownership of the basic means of production, distribution, and exchange (i.e., businesses). His logic was that if the state owned the means of production, the state could ensure that workers were fully com- pensated for their labor. Thus, the idea is to manage state-owned enterprise to benefit society as a whole, rather than individual capitalists.3 In the early twentieth century, the socialist ideology split into two broad camps. The communists believed that socialism could be achieved only through violent revo- lution and totalitarian dictatorship, whereas the social democrats committed them- selves to achieving socialism by democratic means, turning their backs on violent revolution and dictatorship. Both versions of socialism waxed and waned during the twentieth century. The communist version of socialism reached its high point in the late 1970s, when the majority of the world’s population lived in communist states. The countries under Communist Party rule at that time included the former Soviet Union; its eastern European client nations (e.g., Poland, Czechoslovakia, Hungary); China; the Southeast Asian nations of Cambodia, Laos, and Vietnam; various African nations (e.g., Angola and Mozambique); and the Latin American nations of Cuba and Nicaragua.

LO 2-1 Understand how the political systems of countries differ.

42 Part 2 National Differences

By the mid-1990s, however, communism was in retreat worldwide. The Soviet Union had collapsed and had been replaced by a collection of 15 republics, many of which were at least nominally structured as democracies. Communism was swept out of east- ern Europe by the largely bloodless revolutions of 1989. Although China is still nomi- nally a communist state with substantial limits to individual political freedom, in the economic sphere, the country has moved sharply away from strict adherence to com- munist ideology. Other than China, communism hangs on only in a handful of small fringe states, such as North Korea and Cuba. Social democracy also seems to have passed a high-water mark, although the ideology may prove to be more enduring than communism. Social democracy has had perhaps its greatest influence in a number of democratic Western nations, including Australia, France, Germany, Great Britain, Norway, Spain, and Sweden, where social democratic parties have often held political power. Other countries where social democracy has had an important influence include India and Brazil. Consistent with their Marxist roots, many social democratic governments after World War II nationalized private companies in certain industries, transforming them into state-owned enterprises to be run for the “public good rather than private profit.” In Great Britain by the end of the 1970s, for example, state-owned companies had a monopoly in the telecommunications, electricity, gas, coal, railway, and shipbuilding industries, as well as substantial interests in the oil, airline, auto, and steel industries. However, experience demonstrated that state ownership of the means of production ran counter to the public interest. In many countries, state-owned companies performed poorly. Protected from competition by their monopoly position and guaranteed govern- ment financial support, many became increasingly inefficient. Individuals paid for the luxury of state ownership through higher prices and higher taxes. As a consequence, a number of Western democracies voted many social democratic parties out of office in  the late 1970s and early 1980s. They were succeeded by political parties, such as Britain’s Conservative Party and Germany’s Christian Democratic Party, that were more committed to free market economics. These parties sold state-owned enterprises to private investors (a process referred to as privatization). Even where social democratic parties regained the levers of power, as in Great Britain in 1997 when the left-leaning Labor Party won control of the government, they too now seem committed to continued private ownership.

Individualism The opposite of collectivism, individualism refers to a philosophy that an individual should have freedom in his or her economic and political pursuits. In contrast to collectiv- ism, individualism stresses that the interests of the individual should take precedence over the interests of the state. Like collectivism, individualism can be traced to an ancient Greek philosopher, in this case Plato’s disciple Aristotle (384–322 B.C.). In contrast to Plato, Aristotle argued that individual diversity and private ownership are desirable. In a passage that might have been taken from a speech by contemporary politicians who adhere to a free market ideology, he argued that private property is more highly produc- tive than communal property and will thus stimulate progress. According to Aristotle, communal property receives little care, whereas property that is owned by an individual will receive the greatest care and therefore be most productive. Individualism was reborn as an influential political philosophy in the Protestant trad- ing nations of England and the Netherlands during the sixteenth century. The philosophy was refined in the work of a number of British philosophers, including David Hume (1711–1776), Adam Smith (1723–1790), and John Stuart Mill (1806–1873). Individualism exercised a profound influence on those in the American colonies who sought indepen- dence from Great Britain. Indeed, the concept underlies the ideas expressed in the Decla- ration of Independence. In the twentieth century, several Nobel Prize–winning economists—including Milton Friedman, Friedrich von Hayek, and James Buchanan— have championed the philosophy.

National Differences in Political, Economic, and Legal Systems Chapter 2 43

Individualism is built on two central tenets. The first is an emphasis on the impor- tance of guaranteeing individual freedom and self-expression. The second tenet of individualism is that the welfare of society is best served by letting people pursue their own economic self-interest, as opposed to some collective body (such as government) dictating what is in society’s best interest. Or, as Adam Smith put it in a famous passage from The Wealth of Nations, an individual who intends his own gain is led by an invis- ible hand to promote an end that was no part of his intention. Nor is it always worse for  the society that it was no part of it. By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it. This author has never known much good done by those who effect to trade for the public good.4 The central message of individualism, therefore, is that individual economic and po- litical freedoms are the ground rules on which a society should be based. This puts indi- vidualism in conflict with collectivism. Collectivism asserts the primacy of the collective over the individual; individualism asserts the opposite. This underlying ideological con- flict shaped much of the recent history of the world. The Cold War, for example, was in many respects a war between collectivism, championed by the former Soviet Union, and individualism, championed by the United States. From the late 1980s until about 2005, the waning of collectivism was matched by the ascendancy of individualism. Democratic ideals and market economics replaced socialism and communism in many states. Since 2005, there have been some signs of a swing back toward left-leaning socialist ideas in several countries, including several Latin America nations such as Venezuela, Bolivia, and Paraguay, along with Russia (see the accompanying Country Focus, which details what has been occurring in Venezuela). Also, the global financial crisis of 2008–2009 may cause some reevaluation of the trends of the past two decades, and the pendulum might tilt back the other way for a while.

DEMOCRACY AND TOTALITARIANISM

Democracy and totalitarianism are at different ends of a political dimension. Democracy refers to a political system in which government is by the people, exercised either directly or through elected representatives. Totalitarianism is a form of government in which one person or political party exercises absolute control over all spheres of human life and prohibits opposing political parties. The democratic–totalitarian dimension is not inde- pendent of the individualism–collectivism dimension. Democracy and individualism go hand in hand, as do the communist version of collectivism and totalitarianism. However, gray areas exist; it is possible to have a democratic state in which collective values pre- dominate, and it is possible to have a totalitarian state that is hostile to collectivism and in which some degree of individualism—particularly in the economic sphere—is encour- aged. For example, China has seen a move toward greater individual freedom in the economic sphere, but the country is still ruled by a totalitarian dictatorship that con- strains political freedom.

Democracy The pure form of democracy, as originally practiced by several city-states in ancient Greece, is based on a belief that citizens should be directly involved in decision mak- ing. In complex, advanced societies with populations in the tens or hundreds of mil- lions, this is impractical. Most modern democratic states practice representative democracy. In a representative democracy, citizens periodically elect individuals to represent them. These elected representatives then form a government, whose function is to make decisions on behalf of the electorate. In a representative democracy, elected representatives who fail to perform this job adequately will be voted out of office at the next election. To guarantee that elected representatives can be held accountable for their actions by the electorate, an ideal representative democracy has a number of safeguards that are

44 Part 2 National Differences

typically enshrined in constitutional law. These include (1) an individual’s right to freedom of expression, opinion, and organization; (2) a free media; (3) regular elections in which all eligible citizens are allowed to vote; (4) universal adult suffrage; (5) limited terms for elected representatives; (6) a fair court system that is independent from the political sys- tem; (7) a nonpolitical state bureaucracy; (8) a nonpolitical police force and armed ser- vice; and (9) relatively free access to state information.5

Totalitarianism In a totalitarian country, all the constitutional guarantees on which representative democ- racies are built—an individual’s right to freedom of expression and organization, a free media, and regular elections—are denied to the citizens. In most totalitarian states, po- litical repression is widespread, free and fair elections are lacking, media are heavily censored, basic civil liberties are denied, and those who question the right of the rulers to rule find themselves imprisoned, or worse. Four major forms of totalitarianism exist in the world today. Until recently, the most widespread was communist totalitarianism. Communism, however, is in decline worldwide, and most of the Communist Party dictatorships have collapsed since 1989. Exceptions to this trend (so far) are China, Vietnam, Laos, North Korea, and Cuba, al- though most of these states exhibit clear signs that the Communist Party’s monopoly on political power is retreating. In many respects, the governments of China, Vietnam, and Laos are communist in name only because those nations have adopted wide-ranging, market-based economic reforms. They remain, however, totalitarian states that deny many basic civil liberties to their populations. On the other hand, there are signs of a swing back toward communist totalitarian ideas in some states, such as Venezuela, where the late Hugo Chávez’s government displayed totalitarian tendencies (see the Country Focus). A second form of totalitarianism might be labeled theocratic totalitarianism. Theo- cratic totalitarianism is found in states where political power is monopolized by a party, group, or individual that governs according to religious principles. The most common form of theocratic totalitarianism is based on Islam and is exemplified by states such as Iran and Saudi Arabia. These states limit freedom of political and religious expression with laws based on Islamic principles. A third form of totalitarianism might be referred to as tribal totalitarianism. Tribal totalitarianism has arisen from time to time in African countries such as Zimbabwe, Tanzania, Uganda, and Kenya. The borders of most African states reflect the adminis- trative boundaries drawn by the old European colonial powers rather than tribal reali- ties. Consequently, the typical African country contains a number of tribes (e.g., in Kenya there are more than 40  tribes). Tribal totalitarianism occurs when a political party that represents the interests of a particular tribe (and not always the majority tribe) monopolizes power. In Kenya, for example, politicians from the Kikuyu tribe long dominated the political system. A fourth major form of totalitarianism might be described as right-wing totalitarian- ism. Right-wing totalitarianism generally permits some individual economic freedom but restricts individual political freedom, frequently on the grounds that it would lead to the rise of communism. A common feature of many right-wing dictatorships is an overt hos- tility to socialist or communist ideas. Many right-wing totalitarian governments are backed by the military, and in some cases, the government may be made up of military officers. The fascist regimes that ruled Germany and Italy in the 1930s and 1940s were right-wing totalitarian states. Until the early 1980s, right-wing dictatorships, many of which were military dictatorships, were common throughout Latin America (for exam- ple, Brazil was ruled by a military dictatorship between 1964 and 1985). They were also found in several Asian countries, particularly South Korea, Taiwan, Singapore, Indonesia, and the Philippines. Since the early 1980s, however, this form of government has been in retreat. Most Latin American countries are now genuine multiparty democracies.

45

COUNTRY FOCUS

On March 5, 2013, Hugo Chávez, the president of Venezuela, died after losing a battle against cancer. Chávez had been president of Venezuela since 1999. A former military officer who was once jailed for engineering a failed coup attempt, Chávez was a self-styled democratic socialist who won the presidential election by campaigning against corruption, economic mismanagement, and the “harsh realities” of global capitalism. When he took office in February 1999, Chávez claimed he had inherited the worst economic situation in the country’s recent history. He wasn’t far off the mark. A collapse in the price of oil, which accounted for 70 percent of the country’s exports, left Venezuela with a large budget deficit and forced the economy into a deep recession. Soon after taking office, Chávez worked to consolidate his hold over the apparatus of government. By 2012, Free- dom House, which annually assesses political and civil lib- erties worldwide, concluded Venezuela was only “partly free” and that freedoms were being progressively curtailed. On the economic front, things remained rough. The economy shrank in the early 2000s, while unemployment remained persistently high (at 15 to 17 percent) and the poverty rate rose to more than 50 percent of the popula- tion. A 2003 study by the World Bank concluded Venezuela was one of the most regulated economies in the world and that state controls over business activities gave public officials ample opportunities to enrich themselves by de- manding bribes in return for permission to expand opera- tions or enter new lines of business. Indeed, despite Chávez’s anticorruption rhetoric, Transparency Interna- tional, which ranks the world’s nations according to the ex- tent of public corruption, noted that corruption increased under Chávez. In 2012, Transparency International ranked Venezuela 165th out of 174 nations in terms of level of cor- ruption. Consistent with his socialist rhetoric, Chávez pro- gressively took various enterprises into state ownership and required that other enterprises be restructured as “workers’ cooperatives” in return for government loans. In addition, the government has taken over large rural farms and ranches that Chávez claimed were not sufficiently pro- ductive and turned them into state-owned cooperatives. In mid-2000, the world oil market bailed Chávez out of mounting economic difficulties. Oil prices started to surge

from the low $20s in 2003, reaching $150 a barrel by mid- 2008. Venezuela, the world’s fifth-largest producer, reaped a bonanza. On the back of surging oil exports, the econ- omy grew at a robust rate. Chávez used the oil revenues to boost government spending on social programs, many of them modeled after programs in Cuba. In 2006, he an- nounced plans to reduce the stakes held by foreign com- panies in oil projects in the Orinoco regions and to give the state-run oil company a majority position. Riding a wave of popularity at home, in December 2006 Chávez won reelection as president. He celebrated his victory by stepping on the revolutionary accelerator. Parliament gave him the power to legislate by decree for 18 months. In late 2010, Chávez yet again persuaded the National Assembly, where his supporters dominated, to once more grant him the power to rule by decree for an- other 18 months. Notwithstanding his ability to consolidate political power, on the economic front Venezuela’s performance under Chávez was decidedly mixed. His main achieve- ments were to reduce poverty, which fell from 50 percent to 28 percent by 2012, and to bring down unemployment from 14.5 percent at the start of his rule to 7.6 percent in February 2013. State-owned enterprises helped Chávez achieve both these goals. However, despite strong global demand and massive reserves, oil production in Venezuela fell by a third be- tween 2000 and 2012 as foreign oil companies exited the country. Inflation surged and was running at around 28 percent per annum between 2008 and 2012, one of the highest rates in the world. To compound matters, the bud- get deficit expanded to 17 percent of GDP in 2012 as the government spent heavily to support its social programs and various subsidies.

Sources: D. Luhnow and P. Millard, “Chavez Plans to Take More Control of Oil away from Foreign Firms,” The Wall Street Journal, April 24, 2006, p. A1; R. Gallego, “Chavez’s Agenda Takes Shape,” The Wall Street Journal, December 27, 2005, p. A12; “The Sickly Stench of Corruption: Venezuela,” The Economist, April 1, 2006, p. 50; “Chavez Squeezes the Oil Firms,” The Economist, November 12, 2005, p. 61; “Glimpsing the Bottom of the Barrel: Venezuela,” The Economist, February 3, 2007, p. 51; “The Wind Goes Out of the Revolution—Defeat for Hugo Chavez,” The Economist, December 8, 2007, pp. 30–32; “Oil Leak,” The Economist, February 26, 2011, p. 43; “Medieval Policies,” The Economist, August 8, 2011, p. 38; “Now for the Reckoning,” The Economist, May 5, 2013.

Venezuela under Hugo Chávez, 1999–2013

46 Part 2 National Differences

Similarly, South Korea, Taiwan, and the Philippines have all become functioning democ- racies, as has Indonesia.

Pseudo-Democracies Many of the world’s nations are neither pure democracies nor iron-clad totalitarian states. Rather they lie between pure democracies and complete totalitarian systems of govern- ment. They might be described as imperfect or pseudo-democracies, where authoritarian elements have captured some or much of the machinery of state and use this in an attempt to deny basic political and civil liberties. In the Russia of Vladimir Putin, for example, elections are still held, people compete through the ballot box for political office, and the independent press does not always tow the official line. However, Putin has used his posi- tion to systematically limit the political and civil liberties of opposition groups. His con- trol is not yet perfect, though. Voices opposing Putin are still heard in Russia, and in theory, elections are still contested. But in practice, it is becoming increasingly difficult to challenge a man and régime that has systematically extended its political, legal, and economic power over the past 14 years. A similar process occurred in the Venezuela of Hugo Chávez (see the Country Focus). Chávez’s handpicked successor, Nicholas Maduro, seems to be continuing in the same vein.

Economic Systems

It should be clear from the previous section that political ideology and economic systems are connected. In countries where individual goals are given primacy over collective goals, we are more likely to find market-based economic systems. In contrast, in coun- tries where collective goals are given preeminence, the state may have taken control over many enterprises; markets in such countries are likely to be restricted rather than free. We can identify three broad types of economic systems—a market economy, a command economy, and a mixed economy.

MARKET ECONOMY

In the archetypal pure market economy, all productive activities are privately owned, as opposed to being owned by the state. The goods and services that a country produces are not planned by anyone. Production is determined by the interaction of supply and demand and signaled to producers through the price system. If demand for a product exceeds sup- ply, prices will rise, signaling producers to produce more. If supply exceeds demand, prices will fall, signaling producers to produce less. In this system, consumers are sover- eign. The purchasing patterns of consumers, as signaled to producers through the mecha- nism of the price system, determine what is produced and in what quantity. For a market to work in this manner, supply must not be restricted. A supply restriction occurs when a single firm monopolizes a market. In such circumstances, rather than in- crease output in response to increased demand, a monopolist might restrict output and let prices rise. This allows the monopolist to take a greater profit margin on each unit it sells. Although this is good for the monopolist, it is bad for the consumer, who has to pay higher prices. It also is probably bad for the welfare of society. Because a monopolist has no competitors, it has no incentive to search for ways to lower production costs. Rather, it can simply pass on cost increases to consumers in the form of higher prices. The net re- sult is that the monopolist is likely to become increasingly inefficient, producing high- priced, low-quality goods, and society suffers as a consequence. Given the dangers inherent in monopoly, the role of government in a market economy is to encourage vigorous free and fair competition between private producers. Govern- ments do this by outlawing restrictive business practices designed to monopolize a mar- ket (antitrust laws serve this function in the United States). Private ownership also encourages vigorous competition and economic efficiency. Private ownership ensures

TEST PREP Use SmartBook to help retain what you have learned. Access your instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

LO 2-2 Understand how the economic systems of countries differ.

National Differences in Political, Economic, and Legal Systems Chapter 2 47

that entrepreneurs have a right to the profits generated by their own efforts. This gives entrepreneurs an incentive to search for better ways of serving consumer needs. That may be through introducing new products, by developing more efficient production processes, by pursuing better marketing and after-sale service, or simply through managing their businesses more efficiently than their competitors. In turn, the constant improvement in product and process that results from such an incentive has been argued to have a major positive impact on economic growth and development.6

COMMAND ECONOMY

In a pure command economy, the government plans the goods and services that a country produces, the quantity in which they are produced, and the prices at which they are sold. 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, the rationale being that the government can then direct them to make investments that are in the best interests of the nation as a whole rather than in the interests of private individuals. Historically, command economies were found in communist countries where collectivist goals were given priority over individual goals. Since the demise of communism in the late 1980s, the number of command economies has fallen dramatically. Some elements of a command economy were also evident in a number of democratic nations led by socialist-inclined governments. France and India both experimented with extensive government planning and state ownership, although government planning has fallen into disfavor in both countries. While the objective of a command economy is to mobilize economic resources for the public good, the opposite often seems to have occurred. In a command economy, state- owned enterprises have little incentive to control costs and be efficient because they can- not go out of business. Also, the abolition of private ownership means there is no incentive

Kim Jong-un, the leader of the Democratic People’s Republic of Korea, inspecting a factory. North Korea functions as a centralized, single party, and tightly controlled dictatorial command economy. Source: © AFP/Getty Images

48 Part 2 National Differences

for individuals to look for better ways to serve consumer needs; hence, dynamism and innovation are absent from command economies. Instead of growing and becoming more prosperous, such economies tend to stagnate.

MIXED ECONOMY

Mixed economies can be found between market and command economies. In a mixed economy, certain sectors of the economy are left to private ownership and free market mechanisms, while other sectors have significant state ownership and government plan- ning. Mixed economies were once common throughout much of the world, although they are becoming much less so. Until the 1980s, Great Britain, France, and Sweden were mixed economies, but extensive privatization has reduced state ownership of businesses in all three nations. A similar trend occurred in many other countries where there was once a large state-owned sector, such as Brazil, Italy, and India (although there are still state-owned enterprises in all of these nations). As a counterpoint, the involvement of the state in economic activity has been on the rise again in countries such as Russia and Venezuela, where authoritarian regimes have seized control of the political structure, typically by first winning power through democratic means and then subverting those same structures to maintain their grip on power. In mixed economies, governments also tend to take into state ownership troubled firms whose continued operation is thought to be vital to national interests. For example, in 2008 the U.S. government took an 80 percent stake in AIG to stop that financial insti- tution from collapsing, the theory being that if AIG did collapse, it would have very seri- ous consequences for the entire financial system. The U.S. government usually prefers market-oriented solutions to economic problems, and in the AIG case, the intention was to sell the institution back to private investors as soon as possible. The United States also took similar action with respect to a number of other troubled private enterprises, includ- ing Citigroup and General Motors. In all these cases, the government stake was seen as nothing more than a short-term action designed to stave off economic collapse by inject- ing capital into troubled enterprises in highly unusually circumstances. As soon as it was able to, the government sold these stakes. In early 2010, for example, the U.S. government sold its stake in Citigroup. The government stake in AIG was sold off in 2012, and by 2014 it had also disposed of its stake in GM.

Legal Systems

The legal system of a country refers to the rules, or laws, that regulate behavior along with the processes by which the laws are enforced and through which redress for griev- ances is obtained. The legal system of a country is of immense importance to interna- tional business. A country’s 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. The legal environments of countries differ in signifi- cant ways. As we shall see, differences in legal systems can affect the attractiveness of a country as an investment site or market. Like the economic system of a country, the legal system is influenced by the prevailing political system (although it is also strongly influenced by historical tradition). The govern- ment of a country defines the legal framework within which firms do business, and often the laws that regulate business reflect the rulers’ dominant political ideology. For example, collectivist-inclined totalitarian states tend to enact laws that severely restrict private enter- prise, whereas the laws enacted by governments in democratic states where individualism is the dominant political philosophy tend to be pro-private enterprise and pro-consumer. Here, we focus on several issues that illustrate how legal systems can vary—and how such variations can affect international business. First, we look at some basic differences in legal systems. Next we look at contract law. Third, we look at the laws governing property

TEST PREP Use SmartBook to help retain what you have learned. Access your instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

LO 2-3 Understand how the legal systems of countries differ.

National Differences in Political, Economic, and Legal Systems Chapter 2 49

rights with particular reference to patents, copyrights, and trademarks. Then we discuss protection of intellectual property. Finally, we look at laws covering product safety and product liability.

DIFFERENT LEGAL SYSTEMS

There are three main types of legal systems—or legal traditions—in use around the world: common law, civil law, and theocratic law.

Common Law The common law system evolved in England over hundreds of years. It is now found in most of Great Britain’s former colonies, including the United States. Common law is based on tradition, precedent, and custom. Tradition refers to a country’s legal history, precedent to cases that have come before the courts in the past, and custom to the ways in which laws are applied in specific situations. 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. Judges in a common law system have the power to inter- pret the law so that it applies to the unique circumstances of an individual case. In turn, each new interpretation sets a precedent that may be followed in future cases. As new precedents arise, laws may be altered, clarified, or amended to deal with new situations.

Civil Law A civil law system is based on a detailed set of laws organized into codes. When law courts interpret civil law, they do so with regard to these codes. More than 80 countries— including Germany, France, Japan, and Russia—operate with a civil law system. A civil law system tends to be less adversarial than a common law system because the judges rely on detailed legal codes rather than interpreting tradition, precedent, and custom. Judges under a civil law system have less flexibility than those under a common law system. Judges in a common law system have the power to interpret the law, whereas judges in a civil law system have the power only to apply the law.

Theocratic Law A theocratic law system is one in which the law is based on religious teachings. Islamic law is the most widely practiced theocratic legal system in the modern world, although usage of both Hindu and Jewish law persisted into the twentieth century. Islamic law is primarily a moral rather than a commercial law and is intended to govern all aspects of life.7 The foundation for Islamic law is the holy book of Islam, the Koran, along with the Sunnah, or decisions and sayings of the Prophet Muhammad, and the writings of Islamic scholars who have derived rules by analogy from the principles established in the Koran and the Sunnah. Because the Koran and Sunnah are holy documents, the basic founda- tions of Islamic law cannot be changed. However, in practice, Islamic jurists and scholars are constantly debating the application of Islamic law to the modern world. In reality, many Muslim countries have legal systems that are a blend of Islamic law and a common or civil law system. Although Islamic law is primarily concerned with moral behavior, it has been ex- tended to cover certain commercial activities. An example is the payment or receipt of interest, which is considered usury and outlawed by the Koran. To the devout Muslim, acceptance of interest payments is seen as a grave sin; the giver and the taker are equally damned. This is not just a matter of theology; in several Islamic states, it has also become a matter of law. In the 1990s, for example, Pakistan’s Federal Shariat Court, the highest Islamic lawmaking body in the country, pronounced interest to be un-Islamic and therefore illegal and demanded that the government amend all financial laws ac- cordingly. In 1999, Pakistan’s Supreme Court ruled that Islamic banking methods should be used in the country after July 1, 2001.8 By the late 2000s, some 500 Islamic financial

50 Part 2 National Differences

institutions in the world collectively managed more than $500 billion in assets. In addi- tion to Pakistan, Islamic financial institutions are found in many of the Gulf states, Egypt, Malaysia, and Iran.9

DIFFERENCES IN CONTRACT LAW

The difference between common law and civil law systems can be illustrated by the ap- proach of each to contract law (remember, most theocratic legal systems also have ele- ments of common or civil law). A contract is a document that specifies the conditions under which an exchange is to occur and details the rights and obligations of the parties involved. Some form of contract regulates many business transactions. Contract law is the body of law that governs contract enforcement. The parties to an agreement normally resort to contract law when one party feels the other has violated either the letter or the spirit of an agreement. Because common law tends to be relatively ill specified, contracts drafted under a common law framework tend to be very detailed with all contingencies spelled out. In civil law systems, however, contracts tend to be much shorter and less specific because many of the issues are already covered in a civil code. Thus, it is more expensive to draw up contracts in a common law jurisdiction, and resolving contract disputes can be very adversarial in common law systems. But common law systems have the advantage of greater flexibility and allow judges to interpret a contract dispute in light of the prevail- ing situation. International businesses need to be sensitive to these differences; approach- ing a contract dispute in a state with a civil law system as if it had a common law system may backfire, and vice versa. When contract disputes arise in international trade, there is always the question of which country’s laws to apply. To resolve this issue, a number of countries, including the United States, have ratified the United Nations Convention on Contracts for the Inter- national Sale of Goods (CISG). The CISG establishes a uniform set of rules governing certain aspects of the making and performance of everyday commercial contracts be- tween sellers and buyers who have their places of business in different nations. By adopt- ing the CISG, a nation signals to other adopters that it will treat the convention’s rules as part of its law. The CISG applies automatically to all contracts for the sale of goods be- tween different firms based in countries that have ratified the convention, unless the par- ties to the contract explicitly opt out. One problem with the CISG, however, is that as of 2015, only 83 nations have ratified the convention (the CISG went into effect in 1988).10 Some of the world’s important trading nations, including India and the United Kingdom, have not ratified the CISG. When firms do not wish to accept the CISG, they often opt for arbitration by a recog- nized arbitration court to settle contract disputes. The most well known of these courts is the International Court of Arbitration of the International Chamber of Commerce in Paris, which handles more than 500 requests per year from more than 100 countries.11

PROPERTY RIGHTS AND CORRUPTION

In a legal sense, the term property refers to a resource over which an individual or busi- ness holds a legal title, that is, a resource that it owns. Resources include land, buildings, equipment, capital, mineral rights, businesses, and intellectual property (ideas, which are protected by patents, copyrights, and trademarks). Property rights refer to 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.12 Countries differ in the extent to which their legal systems define and protect property rights. Almost all countries now have laws on their books that protect property rights. Even China, still nominally a communist state, despite its booming market economy, finally enacted a law to protect the rights of private prop- erty holders in 2007 (the law gives individuals the same legal protection for their prop- erty as the state has).13 However, in many countries these laws are not enforced by the

National Differences in Political, Economic, and Legal Systems Chapter 2 51

authorities, and property rights are violated. Property rights can be violated in two ways—through private action and through public action.

Private Action In terms of violating property rights, private action refers to theft, piracy, blackmail, and the like by private individuals or groups. Although theft occurs in all countries, a weak legal system allows a much higher level of criminal action. For example, in the chaotic period following the collapse of communism in Russia, an outdated legal system, coupled with a weak police force and judicial system, offered both domestic and foreign busi- nesses scant protection from blackmail by the “Russian Mafia.” Successful business owners in Russia often had to pay “protection money” to the Mafia or face violent retri- bution, including bombings and assassinations (about 500 contract killings of business- men occurred per year in the 1990s).14 Russia is not alone in having Mafia problems (and the situation in Russia has improved since the 1990s). The Mafia has a long history in the United States (Chicago in the 1930s was similar to Moscow in the 1990s). In Japan, the local version of the Mafia, known as the yakuza, runs protection rackets, particularly in the food and entertainment indus- tries.15 However, there was a big difference between the magnitude of such activity in Russia in the 1990s and its limited impact in Japan and the United States. The difference arose because the legal enforcement apparatus, such as the police and court system, was weak in Russia following the collapse of communism. Many other countries from time to time have had problems similar to or even greater than those experienced by Russia.

Public Action and Corruption Public action to violate property rights occurs when public officials, such as politicians and government bureaucrats, extort income, resources, or the property itself from prop- erty holders. This can be done through legal mechanisms such as levying excessive taxa- tion, requiring expensive licenses or permits from property holders, taking assets into state ownership without compensating the owners, or redistributing assets without com- pensating the prior owners. It can also be done through illegal means, or corruption, by demanding bribes from businesses in return for the rights to operate in a country, industry, or location.16 Corruption has been well documented in every society, from the banks of the Congo River to the palace of the Dutch royal family, from Japanese politicians to Brazilian bankers, and from Indonesian government officials to the New York City Police Depart- ment. The government of the late Ferdinand Marcos in the Philippines was famous for demanding bribes from foreign businesses wishing to set up operations in that country. The same was true of government officials in Indonesia under the rule of former presi- dent Suharto. No society is immune to corruption. However, there are systematic differ- ences in the extent of corruption. In some countries, the rule of law minimizes corruption. Corruption is seen and treated as illegal, and when discovered, violators are punished by the full force of the law. In other countries, the rule of law is weak and corruption by bureaucrats and politicians is rife. Corruption is so endemic in some countries that politi- cians and bureaucrats regard it as a perk of office and openly flout laws against corrup- tion. This seems to have been the case in Brazil until recently, although the situation there may be evolving in a more positive direction (see the opening case).  According to Transparency International, an independent nonprofit organization dedicated to exposing and fighting corruption, businesses and individuals spend some $400 billion a year worldwide on bribes related to government procurement contracts alone.17 Transparency International has also measured the level of corruption among public officials in different countries.18 As can be seen in Figure 2.1, the organization rated countries such as Denmark and Sweden as clean; it rated others, such as Russia, India, and Venezuela, as corrupt. Somalia ranked last out of all 175 countries in the survey (the country is often described as a “failed state”).

52 Part 2 National Differences

Economic evidence suggests that high levels of corruption significantly reduce the foreign direct investment, level of international trade, and economic growth rate in a country.19 By siphoning off profits, corrupt politicians and bureaucrats reduce the returns to business investment and, hence, reduce the incentive of both domestic and foreign businesses to invest in that country. The lower level of investment that results hurts eco- nomic growth. Thus, we would expect countries with high levels of corruption such as Indonesia, Nigeria, and Russia to have a much lower rate of economic growth than might otherwise have been the case. A detailed example of the negative effect that corruption can have on economic progress is given in the accompanying Country Focus, which looks at the impact of corruption on economic growth in Nigeria.

Foreign Corrupt Practices Act In the 1970s, the United States passed the Foreign Corrupt Practices Act (FCPA) fol- lowing revelations that U.S. companies had bribed government officials in foreign coun- tries in an attempt to win lucrative contracts. This law makes it illegal to bribe a foreign government official to obtain or maintain business over which that foreign official has authority, and it requires all publicly traded companies (whether or not they are involved in international trade) to keep detailed records that would reveal whether a violation of the act has occurred. In 2012, evidence emerged that in its eagerness to expand in Mexico, Walmart may have run afoul of the FCPA (for details, see the Management Focus feature).

0 10 20 Corruption Index (100 = clean; 0 = totally corrupt)

30 40 50 60 70 80 90 100

Venezuela

Zimbabawe

Nigeria

Russia

India

Colombia

China

South Africa

South Korea

Poland

Italy

Turkey

Brazil

France

USA

United Kingdom

Germany

Canada

Sweden

Denmark

Somalia

F I G U R E 2 . 1

Rankings of corruption by country, 2014. Source: Constructed by the author from raw data from Transparency International, Corruption Perceptions Index 2014.

COUNTRY FOCUS

Corruption in Nigeria When Nigeria gained indepen- dence from Great Britain in 1960, there were hopes that the coun- try might emerge as an economic heavyweight in Africa. Not only was Nigeria Africa’s most popu- lous country, but it also was blessed with abundant natural re- sources, particularly oil. Despite this, Nigeria remains one of the poorest countries in the world. According to the 2012 Human Development Index compiled by the United Nations, Nigeria had “low human development.” The country ranked 153rd out of 187 covered. Gross national income per capita was just $2,102; almost 40 percent of the adult population was illiterate; and life expectancy at birth was only 52.3 years. What went wrong? Although there is no simple answer, a number of factors seem to have conspired to damage economic activity in Nigeria. The country is composed of several competing ethnic, tribal, and religious groups, and the conflict among them has limited political stability and led to political strife, including a brutal civil war in the 1970s. With the legitimacy of the government always in question, political leaders often purchased support by legitimizing bribes and by raiding the national treasury to reward allies. Civilian rule after independence was followed by a series of military dictatorships, each of which seemed more corrupt and inept than the last (the country returned to civilian rule in 1999). During the 1990s, the military dictator Sani Abacha openly and systematically plundered the state treasury for his own personal gain. His most blatant scam was the Pe- troleum Trust Fund that he set up in the mid-1990s, osten- sibly to channel extra revenue from an increase in fuel prices into much-needed infrastructure projects and other investments. The fund was not independently audited, and almost none of the money that passed through it was properly accounted for. It was, in fact, a vehicle for Abacha and his supporters to spend at will a sum that in 1996 was equivalent to some 25 percent of the total federal budget. Abacha, aware of his position as an unpopular and

unelected leader, lavished money on personal security and handed out bribes to those whose sup- port he coveted. With examples like this at the very top of the gov- ernment, it is not surprising that corruption could be found throughout the political and bu- reaucratic apparatus. Has the situation in Nigeria im- proved since the country returned to civilian rule in 1999? In 2003, Olusegun Obasanjo was elected president on a platform that in- cluded a promise to fight corrup- tion. By some accounts, progress has been seen. His anticorruption

chief, Nuhu Ribadu, claimed that whereas 70 percent of the country’s oil revenues were being stolen or wasted in 2002, by the mid-2000s the figure was “only” 40 percent. On the other hand, critics argue that some $20 billion in government oil revenues were still unaccounted for by 2014. Moreover, in its most recent survey (2014), Transparency International still ranked Nigeria 136th out of 175, suggesting that the country still has a long way to go. In early 2015, a new president was elected in Nigeria, Muhammadu Buhari. Buhari won in part by promising to tackle the country’s ongoing corruption problem. Buhari himself was president under the military dictatorship be- tween 1983 and 1985 but, unlike other leaders of that era, he did not use his position to enrich himself, so there are grounds for believing that some positive ac- tions might be taken.  

Sources: “A Tale of Two Giants,” The Economist, January 15, 2000, p. 5; J. Coolidge and S. Rose Ackerman, “High Level Rent Seeking and Corruption in African Regimes,” World Bank policy research working paper no. 1780, June 1997; D. L. Bevan, P. Collier, and J. W. Gunning, Nigeria and Indonesia: The Political Economy of Poverty, Equity and Growth (Oxford, UK: Oxford University Press, 1999); “Democracy and Its Discontents,” The Economist, January 29, 2005, p. 55; A. Field, “Can Reform Save Nigeria?,” Journal of Commerce, November 21, 2005, p. 1; “A Blacklist to Bolster Democracy,” The Economist, Febru- ary 17, 2007, p. 59; J. P. Luna, “Back on Track: Nigeria’s Hard Path towards Reform,” Harvard International Review 29, no. 3 (2007), p. 7; Transparency International, Corruption Perceptions Index, 2014; Aryn Baker, “Here’s 4 Challenges Nigeria’s New Leader Must Over- come,” Time, April 7, 2015.

Muhammadu Buhari was elected president of Nigeria in 2015 (after having also run for president in 2003, 2007, and 2011). He describes himself as a “con- verted democrat.” Source: © Xinhua/Alamy

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54

M A NAG E M E N T F O C U S

In the early 2000s, Walmart wanted to build a new store in San Juan Teotihuacan, Mexico, barely a mile from ancient pyramids that drew tourists from around the world. The owner of the land was happy to sell to Walmart, but one thing stood in the way of a deal—the city’s new zoning laws. These prohibited commercial development in the historic area. Not to be denied, executives at the head- quarters of Walmart de Mexico found a way around the problem: They paid a $52,000 bribe to a local official to redraw the zoning area so that the property Walmart wanted to purchase was placed outside the commercial- free zone. Walmart then went ahead and built the store, despite vigorous local opposition, opening it in late 2004. A former lawyer for Walmart de Mexico subsequently contacted Walmart executives at the company’s corporate headquarters in Bentonville, Arkansas. He told them that Walmart de Mexico routinely resorted to bribery, citing the altered zoning map as just one example. Alarmed, execu- tives at Walmart started their own investigation. Faced with growing evidence of corruption in Mexico, top Walmart ex- ecutives decided to engage in damage control, rather than coming clean. Walmart’s top lawyer shipped the case files back to Mexico and handed over responsibility for the investigation to the general council of Walmart de Mexico. This was an interesting choice as the very same general council was alleged to have authorized bribes. The gen- eral council quickly exonerated fellow Mexican executives, and the internal investigation was closed in 2006. For several years nothing more happened; then, in April 2012, the New York Times published an article detailing

Did Walmart Violate the Foreign Corrupt Practices Act? bribery by Walmart. The Times cited the changed zoning map and several other examples of bribery by Walmart—for example, eight bribes totaling $341,000 enabled Walmart to build a Sam’s Club in one of Mexico City’s most densely populated neighborhoods without a construction license, or an environmental permit, or an urban impact assess- ment, or even a traffic permit. Similarly, thanks to nine bribe payments totaling $765,000, Walmart built a vast refriger- ated distribution center in an environmentally fragile flood basin north of Mexico City, in an area where electricity was so scarce that many smaller developers were turned away. Walmart responded to the New York Times article by ramping up a second internal investigation into bribery that it had initiated in 2011. By mid-2013 there were reportedly more than 300 outside lawyers working on the investiga- tion, and it had cost more than $300 million in fees. In ad- dition, the U.S. Department of Justice and the Securities and Exchange Commission both announced that they had started investigations into Walmart’s practices. In November 2012, Walmart reported that its own investigation into viola- tions had extended beyond Mexico to include China and India. Among other things, it was looking into the allega- tions by the Times that top executives at Walmart, includ- ing former CEO Lee Scott Jr., had deliberately squashed earlier investigations.

Sources: David Barstow, “Vast Mexican Bribery Case Hushed Up by Wal-Mart after Top Level Struggle,” The New York Times, April 21, 2012; Stephanie Clifford and David Barstow, “Wal-Mart Inquiry Reflects Alarm on Corruption,” The New York Times, November 15, 2012; Nathan Vardi, “Why Justice Department Could Hit Wal-Mart Hard over Mexican Bribery Allegations,” Forbes, April 22, 2012.

In 1997, trade and finance ministers from the member states of the Organisation for Economic Co-operation and Development (OECD), an association of 34 major economies including most Western economies (but not Russia, India or China), ad- opted the Convention on Combating Bribery of Foreign Public Officials in Interna- tional Business Transactions.20 The convention obliges member states to make the bribery of foreign public officials a criminal offense. Both the U.S. law and OECD convention include language that allows exceptions known as facilitating or expediting payments (also called grease payments or speed money), the purpose of which is to expedite or to secure the performance of a routine gov- ernmental action.21 For example, they allow small payments made to speed up the issuance of permits or licenses, process paperwork, or just get vegetables off the dock and on their way to market. The explanation for this exception to general antibribery provisions is that while grease payments are, technically, bribes, they are distinguishable from (and, appar- ently, less offensive than) bribes used to obtain or maintain business because they merely facilitate performance of duties that the recipients are already obligated to perform.

National Differences in Political, Economic, and Legal Systems Chapter 2 55

THE PROTECTION OF INTELLECTUAL PROPERTY

Intellectual property refers to property that is the product of intellectual activity, such as computer software, a screenplay, a music score, or the chemical formula for a new drug. Patents, copyrights, and trademarks establish ownership rights over intellectual property. A patent grants the inventor of a new product or process exclusive rights for a defined period to the manufacture, use, or sale of that invention. Copyrights are the exclusive legal rights of authors, composers, playwrights, artists, and publishers to publish and disperse their work as they see fit. Trademarks are designs and names, officially registered, by which merchants or manufacturers designate and differentiate their products (e.g., Christian Dior clothes). In the high-technology “knowledge” economy of the twenty-first century, intellectual property has become an increasingly important source of economic value for businesses. Protecting intel- lectual property has also become increasingly problematic, particularly if it can be rendered in a digital form and then copied and distributed at very low cost via pirated DVDs or over the Internet (e.g., computer software, music, and video recordings).22 The philosophy behind intellectual property laws is to reward the originator of a new invention, book, musical record, clothes design, restaurant chain, and the like for his or her idea and effort. Such laws stimulate innovation and creative work. They provide an incentive for people to search for novel ways of doing things, and they reward creativity. For example, consider innovation in the pharmaceutical industry. A patent will grant the inventor of a new drug a 20-year monopoly in production of that drug. This gives phar- maceutical firms an incentive to undertake the expensive, difficult, and time-consuming basic research required to generate new drugs (it can cost $1 billion in R&D and take 12 years to get a new drug on the market). Without the guarantees provided by patents, companies would be unlikely to commit themselves to extensive basic research.23 The protection of intellectual property rights differs greatly from country to country. Although many countries have stringent intellectual property regulations on their books, the enforcement of these regulations has often been lax. This has been the case even among many of the 185 countries that are now members of the World Intellectual Property Organization, all of which have signed international treaties designed to protect intellectual property, including the oldest such treaty, the Paris Convention for the Protection of Industrial Property, which dates to 1883 and has been signed by more than 170 nations. Weak enforcement encourages the piracy (theft) of intellectual property. China and Thailand have often been among the worst offenders in Asia. Pirated computer software is widely available in China. Similarly, the streets of Bangkok, Thailand’s capital, are lined with stands selling pirated copies of Rolex watches, Levi’s jeans, DVDs, and computer software. The computer software industry is an example of an industry that suffers from lax en- forcement of intellectual property rights. Estimates suggest that violations of intellectual property rights cost personal computer software firms revenues equal to $63 billion in 2011.24 According to the Business Software Alliance, a software industry association, in 2011 some 42 percent of all software applications used in the world were pirated. One of the worst countries was China, where the piracy rate in 2011 ran at 77 percent and cost the in- dustry more than $9.8 billion in lost sales, up from $444 million in 1995. The piracy rate in the United States was much lower at 19 percent; however, the value of sales lost was signifi- cant because of the size of the U.S. market, reaching an estimated $9.8 billion in 2011.25 International businesses have a number of possible responses to violations of their intel- lectual property. They can lobby their respective governments to push for international agreements to ensure that intellectual property rights are protected and that the law is en- forced. Partly as a result of such actions, international laws are being strengthened. As we shall see in Chapter 7, the most recent world trade agreement, signed in 1994, for the first time extends the scope of the General Agreement on Tariffs and Trade to cover intellectual property. Under the new agreement, known as the Trade-Related Aspects of Intellectual Property Rights (TRIPS), as of 1995 a council of the World Trade Organization is oversee- ing enforcement of much stricter intellectual property regulations. These regulations

M A NAG E M E N T F O C U S

Starbucks has big plans for China. It believes the fast- growing nation will become the company’s second-largest market after the United States. Starbucks entered the country in 1999, and by the end of 2012 it had opened more than 400 stores. But in China, copycats of well- established Western brands are common. Starbucks faced competition from a look-alike, Shanghai Xing Ba Ke Coffee Shop, whose stores closely matched the Starbucks format, right down to a green-and-white Xing Ba Ke circular logo that mimics Starbucks’ ubiquitous logo. The name also mimics the standard Chinese translation for Starbucks. Xing means “star,” and Ba Ke sounds like “bucks.” In 2003, Starbucks decided to sue Xing Ba Ke in Chi- nese court for trademark violations. Xing Ba Ke’s general manager responded by claiming it was just an accident that the logo and name were so similar to that of Star- bucks. He claimed the right to use the logo and name be- cause Xing Ba Ke had registered as a company in Shanghai in 1999, before Starbucks entered the city. “I hadn’t heard of Starbucks at the time,” claimed the man- ager, “so how could I imitate its brand and logo?”

Starbucks Wins Key Trademark Case in China However, in January 2006 a Shanghai court ruled that Starbucks had precedence, in part because it had regis- tered its Chinese name in 1998. The court stated that Xing Ba Ke’s use of the name and similar logo was “clearly malicious” and constituted improper competi- tion. The court ordered Xing Ba Ke to stop using the name and to pay Starbucks $62,000 in compensation. While the money involved here may be small, the prec- edent is not. In a country where violation of trademarks has been common, the courts seem to be signaling a shift toward greater protection of intellectual property rights. This is perhaps not surprising because foreign governments and the World Trade Organization have been pushing China hard recently to start respecting in- tellectual property rights.

Sources: M. Dickie, “Starbucks Wins Case against Chinese Copycat,” Financial Times, January 3, 2006, p. 1; “Starbucks: Chinese Court Backs Company over Trademark Infringement,” The Wall Street Jour- nal, January 2, 2006, p. A11; “Starbucks Calls China Its Top Growth Focus,” The Wall Street Journal, February 14, 2006, p. 1.

oblige WTO members to grant and enforce patents lasting at least 20 years and copyrights lasting 50 years after the death of the author. Rich countries had to comply with the rules within a year. Poor countries, in which such protection generally was much weaker, had five years of grace, and the very poorest have 10 years.26 (For further details of the TRIPS agreement, see Chapter 7.) In addition to lobbying governments, firms can file lawsuits on their own behalf. For example, Starbucks won a landmark trademark copyright case in China against a copycat that signaled a change in the approach in China (see the accompanying Management Fo- cus for details). Firms may also choose to stay out of countries where intellectual property laws are lax, rather than risk having their ideas stolen by local entrepreneurs. Firms also need to be on the alert to ensure that pirated copies of their products produced in countries with weak intellectual property laws don’t turn up in their home market or in third coun- tries. U.S. computer software giant Microsoft, for example, discovered that pirated Micro- soft software, produced illegally in Thailand, was being sold worldwide as the real thing.

PRODUCT SAFETY AND PRODUCT LIABILITY

Product safety laws set certain safety 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. Product liability can be much greater if a product does not conform to required safety standards. Both civil and criminal product liability laws exist. 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, although many other Western nations also have comprehensive liabil- ity laws. Liability laws are typically the least extensive in less developed nations. A boom in product liability suits and awards in the United States resulted in a dramatic increase in the

56

National Differences in Political, Economic, and Legal Systems Chapter 2 57

cost of liability insurance. Many business executives argue that the high costs of liability insurance make American businesses less competitive in the global marketplace. In addition to the competitiveness issue, country differences in product safety and li- ability laws raise an important ethical issue for firms doing business abroad. When prod- uct safety laws are tougher in a firm’s home country than in a foreign country 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? While the ethical thing to do is undoubtedly to adhere to home-country standards, firms have been known to take advantage of lax safety and liability laws to do business in a manner that would not be allowed at home.

TEST PREP Use SmartBook to help retain what you have learned. Access your instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

F O C U S O N M A NAG E R I A L I M P L I C AT I O N S

THE MACRO ENVIRONMENT INFLUENCES MARKET ATTRACTIVENESS

The material discussed in this chapter has two broad implications for international business. First, the political, economic, and legal systems of a country raise impor-

tant ethical issues that have implications for the practice of international business. For example, what ethical implications are associated with doing business in to- talitarian countries where citizens are denied basic human rights, corruption is

rampant, and bribes are necessary to gain permission to do business? Is it right to operate in such a setting? A full discussion of the ethical implications of country dif-

ferences in political economy is reserved for Chapter 5, where we explore ethics in interna- tional business in much greater depth. Second, the political, economic, and legal environments of a country clearly influence the attractiveness of that country as a market or investment site. The benefits, costs, and risks associated with doing business in a country are a function of that country’s political, eco- nomic, and legal systems. The overall attractiveness of a country as a market or investment site depends on balancing the likely long-term benefits of doing business in that country against the likely costs and risks. Because this chapter is the first of two dealing with issues of political economy, we will delay a detailed discussion of how political economy impacts the benefits, costs, and risks of doing business in different nation-states until the end of the next chapter, when we have a full grasp of all the relevant variables that are important for assessing benefits, costs, and risks. For now, other things being equal, a nation with democratic political institutions, a market- based economic system, and strong legal system that protects property rights and limits corruption is clearly more attractive as a place in which to do business than a nation that lacks democratic institutions, where economic activity is heavily regulated by the state, and where corruption is rampant and the rule of law is not respected. On this basis, for example, a country like Canada is a better place in which to do business than the Venezuela of Hugo Chávez (see the Country Focus on Venezuela). That being said, the reality is of- ten more nuanced and complex. For example, China lacks democratic institutions, corrup- tion is widespread, property rights are not always respected, and even though the country has embraced many market-based economic reforms, there are still large numbers of state-owned enterprises, yet many Western businesses feel that they must invest in China. They do so despite the risks because the market is large, the nation is moving toward a market-based system, economic growth is strong, legal protection of property rights has been improving, and in the not too distant future China may become the largest economy in the world. Thus, China is becoming increasingly attractive as a place in which to do business, and given the future growth trajectory, significant opportunities may be lost by not investing in the country. We will explore how changes in political economy impact the attractiveness of a nation as a place in which to do business in the next chapter.

LO 2- 4 Explain the implications for management practice of national differences in political economy.

58 Part 2 National Differences

political economy, p. 40 political system, p. 41 collectivism, p. 41 socialists, p. 41 communists, p. 41 social democrats, p. 41 privatization, p. 42 individualism, p. 42 democracy, p. 43 totalitarianism, p. 43 representative democracy, p. 43 communist totalitarianism, p. 44 theocratic totalitarianism, p. 44 tribal totalitarianism, p. 44

right-wing totalitarianism, p. 44 market economy, p. 46 command economy, p. 47 legal system, p. 48 common law, p. 49 civil law system, p. 49 theocratic law system, p. 49 contract, p. 50 contract law, p. 50 United Nations Convention on

Contracts for the International Sale of Goods (CISG), p. 50

property rights, p. 50 private action, p. 51

public action, p. 51 Foreign Corrupt Practices

Act, (FCPA), p. 52 intellectual property, p. 55 patent, p. 55 copyrights, p. 55 trademarks, p. 55 World Intellectual Property

Organization, p. 55 Paris Convention for the

Protection of Industrial Property, p. 55

product safety laws, p. 56 product liability, p. 56

Key Terms

C H A P T E R S U M M A R Y

This chapter has reviewed how the political, economic, and legal systems of countries vary. The potential bene- fits, costs, and risks of doing business in a country are a function of its political, economic, and legal systems. The chapter made the following points:

1. Political systems can be assessed according to two dimensions: the degree to which they emphasize collectivism as opposed to individualism and the degree to which they are democratic or totalitarian.

2. Collectivism is an ideology that views the needs of society as being more important than the needs of the individual. Collectivism translates into an advocacy for state intervention in economic activity and, in the case of commu- nism, a totalitarian dictatorship.

3. Individualism is an ideology that is built on an emphasis of the primacy of the individual’s freedoms in the political, economic, and cultural realms. Individualism translates into an advocacy for democratic ideals and free market economics.

4. Democracy and totalitarianism are at different ends of the political spectrum. In a representative

democracy, citizens periodically elect individu- als to represent them, and political freedoms are guaranteed by a constitution. In a totalitarian state, political power is monopolized by a party, group, or individual, and basic political freedoms are denied to citizens of the state.

5. There are three broad types of economic systems: a market economy, a command economy, and a mixed economy. In a market economy, prices are free of controls, and private ownership is predominant. In a command economy, prices are set by central planners, productive assets are owned by the state, and private ownership is for- bidden. A mixed economy has elements of both a market economy and a command economy.

6. Differences in the structure of law between countries can have important implications for the practice of international business. The degree to which property rights are protected can vary dramatically from country to country, as can product safety and product liability legislation and the nature of contract law.

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. Free market economies stimulate greater eco- nomic growth, whereas state-directed economies stifle growth. Discuss.

2. A democratic political system is an essential condition for sustained economic progress. Discuss.

3. What is the relationship between corruption in a country (i.e., government officials taking bribes) and economic growth? Is corruption always bad?

4. You are the CEO of a company that has to choose between making a $100 million invest- ment in Russia or Poland. Both investments

National Differences in Political, Economic, and Legal Systems Chapter 2 59

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises:

1. The definition of words and political ideas can have different meanings in different contexts worldwide. In fact, the Freedom in the World survey published by Freedom House evaluates the state of political rights and civil liberties around the world. Provide a description of this survey and a ranking (in terms of “freedom”) of the world’s country leaders and laggards. What factors are taken into consideration in this survey?

promise the same long-run return, so your choice is driven by risk considerations. Assess the various risks of doing business in each of these nations. Which investment would you favor, and why?

5. Read the Country Focus on Venezuela under the leadership of Hugo Chávez; then answer the following questions:

a. Under Chávez’s leadership, what kind of economic system was put in place in Venezuela? How would you characterize the political system?

b. How do you think that Chávez’s unilateral changes to contracts with foreign oil compa- nies will affect future investment by foreign- ers in Venezuela?

2. As the chapter discusses, differences in political, economic, and legal systems have considerable impact on the benefits, costs, and risks of doing business in various countries. The World Bank’s “Doing Business Indicators” measure the extent of business regulations in countries around the world. Compare Brazil, Ghana, India, New Zealand, the United States, Sweden, and Turkey in terms of how easily contracts are enforced, how prop- erty can be registered, and how investors can be protected. Identify in which area you see the greatest variation from one country to the next.

c. How will the high level of public corruption in Venezuela affect future growth rates?

d. Currently, Venezuela is benefiting from a boom in oil prices. What do you think might happen if oil prices retreat from their current high level?

e. In your estimation, what is the long-run prognosis for the Venezuelan economy? Is this a country that is attractive to interna- tional businesses?

6. Read the Management Focus feature titled Did Walmart Violate the Foreign Corrupt Practices Act? What is your opinion? If you think it did, what do you think the consequences will be for Walmart?

The modern Russian state was born in 1991 after the dramatic collapse of the Soviet Union. Early in the post- Soviet era, Russia embraced ambitious policies designed to transform a communist dictatorship with a centrally planned economy into a democratic state with a market- based economic system. The policies, however, were im- perfectly implemented. Political reform left Russia with a strong presidency that—in hindsight—had the ability to subvert the democratic process. On the economic front, the privatization of many state-owned enterprises was done in such a way as to leave large shareholdings in the hands of the politically connected, many of whom were party officials and factory managers under the old

Soviet system. Corruption was also endemic, and orga- nized crime was able to seize control of some newly privatized enterprises. In 1998, the poorly managed Russian economy went through a financial crisis that nearly bought the country to its knees. Fast-forward to 2015, and Russia still has a long way to go before it resembles a modern democracy with a functioning free market–based economic system. On the positive side, the economy grew at a healthy clip during most of the 2000s, helped in large part by high prices for oil and gas, Russia’s largest exports (in 2013 oil and gas accounted for 75 percent of all Russian exports). Between 2000 and 2013, Russia’s gross domestic product (GDP)

C L O S I N G C A S E

Putin’s Russia

60 Part 2 National Differences

per capita more than doubled when measured by purchas- ing power parity. The country now boasts the world’s ninth-largest economy. Thanks to government oil reve- nues, public debt is also low by international standards— at just 9.2 percent of GDP (in the United States, by comparison, public debt amounts to 70 percent of GDP). Indeed, Russia has run a healthy trade surplus on the back of strong oil and gas exports for the last decade. On the other hand, the economy is overly dependent on commodities, particularly oil and gas. This was ex- posed in mid-2014 when the price of oil started to tum- ble as a result of rapidly increasing supply from the United States. Between mid-2014 and March 2015 the price of oil fell from $110 a barrel to around $50. This drove a freight train through Russia’s public finances. Much of Russia’s oil and gas production remains in the hands of enterprises in which the state still has a signifi- cant ownership stake. The government has a controlling ownership position in Gazprom and Rosneft, two of the country’s largest oil and gas companies. The government used the rise in oil and gas revenues between 2004 and 2014 to increase public spending through state-led in- vestment projects and increases in wages and pensions for government workers. While this boosted private con- sumption, there has been a dearth of private investment, and productivity growth remains low. This is particularly true among many state-owned enterprises that collec- tively still account for about half of the Russian econ- omy. Now with oil prices tumbling, Russia is having to issue ever more debt to finance public spending.  Russian private enterprises are also hamstrung by bu- reaucratic red tape and endemic corruption. The World Bank ranks Russia 92nd in the world in terms of the ease of doing business and 88th when it comes to starting a business (for comparison, the United States is ranked 4th and 20th, respectively). Transparency International, which ranks countries by the extent of corruption, ranked Russia 136th out of 175 nations in 2014. The state and state-owned enterprises are famous for pushing work to private enterprises that are owned by political allies, which further subverts market-based processes. On the political front, Russia is becoming less dem- ocratic with every passing year. Since 1999, Vladimir Putin has exerted increasingly tight control over Rus- sian politics, either as president or as prime minister. Under Putin, potential opponents have been sidelined, civil liberties have been progressively reduced, and the freedom of the press has been diminished. For exam- ple, in response to opposition protests in 2011 and 2012, the Russian government passed laws increasing its control over the Internet, dramatically raising fines for participating in “unsanctioned” street protests, and expanded the definition of treason to further limit op- position activities. Vocal opponents of the régime—

from business executives who do not tow the state line to protest groups such as the punk rock protest band Pussy Riot—have found themselves jailed on dubious charges. To make matters worse, Putin has recently been tightening his grip on the legal system. In late 2013, Russia’s parliament, which is dominated by Putin supporters, gave the president more power to appoint and fire prosecutors, thereby diminishing the indepen- dence of the legal system. Freedom House, which produces an annual ranking tracking freedom in the world, classifies Russia as “not free” and gives it low scores for political and civil liber- ties. Freedom House notes that in the March 2012 presi- dential elections, Putin benefited from preferential treatment by state-owned media, numerous abuses of in- cumbency, and procedural “irregularities” during the vote count. Putin won 63.6 percent of the vote against a field of weak, hand-chosen opponents, led by Commu- nist Party leader Gennadiy Zyuganove, with 17.2 percent of the vote. Under a Putin-inspired 2008 constitutional amendment, the term of the presidency was expanded from four years to six. Putin will be eligible for another six-year term in 2018. In 2014, Putin burnished his growing reputation for authoritarianism when he took advantage of unrest in the neighboring country of Ukraine to annex the Crimea re- gion, and to support armed revolt by Russian-speaking separatists in eastern Ukraine. Western powers re- sponded to this aggression by imposing economic sanc- tions on Russia. Taken together with the rapid fall in oil prices, this pushed the once booming Russian economy into a recession. In 2014 the economy grew by just 0.6 percent, while the Russian ruble tumbled, losing half of its value against other major currencies. Despite eco- nomic weaknesses, however, there is no sign that Putin’s hold on power has been diminished; in fact, quite the op- posite seems to have occurred.

Sources: “Putin’s Russia: Sochi or Bust,” The Economist, February 1, 2014; “Russia’s Economy: The S Word,” The Economist, November 9, 2013; Freedom House, Freedom in the World 2014: Russia, www. freedomhouse.org/report/freedom-world/2014/; K. Hille, “Putin Tightens Grip on Legal System,” Financial Times, November 27, 2013.

C a s e D i s c u s s i o n Q u e s t i o n s 1. Why did the Russian economy perform well

during the 2001–2013 period? Why did it run into trouble in 2014? What does this tell you about the efficacy of post-communist economic and political reforms? 

2. How has Vladimir Putin been able to accu- mulate so much political power in Russia? 

3. At this point, how secure do you think Putin’s hold on power is? What might change things?

National Differences in Political, Economic, and Legal Systems Chapter 2 61

4. After the collapse of communism, many Western businesses started to invest in Russia. How do you think the current political and economic climate is impacting on the profitability of those investments? 

5. Given what is happening in Russia today, what do you think will happen to foreign direct investment in Russia going forward? Is this a country where a Western enterprise would want to do business? 

E n d n o t e s

1. As we shall see, there is not a strict one-to-one correspon- dence between political systems and economic systems. A. O. Hirschman, “The On-and-Off Again Connection between Political and Economic Progress,” American Economic Review 84, no. 2 (1994), pp. 343–48.

2. For a discussion of the roots of collectivism and individualism, see H. W. Spiegel, The Growth of Economic Thought (Durham, NC: Duke University Press, 1991). A discussion of collectivism and individualism can be found in M. Friedman and R. Friedman, Free to Choose (London: Penguin Books, 1980).

3. For a classic summary of the tenets of Marxism, see A. Giddens, Capitalism and Modern Social Theory (Cambridge, UK: Cambridge University Press, 1971).

4. A. Smith, The Wealth of Nations, Vol. 1 (London: Penguin Book), p. 325.

5. R. Wesson, Modern Government—Democracy and Authoritar- ianism, 2nd ed. (Englewood Cliffs, NJ: Prentice Hall, 1990).

6. For a detailed but accessible elaboration of this argument, see Friedman and Friedman, Free to Choose. Also see P. M. Romer, “The Origins of Endogenous Growth,” Journal of Economic Perspectives 8, no. 1 (1994), pp. 2–32.

7. T. W. Lippman, Understanding Islam (New York: Meridian Books, 1995).

8. “Islam’s Interest,” The Economist, January 18, 1992, pp. 33–34. 9. M. El Qorchi, “Islamic Finance Gears Up,” Finance and Devel-

opment, December 2005, pp. 46–50; S. Timewell, “Islamic Finance—Virtual Concept to Critical Mass,” The Banker, March 1, 2008, pp. 10–16.

10. This information can be found on the UN’s treaty website at www.uncitral.org/uncitral/en/uncitral_texts/sale_goods/ 1980CISG.html.

11. International Court of Arbitration, www.iccwbo.org/index_ court.asp.

12. D. North, Institutions, Institutional Change, and Economic Per- formance (Cambridge, UK: Cambridge University Press, 1991).

13. “China’s Next Revolution,” The Economist, March 10, 2007, p. 9. 14. P. Klebnikov, “Russia’s Robber Barons,” Forbes, November 21,

1994, pp. 74–84; C. Mellow, “Russia: Making Cash from Chaos,” Fortune, April 17, 1995, pp. 145–51; “Mr. Tatum Checks Out,” The Economist, November 9, 1996, p. 78.

15. K. van Wolferen, The Enigma of Japanese Power (New York: Vintage Books, 1990), pp. 100–105.

16. P. Bardhan, “Corruption and Development: A Review of the Issues,” Journal of Economic Literature, September 1997, pp. 1320–46.

17. Transparency International, “Global Corruption Report, 2014,” www.transparency.org, 2014.

18. Ibid. 19. J. Coolidge and S. Rose Ackerman, “High Level Rent Seeking

and Corruption in African Regimes,” World Bank policy re- search working paper no. 1780, June 1997; K. Murphy, A. Shleifer, and R. Vishny, “Why Is Rent-Seeking So Costly to Growth?,” AEA Papers and Proceedings, May 1993, pp. 409–14; M. Habib and L. Zurawicki, “Corruption and Foreign Direct Investment,” Journal of International Business Studies 33 (2002), pp. 291–307; J. E. Anderson and D. Marcouiller, “Insecurity and the Pattern of International Trade,” Review of Economics and Statistics 84 (2002), pp. 342–52; T. S. Aidt, “Economic Analysis of Corruption: A Survey,” The Economic Journal 113 (November 2003), pp. 632–53; D. A. Houston, “Can Corruption Ever Improve an Economy?,” Cato Institute 27 (2007), pp. 325–43.

20. Details can be found at www.oecd.org/corruption/ oecdantibriberyconvention.htm.

21. D. Stackhouse and K. Ungar, “The Foreign Corrupt Practices Act: Bribery, Corruption, Record Keeping and More,” Indiana Lawyer, April 21, 1993.

22. For an interesting discussion of strategies for dealing with the low cost of copying and distributing digital information, see the chapter on rights management in C. Shapiro and H. R. Varian, Information Rules (Boston: Harvard Business School Press, 1999). Also see C. W. L. Hill, “Digital Piracy,” Asian Pacific Journal of Management, 2007, pp. 9–25.

23. Douglass North has argued that the correct specification of in- tellectual property rights is one factor that lowers the cost of doing business and, thereby, stimulates economic growth and development. See North, Institutions, Institutional Change, and Economic Performance.

24. Business Software Alliance, “Ninth Annual BSA Global Soft- ware Piracy Study,” May 2012, www.bsa.org.

25. Ibid. 26. “Trade Tripwires,” The Economist, August 27, 1994, p. 61.

Credit: ©Federal Reserve Board.

Source: © Frans lemmens/Alamy

National Differences in Economic Development L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO3 -1 Explain what determines the level of economic development of a nation.

LO3-2 Identify the macropolitical and macroeconomic changes occurring worldwide.

LO3-3 Describe how transition economies are moving toward market-based systems.

LO3-4 Explain the implications for management practice of national difference in political economy.

part two National Dif ferences

3

63

introduce economic reforms designed to free up markets, reduce state control over many sectors, and make it easier for entrepreneurial Africans to start businesses. A recent World Bank report titled “Doing Businesses” revealed that during 2013–2014 sub-Saharan Africa did more to improve regulations than any other region. Foreign investors are noticing; their investments in the region are growing. Between 2012 and 2014 foreign corporations invested $122 billion in the region, a sharp increase from historic norms and a record for a three-year period. Helped by such reforms, over the past decade sub- Saharan Africa has been among the world’s fastest-growing regions—its average annual growth rate was more than 5 percent. True, high commodity prices have also helped here, but there are signs that some African economies are reducing their dependence on commodities. Despite a sharp fall in commodity prices during 2014, the World Bank forecasts that the region will continue to expand by about 5 percent in 2015 and 2016. Manufacturing and service sectors are expanding, while tourism is booming. Telecom- munications and banking have been a bright spot in sev- eral countries, including Kenya which leads the world in adoption of mobile payment systems.  None of this means that Africa’s future is ensured. Too many nations still languish under autocratic governments and poor economic systems for that to be the case. But at least things are headed in the right direction across much of the region, and for the first time a new generation of Africans have hope that their future will be better than their past.

Sources: Freedom House, “Freedom in the World 2015”; UNCTAD, “Global FDI Flows Declines in 2014,” Global Investment Trends Moni- tor, January 29, 2015; Drew Hinshaw and Patrick McGroarty, “The Re- turn of Africa’s Strongmen,” The Wall Street Journal, December 6, 2014; The Economist, “A Glass Half Full,” March 31, 2014; The Econo- mist, “The Twilight of the Resource Curse?,” January 10, 2015.

O P E N I N G C A S E For decades, sub-Saharan Africa was the poorest region in the world. Dominated by largely autocratic governments, many of them military dictatorships that were rife with corrup- tion, economic growth was meager and poverty endemic. For the bulk of their exports many African countries were overly dependent on basic commodities such as oil, minerals and agricultural products. When commodity prices were high, those in power took much of the gains for themselves, amass- ing large personal fortunes while the bulk of the population languished in crushing poverty. When commodity prices fell, these nations couldn’t service the debt that the government had taken on in good times. With their currencies collapsing, foreign exchange reserves exhausted, and economic growth turning negative, they often had to seek help from the IMF. The last 25 years, however, have seen some promising changes. On the political front, democracy has started to gain hold. In 1990 just 3 of the countries in the region were classified as electoral democracies. Today 19 of the 49 states in sub-Saharan Africa are elected democracies. In early 2015 the most populous country in the region, Nigeria, recorded a major landmark when for the first time power was transferred peacefully after a general election. Many of these democracies, however, remain imperfect. The military often looms in the background, stepping in to enforce its will during troubled times, and accusations of electoral fraud are widespread. Freedom House, which monitors freedom worldwide, estimated that today only 10 countries in the region enjoy full political and civil liberties, whereas basic freedoms are still denied in 21 countries.  Notwithstanding the imperfect march toward democracy in the region, improvements in governance have helped stimulate economic growth. Significant steps have been taken in several nations to tackle endemic corruption,

Democracy and Economic Development in Sub-Saharan Africa

Introduction

In the previous chapter, we described how countries differ with regard to their political systems, economic systems, and legal systems. In this chapter, we build on this material to explain how these differences influence the level of economic development of a nation and, thus, how attractive it is as a place for doing business. We also look at how economic, politi- cal, and legal systems are changing around the world and what the implications of this are for the future rate of economic development of nations and regions. The past three decades have seen a general move toward more democratic forms of government, market-based economic reforms, and adoption of legal systems that better enforce property rights. Taken together, these trends have helped foster greater economic development around the world and have cre- ated a more favorable environment for international business. In the final section of this chap- ter, we pull all this material together to explore how differences in political, economic, and legal institutions affect the benefits, costs, and risks of doing business in different nations.

64 Part 2 National Differences

The opening case, which looks at changes in sub-Saharan Africa over the last 25 years, highlights many of the issues that we discuss here. For decades many countries in the region were run by corrupt military dictatorships that systematically plundered their na- tions. Now democracy is on the rise, political and civil freedoms are becoming en- trenched in several nations, and economic reforms have reduced corruption, deregulated markets, and made it easier for entrepreneurs to start businesses. As a result, during the last decade sub-Saharan Africa has been one of the world’s fastest-growing regions.

Differences in Economic Development

Different countries have dramatically different levels of economic development. One common measure of economic development is a country’s gross national income (GNI) per head of population. GNI is regarded as a yardstick for the economic activity of a country; it measures the total annual income received by residents of a nation. Map 3.1 summarizes the GNI per capita of the world’s nations in 2013. As can be seen, countries such as Japan, Sweden, Switzerland, the United States, and Australia are among the rich- est on this measure, whereas the large developing countries of China and India are significantly poorer. Japan, for example, had a 2013 GNI per capita of $46,330, but China achieved only $6,560 and India just $1,570.1

LO 3 -1 Explain what determines the level of economic development of a nation.

PACIFIC OCEAN

ARCTIC OCEAN

PACIFIC OCEAN

ATLANTIC OCEAN

INDIAN OCEAN

Low Income: $765 or less

Upper Middle Income: $3,035–$9,385 Lower High Income: $9,385–$20,000 Upper High Income: $20,001 or more No data

The values for the class intervals above are taken from the World Bank’s cutoff figures for high-income, upper-middle-income, lower-middle- income, and low-income economies.

GNI per Capita in U.S. Dollars

Lower Middle Income: $765–$3,035

1000

0

0

1000 2000 Miles

2000 3000 Kilometers Scale: 1 to 174,385,000

M A P 3 . 1

GNI per capita, 2013.

National Differences in Economic Development Chapter 3 65

TA B L E 3 . 1

Economic Data for Select Countries

Source: World Development Indicators Online, 2015.

Annual Average Size of GNI per GNI PPP GDP Growth Economy Capita, per Capita, Rate, 2004– GDP, 2013 Country 2013 ($) 2013 ($) 2013 (%) ($ billions) Brazil $11,690 $14,750 3.80% $ 2,246

China 6,560 11,850 10.2 9,240

Germany 47,250 45,010 1.20 3,730

India 1,580 5,350 7.80 1,875

Japan 46,330 37,550 0.90 4,920

Nigeria 2,710 5,360 8.8 522

Poland 13,240 22,830 4.10 526

Russia 13,850 24,280 4.10 2,097

Switzerland 90,680 59,610 2.20 685

United Kingdom 41,680 37,970 1.20 2,678

United States 53,470 53,750 1.70 16,768

GNI per person figures can be misleading because they don’t consider differences in the cost of living. For example, although the 2013 GNI per capita of Switzerland at $90,680 exceeded that of the United States by a wide margin, which was $53,470, the higher cost of living in Switzerland meant that U.S. citizens could actually afford almost as many goods and services as the average Swiss citizen. To account for differences in the cost of living, one can adjust GNI per capita by purchasing power. Referred to as a purchasing power parity (PPP) adjustment, it allows a more direct comparison of living standards in different countries. The base for the adjustment is the cost of living in the United States. The PPP for different countries is then adjusted (up or down) depending on whether the cost of living is lower or higher than in the United States. For example, in 2013 the GNI per capita for China was $6,560, but the PPP per capita was $11,850, suggesting that the cost of living was lower in China and that $6,560 in China would buy as much as $11,850 in the United States. Ta- ble 3.1 gives the GNI per capita measured at PPP in 2013 for a selection of countries, along with their GNI per capita and their growth rate in gross domestic product (GDP) from 2004 to 2013. Map 3.2 summarizes the GNI PPP per capita in 2013 for the nations of the world. As can be seen, there are striking differences in the standards of living among coun- tries. Table 3.1 suggests the average Indian citizen can afford to consume only about 10 percent of the goods and services consumed by the average U.S. citizen on a PPP basis. Given this, we might conclude that despite having a population of 1.2 billion, India is unlikely to be a very lucrative market for the consumer products produced by many West- ern international businesses. However, this would be incorrect because India has a fairly wealthy middle class of close to 250 million people, despite its large number of poor citizens. In absolute terms, the Indian economy now rivals that of Russia. To complicate matters, in many countries the “official” figures do not tell the entire story. Large amounts of economic activity may be in the form of unrecorded cash trans- actions, or barter agreements. People engage in such transactions to avoid paying taxes, and although the share of total economic activity accounted for by such transactions may be small in developed economies such as the United States, in some countries (India be- ing an example), they are reportedly very significant. Known as the black economy or shadow economy, estimates suggest that in India it may be around 50 percent of GDP, which implies that the Indian economy is half as big again as the figures reported in Table 3.1. Estimates produced by the European Union suggest that in 2012 the shadow

66 Part 2 National Differences

economy accounted for around 10 percent of GDP in the UK and France, but 24 percent in Greece and as much as 32 percent in Bulgaria.2 The GNI and PPP data give a static picture of development. They tell us, for example, that China is much poorer than the United States, but they do not tell us if China is clos- ing the gap. To assess this, we have to look at the economic growth rates achieved by countries. Table 3.1 gives the rate of growth in gross domestic product (GDP) achieved by a number of countries between 2004 and 2013. Map 3.3 summarizes the annual average percentage growth rate in GDP from 2004 to 2013. Although countries such as China and India are currently relatively poor, their economies are already large in absolute terms and growing far more rapidly than those of many advanced nations. They are already huge markets for the products of international businesses. In 2010, China overtook Japan to become the second-largest economy in the world after the United States. Indeed, if both China and the United States maintain their current economic growth rates, China will become the world’s largest economy sometime during the next decade. On current trends, India too will be among the largest economies in the world. Given that potential, many international businesses are trying to establish a strong presence in these markets.

BROADER CONCEPTIONS OF DEVELOPMENT: AMARTYA SEN

The Nobel Prize–winning economist Amartya Sen has argued that development should be assessed less by material output measures such as GNI per capita and more by the capabilities and opportunities that people enjoy.3 According to Sen, development should

M A P 3 . 2

GNI PPP per capita, 2013.

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Low Income: $1,990 or less

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Lower Middle Income: $1,991–$4,580

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National Differences in Economic Development Chapter 3 67

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Average Annual Growth Rate, GDP: 2004–2013

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Average annual growth rate in GDP, 2004–2013.

C O U N T R Y C O M PA R AT O R

The “Country Comparator” tool on globalEDGE (globaledge.msu.edu/comparator) includes data from as early as 1960 to the most recent year. Using this tool, it is easy to compare countries across a variety of macro variables to better understand the economic changes occurring in countries. As related to Chapter 3 of the text, the globalEDGE Country Com- parator tool is an effective way to statistically get an overview of the political economy and economic development by country worldwide. Comparisons of up to 20 countries at a time can be made in table format. Sometimes we talk about the BRIC countries when referring to Brazil, Russia, India, and China—in essence, we broadly classify them as “superstar” emerging markets, but are they really that similar? Using the Country Comparator tool on globalEDGE, we find that the GDP adjusted for purchasing power parity is by far the greatest in Russia. Where do you think Brazil, India, and China fall on the GDP PPP scale?

be seen as a process of expanding the real freedoms that people experience. Hence, devel- opment requires the removal of major impediments to freedom: poverty as well as tyr- anny, poor economic opportunities as well as systematic social deprivation, and neglect of public facilities as well as the intolerance of repressive states. In Sen’s view, develop- ment is not just an economic process, but is a political one too, and to succeed requires

68 Part 2 National Differences

the “democratization” of political communities to give citizens a voice in the important decisions made for the community. This perspective leads Sen to emphasize basic health care, especially for children, and basic education, especially for women. Not only are these factors desirable for their instrumental value in helping achieve higher income lev- els, but they are also beneficial in their own right. People cannot develop their capabili- ties if they are chronically ill or woefully ignorant. Sen’s influential thesis has been picked up by the United Nations, which has developed the Human Development Index (HDI) to measure the quality of human life in different nations. The HDI is based on three measures: life expectancy at birth (a function of health care); educational attainment (measured by a combination of the adult literacy rate and enrollment in primary, secondary, and tertiary education); and whether average in- comes, based on PPP estimates, are sufficient to meet the basic needs of life in a country (adequate food, shelter, and health care). As such, the HDI comes much closer to Sen’s conception of how development should be measured than narrow economic measures such as GNI per capita—although Sen’s thesis suggests that political freedoms should also be included in the index, and they are not. The HDI is scaled from 0 to 1. Countries scoring less than 0.5 are classified as having low human development (the quality of life is poor); those scoring from 0.5 to 0.8 are classified as having medium human develop- ment; and those that score above 0.8 are classified as having high human development. Map 3.4 summarizes the HDI scores for 2013.

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Very High Human Development: 0.800–1.00 High Human Development: 0.700–07.99 Medium Human Development: 0.550– 0.699 Low Human Development: less than 0.550 No data

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Human Development Index, 2013.

National Differences in Economic Development Chapter 3 69

Political Economy and Economic Progress

It is often argued that a country’s economic development is a function of its economic and political systems. What then is the nature of the relationship between political economy and economic progress? Despite the long debate over this question among academics and policymakers, it is not possible to give an unambiguous answer. However, it is possible to untangle the main threads of the arguments and make a few generalizations as to the nature of the relationship between political economy and economic progress.

INNOVATION AND ENTREPRENEURSHIP ARE THE ENGINES OF GROWTH

There is substantial agreement among economists that innovation and entrepreneurial activity are the engines of long-run economic growth.4 Those who make this argument define innovation broadly to include not just new products but also new processes, new organizations, new management practices, and new strategies. Thus, the Toys “R” Us strategy of establishing large warehouse-style toy stores and then engaging in heavy ad- vertising and price discounting to sell the merchandise can be classified as an innovation because it was the first company to pursue this strategy in its industry. Similarly, the de- velopment of mass-market online retailing by Amazon.com can be seen as an innovation. Innovation and entrepreneurial activity help increase economic activity by creating new products and markets that did not previously exist. Moreover, innovations in production and business processes lead to an increase in the productivity of labor and capital, which further boosts economic growth rates.5 Innovation is also seen as the product of entrepreneurial activity. Often, entrepreneurs first commercialize innovative new products and processes, and entrepreneurial activity provides much of the dynamism in an economy. For example, the U.S. economy has benefited greatly from a high level of entrepreneurial activity, which has resulted in rapid innovation in products and process. Firms such as Google, Facebook, Amazon, Cisco Systems, Dell, Microsoft, and Oracle were all founded by entrepreneurial individuals to exploit new technology. All these firms created significant economic value and boosted productivity by helping commercialize innovations in products and processes. Thus, we can conclude that if a country’s economy is to sustain long-run economic growth, the business environment must be conducive to the consistent production of product and pro- cess innovations and to entrepreneurial activity.

INNOVATION AND ENTREPRENEURSHIP REQUIRE A MARKET ECONOMY

This leads logically to a further question: What is required for the business environment of a country to be conducive to innovation and entrepreneurial activity? Those who have considered this issue highlight the advantages of a market economy.6 It has been argued that the economic freedom associated with a market economy creates greater incentives for innovation and entrepreneurship than either a planned or a mixed economy. In a mar- ket economy, any individual who has an innovative idea is free to try to make money out of that idea by starting a business (by engaging in entrepreneurial activity). Similarly, existing businesses are free to improve their operations through innovation. To the extent that they are successful, both individual entrepreneurs and established businesses can reap rewards in the form of high profits. Thus, market economies contain enormous in- centives to develop innovations. In a planned economy, the state owns all means of production. Consequently, entrepre- neurial individuals have few economic incentives to develop valuable new innovations because it is the state, rather than the individual, that captures most of the gains. The lack of economic freedom and incentives for innovation was probably a main factor in the economic stagnation of many former communist states and led ultimately to their col- lapse at the end of the 1980s. Similar stagnation occurred in many mixed economies in those sectors where the state had a monopoly (such as coal mining and telecommunications in Great Britain). This stagnation provided the impetus for the widespread privatization

70 Part 2 National Differences

of state-owned enterprises that we witnessed in many mixed economies during the mid- 1980s and that is still going on today (privatization refers to the process of selling state- owned enterprises to private investors—see Chapter 2 for details). A study of 102 countries over a 20-year period provided evidence of a strong relation- ship between economic freedom (as provided by a market economy) and economic growth.7 The study found that the more economic freedom a country had between 1975 and 1995, the more economic growth it achieved and the richer its citizens became. The 6 countries that had persistently high ratings of economic freedom from 1975 to 1995 (Hong Kong, Switzerland, Singapore, the United States, Canada, and Germany) were also all in the top 10 in terms of economic growth rates. In contrast, no country with persis- tently low economic freedom achieved a respectable growth rate. In the 16 countries for which the index of economic freedom declined the most during 1975 to 1995, gross do- mestic product fell at an annual rate of 0.6 percent.

INNOVATION AND ENTREPRENEURSHIP REQUIRE STRONG PROPERTY RIGHTS

Strong legal protection of property rights is another requirement for a business environ- ment to be conducive to innovation, entrepreneurial activity, and hence economic growth.8 Both individuals and businesses must be given the opportunity to profit from innovative ideas. Without strong property rights protection, businesses and individuals run the risk that the profits from their innovative efforts will be expropriated, either by criminal ele- ments or by the state. The state can expropriate the profits from innovation through legal means, such as excessive taxation, or through illegal means, such as demands from state bureaucrats for kickbacks in return for granting an individual or firm a license to do business in a certain area (i.e., corruption). According to the Nobel Prize–winning econo- mist Douglass North, throughout history many governments have displayed a tendency to engage in such behavior.9 Inadequately enforced property rights reduce the incentives for innovation and entrepreneurial activity—because the profits from such activity are “stolen”—and hence reduce the rate of economic growth. The influential Peruvian development economist Hernando de Soto has argued that much of the developing world will fail to reap the benefits of capitalism until property rights are better defined and protected.10 De Soto’s arguments are interesting because he says the key problem is not the risk of expropriation, but the chronic inability of property owners to establish legal title to the property they own. As an example of the scale of the problem, he cites the situation in Haiti, where individuals must take 176 steps over 19 years to own land legally. Because most property in poor countries is informally “owned,” the absence of legal proof of ownership means that property holders cannot convert their assets into capital, which could then be used to finance business ventures. Banks will not lend money to the poor to start businesses because the poor possess no proof that they own property, such as farmland, that can be used as collateral for a loan. By de Soto’s calculations, the total value of real estate held by the poor in third-world and former com- munist states amounted to more than $9.3 trillion in 2000. If those assets could be con- verted into capital, the result could be an economic revolution that would allow the poor to bootstrap their way out of poverty. Interestingly enough, the Chinese seem to have taken de Soto’s arguments to heart. Despite still being nominally a communist country, in October 2007 the government passed a law that gave private property owners the same rights as the state, which significantly improved the rights of urban and rural landowners to the land that they use (see the accompanying Country Focus).

THE REQUIRED POLITICAL SYSTEM

Much debate surrounds which kind of political system best achieves a functioning market economy with strong protection for property rights.11 People in the West tend to associate a representative democracy with a market economic system, strong property rights pro- tection, and economic progress. Building on this, we tend to argue that democracy is good for growth. However, some totalitarian regimes have fostered a market economy

71

COUNTRY FOCUS

Emerging Property Rights in China On October 1, 2007, a new property law took effect in China, granting rural and urban landholders far more secure prop- erty rights. The law was a much-needed response to how China’s economy has changed over the past 30 years as it transitions from a centrally planned system to a more dy- namic market-based economy where two-thirds of eco- nomic activity is in the hands of private enterprises. Although all land in China still technically belongs to the state—an ideological necessity in a country where the gov- ernment still claims to be guided by Marxism—urban land- holders had been granted 40- to 70-year leases to use the land, while rural farmers had 30-year leases. However, the lack of legal title meant that landholders were at the whim of the state. Large-scale appropriation of rural land for housing and factory construction had rendered millions of farmers landless. Many were given little or no compensa- tion, and they drifted to the cities where they added to a growing underclass. In both urban and rural areas, property and land disputes had become a leading cause of social unrest. According to government sources, in 2006 there were about 23,000 “mass incidents” of social unrest in China, many related to disputes over property rights. The 2007 law, which was 14 years in gestation due to a rearguard action fought by left-wing Communist Party

activists who objected to it on ideological grounds, gives urban and rural land users the right to automatic renewal of their leases after the expiration of the 30- to 70-year terms. In addition, the law requires that land users be fairly compensated if the land is required for other purposes, and it gives individuals the same legal protection for their property as the state. Taken together with a 2004 change in China’s constitution, which stated that private property “was not to be encroached upon,” the new law significantly strengthens property rights in China. Nevertheless, the law has its limitations; most notably, it still falls short of giving peasants marketable ownership rights to the land they farm. If they could sell their land, tens of millions of underemployed farmers might find more productive work elsewhere. Those who stayed could ac- quire bigger landholdings that could be used more effi- ciently. Also, farmers might be able to use their landholdings as security against which they could borrow funds for investments to boost productivity.

Sources: “China’s Next Revolution—Property Rights in China,” The Economist, March 10, 2007, p. 11; “Caught between the Right and Left,” The Economist, March 10, 2007, pp. 25–27; Z. Keliang and L. Ping, “Rural Land Rights under the PRC Property Law,” China Law and Practice, November 2007, pp. 10–15.

and strong property rights protection and have experi- enced rapid economic growth. Five of the fastest-grow- ing economies of the past 30 years—China, South Korea, Taiwan, Singapore, and Hong Kong—had one thing in common at the start of their economic growth: undemocratic governments. At the same time, countries with stable democratic governments, such as India, expe- rienced sluggish economic growth for long periods. In 1992, Lee Kuan Yew, Singapore’s leader for many years, told an audience, “I do not believe that democracy neces- sarily leads to development. I believe that a country needs to develop discipline more than democracy. The exuberance of democracy leads to undisciplined and dis- orderly conduct which is inimical to development.”12 However, those who argue for the value of a totalitar- ian regime miss an important point: If dictators made countries rich, then much of Africa, Asia, and Latin America should have been growing rapidly during 1960 to 1990, and this was not the case. Only a totalitarian regime that is committed to a market system and strong protection of property rights is capable of promoting economic growth. Also, there is no guarantee that a

dictatorship will continue to pursue such progressive pol- icies. Dictators are rarely benevolent. Many are tempted to use the apparatus of the state to further their own pri- vate ends, violating property rights and stalling eco- nomic growth. Given this, it seems likely that democratic regimes are far more conducive to long-term economic growth than are dictatorships, even benevolent ones. Only in a well-functioning, mature democracy are prop- erty rights truly secure.13 Nor should we forget Amartya Sen’s arguments reviewed earlier. Totalitarian states, by limiting human freedom, also suppress human develop- ment and therefore are detrimental to progress.

ECONOMIC PROGRESS BEGETS DEMOCRACY

While it is possible to argue that democracy is not a nec- essary precondition for a free market economy in which property rights are protected, subsequent economic growth often leads to establishment of a democratic re- gime. Several of the fastest-growing Asian economies adopted more democratic governments during the past three decades, including South Korea and Taiwan. Thus,

72 Part 2 National Differences

although democracy may not always be the cause of initial economic progress, it seems to be one consequence of that progress. A strong belief that economic progress leads to adoption of a democratic regime underlies the fairly permissive attitude that many Western governments have adopted toward human rights violations in China. Although China has a totalitarian government in which human rights are violated, many Western countries have been hesitant to criticize the country too much for fear that this might hamper the country’s march toward a free market system. The belief is that once China has a free market system, greater individual freedoms and democ- racy will follow. Whether this optimistic vision comes to pass remains to be seen.

GEOGRAPHY, EDUCATION, AND ECONOMIC DEVELOPMENT

While a country’s political and economic systems are probably the big engine driving its rate of economic development, other factors are also important. One that has received attention is geography.14 But the belief that geography can influence economic policy, and hence economic growth rates, goes back to Adam Smith. The influential economist Jeffrey Sachs argues that

throughout history, coastal states, with their long engagements in international trade, have been more supportive of market institutions than landlocked states, which have tended to organize themselves as hierarchical (and often militarised) societies. Mountainous states, as a result of physical isolation, have often neglected market-based trade. Temperate climes have generally supported higher densities of population and thus a more extensive division of labour than tropical regions.15

Sachs’s point is that by virtue of favorable geography, certain societies are more likely to engage in trade than others and are thus more likely to be open to and develop market-based economic systems, which in turn promotes faster economic growth. He also argues that, ir- respective of the economic and political institutions a country adopts, adverse geographic conditions—such as the high rate of disease, poor soils, and hostile climate that afflict many tropical countries—can have a negative impact on development. Together with colleagues at Harvard’s Institute for International Development, Sachs tested for the impact of geography on a country’s economic growth rate between 1965 and 1990. He found that landlocked countries grew more slowly than coastal economies and that being entirely landlocked re- duced a country’s growth rate by roughly 0.7 percent per year. He also found that tropical countries grew 1.3 percent more slowly each year than countries in the temperate zone. Education emerges as another important determinant of economic development (a point that Amartya Sen emphasizes). The general assertion is that nations that invest more in education will have higher growth rates because an educated population is a more produc- tive population. Anecdotal comparisons suggest this is true. In 1960, Pakistanis and South Koreans were on equal footing economically. However, just 30 percent of Pakistani chil- dren were enrolled in primary schools, while 94 percent of South Koreans were. By the mid-1980s, South Korea’s GNP per person was three times that of Pakistan.16 A survey of 14 statistical studies that looked at the relationship between a country’s investment in edu- cation and its subsequent growth rates concluded investment in education did have a posi- tive and statistically significant impact on a country’s rate of economic growth.17 Similarly, the work by Sachs discussed earlier suggests that investments in education help explain why some countries in Southeast Asia, such as Indonesia, Malaysia, and Singapore, have been able to overcome the disadvantages associated with their tropical geography and grow far more rapidly than tropical nations in Africa and Latin America.

States in Transition

The political economy of many of the world’s nation-states has changed radically since the late 1980s. Two trends have been evident. First, during the late 1980s and early 1990s, a wave of democratic revolutions swept the world. Totalitarian governments collapsed

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National Differences in Economic Development Chapter 3 73

and were replaced by democratically elected governments that were typically more committed to free market capitalism than their predecessors had been. Second, there has been a strong move away from centrally planned and mixed economies and toward a more free market economic model.

THE SPREAD OF DEMOCRACY

One notable development of the past 30 years has been the spread of democracy (and, by extension, the decline of totalitarianism). Map 3.5 reports on the extent of totalitarianism in the world as determined by Freedom House.18 This map charts political free- dom in 2015, grouping countries into three broad groupings: free, partly free, and not free. In “free” countries, citizens enjoy a high degree of political and civil freedoms. “Partly free” countries are characterized by some restrictions on political rights and civil lib- erties, often in the context of corruption, weak rule of law, ethnic

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Freedom in the world in 2015. Source: From The Freedom House Survey Team, “Freedom in the World 2015,” www.freedomhouse.org. Reprinted with permission.

Image of Nigeria, where a peaceful transfer of power occurred after elections in March 2015. Muhammadu Buhari is the new president of Nigeria, taking office on May 29, 2015. Source: © Anadolu Agency/Getty Images

74 Part 2 National Differences

strife, or civil war. In “not free” countries, the political process is tightly controlled and basic freedoms are denied. Freedom House classified some 89 countries as free in 2015 accounting for about 46 percent of the world’s nations. These countries respect a broad range of political rights. Another 55 countries accounting for 28 percent of the world’s nations were classified as partly free, while 51 countries representing approximately 26 percent of the world’s na- tions were classified as not free. The number of democracies in the world has increased from 69 nations in 1987 to 125 in 2015. But not all democracies are free, according to Freedom House, because some democracies still restrict certain political and civil liber- ties. For example, although Russia is nominally a democracy, it has consistently been rated “not free” since the early 2000s. According to Freedom House,

Russia’s step backwards into the Not Free category is the culmination of a growing trend . . . to concentrate political authority, harass and intimidate the media, and politicize the country’s law-enforcement system.19

Similarly, Freedom House argues that democracy was restricted in Venezuela under the leadership of the late Hugo Chávez, and that trend continues under his successor. Many of the newer democracies are to be found in eastern Europe and Latin America, although there also have been notable gains in Africa during this time, such as in South Africa and more recently Libya. Entrants into the ranks of the world’s democracies dur- ing the last 25 years include Mexico, which held its first fully free and fair presidential election in 2000 after free and fair parliamentary and state elections in 1997 and 1998; Senegal, where free and fair presidential elections led to a peaceful transfer of power; Ukraine, where popular unrest following widespread ballot fraud in the 2004 presidential election resulted in a second election, the victory of a reform candidate, and a marked improvement in civil liberties (although sadly, the reform candidate also proved to be cor- rupt); and Libya, which held successful elections in 2012 after the removal by popular revolt of that country’s long-standing dictator, Muammar Gaddafi.  Three main reasons account for the spread of democracy.20 First, many totalitarian regimes failed to deliver economic progress to the vast bulk of their populations. The col- lapse of communism in eastern Europe, for example, was precipitated by the growing gulf between the vibrant and wealthy economies of the West and the stagnant economies of the communist East. In looking for alternatives to the socialist model, the populations of these countries could not have failed to notice that most of the world’s strongest econo- mies were governed by representative democracies. Today, the economic success of many of the newer democracies—such as Poland and the Czech Republic in the former com- munist bloc, the Philippines and Taiwan in Asia, and Chile in Latin America—has strengthened the case for democracy as a key component of successful economic advancement. Second, new information and communication technologies—including satellite televi- sion, fax machines, desktop publishing, and, most important, the Internet—have reduced a state’s ability to control access to uncensored information. These technologies have created new conduits for the spread of democratic ideals and information from free soci- eties. Today, the Internet is allowing democratic ideals to penetrate closed societies as never before.21 Young people who utilized Facebook and Twitter to reach large numbers of people very quickly and coordinate their actions organized the demonstrations in 2011 that led to the overthrow of the Egyptian government. Third, in many countries, economic advances have led to the emergence of increas- ingly prosperous middle and working classes that have pushed for democratic reforms. This was certainly a factor in the democratic transformation of South Korea. Entrepre- neurs and other business leaders, eager to protect their property rights and ensure the dispassionate enforcement of contracts, are another force pressing for more accountable and open government. Despite this, it would be naive to conclude that the global spread of democracy will continue unchallenged. Democracy is still rare in large parts of the world. In sub-Saharan

National Differences in Economic Development Chapter 3 75

Africa in 2015, only 10 countries were considered free, 19 were partly free, and 20 were not free. Among the post-communist countries in eastern and central Europe and the former Soviet Union, only 13 are classified as free (primarily in eastern Europe). And there is only 1 free state among the 18 nations of the Middle East and North Africa, even though the wave of unrest that spread across the Middle East during 2011–2013 created hope for change.   Moreover, there are disturbing signs that authoritarianism is gaining ground in several countries where political and civil liberties have been progressively limited in recent years, including Russia, Ukraine, Indonesia, and Venezuela. An increasingly autocratic Russia annexed the Crimea region from the Ukraine in 2014, and has actively supported pro-Russian rebels in eastern Ukraine. Libya, where there was hope that a democracy might be established, appears to be slipping into anarchy. In Egypt, after a brief flirtation with democracy, the military stepped in, removing the government of Mohamed Morsi, after Morsi and his political movement, the Muslim Brotherhood, had exhibited its own authoritarian tendencies. The military-backed government, however, has also acted in an authoritarian manner, effectively reversing much of the progress that had occurred after the revolution of 2011.

THE NEW WORLD ORDER AND GLOBAL TERRORISM

The end of the Cold War and the “new world order” that followed the collapse of com- munism in eastern Europe and the former Soviet Union, taken together with the demise of many authoritarian regimes in Latin America, gave rise to intense speculation about the future shape of global geopolitics. Author Francis Fukuyama argued, “We may be witnessing . . . the end of history as such: that is, the end point of mankind’s ideological evolution and the universalization of Western liberal democracy as the final form of hu- man government.”22 Fukuyama goes on to say that the war of ideas may be at an end and that liberal democracy has triumphed. Others questioned Fukuyama’s vision of a more harmonious world dominated by a universal civilization characterized by democratic regimes and free market capitalism. In a controversial book, the late influential political scientist Samuel Huntington argued there is no “universal” civilization based on widespread acceptance of Western liberal democratic ideals.23 Huntington maintained that while many societies may be modernizing—they are adopting the material paraphernalia of the modern world, from automobiles to Coca-Cola and MTV—they are not becoming more Western. On the contrary, Huntington theorized that modernization in non-Western societies can result in a retreat toward the traditional, such as the resurgence of Islam in many traditionally Muslim societies. He wrote,

The Islamic resurgence is both a product of and an effort to come to grips with moderniza- tion. Its underlying causes are those generally responsible for indigenization trends in non- Western societies: urbanization, social mobilization, higher levels of literacy and education, intensified communication and media consumption, and expanded interaction with Western and other cultures. These developments undermine traditional village and clan ties and cre- ate alienation and an identity crisis. Islamist symbols, commitments, and beliefs meet these psychological needs, and Islamist welfare organizations, the social, cultural, and economic needs of Muslims caught in the process of modernization. Muslims feel a need to return to Islamic ideas, practices, and institutions to provide the compass and the motor of modernization.24

Thus, the rise of Islamic fundamentalism is portrayed as a response to the alienation produced by modernization. In contrast to Fukuyama, Huntington envisioned a world split into different civiliza- tions, each of which has its own value systems and ideology. Huntington predicted conflict between the West and Islam and between the West and China. While some commentators originally dismissed Huntington’s thesis, in the aftermath of the terrorist attacks on the United States on September 11, 2001, Huntington’s views received new attention.

76 Part 2 National Differences

If Huntington’s views are even partly correct, they have important implications for international business. They suggest many countries may be difficult places in which to do business, either because they are shot through with violent conflicts or because they are part of a civilization that is in conflict with an enterprise’s home country. Huntington’s views are speculative and controversial. More likely than his predictions coming to pass is the evolution of a global political system that is positioned somewhere be- tween Fukuyama’s universal global civilization based on liberal democratic ideals and Huntington’s vision of a fractured world. That would still be a world, however, in which geopolitical forces periodically limit the ability of business enterprises to operate in cer- tain foreign countries. In Huntington’s thesis, global terrorism is a product of the tension between civiliza- tions and the clash of value systems and ideology. Others point to terrorism’s roots in long-standing conflicts that seem to defy political resolution—the Palestinian, Kashmir, and Northern Ireland conflicts being obvious examples. It should also be noted that a substantial amount of terrorist activity in some parts of the world, such as Colombia, has been interwoven with the illegal drug trade. As former U.S. secretary of state Colin Powell has maintained, terrorism represents one of the major threats to world peace and eco- nomic progress in the twenty-first century.25

THE SPREAD OF MARKET-BASED SYSTEMS

Paralleling the spread of democracy since the 1980s has been the transformation from centrally planned command economies to market-based economies. More than 30 coun- tries that were in the former Soviet Union or the eastern European communist bloc have changed their economic systems. A complete list of countries where change is now oc- curring also would include Asian states such as China and Vietnam, as well as African countries such as Angola, Ethiopia, and Mozambique.26 There has been a similar shift away from a mixed economy. Many states in Asia, Latin America, and western Europe have sold state-owned businesses to private investors (privatization) and deregulated their economies to promote greater competition.

Rapid economic development has taken place in China and Vietnam since the shift toward a more market-based system. © Per-Anders Pettersson/Terra/Corbis

National Differences in Economic Development Chapter 3 77

The rationale for economic transformation has been the same the world over. In gen- eral, command and mixed economies failed to deliver the kind of sustained economic performance that was achieved by countries adopting market-based systems, such as the United States, Switzerland, Hong Kong, and Taiwan. As a consequence, even more states have gravitated toward the market-based model. Map 3.6, based on data from the Heri- tage Foundation, a politically conservative U.S. research foundation, gives some idea of the degree to which the world has shifted toward market-based economic systems (given that the Heritage Foundation has an overt political agenda and generally supports the “Tea Party” wing of the Republican Party, its work should be viewed with caution). The Heritage Foundation’s index of economic freedom is based on 10 indicators, including the extent to which the government intervenes in the economy, trade policy, the degree to which property rights are protected, foreign investment regulations, taxation rules, free- dom from corruption, and labor freedom. A country can score between 100 (freest) and 0 (least free) on each of these indicators. The higher a country’s average score across all 10 indicators, the more closely its economy represents the pure market model. Accord- ing to the 2015 index, which is summarized in Map 3.6, the world’s freest economies are (in rank order) Hong Kong, Singapore, New Zealand, Australia, Switzerland, Canada, Chile, Estonia, Ireland and Mauritius. The United States came in at 12, Japan at 20,

PACIFIC OCEAN

ARCTIC OCEAN

PACIFIC OCEAN

ATLANTIC OCEAN

INDIAN OCEAN

FALKLAND ISLANDS

ARMENIA

AZERBAIJAN

NEW ZEALAND

SPAIN

C A N A D A

U N I T E D S T A T E S

BAHAMAS CUBA

JAMAICA

HAITI DOMINICAN REPUBLIC

PUERTO RICO (U.S.)

Alaska (United States)

GUADELOUPE (Fr.) DOMINICA

ST. LUCIA TRINIDAD & TOBAGO

GUATEMALA

Hawaii (U.S.)

EL SALVADOR NICARAGUA

HONDURAS

BELIZE

COSTA RICA

PANAMA VENEZUELA

GUYANA SURINAME

FRENCH GUIANA ECUADOR

B R A Z I L

CHILE URUGUAY

MOROCCO

L I B Y A EGYPT

TUNISIA

WESTERN SAHARA

MAURITANIA MALI CHAD

S U D A N

ETHIOPIA DJIBOUTI

ERITREA

SENEGAL GAMBIA

GUINEA-BISSAU GUINEA

SIERRA LEONE LIBERIA

CÔTE D’IVOIRE BENIN

NIGERIA CENTRAL AFRICAN

REPUBLIC

SOUTH SUDAN

EQUATORIAL GUINEA

SÃO TOMÉ AND PRÍNCIPE GABON

DOM. REP. OF THE CONGO

RWANDA

BURUNDI

UGANDA KENYA

ANGOLA ZAMBIA

MALAWI

ZIMBABWE

BOTSWANA

NAMIBIA

SWAZILAND

LESOTHO

SOUTH AFRICA

LEBANON

ISRAEL JORDAN

SYRIA

IRAQ KUWAIT

BAHRAIN

QATAR

UNITED ARAB EMIRATES

IRAN AFGHANISTAN

TAJIKISTAN

KYRGYZSTAN

BHUTAN

I N D I A

BANGLADESH

MYANMAR (BURMA)

THAILAND

LAOS

CAMBODIA

VIETNAM

BRUNEI

SINGAPORE

TIMOR-LESTE

TAIWAN

C H I N A JAPAN

MONGOLIA

PHILIPPINES

MICRONESIA

PALAU

NAURU KIRIBATI

TUVALU

VANUATU

NEW CALEDONIA

(Fr.)

MARSHALL ISLANDS

SOLOMON ISLANDS

FIJI

NORTH KOREA

SOUTH KOREA

A U S T R A L I A

R U S S I A

PAPUA NEW GUINEA

GREENLAND (DENMARK)

KAZAKHSTAN

SRI LANKAMALDIVES

MAURITIUS REUNION (Fr.)

COMOROS

CAPE VERDE

SAUDI ARABIA

BURKINA FASO

BOLIVIA

TANZANIA

NORWAYICELAND

ESTONIA

LATVIA

LITHUANIA

BEL ARU

S POLAND

UKRAINE

GERMANY

DENMARK

NETHERLANDS

IRELAND

LUX.

FRANCE

CZECH REP.

SLOVAKIA AUSTRIALIECH.

SWITZERLAND HUNGARY

ROMANIA

BULGARIA

TURKEY ALBANIA

MALTA

SLOVENIA CROATIA

BOSNIA & HERZEGOVINA

MONTENEGRO KOSOVO

MACEDONIA

ANDORRA

MONACO

CYPRUS

MOLDOVA

C O

N G

O

SER B

IA

M E

X I C

O

COLOMBIA

P E

R U

PARAGUAY

A R

G E

N T

I N

A

S W

E D

E N

F I

N L

A N

D

UNITED KINGDOM

PORTUGAL

BELGIUM

I T A

L Y

GREECE

GEORGIA

YEME N

O M

A N

A L G E R I A

TOGO

G H

A N

A

NIGER

SO M

AL IA

M O

Z A

M B

IQ U

E

M A

D A

G A

S C

A R

UZBEKISTANTURKMENISTAN

P A

K IS

TA N

NEPAL

MALAYSIA

I N D O N E S I A

C AM

ER O

O N

1000

0

0

1000 2000 Miles

2000 3000 Kilometers Scale: 1 to 174,385,000

80%–100% Free 70%–79.9% Mostly Free 60%–69.9% Moderately Free 50%–59.9% Mostly Unfree 0%–49.9% Repressed Not ranked

Economic Freedom

M A P 3 . 6

Distribution of economic freedom, 2015. Source: From The Freedom House Survey Team, “Freedom in the World 2015,” www.freedomhouse.org. Reprinted with permission.

78 Part 2 National Differences

Mexico at 59, France at 73, Brazil at 118, India at 128, China at 139, and Russia at 143. The economies of Cuba, Iran, Venezuela, Zimbabwe, and North Korea are to be found at the bottom of the rankings.27 Economic freedom does not necessarily equate with political freedom, as detailed in Map 3.6. For example, the two top states in the Heritage Foundation index, Hong Kong and Singapore, cannot be classified as politically free. Hong Kong was reabsorbed into communist China in 1997, and the first thing Beijing did was shut down Hong Kong’s freely elected legislature. Singapore is ranked as only partly free on Freedom House’s index of political freedom due to practices such as widespread press censorship.

The Nature of Economic Transformation

The shift toward a market-based economic system often entails a number of steps: de- regulation, privatization, and creation of a legal system to safeguard property rights.28

DEREGULATION

Deregulation involves removing legal restrictions to the free play of markets, the estab- lishment of private enterprises, and the manner in which private enterprises operate. Be- fore the collapse of communism, the governments in most command economies exercised tight control over prices and output, setting both through detailed state planning. They also prohibited private enterprises from operating in most sectors of the economy, se- verely restricted direct investment by foreign enterprises, and limited international trade. Deregulation in these cases involved removing price controls, thereby allowing prices to be set by the interplay between demand and supply; abolishing laws regulating the estab- lishment and operation of private enterprises; and relaxing or removing restrictions on direct investment by foreign enterprises and international trade. In mixed economies, the role of the state was more limited; but here, too, in certain sectors the state set prices, owned businesses, limited private enterprise, restricted invest- ment by foreigners, and restricted international trade. For these countries, deregulation has involved the same kind of initiatives that we have seen in former command econo- mies, although the transformation has been easier because these countries often had a vibrant private sector. India is an example of a country that has substantially deregulated its economy over the past two decades (see the accompanying Country Focus on India).

PRIVATIZATION

Hand in hand with deregulation has come a sharp increase in privatization. Privatization, as we discussed in Chapter 2, transfers the ownership of state property into the hands of private individuals, frequently by the sale of state assets through an auction.29 Privatiza- tion is seen as a way to stimulate gains in economic efficiency by giving new private owners a powerful incentive—the reward of greater profits—to search for increases in productivity, to enter new markets, and to exit losing ones.30 The privatization movement started in Great Britain in the early 1980s when then prime minister Margaret Thatcher started to sell state-owned assets such as the British telephone company, British Telecom (BT). In a pattern that has been repeated around the world, this sale was linked with the deregulation of the British telecommunications in- dustry. By allowing other firms to compete head to head with BT, deregulation ensured that privatization did not simply replace a state-owned monopoly with a private monop- oly. Since the 1980s, privatization has become a worldwide phenomenon. More than 8,000 acts of privatization were completed around the world between 1995 and 1999.31 Some of the most dramatic privatization programs occurred in the economies of the for- mer Soviet Union and its eastern European satellite states. In the Czech Republic, for example, three-quarters of all state-owned enterprises were privatized between 1989 and 1996, helping push the share of gross domestic product accounted for by the private sec- tor up from 11 percent in 1989 to 60 percent in 1995.32

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LO 3 -3 Describe how transition economies are moving toward market-based systems.

79

COUNTRY FOCUS

After gaining independence from Britain in 1947, India ad- opted a democratic system of government. The economic system that developed in India after 1947 was a mixed economy characterized by a large number of state-owned enterprises, centralized planning, and subsidies. This sys- tem constrained the growth of the private sector. Private companies could expand only with government permis- sion. It could take years to get permission to diversify into a new product. Much of heavy industry, such as auto, chemi- cal, and steel production, was reserved for state-owned enterprises. Production quotas and high tariffs on imports also stunted the development of a healthy private sector, as did labor laws that made it difficult to fire employees. By the early 1990s, it was clear this system was incapa- ble of delivering the kind of economic progress that many Southeast Asian nations had started to enjoy. In 1994, India’s economy was still smaller than Belgium’s, despite having a population of 950 million. Its GDP per capita was a paltry $310, less than half the population could read, only 6 million had access to telephones, and only 14 percent had access to clean sanitation; the World Bank estimated that some 40 percent of the world’s desperately poor lived in India, and only 2.3 percent of the population had a household income in excess of $2,484. The lack of progress led the government to embark on an ambitious economic reform program. Starting in 1991, much of the industrial licensing system was dismantled, and several areas once closed to the private sector were opened, including electricity generation, parts of the oil in- dustry, steelmaking, air transport, and some areas of the telecommunications industry. Investment by foreign enter- prises, formerly allowed only grudgingly and subject to arbitrary ceilings, was suddenly welcomed. Approval was made automatic for foreign equity stakes of up to 51 per- cent in an Indian enterprise, and 100 percent foreign own- ership was allowed under certain circumstances. Raw materials and many industrial goods could be freely im- ported, and the maximum tariff that could be levied on im- ports was reduced from 400 percent to 65 percent. The top income tax rate was also reduced, and corporate tax fell from 57.5 percent to 46 percent in 1994, and then to 35 percent in 1997. The government also announced plans to start privatizing India’s state-owned businesses, some 40 percent of which were losing money in the early 1990s. Judged by some measures, the response to these eco- nomic reforms has been impressive. The Indian economy

expanded at an annual rate of about 6.3 percent from 1994 to 2004 and then accelerated to 7 to 8 percent annually during 2005–2013. Foreign investment, a key indicator of how attractive foreign companies thought the Indian econ- omy was, jumped from $150 million in 1991 to a record $28 billion in 2013. Some economic sectors have done par- ticularly well, such as the information technology sector, where India has emerged as a vibrant global center for software development with sales of $110 billion in 2013, up from $150 million in 1990. In pharmaceuticals, too, Indian companies are emerging as credible players in the global marketplace, primarily by selling low-cost, generic versions of drugs that have come off patent in the developed world. However, the country still has a long way to go. At- tempts to further reduce import tariffs have been stalled by political opposition from employers, employees, and politi- cians, who fear that if barriers come down, a flood of inex- pensive Chinese products will enter India. The privatization program continues to hit speed bumps—the latest in Sep- tember 2003 when the Indian Supreme Court ruled that the government could not privatize two state-owned oil companies without explicit approval from the parliament. State-owned firms still account for 38 percent of national output in the nonfarm sector, yet India’s private firms are 30 to 40 percent more productive than state-owned enter- prises. There has also been strong resistance to reforming many of India’s laws that make it difficult for private busi- ness to operate efficiently. For example, labor laws make it almost impossible for firms with more than 100 employees to fire workers, creating a disincentive for entrepreneurs to increase their enterprises beyond 100 employees. Other laws mandate that certain products can be manufactured only by small companies, effectively making it impossible for companies in these industries to attain the scale required to compete internationally.

Sources: “India’s Breakthrough Budget?,” The Economist, March 3, 2001; Shankar Aiyar, “Reforms: Time to Just Do It,” India Today, Janu- ary 24, 2000, p. 47; “America’s Pain, India’s Gain,” The Economist, January 11, 2003, p. 57; Joanna Slater, “In Once Socialist India, Priva- tizations Are Becoming More Like Routine Matters,” The Wall Street Journal, July 5, 2002, p. A8; “India’s Economy: Ready to Roll Again?,” The Economist, September 20, 2003, pp. 39–40; Joanna Slater, “In- dian Pirates Turned Partners,” The Wall Street Journal, November 13, 2003, p. A14; “The Next Wave: India,” The Economist, December 17, 2005, p. 67; M. Dell, “The Digital Sector Can Make Poor Nations Prosper,” Financial Times, May 4, 2006, p. 17; “What’s Holding India Back,” The Economist, March 8, 2008, p. 11; “Battling the Babu Raj,” The Economist, March 8, 2008, pp. 29–31.

India’s Economic Transformation

80 Part 2 National Differences

Despite this three-decade trend, large amounts of economic activity are still in the hands of state-owned enterprises in many nations. In China, for example, state-owned companies still dominate the banking, energy, telecom, health care, and technology sec- tors. Overall, they account for about 40 percent of the country’s GDP. In a report released in early 2012, the World Bank cautioned China that unless it reformed these sectors— liberalizing them and privatizing many state-owned enterprises—the country runs the risk of experiencing a serious economic crisis.33 As privatization has proceeded, it has become clear that simply selling state-owned assets to private investors is not enough to guarantee economic growth. Studies of priva- tization in central Europe have shown that the process often fails to deliver predicted benefits if the newly privatized firms continue to receive subsidies from the state and if they are protected from foreign competition by barriers to international trade and foreign direct investment.34 In such cases, the newly privatized firms are sheltered from competi- tion and continue acting like state monopolies. When these circumstances prevail, the newly privatized entities often have little incentive to restructure their operations to be- come more efficient. For privatization to work, it must also be accompanied by a more general deregulation and opening of the economy. Thus, when Brazil decided to privatize the state-owned telephone monopoly, Telebrás Brazil, the government also split the com- pany into four independent units that were to compete with each other and removed bar- riers to foreign direct investment in telecommunications services. This action ensured that the newly privatized entities would face significant competition and thus would have to improve their operating efficiency to survive.

LEGAL SYSTEMS

As noted in Chapter 2, a well-functioning market economy requires laws protecting pri- vate property rights and providing mechanisms for contract enforcement. Without a legal system that protects property rights, and without the machinery to enforce that system, the incentive to engage in economic activity can be reduced substantially by private and public entities, including organized crime, that expropriate the profits generated by the efforts of private-sector entrepreneurs. For example, when communism collapsed in eastern Europe, many countries lacked the legal structure required to protect property rights, all property having been held by the state. Although many nations have made big strides toward insti- tuting the required system, it may be years before the legal system is functioning as smoothly as it does in the West. For example, in most eastern European nations, the title to urban and agricultural property is often uncertain because of incomplete and inaccurate records, multiple pledges on the same property, and unsettled claims resulting from de- mands for restitution from owners in the pre-communist era. Also, although most coun- tries have improved their commercial codes, institutional weaknesses still undermine contract enforcement. Court capacity is often inadequate, and procedures for resolving contract disputes out of court are often lacking or poorly developed.35 Nevertheless, prog- ress is being made. In 2004, for example, China amended its constitution to state that “private property was not to be encroached upon,” and in 2007 it enacted a new law on property rights that gave property holders many of the same protections as those enjoyed by the state (see the earlier Country Focus on China’s emerging property rights).36

Implications of Changing Political Economy

The global changes in political and economic systems discussed earlier have several im- plications for international business. The long-standing ideological conflict between col- lectivism and individualism that defined the twentieth century is less in evidence today. The West won the Cold War, and Western ideology is now widespread. Although com- mand economies remain and totalitarian dictatorships can still be found around the world, the tide has been running in favor of free markets and democracy. It remains to be seen, however, whether the global financial crisis of 2008–2009, and the recession that

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National Differences in Economic Development Chapter 3 81

followed, will lead to a retrenchment. Certainly many commentators have blamed the problems that led to this crisis on a lack of regulation, and some reassessment of Western political ideology seems likely. Notwithstanding the crisis of 2008–2009, the trends of the past 25 years have enormous implications for business. For nearly 50 years, half of the world was off-limits to Western businesses. Now much of that has changed. Many of the national markets of eastern Europe, Latin America, Africa, and Asia may still be underdeveloped, but they are poten- tially enormous. With a population of more than 1.3 billion, the Chinese market alone is potentially bigger than that of the United States, the European Union, and Japan com- bined. Similarly, India, with about 1.2 billion people, is a potentially huge market. Latin America has another 600 million potential consumers. It is unlikely that China, Russia, Vietnam, or any of the other states now moving toward a market system will attain the living standards of the West soon. Nevertheless, the upside potential is so large that com- panies need to consider making inroads now. For example, if China and the United States continue to grow at the rates they did during 1996–2014, China will surpass the United States to become the world’s largest national economy within the next 15 years. Just as the potential gains are large, so are the risks. There is no guarantee that de- mocracy will thrive in many of the world’s newer democratic states, particularly if these states have to grapple with severe economic setbacks. Totalitarian dictatorships could return, although they are unlikely to be of the communist variety. Although the bipolar world of the Cold War era has vanished, it may be replaced by a multipolar world domi- nated by a number of civilizations. In such a world, much of the economic promise in- herent in the global shift toward market-based economic systems may stall in the face of conflicts between civilizations. While the long-term potential for economic gain from investment in the world’s new market economies is large, the risks associated with any such investment are also substantial. It would be foolish to ignore these. The financial system in China, for example, is not transparent, and many suspect that Chinese banks hold a high proportion of nonperforming loans on their books. If true, these bad debts could trigger a significant financial crisis during the next decade in China, which would dramatically lower growth rates.

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F O C U S O N M A NAG E R I A L I M P L I C AT I O N S

BENEFITS, COSTS, RISKS, AND OVERALL ATTRACTIVENESS OF DOING BUSINESS INTERNATIONALLY

As noted in the previous chapter, the political, economic, and legal environments of a country clearly influence the attractiveness of that country as a market or invest-

ment site. In this chapter, we argued that countries with democratic regimes, market-based economic policies, and strong protection of property rights are more likely to attain high and sustained economic growth rates and are thus a

more attractive location for international business. It follows that the benefits, costs, and risks associated with doing business in a country are a function of that country’s

political, economic, and legal systems. The overall attractiveness of a country as a market or investment site depends on balancing the likely long-term benefits of doing business in that country against the likely costs and risks. Here, we consider the determinants of benefits, costs, and risks.

BENEFITS In the most general sense, the long-run monetary benefits of doing business in a country are a function of the size of the market, the present wealth (purchasing power) of consumers in that market, and the likely future wealth of consumers. While some markets are very large

LO 3 - 4 Explain the implications for management practice of national difference in political economy.

82 Part 2 National Differences

when measured by number of consumers (e.g., China and India), low living standards may imply limited purchasing power and therefore a relatively small market when measured in economic terms. International businesses need to be aware of this distinction, but they also need to keep in mind the likely future prospects of a country. In 1960, South Korea was viewed as just another impoverished third-world nation. By 2011, it had the world’s 15th- largest economy. International firms that recognized South Korea’s potential in 1960 and began to do business in that country may have reaped greater benefits than those that wrote off South Korea. By identifying and investing early in a potential future economic star, international firms may build brand loyalty and gain experience in that country’s business practices. These will pay back substantial dividends if that country achieves sustained high economic growth rates. In contrast, late entrants may find that they lack the brand loyalty and experience nec- essary to achieve a significant presence in the market. In the language of business strategy, early entrants into potential future economic stars may be able to reap substantial first- mover advantages, while late entrants may fall victim to late-mover disadvantages.37 (First-mover advantages are the advantages that accrue to early entrants into a market. Late-mover disadvantages are the handicaps that late entrants might suffer.) This kind of reasoning has been driving significant inward investment into China, which may become the world’s first-largest economy by 2030 if it continues growing at current rates (China is al- ready the world’s second-largest national economy). For more than two decades, China has been the largest recipient of foreign direct investment in the developing world as interna- tional businesses—including General Motors, Volkswagen, Coca-Cola, and Unilever—try to establish a sustainable advantage in this nation. A country’s economic system and property rights regime are reasonably good predictors of economic prospects. Countries with free market economies in which property rights are protected tend to achieve greater economic growth rates than command economies or economies where property rights are poorly protected. It follows that a country’s economic system, property rights regime, and market size (in terms of population) probably constitute reasonably good indicators of the potential long-run benefits of doing business in a country. In contrast, countries where property rights are not well respected and where corruption is rampant tend to have lower levels of economic growth. We must be careful about generalizing

Coca-Cola has ramped up spending on marketing and advertising in emerging markets such as China. Source: © Keith Bedford/Bloomberg/Getty Images

National Differences in Economic Development Chapter 3 83

too much from this, however, because both China and India have achieved high growth rates despite relatively weak property rights regimes and high levels of corruption. In both countries, the shift toward a market-based economic system has produced large gains despite weak property rights and endemic corruption.

COSTS A number of political, economic, and legal factors determine the costs of doing business in a country. With regard to political factors, a company may have to pay off politically powerful entities in a country before the government allows it to do business there. The need to pay what are essentially bribes is greater in closed totalitarian states than in open democratic so- cieties where politicians are held accountable by the electorate (although this is not a hard- and-fast distinction). Whether a company should actually pay bribes in return for market access should be determined on the basis of the legal and ethical implications of such action. We discuss this consideration in Chapter 5, when we look closely at the issue of business ethics. With regard to economic factors, one of the most important variables is the sophistication of a country’s economy. It may be more costly to do business in relatively primitive or unde- veloped economies because of the lack of infrastructure and supporting businesses. At the extreme, an international firm may have to provide its own infrastructure and supporting business, which obviously raises costs. When McDonald’s decided to open its first restau- rant in Moscow, it found that to serve food and drink indistinguishable from that served in McDonald’s restaurants elsewhere, it had to vertically integrate backward to supply its own needs. The quality of Russian-grown potatoes and meat was too poor. Thus, to protect the quality of its product, McDonald’s set up its own dairy farms, cattle ranches, vegetable plots, and food-processing plants within Russia. This raised the cost of doing business in Russia, relative to the cost in more sophisticated economies where high-quality inputs could be purchased on the open market. As for legal factors, it can be more costly to do business in a country where local laws and regulations set strict standards with regard to product safety, safety in the workplace, environmental pollution, and the like (because adhering to such regulations is costly). It can also be more costly to do business in a country like the United States, where the absence of a cap on damage awards has meant spiraling liability insurance rates. It can be more costly to do business in a country that lacks well-established laws for regulating business practice (as is the case in many of the former communist nations). In the absence of a well-developed body of business contract law, international firms may find no satisfactory way to resolve contract disputes and, consequently, routinely face large losses from contract violations. Similarly, local laws that fail to adequately protect intellectual property can lead to the theft of an international business’s intellectual property and lost income.

RISKS As with costs, the risks of doing business in a country are determined by a number of politi- cal, economic, and legal factors. Political risk has been defined as the likelihood that politi- cal forces will cause drastic changes in a country’s business environment that adversely affect the profit and other goals of a business enterprise.38 So defined, political risk tends to be greater in countries experiencing social unrest and disorder or in countries where the underlying nature of a society increases the likelihood of social unrest. Social unrest typi- cally finds expression in strikes, demonstrations, terrorism, and violent conflict. Such unrest is more likely to be found in countries that contain more than one ethnic nationality, in coun- tries where competing ideologies are battling for political control, in countries where eco- nomic mismanagement has created high inflation and falling living standards, or in countries that straddle the “fault lines” between civilizations. Social unrest can result in abrupt changes in government and government policy or, in some cases, in protracted civil strife. Such strife tends to have negative economic implica- tions for the profit goals of business enterprises. For example, in the aftermath of the 1979 Islamic revolution in Iran, the Iranian assets of numerous U.S. companies were seized by the new Iranian government without compensation. Similarly, the violent disintegration of the

84 Part 2 National Differences

Yugoslavian federation into warring states, including Bosnia, Croatia, and Serbia, precipitated a collapse in the local economies and in the profitability of investments in those countries. More generally, a change in political regime can result in the enactment of laws that are less favorable to international business. In Venezuela, for example, the populist socialist poli- tician Hugo Chávez held power from 1998 until his death in 2013. Chávez declared himself to be a “Fidelista,” a follower of Cuba’s Fidel Castro. He pledged to improve the lot of the poor in Venezuela through government intervention in private business and frequently railed against American imperialism, all of which is of concern to Western enterprises doing busi- ness in the country. Among other actions, he increased the royalties that foreign oil compa- nies operating in Venezuela have to pay the government from 1 to 30 percent of sales. Other risks may arise from a country’s mismanagement of its economy. An economic risk can be defined as the likelihood that economic mismanagement will cause drastic changes in a country’s business environment that hurt the profit and other goals of a particu- lar business enterprise. Economic risks are not independent of political risk. Economic mis- management may give rise to significant social unrest and, hence, political risk. Nevertheless, economic risks are worth emphasizing as a separate category because there is not always a one-to-one relationship between economic mismanagement and social unrest. One visi- ble indicator of economic mismanagement tends to be a country’s inflation rate. Another is the level of business and government debt in the country. The global financial crisis that arose in 2008–2009 was a dramatic example of the nature of economic risks. The global financial crisis was caused in part by a housing bubble in the United States, which was triggered by the easy availability of mortgage debt, particularly adjustable rate mortgages with lower “teaser” interest rates for the first year or so. Many of the mortgages written in the 2001–2007 period were of very low quality, but they were bundled into bonds containing thousands of mortgages and sold to investors as AAA-rated assets—which, in fact, they were not. By 2008, the market for mortgage-backed bonds and related assets, including the insurance on such securities, was worth trillions of dollars. When borrowers started to default on their mortgage payments in large numbers, the value of the bonds tumbled, and holders—many of whom were major financial institutions them- selves or national governments—found that the supposedly AAA bonds in their portfolios were actually junk. This decimated the balance sheets of many banks and more than a few local and national governments, precipitating a banking crisis that almost bought the global economy to its knees and ushered in a recession that the world was struggling to emerge from five years later. With the benefit of hindsight, it is clear that economic mismanagement was a major cause of the crisis. The U.S. government and Federal Reserve had been pursuing a permissive monetary policy during the early 2000s, in part to counter the recessionary aftermath of the September 2001 terrorist attack on the United States. Easy monetary policy allowed for the unprecedented expansion of mortgage debt, which fed the bubble in housing prices—and the bubble in housing prices persuaded more and more people to buy houses that they could not afford, in the belief that as prices rose even further, they could make up any pay- ment shortfall by selling the house for a profit or by taking out a second mortgage secured on the hoped-for increase in the value of the equity in their home. To compound matters, the markets for mortgage-backed securities were poorly understood, largely unregulated, and not transparent. Consequently, many investors, including large financial institutions and local and national governments, were misled about, or did not begin to appreciate, the riskiness of the mortgage-backed bonds they were buying. As a consequence, they invested too much money in poor-quality assets—and realized this only when it was too late and the value of those assets was plummeting through the floor. Had the U.S. government acted decisively to pop the housing bubble in the early 2000s by tightening monetary policy, had it made it more difficult for banks to issue poor-quality mortgages and to bundle those mortgages into bonds and pass them off as higher-quality assets, and had it insisted on greater transparency in the market for mortgage-backed debt, the crisis may have been avoided. But none of this happened. The consequence of this economic mismanagement was the worst economic recession since the Great Depression of the 1930s.

National Differences in Economic Development Chapter 3 85

On the legal front, risks arise when a country’s legal system fails to provide adequate safeguards in the case of contract violations or to protect property rights. When legal safe- guards are weak, firms are more likely to break contracts or steal intellectual property if they perceive it as being in their interests to do so. Thus, a legal risk can be defined as the likeli- hood that a trading partner will opportunistically break a contract or expropriate property rights. When legal risks in a country are high, an international business might hesitate enter- ing into a long-term contract or joint-venture agreement with a firm in that country. For ex- ample, in the 1970s when the Indian government passed a law requiring all foreign investors to enter into joint ventures with Indian companies, U.S. companies such as IBM and Coca- Cola closed their investments in India. They believed that the Indian legal system did not provide adequate protection of intellectual property rights, creating the very real danger that their Indian partners might expropriate the intellectual property of the American companies— which for IBM and Coca-Cola amounted to the core of their competitive advantage.

OVERALL ATTRACTIVENESS The overall attractiveness of a country as a potential market or investment site for an inter- national business depends on balancing the benefits, costs, and risks associated with doing business in that country (see Figure 3.1). Generally, the costs and risks associated with doing business in a foreign country are typically lower in economically advanced and politically stable democratic nations and greater in less developed and politically unstable nations. The calculus is complicated, however, because the potential long-run benefits are depen- dent not only on a nation’s current stage of economic development or political stability, but also on likely future economic growth rates. Economic growth appears to be a function of a free market system and a country’s capacity for growth (which may be greater in less devel- oped nations). This leads us to conclude that, other things being equal, the benefit–cost– risk trade-off is likely to be most favorable in politically stable developed and developing nations that have free market systems and no dramatic upsurge in either inflation rates or private-sector debt. It is likely to be least favorable in politically unstable developing nations that operate with a mixed or command economy or in developing nations where speculative financial bubbles have led to excess borrowing.

F I G U R E 3 . 1

Country attractiveness.

Overall Attractiveness

Risks Political Risks: Social Unrest/Antibusiness Trends

Economic Risks: Economic Mismanagement Legal Risks: Failure to Safeguard Property Rights

Benefits Size of Economy

Likely Economic Growth

Costs Corruption

Lack of Infrastructure Legal Costs

86 Part 2 National Differences

gross national income (GNI), p. 64 purchasing power parity (PPP), p. 65 Human Development Index

(HDI), p. 68

innovation, p. 69 entrepreneurs, p. 69 deregulation, p. 78 first-mover advantages, p. 82

late-mover disadvantages, p. 82 political risk, p. 83 economic risk, p. 84 legal risk, p. 85

Key Terms

C H A P T E R S U M M A R Y

This chapter reviewed how the political, economic, and legal systems of countries vary. The potential benefits, costs, and risks of doing business in a country are a func- tion of its political, economic, and legal systems. The chapter made the following points:

1. The rate of economic progress in a country seems to depend on the extent to which that country has a well-functioning market economy in which property rights are protected.

2. Many countries are now in a state of transition. There is a marked shift away from totalitarian governments and command or mixed economic systems and toward democratic political institu- tions and free market economic systems.

3. The attractiveness of a country as a market and/or investment site depends on balancing the likely long-run benefits of doing business in that country against the likely costs and risks.

4. The benefits of doing business in a country are a function of the size of the market (population), its present wealth (purchasing power), and its future growth prospects. By investing early in countries that are currently poor but are never- theless growing rapidly, firms can gain first- mover advantages that will pay back substantial dividends in the future.

5. The costs of doing business in a country tend to be greater where political payoffs are required to gain market access, where support- ing infrastructure is lacking or underdeveloped, and where adhering to local laws and regulations is costly.

6. The risks of doing business in a country tend to be greater in countries that are politically unstable, subject to economic mismanagement, and lacking a legal system to provide adequate safeguards in the case of contract or property rights violations.

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. What is the relationship among property rights, corruption, and economic progress? How important are anticorruption efforts in the effort to improve a country’s level of economic development?

2. You are a senior manager in a U.S. automobile company considering whether to invest in pro- duction facilities in China, Russia, or Germany. These facilities will serve local market demand. Evaluate the benefits, costs, and risks associated with doing business in each nation. Which coun- try seems the most attractive target for foreign direct investment? Why?

3. Reread the Country Focus on India, and answer the following questions:

a. What kind of economic system did India operate under during 1947–1990? What kind of system is it moving toward today? What

are the impediments to completing this transformation?

b. How might widespread public ownership of businesses and extensive government regulations have affected (i) the efficiency of state and private businesses and (ii) the rate of new business formation in India during the 1947–1990 time frame? How do you think these factors affected the rate of economic growth in India during this time frame?

c. How would privatization, deregulation, and the removal of barriers to foreign direct in- vestment affect the efficiency of business, new business formation, and the rate of economic growth in India during the post-1990 time period?

National Differences in Economic Development Chapter 3 87

d. India now has pockets of strengths in key high-technology industries such as software and pharmaceuticals. Why do you think India is developing strength in these areas? How might success in these industries help generate growth in the other sectors of the Indian economy?

e. Given what is now occurring in the Indian economy, do you think the country repre- sents an attractive target for inward invest- ment by foreign multinationals selling consumer products? Why?

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises:

1. Increased instability in the global marketplace can introduce unanticipated risks in a compa- ny’s daily transactions. As such, your company must evaluate these commercial transaction risks for its foreign operations in Argentina, China, Egypt, Poland, and South Africa. A risk analyst at your firm said that you could evaluate both the political and commercial risk of these countries simultaneously. Provide a commercial transaction risk overview of all five countries for top management. In

your evaluation, indicate possible corrective measures in the countries with considerably high political and/or commercial risk.

2. Managers at your firm are very concerned about the influence of terrorism on its long-term strategy. To counter this issue, the CEO has indicated you must identify the countries where terrorism threat and political risk are minimal. This will provide the basis for the development of future company facili- ties, which need to be built in all major continents in the world. Include recommendations on which countries in each continent would serve as a good candidate for your company to further analyze.

For decades, the Southeast Asian nation of Myanmar (formerly known as Burma) was an international pariah. Ruled by a brutal military dictatorship since the 1960s, political dissent was not tolerated, the press was tightly controlled, and opposition parties were shut down. Much economic activity was placed in the hands of the state—which effectively meant the hands of the military elite—who siphoned off economic profits for their own benefit. Corruption was rampant. In the 1990s, America and the European Union imposed sweeping economic sanctions on the country to punish the military junta for stealing elections and jailing opponents. The de facto leader of the country’s democratic opposition movement, Nobel Peace Prize–winner Aung San Suu Kyi, was repeatedly placed under house arrest from 1989 through 2010. None of this was good for the country’s economy. Despite having a wealth of natural resources, including timber, minerals, oil, and gas, the economy stagnated

while its Southeast Asian neighbors flourished. By 2012, Myanmar’s GDP per capita was $1,400. In neighboring Thailand, it was $10,000 per capita. The economy was still largely rural, with 70 percent of the country’s nearly 60 million people involved in agriculture. This compares with 8.6 percent in Thailand. Few people own cars or cell phones, and there are no major road or rail links be- tween Myanmar and its neighbors—China, India, and Thailand. In 2010, the military again won elections that were clearly rigged. Almost no one expected any changes, but the new president, Thein Sein, was to defy expectations. The government released hundreds of political prisoners, removed restrictions on the press, freed Aung San Suu Kyi, and allowed opposition parties to contest seats in a series of by-elections. When Aung San Suu Kyi won a by-election, thrashing her military-backed opponent, they let her take the seat, raising hopes that Myanmar was at last joining the modern world. In response, both

C L O S I N G C A S E

Political and Economic Reform in Myanmar

88 Part 2 National Differences

America and the European Union began to lift their sanctions. Thein Sein also started to initiate much-needed eco- nomic reforms. Even before the 2010 elections, the mili- tary had begun to quietly privatize state-owned enterprises, although many were placed in the hands of cronies of the regime. In 2012, Thein Sein stated that the government would continue to reduce its role in a wide range of sectors, including energy, forestry, health care, finance, and telecommunications. Land reforms are also under way. The government also abandoned the of- ficial fixed exchange rate for the Myanmar currency, the kyat, replacing it with a managed float. From 2001 to 2012, the official exchange rate for the kyat varied be- tween 5.75 and 6.70 per U.S. dollar, while the black-market rate was between 750 and 1,335 per U.S. dollar. The of- ficial fixed exchange rate had effectively priced Myan- mar’s exports out of the world market, although it did benefit the military elite who were able to exchange their worthless kyat for valuable U.S. dollars on very favorable terms. Implemented in April 2012, the managed float val- ued the kyat at 818 per U.S. dollar. The dramatic fall in the value of the kyat is expected to stimulate demand for exports from Myanmar, and help the economy grow. To further encourage economic growth, the govern- ment has signaled that it will now welcome foreign di- rect investment and is encouraging foreign enterprises to enter into partnerships with domestic enterprises in its underdeveloped telecommunications sector. General Electric and IBM are among the companies stating that they may invest in the country. Between 2010 and 2013 Myanmar recorded the largest increase in inward FDI of any country in Southeast Asia apart from the Philippines, although admittedly from a low base. 

Much clearly remains to be done. Observers predict that it will be decades before Myanmar catches up with its Southeast Asian neighbors. The next big test for the government of Thein Sein will occur in 2015, when gen- eral elections are scheduled to be held. If current trends hold, the military-backed government could be swept out of power, losing most of its parliamentary seats. It’s an open question as to whether the military will allow this to happen. If it does, and power is passed on to the demo- cratic opposition, Myanmar may finally emerge from its isolation. Sources: Lex Rieffel, “Myanmar’s Economy Confronts Tough Policy Challenges,” East Asian Forum, July 31, 2012; “Opening Soon: Myanmar Gets Ready for Business,” The Economist, March 3, 2012; “Myanmar on the Move,” The Economist, November 21, 2012; The World Factbook (Washington, DC, CIA), www.cia.gov/library/publications/the-world- factbook/geos/bm.html; “An Unfinished Peace,” The Economist, March 11, 2015. 

C a s e D i s c u s s i o n Q u e s t i o n s 1. What explains the economic stagnation of

Myanmar until very recently?  2. What do you think motivated the govern-

ment of Myanmar to start undertaking political and economic reforms from 2010 onward?  

3. How would you characterize the nature of the economic reforms now being imple- mented in Myanmar? What is the govern- ment trying to do here? What do you think the results will be?

4. What potential impediments do you think might stand in the way of further improve- ments in Myanmar?  

E n d n o t e s

1. World Bank, World Development Indicators Online, 2015. 2. P. Sinha and N. Singh, “The Economy’s Black Hole,” The

Times of India, March 22, 2010. EU estimates for 2012 can be found at http://ec.europa.eu/europe2020/pdf/themes/07_ shadow_economy.pdf.

3. A. Sen, Development as Freedom (New York: Knopf, 1999). 4. G. M. Grossman and E. Helpman, “Endogenous Innovation in

the Theory of Growth,” Journal of Economic Perspectives 8, no. 1 (1994), pp. 23–44; and P. M. Romer, “The Origins of En- dogenous Growth,” Journal of Economic Perspectives 8, no. 1 (1994), pp. 2–22.

5. W. W. Lewis, The Power of Productivity (Chicago: University of Chicago Press, 2004).

6. F. A. Hayek, The Fatal Conceit: Errors of Socialism (Chicago: University of Chicago Press, 1989).

7. J. Gwartney, R. Lawson, and W. Block, Economic Freedom of the World: 1975–1995 (London: Institute of Economic Affairs, 1996).

8. D. North, Institutions, Institutional Change, and Economic Performance (Cambridge, UK: Cambridge University Press, 1991). See also K. M. Murphy, A. Shleifer, and R. Vishney, “Why Is Rent Seeking So Costly to Growth?,” American

National Differences in Economic Development Chapter 3 89

Economic Review 83, no. 2 (1993), pp. 409–14; K. E. Maskus, “Intellectual Property Rights in the Global Economy,” Institute for International Economics, 2000.

9. North, Institutions, Institutional Change and Economic Performance.

10. H. de Soto, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else (New York: Basic Books, 2000).

11. A. O. Hirschman, “The On-and-Off Again Connection between Political and Economic Progress,” American Economic Review 84, no. 2 (1994), pp. 343–48; A. Przeworski and F. Limongi, “Political Regimes and Economic Growth,” Journal of Eco- nomic Perspectives 7, no. 3 (1993), pp. 51–59.

12. Ibid. 13. For details of this argument, see M. Olson, “Dictatorship,

Democracy, and Development,” American Political Science Review, September 1993.

14. For example, see Jared Diamond’s Pulitzer Prize–winning book, Guns, Germs, and Steel (New York: Norton, 1997). Also see J. Sachs, “Nature, Nurture and Growth,” The Economist, June 14, 1997, pp. 19–22; J. Sachs, The End of Poverty (New York: Penguin Books, 2005).

15. Sachs, “Nature, Nurture and Growth.” 16. “What Can the Rest of the World Learn from the Classrooms of

Asia?,” The Economist, September 21, 1996, p. 24. 17. J. Fagerberg, “Technology and International Differences

in Growth Rates,” Journal of Economic Literature 32 (September 1994), pp. 1147–75.

18. See The Freedom House Survey Team, “Freedom in the World 2015” and associated materials, www.freedomhouse.org.

19. “Russia Downgraded to Not Free,” Freedom House press release, December 20, 2004, www.freedomhouse.org.

20. Freedom House, “Democracies Century: A Survey of Political Change in the Twentieth Century, 1999,” www.freedomhouse.org.

21. L. Conners, “Freedom to Connect,” Wired, August 1997, pp. 105–6.

22. F. Fukuyama, “The End of History,” The National Interest 16 (Summer 1989), p. 18.

23. S. P. Huntington, The Clash of Civilizations and the Remaking of World Order (New York: Simon & Schuster, 1996).

24. Ibid., p. 116. 25. U.S. National Counterterrorism Center, Reports on Incidents of

Terrorism, 2005, April 11, 2006. 26. S. Fisher, R. Sahay, and C. A. Vegh, “Stabilization and the Growth

in Transition Economies: The Early Experience,” Journal of Economic Perspectives 10 (Spring 1996), pp. 45–66.

27. M. Miles et al., 2013 Index of Economic Freedom (Washington, DC: Heritage Foundation, 2013).

28. International Monetary Fund, World Economic Outlook: Focus on Transition Economies (Geneva: IMF, October 2000).

29. J. C. Brada, “Privatization Is Transition—Is It?,” Journal of Economic Perspectives, Spring 1996, pp. 67–86.

30. See S. Zahra et al., “Privatization and Entrepreneurial Trans- formation,” Academy of Management Review 3, no. 25 (2000), pp. 509–24.

31. N. Brune, G. Garrett, and B. Kogut, “The International Monetary Fund and the Global Spread of Privatization,” IMF Staff Papers 51, no. 2 (2003), pp. 195–219.

32. Fischer et al., “Stabilization and Growth in Transition Economies.”

33. “China 2030” (Washington, DC: World Bank, 2012). 34. J. Sachs, C. Zinnes, and Y. Eilat, “The Gains from Privatization

in Transition Economies: Is Change of Ownership Enough?,” CAER discussion paper no. 63 (Cambridge, MA: Harvard Institute for International Development, 2000).

35. M. S. Borish and M. Noel, “Private Sector Development in the Visegrad Countries,” World Bank, March 1997.

36. “Caught between Right and Left,” The Economist, March 8, 2007. 37. For a discussion of first-mover advantages, see M. Liberman

and D. Montgomery, “First-Mover Advantages,” Strategic Management Journal 9 (Summer Special Issue, 1988), pp. 41–58.

38. S. H. Robock, “Political Risk: Identification and Assessment,” Columbia Journal of World Business, July–August 1971, pp. 6–20.

Credit: ©Federal Reserve Board.

Differences in Culture L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO4 -1 Explain what is meant by the culture of a society.

LO4 -2 Identify the forces that lead to differences in social culture.

LO4 -3 Identify the business and economic implications of differences in culture.

LO4 - 4 Recognize how differences in social culture influence values in business.

LO4 -5 Demonstrate an appreciation for the economic and business implications of cultural change.

part two National Dif ferences

4

Source: © Pu Chen/Moment/Getty Images

91

Best Buy and eBay in China

continue to grow, albeit not at the historic levels seen be- tween 2000 and 2010 when it grew about 10.4 percent annually. The growth from 2010 to 2020 is expected to be about 7.9 percent per year, which is still far above the ex- pected growth for the United States (2.8 percent annually), Japan (1.2 percent annually), and Germany (1.7 percent annually)—the three countries among the top four world- wide economies along with China. And, the key is that consumption will now be the driving force behind the growth instead of foreign investment. The consumption forecast opens up opportunities for foreign companies to engage with Chinese consumers who are expected to have more purchasing power and discretionary spending. But culturally translating market success from one country or even a large number of countries to the Chinese mar- ketplace is not necessarily as straightforward as it may seem. Often, a combination of naiveté, arrogance, and cul- tural misunderstanding have led many well-known compa- nies to fail in China. Lack of an understanding of issues such as local demands, buying habits, consumption values, and Chinese customers' personal beliefs led to struggles for companies that had been very successful elsewhere in the world. Let’s take a brief look at Best Buy and eBay as two examples. Best Buy, the mega-store mainly focused on consumer electronics, was founded in 1966 as an audio specialty store. Best Buy entered China in 2006 by acquiring a ma- jority interest in China’s fourth-largest appliance retailer, Jiangsu Five Star Appliance, for $180 million. But culture shock hit Best Buy, best described by Shaun Rein, the founder of China Market Research Group. He pointed to a few reasons for this culture shock and lack of success. First, the Chinese will not pay for Best Buy’s overly expen- sive products unless they are a brand like Apple. Second, there is too much piracy in the Chinese market, and this reduces demand for electronics products at competitive market prices. Third, like many Europeans, the Chinese do not want to shop at huge mega-stores. So, these three seemingly easy-to-understand cultural issues created dif- ficulties for Best Buy. Solving these issues, Best Buy be- lieved that it would have to develop and implement a different business model for the Chinese market than it has used, for example, in the United States. Now, how far should a company go outside its normal business model to adhere to cultural values and beliefs of a new market? Strategically moving forward, Best Buy opted to close all of its Best Buy–branded stores in China and focus on its wholly owned local Jiangsu Five Star chain of stores. But will this new strategic business model be successful with the new makeup of customers in China expected by 2020? eBay, the popular e-business site focused on consumer- to-consumer purchases, was founded in 1995. The com- pany was one of the true success stories that lived through the dot-com bubble in the 1990s. It is now a multi-billion- dollar business with operations in more than 30 countries. But China’s unique culture created problems for eBay in

O P E N I N G C A S E The People’s Republic of China opened up to foreign invest- ments in the late 1970s. Since that time, numerous compa- nies have tried to establish operations and sell their products to customers in China. Many more companies will try in the years to come—China is expected to have some 190 million people in the middle- and upper-income cate- gories by 2020. This is an increase from only about 17 million people in these income brackets as recently as in 2010. China’s purchasing power for virtually all products and services has strong potential, and foreign companies will seek these market opportunities. What have we learned culturally that can help Western-based companies in China’s marketplace? Some background on China can serve as a starting point for better understanding the culture in China and what some well-known companies such as Best Buy and eBay have done to target the Chinese marketplace. The motiva- tion for many foreign companies to enter China—beyond those that have been there for a few decades for reasons of low-cost production—was the triple growth of the Chinese economy that was seen from 2000 to 2010. China over- took Japan to become the second-largest economy in the world behind only the United States, and its large popula- tion makes for an enormous target market. Investment from foreign companies was the largest driver of China’s growth in the decade from 2000 to 2010. However, many companies also increased their exports to China. The United States, for example, saw its companies increase ex- ports to China by 542 percent from 2000 to 2011 (from about $16.2 billion to $103.9 billion), while total exports to the rest of the world increased by only 80 percent in the same time period. Interestingly, while foreign investments grew, domestic consumption as a share of the Chinese economy declined from 46 percent in 2000 to 33 percent in 2010. This con- sumption decline—coupled with slower growth globally and, ultimately, the worldwide economic downturn that started in 2008—raised questions about China’s momen- tum. Right now, around 85 percent of mainstream Chinese consumers are living in the top 100 wealthiest cities. By the year 2020, these advanced and developing cities will have relatively few customers who are lower than the middle- and upper-income brackets by Chinese standards. The expectation is that these consumers will be able to afford a range of products and services, such as flat- screen televisions and overseas travel, making the Chinese customer much more of a target for a wide variety of con- sumption. This begs the question, can the unprecedented Chinese growth really continue, and would it come from increased consumption? The resounding answer is yes according to research conducted by McKinsey & Company. McKinsey found that barring another major economic shock similar to what we saw in 2008, China’s gross domestic product (GDP) will

that market. Contrary to the widespread cultural issues that faced Best Buy, one company in particular (TaoBao) and one feature more specifically (built-in instant mes- saging) shaped a lot of the problems that eBay ran into in  China. Some 200 million shoppers are using TaoBao to buy products, and the company accounts for almost 80 percent of online transaction value in China. Uniquely, TaoBao’s built-in instant messaging system has been cited as a main reason for its edge over eBay in China. Basically, customers wanted to be able to identify a seller’s online status and communicate with them directly and easily—a function not seamlessly incorporated into eBay’s China system. Clearly, built-in instant text messaging is a solvable obstacle in doing business in China. It sounds easy now

when we know about it, but may not always be the case when we take into account all the little things that are important in a market. How can a foreign company enter- ing China ensure that it tackles the most important “little” things that end up being huge barriers to success as we approach the year 2020 when China is expected to have significantly increased purchasing power among its middle class?

Sources: B. Carlson, “Why Big American Businesses Fail in China,” GlobalPost, September 22, 2013; Y. Atsmon, M. Magni, L. Li, and W. Liao, “Meet the 2020 Chinese Consumer,” McKinsey Consumer & Shopper Insights, March 2012; “Exports to China by State 2000–2011,” The US-China Business Council, 2012; A. Groth, “Best Buy’s Overseas Strategy Is Failing in Europe and China,” Business Insider, November 4, 2011.

Introduction

In Chapters 2 and 3, we saw how national differences in political, economic, and legal systems influence the benefits, costs, and risks associated with doing business in different countries. In this chapter, we explore how differences in culture across and within countries can affect international business strategies and operations of small, medium, and large companies. Several themes run through this chapter. The first is that business success in a variety of countries requires cross-cultural literacy. By cross-cultural literacy, we mean an understanding of how cultural differences across and within nations can affect the way business is practiced. Global communications, global brands, fast cycle times, worldwide markets, technology, and global supply chains characterize today’s world. This is an era in which the global village seems to be just around the corner. At the same time, it is sometimes easy to forget how different various cultures really are, even today.1 Underneath the veneer of modernism and globalization, deep cultural differences often remain.2 The opening case deals with precisely this point. We focused on two well-known and, by most standards, very successful global companies—Best Buy and eBay—and their venture into China. The failure of both companies in China was due in large part to their inability to come to grips with the cultural differences between China and the United States. Best Buy displayed a remarkable lack of cross-cultural literacy when it did not gauge the price sensitivity of the Chinese consumers, when it did not account for very well-known issues related to piracy in the electronics market, and when it did not under- stand the type of shopping experience Chinese customers really wanted. Previous success with their established business model directly led to Best Buy’s lack of success in the Chinese market. Likewise, but at a more fine-grained level, eBay ran into its own cultural issues in China. eBay failed to recognize the power of the established market leader (TaoBao) and the core feature provided by this market leader—built-in instant messag- ing. Customers valued, depended on, and saw instant messaging as an integral part of their shopping experience. Generalizing from the examples of Best Buy and eBay, in this chapter we argue that it is important for foreign businesses to gain an understanding of the culture that prevails in those countries where they do business and that success requires a foreign enterprise to adapt to the culture of its host country.3 Another theme developed in this chapter is that a relationship may exist between cul- ture and the cost of doing business in a country or region. Different cultures are more or less supportive of the capitalist mode of production and may increase or lower the costs of doing business. For example, some observers have argued that cultural factors lowered the costs of doing business in Japan and helped explain Japan’s rapid economic ascent during the 1960s, 1970s, and 1980s.4 Similarly, cultural factors can sometimes raise the

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costs of doing business. Historically, class divisions were an important aspect of British culture, and for a long time, firms operating in Great Britain found it difficult to achieve cooperation between management and labor. Class divisions led to a high level of indus- trial disputes in that country during the 1960s and 1970s and raised the costs of doing business relative to the costs in countries such as Germany, Japan, Norway, Sweden, and Switzerland, where class conflict was historically less prevalent. The British example, however, brings us to another theme we explore in this chapter. Culture is not static. It can and does evolve, although the rate at which culture can change is the subject of some dispute. Generally, culture evolves as behaviors of people become ingrained in their values and norms. This means that after some time, when a person has behaved a certain way for a while, that person (and perhaps those around the person) adopts a cultural value mindset consistent with the type of behavior illustrated by the person’s actions. Culture in society evolves when large population segments in a country or region adopt cultural values based on common ways of behaving. This cultural evolu- tion is the reason important aspects of British culture have changed significantly over the past 30 years, and the changes have been reflected in weaker class distinctions and a lower level of industrial disputes.5 Finally, it is important to note that multinational enter- prises can themselves be engines of cultural change. In India, for example, McDonald’s and other Western fast-food companies facilitated change in the dining culture of that nation, drawing them away from traditional restaurants and toward fast-food outlets.

What Is Culture?

Scholars have never been able to agree on a simple definition of culture. In the 1870s, anthropologist Edward Tylor defined culture as “that complex whole which includes knowledge, belief, art, morals, law, custom, and other capabilities acquired by man as a member of society.”6 Since then hundreds of other definitions have been offered. At the basic level, Florence Kluckhohn and Fred Strodtbeck’s values orientation theory illus- trates that all culture definitions must answer a limited number of universal problems, that the value-based solutions are limited in number and universally known, and that dif- ferent cultures have different preferences among them.7 Following their work, other prominent culture specialists have supported the idea of a universal set of human values serving as the basis for culture, such as Milton Rokeach with his work on “the nature of human values” and Shalom Schwartz with his work on the “theory of basic human values.”8 Also supportive of this finite set of human values, Geert Hofstede, an expert on cross-cultural differences and management, defined culture as “the collective program- ming of the mind which distinguishes the members of one human group from another. Culture, in this sense, includes systems of values; and values are among the building blocks of culture.”9 Another complementary definition of culture comes from sociologists Zvi Namenwirth and Robert Weber, who see culture as a system of ideas and argue that these ideas constitute a design for living.10 In our view, we subscribe to the definitions of both Hofstede and Namenwirth and Weber by viewing culture as a system of values and norms that are shared among a group of people and that when taken together constitute a design for living. By values, we mean abstract ideas about what a group believes to be good, right, and desirable. Put differently, values are shared assumptions about how things ought to be.11 By norms, we mean the social rules and guidelines that prescribe appropriate behavior in partic- ular situations. We shall use the term society to refer to a group of people sharing a common set of values and norms. While a society may be equivalent to a country, some countries harbor several societies or subcultures (i.e., they support multiple cultures), and

LO 4 -1 Explain what is meant by the culture of a society.

Geert Hofstede, often viewed as the foremost expert on cross-cultural differences in international business, presents his work in Istanbul, Turkey, at the Academy of International Business conference in 2013. Source: Courtesy of Academy of International Business

94 Part 2 National Differences

some societies embrace more than one country (e.g., the Scandinavian countries of Denmark, Norway, and Sweden are often viewed as culturally being a part of one society in terms of the business marketplace).

VALUES AND NORMS

Values form the bedrock of a culture. They provide the context within which a society’s norms are established and justified. They may include a society’s attitudes toward such concepts as individual freedom, democracy, truth, justice, honesty, loyalty, social obliga- tions, collective responsibility, the role of women, love, sex, marriage, and so on. Values are not just abstract concepts; they are invested with considerable emotional significance. People argue, fight, and even die over values such as freedom. Values are also often reflected in the political and economic systems of a society. As we saw in Chapter 2, democratic free market capitalism is a reflection of a philosophical value system that emphasizes individual freedom.12 Norms are the social rules that govern people’s actions toward one another. Norms can be subdivided further into two major categories: folkways and mores. Both of these terms were coined by William Graham Sumner, an early American sociologist, in 1906. Folkways are the routine conventions of everyday life. Generally, folkways are actions of little moral significance. Rather, they are social conventions concerning things such as the appropriate dress code in a particular situation, good social manners, eating with the correct utensils, neighborly behavior, and the like. Although folkways define the way people are expected to behave, violation of them is not normally a serious matter. People who violate folkways may be thought of as eccentric or ill-mannered, but they are not usually considered to be evil or bad. In many countries, foreigners may initially be ex- cused for violating folkways. However, with the increasing availability of information on folkways for the various countries in the world, businesspeople are increasingly expected to know about dress code in a particular situation, good social and professional manners, eating with the correct utensils, and general business etiquette. The evolution of norms now demand in many cases that business partners at least try to behave according to the folkways norms in the country in which they are doing business. A good example of folkways concerns attitudes toward time in different countries. People are keenly aware of the passage of time in the United States and northern European cultures such as Germany, Netherlands, and the Scandinavian countries. Businesspeople are very conscious about scheduling their time and are quickly irritated when their time is wasted because a business associate is late for a meeting or if they are kept waiting. They talk about time as though it were money, as something that can be spent, saved, wasted, and lost.13 Alternatively, in many Arabic, Latin, and African cultures, time has a more elastic character. Keeping to a schedule is viewed as less important than finishing an interaction with people. For example, an American businessperson might feel slighted if he or she is kept waiting for 30 minutes outside the office of a Latin American execu- tive before a meeting. However, the Latin American person may simply be completing an interaction with an associate and view the information gathered from this as more impor- tant than sticking to a rigid schedule. The Latin American executive intends no disre- spect, but due to a mutual misunderstanding about the importance of time, the American may see things differently. Similarly, Saudi Arabian attitudes toward time have been shaped by their nomadic Bedouin heritage, in which precise time played no real role and arriving somewhere tomorrow might mean next week. Like Latin Americans, many Saudis are unlikely to understand Westerners’ obsession with precise time and schedules, and they need to adjust their expectations accordingly. Folkways also include rituals and symbolic behavior. Rituals and symbols are the most visible manifestations of a culture and constitute the outward expression of deeper values. For example, upon meeting a foreign business executive, a Japanese executive will hold his business card in both hands and bow while presenting the card to the foreigner.14 This ritual behavior is loaded with deep cultural symbolism. The card specifies the rank of the Japanese executive, which is a very important piece of information in a hierarchical

Differences in Culture Chapter 4 95

society such as Japan. The bow is a sign of respect, and the deeper the angle of the bow, the greater the reverence one person shows for the other. The person receiving the card is expected to examine it carefully (Japanese often have business cards with Japanese printed on one side and English printed on the other), which is a way of returning respect and acknowledging the card giver’s position in the hierarchy. The foreigner is also ex- pected to bow when taking the card and to return the greeting by presenting the Japanese executive with his or her own card, similarly bowing in the process. To not do so, and to fail to read the card that he or she has been given, instead casually placing it in a jacket, pocket, or purse, violates this important folkway and is considered rude. Mores is a term that refers to norms that are more widely observed, have greater moral significance than other norms, and are central to the functioning of a society and to its social life. This means that mores have a much greater significance than folkways. Accord- ingly, violating mores can bring serious retribution, ill will, and collapse of any business deal in the making. Mores include such factors as indictments against theft, adultery, incest, and cannibalism. In many societies, certain mores have been enacted into law. Specifi- cally, all advanced societies have laws against theft, incest, and cannibalism. However, there are also many differences among cultures. In the United States, for example, drink- ing alcohol is widely accepted, whereas in Saudi Arabia the consumption of alcohol is viewed as violating important social mores and is punishable by imprisonment (as some Western citizens working in Saudi Arabia have discovered). In some way, mores are be- ing implemented differently depending on where you are and who you are. For example, like Saudi Arabia, the United Arab Emirates have laws against drinking alcohol in public places, but alcohol is often present and a part of business relationships involving Western- ers in Dubai and elsewhere in the country (especially in the bars of luxury hotels).

CULTURE, SOCIETY, AND THE NATION-STATE

We have defined a society as a group of people who share a common set of values and norms; that is, people who are bound together by a common culture. There is not a strict one-to-one correspondence between a society and a nation-state. Nation-states are politi- cal creations. While these nation-states are often studied for their “national identity,” “national character,” and even “competitive advantage of nations,” in reality they may contain a single culture or several cultures.15 Representative of a single culture setting, the French nation can be thought of as the political embodiment of French culture. However, the nation of Canada has at least three cultures—an Anglo culture, a French-speaking “Quebecois” culture, and a Native American culture. Similarly, many of the 55 African nations have important cultural differences among tribal groups, as exhibited in the early 1990s when Rwanda dissolved into a bloody civil war between two tribes, the Tutsis and Hutus. Africa is not alone in this regard. India, for example, is composed of many distinct cultural groups with their own rich history and traditions (e.g., Andhras, Gonds, Gujaratis, Marathas, Oriya, Rajputs, and Tamils). At the other end of the scale are cultures that embrace several nations. Several scholars argue that we can speak of an Islamic society or culture that is shared by the citizens of many different nations in the Middle East, Asia, and Africa. As you will recall from the previous chapter, this view of expansive cultures that embrace several nations underpins Samuel Huntington’s view of a world that is fragmented into different civilizations, in- cluding Western, Islamic, and Sinic (Chinese).16 To complicate things further, it is also possible to talk about culture at different levels. It is reasonable to talk about “American society” and “American culture,” but there are several societies within America, each with its own culture. For example, in the United States of America, which is one country, one can talk about African American culture, Cajun culture, Chinese American culture, Hispanic culture, Indian culture, Irish Ameri- can culture, and Southern culture. The relationship between culture and country is often ambiguous. Even if a country can be characterized as having a single homogeneous culture, often that national culture is a mosaic of subcultures. To abide by these cultural nuances, businesspeople should be aware of the delicate issues pertaining to folkways, as

96 Part 2 National Differences

appropriate, and not violate mores in the country in which they intend to do business. Increased globalization has meant an increased number of business relationships across countries and cultures, but not necessarily an increased culturally homogeneity in all parts of the world. Culture is still a complex phenomenon with multiple dimensions and multiple levels.17

THE DETERMINANTS OF CULTURE

The values and norms of a culture do not emerge fully formed. They evolve over time in response to a number of factors, including prevailing political and economic philosophies, the social structure of a society, and the dominant religion, language, and education (see Figure 4.1). We discussed political and economic philosophies in Chapter 2. Such phi- losophies clearly influence the value systems of a society. For example, the values found in communist North Korea toward freedom, justice, and individual achievement are clearly different from the values found in the United States, precisely because each society operates according to different political and economic philosophies. In the next sections of this chapter, we discuss the influence of social structure, religion, language, and educa- tion. The chain of causation runs both ways. While factors such as social structure and religion clearly influence the values and norms of a society, the values and norms of a society can influence social structure and religion.

Social Structure

A society’s social structure refers to its basic social organization, and this social organi- zation is both emergent from and determinant of the behaviors of individuals. Although social structure consists of many different aspects, two dimensions are particularly im- portant when explaining differences among cultures. The first is the degree to which the basic unit of a social organization is the individual, as opposed to the group. In general, Western societies tend to emphasize the importance of the individual, whereas groups tend to figure much larger in many other societies. The second dimension is the degree to which a society is stratified into classes or castes. Some societies are characterized by a relatively high degree of social stratification and relatively low mobility between strata (e.g., Indian); other societies are characterized by a low degree of social stratification and high mobility between strata (e.g., American).

LO 4 -2 Identify the forces that lead to differences in social culture.

TEST PREP Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

Social Structure

Culture Norms and Value Systems

Language

Political Philosophy

Economic Philosophy

Education

Religion

F I G U R E 4 . 1

The determinants of culture.

Differences in Culture Chapter 4 97

INDIVIDUALS AND GROUPS

A group is an association of two or more individuals who have a shared sense of identity and who interact with each other in structured ways on the basis of a common set of ex- pectations about each other’s behavior.18 Human social life is group life. Individuals are involved in families, work groups, social groups, recreational groups, and so on. In a way, social media have expanded the boundaries and what is included in group life and placed an added emphasis on what we can call the extended social groups. When research on social structure was developed, social media clearly did not enter into the equation of what was possible in terms of group life. This new form of social media group life has unique possibilities that affect both individuals within a social group and the group itself. For example, consumers are significantly more likely to buy from the brands they follow on Twitter and Facebook due to group influences. However, while groups are found in all societies, some societies differ according to the degree to which the group is viewed as the primary means of social organization.19 In some societies, individual attributes and achievements are viewed as being more important than group membership; in others, the reverse is true.

The Individual In Chapter 2, we discussed individualism as a political philosophy. However, individualism is more than just an abstract political philosophy. In many Western societies, the indi- vidual is the basic building block of social organization. This is reflected not just in the political and economic organization of society but also in the way people perceive them- selves and relate to each other in social and business settings. The value systems of many Western societies, for example, emphasize individual achievement. The social standing of individuals is not so much a function of whom they work for as of their individual perfor- mance in whatever work setting they choose. More and more, individuals are regarded as “independent contractors” even though they belong to and work for a company. These individuals, in essence, build their personal brands by the knowledge, skills, and experi- ence that they have; which often translates to increased salaries and promotions at the current company or another company that believes that it can benefit from that person’s capabilities. In science, the label “star scientist” has become synonymous with these individualistic high-producers of innovative products based on their knowledge, skills, and experience.20 The emphasis on individual performance in many Western societies has both beneficial and harmful aspects. In the United States, the emphasis on individual performance finds expression in an admiration of rugged individualism, entrepreneurship, and innovation. One benefit of this is the high level of entrepreneurial activity in the United States and other Western societies. Entrepreneurial individuals in the United States have created many new products and new ways of doing business (e.g., personal computers, photocopiers, computer software, biotechnology, supermarkets, and discount retail stores). One can argue that the dynamism of the U.S. economy owes much to the philosophy of individualism. Highly individualistic societies are often synonymous with people who are capable and have the capacity to constantly innovate by their creative ideas for products and services. Individualism also finds expression in a high degree of managerial mobility between companies, as our “personal brand” example illustrated earlier, and this is not always a good thing. Although moving from company to company may be good for individual managers who are trying to build impressive résumés, it is not necessarily a good thing for companies. The lack of loyalty and commitment to an individual company, and the tendency to move on for a better offer, can result in managers who have good general skills but lack the knowledge, experience, and network of interpersonal contacts that come from years of working within the same company. An effective manager draws on company-specific experience, knowledge, and a network of contacts to find solutions to current problems, and companies may suffer if their managers lack these attributes. One positive aspect of high managerial mobility is that executives are exposed to different

LO 4 -3 Identify the business and economic implications of differences in culture.

98 Part 2 National Differences

ways of doing business. The ability to compare business practices helps executives identify how good practices and techniques developed in one firm might be profitably applied to other firms.

The Group In contrast to the Western emphasis on the individual, the group is the primary unit of social organization in many other societies. For example, in Japan, the social status of an individual has traditionally been determined as much by the standing of the group to which he or she belongs as by his or her individual performance.21 In traditional Japanese society, the group was the family or village to which an individual belonged. Today, the group has frequently come to be associated with the work team or business organization to which an individual belongs. In a now-classic study of Japanese society, Nakane noted how this expresses itself in everyday life:

When a Japanese faces the outside (confronts another person) and affixes some position to himself socially he is inclined to give precedence to institution over kind of occupation. Rather than saying, “I am a typesetter” or “I am a filing clerk,” he is likely to say, “I am from B Publishing Group” or “I belong to S company.”22

Nakane goes on to observe that the primacy of the group to which an individual be- longs often evolves into a deeply emotional attachment in which identification with the group becomes all-important in one’s life. One central value of Japanese culture is the importance attached to group membership. This may have beneficial implications for business firms. Strong identification with the group is argued to create pressures for mutual self-help and collective action. If the worth of an individual is closely linked to the achievements of the group (e.g., firm), as Nakane maintains is the case in Japan, this creates a strong incentive for individual members of the group to work together for the common good. Some argue that the success of some Japanese enterprises in the global economy has been based partly on their ability to achieve close cooperation between individuals within a company and between companies. This has found expression in the widespread diffusion of self-managing work teams within Japanese organizations; the close coopera- tion among different functions within Japanese companies (e.g., among manufacturing, marketing, and R&D); and the cooperation between a company and its suppliers on issues such as design, quality control, and inventory reduction.23 In all these cases, cooperation is driven by the need to improve the performance of the group (i.e., the business firm). The primacy of the value of group identification also discourages managers and workers from moving from company to company. Lifetime employment in a particular company was long the norm in certain sectors of the Japanese economy (estimates suggest that between 20 and 40 percent of all Japanese employees have formal or informal lifetime employment guarantees). Over the years, managers and workers build up knowledge, experience, and a network of interpersonal business contacts. All these things can help managers perform their jobs more effectively and achieve cooperation with others. However, the primacy of the group is not always beneficial. Just as U.S. society is characterized by a great deal of dynamism and entrepreneurship, reflecting the primacy of values associated with individualism, some argue that Japanese society is characterized by a corresponding lack of dynamism and entrepreneurship. Although the long-run con- sequences are unclear, one implication is that the United States could continue to create more new industries than Japan and continue to be more successful at pioneering radi- cally new products and new ways of doing business. By most estimates, the United States has led the world in innovation for some time, especially radically new products and services, and the country’s individualism is a strong contributor to this innovative mindset. At the same time, some group-oriented countries such as Japan also do well in innova- tion, especially nonradical “normal” innovations, according to the GE Global Innovation Barometer.24 This is an indication that multiple paths to being innovative exists in both individualistic and group-oriented cultures, drawing from the uniqueness of the particular culture and what core competencies are reflected in the culture.25

Differences in Culture Chapter 4 99

SOCIAL STRATIFICATION

All societies are stratified on a hierarchical basis into social categories—that is, into social strata. These strata are typically defined on the basis of socioeconomic character- istics such as family background, occupation, and income. Individuals are born into a particular stratum. They become a member of the social category to which their parents belong. Individuals born into a stratum toward the top of the social hierarchy tend to have better life chances than those born into a stratum toward the bottom of the hierarchy. They are likely to have better education, health, standard of living, and work opportunities. Although all societies are stratified to some degree, they differ in two related ways. First, they differ from each other with regard to the degree of mobility between social strata. Second, they differ with regard to the significance attached to social strata in business contexts. Overall, social stratification is based on four basic principles:26

1. Social stratification is a trait of society, not a reflection of individual differences. 2. Social stratification carries over a generation to the next generation. 3. Social stratification is generally universal but variable. 4. Social stratification involves not just inequality but also beliefs.

Social Mobility The term social mobility refers to the extent to which individuals can move out of the strata into which they are born. Social mobility varies significantly from society to soci- ety. The most rigid system of stratification is a caste system. A caste system is a closed system of stratification in which social position is determined by the family into which a person is born, and change in that position is usually not possible during an individual’s lifetime. Often, a caste position carries with it a specific occupation. Members of one caste might be shoemakers, members of another might be butchers, and so on. These occu- pations are embedded in the caste and passed down through the family to succeeding generations. Although the number of societies with caste systems diminished rapidly during the twentieth century, one partial example still remains. India has four main castes and several thousand subcastes. Even though the caste system was officially abolished in 1949, two years after India became independent, it is still a force in rural Indian society where occupation and marital opportunities are still partly related to caste (for more details, see the accompanying Country Focus on the caste system in India today).27 A class system is a less rigid form of social stratification in which social mobility is possible. It is a form of open stratification in which the position a person has by birth can be changed through his or her own achievements or luck. Individuals born into a class at the bottom of the hierarchy can work their way up; conversely, individuals born into a class at the top of the hierarchy can slip down. While many societies have class systems, social mobility within a class system varies from society to society. For example, some sociologists have argued that Britain has a more rigid class structure than certain other Western societies, such as the United States.28 Historically, British society was divided into three main classes: the upper class, which was made up of individuals whose families for generations had wealth, prestige, and oc- casionally power; the middle class, whose members were involved in professional, mana- gerial, and clerical occupations; and the working class, whose members earned their living from manual occupations. The middle class was further subdivided into the upper- middle class, whose members were involved in important managerial occupations and the prestigious professions (e.g., lawyers, accountants, doctors), and the lower-middle class, whose members were involved in clerical work (e.g., bank tellers) and the less prestigious professions (e.g., schoolteachers). The British class system exhibited significant divergence between the life chances of members of different classes. The upper and upper-middle classes typically sent their children to a select group of private schools, where they wouldn’t mix with lower-class children and where they picked up many of the speech accents and social norms that

LO 4 -2 Identify the forces that lead to differences in social culture.

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COUNTRY FOCUS

Using IT to Break India’s Caste System Modern India is a country of dramatic contrasts. Its informa- tion technology (IT) sector is among the most vibrant in the world with companies such as Tata Consultancy Services, Cognizant Technology Solutions, Infosys, and Wipro emerging as powerful global players. Cognizant is an inter- esting company in that it was founded as a technology arm of Dun & Bradstreet (USA) in 1994 but is typically consid- ered an Indian IT company because a majority of its em- ployees are based in India. In fact, many IT companies locate or operate in India because of its strong IT knowl- edge, human capital, and culture. Traditionally, India has had one of the strongest caste systems in the world. At the core, the caste system has no legality in India, and discrimination against lower castes is illegal. India has also enacted numerous new laws and social initiatives to protect and improve living conditions of lower castes in the country. Historically, however, India’s caste system was an impediment to social mobility. But, steadily the stranglehold on people’s socioeconomic con- ditions is becoming a fading memory among the educated, urban middle-class Indians who make up the majority of employees in the high-tech economy. Unfortunately, the same is not true in rural India, where some 70 percent of the nation’s population still resides. There caste remains a pervasive influence. For example, a young female engineer at Infosys who grew up in a small rural village and is a dalit (sometimes called a “scheduled caste”) recounts how she never entered the house of a Brahmin, India’s elite priestly caste, even though half of her village were Brahmins. When a dalit was hired to cook at the school in her native village, Brahmins withdrew their children from the school. The engineer herself is the beneficiary of a charitable training scheme that Infosys launched in 2006. Her caste, making up about 16 percent

of the country (or around 165 million people), is among the poorest in India, with some 91 percent making less than $100 a month, compared to 65 percent of Brahmins. To try to correct this historic inequality, politicians have talked for years about extending the employment quota system to private enterprises. The government has told private companies to hire more dalits and members of tribal communities and warned that “strong measures” will be taken if companies do not comply. Private employers are resisting attempts to impose quotas, arguing with some justification that people who are guaranteed a job by a quota system are unlikely to work very hard. At the same time, progressive employers realize they need to do something to correct the inequalities, and unless India taps into the lower castes, it may not be able to find the employ- ees required to staff rapidly growing high-technology enter- prises. Thus, the Confederation of Indian Industry recently introduced a package of dalit-friendly measures, including scholarships for bright lower-caste children. Building on this, Infosys is leading the way among high-tech enter- prises. The company provides special training to low-caste engineering graduates who have failed to get a job in indus- try after graduation. While the training does not promise employment, so far almost all graduates who completed the seven-month training program have been hired by Infosys and other enterprises. Infosys programs are priva- tized version of the education offered in India to try to break down India’s caste system.

Sources: B. Hardzinski, S. Grillot, and M. Addison, “Breaking Down India’s Caste System through Education,” KGOU, November 29, 2013, http://kgou.org/post/breaking-down-india-s-caste-system- through-education, accessed April 19, 2015; “With Reservations: Business and Caste in India,” The Economist, October 6, 2007, pp. 81–83; Eric Bellman, “Reversal of Fortune Isolates India’s Brahmins,” The Wall Street Journal, December 24, 2007, p. 4.

marked them as being from the higher strata of society. These same private schools also had close ties with the most prestigious universities, such as Oxford and Cambridge. Until fairly recently, Oxford and Cambridge guaranteed a certain number of places for the graduates of these private schools. Having been to a prestigious university, the offspring of the upper and upper-middle classes then had an excellent chance of being offered a prestigious job in companies, banks, brokerage firms, and law firms run by members of the upper and upper-middle classes. In contrast, the members of the British working and lower-middle classes typically went to state schools. The majority left at age 16, and those who went on to higher educa- tion found it more difficult to get accepted at the best universities. When they did, they found that their lower-class accent and lack of social skills marked them as being from a

Differences in Culture Chapter 4 101

lower social stratum, which made it more difficult for them to get access to the most pres- tigious jobs. Because of this, the class system in Britain perpetuated itself from generation to gen- eration, and mobility was limited. Although upward mobility was possible, it could not normally be achieved in one generation. While an individual from a working-class back- ground may have established an income level that was consistent with membership in the upper-middle class, he or she may not have been accepted as such by others of that class due to accent and background. However, by sending his or her offspring to the “right kind of school,” the individual could ensure that his or her children were accepted. According to some commentators, modern British society is now rapidly leaving be- hind this class structure and moving toward a classless society. However, sociologists continue to dispute this finding and present evidence that this is not the case. For exam- ple, one study reported that state schools in the London Borough (suburb) of Islington, which now has a population of 215,000, had only 79 candidates for university, while one prestigious private school alone, Eton, sent more than that number to Oxford and Cam- bridge.29 This, according to the study’s authors, implies that “money still begets money.” They argue that a good school means a good university, a good university means a good job, and merit has only a limited chance of elbowing its way into this tight little circle. In another recent survey of the empirical literature, a sociologist noted that class differen- tials in educational achievement have changed surprisingly little over the last few decades in many societies, despite assumptions to the contrary.30 The class system in the United States is less pronounced than in Britain and mobility is greater. Like Britain, the United States has its own upper, middle, and working classes. However, class membership is determined to a much greater degree by individual eco- nomic achievements, as opposed to background and schooling. Thus, an individual can, by his or her own economic achievement, move smoothly from the working class to the upper class in a lifetime. Successful individuals from humble origins are highly respected in American society. Another society for which class divisions have historically been of some importance has been China, where there has been a long-standing difference between the life chances of the rural peasantry and urban dwellers. Ironically, this historic division was strength- ened during the high point of communist rule because of a rigid system of household registration that restricted most Chinese to the place of their birth for their lifetime. Bound to collective farming, peasants were cut off from many urban privileges—compulsory education, quality schools, health care, public housing, varieties of foodstuffs, to name only a few—and they largely lived in poverty. Social mobility was thus very limited. This system crumbled following reforms of the late 1970s and early 1980s, and as a conse- quence, migrant peasant laborers have flooded into China’s cities looking for work. Soci- ologists now hypothesize that a new class system is emerging in China based less on the rural–urban divide and more on urban occupation.31

Significance From a business perspective, the stratification of a society is significant if it affects the operation of business organizations. In American society, the high degree of social mo- bility and the extreme emphasis on individualism limit the impact of class background on business operations. The same is true in Japan, where most of the population perceives itself to be middle class. In a country such as Great Britain, however, the relative lack of class mobility and the differences between classes have resulted in the emergence of class consciousness. Class consciousness refers to a condition by which people tend to perceive themselves in terms of their class background, and this shapes their relationships with members of other classes. This has been played out in British society in the traditional hostility between upper- middle-class managers and their working-class employees. Mutual antagonism and lack of respect historically made it difficult to achieve cooperation between management and labor in many British companies and resulted in a relatively high level of industrial disputes.

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102 Part 2 National Differences

However, the past two decades have seen a dramatic reduction in industrial disputes, which bolsters the arguments of those who claim that the country is moving toward a classless society. Alternatively, as noted earlier, class consciousness may be reemerging in urban China, and it may ultimately prove to be significant there. An antagonistic relationship between management and labor classes, and the resulting lack of cooperation and high level of industrial disruption, tends to raise the costs of pro- duction in countries characterized by significant class divisions. In turn, this can make it more difficult for companies based in such countries to establish a competitive advantage in the global economy.

Religious and Ethical Systems

Religion may be defined as a system of shared beliefs and rituals that are concerned with the realm of the sacred.32 An ethical system refers to a set of moral principles, or values, that are used to guide and shape behavior.33 Most of the world’s ethical systems are the product of religions. Thus, we can talk about Christian ethics and Islamic ethics. However, there is a major exception to the principle that ethical systems are grounded in religion. Confucianism and Confucian ethics influence behavior and shape culture in parts of Asia, yet it is incorrect to characterize Confucianism as a religion. The relationship among religion, ethics, and society is subtle and complex. Among the thousands of religions in the world today, four dominate in terms of numbers of adherents: Christianity with roughly 2.20 billion adherents, Islam with around 1.80 billion adherents, Hinduism with 1.10 billion adherents (primarily in India), and Buddhism with about 490 million adherents (see Map 4.1). Although many other religions have an important influence in certain parts of the modern world (e.g., Shintoism in Japan, with roughly 40 million followers, and Judaism, which has 18 million adherents and accounts for 75 percent of the population of Israel), their numbers pale in comparison with these dom- inant religions (although as the precursor of both Christianity and Islam, Judaism has an indirect influence that goes beyond its numbers). We review these four religions, along with Confucianism, focusing on their potential economic and business implications. Some scholars have theorized that the most important business implications of religion center on the extent to which different religions shape attitudes toward work and entrepre- neurship and the degree to which the religious ethics affects the costs of doing business in a country. However, it is hazardous to make sweeping generalizations about the nature of the relationship between religion and ethical systems and business practice. While some professionals argue that there is a relationship between religious and ethical systems and business practice in a society, in a world where nations with Catholic, Protestant, Muslim, Hindu, and Buddhist majorities all show evidence of entrepreneurial activity and sustainable economic growth, it is important to view such proposed relationships with a degree of skepticism. The proposed relationships may exist, but their impact may be small compared with the impact of economic policy. On the other hand, research by economists Robert Barro and Rachel McCleary does suggest that strong religious beliefs, particularly beliefs in heaven, hell, and an afterlife, have a positive impact on economic growth rates, irrespective of the particular religion in question.34 Barro and McCleary looked at religious beliefs and economic growth rates in 59 countries. Their conjecture was that higher religious beliefs stimulate economic growth because they help sustain aspects of individual behavior that lead to higher productivity.

CHRISTIANITY

Christianity is the most widely practiced religion in the world with some 2.20 billion fol- lowers. The vast majority of Christians live in Europe and the Americas, although their numbers are growing rapidly in Africa. Christianity grew out of Judaism. Like Judaism, it is a monotheistic religion (monotheism is the belief in one God). A religious division in the eleventh century led to the establishment of two major Christian organizations—the

LO 4 -2 Identify the forces that lead to differences in social culture.

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Differences in Culture Chapter 4 103

Roman Catholic Church and the Orthodox Church. Today, the Roman Catholic Church accounts for more than half of all Christians, most of whom are found in southern Europe and Latin America. The Orthodox Church, while less influential, is still of major impor- tance in several countries (e.g., Greece and Russia). In the sixteenth century, the Reformation led to a further split with Rome; the result was Protestantism. The nonconformist nature of Protestantism has facilitated the emergence of numerous denominations under the Protestant umbrella (e.g., Baptist, Methodist, Calvinist).

Economic Implications of Christianity Several sociologists have argued that of the main branches of Christianity—Catholic, Orthodox, and Protestant—the latter has the most important economic implications. In 1904, prominent German sociologist Max Weber made a connection between Protestant ethics and “the spirit of capitalism” that has since become famous.35 Weber noted that capitalism emerged in western Europe, where

business leaders and owners of capital, as well as the higher grades of skilled labor, and even more the higher technically and commercially trained personnel of modern enterprises, are overwhelmingly Protestant.36

LO 4 -3 Identify the business and economic implications of differences in culture.

PACIFIC OCEAN

ARCTIC OCEAN

ARCTIC OCEAN

PACIFIC OCEAN

ATLANTIC OCEAN

INDIAN OCEAN

M C

C

C

J H

C

M

J

J

M

J

M

M

M C

B

MH

C C

C

J

J

HM H

J J

1000

0

0

1000 2000 Miles

2000 3000 Kilometers Scale: 1 to 190,080,000

PACIFICPACIFICCIFIC OCCEAN

ARCTIC OCEAN

ARCCTIC OCEEAN

CIFICCIFICPACC CEANOOCCCC

TLANNTICTLANTLANNTICNATATAT OCEOOOO EANNOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOOO

DINDDIIAN OCEANEANEEANN

MM CCCCCCC

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J H

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J

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M

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J

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JJ J

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2000 3000 Kilometers Scale: 1 to 190,080,000

Christianity (C)*

Predominant Religions

Islam (M) Sunni

Shi’a

Buddhism (B) Hinayanistic

Lamaistic

Hinduism (H)

Judaism (J)

Sikhism

Animism (tribal)

Chinese complex (Confucianism, Taoism, and Buddhism) Korean complex (Buddhism, Confucianism, Christianity, and Chondogyo) Japanese complex (Shinto and Buddhism) Vietnamese complex (Buddhism, Taoism, Confucianism, and Cao Dai)

* Capital letters indicate the presence of locally important minority adherents of nonpredominant faiths.

Unpopulated regions

Roman Catholic

Protestant

Mormon (LDS)

Eastern churches

Mixed sects

M A P 4 . 1

World religions. Source: From John L. Allen, Student Atlas of World Politics,10th ed., map 14. Copyright © 2013 by The McGraw- Hill Companies. Reproduced by permission of McGraw-Hill Contemporary Learning Series.

104 Part 2 National Differences

Weber theorized that there was a relationship between Protestantism and the emer- gence of modern capitalism. He argued that Protestant ethics emphasizes the importance of hard work and wealth creation (for the glory of God) and frugality (abstinence from worldly pleasures). According to Weber, this kind of value system was needed to facilitate the development of capitalism. Protestants worked hard and systematically to accumulate wealth. However, their ascetic beliefs suggested that rather than consuming this wealth by indulging in worldly pleasures, they should invest it in the expansion of capitalist enter- prises. Thus, the combination of hard work and the accumulation of capital, which could be used to finance investment and expansion, paved the way for the development of capitalism in western Europe and subsequently in the United States. In contrast, Weber argued that the Catholic promise of salvation in the next world, rather than this world, did not foster the same kind of work ethic. Protestantism also may have encouraged capitalism’s development in another way. By breaking away from the hierarchical domination of religious and social life that character- ized the Catholic Church for much of its history, Protestantism gave individuals signifi- cantly more freedom to develop their own relationship with God. The right to freedom of form of worship was central to the nonconformist nature of early Protestantism. This emphasis on individual religious freedom may have paved the way for the subsequent emphasis on individual economic and political freedoms and the development of indi- vidualism as an economic and political philosophy. As we saw in Chapter 2, such a phi- losophy forms the bedrock on which entrepreneurial free market capitalism is based. Building on this, some scholars claim there is a connection between individualism, as inspired by Protestantism, and the extent of entrepreneurial activity in a nation.37 Again, we must be careful not to generalize too much from this historical sociological view. While nations with a strong Protestant tradition such as Britain, Germany, and the United States were early leaders in the industrial revolution, nations with Catholic or Orthodox majorities show significant and sustained entrepreneurial activity and economic growth in the modern world.

ISLAM

With about 1.80 billion adherents, Islam is the second largest of the world’s major reli- gions. Islam dates back to A.D. 610 when the Prophet Muhammad began spreading the word, although the Muslim calendar begins in A.D. 622 when, to escape growing opposi- tion, Muhammad left Mecca for the oasis settlement of Yathrib, later known as Medina. Adherents of Islam are referred to as Muslims. Muslims constitute a majority in more than 40 countries and inhabit a nearly contiguous stretch of land from the northwest coast of Africa, through the Middle East, to China and Malaysia in the Far East. Islam has roots in both Judaism and Christianity (Islam views Jesus Christ as one of God’s prophets). Like Christianity and Judaism, Islam is a monotheistic religion. The central principle of Islam is that there is but the one true omnipotent God (Allah). Islam requires unconditional acceptance of the uniqueness, power, and authority of God and the understanding that the objective of life is to fulfill the dictates of His will in the hope of admission to paradise. According to Islam, worldly gain and temporal power are an illu- sion. Those who pursue riches on earth may gain them, but those who forgo worldly ambitions to seek the favor of Allah may gain the greater treasure—entry into paradise. Other major principles of Islam include (1) honoring and respecting parents, (2) respect- ing the rights of others, (3) being generous but not a squanderer, (4) avoiding killing ex- cept for justifiable causes, (5) not committing adultery, (6) dealing justly and equitably with others, (7) being of pure heart and mind, (8) safeguarding the possessions of orphans, and (9) being humble and unpretentious.38 Obvious parallels exist with many of the central principles of both Judaism and Christianity. Islam is an all-embracing way of life governing the totality of a Muslim’s being.39 As God’s surrogate in this world, a Muslim is not a totally free agent but is circumscribed by religious principles—by a code of conduct for interpersonal relations—in social and

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Differences in Culture Chapter 4 105

economic activities. Religion is paramount in all areas of life. The Muslim lives in a social structure that is shaped by Islamic values and norms of moral conduct. The ritual nature of everyday life in a Muslim country is striking to a Western visitor. Among other things, orthodox Muslim ritual requires prayer five times a day (business meetings may be put on hold while the Muslim participants engage in their daily prayer ritual), demands that women should be dressed in a certain manner, and forbids the consumption of pork and alcohol.

Islamic Fundamentalism The past three decades have witnessed the growth of a social movement often referred to as Islamic fundamentalism.40 In the West, Islamic fundamentalism is associated in the media with militants, terrorists, and violent upheavals, such as the bloody conflict occurring in Algeria, the killing of foreign tourists in Egypt, and the September 11, 2001, attacks on the World Trade Center and Pentagon in the United States. This char- acterization is misleading. Just as Christian fundamentalists are motivated by sincere and deeply held religious values firmly rooted in their faith, so are Islamic fundamen- talists. A small minority of radical “fundamentalists” who have hijacked the religion to further their own political and violent ends perpetrates the violence that the West- ern media associates with Islamic fundamentalism. (Some Christian “fundamental- ists” have done exactly the same, including Jim Jones and David Koresh.) The vast majority of Muslims point out that Islam teaches peace, justice, and tolerance, not vio- lence and intolerance, and that Islam explicitly repudiates the violence that a radical minority practices. The rise of Islamic fundamentalism has no one cause. In part, it is a response to the social pressures created in traditional Islamic societies by the move toward modernization and by the influence of Western ideas, such as liberal democracy, materialism, equal rights for women, and attitudes toward sex, marriage, and alcohol. In many Muslim coun- tries, modernization has been accompanied by a growing gap between a rich urban mi- nority and an impoverished urban and rural majority. For the impoverished majority, modernization has offered little in the way of tangible economic progress, while threaten- ing the traditional value system. Thus, for a Muslim who cherishes his or her traditions and feels that his or her identity is jeopardized by the encroachment of alien Western values, Islamic fundamentalism has become a cultural anchor. Fundamentalists demand commitment to traditional religious beliefs and rituals. The result has been a marked increase in the use of symbolic gestures that confirm Islamic values. In areas where fundamentalism is strong, women have resumed wearing floor- length, long-sleeved dresses and covering their hair; religious studies have increased in universities; the publication of religious tracts has increased; and public religious orations have risen.41 Also, the sentiments of some fundamentalist groups are often anti-Western. Rightly or wrongly, Western influence is blamed for a range of social ills, and many funda- mentalists’ actions are directed against Western governments, cultural symbols, businesses, and even individuals. In several Muslim countries, fundamentalists have gained political power and have used this to try to make Islamic law (as set down in the Koran, the bible of Islam) the law of the land. There are grounds for this in Islam doctrine. Islam makes no distinction between church and state. It is not just a religion; Islam is also the source of law, a guide to statecraft, and an arbiter of social behavior. Muslims believe that every human endeavor is within the purview of the faith—and this includes political activity—because the only purpose of any activity is to do God’s will.42 (Some Christian fundamentalists also share this view.) Muslim fundamentalists have been most successful in Iran, where a funda- mentalist party has held power since 1979, but they also have had an influence in many other countries, such as Afghanistan (where the Taliban established an extreme funda- mentalist state until removed by the U.S.-led coalition in 2002), Algeria, Egypt, Pakistan, Saudi Arabia, and the Sudan.

106 Part 2 National Differences

Economic Implications of Islam The Koran establishes some explicit economic principles, many of which are pro–free enterprise.43 The Koran speaks approvingly of free enterprise and of earning legitimate profit through trade and commerce (the Prophet Muhammad himself was once a trader). The protection of the right to private property is also embedded within Islam, although Islam asserts that all property is a favor from Allah (God), who created and so owns every- thing. Those who hold property are regarded as trustees rather than owners in the West- ern sense of the word. As trustees, they are entitled to receive profits from the property but are admonished to use it in a righteous, socially beneficial, and prudent manner. This reflects Islam’s concern with social justice. Islam is critical of those who earn profit through the exploitation of others. In the Islamic view of the world, humans are part of a collective in which the wealthy and successful have obligations to help the disadvantaged. Put simply, in Muslim countries, it is fine to earn a profit, so long as that profit is justly earned and not based on the exploitation of others for one’s own advantage. It also helps if those making profits undertake charitable acts to help the poor. Furthermore, Islam stresses the importance of living up to contractual obligations, of keeping one’s word, and of abstaining from deception. For a closer look at how Islam, capitalism, and globalization can coexist, see the accompanying Country Focus about the region around Kayseri in central Turkey. Given the Islamic proclivity to favor market-based systems, Muslim countries are likely to be receptive to international businesses as long as those businesses behave in a manner that is consistent with Islamic ethics, customs, and business practices. Businesses that are perceived as making an unjust profit through the exploitation of others, by decep- tion, or by breaking contractual obligations are unlikely to be welcomed in an Islamic country. In addition, in Islamic countries where fundamentalism is on the rise, hostility toward Western-owned businesses is likely to increase. One economic principle of Islam prohibits the payment or receipt of interest, which is considered usury. This is not just a matter of theology; in several Islamic states, it is also a matter of law. The Koran clearly condemns interest, which is called riba in Arabic, as ex- ploitative and unjust. For many years, banks operating in Islamic countries conveniently ignored this condemnation, but starting in the 1970s with the establishment of an Islamic bank in Egypt, Islamic banks opened in predominantly Muslim countries. Now there are hundreds of Islamic banks in more than 50 countries with assets of around $1.6 trillion; plus more than $1 trillion is managed by mutual funds that adhere to Islamic principles.44 Even conventional banks are entering the market—both Citigroup and HSBC, two of the world’s largest financial institutions, now offer Islamic financial services. While only Iran and the Sudan enforce Islamic banking conventions, in an increasing number of countries customers can choose between conventional banks and Islamic banks.

Conventional banks make a profit on the spread between the interest rate they have to pay to depositors and the higher interest rate they charge borrowers. Because Islamic banks cannot pay or charge interest, they must find a different way of making money. Islamic banks have experimented with two different banking methods—the mudarabah and the murabaha.45 A mudarabah contract is similar to a profit-sharing scheme. Under mudarabah, when an Islamic bank lends money to a busi- ness, rather than charging that business interest on the loan, it takes a share in the profits that are derived from the investment. Similarly, when a business (or individual) deposits money at an Islamic bank in a savings account, the deposit is treated as an eq- uity investment in whatever activity the bank uses the capital for. Thus, the depositor receives a share in the profit from the bank’s investment (as opposed to interest payments) according to an agreed-upon ratio. Some Muslims claim this is a more efficient system than the Western banking system because it encourages

LO 4 -3 Identify the business and economic implications of differences in culture.

Islamic banks function differently than conventional banks in the world, as the Islamic banks cannot pay or charge interest. Source: © Ali Al Saadi/AFP/Getty Images

COUNTRY FOCUS

For years now, Turkey has been lobbying the European Union to allow it to join the free trade bloc as a member state. If the EU says yes, it will be the first Muslim state in the union. Many critics in the EU worry that Islam and Western- style capitalism do not mix well and that, as a conse- quence, allowing Turkey into the EU would be a mistake. However, a close look at what is going on in Turkey sug- gests this view may be misplaced. Consider the area around the city of Kayseri in central Turkey. Many dismiss this poor, largely agricultural region of Turkey as a non- European backwater, far removed from the secular bustle of Istanbul. It is a region where traditional Islamic values hold sway. And yet, it is a region that has produced so many thriving Muslim enterprises that it is sometimes called the “Anatolian Tiger.” Businesses based here include large food manufacturers, textile companies, furniture manufacturers, and engineering enterprises, many of which export a substantial percentage of their production. Local business leaders attribute the success of compa- nies in the region to an entrepreneurial spirit that they say is part of Islam. They point out that the Prophet Muhammad, who was himself a trader, preached merchant honor and commanded that 90 percent of a Muslim’s life be devoted to work in order to put food on the table. Outside observers have gone further, arguing that what is occurring around Kayseri is an example of Islamic Calvinism, a fusion of tradi- tional Islamic values and the work ethic often associated with Protestantism in general and Calvinism in particular.

However, not everyone agrees that Islam is the driving force behind the region’s success. Saffet Arslan, the man- aging director of Ipek, the largest furniture producer in the region (which exports to more than 30 countries), says an- other force is at work—globalization! According to Arslan, over the past three decades, local Muslims who once eschewed making money in favor of focusing on religion are now making business a priority. They see the Western world, and Western capitalism, as a model, not Islam, and because of globalization and the opportunities associated with it, they want to become successful. If there is a weakness in the Islamic model of business that is emerging in places such as Kayseri, some say it can be found in traditional attitudes toward the role of women in the workplace and the low level of female employment in the region. According to a report by the European Stability Initiative, the same group that holds up the Kayseri region as an example of Islamic Calvinism, the low participation of women in the local workforce is the Achilles’ heel of the economy and may stymie the attempts of the region to catch up with the countries of the European Union.

Sources: “Turkey’s Future Forward to the Past: Can Turkey’s Past Glories Be Revived by Its Grandiose Islamist President?,” The Econo- mist, January 3, 2015, www.economist.com/news/europe/21637417- can-turkeys-past-glories-be-revived-its-grandiose-islamist-president- forward-past; D. Bilefsky, “Turks Knock on Europe’s Door with Evidence That Islam and Capitalism Can Coexist,” The New York Times, August 27, 2006, p. 4; European Stability Initiative, Islamic Calvinists, September 19, 2005, archived at www.esiweb.org.

Islamic Capitalism in Turkey

both long-term savings and long-term investment. However, there is no hard evidence of this, and many believe that a mudarabah system is less efficient than a conventional Western banking system. The second Islamic banking method, the murabaha contract, is the most widely used among the world’s Islamic banks, primarily because it is the easiest to implement. In a murabaha contract, when a firm wishes to purchase something using a loan—let’s say a piece of equipment that costs $1,000—the firm tells the bank after having negotiated the price with the equipment manufacturer. The bank then buys the equipment for $1,000, and the borrower buys it back from the bank at some later date for, say, $1,100, a price that includes a $100 markup for the bank. A cynic might point out that such a markup is func- tionally equivalent to an interest payment, and it is the similarity between this method and conventional banking that makes it so much easier to adopt.

HINDUISM

Hinduism has approximately 1.10 billion adherents, most of them on the Indian subcon- tinent. Hinduism began in the Indus Valley in India more than 4,000 years ago, making it the world’s oldest major religion. Unlike Christianity and Islam, its founding is not linked

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108 Part 2 National Differences

to a particular person. Nor does it have an officially sanctioned sacred book such as the Bible or the Koran. Hindus believe that a moral force in society requires the acceptance of certain responsibilities, called dharma. Hindus believe in reincarnation, or rebirth into a different body, after death. Hindus also believe in karma, the spiritual progression of each person’s soul. A person’s karma is affected by the way he or she lives. The moral state of an individual’s karma determines the challenges he or she will face in the next life. By perfecting the soul in each new life, Hindus believe that an individual can eventu- ally achieve nirvana, a state of complete spiritual perfection that renders reincarnation no longer necessary. Many Hindus believe that the way to achieve nirvana is to lead a severe ascetic lifestyle of material and physical self-denial, devoting life to a spiritual rather than material quest.

Economic Implications of Hinduism Max Weber, famous for expounding on the Protestant work ethic, also argued that the ascetic principles embedded in Hinduism do not encourage the kind of entrepreneurial activity in pursuit of wealth creation that we find in Protestantism.46 According to Weber, traditional Hindu values emphasize that individuals should be judged not by their mate- rial achievements but by their spiritual achievements. Hindus perceive the pursuit of ma- terial well-being as making the attainment of nirvana more difficult. Given the emphasis on an ascetic lifestyle, Weber thought that devout Hindus would be less likely to engage in entrepreneurial activity than devout Protestants. Mahatma Gandhi, the famous Indian nationalist and spiritual leader, was certainly the embodiment of Hindu asceticism. It has been argued that the values of Hindu as- ceticism and self-reliance that Gandhi advocated had a negative impact on the eco- nomic development of postindependence India.47 But we must be careful not to read too much into Weber’s rather old arguments. Modern India is a very dynamic entre- preneurial society, and millions of hardworking entrepreneurs form the economic backbone of the country’s rapidly growing economy, especially in the information technology sector.48 Historically, Hinduism also supported India’s caste system. The concept of mobility between castes within an individual’s lifetime makes no sense to traditional Hindus. Hin- dus see mobility between castes as something that is achieved through spiritual progres- sion and reincarnation. An individual can be reborn into a higher caste in his or her next life if he or she achieves spiritual development in this life. Although the caste system has been abolished in India, as discussed earlier in the chapter, it still casts a long shadow over Indian life.

LO 4 -3 Identify the business and economic implications of differences in culture.

C U LT U R E O N G L O B A L E D G E

The “Culture” section of globalEDGE (globaledge.msu.edu/global-resources/culture) offers a variety of sources, information, and data on culture and international business. In addition, the “Insights by Country” section (globaledge.msu.edu/global-insights/by/country), with cov- erage of more than 200 countries, has country-specific culture issues (e.g., what to do and not to do when visiting a country). These globalEDGE culture resources are nice comple- ments to the material in Chapter 4. In this chapter, we cover a lot of material on culture, and Geert Hofstede’s research has been the most influential on culture and business. globalEDGE has “The Hofstede Centre” as one of its cultural reference sources. This reference focuses on Hofstede’s research on cultural dimensions, including scores on countries, regions, charts, and graphs. Are you interested in the scores for a country we do not illustrate in Table 4.1? If so, check out “The Hofstede Centre” and its “Culture Compass,” and see what the scores are for your favored country.

Differences in Culture Chapter 4 109

BUDDHISM

Buddhism, with some 490 million adherents, was founded in the sixth century B.C. by Siddhartha Gautama, in what is now Nepal. Siddhartha renounced his wealth to pursue an ascetic lifestyle and spiritual perfection. His adherents claimed he achieved nirvana but decided to remain on earth to teach his followers how they, too, could achieve this state of spiritual enlightenment. Siddhartha became known as the Buddha (which means “the awakened one”). Today, most Buddhists are found in Central and Southeast Asia, China, Korea, and Japan. According to Buddhism, suffering originates in people’s desires for pleasure. Cessation of suffering can be achieved by following a path for transforma- tion. Siddhartha offered the Noble Eightfold Path as a route for transformation. This em- phasizes right seeing, thinking, speech, action, living, effort, mindfulness, and meditation. Unlike Hinduism, Buddhism does not support the caste system. Nor does Buddhism ad- vocate the kind of extreme ascetic behavior that is encouraged by Hinduism. Neverthe- less, like Hindus, Buddhists stress the afterlife and spiritual achievement rather than involvement in this world.

Economic Implications of Buddhism The emphasis on wealth creation that is embedded in Protestantism is historically not found in Buddhism. Thus, in Buddhist societies, we do not see the same kind of cultural stress on entrepreneurial behavior that Weber claimed could be found in the Protestant West. But unlike Hinduism, the lack of support for the caste system and extreme ascetic behavior suggests that a Buddhist society may represent a more fertile ground for entre- preneurial activity than a Hindu culture. In effect, innovative ideas and entrepreneurial activities may take hold throughout society independent of which caste a person may be- long to, but again, each culture is uniquely oriented toward its own types of entrepreneur- ial behavior. In Buddhism, societies were historically more deeply rooted to their local place in the natural world.49 This means that economies were more localized, with relations between people and also between culture and nature being relatively unmediated. In the modern economy, complex technologies and large-scale social institutions have led to a separa- tion between people and also between people and the natural world. Plus, as the economy grows, it is difficult to understand and appreciate the potential effects people have on the natural world. Both of these separations are the antithetical to the Buddha’s teachings. Interestingly, recent trends actually bring in the “Zen” orientation from Buddhism into business in the Western world.50 By 2013, there were 657 live trademarks containing the word Zen in them in the United States alone, according to the U.S. Patent and Trademark Office. “In business, ‘Zen’ is often a synonym for ordinary nothingness,” blogged Nancy Friedman, a corporate copywriter who consults with businesses on naming and branding. She said that “Zen can be combined with mail to describe ‘an incoming e-mail message with no message or attachments.’ Zen spin is a verb meaning ‘to tell a story without say- ing anything at all.’ And to zen a computing problem means to figure it out in an intuitive flash—perhaps while you’re plugged into the earphones of your ZEN MP3 player, now available from Creative with a 16Gb capacity.”51

CONFUSIANISM

Confucianism was founded in the fifth century B.C. by K’ung-Fu-tzu, more generally known as Confucius. For more than 2,000 years until the 1949 communist revolution, Confucianism was the official ethical system of China. While observance of Confucian ethics has been weakened in China since 1949, many people still follow the teachings of Confucius, principally in China, Korea, and Japan. Confucianism teaches the importance of attaining personal salvation through right action. Although not a religion, Confucian ideology has become deeply embedded in the culture of these countries over the centuries and, through that, has an impact on the lives of many millions more.52 Confucianism is built around a comprehensive ethical code that sets down guidelines for relationships

LO 4 -2 Identify the forces that lead to differences in social culture.

LO 4 -3 Identify the business and economic implications of differences in culture.

LO 4 -2 Identify the forces that lead to differences in social culture.

110 Part 2 National Differences

with others. High moral and ethical conduct and loyalty to others are central to Confu- cianism. Unlike religions, Confucianism is not concerned with the supernatural and has little to say about the concept of a supreme being or an afterlife.

Economic Implications of Confucianism Some scholars maintain that Confucianism may have economic implications as profound as those Weber argued were to be found in Protestantism, although they are of a different nature.53 Their basic thesis is that the influence of Confucian ethics on the culture of China, Japan, South Korea, and Taiwan, by lowering the costs of doing business in those countries, may help explain their economic success. In this regard, three values central to the Confucian system of ethics are of particular interest: loyalty, reciprocal obligations, and honesty in dealings with others. In Confucian thought, loyalty to one’s superiors is regarded as a sacred duty—an absolute obligation. In modern organizations based in Confucian cultures, the loyalty that binds employees to the heads of their organization can reduce the conflict between management and labor that we find in more class-conscious societies. Cooperation between management and labor can be achieved at a lower cost in a culture where the virtue of loyalty is emphasized in the value systems. However, in a Confucian culture, loyalty to one’s superiors, such as a worker’s loyalty to management, is not blind loyalty. The concept of reciprocal obligations is important. Confucian ethics stresses that superiors are obliged to reward the loyalty of their subor- dinates by bestowing blessings on them. If these “blessings” are not forthcoming, then neither will be the loyalty. This Confucian ethic is central to the Chinese concept of guanxi, which refers to relationship networks supported by reciprocal obligations.54 Guanxi means relationships, although in business settings it can be better understood as connections. Today, Chinese will often cultivate a guanxiwang, or “relationship net- work,” for help. Reciprocal obligations are the glue that holds such networks together. If those obligations are not met—if favors done are not paid back or reciprocated—the reputation of the transgressor is tarnished, and the person will be less able to draw on his or her guanxiwang for help in the future. Thus, the implicit threat of social sanctions is often sufficient to ensure that favors are repaid, obligations are met, and relationships are honored. In a society that lacks a rule-based legal tradition, and thus legal ways of redressing wrongs such as violations of business agreements, guanxi is an important mechanism for building long-term business relationships and getting business done in China. For an example of the importance of guanxi, read the Management Focus on DMG-Shanghai. A third concept found in Confucian ethics is the importance attached to honesty. Confucian thinkers emphasize that although dishonest behavior may yield short-term benefits for the transgressor, dishonesty does not pay in the long run. The importance attached to honesty has major economic implications. When companies can trust each other not to break contractual obligations, the costs of doing business are lowered. Expensive lawyers are not needed to resolve contract disputes. In a Confucian society, people may be less hesitant to commit substantial resources to cooperative ventures than in a society where honesty is less pervasive. When companies adhere to Confucian ethics, they can trust each other not to violate the terms of cooperative agreements. Thus, the costs of achieving cooperation between companies may be lower in societies such as Japan relative to societies where trust is less pervasive. For example, it has been argued that the close ties between the automobile compa- nies and their component parts suppliers in Japan are facilitated by a combination of trust and reciprocal obligations. These close ties allow the auto companies and their suppliers to work together on a range of issues, including inventory reduction, quality control, and design. The competitive advantage of Japanese auto companies such as Toyota may in part be explained by such factors.55 Similarly, the combination of trust and reciprocal obligations is central to the workings and persistence of guanxi networks in China.

LO 4 -3 Identify the business and economic implications of differences in culture.

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M A NAG E M E N T F O C U S

DMG-Shanghai In 1993, New Yorker Dan Mintz moved to China as a free- lance film director with no contacts, no advertising experi- ence, and no Mandarin skills. By 2009, the company he subsequently founded in China, DMG, had emerged as one of China’s fastest-growing advertising agencies with a client list that includes Budweiser, Unilever, Sony, Nabisco, Audi, Volkswagen, China Mobile, and dozens of other Chinese brands. Mintz attributes his success in part to what the Chinese call guanxi. Guanxi literally means relationships, although in busi- ness settings it can be better understood as connections. Guanxi has its roots in the Confucian philosophy of valuing social hierarchy and reciprocal obligations. Confucian ide- ology has a 2,000-year-old history in China. Confucianism stresses the importance of relationships, both within the family and between master and servant. Confucian ideol- ogy teaches that people are not created equal. In Confu- cian thought, loyalty and obligations to one’s superiors (or to family) are regarded as a sacred duty, but at the same time, this loyalty has its price. Social superiors are obli- gated to reward the loyalty of their social inferiors by bestowing “blessings” upon them; thus, the obligations are reciprocal. Chinese will often cultivate a guanxiwang, or “relationship network,” for help. There is a tacit acknowl- edgment that if you have the right guanxi, legal rules can be broken, or at least bent. Mintz, who is now fluent in Mandarin, cultivated his guanxiwang by going into business with two young Chinese who had connections, Bing Wu and Peter Xiao. Wu, who works on the production side of the business, was a former national gymnastics champion, which trans- lates into prestige and access to business and govern- ment officials. Xiao comes from a military family with major political connections. Together, these three have been able to open doors that long-established Western adver- tising agencies could not. They have done it in large part by leveraging the contacts of Wu and Xiao and by backing up their connections with what the Chinese call Shi li, the ability to do good work.

A case in point was DMG’s campaign for Volkswagen, which helped the German company become ubiquitous in China. The ads used traditional Chinese characters, which had been banned by Chairman Mao during the cultural revolution in favor of simplified versions. To get permission to use the characters in film and print ads—a first in modern China—the trio had to draw on high-level government con- tacts in Beijing. They won over officials by arguing that the old characters should be thought of not as “characters” but as art. Later, they shot TV spots for the ad on Shanghai’s famous Bund, a congested boulevard that runs along the waterfront of the old city. Drawing again on government contacts, they were able to shut down the Bund to make the shoot. Steven Spielberg had been able to close down only a portion of the street when he filmed Empire of the Sun there in 1986. DMG has also filmed inside Beijing’s Forbidden City, even though it is against the law to do so. Using his contacts, Mintz persuaded the government to lift the law for 24 hours. As Mintz has noted, “We don’t stop when we come across regulations. There are restrictions everywhere you go. You have to know how get around them and get things done.” Today, DMG Entertainment is a Chinese-based produc- tion and distribution company. While it began as an adver- tising agency in 1993, the company started distributing non-Chinese movies in the Chinese market in the late 2000s (e.g., Iron Man 3, the sixth-highest-grossing film of all time in China) as well as producing Chinese films, the first being Founding of a Republic in 2009. This is a movie that marked the 60th anniversary of the People’s Republic of China. In these new activities, DMG is also enjoying guanxi in the country. Variety reported that DMG benefited from “strong connections” with Chinese government officials and the state-run China Film Group Corporation.

Sources: A. Busch, “China’s DMG and Valiant Entertainment Partner to Expand Superhero Universe,” Deadline Hollywood, March 12, 2015; J. Bryan, “The Mintz Dynasty,” Fast Company, April 2006, pp. 56–62; M. Graser, “Featured Player,” Variety, October 18, 2004, p. 6.; C. Coonan, “DMG’s Dan Mintz: Hollywood’s Man in China,” Variety, June 5, 2013.

Language

One obvious way in which many countries differ is language. By language, we mean both the spoken and the unspoken means of communication. Language is one of the defining characteristics of a culture.

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SPOKEN LANGUAGE

Language does far more than just enable people to communicate with each other. The nature of a language also structures the way we perceive the world. The language of a society can direct the attention of its members to certain features of the world rather than others. The classic illustration of this phenomenon is that whereas the English language has but one word for snow, the language of the Inuit (Eskimos) lacks a general term for it. Instead, because distinguishing different forms of snow is so important in the lives of the Inuit, they have 24 words that describe different types of snow (e.g., powder snow, falling snow, wet snow, drifting snow).56 Because language shapes the way people perceive the world, it also helps define culture. Countries with more than one language often have more than one culture. Canada has an English-speaking culture and a French-speaking culture. Tensions between the two can run quite high, with a substantial proportion of the French-speaking minority demanding independence from a Canada “dominated by English speakers.” The same phenomenon can be observed in many other countries. Belgium is divided into Flemish and French speakers, and tensions between the two groups exist; in Spain, a Basque- speaking minority with its own distinctive culture has been agitating for independence from the Spanish-speaking majority for decades; on the Mediterranean island of Cyprus, the culturally diverse Greek- and Turkish-speaking populations of the island engaged in open conflict in the 1970s, and the island is now partitioned into two parts. While it does not necessarily follow that language differences create differences in culture and, there- fore, separatist pressures (e.g., witness the harmony in Switzerland, where four languages are spoken), there certainly seems to be a tendency in this direction.57 Mandarin (Chinese) is the mother tongue of the largest number of people, followed by English and Hindi, which is spoken in India. However, the most widely spoken language in the world is English, followed by French, Spanish, and Mandarin (i.e., many people speak English as a second language). And, English is increasingly becoming the language of international business. When Japanese and German businesspeople get together to do business, it is almost certain that they will communicate in English. However, although English is widely used, learning the local language yields considerable advantages. Most people prefer to converse in their own language, and being able to speak the local language can build rapport and goodwill, which may be very important for a business deal. Inter- national businesses that do not understand the local language can make major blunders through improper translation. For example, the Sunbeam Corporation used the English words for its “Mist-Stick” mist-producing hair-curling iron when it entered the German market, only to discover after an expensive advertising campaign that mist means excrement in German. General Motors was troubled by the lack of enthusiasm among Puerto Rican dealers for its new Chevrolet Nova. When literally translated into Spanish, nova means star. However, when spoken it sounds like “no va,” which in Spanish means “it doesn’t go.” General Motors changed the name of the car to Caribe.58 Ford made a similar and somewhat embarrassing mistake in Brazil. The Ford Pinto may well have been a good car but the Brazilians wanted no part of a car called “pinto” which is slang for tiny male genitals in Brazil. Even the world’s largest furniture manufacturer, IKEA from Sweden, ran into branding issues when it named a plant pot “Jättebra” (which means great or superbly good in Swedish). Unfortunately, Jättebra resembles the Thai slang word for sex! As one final example, and there are numerous, of companies using product names, advertising slogans, and brand- ing campaigns that translate poorly, Pepsi’s slogan “come alive with the Pepsi Generation” did not quite work in China. People in China took it literally to mean “bring your ancestors back from the grave.”

UNSPOKEN LANGUAGE

Unspoken language refers to nonverbal communication. We all communicate with each other by a host of nonverbal cues. The raising of eyebrows, for example, is a sign of recog- nition in most cultures, while a smile is a sign of joy. Many nonverbal cues, however, are

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culturally bound. A failure to understand the nonverbal cues of another culture can lead to a communication failure. For example, making a circle with the thumb and the forefin- ger is a friendly gesture in the United States, but it is a vulgar sexual invitation in Greece and Turkey. Similarly, while most Americans and Europeans use the thumbs-up gesture to indicate that “it’s all right,” in Greece the gesture is obscene. Another aspect of nonverbal communication is personal space, which is the comfort- able amount of distance between you and someone you are talking with. In the United States, the customary distance apart adopted by parties in a business discussion is five to eight feet. In Latin America, it is three to five feet. Consequently, many North Americans unconsciously feel that Latin Americans are invading their personal space and can be seen backing away from them during a conversation. Indeed, the American may feel that the Latin is being aggressive and pushy. In turn, the Latin American may interpret such backing away as aloofness. The result can be a regrettable lack of rapport between two businesspeople from different cultures.

Education

Formal education plays a key role in a society. Formal education is the medium through which individuals learn many of the language, conceptual, and technical skills that are indispensable in a modern society. Formal education also supplements the family’s role in socializing the young into the values and norms of a society. Values and norms are taught both directly and indirectly. Schools generally teach basic facts about the social and politi- cal nature of a society. They also focus on the fundamental obligations of citizenship. Cultural norms are also taught indirectly at school. Respect for others, obedience to au- thority, honesty, neatness, being on time, and so on, are all part of the “hidden curriculum” of schools. The use of a grading system also teaches children the value of personal achievement and competition.59 From an international business perspective, one important aspect of education is its role as a determinant of national competitive advantage.60 The availability of a pool of skilled and knowledgeable workers is a major determinant of the likely economic success of a country. In analyzing the competitive success of Japan since 1945, for example, Michael Porter notes that after the war, Japan had almost nothing except for a pool of skilled and educated human resources:

With a long tradition of respect for education that borders on reverence, Japan possessed a large pool of literate, educated, and increasingly skilled human resources. . . . Japan has benefited from a large pool of trained engineers. Japanese universities graduate many more engineers per capita than in the United States. . . . A first-rate primary and secondary edu- cation system in Japan operates based on high standards and emphasizes math and science. Primary and secondary education is highly competitive. . . . Japanese education provides most students all over Japan with a sound education for later education and training. A Japanese high school graduate knows as much about math as most American college graduates.61

Porter’s point is that Japan’s excellent education system is an important factor explain- ing the country’s postwar economic success. Not only is a good education system a deter- minant of national competitive advantage, but it is also an important factor guiding the location choices of international businesses. The recent trend to outsource information technology jobs to India, for example, is partly due to the presence of significant numbers of trained engineers in India, which in turn is a result of the Indian education system. By the same token, it would make little sense to base production facilities that require highly skilled labor in a country where the education system was so poor that a skilled labor pool was not available, no matter how attractive the country might seem on other dimen- sions. It might make sense to base production operations that require only unskilled labor in such a country. The general education level of a country is also a good index of the kind of products that might sell in a country and of the type of promotional material that should be used.

LO 4 -2 Identify the forces that lead to differences in social culture.

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114 Part 2 National Differences

As a direct example, a country where more than 70 percent of the population is illiterate is unlikely to be a good market for popular books. But perhaps more importantly, promo- tional material containing written descriptions of mass-marketed products is unlikely to have an effect in a country where almost three-quarters of the population cannot read. It is far better to use pictorial promotions in such circumstances.

Culture and Business

Of considerable importance for an international business with operations in different countries is how a society’s culture affects the values found in the workplace. Manage- ment process and practices may need to vary according to culturally determined work- related values. For example, if the cultures of Brazil and Great Britain or the United States and Sweden result in different work-related values, an international business with operations in both countries should vary its management process and practices to account for these differences. The most famous study of how culture relates to values in the workplace was under- taken by Geert Hofstede.62 As part of his job as a psychologist working for IBM, Hofstede collected data on employee attitudes and values for more than 116,000 individuals in 1968 and 1972; respondents were matched on occupation, age, and gender. These data later on enabled him to compare dimensions of culture across 50 countries. Hofstede initially isolated four dimensions that he claimed summarized different cultures63— power distance, uncertainty avoidance, individualism versus collectivism, and masculinity versus femininity—and then in 1991 he added a fifth dimension inspired by Confucian- ism called long-term versus short-term orientation.64 The fifth dimension was added as a function of the data obtained via the Chinese Value Survey (CVS), an instrument developed by Michael Harris Bond based on discussions with Hofstede in relation to a joint article they wrote.65 Bond used input from “Eastern minds” as Hofstede called it to develop CVS. (Bond references Chinese scholars as helping him create the values that exemplify this new long-term versus short-term orientation.) In his original research, Bond called this new dimension “Confucian work dynamism” but Hofstede said that in practical terms the dimension refers to a long-term versus short-term orientation. Hofstede’s power distance dimension focused on how a society deals with the fact that people are unequal in physical and intellectual capabilities. According to Hofstede, high power distance cultures were found in countries that let inequalities grow over time into inequalities of power and wealth. Low power distance cultures were found in societ- ies that tried to play down such inequalities as much as possible. The individualism versus collectivism dimension focused on the relationship between the individual and his or her fellows. In individualistic societies, the ties between individuals were loose, and individual achievement and freedom were highly valued. In societies where collectivism was emphasized, the ties between individuals were tight. In such societies, people were born into collectives, such as extended families, and every- one was supposed to look after the interest of his or her collective. Hofstede’s uncertainty avoidance dimension measured the extent to which different cultures socialized their members into accepting ambiguous situations and tolerating un- certainty. Members of high uncertainty avoidance cultures placed a premium on job security, career patterns, retirement benefits, and so on. They also had a strong need for rules and regulations; the manager was expected to issue clear instructions, and subordi- nates’ initiatives were tightly controlled. Lower uncertainty avoidance cultures were characterized by a greater readiness to take risks and less emotional resistance to change. Hofstede’s masculinity versus femininity dimension looked at the relationship between gender and work roles. In masculine cultures, sex roles were sharply differentiated, and traditional “masculine values,” such as achievement and the effective exercise of power, determined cultural ideals. In feminine cultures, sex roles were less sharply distinguished, and little differentiation was made between men and women in the same job.

LO 4 - 4 Recognize how differences in social culture influence values in business.

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The long-term versus short-term orientation dimension refers to the extent to which a culture programs its citizens to accept delayed gratification of their material, social, and emotional needs. It captures attitudes toward time, persistence, ordering by status, protection of face, respect for tradition, and reciprocation of gifts and favors. The label refers to these “values” being derived from Confucian teachings. Hofstede created an index score for each of these five dimensions that ranged from 0 to 100 and scored high for high individualism, high power distance, high uncertainty avoidance, high masculinity, and high for long-term orientation.66 He averaged the score for all employees from a given country. Interestingly, there is movement to add a sixth dimension to Hofstede’s work. Geert Hofstede, working with Michael Minkov’s analysis of the World Values Survey, added a promising new dimension called indulgence versus restraint (IND) in 2010.67 On January 17, 2011, Hofstede delivered a webinar for SIETAR Europe, called “new software of the mind,” to introduce the third edition of Cultures and Organizations, in which the research results of Minkov were included to support this sixth dimension. In addition, in a keynote delivered at the annual meeting of the Acad- emy of International Business (http://aib.msu.edu) in Istanbul, Turkey, on July 6, 2013, Hofstede again presented results and theoretical rationale to support the indulgence ver- sus restraint dimension. Indulgence refers to a society that allows relatively free gratifi- cation of basic and natural human drives related to enjoying life and having fun. Restraint refers to a society that suppresses gratification of needs and regulates it by means of strict social norms. Table 4.1 summarizes data for 15 selected countries for the five established dimen- sions of individualism versus collectivism, power distance, uncertainty avoidance, mas- culinity versus femininity, and long-term versus short-term orientation (the Hofstede data

TA B L E 4 . 1

Work-Related Values for 15 Selected Countries

Source: From Geert Hofstede, “The Cultural Relativity of Organizational Practices and Theories,” Journal of Inter- national Business Studies 14 (Fall 1983), pp. 75–89. Reprinted by permission of Dr. Geert Hofstede.

Power Uncertainty Long-Term Distance Avoidance Individualism Masculinity Orientation Australia 36 51 90 61 31

Brazil 69 76 38 49 65

Canada 39 48 80 52 23

Germany (F.R.) 35 65 67 66 31

Great Britain 35 35 89 66 25

India 77 40 48 56 61

Japan 54 92 46 95 80

Netherlands 38 53 80 14 44

New Zealand 22 49 79 58 30

Pakistan 55 70 14 50 00

Philippines 94 44 32 64 19

Singapore 74 8 20 48 48

Sweden 31 29 71 5 33

Thailand 64 64 20 34 56

United States 40 46 91 62 29

116 Part 2 National Differences

were collected for 50 countries and the Bond data were collected for 23 countries; since those two researchers’ data collection, numerous other researchers have also added to the country samples). Western nations such as the United States, Canada, and Great Britain score high on the individualism scale and low on the power distance scale. At the other extreme are a group of Latin American and Asian countries that emphasize collectivism over individualism and score high on the power distance scale. Table 4.1 also reveals that Japan’s culture has strong uncertainty avoidance and high masculinity. This characteriza- tion fits the standard stereotype of Japan as a country that is male dominant and where uncertainty avoidance exhibits itself in the institution of lifetime employment. Sweden and Denmark stand out as countries that have both low uncertainty avoidance and low masculinity (high emphasis on “feminine” values). Hofstede’s results are interesting for what they tell us in a very general way about dif- ferences between cultures. Many of Hofstede’s findings are consistent with standard ste- reotypes about cultural differences. For example, many people believe Americans are more individualistic and egalitarian than the Japanese (they have a lower power distance), who in turn are more individualistic and egalitarian than Mexicans. Similarly, many might agree that Latin countries place a higher emphasis on masculine value—they are machismo cultures—than the Nordic countries of Denmark and Sweden. As might be expected, East Asian countries such as Japan and Thailand scored high on long-term orientation, while nations such as the United States and Canada scored low. Hofstede and his associates went on to argue that their evidence suggested that nations with higher economic growth rates scored high on long-term orientation and low on indi- vidualism—the implication being Confucianism is good for growth. However, subse- quent studies have shown that this finding does not hold up under more sophisticated statistical analysis.68 Since the economy has come back from the downturn in 2008, coun- tries with high individualism and short-term orientation such as the United States have attained high growth rates, while some Confucian cultures such as Japan have had stag- nant economic growth. However, we should be careful about reading too much into Hofstede’s research. It has been criticized on a number of points.69 First, Hofstede assumes there is a one-to-one cor- respondence between culture and the nation-state, but as we discussed earlier, many countries have more than one culture. Hofstede’s results do not capture this distinction. Second, the research may have been culturally bound. The research team was composed of Europeans and Americans. The questions they asked of IBM employees—and their analysis of the answers—may have been shaped by their own cultural biases and con- cerns. So it is not surprising that Hofstede’s results confirm Western stereotypes because it was Westerners who undertook the research. The later addition of the long-term versus short-term dimension illustrates this point. Third, Hofstede’s informants worked not only within a single industry, the computer industry, but also within one company, IBM. At the time, IBM was renowned for its own strong corporate culture and employee selection procedures, making it possible that the employees’ values were different in important respects from the values of the cultures from which those employees came. Also, certain social classes (such as unskilled manual workers) were excluded from Hofstede’s sample. A final caution is that Hofstede’s work is now beginning to look dated. Cultures do not stand still; they evolve, albeit slowly. What was a reasonable characterization in the late 1960s and early 1970s may not be so today. Still, just as it should not be accepted without question, Hofstede’s work should not be dismissed either. As such, it represents a starting point for managers trying to figure out how cultures differ and what that might mean for management practices. Also, several other scholars have found strong evidence that differences in culture affect values and practices in the workplace, and Hofstede’s basic results have been replicated using more diverse samples of individuals in different settings.70 Nevertheless, managers should use the results with caution. One reason for caution is the plethora of new cultural values surveys and data points that are starting to become important additions to Hofstede’s work. However, in many cases, they build on or are related to Hofstede’s tone-setting

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work. Two additional cultural values frameworks that have been examined and have been related to work-related and/or business-related issues are the Global Leadership and Or- ganizational Behavior Effectiveness Instrument and the World Values Survey. The Global Leadership and Organizational Behavior Effectiveness (GLOBE) instru- ment is designed to address the notion that a leader’s effectiveness is contextual.71 It is embedded in the societal and organizational norms, values, and beliefs of the people be- ing led. The initial GLOBE findings from 62 societies involving 17,300 middle managers from 951 organizations build on findings by Hofstede and other culture researchers. The GLOBE research established nine cultural dimensions: power distance, uncertainty avoidance, humane orientation, institutional collectivism, in-group collectivism, asser- tiveness, gender egalitarianism, future orientation, and performance orientation. The World Values Survey (WVS) is a research project spanning more than 100 coun- tries that explores people’s values and norms, how they change over time, and what im- pact they have in society and business.72 The WVS includes dimensions for support for democracy; tolerance of foreigners and ethnic minorities; support for gender equality; the role of religion and changing levels of religiosity; the impact of globalization; attitudes toward the environment, work, family, politics, national identity, culture, diversity, and insecurity; and subjective well-being. Despite Hofstede’s work along with findings from GLOBE, WVS, and others, culture is just one of many factors that might influence the economic success of a nation. While culture’s importance should not be ignored, neither should it be overstated. The Hofstede framework is the most significant and studied framework of culture as it relates to work values and business that we have ever seen. But some of the newer culture frameworks (e.g., GLOBE, WVS) are also becoming popular in the literature, and they have potential to complement and perhaps even supplant Hofstede’s work with additional validation and connection to work-related values, business, and marketplace issues. At the same time, the factors discussed in Chapters 2 and 3—economic, political, and legal systems—are probably more important than culture in explaining differential economic growth rates over time.

Cultural Change

An important point we want to make in this chapter on culture is that culture is not a constant; it evolves over time.73 Changes in value systems can be slow and painful for a society. In the 1960s, for example, American values toward the role of women, love, sex, and marriage underwent significant changes. Much of the social turmoil of that time re- flected these changes. Change, however, does occur and can often be quite profound. At the beginning of the 1960s, the idea that women might hold senior management positions in major corporations was not widely accepted. Many scoffed at the idea. Today, it is a reality. For example, in 2012 Virginia ("Ginny") Rometty became the CEO of IBM; Marissa Mayer became CEO of Yahoo! in 2012; and Mary Teresa Barra became the CEO of Gen- eral Motors in 2014. Barra, as but one of many examples (in 2015, 23 of the CEO posi- tions at S&P 500 companies were held by women), was named to the Time 100 and  Forbes  named her one of the World's 100 Most Powerful Women. No one in the mainstream of American society now questions the development or the capability of women in the business world. American culture has changed (although it is still more dif- ficult for women to gain senior management positions than men). For another illustration of cultural change, consider Japan. Some academics argue that a major cultural shift has been occurring in Japan, with a move toward greater individual- ism.74 The model Japanese office worker, or “salaryman,” is characterized as being loyal to his boss and the organization to the point of giving up evenings, weekends, and vaca- tions to serve the organization, which is the collective the employee is a member of. How- ever, a new generation of office workers may not fit this model. An individual from the

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LO 4 -5 Demonstrate an apprecia- tion for the economic and business implications of cultural change.

118 Part 2 National Differences

new generation is likely to be more direct than the traditional Japanese. He acts more like a Westerner, a gaijin. He does not live for the company and will move on if he gets the offer of a better job. He is not keen on overtime, especially if he has a date. He has his own plans for his free time, and they may not include drinking or playing golf with the boss.75 Several studies have suggested that economic advancement and globalization may be important factors in societal change.76 There is evidence that economic progress is ac- companied by a shift in values away from collectivism and toward individualism.77 Thus, as Japan has become richer, the cultural emphasis on collectivism has declined and greater individualism is being witnessed. One reason for this shift may be that richer so- cieties exhibit less need for social and material support structures built on collectives, whether the collective is the extended family or the paternalistic company. People are better able to take care of their own needs. As a result, the importance attached to col- lectivism declines, while greater economic freedoms lead to an increase in opportunities for expressing individualism. The culture of societies may also change as they become richer because economic progress affects a number of other factors, which in turn influence culture. For example, increased urbanization and improvements in the quality and availability of education are both a function of economic progress, and both can lead to declining emphasis on the traditional values associated with poor rural societies. The World Values Survey, which we mentioned earlier, has documented how values change. The study linked these changes in values to changes in a country’s level of economic development.78 According to this research, as countries get richer, a shift occurs away from “traditional values” linked to religion, family, and country, and toward “secular rational” values. Traditional- ists say religion is important in their lives. They have a strong sense of national pride; they also think that children should be taught to obey and that the first duty of a child is to make his or her parents proud. They say abortion, euthanasia, divorce, and suicide are never justified. At the other end of this spectrum are secular rational values. Another category in the World Values Survey is quality of life attributes. At one end of this spectrum are “survival values,” the values people hold when the struggle for survival is of paramount importance. These values tend to stress that economic and physical secu- rity are more important than self-expression. People who cannot take food or safety for granted tend to be xenophobic, are wary of political activity, have authoritarian tenden- cies, and believe that men make better political leaders than women. “Self-expression” or “well-being” values stress the importance of diversity, belonging, and participation in political processes. As countries get richer, there seems to be a shift from “traditional” to “secular ratio- nal” values, and from “survival values” to “well-being” values. The shift, however, takes time, primarily because individuals are socialized into a set of values when they are young and find it difficult to change as they grow older. Substantial changes in values are linked to generations, with younger people typically being in the vanguard of a signifi- cant change in values. With regard to globalization, some have argued that advances in transportation and communication technologies; the dramatic increase in trade that we have witnessed since World War II; and the rise of global corporations such as Hitachi, Disney, Microsoft, IBM, Google, and Levi Strauss (whose products and operations can be found around the globe) are helping create conditions for the merging or convergence of cultures.79 With McDonald’s hamburgers in China, The Gap in India, iPods in South Africa, and MTV everywhere helping foster a ubiquitous youth culture, and with countries around the world climbing the ladder of economic progress, some argue that the conditions for less cultural variation have been created. There may be, in other words, a slow but steady convergence occurring across different cultures toward some universally accepted values and norms: This is known as the convergence hypothesis.80 Having said this, we must not ignore important countertrends, such as the shift toward Islamic fundamentalism in several countries; the continual separatist movement in Quebec,

Mary T. Barra became the chief executive officer (CEO) of General Motors (GM) on January 15, 2014. She is the first CEO of a major global automaker. Source: © Andrew Harrer/ Bloomberg/Getty Images

Differences in Culture Chapter 4 119

Canada; or ethnic strains and separatist movements in Russia. Such countertrends in many ways are a reaction to the pressures for cultural convergence. In an increasingly modern and materialistic world, some societies are trying to reemphasize their cultural roots and uniqueness. Cultural change is not unidirectional, with national cultures con- verging toward some homogeneous global entity. It is also important to note that while some elements of culture change quite rapidly—particularly the use of material sym- bols—other elements change slowly if at all. Thus, just because people the world over wear jeans, eat at McDonald’s, use smartphones, watch their national version of Ameri- can Idol, and drive Ford cars to work, we should not assume that they have also adopted American (or Western) values—for often they have not.81 To illustrate, consider that many Westerners eat Chinese food, watch Chinese martial arts movies, and take classes in kung fu, but their values are still those of Westerners. Thus, a distinction needs to be made between the visible material aspects of culture and the deep structure, particularly core social values and norms. The deep structure changes only slowly, and differences here are often far more persistent than we might suppose.

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F O C U S O N M A NAG E R I A L I M P L I C AT I O N S

CROSS-CULTURAL LITERACY AND COMPETITIVE ADVANTAGE International business is different from national business because countries and soci-

eties are different. In this chapter, we have seen just how different societies can be. Societies differ because their cultures vary. Their cultures vary because of pro-

found differences in social structure, religion, language, education, economic phi- losophy, and political philosophy. Three important implications for international business flow from these differences. The first is the need to develop cross-

cultural literacy. There is a need not only to appreciate that cultural differences exist but also to appreciate what such differences mean for international business. A

second implication centers on the connection between culture and national competitive advantage. A third implication looks at the connection between culture and ethics in decision making. In this section, we explore the first two of these issues in depth. The connection between culture and ethics is explored in the next chapter.

CROSS-CULTURAL LITERACY One of the biggest dangers confronting a company that goes abroad for the first time is the danger of being ill-informed. International businesses that are ill-informed about the prac- tices of another culture are likely to fail. Doing business in different cultures requires adapta- tion to conform to the value systems and norms of that culture. Adaptation can embrace all aspects of an international firm’s operations in a foreign country. The way in which deals are negotiated, the appropriate incentive pay systems for salespeople, the structure of the orga- nization, the name of a product, the tenor of relations between management and labor, the manner in which the product is promoted, and so on, are all sensitive to cultural differences. What works in one culture might not work in another (see the opening case on Best Buy and eBay in China, for example). To combat the danger of being ill-informed, international businesses should consider em- ploying local citizens to help them do business in a particular culture. They must also ensure that home-country executives are cosmopolitan enough to understand how differences in culture affect the practice of business. Transferring executives overseas at regular intervals to expose them to different cultures will help build a cadre of cosmopolitan executives. An inter- national business must also be constantly on guard against the dangers of ethnocentric

120 Part 2 National Differences

behavior. Ethnocentrism is a belief in the superiority of one’s own ethnic group or culture. Hand in hand with ethnocentrism goes a disregard or contempt for the culture of other coun- tries. Unfortunately, ethnocentrism is all too prevalent; many Americans are guilty of it, as are many French people, Japanese people, British people, and so on. Ugly as it is, ethnocentrism is a fact of life, one that international businesses must be on guard against. Simple examples illustrate how important cross-cultural literacy can be. Anthropologist Edward T. Hall has described how Americans, who tend to be informal in nature, react strongly to being corrected or reprimanded in public.82 This can cause problems in Germany, where a cultural tendency toward correcting strangers can shock and offend most Americans. For their part, Germans can be a bit taken aback by the tendency of Americans to call people by their first name. This is uncomfortable enough among executives of the same rank, but it can be seen as insulting when a young and junior American executive ad- dresses an older and more senior German manager by his first name without having been invited to do so. Hall concludes it can take a long time to get on a first-name basis with a German; if you rush the process, you will be perceived as overfriendly and rude—and that may not be good for business. Hall also notes that cultural differences in attitude to time can cause myriad problems. He notes that in the United States, giving a person a deadline is a way of increasing the urgency or relative importance of a task. However, in the Middle East, giving a deadline can have ex- actly the opposite effect. The American who insists an Arab business associate make his mind up in a hurry is likely to be perceived as overly demanding and exerting undue pressure. The result may be exactly the opposite of what the American intended, with the Arab going slow as a reaction to the American’s arrogance and rudeness. For his part, the American may believe that an Arab associate is being rude if he shows up late to a meeting because he met a friend in the street and stopped to talk. The American, of course, is very concerned about time and scheduling. But for the Arab, who lives in a society where social networks are a major source of information and maintaining relationships is important, finishing the discussion with a friend is more important than adhering to a strict schedule. Indeed, the Arab may be puzzled as to why the American attaches so much importance to time and schedule.

CULTURE AND COMPETITIVE ADVANTAGE One theme that surfaces in this chapter is the relationship between culture and national competitive advantage.83 Put simply, the value systems and norms of a country influence the costs of doing business in that country. The costs of doing business in a country influence the ability of firms to establish a competitive advantage in the global marketplace. We have seen how attitudes toward cooperation between management and labor, toward work, and toward the payment of interest are influenced by social structure and religion. It can be ar- gued that the class-based conflict between workers and management in class-conscious societies, when it leads to industrial disruption, raises the costs of doing business in that society. Similarly, we have seen how some sociologists have argued that the ascetic “other- worldly” ethics of Hinduism may not be as supportive of capitalism as the ethics embedded in Protestantism and Confucianism. Also, Islamic laws banning interest payments may raise the costs of doing business by constraining a country’s banking system. Japan presents an interesting case study of how culture can influence competitive ad- vantage. Some scholars have argued that the culture of modern Japan lowers the costs of doing business relative to the costs in most Western nations. Japan’s emphasis on group affiliation, loyalty, reciprocal obligations, honesty, and education all boost the competitive- ness of Japanese companies. The emphasis on group affiliation and loyalty encourages in- dividuals to identify strongly with the companies in which they work. This tends to foster an ethic of hard work and cooperation between management and labor “for the good of the company.” Similarly, reciprocal obligations and honesty help foster an atmosphere of trust between companies and their suppliers. This encourages them to enter into long-term rela- tionships with each other to work on inventory reduction, quality control, and design—all of which have been shown to improve an organization’s competitiveness. This level of cooperation has often been lacking in the West, where the relationship between a company

Differences in Culture Chapter 4 121

and its suppliers tends to be a short-term one structured around competitive bidding rather than one based on long-term mutual commitments. In addition, the availability of a pool of highly skilled labor, particularly engineers, has helped Japanese enterprises develop cost- reducing process innovations that have boosted their productivity.84 Thus, cultural factors may help explain the success enjoyed by many Japanese businesses in the global market- place. Most notably, it has been argued that the rise of Japan as an economic power during the second half of the twentieth century may be in part attributed to the economic conse- quences of its culture.85

It also has been argued that the Japanese culture is less supportive of entrepreneurial activity than, say, American society. In many ways, entrepreneurial activity is a product of an individualistic mindset, not a classic characteristic of the Japanese. This may explain why American enterprises, rather than Japanese corporations, dominate industries where entre- preneurship and innovation are highly valued, such as computer software and biotechnol- ogy. Of course, obvious and significant exceptions to this generalization exist. Masayoshi Son recognized the potential of software far faster than any of Japan’s corporate giants; set up his company, Softbank, in 1981; and over the past 30 years has built it into Japan’s top software distributor. Similarly, dynamic entrepreneurial individuals established major Japa- nese companies such as Sony and Matsushita. But these examples may be the exceptions that prove the rule, for as yet there has been no surge in entrepreneurial high-technology enterprises in Japan equivalent to what has occurred in the United States. For international business, the connection between culture and competitive advantage is important for two reasons. First, the connection suggests which countries are likely to pro- duce the most viable competitors. For example, we might argue that U.S. enterprises are likely to see continued growth in aggressive, cost-efficient competitors from those Pacific Rim nations where a combination of free market economics, Confucian ideology, group-oriented social structures, and advanced education systems can all be found (e.g., South Korea, Taiwan, Japan, and, increasingly, China). Second, the connection between culture and competitive advantage has important impli- cations for the choice of countries in which to locate production facilities and do business. Consider a hypothetical case when a company has to choose between two countries, A and B, for locating a production facility. Both countries are characterized by low labor costs and good access to world markets. Both countries are of roughly the same size (in terms of population), and both are at a similar stage of economic development. In country A, the edu- cation system is undeveloped, the society is characterized by a marked stratification be- tween the upper and lower classes, and there are six major linguistic groups. In country B, the education system is well developed, social stratification is lacking, group identification is valued by the culture, and there is only one linguistic group. Which country makes the best investment site? Country B probably does. In country A, conflict between management and labor, and between different language groups, can be expected to lead to social and industrial disrup- tion, thereby raising the costs of doing business.86 The lack of a good education system also can be expected to work against the attainment of business goals. The same kind of comparison could be made for an international business trying to de- cide where to push its products, country A or B. Again, country B would be the logical choice because cultural factors suggest that in the long run, country B is the nation most likely to achieve the greatest level of economic growth. But as important as culture is to people, companies, and society, it is probably less impor- tant than economic, political, and legal systems in explaining differential economic growth between nations. Cultural differences are significant, but we should not overemphasize their importance in the economic sphere. For example, earlier we noted that Max Weber argued that the ascetic principles embedded in Hinduism do not encourage entrepreneurial activity. While this is an interesting academic thesis, recent years have seen an increase in entrepre- neurial activity in India, particularly in the information technology sector, where India is rap- idly becoming an important global player. The ascetic principles of Hinduism and caste-based social stratification have apparently not held back entrepreneurial activity in this sector.

122 Part 2 National Differences

cross-cultural literacy, p. 92 culture, p. 93 values, p. 93 norms, p. 93 society, p. 93 folkways, p. 94 mores, p. 95 social structure, p. 96

group, p. 97 social strata, p. 99 social mobility, p. 99 caste system, p. 99 class system, p. 99 class consciousness, p. 101 religion, p. 102 ethical systems, p. 102

power distance, p. 114 individualism versus

collectivism, p. 114 uncertainty avoidance, p. 114 masculinity versus femininity, p. 114 long-term versus short-term

orientation, p. 115 ethnocentrism, p. 120

Key Terms

C H A P T E R S U M M A R Y

This chapter looked at the nature of social culture and studied some implications for business practice. The chapter made the following points:

1. Culture is a complex whole that includes knowl- edge, beliefs, art, morals, law, customs, and other capabilities acquired by people as members of society.

2. Values and norms are the central components of a culture. Values are abstract ideals about what a so- ciety believes to be good, right, and desirable. Norms are social rules and guidelines that pre- scribe appropriate behavior in particular situations.

3. Values and norms are influenced by political and economic philosophy, social structure, religion, language, and education.

4. The social structure of a society refers to its basic social organization. Two main dimensions along which social structures differ are the individual– group dimension and the stratification dimension.

5. In some societies, the individual is the basic building block of social organization. These so- cieties emphasize individual achievements above all else. In other societies, the group is the basic building block of social organization. These so- cieties emphasize group membership and group achievements above all else.

6. All societies are stratified into different classes. Class-conscious societies are characterized by low social mobility and a high degree of stratifi- cation. Less class-conscious societies are charac- terized by high social mobility and a low degree of stratification.

7. Religion may be defined as a system of shared beliefs and rituals that is concerned with the realm of the sacred. Ethical systems refer to a set

of moral principles, or values, that are used to guide and shape behavior. The world’s major re- ligions are Christianity, Islam, Hinduism, and Buddhism. Although not a religion, Confucian- ism has an impact on behavior that is as pro- found as that of many religions. The value systems of different religious and ethical systems have different implications for business practice.

8. Language is one defining characteristic of a cul- ture. It has both spoken and unspoken dimen- sions. In countries with more than one spoken language, we tend to find more than one culture.

9. Formal education is the medium through which individuals learn skills and are socialized into the values and norms of a society. Education plays an important role in the determination of national competitive advantage.

10. Geert Hofstede studied how culture relates to values in the workplace. He isolated five dimen- sions that he claimed summarized different cul- tures: power distance, uncertainty avoidance, individualism versus collectivism, masculinity versus femininity, and long-term versus short- term orientation.

11. Culture is not a constant; it evolves. Economic progress and globalization seem to be two im- portant engines of cultural change.

12. One danger confronting a company that goes abroad for the first time is being ill-informed. To develop cross-cultural literacy, international busi- nesses need to employ host-country nationals, build a cadre of cosmopolitan executives, and guard against the dangers of ethnocentric behavior.

13. The value systems and norms of a country can affect the costs of doing business in that country.

Differences in Culture Chapter 4 123

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. Outline why the culture of a country might influ- ence the costs of doing business in that country. Illustrate your answer with examples.

2. Do you think that business practices in an Islamic country are likely to differ from busi- ness practices in a Christian country? If so, how?

3. What are the implications for international busi- ness of differences in the dominant religion or ethical system of a country?

4. Choose two countries that appear to be cultur- ally diverse. Compare the cultures of those countries, and then indicate how cultural differ- ences influence (a) the costs of doing business in each country, (b) the likely future economic development of that country, and (c) business practices.

5. Reread the Country Focus about Islamic capi- talism in Turkey. Then answer the following questions: a. Can you see anything in the values and

norms of Islam that is hostile to business?

b. What does the experience of the region around Kayseri teach about the relationship between Islam and business?

c. What are the implications of Islamic values to- ward business for the participation of a country such as Turkey in the global economy or be- coming a member of the European Union?

6. Reread the Management Focus on DMG- Shanghai and answer the follow questions: a. Why do you think it is so important to culti-

vate guanxi and guanxiwang in China? b. What does the experience of DMG tells us

about the way things work in China? What would likely happen to a business that obeyed all the rules and regulations, rather than trying to find a way around them as Dan Mintz apparently does?

c. What ethical issues might arise when draw- ing on guanxiwang to get things done in China? What does this suggest about the lim- its of using guanxiwang for a Western busi- ness committed to high ethical standards?

r e s e a r c h t a s k g l o b a l E D G E . m s u . e d u

Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises:

1. You are preparing for a business trip to Chile where you will need to interact extensively with local professionals. Therefore, you would like to collect information regarding local cul- ture and business practices prior to your depar- ture. A colleague from Latin America recommends you visit the “Centre for Intercul- tural Learning” and read through the country insights provided for Chile. Prepare a short description of the most striking cultural

characteristics that may affect business interac- tions in this country.

2. Typically, cultural factors drive the differences in business etiquette encountered during international business travel. In fact, Middle Eastern cultures ex- hibit significant differences in business etiquette when compared to Western cultures. Prior to leav- ing for your first business trip to the region, a col- league informed you that a guide named Business Etiquette around the World may help you. Using this guide, identify five tips regarding business eti- quette in the Middle Eastern country of your choice.

The United Arab Emirates (UAE) was established in 1971 and is a country located in the Middle East. The country is often called “the Emirates” or simply “UAE.”

UAE borders the Gulf of Oman and the Persian Gulf. Neighboring countries include Oman and Saudi Arabia, and UAE also shares sea borders with Quatar, Iran, and

C L O S I N G C A S E

World Expo 2020 in Dubai, UAE

124 Part 2 National Differences

Pakistan. Strategically, UAE is in an important location along the southern approaches to the Strait of Hormuz, a transit point for the world’s crude oil. UAE is also in the top 10 countries for the largest oil reserves in the world. The geography of UAE includes lots of rolling sand dunes of desert and also mountains in the eastern part of the country. The government consists of a federation with specified powers delegated to the UAE federal govern- ment and other powers reserved to the member emirates (equivalent to principalities). The chief of state is the pres- ident and the head of government is the prime minister. UAE has an open-market economy in which the prices of products and services are set using a free price system. The foundation for this market economy lies in the col- laboration between the seven emirates that are part of the UAE. They include the emirates of Abu Dhabi, Ajman, Dubai, Fujairah, Ras al-Khaimah, Sharjah, and Umm al- Quwain. Each emirate is governed by a hereditary emir, similar to succession planning in countries with royalty (king or queen) as the head of state. These emirs jointly make up the Federal Supreme Council, which serves as the highest legislative and executive body in the UAE. One of the seven emirs is selected as the president of the United Arab Emirates. The capital of the country is Abu Dhabi, Islam is the official religion, and Arabic is the of- ficial language. Most people have heard of Abu Dhabi and Dubai because they are the country’s centers of com- mercial and cultural activities. Dubai is UAE’s most pop- ulous city, with more than 2 million people, and it has emerged as a true global city with an eclectic cultural makeup. It also has a strategic location as a business gate- way for the Middle East and Africa for multinational en- terprises from all of the world’s continents. Dubai has frequently been rated as one of the best places to live in the Middle East (although it is also one of the most expensive). The emirate of Dubai has been ruled by the Al Maktoum family since 183; the emirate is considered a constitutional monarchy. In 2013, the Norway-based Global Network for Rights and Develop- ment ranked UAE as the 14th country in its annual Inter- national Human Rights Indicator report. This was a first among Arab countries, with the next Arab country on the list, Tunisia, at a distant 72nd place. Only about 10 per- cent of the population in Dubai are Arabs, with the re- maining 90 percent being expatriates. Most of the expatriates are from Asia, with India (50 percent) and Pakistan (16 percent) prominently featured. The largest group of Westerners is from the United Kingdom. With this eclectic cultural background, Dubai’s bid to host the World Expo 2020 with a theme of “connecting minds, creating the future” makes sense both logically and strategically. The theme resonates well with issues related to culture. In essence, the theme illustrates and acknowledges differences in culture (as does this chap- ter), and the theme supports the notion that we strive to

emphasize similarities across the globe. Today, multina- tional enterprises have to evaluate their core uniqueness and how they can leverage this strategic uniqueness in the global marketplace. The leveraging of the uniqueness typically requires a focus on similarities across cultures instead of differences. Connecting minds is a great way to illustrate how people, companies, and countries can stress the importance of looking for similarities first and then focus on the similarities that outweigh the differ- ences in creating strategic options. As with any World Expo, the expectation is that the world will be treated to an important event in the year 2020 in Dubai. The Expo on “connecting minds, creating the future” will span six months, following World Expo 2015 in Milan, Italy, and World Expo 2017 in Astana, Kazakhstan. The expectation is also that countries will showcase who they are and what they can do in the spirit of today’s era of “nation branding.” Tracing history, the best-known first World Expo was held in the Crystal Pal- ace in Hyde Park, London (United Kingdom), in 1851 under the title “Great Exhibition of the Works of Indus- try of All Nations.” Since 1928, the Bureau International des Expositions (International Exhibitions Bureau) has served as an international sanctioning body for the World Expo. These Expo showcases have generally gone through three eras: the era of industrialization (1851– 1938), the era of cultural exchange (1939–1987), and the era of nation branding (1988–present). The theme for Dubai’s World Expo 2020 is a direct connection to its cultural values and beliefs in facilitating connections and pioneering new ideas. The organizers expect 70 percent of the 25 million visitors to originate outside UAE, making it the most globally oriented World Expo in its long history. The idea is that the global com- munity will come together and explore creative and pio- neering solutions to three key drivers of global development: sustainability, mobility, and opportunity. As viewed by the World Expo 2020 organizing team, sustainability centers on lasting sources of energy and water. Mobility focuses on smart systems of logistics and transportation. And opportunity refers to new paths to economic development. Sources: Expo 2020, http://expo2020dubai.ae/en, accessed March 5, 2014; globalEDGE—United Arab Emirates, globaledge.msu.edu/countries/ united-arab-emirates, accessed March 5, 2014; A. Ahmed, “After Winning Expo, Emirate Fumes at Allies It Says Didn’t Back It,” The New York Times, January 6, 2014; S. Potter, “Expo 2020 Win to Boost Dubai Sukuk on Spending: Islamic Finance,” Bloomberg Businessweek, November 27, 2013; “Dubai—It’s Bouncing Back,” The Economist, November 23, 2013.

C a s e D i s c u s s i o n Q u e s t i o n s 1. What forces shaped the culture in the country

of UAE and Dubai in particular? How similar or different are these forces from those that shaped the culture of Western nations?

Differences in Culture Chapter 4 125

2. What kinds of misunderstandings, if any, are likely to arise between Western-based visitors and people from the UAE during World Expo 2020?

3. If you were in a position to advise a Western company that was considering doing business

in UAE for the first time, what would your advice be?

4. Using Dubai as an example, do you believe that cultural similarities among people can outweigh cultural differences that exist in terms of doing business together in the future?

E n d n o t e s

1. D. Barry, Exporters! The Wit and Wisdom of Small Business- people Who Sell Globally (Washington, DC: International Trade Administration, U.S. Department of Commerce, 2013); T. Hult, D. Ketchen, D. Griffith, C. Finnegan, T. Padron- Gonzalez, F. Harmancioglu, Y. Huang, M. Talay, and S. Cavusgil, “Data Equivalence in Cross-Cultural International Business Research: Assessment and Guidelines,” Journal of International Business Studies, 2008, pp. 1027–44; and S. Ronen and O. Shenkar, “Mapping World Cultures: Cluster Formation, Sources, and Implications,” Journal of Interna- tional Business Studies, 2013, pp. 867–97.

2. This is a point made effectively by K. Leung, R. S. Bhagat, N. R. Buchan, M. Erez, and C. B. Gibson, “Culture and Inter- national Business: Recent Advances and Their Implications for Future Research,” Journal of International Business Studies, 2005, pp. 357–78. Several research articles and books also sup- port the notion that significant cultural differences still exist in the world; for example, T. Hult, D. Closs, and D. Frayer, Global Supply Chain Management: Leveraging Processes, Measure- ments, and Tools for Strategic Corporate Advantage (New York: McGraw-Hill, 2014).

3. M. Y. Brannen, “When Micky Loses Face: Recontextualiza- tion, Semantic Fit, and the Semiotics of Foreignness,” Academy of Management Review, 2004, pp. 593–616.

4. See R. Dore, Taking Japan Seriously (Stanford, CA: Stanford University Press, 1987).

5. Data come from J. Monger, “International Comparison of Labor Disputes in 2004,” Labor Market Trends, April 2006, pp. 117–28.

6. E. B. Tylor, Primitive Culture (London: Murray, 1871). 7. F. Kluckhohn and F. Strodtbeck, Variations in Value Orienta-

tions (Evanston, IL: Row, Peterson, 1961); C. Kluckhohn, “Values and Value Orientations in the Theory of Action,” in T. Parsons and E. A. Shils (Eds.), Toward a General Theory of Action (Cambridge, MA: Harvard University Press, 1951).

8. M. Rokeach, The Nature of Human Values (New York: Free Press, 1973); S. Schwartz, “Universals in the Content and Structure of Values: Theory and Empirical Tests in 20 Coun- tries,” in M. Zanna (Ed.), Advances in Experimental Social

Psychology, Vol. 25, pp. 1–65 (New York: Academic Press, 1992).

9. G. Hofstede, Culture’s Consequences: International Differ- ences in Work-Related Values (Beverly Hills, CA: Sage, 1984), p. 21.

10. J. Z. Namenwirth and R. B. Weber, Dynamics of Culture (Boston: Allen & Unwin, 1987), p. 8.

11. R. Mead, International Management: Cross-Cultural Dimensions (Oxford: Blackwell Business, 1994), p. 7.

12. G. Hofstede, Culture’s Consequences: Comparing Values, Beliefs, Behaviors, Institutions and Organizations Across Nations (Thousand Oaks, CA: Sage, 2001).

13. E. T. Hall and M. R. Hall, Understanding Cultural Differences (Yarmouth, ME: Intercultural Press, 1990).

14. E. T. Hall and M. R. Hall, Hidden Differences: Doing Business with the Japanese (New York: Doubleday, 1987).

15. B. Keillor and T. Hult, “A Five-Country Study of National Identity: Implications for International Marketing Research and Practice,” International Marketing Review, 1999, pp. 65–82; T. Clark, “International Marketing and National Character: A Review and Proposal for an Integrative Theory,” Journal of Marketing, 1990, pp. 66–79; M. E. Porter, The Com- petitive Advantage of Nations (New York: Free Press, 1990).

16. S. P. Huntington, The Clash of Civilizations (New York: Simon & Schuster, 1996).

17. F. Vijver, D. Hemert, and Y. Poortinga, Multilevel Analysis of Individuals and Cultures (New York: Taylor & Francis, 2010).

18. M. Thompson, R. Ellis, and A. Wildavsky, Cultural Theory (Boulder, CO: Westview Press, 1990).

19. M. Douglas, In the Active Voice (London: Routledge, 1982), pp. 183–254.

20. L. Zucker and M. Darby, “Star-Scientist Linkages to Firms in APEC and European Countries: Indicators of Regional Institu- tional Differences Affecting Competitive Advantage,” Interna- tional Journal of Biotechnology, 1999, pp. 119–131.

21. C. Nakane, Japanese Society (Berkeley: University of California Press, 1970).

126 Part 2 National Differences

22. Ibid. 23. For details, see M. Aoki, Information, Incentives, and Bar-

gaining in the Japanese Economy (Cambridge, UK: Cambridge University Press, 1988); and M. L. Dertouzos, R. K. Lester, and R. M. Solow, Made in America (Cambridge, MA: MIT Press, 1989).

24. Global Innovation Barometer 2013 is a product by Ideas Lab and supported by General Electric (GE). The GE Global Innovation Barometer explores how business leaders around the world view innovation and how those perceptions are influ- encing business strategies in an increasingly complex and glo- balized environment. It is the largest global survey of business executives dedicated to innovation. GE expanded the global study in 2013, surveying more than 3,000 executives in 25 countries, www.ideaslaboratory.com/projects/ innovation-barometer-2013/.

25. P. Skarynski and R. Gibson, Innovation to the Core: A Blue- print for Transforming the Way Your Company Innovates (Boston, MA: Harvard Business School Press, 2008); L. Edvinsson and M. Malone, Intellectual Capital: Realizing Your Company’s True Value by Finding Its Hidden Brainpower (New York: Harper Collins, 1997); T. Davenport and L. Prusak, Working Knowledge: How Organizations Manage What They Know (Boston, MA: Harvard Business School Press, 1998).

26. G. Macionis and L. John, Sociology (Toronto, Ontario: Pearson Canada Inc., 2010), pp. 224–25.

27. E. Luce, The Strange Rise of Modern India (Boston: Little, Brown, 2006); D. Pick and K. Dayaram, “Modernity and Tra- dition in the Global Era: The Re-invention of Caste in India,” International Journal of Sociology and Social Policy, 2006, pp. 284–301.

28. For an excellent historical treatment of the evolution of the English class system, see E. P. Thompson, The Making of the English Working Class (London: Vintage Books, 1966). See also R. Miliband, The State in Capitalist Society (New York: Basic Books, 1969), especially Chapter 2. For more recent studies of class in British societies, see Stephen Brook, Class: Knowing Your Place in Modern Britain (London: Victor Gollancz, 1997); A. Adonis and S. Pollard, A Class Act: The Myth of Britain’s Classless Society (London: Hamish Hamilton, 1997); J. Gerteis and M. Savage, “The Salience of Class in Britain and America: A Comparative Analysis,” British Journal of Sociology, June 1998.

29. Adonis and Pollard, A Class Act. 30. J. H. Goldthorpe, “Class Analysis and the Reorientation of

Class Theory: The Case of Persisting Differentials in Education Attainment,” British Journal of Sociology, 2010, pp. 311–35.

31. Y. Bian, “Chinese Social Stratification and Social Mobility,” Annual Review of Sociology 28 (2002), pp. 91–117.

32. N. Goodman, An Introduction to Sociology (New York: Harper Collins, 1991).

33. O. C. Ferrell, J. Fraedrich, and L. Ferrell, Business Ethics: Ethical Decision Making and Cases (Mason, OH: Cengage Learning, 2012).

34. R. J. Barro and R. McCleary, “Religion and Economic Growth across Countries,” American Sociological Review, October 2003,

pp. 760–82; R. McCleary and R. J. Barro, “Religion and Economy,” Journal of Economic Perspectives, Spring 2006, pp. 49–72.

35. M. Weber, The Protestant Ethic and the Spirit of Capitalism (New York: Scribner’s, 1958, original 1904–1905). For an ex- cellent review of Weber’s work, see A. Giddens, Capitalism and Modern Social Theory (Cambridge, UK: Cambridge University Press, 1971).

36. Weber, The Protestant Ethic and the Spirit of Capitalism, p. 35. 37. A. S. Thomas and S. L. Mueller, “The Case for Comparative

Entrepreneurship,” Journal of International Business Studies 31, no. 2 (2000), pp. 287–302; S. A. Shane, “Why Do Some Societies Invent More than Others?,” Journal of Business Venturing 7 (1992), pp. 29–46.

38. See S. M. Abbasi, K. W. Hollman, and J. H. Murrey, “Islamic Economics: Foundations and Practices,” International Journal of Social Economics 16, no. 5 (1990), pp. 5–17; R. H. Dekmejian, Islam in Revolution: Fundamentalism in the Arab World (Syr- acuse, NY: Syracuse University Press, 1995).

39. T. W. Lippman, Understanding Islam (New York: Meridian Books, 1995).

40. Dekmejian, Islam in Revolution. 41. M. K. Nydell, Understanding Arabs (Yarmouth, ME: Intercul-

tural Press, 1987). 42. Lippman, Understanding Islam. 43. The material in this section is based largely on Abbasi et al.,

“Islamic Economics.” 44. “Sharia Calling,” The Economist, November 12, 2010;

N. Popper, “Islamic Banks, Stuffed with Cash, Explore Part- nerships in West,” The New York Times, December 26, 2013.

45. “Forced Devotion,” The Economist, February 17, 2001, pp. 76–77.

46. For details of Weber’s work and views, see Giddens, Capital- ism and Modern Social Theory.

47. See, for example, the views expressed in “A Survey of India: The Tiger Steps Out,” The Economist, January 21, 1995.

48. “High-Tech Entrepreneurs Flock to India,” PBS News Hour, February 9, 2014, www.pbs.org/newshour/bb/high-tech- entrepreneurs-flock-india, accessed March 7, 2014.

49. H. Norberg-Hodge, “Buddhism in the Global Economy,” Inter- national Society for Ecology and Culture, www.localfutures. org/publications/online-articles/buddhism-in-the-global- economy, accessed March 7, 2014.

50. P. Clark, “Zen and the Art of Startup Naming,” Bloomberg Businessweek, August 30, 2013, www.businessweek.com/ articles/2013-08-30/zen-and-the-art-of-startup-naming, accessed March 7, 2014.

51. Ibid. 52. Hofstede, Culture’s Consequences. 53. See Dore, Taking Japan Seriously; C. W. L. Hill, “Transaction

Cost Economizing as a Source of Comparative Advantage: The Case of Japan,” Organization Science 6 (1995).

54. C. C. Chen, Y. R. Chen, and K. Xin, “Guanxi Practices and Trust in Management,” Organization Science 15, no. 2 (March–April 2004), pp. 200–10.

Differences in Culture Chapter 4 127

55. See Aoki, Information, Incentives, and Bargaining; J. P. Womack, D. T. Jones, and D. Roos, The Machine That Changed the World (New York: Rawson Associates, 1990).

56. This hypothesis dates back to two anthropologists, Edward Sapir and Benjamin Lee Whorf. See E. Sapir, “The Status of Linguistics as a Science,” Language 5 (1929), pp. 207–14; B. L. Whorf, Language, Thought, and Reality (Cambridge, MA: MIT Press, 1956).

57. The tendency has been documented empirically. See A. Annett, “Social Fractionalization, Political Instability, and the Size of Government,” IMF Staff Papers 48 (2001), pp. 561–92.

58. D. A. Ricks, Big Business Blunders: Mistakes in Multinational Marketing (Homewood, IL: Dow Jones–Irwin, 1983).

59. Goodman, An Introduction to Sociology. 60. Porter, The Competitive Advantage of Nations. 61. Ibid., pp. 395–97. 62. G. Hofstede, “The Cultural Relativity of Organizational Prac-

tices and Theories,” Journal of International Business Studies, Fall 1983, pp. 75–89; Hofstede, Cultures and Organizations; Hofstede, Culture’s Consequences.

63. Hofstede, “The Cultural Relativity of Organizational Practices and Theories”; Hofstede, Cultures and Organizations.

64. Hofstede, Culture’s Consequences. 65. G. Hofstede and M. Bond, “Hofstede’s Culture Dimensions:

An Independent Validation Using Rokeach’s Value Survey,” Journal of Cross-Cultural Psychology, 15 (December 1984), pp. 417–33.

66. The factor scores for the long-term versus short-term orienta- tion, using Bond’s survey, were brought into a 0–100 range by a linear transformation (LTO = 50 × F + 50, in which F is the factor score). However, the data for China came in after Hofstede and Bond had standardized the scale, and they put China outside the range at LTO = 118 (which indicates a very strong long-term orientation).

67. G. Hofstede, G. J. Hofstede, and M. Minkov, Cultures and Organizations: Software of the Mind, 3rd ed. (New York: McGraw-Hill, 2010).

68. R. S. Yeh and J. J. Lawrence, “Individualism and Confucian Dynamism,” Journal of International Business Studies 26, no. 3 (1995), pp. 655–66.

69. For a more detailed critique, see Mead, International Manage- ment, pp. 73–75.

70. For example, see W. J. Bigoness and G. L. Blakely, “A Cross- National Study of Managerial Values,” Journal of Interna- tional Business Studies, December 1996, p. 739; D. H. Ralston, D. H. Holt, R. H. Terpstra, and Y. Kai-Cheng, “The Impact of National Culture and Economic Ideology on Managerial Work Values,” Journal of International Business Studies 28, no. 1

(1997), pp. 177–208; P. B. Smith, M. F. Peterson, and Z. Ming Wang, “The Manager as a Mediator of Alternative Meanings,” Journal of International Business Studies 27, no. 1 (1996), pp. 115–37; L. Tang and P. E. Koves, “A Framework to Update Hofstede’s Cultural Value Indices,” Journal of International Business Studies 39 (2008), pp. 1045–63.

71. R. House, P. Hanges, M. Javidan, P. Dorfman, and V. Gupta, Culture, Leadership, and Organizations: The GLOBE Study of 62 Societies (Thousand Oaks, CA: Sage, 2004); J. Chhokar, F. Brodbeck, and R. House, Culture and Leadership across the World: The GLOBE Book of In-Depth Studies of 25 Societies (New York: Routledge, 2012).

72. R. Inglehart, Modernization and Postmodernization: Cultural, Economic, and Political Change in 43 Societies (Princeton, NJ: Princeton University Press, 1997). Information and data on the World Values Survey can be found at www.worldvalues survey.org.

73. For evidence of this, see R. Inglehart, “Globalization and Postmodern Values,” The Washington Quarterly, Winter 2000, pp. 215–28.

74. Mead, International Management, chap. 17. 75. “Free, Young, and Japanese,” The Economist, December 21,

1991. 76. Namenwirth and Weber, Dynamics of Culture; Inglehart,

“Globalization and Postmodern Values.” 77. G. Hofstede, “National Cultures in Four Dimensions,” Interna-

tional Studies of Management and Organization 13, no. 1 (1983), pp. 46–74; Tang and Koves, “A Framework to Update Hofstede’s Cultural Value Indices.”

78. See Inglehart, “Globalization and Postmodern Values.” For up- dates, go to http://wvs.isr.umich.edu/index.html.

79. Hofstede, “National Cultures in Four Dimensions.” 80. D. A. Ralston, D. H. Holt, R. H. Terpstra, and Y. Kai-Chung,

“The Impact of National Culture and Economic Ideology on Managerial Work Values,” Journal of International Business Studies, 2007, pp. 1–19.

81. See Leung et al., “Culture and International Business.” 82. Hall and Hall, Understanding Cultural Differences. 83. Porter, The Competitive Advantage of Nations. 84. See Aoki, Information, Incentives, and Bargaining; Dertouzos

et al., Made in America; Porter, The Competitive Advantage of Nations, pp. 395–97.

85. See Dore, Taking Japan Seriously; Hill, “Transaction Cost Economizing as a Source of Comparative Advantage.”

86. For empirical work supporting such a view, see Annett, “Social Fractionalization, Political Instability, and the Size of Government.”

Credit: ©Federal Reserve Board.

Ethics, Corporate Social Responsibility, and Sustainability L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO5 -1 Understand the ethical issues faced by international businesses.

LO5-2 Recognize an ethical dilemma.

LO5-3 Identify the causes of unethical behavior by managers.

LO5-4 Describe the different philosophical approaches to ethics.

LO5-5 Explain how managers can incorporate ethical considerations into their decision making.

part two National Dif ferences

5

Source: © Philippe Huguen/AFP/Getty Images

129

Making Toys Globally

Several organizations—both governmental and private— are examining lead-based paint in toys on a continual ba- sis. For example, the New York Times and Consumer Reports recently found that dangerous products for chil- dren are still widely available. The Ecology Center has created a website called HealthyStuff.org that contains a database of toys and other products that have been tested for dangerous chemicals. While lead in paint seems to be in focus, the use of lead in plastics has not been banned! Lead is used to soften the plastic and make it more flexible to allow it to go back to its original shape after children play with the toys. Plus, lead may also be used in plastic toys to stabilize molecules from heat. Unfortunately, when the plastic is exposed to sunlight, air, and detergents, for example, the chemical bond between the lead and plastics breaks down and forms dust that can enter the human body. Another unfor- tunate part about lead is that it is invisible to the naked eye and has no detectable smell. This means that children may be exposed to lead from toys (and other consumer prod- ucts) through normal playing activity (e.g., hand-to-mouth activity). As everyone with children knows, children often put toys, fingers, and other objects in their mouth, expos- ing themselves to lead paint or dust. Children are also more vulnerable to lead than adults; there is no safe level of lead for children. The worldwide toy industry has published a voluntary standard of 90 ppm for lead in toys, which, of course, is greater than a ban on lead in paint used for toys and in the materials used to make the toys (such as plastics). But since 2007, the world has at least seen stricter standards—either voluntary or regulated standards—that make it safer for children to play with newly purchased toys. The CPSC in the United States, the European Union, and China’s AQSIQ are actively monitoring and seemingly enforcing stricter standards. But, according to Scott Wolfson of the CPSC, many toy manufacturers have been violating safety regulations for almost 30 years. So, are toys safer now than they were before 2007, and are they really safe to play with throughout the world? What do we do with the old toys?

Sources: M. Moore, “One Third of Chinese Toys Contain Heavy Metals,” The Telegraph, December 8, 2011; P. Kavilanz, “China to Eliminate Lead Paint in Toy Exports,” CNN Money, September 11, 2007; U.S. Centers for Disease Control and Prevention, www.cdc. gov/nceh/lead/tips/toys.htm, accessed March 8, 2014; “U.S. Pros- ecutes Importers of Toys Containing Lead, Phthalates,” AmeriScan, February 26, 2014.

O P E N I N G C A S E Toys for children are made in numerous countries and then exported to buyers throughout the world. In some countries, such as the United States, certain protection ex- ists to make sure that toys are safe for children. The U.S. Consumer Product Safety Commission (CPSC) regularly is- sues recalls of toys that have the potential to expose chil- dren to danger such as lead or other heavy metals. For example, lead may be found in the paint used on toys and in the plastic used to make the toys. If ingested (e.g., chil- dren chewing on toys), lead is poisonous and can damage the nervous system and cause brain disorders. Lead is also a neurotoxin that can accumulate in both soft tissue and bones in the body. For these reasons, lead was banned in house paint, on toys marketed to children, and in dishes or cookware in the United States in 1978. In addition, in an agreement between China’s General Administration of Quality Supervision, Inspection and Quarantine (AQSIQ) and CPSC, the Chinese agreed to take immediate action in 2007 to eliminate the use of lead paint on Chinese manufactured toys that are ex- ported to the United States. With China’s prominence as a toy manufacturing country, this agreement was a step toward making safe products for children. Still, lead continues to be a hazard in a quarter of all U.S. homes with children under age six. In fact, a wide range of toys and children’s products, including many market-leading and reputable brands, often contain ei- ther lead or other heavy metals (e.g., arsenic, cadmium, mercury, antimony, or chromium). Estimates exist that suggest that one-third of Chinese toys contain heavy metals. This is a major problem given that China manu- factures 80 percent of the toys sold in the United States. Researchers from Greenpeace and IPEN conducted a study by buying 500 toys and children’s products in five Chinese cities. They tested the products with handheld X-ray scanners and found that 163 of the toys were tainted with heavy metals above the norm (32.6 per- cent). “These contaminated toys not only poison chil- dren when chewed or touched, but can enter the body through the air they breathe,” said Ada Kong Cheuk-san at Greenpeace. While lead in the paint on toys has not been elimi- nated, the focus on cleaning up lead in the paint has been given front-page coverage ever since the agree- ment to eliminate it in 2007. It is certainly not gone, but at least more and more people are paying attention.

130 Part 2 National Differences

Introduction

The opening case describes the thriving toy manufacturing business and ethical concerns that exist in toy production. Total sales of toys worldwide are estimated to be about $85  billion annually according to the Toy Industry Association’s data, with the U.S. domestic toy market being around $21 billion. It is a large industry, especially in North America, Europe, and Asia; each of these regions has between $23 billion and $24 billion in toy sales annually.1 As noted in the opening case, there is evidence that some companies and countries are less ethical in their toy manufacturing. While the worldwide toy industry has published a voluntary standard of 90 ppm for lead in toys, it is, after all, a voluntary standard and not a regulation that can be enforced worldwide. And while the U.S. Consumer Product Safety Commission and China’s General Administration of Quality Supervision, Inspec- tion and Quarantine agreed that toys exported from China to the United States will no longer contain lead in paints, no such agreement exists for other materials such as plastics used in toy production, nor does the regulation appear to be working as effectively as it might.

M O D U L E O N I N T E R N AT I O N A L E T H I C S

globalEDGE has a series of interactive educational modules for businesspeople, policy offi- cials, and students. These modules focus on issues pertinent to international business and include a case study or anecdotes, a glossary of terms, quiz questions, and a list of refer- ences when applicable. The combination of our textbook on international business and the free globalEDGE online course modules serves as an excellent resource to prepare for NASBITE’s Certified Global Business Professional Credential (the CGBP includes a testing focus on management, marketing, supply chain management, and finance). Achieving the industry-leading CGBP credential ensures that employees are able to practice global busi- ness at the professional level required in today’s competitive environment. As related to this chapter, check out globalEDGE’s online module on international ethics at globaledge.msu. edu/reference-desk/online-course-modules. View the questions in the module as a quick test on your understanding of the main issues in international ethics and your readiness to achieve the CGBP credential.

Perhaps some toy manufacturers have been violating safety regulations for almost 30 years and many will continue to do so in the future; time will tell, assuming we can track the ingredients in the materials being used to make toys. But, what we do know is that about a third of the toys that are exported out of China are tainted with heavy metals above the norm. Unfortunately, it is not illegal to use lead, for example, in plastics at this time; it is an ethical issue—and usually a voluntary one—that some companies tackle ethically and others choose to side-step given the large size of market opportunities in the toy industry. A basic question then is: Can it be considered unethical to manufacture toys that include heavy metals that are bad for children to ingest and come in contact with when using the toys in their proper way? Ethical issues like the ones in the toys example arise frequently in international busi- ness, often because business practices and regulations differ from nation to nation. With regard to lead pollution, for example, what is allowed in Mexico is outlawed in the United States. These differences can create ethical dilemmas for businesses. Understanding the nature of an ethical dilemma, and deciding the course of action to pursue when con- fronted with one, is a central theme in this chapter. Ethics serves as the foundation for

Ethics, Corporate Social Responsibility, and Sustainability Chapter 5 131

what people do or not, and ultimately what companies engage in globally. As such, com- panies’ involvement in corporate social responsibility practices and sustainability initia- tives can be traced to the ethical foundation of its employees and other stakeholders such as customers, shareholders, suppliers, regulators, and communities.2 The term ethics refers to accepted principles of right or wrong that govern the conduct of a person, the members of a profession, or the actions of an organization. Business ethics are the accepted principles of right or wrong governing the conduct of businesspeople, and an ethical strategy is a strategy, or course of action, that does not violate these ac- cepted principles. This chapter looks at how ethical issues should be incorporated into decision making in an international business. The chapter also reviews the reasons for poor ethical decision making and discusses different philosophical approaches to busi- ness ethics. Then, using the ethical decision-making process as platform, we include a series of illustrations via Management Focus boxes throughout the chapter, including is- sues related to Apple, Inc., Myanmar, Daimler, corporate social responsibility, and sus- tainability. The chapter closes by reviewing the different processes that managers can adopt to make sure that ethical considerations are incorporated into decision making in international business.

Ethical Issues in International Business

Many of the ethical issues in international business are rooted in the fact that political systems, law, economic development, and culture vary significantly from nation to na- tion. What is considered normal practice in one nation may be considered unethical in another. Because they work for an institution that transcends national borders and cul- tures, managers in a multinational firm need to be particularly sensitive to these differ- ences. In the international business setting, the most common ethical issues involve employment practices, human rights, environmental regulations, corruption, and the moral obligation of multinational corporations.

EMPLOYMENT PRACTICES

When work conditions in a host nation are clearly inferior to those in a multinational’s home nation, which standards should be applied? Those of the home nation, those of the host nation, or something in between? While few would suggest that pay and work condi- tions should be the same across nations, how much divergence is acceptable? For exam- ple, while 12-hour workdays, extremely low pay, and a failure to protect workers against toxic chemicals may be common in some less developed nations, does this mean that it is okay for a multinational to tolerate such working conditions in its subsidiaries there or to condone it by using local subcontractors? In the mid-1990s, Nike found itself in the center of a storm of protests when news reports revealed that working conditions at many of its subcontractors were very poor. Typical of the allegations were those detailed in a 48 Hours program that aired in 1996. The report painted a picture of young women who worked with toxic materials six days a week in poor conditions for only 20 cents an hour at a Vietnamese subcontractor. The report also stated that a living wage in Vietnam was at least $3 a day, an income that could not be achieved at the subcontractor without working substantial overtime. Nike and its subcontractors were not breaking any laws, but this report, and others like it, raised questions about the ethics of using sweatshop labor to make what were essentially fashion accessories. It may have been legal, but was it ethical to use subcontractors who, by Western standards, clearly exploited their workforce? Nike’s critics thought not, and the company found itself the focus of a wave of demonstrations and consumer boycotts. These exposés surrounding Nike’s use of sub- contractors forced the company to reexamine its policies. Realizing that even though it was breaking no law, its subcontracting policies were perceived as unethical, Nike’s manage- ment established a code of conduct for Nike subcontractors and instituted annual monitor- ing by independent auditors of all subcontractors.3

LO 5 -1 Understand the ethical issues faced by international businesses.

132 Part 3 Part Title

M A NAG E M E N T F O C U S

132

In mid-2006, news reports surfaced suggesting there were systematic labor abuses at a factory in China that makes the iPhone and iPod for Apple, Inc. According to the reports, workers at Hongfujin Precision Industry were paid as little as $50 a month to work 15-hour shifts making Apple products. There were also reports of forced over- time and poor living conditions for the workers, many of them young women who had migrated from the country- side to work at the plant and lived in company-owned dormitories. The 2006 articles were the work of two Chinese jour- nalists, Wang You and Weng Bao, employed by China Business News, a state-run newspaper. The target of the reports, Hongfujin Precision Industry, was reportedly Chi- na’s largest export manufacturer with overseas sales total- ing $14.5 billion. Hongfujin is owned by Foxconn, a large Taiwanese conglomerate, whose customers (in addition to Apple) include Intel, Dell, and Sony Corporation. The Hongfujin factory is a small city in its own right, with clinics, recreational facilities, buses, and 13 restaurants that serve the 200,000 employees. Upon hearing the news, Apple management re- sponded quickly, pledging to audit the operations to make sure Hongfujin was complying with Apple’s code on labor standards for subcontractors. Managers at Hongfujin took a somewhat different tack; they filed a defamation suit against the two journalists, suing them for $3.8 million in a local court, which promptly froze the journalists’ personal assets pending a trial. Clearly, the management of Hongfujin was trying to send a mes- sage to the journalist community—criticism would be costly. The suit sent a chill through the Chinese journalist community because Chinese courts have shown a ten- dency to favor powerful, locally based companies in legal proceedings. Within six weeks, Apple had completed its audit. The company’s report suggested that although workers had not been forced to work overtime and were earning at least the local minimum wage, many had worked more than the 60 hours a week allowed for by Apple, and their housing was substandard. Under pressure from Apple, management at Hongfujin agreed to bring prac- tices in line with Apple’s code, committing to building

Ethical Issues at Apple new housing for employees and limiting work to 60 hours a week. However, Hongfujin did not immediately withdraw the defamation suit. In an unusually bold move in a country where censorship is still common, China Business News gave its unconditional backing to Wang and Weng. The Shanghai-based news organization issued a statement ar- guing that what the two journalists did “was not a violation of any rules, laws, or journalistic ethics.” The Paris-based Reporters Without Borders also took up the case of Wang and Weng, writing a letter to Apple’s then CEO, the late Steve Jobs, stating, “We believe that all Wang and Weng did was to report the facts and we condemn Foxconn’s re- action. We therefore ask you to intercede on behalf of these two journalists so that their assets are unfrozen and the lawsuit is dropped.” Once again, Apple moved quickly, pressuring Foxconn behind the scenes to drop the suit. Foxconn agreed to do so and issued a “face-saving” statement saying the two sides had agreed to end the dispute after apologizing to each other “for the disturbances brought to both of them by the lawsuit.” The experience shed a harsh light on labor conditions in China. At the same time, the response of the Chinese media, and China Business News in particular, point toward the emergence of some journalistic freedoms in a nation that has historically seen news organizations as a mouthpiece for the state. More recent news may indicate new ethical concerns at Apple’s production facilities in China. In a 2014 story by BBC News, Apple is again the center of issues related to workers’ hours, ID cards, housing arrangements, work meetings, and juvenile workers at its Pegatron facilities on the outskirts of Shanghai. Apple disagreed strongly with the portray of the Pegatron factory’s working conditions, and stated in the BBC News article that “We are aware of no other company doing as much as Apple to ensure fair and safe working conditions.” 

Sources: R. Bilton, “Apple Failing to Protect Chinese Factory Workers,” BBC News, December 18, 2014; E. Kurtenbach, “The Foreign Factory Factor,” Seattle Times, August 31, 2006, pp. C1, C3; Elaine Kurtenbach, “Apple Says It’s Trying to Resolve Dispute over Labor Conditions at Chinese iPod Factory,” Associated Press Financial Wire, August 30, 2006; “Chinese iPod Supplier Pulls Suit,” Associated Press Financial Wire, September 3, 2006.

Ethics, Corporate Social Responsibility, and Sustainability Chapter 5 133

As the Nike case demonstrates, a strong argument can be made that it is not okay for a multinational firm to tolerate poor working conditions in its foreign operations or those of subcontractors. However, this still leaves unanswered the question of which standards should be applied. We shall return to and consider this issue in more detail later in the chap- ter. For now, note that establishing minimal acceptable standards that safeguard the basic rights and dignity of employees, auditing foreign subsidiaries and subcontractors on a regu- lar basis to make sure those standards are met, and taking corrective action if they are not up to standards are a good way to guard against ethical abuses. For another example of problems with working practices among suppliers, read the accompanying Management Focus, which looks at working conditions in a factory that supplied Apple with iPods.

HUMAN RIGHTS

Questions of human rights can arise in international business. Basic human rights still are not respected in many nations. Rights taken for granted in developed nations, such as freedom of association, freedom of speech, freedom of assembly, freedom of movement, freedom from political repression, and so on, are by no means universally accepted (see Chapter 2 for details). One of the most obvious historic examples was South Africa during the days of white rule and apartheid, which did not end until 1994. The apartheid system denied basic political rights to the majority nonwhite population of South Africa, mandated segregation between whites and nonwhites, reserved certain occupations exclusively for whites, and prohibited blacks from be- ing placed in positions where they would manage whites. Despite the odious nature of this system, Western businesses operated in South Africa. By the 1980s, however, many questioned the ethics of doing so. They argued that inward investment by foreign multinationals, by boost- ing the South African economy, supported the repressive apartheid regime. Several Western businesses started to change their policies in the late 1970s and early 1980s, and in the 2010s businesses are more and more competing on being ethical as a core philosophy promoted to customers.4 General Motors, which had significant activities in South Africa, was at the forefront of this trend. GM adopted what came to be called the Sullivan principles, named after Leon Sullivan, a black Baptist minister and a member of GM’s board of directors. Sullivan argued that it was ethically justified for GM to operate in South Africa so long as two conditions were fulfilled. First, the company should not obey the apartheid laws in its own South African operations (a form of passive resis- tance). Second, the company should do everything within its power to promote the aboli- tion of apartheid laws. Sullivan’s principles were widely adopted by U.S. firms operating in South Africa. Their violation of the apartheid laws was ignored by the South African government, which clearly did not want to antagonize important foreign investors. After 10 years, Leon Sullivan concluded that simply following the principles was not suf- ficient to break down the apartheid regime and that any American company, even those ad- hering to his principles, could not ethically justify their continued presence in South Africa. Over the next few years, numerous companies divested their South African operations, in- cluding Exxon, General Motors, Kodak, IBM, and Xerox. At the same time, many state pension funds signaled they would no longer hold stock in companies that did business in South Africa, which helped persuade several companies to divest their South African opera- tions. These divestments, coupled with the imposition of economic sanctions from the United States and other governments, contributed to the abandonment of white minority rule and apartheid in South Africa and the introduction of democratic elections in 1994. Thus, adopt- ing an ethical stance was argued to have helped improve human rights in South Africa.5 Although change has come in South Africa, many repressive regimes still exist in the world. Is it ethical for multinationals to do business in them? It is often argued that inward investment by a multinational can be a force for economic, political, and social progress that ultimately improves the rights of people in repressive regimes. This position was first discussed in Chapter 2, when we noted that economic progress in a nation could create pressure for democratization. In general, this belief suggests it is ethical for a multinational to do business in nations that lack the democratic structures and human rights records of developed nations. Investment in China,

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Unocal in Myanmar A couple of decades ago, in 1995, Unocal, an oil and gas en- terprise based in California, took a 29 percent stake in a part- nership with the French oil company Total and state-owned companies from both Myanmar and Thailand to build a gas pipeline from Myanmar to Thailand. At the time, the $1 billion project was expected to bring Myanmar about $200 million in annual export earnings, a quarter of the country’s total. The gas used domestically would increase Myanmar’s generating capacity by 30 percent. This investment was made when a number of other American companies were exiting Myanmar. Myanmar’s government, a military dictatorship, had a reputa- tion for brutally suppressing internal dissent. Citing the politi- cal climate, the apparel companies Levi Strauss and Eddie Bauer had both withdrawn from the country. However, as far as Unocal’s management was concerned, the giant infra- structure project would generate healthy returns for the com- pany and, by boosting economic growth, a better life for Myanmar’s now 53 million people. Moreover, while Levi Strauss and Eddie Bauer could easily shift production of clothes to another low-cost location, Unocal argued it had to go where the oil and gas were located. However, Unocal’s investment quickly became highly con- troversial. Under the terms of the contract, the government of Myanmar was contractually obliged to clear a corridor for the pipeline through Myanmar’s tropical forests and to protect the pipeline from attacks by the government’s enemies. Accord- ing to human rights groups, the Myanmar army forcibly moved villages and ordered hundreds of local peasants to work on the pipeline in conditions that were no better than

slave labor. Those who refused suffered retaliation. News re- ports cited the case of one woman who was thrown into a fire, along with her baby, after her husband tried to escape from troops forcing him to work on the project. The baby died and she suffered burns. Other villagers reported being beaten, tortured, raped, and otherwise mistreated when the alleged slave labor conditions were occurring. In 1996, human rights activists brought a lawsuit against Unocal in the United States on behalf of 15 Myan- mar villagers who had fled to refugee camps in Thailand. The suit claimed that Unocal was aware of what was go- ing on, even if it did not participate or condone it, and that awareness was enough to make Unocal in part re- sponsible for the alleged crimes. The presiding judge dismissed the case, arguing that Unocal could not be held liable for the actions of a foreign government against its own people—although the judge did note that Unocal was indeed aware of what was going on in Myanmar. The plaintiffs appealed, and in late 2003 the case wound up at a superior court. In 2004, the case was settled out of court for an undisclosed amount. Unocal itself was ac- quired by Chevron in 2005.

Sources: Jim Carlton, “Unocal Trial for Slave Labor Claims Is Set to Start Today,” The Wall Street Journal, December 9, 2003, p. A19; Seth Stern, “Big Business Targeted for Rights Abuse,” Christian Science Monitor, September 4, 2003, p. 2; “Trouble in the Pipeline,” The Econ- omist, January 18, 1997, p. 39; Irtani Evelyn, “Feeling the Heat: Unocal Defends Myanmar Gas Pipeline Deal,” Los Angeles Times, February 20, 1995, p. D1; “Unocal Settles Myanmar Human Rights Cases,” Busi- ness and Environment, February 16, 2005, pp. 14–16.

for example, is frequently justified on the grounds that although China’s human rights record is often questioned by human rights groups, and although the country is not a democracy, con- tinuing inward investment will help boost economic growth and raise living standards. These developments will ultimately create pressures from the Chinese people for more participative government, political pluralism, and freedom of expression and speech. There is a limit to this argument. As in the case of South Africa, some regimes are so repressive that investment cannot be justified on ethical grounds. Another example would be Myanmar (formerly known as Burma). Ruled by a military dictatorship for more than 45 years, Myanmar has one of the worst human rights records in the world. Beginning in the mid-1990s, many Western companies exited Myanmar, judging the human rights vio- lations to be so extreme that doing business there cannot be justified on ethical grounds. (In contrast, the accompanying Management Focus looks at the controversy surrounding one company, Unocal, which chose to stay in Myanmar.) However, a cynic might note that Myanmar has a small economy and that divestment carries no great economic penalty for Western firms, unlike, for example, divestment from China. Interestingly, after decades of pressure from the international community, in 2012 the military government of Myanmar finally acquiesced and allowed limited democratic elections to be held.

Ethics, Corporate Social Responsibility, and Sustainability Chapter 5 135

ENVIRONMENTAL POLLUTION

Ethical issues arise when environmental regulations in host nations are inferior to those in the home nation. Many developed nations have substantial regulations governing the emission of pollutants, the dumping of toxic chemicals, the use of toxic materials in the workplace, and so on. Those regulations are often lacking in developing nations, and ac- cording to critics, the result can be higher levels of pollution from the operations of mul- tinationals than would be allowed at home. Should a multinational feel free to pollute in a developing nation? To do so hardly seems ethical. Is there a danger that amoral management might move production to a developing nation precisely because costly pollution controls are not required and the company is, therefore, free to despoil the environment and perhaps endanger local people in its quest to lower production costs and gain a competitive advantage? What is the right and moral thing to do in such circumstances: pollute to gain an economic advantage, or make sure that foreign subsidiaries adhere to common standards regarding pollution controls? These questions take on added importance because some parts of the environment are a public good that no one owns but anyone can despoil. No one owns the atmosphere or the oceans, but polluting both, no matter where the pollution originates, harms all.6 The atmosphere and oceans can be viewed as a global commons from which everyone bene- fits but for which no one is specifically responsible. In such cases, a phenomenon known as the tragedy of the commons becomes applicable. The tragedy of the commons occurs when a resource held in common by all, but owned by no one, is overused by individuals, resulting in its degradation. The phenomenon was first named by Garrett Hardin when describing a particular problem in sixteenth-century England. Large open areas, called commons, were free for all to use as pasture. The poor put out livestock on these com- mons and supplemented their meager incomes. It was advantageous for each to put out more and more livestock, but the social consequence was far more livestock than the

Early morning smog hangs over office towers in Shanghai, China. Companies are faced with ethi- cal decisions in moving to host nations where environmental regulations are less stringent. Source: © Grant Faint/Photodisc/Getty Images, RF

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commons could handle. The result was overgrazing, degradation of the commons, and the loss of this much-needed supplement.7 Corporations can contribute to the global tragedy of the commons by moving produc- tion to locations where they are free to pump pollutants into the atmosphere or dump them in oceans or rivers, thereby harming these valuable global commons. While such action may be legal, is it ethical? Again, such actions seem to violate basic societal no- tions of ethics and corporate social responsibility. This issue is taking on greater impor- tance as concerns about human-induced global warming move to center stage. Most climate scientists argue that human industrial and commercial activity is increasing the amount of carbon dioxide in the atmosphere; carbon dioxide is a greenhouse gas, which reflects heat back to the earth’s surface, warming the globe; and as a result, the average temperature of the earth is increasing. The accumulated scientific evidence from numer- ous databases supports this argument.8 Consequently, societies around the world are starting to restrict the amount of carbon dioxide that can be emitted into the atmosphere as a by-product of industrial and commercial activity. However, regulations differ from nation to nation. Given this, is it ethical for a company to try to escape tight emission limits by moving production to a country with lax regulations, given that doing so will contribute to global warming? Again, many would argue that doing so violates basic ethi- cal principles.

CORRUPTION

As noted in Chapter 2, corruption has been a problem in almost every society in history, and it continues to be one today.9 There always have been and always will be corrupt government officials. International businesses can and have gained economic advantages by making payments to those officials. A historical and classic example concerns a well- publicized incident in the 1970s. Carl Kotchian, the president of Lockheed, made a $12.6 million payment to Japanese agents and government officials to secure a large order for Lockheed’s TriStar jet from Nippon Air. When the payments were discovered, U.S. offi- cials charged Lockheed with falsification of its records and tax violations. Although such payments were supposed to be an accepted business practice in Japan (they might be viewed as an exceptionally lavish form of gift-giving), the revelations created a scandal there too. The government ministers in question were criminally charged, one committed suicide, the government fell in disgrace, and the Japanese people were outraged. Appar- ently, such a payment was not an accepted way of doing business in Japan! The payment was nothing more than a bribe, paid to corrupt officials, to secure a large order that might otherwise have gone to another manufacturer, such as Boeing. Kotchian clearly engaged in unethical behavior—and to argue that the payment was an “acceptable form of doing business in Japan” was self-serving and incorrect. The Lockheed case was the impetus for the 1977 passage of the Foreign Corrupt Practices Act (FCPA) in the United States, discussed in Chapter 2. The act outlawed the paying of bribes to foreign government officials to gain business. Some U.S. businesses immediately objected that the act would put U.S. firms at a competitive disadvantage (there is no evidence that has occurred).10 The act was subsequently amended to allow for “facilitating payments.” Sometimes known as speed money or grease payments, facilitat- ing payments are not payments to secure contracts that would not otherwise be secured, nor are they payments to obtain exclusive preferential treatment. Rather they are pay- ments to ensure receiving the standard treatment that a business ought to receive from a foreign government, but might not due to the obstruction of a foreign official. The accom- panying Management Focus looks at what happened when the German company Daimler ran afoul of the FCPA. In 1997, the trade and finance ministers from the member states of the Organisation for Economic Co-operation and Development (OECD) followed the U.S. lead and ad- opted the Convention on Combating Bribery of Foreign Public Officials in Interna- tional Business Transactions.11 The convention, which went into force in 1999, obliges

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Corruption at Daimler In 1998, Daimler, one of the world’s largest manufacturers of automobiles, purchased the Chrysler Corporation for what was a reported $38 billion. Soon afterward, a former Chrysler auditor identified suspicious payments being made by subsidiaries. For example, in 2002 Daimler’s Chi- nese subsidiary paid $25,000 to a Texas company listed at a residential apartment complex in Houston. The auditor suspected that such payments were bribes and reported the issue to the U.S. Securities and Exchange Commission (SEC), which then teamed up with the U.S. Department of Justice (DOJ) and began an investigation. The investigation took eight years. During that time, in- vestigators uncovered a pattern of corruption so wide- spread that an SEC official described it as “standard operating practice at Daimler.” In the case of the $25,000 payment, the Texas company was a shell organization es- tablished to launder the money, and the payment was to be passed on to the wife of a Chinese government official who was involved in contract negotiations for about $1.3 million in commercial vehicles. In another case, bribes were given to secure the sale of passenger and commer- cial vehicles to government entities in Russia. Daimler overcharged for the cars on invoices and passed the over- payments to bank accounts in Latvia controlled by the Rus- sian officials responsible for the purchase decision. In certain cases, Daimler made bribes from “cash desks,” al- lowing employees to take out large amounts of currency to make payments to foreign officials. In total, the investigation uncovered hundreds of such payments in at least 22 countries that were linked to the

sale of vehicles valued at $1.9 billion. The SEC stated, “The bribery was so pervasive in Daimler’s decentralized corpo- rate structure that it extended outside of the sales organi- zation to internal audit, legal, and finance departments. These departments should have caught and stopped the illegal sales practices, but instead they permitted or were directly involved in the company’s bribery practices.” Threatened with court proceedings in the United States, in 2010 Daimler entered into a consent decree with the SEC under which it agreed to pay $185 million in criminal and civil fines. While subsidiaries of Daimler in Germany and Russia pleaded guilty to corruption charges, the cor- porate parent and the Chinese subsidiary will avoid indict- ment so long as they live up to an agreement to halt such practices. Some 10 years after Daimler bought Chrysler (some say it was a merger of equals) and became a target of the SEC because of a Chrysler employee’s whistle-blower actions, Daimler sold off Chrysler in 2007 to Cerberus Capital Man- agement for $6 billion, and the name was changed to sim- ply “Daimler AG.” Since Chrysler’s bankruptcy filing in the United States in 2009, the company has been controlled as a unit by Italian automaker Fiat. Chrysler Automobiles, with main offices in Auburn Hills, Michigan, has shown strong improvements in sales and profits in recent years. 

Sources: M. Wayland, “Fiat Chrysler-UAW Profit Sharing Increases to $2750,” Detroit News, February 3, 2015; A. R. Sorkin, “Daimler to Pay $185 Million to Settle Corruption Charges,” The New York Times, March 24, 2010; “Corruption: Daimler Settles with DOJ; SEC Wades in: Germany Next,” Chiefofficers.net, March 25, 2010.

member states and other signatories to make the bribery of foreign public officials a criminal offense. The convention excludes facilitating payments made to expedite routine government action from the convention. While facilitating payments, or speed money, are excluded from both the Foreign Cor- rupt Practices Act and the OECD convention on bribery, the ethical implications of mak- ing such payments are unclear. From a pragmatic standpoint, giving bribes, although a little evil, might be the price that must be paid to do a greater good (assuming the invest- ment creates jobs where none existed and assuming the practice is not illegal). Several economists advocate this reasoning, suggesting that in the context of pervasive and cum- bersome regulations in developing countries, corruption may improve efficiency and help growth! These economists theorize that in a country where preexisting political struc- tures distort or limit the workings of the market mechanism, corruption in the form of black-marketeering, smuggling, and side payments to government bureaucrats to “speed up” approval for business investments may enhance welfare.12 Arguments such as this persuaded the U.S. Congress to exempt facilitating payments from the FCPA.

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In contrast, other economists have argued that corruption reduces the returns on busi- ness investment and leads to low economic growth.13 In a country where corruption is common, unproductive bureaucrats who demand side payments for granting the enter- prise permission to operate may siphon off the profits from a business activity. This re- duces businesses’ incentive to invest and may retard a country’s economic growth rate. One study of the connection between corruption and economic growth in 70 countries found that corruption had a significant negative impact on a country’s growth rate.14 An- other study found that firms that paid more in bribes are likely to spend more, not less, management time with bureaucrats negotiating regulations, and that this tended to raise the costs of the firm.15 Given the debate and the complexity of this issue, we again might conclude that generalization is difficult and the demand for speed money creates a genuine ethical dilemma. Yes, corruption is bad, and yes, it may harm a country’s economic develop- ment, but yes, there are also cases where side payments to government officials can remove the bureaucratic barriers to investments that create jobs. However, this prag- matic stance ignores the fact that corruption tends to corrupt both the bribe giver and the bribe taker. Corruption feeds on itself, and once an individual starts down the road of corruption, pulling back may be difficult if not impossible. This argument strength- ens the ethical case for never engaging in corruption, no matter how compelling the benefits might seem. Many multinationals have accepted this argument. The large oil multinational BP, for example, has a zero-tolerance approach toward facilitating payments. Other corporations have a more nuanced approach. For example, Dow Corning used to formally state a few years ago in its Code of Conduct that “in countries where local business practice dictates such [facilitating] payments and there is no alternative, facilitating payments are to be for the minimum amount necessary and must be accurately documented and recorded.”16 This statement recognized that business practices and customs differ from country to country. At the same time, Dow Corning allowed for facilitating payments when “there is no alternative,” although they were also stated to be strongly discouraged. More recently, the latest version of Dow Corning’s Code of Conduct has removed the section on “inter- national business guidelines” altogether, so our assumption has to be that the company is taking a stronger zero-tolerance approach at this time. Dow Corning may have simply realized that the nuances between a bribe and a facili- tating payment are very unclear in interpretation. Many U.S. companies have sustained FCPA violations due to facilitating payments that were made but did not fall within the general rules allowing such payments. For example, in 2008 the global freight forwarder Con-way paid a $300,000 penalty for making hundreds of what could be considered small payments to various customs officials in the Philippines. In total, Con-way distrib- uted some $244,000 to these officials who were induced to violate customs regulations, settle disputes, and not enforce fines for administrative violations.17

Ethical Dilemmas

The ethical obligations of a multinational corporation toward employment conditions, human rights, corruption, and environmental pollution are not always clear-cut. How- ever, what is becoming clear-cut is the businesses are feeling more and more of the marketplace pressures from customers and other stakeholders to be transparent in their ethical decision making and operations. At the same time, there are no universal worldwide agreement about what constitutes accepted ethical principles. From an in- ternational business perspective, some argue that what is ethical depends on one’s cultural perspective.18 In the United States, it is considered acceptable to execute mur- derers, but in many cultures this is not acceptable—execution is viewed as an affront to human dignity, and the death penalty is outlawed. Many Americans find this atti- tude very strange, but, for example, many Europeans find the American approach

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LO 5 -2 Recognize an ethical dilemma.

Ethics, Corporate Social Responsibility, and Sustainability Chapter 5 139

barbaric. For a more business-oriented example, consider the practice of “gift-giving” between the parties to a business nego- tiation. While this is considered right and proper behavior in many Asian cultures, some Westerners view the practice as a form of bribery, and therefore unethical, particularly if the gifts are substantial. Managers often confront very real ethical dilemmas where the appropriate course of action is not clear. For example, imagine that a visiting American executive finds that a foreign subsidiary in a poor nation has hired a 12-year-old girl to work on a factory floor. Appalled to find that the subsidiary is using child labor in direct violation of the company’s own ethical code, the American instructs the local manager to replace the child with an adult. The local manager dutifully complies. The girl, an orphan, who is the only breadwinner for herself and her six-year-old brother, is un- able to find another job, so in desperation she turns to prostitution. Two years later she dies of AIDS. Had the visiting American understood the gravity of the girl’s situation, would he still have requested her replacement? Perhaps not! Would it have been better, therefore, to stick with the status quo and allow the girl to continue working? Probably not, because that would have violated the reasonable prohibition against child labor found in the com- pany’s own ethical code. What then would have been the right thing to do? What was the obligation of the executive given this ethical dilemma? There are no easy answers to these questions. That is the nature of ethical dilemmas— situations in which none of the available alternatives seems ethically acceptable.19 In this case, employing child labor was not acceptable, but given that she was employed, neither was denying the child her only source of income. What this American executive needs, what all managers need, is a moral compass, or perhaps an ethical algorithm, to guide them through such an ethical dilemma to find an acceptable solution. Later, we will outline what such a moral compass, or ethical algorithm, might look like. For now, it is enough to note that ethical dilemmas exist because many real-world decisions are complex, difficult to frame, and involve first-, second-, and third-order consequences that are hard to quantify. Doing the right thing, or even knowing what the right thing might be, is often far from easy.20

The Roots of Unethical Behavior

Examples are plentiful of managers behaving in a manner that might be judged unethical in an international business setting. Why do managers behave in an unethical manner? There is no simple answer to this question because the causes are complex, but some generalizations can be made and these issues are rooted in six determinants of ethical behavior: personal ethics, decision-making processes, organizational culture, unrealistic performance goals, leadership, and societal culture (see Figure 5.1).21

PERSONAL ETHICS

Societal business ethics are not divorced from personal ethics, which are the generally accepted principles of right and wrong governing the conduct of individuals. As individu- als, we are typically taught that it is wrong to lie and cheat—it is unethical—and that it is right to behave with integrity and honor and to stand up for what we believe to be right and true. This is generally true across societies. The personal ethical code that guides our behavior comes from a number of sources, including our parents, our schools, our reli- gion, and the media. Our personal ethical code exerts a profound influence on the way we behave as businesspeople. An individual with a strong sense of personal ethics is less likely to behave in an unethical manner in a business setting. It follows that the first step

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Child labor is still common in many poor nations. Source: © Ata Mohammad Adnan/Moment/Getty Images

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to establishing a strong sense of business ethics is for a society to emphasize strong per- sonal ethics. Home-country managers working abroad in multinational firms (expatriate managers) may experience more than the usual degree of pressure to violate their personal ethics. They are away from their ordinary social context and supporting culture, and they are psychologically and geographically distant from the parent company. They may be based in a culture that does not place the same value on ethical norms important in the manag- er’s home country, and they may be surrounded by local employees who have less rigor- ous ethical standards. The parent company may pressure expatriate managers to meet unrealistic goals that can only be fulfilled by cutting corners or acting unethically. For example, to meet centrally mandated performance goals, expatriate managers might give bribes to win contracts or might implement working conditions and environmental con- trols that are below minimal acceptable standards. Local managers might encourage the expatriate to adopt such behavior. Due to its geographic distance, the parent company may be unable to see how expatriate managers are meeting goals or may choose not to see how they are doing so, allowing such behavior to flourish and persist.

DECISION-MAKING PROCESSES

Several studies of unethical behavior in a business setting have concluded that business- people sometimes do not realize they are behaving unethically, primarily because they simply fail to ask, “Is this decision or action ethical?”22 Instead, they apply a straightfor- ward business calculus to what they perceive to be a business decision, forgetting that the decision may also have an important ethical dimension. The fault lies in processes that do not incorporate ethical considerations into business decision making. This may have been the case at Nike when managers originally made subcontracting decisions (see the earlier discussion). Those decisions were probably made based on good economic logic. Subcon- tractors were probably chosen based on business variables such as cost, delivery, and product quality, but the key managers simply failed to ask, “How does this subcontractor treat its workforce?” If they thought about the question at all, they probably reasoned that it was the subcontractor’s concern, not theirs. To improve ethical decision making in a multinational firm, the best starting point is to better understand how individuals make decisions that can be considered ethical or unethi- cal in an organizational environment.23 Two misnomers must be taken into account. First, too often it is assumed that individuals in the workplace make ethical decisions in the

Ethical Behavior

Unrealistic Performance

Goals

Leadership

Decision-Making Processes

Organizational Culture

Societal Culture

Personal Ethics

F I G U R E 5 . 1

Determinants of ethical behavior.

Ethics, Corporate Social Responsibility, and Sustainability Chapter 5 141

same way as they would if they were home. Second, too often it is assumed that people from different cultures make ethical decisions following a similar process (see Chapter 4 for more on cultural differences). Both of these assumptions are problematic. First, within an organization there are very few individuals who have the freedom (e.g., power) to de- cide ethical issues independent of pressures that may exist in an organizational setting (e.g., should we make a facilitating payment or resort to bribery?). Second, while the pro- cess for making an ethical decision may largely be the same in many countries, the relative emphasis on certain issues are unlikely to be the same. Some cultures may stress organi- zational factors (e.g., Japan) while others stress individual personal factors (e.g., the United States), yet some may base it purely on opportunity (e.g., Myanmar) and others base it on the importance to their superiors, for example (e.g., India).

ORGANIZATIONAL CULTURE

The culture in some businesses does not encourage people to think through the ethical consequences of business decisions. This brings us to the third cause of unethical behav- ior in businesses—an organizational culture that deemphasizes business ethics, reducing all decisions to the purely economic. The term organizational culture refers to the val- ues and norms that are shared among employees of an organization. You will recall from Chapter 4 that values are abstract ideas about what a group believes to be good, right, and desirable, while norms are the social rules and guidelines that prescribe appropriate be- havior in particular situations. Just as societies have cultures, so do business organiza- tions. Together, values and norms shape the culture of a business organization, and that culture has an important influence on the ethics of business decision making. The Management Focus on corruption at Daimler, for example, strongly suggests that paying bribes to secure business contracts was long viewed as an acceptable way of doing business within that company. It was, in the words of an investigator, “standard business practice” that permeated much of the organization, including departments such as audit- ing and finance that were meant to detect and halt such behavior. It can be argued that such a widespread practice could have persisted only if the values and norms of the orga- nization implicitly approved of paying bribes to secure business.

UNREALISTIC PERFORMANCE GOALS

A fourth cause of unethical behavior has already been hinted at—pressure from the par- ent company to meet unrealistic performance goals that can be attained only by cutting corners or acting in an unethical manner. In the Daimler case, for example, bribery may have been viewed as a way to hit challenging performance goals. The combination of an organizational culture that legitimizes unethical behavior, or at least turns a blind eye to such behavior, and unrealistic performance goals may be particularly toxic. In such cir- cumstances, there is a greater than average probability that managers will violate their own personal ethics and engage in unethical behavior. Conversely, an organization cul- ture can do just the opposite and reinforce the need for ethical behavior. At Hewlett- Packard, for example, Bill Hewlett and David Packard, the company’s founders, propagated a set of values known as The HP Way. These values, which shape the way business is conducted both within and by the corporation, have an important ethical com- ponent. Among other things, they stress the need for confidence in and respect for people, open communication, and concern for the individual employee.

LEADERSHIP

The Hewlett-Packard example suggests a fifth root cause of unethical behavior—leader- ship. Leaders help establish the culture of an organization, and they set the example, rules, and guidelines that others follow as well as the structure and processes for operat- ing both strategically and in daily operations. Employees often operate and work within a defined structure with a mindset very much similar to the overall culture of the organi- zation that employs them.

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Additionally, employees in a business often take their cue from business leaders, and if those leaders do not behave in an ethical manner, the employees might not either. It is not just what leaders say that matters, but what they do or do not do. What message, then, did the leaders at Daimler send about corrupt practices? Presumably, they did very little to discourage them and may have encouraged such behavior.

SOCIETAL CULTURE

Societal culture may well have an impact on the propensity of people, and organizations, to behave in an unethical manner. One study of 2,700 firms in 24 countries found that there were significant differences among the ethical policies of firms headquartered in different countries.24 Using Hofstede’s dimensions of social culture (see Chapter 4), the study found that enterprises headquartered in cultures where individualism and uncer- tainty avoidance are strong were more likely to emphasize the importance of behaving ethically than firms headquartered in cultures where masculinity and power distance are important cultural attributes. Such analysis suggests that enterprises headquartered in a country such as Russia, which scores high on masculinity and power distance measures, and where corruption is endemic, are more likely to engage in unethical behavior than enterprises headquartered in Scandinavia.

Philosophical Approaches to Ethics

In this section on philosophical approaches to ethics in the global marketplace, we look at several different approaches to business ethics. Basically, all individuals adopt a pro- cess for making ethical (or unethical) decisions. This process is based on their personal philosophical approach to ethics—that is, the underlying moral fabric of the individual. We begin with what can best be described as straw men, which either deny the value of business ethics or apply the concept in a very unsatisfactory way. Having discussed, and, we hope you agree, dismissed the straw men, we move on to consider approaches that are favored by most moral philosophers and form the basis for current models of ethical behavior in international businesses.

STRAW MEN

Straw men approaches to business ethics are raised by business ethics scholars primarily to demonstrate that they offer inappropriate guidelines for ethical decision making in a multinational enterprise. Four such approaches to business ethics are commonly dis- cussed in the literature. These approaches can be characterized as the Friedman doctrine, cultural relativism, the righteous moralist, and the naive immoralist. All these approaches have some inherent value, but all are unsatisfactory in important ways. Nevertheless, sometimes companies adopt these approaches.

The Friedman Doctrine The Nobel Prize–winning economist Milton Friedman wrote an article in the New York Times in 1970 that has since become a classic straw man example that business ethics schol- ars outline only to then tear down.25 Friedman’s basic position is that “the social responsibil- ity of business is to increase profits,” so long as the company stays within the rules of law. He explicitly rejects the idea that businesses should undertake social expenditures beyond those mandated by the law and required for the efficient running of a business. For example, his arguments suggest that improving working conditions beyond the level required by the law and necessary to maximize employee productivity will reduce profits and are therefore not appropriate. His belief is that a firm should maximize its profits because that is the way to maximize the returns that accrue to the owners of the firm, its shareholders. If the sharehold- ers then wish to use the proceeds to make social investments, that is their right, according to Friedman, but managers of the firm should not make that decision for them. 

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LO 5 - 4 Describe the different philosophical approaches to ethics.

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Although Friedman is talking about social responsibility and “ethical custom,” rather than business ethics per se, many business ethics scholars equate social responsibility with ethical behavior and thus believe Friedman is also arguing against business ethics. However, the assumption that Friedman is arguing against ethics is not quite true, for Friedman does argue that there is only one social responsibility of business: to increase the profitability of the enterprise so long as it stays within the law, which is taken to mean that it engages in open and free competition without deception or fraud.26 In other words, Friedman argues that businesses should behave in a socially responsi- ble manner, according to ethical custom, and without deception and fraud. Critics charge that Friedman’s arguments do break down under examination. This is particularly true in international business, where the “rules of the game” are not well es- tablished and differ from country to county. Consider again the case of sweatshop labor. Child labor may not be against the law in a developing nation, and maximizing produc- tivity may not require that a multinational firm stop using child labor in that country, but it is still immoral to use child labor because the practice conflicts with widely held views about what is the right and proper thing to do. Similarly, there may be no rules against pollution in a less developed nation and spending money on pollution control may reduce the profit rate of the firm, but generalized notions of morality would hold that it is still unethical to dump toxic pollutants into rivers or foul the air with gas releases. In addition to the local consequences of such pollution, which may have serious health effects for the surrounding population, there is also a global consequence as pollutants degrade those two global commons so important to us all—the atmosphere and the oceans.

Cultural Relativism Another straw man often raised by business ethics scholars is cultural relativism, which is the belief that ethics are nothing more than the reflection of a culture—all ethics are cultur- ally determined—and that accordingly, a firm should adopt the ethics of the culture in which it is operating.27 This approach is often summarized by the maxim when in Rome, do as the Romans. As with Friedman’s approach, cultural relativism does not stand up to a closer look. At its extreme, cultural relativism suggests that if a culture supports slavery, it is okay to use slave labor in a country. Clearly, it is not! Cultural relativism implicitly rejects the idea that universal notions of morality transcend different cultures, but, as we argue later in the chapter, some universal notions of morality are found across cultures. While dismissing cultural relativism in its most sweeping form, some ethicists argue there is residual value in this approach.28 We agree. As we noted in Chapter 3, societal values and norms do vary from culture to culture, and customs do differ, so it might fol- low that certain business practices are ethical in one country but not another. Indeed, the facilitating payments allowed in the Foreign Corrupt Practices Act can be seen as an ac- knowledgment that in some countries, the payment of speed money to government offi- cials is necessary to get business done, and if not ethically desirable, it is at least ethically acceptable.

The Righteous Moralist A righteous moralist claims that a multinational’s home-country standards of ethics are the appropriate ones for companies to follow in foreign countries. This approach is typi- cally associated with managers from developed nations. While this seems reasonable at first blush, the approach can create problems. Consider the following example: An Amer- ican bank manager was sent to Italy and was appalled to learn that the local branch’s ac- counting department recommended grossly underreporting the bank’s profits for income tax purposes.29 The manager insisted that the bank report its earnings accurately, Ameri- can style. When he was called by the Italian tax department to the firm’s tax hearing, he was told the firm owed three times as much tax as it had paid, reflecting the department’s standard assumption that each firm underreports its earnings by two-thirds. Despite his protests, the new assessment stood. In this case, the righteous moralist has run into a

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problem caused by the prevailing cultural norms in the country where he was doing busi- ness. How should he respond? The righteous moralist would argue for maintaining the position, while a more pragmatic view might be that in this case, the right thing to do is to follow the prevailing cultural norms because there is a big penalty for not doing so. The main criticism of the righteous moralist approach is that its proponents go too far. While there are some universal moral principles that should not be violated, it does not always follow that the appropriate thing to do is adopt home-country standards. For ex- ample, U.S. laws set down strict guidelines with regard to minimum wage and working conditions. Does this mean it is ethical to apply the same guidelines in a foreign country, paying people the same as they are paid in the United States, providing the same benefits and working conditions? Probably not, because doing so might nullify the reason for in- vesting in that country and therefore deny locals the benefits of inward investment by the multinational. Clearly, a more nuanced approach is needed.

The Naive Immoralist A naive immoralist asserts that if a manager of a multinational sees that firms from other nations are not following ethical norms in a host nation, that manager should not either. The classic example to illustrate the approach is known as the drug lord problem. In one variant of this problem, an American manager in Colombia routinely pays off the local drug lord to guarantee that her plant will not be bombed and that none of her em- ployees will be kidnapped. The manager argues that such payments are ethically defen- sible because everyone is doing it. The objection is twofold. First, to say that an action is ethically justified if everyone is doing it is not sufficient. If firms in a country routinely employ 12-year-olds and make them work 10-hour days, is it therefore ethically defensible to do the same? Obviously not, and the company does have a clear choice. It does not have to abide by local prac- tices, and it can decide not to invest in a country where the practices are particularly odi- ous. Second, the multinational must recognize that it does have the ability to change the prevailing practice in a country. It can use its power for a positive moral purpose. This is what BP is doing by adopting a zero-tolerance policy with regard to facilitating payments. BP is stating that the prevailing practice of making facilitating payments is ethically wrong, and it is incumbent upon the company to use its power to try to change the stan- dard. While some might argue that such an approach smells of moral imperialism and a lack of cultural sensitivity, if it is consistent with widely accepted moral standards in the global community, it may be ethically justified.

UTILITARIAN AND KANTIAN ETHICS

In contrast to the straw men just discussed, most moral philosophers see value in utilitar- ian and Kantian approaches to business ethics. These approaches were developed in the eighteenth and nineteenth centuries, and although they have been largely superseded by more modern approaches, they form part of the tradition on which newer approaches have been constructed. The utilitarian approach to business ethics dates to philosophers such as David Hume (1711–1776), Jeremy Bentham (1748–1832), and John Stuart Mill (1806–1873). Utilitarian approaches to ethics hold that the moral worth of actions or practices is determined by their consequences.30 An action is judged desirable if it leads to the best possible balance of good consequences over bad consequences. Utilitarianism is com- mitted to the maximization of good and the minimization of harm. Utilitarianism rec- ognizes that actions have multiple consequences, some of which are good in a social sense and some of which are harmful. As a philosophy for business ethics, it focuses attention on the need to weigh carefully all the social benefits and costs of a business action and to pursue only those actions where the benefits outweigh the costs. The best decisions, from a utilitarian perspective, are those that produce the greatest good for the greatest number of people.

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Many businesses have adopted specific tools such as cost–benefit analysis and risk as- sessment that are firmly rooted in a utilitarian philosophy. Managers often weigh the benefits and costs of an action before deciding whether to pursue it. An oil company considering drilling in the Alaskan wildlife preserve must weigh the economic benefits of increased oil production and the creation of jobs against the costs of environmental degradation in a fragile ecosystem. An agricultural biotechnology company such as Monsanto must decide whether the benefits of genetically modified crops that produce natural pesticides outweigh the risks. The benefits include increased crop yields and reduced need for chemical fertilizers. The risks include the possibility that Monsanto’s insect- resistant crops might make matters worse over time if insects evolve a resistance to the natural pesticides engineered into Monsanto’s plants, rendering the plants vulnerable to a new generation of superbugs. The utilitarian philosophy does have some serious drawbacks as an approach to busi- ness ethics. One problem is measuring the benefits, costs, and risks of a course of action. In the case of an oil company considering drilling in Alaska, how does one measure the potential harm done to the region’s ecosystem? The second problem with utilitarianism is that the philosophy omits the consideration of justice. The action that produces the great- est good for the greatest number of people may result in the unjustified treatment of a minority. Such action cannot be ethical, precisely because it is unjust. For example, sup- pose that in the interests of keeping down health insurance costs, the government decides to screen people for the HIV virus and deny insurance coverage to those who are HIV positive. By reducing health costs, such action might produce significant benefits for a large number of people, but the action is unjust because it discriminates unfairly against a minority. Kantian ethics is based on the philosophy of Immanuel Kant (1724–1804). Kantian ethics holds that people should be treated as ends and never purely as means to the ends of others. People are not instruments, like a machine. People have dignity and need to be respected as such. Employing people in sweatshops, making them work long hours for low pay in poor working conditions, is a violation of ethics, according to Kantian philoso- phy, because it treats people as mere cogs in a machine and not as conscious moral beings that have dignity. Although contemporary moral philosophers tend to view Kant’s ethical philosophy as incomplete—for example, his system has no place for moral emotions or sentiments such as sympathy or caring—the notion that people should be respected and treated with dignity resonates in the modern world.

RIGHTS THEORIES

Developed in the twentieth century, rights theories recognize that human beings have fundamental rights and privileges that transcend national boundaries and cultures. Rights establish a minimum level of morally acceptable behavior. One well-known definition of a fundamental right construes it as something that takes precedence over or “trumps” a collective good. Thus, we might say that the right to free speech is a fundamental right that takes precedence over all but the most compelling collective goals and overrides, for example, the interest of the state in civil harmony or moral consensus.31 Moral theorists argue that fundamental human rights form the basis for the moral compass that managers should navigate by when making decisions that have an ethical component. More pre- cisely, they should not pursue actions that violate these rights. The notion that there are fundamental rights that transcend national borders and cul- tures was the underlying motivation for the United Nations Universal Declaration of Human Rights, adopted in 1948, which has been ratified by almost every country on the planet and lays down basic principles that should always be adhered to irrespective of the culture in which one is doing business.32 Echoing Kantian ethics, Article 1 of this decla- ration states:

All human beings are born free and equal in dignity and rights. They are endowed with reason and conscience and should act towards one another in a spirit of brotherhood.

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Article 23 of this declaration, which relates directly to employment, states: 1. Everyone has the right to work, to free choice of employment, to just and favor-

able conditions of work, and to protection against unemployment. 2. Everyone, without any discrimination, has the right to equal pay for equal work. 3. Everyone who works has the right to just and favorable remuneration ensuring

for himself and his family an existence worthy of human dignity, and supple- mented, if necessary, by other means of social protection.

4. Everyone has the right to form and to join trade unions for the protection of his interests.

Clearly, the rights to “just and favorable conditions of work,” “equal pay for equal work,” and remuneration that ensures an “existence worthy of human dignity” embodied in Article 23 imply that it is unethical to employ child labor in sweatshop settings and pay less than subsistence wages, even if that happens to be common practice in some countries. These are fundamental human rights that transcend national borders. It is important to note that along with rights come obligations. Because we have the right to free speech, we are also obligated to make sure that we respect the free speech of others. The notion that people have obligations is stated in Article 29 of the Universal Declaration of Human Rights:

1. Everyone has duties to the community in which alone the free and full develop- ment of his personality is possible.

Within the framework of a theory of rights, certain people or institutions are obligated to provide benefits or services that secure the rights of others. Such obligations also fall on more than one class of moral agent (a moral agent is any person or institution that is ca- pable of moral action such as a government or corporation). For example, to escape the high costs of toxic waste disposal in the West, in the late 1980s several firms shipped their waste in bulk to African nations, where it was disposed of at a much lower cost. In 1987, five European ships unloaded toxic waste containing dangerous poisons in Nigeria. Workers wearing sandals and shorts unloaded the barrels for $2.50 a day and placed them in a dirt lot in a residential area. They were not told about the contents of the barrels.33 Who bears the obligation for protecting the rights of workers and residents to safety in a case like this? According to rights theorists, the obligation rests not on the shoulders of one moral agent, but on the shoulders of all moral agents whose actions might harm or contribute to the harm of the workers and residents. Thus, it was the obligation not just of the Nigerian government but also of the multinational firms that shipped the toxic waste to make sure it did no harm to residents and workers. In this case, both the government and the multinationals apparently failed to recognize their basic obligation to protect the fundamental human rights of others.

JUSTICE THEORIES

Justice theories focus on the attainment of a just distribution of economic goods and ser- vices. A just distribution is one that is considered fair and equitable. There is no one theory of justice, and several theories of justice conflict with each other in important ways.34 Here, we focus on one particular theory of justice that is both very influential and has important ethical implications. The theory is attributed to philosopher John Rawls.35 Rawls argues that all economic goods and services should be distributed equally except when an unequal distribution would work to everyone’s advantage. According to Rawls, valid principles of justice are those with which all persons would agree if they could freely and impartially consider the situation. Impartiality is guaranteed by a conceptual device that Rawls calls the veil of ignorance. Under the veil of ignorance, everyone is imagined to be ignorant of all of his or her particular charac- teristics, for example, race, sex, intelligence, nationality, family background, and spe- cial talents. Rawls then asks what system people would design under a veil of ignorance.

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Under these conditions, people would unanimously agree on two fundamental princi- ples of justice. The first principle is that each person be permitted the maximum amount of basic liberty compatible with a similar liberty for others. Rawls takes these to be political lib- erty (e.g., the right to vote), freedom of speech and assembly, liberty of conscience and freedom of thought, the freedom and right to hold personal property, and freedom from arbitrary arrest and seizure. The second principle is that once equal basic liberty is ensured, inequality in basic social goods—such as income and wealth distribution, and opportunities—is to be allowed only if such inequalities benefit everyone. Rawls accepts that inequalities can be just if the system that produces inequalities is to the advantage of everyone. More precisely, he formulates what he calls the difference principle, which is that inequalities are justified if they benefit the position of the least-advantaged person. So, for example, wide variations in income and wealth can be considered just if the market-based system that produces this unequal distri- bution also benefits the least-advantaged members of society. One can argue that a well- regulated, market-based economy and free trade, by promoting economic growth, benefit the least-advantaged members of society. In principle at least, the inequalities inherent in such systems are therefore just (in other words, the rising tide of wealth created by a market- based economy and free trade lifts all boats, even those of the most disadvantaged). In the context of international business ethics, Rawls’s theory creates an interesting perspective. Managers could ask themselves whether the policies they adopt in foreign operations would be considered just under Rawls’s veil of ignorance. Is it just, for exam- ple, to pay foreign workers less than workers in the firm’s home country? Rawls’s theory would suggest it is, so long as the inequality benefits the least-advantaged members of the global society (which is what economic theory suggests). Alternatively, it is difficult to imagine that managers operating under a veil of ignorance would design a system where foreign employees were paid subsistence wages to work long hours in sweatshop condi- tions and where they were exposed to toxic materials. Such working conditions are clearly unjust in Rawls’s framework, and therefore, it is unethical to adopt them. Similarly, oper- ating under a veil of ignorance, most people would probably design a system that imparts some protection from environmental degradation to important global commons, such as the oceans, atmosphere, and tropical rain forests. To the extent that this is the case, it fol- lows that it is unjust, and by extension unethical, for companies to pursue actions that contribute toward extensive degradation of these commons. Thus, Rawls’s veil of igno- rance is a conceptual tool that contributes to the moral compass that managers can use to help them navigate through difficult ethical dilemmas.

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F O C U S O N M A NAG E R I A L I M P L I C AT I O N S

MAKING ETHICAL DECISIONS INTERNATIONALLY What, then, is the best way for managers in a multinational firm to make sure that ethi-

cal considerations figure into international business decisions? How do managers decide on an ethical course of action when confronted with

decisions pertaining to working conditions, human rights, corruption, and environ- mental pollution? From an ethical perspective, how do managers determine the moral obligations that flow from the power of a multinational? In many cases,

there are no easy answers to these questions—many of the most vexing ethical problems arise because there are very real dilemmas inherent in them and no obvi-

ous correct action. Nevertheless, managers can and should do many things to make sure that basic ethical principles are adhered to and that ethical issues are routinely inserted into international business decisions.

LO 5 -5 Explain how managers can incorporate ethical considerations into their decision making.

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Here, we focus on seven actions that an international business and its managers can take to make sure ethical issues are considered in business decisions: (1) favor hiring and promot- ing people with a well-grounded sense of personal ethics; (2) build an organizational culture and exemplify leadership behaviors that place a high value on ethical behavior; (3) put decision- making processes in place that require people to consider the ethical dimension of  business decisions; (4) institute ethical officers in the organization, (5) develop moral courage; (6) make corporate social responsibility a cornerstone of enterprise policy; and (7) pursue strategies that are sustainable.

HIRING AND PROMOTION It seems obvious that businesses should strive to hire people who have a strong sense of personal ethics and would not engage in unethical or illegal behavior. Similarly, you would not expect a business to promote people, and perhaps to fire people, whose behavior does not match generally accepted ethical standards. However, actually doing so is very difficult. How do you know that someone has a poor sense of personal ethics? In our society, we have an incentive to hide a lack of personal ethics from public view. Once people realize that you are unethical, they will no longer trust you. Is there anything that businesses can do to make sure they do not hire people who subse- quently turn out to have poor personal ethics, particularly given that people have an incentive to hide this from public view (indeed, the unethical person may lie about his or her nature)? Businesses can give potential employees psychological tests to try to discern their ethical predispositions, and they can check with prior employees regarding someone’s reputation (e.g., by asking for letters of reference and talking to people who have worked with the pro- spective employee). The latter is common and does influence the hiring process. Promoting people who have displayed poor ethics should not occur in a company where the organiza- tional culture values the need for ethical behavior and where leaders act accordingly. Not only should businesses strive to identify and hire people with a strong sense of per- sonal ethics, but it also is in the interests of prospective employees to find out as much as they can about the ethical climate in an organization. Who wants to work at a multinational such as Enron, which ultimately entered bankruptcy because unethical executives had es- tablished risky partnerships that were hidden from public view and that existed in part to enrich those same executives?

ORGANIZATIONAL CULTURE AND LEADERSHIP To foster ethical behavior, businesses need to build an organizational culture that values ethical behavior. Three things are particularly important in building an organizational culture that emphasizes ethical behavior. First, the businesses must explicitly articulate values that emphasize ethical behavior. Many companies now do this by drafting a code of ethics, which is a formal statement of the ethical priorities a business adheres to. Often, the code of ethics draws heavily on documents such as the UN Universal Declaration of Human Rights, which itself is grounded in Kantian and rights-based theories of moral philosophy. Others have incorporated ethical statements into documents that articulate the values or mission of the business. For example, the food and consumer products multinational Unilever has a code of ethics that includes the following points:36

Employees: Unilever is committed to diversity in a working environment where there is mutual trust and respect and where everyone feels responsible for the performance and reputation of our company. We will recruit, employ, and promote employees on the sole basis of the qualifications and abilities needed for the work to be performed. We are committed to safe and healthy working conditions for all employees. We will not use any form of forced, compulsory, or child labor. We are committed to working with employees to develop and enhance each individual’s skills and capabilities. We respect the dignity of the individual and the right of employees to freedom of associa- tion. We will maintain good communications with employees through company-based information and consultation procedures.

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Business Integrity: Unilever does not give or receive, whether directly or indirectly, bribes or other improper advantages for business or financial gain. No employee may offer, give, or receive any gift or payment which is, or may be construed as be- ing, a bribe. Any demand for, or offer of, a bribe must be rejected immediately and reported to management. Unilever accounting records and supporting documents must accurately describe and reflect the nature of the underlying transactions. No undisclosed or unrecorded account, fund, or asset will be established or maintained.

It is clear from these principles that among other things, Unilever will not tolerate substan- dard working conditions, use child labor, or give bribes under any circumstances. Note also the reference to respecting the dignity of employees, a statement that is grounded in Kantian ethics. Unilever’s principles send a very clear message about appropriate ethics to manag- ers and employees. Having articulated values in a code of ethics or some other document, leaders in the business must give life and meaning to those words by repeatedly emphasizing their impor- tance and then acting on them. This means using every relevant opportunity to stress the importance of business ethics and making sure that key business decisions not only make good economic sense but also are ethical. Many companies have gone a step further, hiring independent auditors to make sure they are behaving in a manner consistent with their ethi- cal codes. Nike, for example, has hired independent auditors to make sure that subcontrac- tors used by the company are living up to Nike’s code of conduct. Finally, building an organizational culture that places a high value on ethical behavior re- quires incentive and reward systems, including promotions that reward people who engage in ethical behavior and sanction those who do not. At General Electric, for example, the for- mer CEO Jack Welch has described how he reviewed the performance of managers, divid- ing them into several different groups. These included overperformers who displayed the right values and were singled out for advancement and bonuses and overperformers who displayed the wrong values and were let go. Welch was not willing to tolerate leaders within the company who did not act in accordance with the central values of the company, even if they were in all other respects skilled managers.37

DECISION-MAKING PROCESSES In addition to establishing the right kind of ethical culture in an organization, businesspeople must be able to think through the ethical implications of decisions in a systematic way. To do this, they need a moral compass, and both rights theories and Rawls’s theory of justice help provide such a compass. Beyond these theories, some experts on ethics have proposed a straightforward practical guide—or ethical algorithm—to determine whether a decision is ethical.38 According to these experts, a decision is acceptable on ethical grounds if a busi- nessperson can answer yes to each of these questions:

the organizational environment (as articulated in a code of ethics or some other cor- porate statement)?

example, by having it reported in newspapers, on television, or via social media?

family members, friends, or even managers in other businesses, approve of the decision?

Others have recommended a five-step process to think through ethical problems (this is another example of an ethical algorithm).39 In step 1, businesspeople should identify which stakeholders a decision would affect and in what ways. A firm’s stakeholders are indi- viduals or groups that have an interest, claim, or stake in the company, in what it does, and in how well it performs.40 They can be divided into internal stakeholders and external stakeholders. Internal stakeholders are individuals or groups who work for or own the

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business. They include primary stakeholders such as employees, the board of directors, and shareholders. External stakeholders are all the other individuals and groups that have some direct or indirect claim on the firm. Typically, this group comprises primary stakeholders such as customers, suppliers, governments, and local communities as well as secondary stakeholders such as special-interest groups, competitors, trade associa- tions, mass media, and social media.41

All stakeholders are in an exchange relationship with the company.42 Each stakeholder group supplies the organization with important resources (or contributions), and in exchange each expects its interests to be satisfied (by inducements).43 For example, employees pro- vide labor, skills, knowledge, and time and in exchange expect commensurate income, job satisfaction, job security, and good working conditions. Customers provide a company with its revenues and in exchange want quality products that represent value for money. Com- munities provide businesses with local infrastructure and in exchange want businesses that are responsible citizens and seek some assurance that the quality of life will be improved as a result of the business firm’s existence. Stakeholder analysis involves a certain amount of what has been called moral imagina- tion.44 This means standing in the shoes of a stakeholder and asking how a proposed deci- sion might impact that stakeholder. For example, when considering outsourcing to subcontractors, managers might need to ask themselves how it might feel to be working under substandard health conditions for long hours. Step 2 involves judging the ethics of the proposed strategic decision, given the infor- mation gained in step 1. Managers need to determine whether a proposed decision would violate the fundamental rights of any stakeholders. For example, we might argue that the right to information about health risks in the workplace is a fundamental entitle- ment of employees. Similarly, the right to know about potentially dangerous features of a product is a fundamental entitlement of customers (something tobacco companies vio- lated when they did not reveal to their customers what they knew about the health risks of smoking). Managers might also want to ask themselves whether they would allow the proposed strategic decision if they were designing a system under Rawls’s veil of igno- rance. For example, if the issue under consideration was whether to outsource work to a subcontractor with low pay and poor working conditions, managers might want to ask themselves whether they would allow such action if they were considering it under a veil of ignorance, where they themselves might ultimately be the ones to work for the subcontractor. The judgment at this stage should be guided by various moral principles that should not be violated. The principles might be those articulated in a corporate code of ethics or other company documents. In addition, certain moral principles that we have adopted as mem- bers of society—for instance, the prohibition on stealing—should not be violated. The judg- ment at this stage will also be guided by the decision rule that is chosen to assess the proposed strategic decision. Although maximizing long-run profitability is the decision rule that most businesses stress, it should be applied subject to the constraint that no moral prin- ciples are violated—that the business behaves in an ethical manner. Step 3 requires managers to establish moral intent. This means the business must re- solve to place moral concerns ahead of other concerns in cases where either the funda- mental rights of stakeholders or key moral principles have been violated. At this stage, input from top management might be particularly valuable. Without the proactive encouragement of top managers, middle-level managers might tend to place the narrow economic interests of the company before the interests of stakeholders. They might do so in the (usually erro- neous) belief that top managers favor such an approach. Step 4 requires the company to engage in ethical behavior. Step 5 requires the business to audit its decisions, reviewing them to make sure they were consistent with ethical princi- ples, such as those stated in the company’s code of ethics. This final step is critical and often overlooked. Without auditing past decisions, businesspeople may not know if their decision process is working and if changes should be made to ensure greater compliance with a code of ethics.

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ETHICS OFFICERS To make sure that a business behaves in an ethical manner, firms now must have oversight by a high-ranking person or people known to respect legal and ethical standards. These individuals—often referred to as ethics officers—are responsible for managing their organi- zations ethics and legal compliance programs. They are typically responsible for (1) assess- ing the needs and risks that an ethics program must address; (2) developing and distributing a code of ethics; (3) conducting training programs for employees; (4) establishing and main- taining a confidential service to address employees’ questions about issues that may be ethical or unethical; (5) making sure that the organization is in compliance with government laws and regulations; (6) monitoring and auditing ethical conduct; (7) taking action, as appro- priate, on possible violations; and (8) reviewing and updating the code of ethics periodi- cally.45 Because of these broad topics covered by the ethics officer, in many businesses ethics officers act as an internal ombudsperson with responsibility for handling confidential inquiries from employees, investigating complaints from employees or others, reporting find- ings, and making recommendations for change. For example, United Technologies, a multinational aerospace company with worldwide revenues of more than $30 billion, has had a formal code of ethics since 1990.46 United Technologies has some 450 business practices officers (the company’s name for ethics of- ficers). They are responsible for making sure the code is followed. United Technologies also established an ombudsperson program in 1986 that lets employees inquire anonymously about ethics issues. The program has received some 60,000 inquiries since 1986, and more than 10,000 cases have been handled by an ombudsperson.

MORAL COURAGE It is important to recognize that employees in an international business may need significant moral courage. Moral courage enables managers to walk away from a decision that is profit- able but unethical. Moral courage gives an employee the strength to say no to a superior who instructs her to pursue actions that are unethical. Moral courage gives employees the integrity to go public to the media and blow the whistle on persistent unethical behavior in a company. Moral courage does not come easily; there are well-known cases where individu- als have lost their jobs because they blew the whistle on corporate behaviors they thought unethical, telling the media about what was occurring.47

However, companies can strengthen the moral courage of employees by committing themselves to not retaliate against employees who exercise moral courage, say no to supe- riors, or otherwise complain about unethical actions. For example, consider the following excerpt from Unilever.com “Our Principles”:

Any breaches of the Code must be reported in accordance with the procedures speci- fied by the Chief Legal Officer. The Board of Unilever will not criticize management for any loss of business resulting from adherence to these principles and other manda- tory policies and instructions. The Board of Unilever expects employees to bring to their attention, or to that of senior management, any breach or suspected breach of these principles. Provision has been made for employees to be able to report in con- fidence and no employee will suffer as a consequence of doing so.48

This statement gives permission to employees to exercise moral courage. Companies can also set up ethics hotlines, which allow employees to anonymously register a complaint with a corporate ethics officer.

CORPORATE SOCIAL RESPONSIBILITY Multinational corporations have power that comes from their control over resources and their ability to move production from country to country. Although that power is constrained not only by laws and regulations but also by the discipline of the market and the competitive process, it is substantial. Some moral philosophers argue that with power comes the social responsibil- ity for multinationals to give something back to the societies that enable them to prosper and

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grow. The concept of corporate social responsibility (CSR) refers to the idea that business- people should consider the social consequences of economic actions when making business decisions and that there should be a presumption in favor of decisions that have both good economic and social consequences.49 In its purest form, corporate social responsibility can be supported for its own sake simply because it is the right way for a business to behave. Advo- cates of this approach argue that businesses, particularly large successful businesses, need to

M A NAG E M E N T F O C U S

Corporate Social Responsibility at Stora Enso Stora Enso is a Finnish pulp and paper manufacturer that was formed by the merger of Swedish mining and forestry products company Stora and Finnish forestry products company Enso-Gutzeit Oy in 1998. The company is head- quartered in Helsinki, the capital of Finland, and it has ap- proximately 29,000 employees. In 2000, the company bought Consolidated Papers in North America. Stora Enso also expanded into South America, Asia, and Russia. By 2005, Stora Enso had become the world’s largest pulp and paper manufacturer as measured by production ca- pacity. However, the North American operations were sold in 2007 to NewPage Corporation. Stora Enso has a long-standing tradition of corporate social responsibility on a global scale. As part of the com- pany’s section “Global Responsibility in Stora Enso,” the company states that “for Stora Enso, Global Responsibility means realizing concrete actions that will help us fulfil [sic] our Purpose, which is to do good for the people and the planet.” Stora Enso continues to state:

Our purpose “do good for the people and the planet” is the ultimate reason why we run our business. It is the overriding rule that guides us in all that we do: producing and selling our renewable products, buy- ing trees from a local forest-owner in Finland, selling electricity generated at Stora Enso Skoghall Mill, or managing our logistics on a global scale.

Interestingly, Stora Enso also asserts that it realizes that this statement is rather bold and perhaps not even fully believable. But, the company suggests that it makes the company accountable for its actions; that is, setting its purpose boldly in writing. At the same time, Stora Enso positions the company as though it has always been at- tending to the “socially responsible” needs of doing good for the people and the planet. It illustrates this by main- taining that it has created and enhanced communities around its mills, developed innovative systems to reduce the use of scarce resources, and maintained good rela- tionships with key stakeholders such as forest-owners,

their own employees, governments, and local communi- ties near its mills. Tracing to its past and reflecting on its future, Stora Enso has adopted three lead areas for its global responsi- bility strategy: people and ethics, forests and land use, and environment and efficiency. For people and ethics, the company focuses on conducting business in a socially re- sponsible manner throughout its global value chain. For forests and land use, it focuses on an innovative and re- sponsible approach on forestry and land use to make it a preferred partner and a good local community citizen. For the environment and efficiency, the focus is on resource- efficient operations that help the company achieve supe- rior environmental performance related to its products. While a number of companies have corporate social re- sponsibility statements incorporated as part of their web- sites, annual reports, and talking points, Stora Enso also presents clear targets and performance goals that are as- sessed by established metrics. Its overall operations are guided by corporate-level targets for environmental and social performance, aptly named Stora Enso’s Global Re- sponsibility Key Performance Indicators (KPIs). Targets are publicly listed in a document titled “Targets and Perfor- mance” and include two to five basic categories of mea- sures for each of the three lead areas. For people and ethics, the dimensions cover health and safety, human rights, ethics and compliance, sustainable leadership, and responsible sourcing. For forests and land use, the dimen- sions cover efficiency of land use and sustainable forestry. For environment and efficiency, the dimensions cover cli- mate and energy, material efficiency, and process water discharges. The “Targets and Performance” document also lists performance in the prior year, targets in the current year, and strategic objectives related to each dimension.

Sources: “Global Responsibility in Stora Enso,” www.storaenso.com/ Rethink-Site/Responsibility-Site, accessed March 9, 2014; K. Vita, “Stora Enso Falls as UBS Plays Down Merger Talk: Helsinki Mover,” Bloomberg Businessweek, September 30, 2013; M. Huuhtanen, “Paper Maker Stora Enso Selling North American Mills,” USA Today, September 21, 2007.

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recognize their noblesse oblige and give something back to the societies that have made their success possible. Noblesse oblige is a French term that refers to honorable and benevo- lent behavior considered the responsibility of people of high (noble) birth. In a business set- ting, it is taken to mean benevolent behavior that is the responsibility of successful enterprises. This has long been recognized by many businesspeople, resulting in a substantial and vener- able history of corporate giving to society, with businesses making social investments de- signed to enhance the welfare of the communities in which they operate. Power itself is morally neutral; how power is used is what matters. It can be used in a positive way to increase social welfare, which is ethical, or it can be used in a manner that is ethically and morally suspect. Managers at some multinationals have acknowledged a moral obligation to use their power to enhance social welfare in the communities where they do business. BP, one of the world’s largest oil companies, has made it part of the company policy to undertake “social investments” in the countries where it does business.50 In Algeria, BP has been investing in a major project to develop gas fields near the desert town of Salah. When the company noticed the lack of clean water in Salah, it built two desalination plants to provide drinking water for the local community and distributed containers to resi- dents so they could take water from the plants to their homes. There was no economic reason for BP to make this social investment, but the company believes it is morally obli- gated to use its power in constructive ways. The action, while a small thing for BP, is a very important thing for the local community. For another example of corporate social responsibil- ity in practice, see the Management Focus feature on the Finnish company Stora Enso.

SUSTAINABILITY As managers in international businesses strive to translate ideas about corporate social re- sponsibility into strategic actions, many are gravitating toward strategies that are viewed as sustainable. By sustainable strategies, we mean strategies that not only help the multina- tional firm make good profits, but that also do so without harming the environment while si- multaneously ensuring that the corporation acts in a socially responsible manner with regard to its stakeholders.51 The core idea of sustainability is that the organization—through its actions—does not exert a negative impact on the ability of future generations to meet their own economic needs and that its actions impart long-run economic and social benefits on stakeholders.52 A company pursuing a sustainable strategy would not adopt business prac- tices that deplete the environment for short-term economic gain because doing so would impose a cost on future generations. In other words, international businesses that pursue sustainable strategies try to ensure that they do not precipitate or participate in a situation that results in a tragedy of the commons. Thus, for example, a company pursuing a sustain- able strategy would try to reduce its carbon footprint (CO2 emissions) so that it does not contribute to global warming. Nor would a company pursuing a sustainable strategy adopt policies that negatively af- fect the well-being of key stakeholders such as employees and suppliers because manag- ers would recognize that in the long run, this would harm the company. The company that pays its employees so little that it forces them into poverty, for example, may find it hard to recruit employees in the future and may have to deal with high employee turnover, which imposes its own costs on an enterprise. Similarly, a company that drives down the prices it pays to its suppliers so far that the suppliers cannot make enough money to invest in up- grading their operations may find that in the long run, its business suffers poor-quality inputs and a lack of innovation among its supplier base. Stora Enso, profiled in the Management Focus feature, is in essence pursuing sustainable strategies because, through its actions, it is trying to make sure that forest resources are well managed and available for future generations and that the communities with which it inter- acts benefit from its presence and will, therefore, support the company going forward. For another example, consider Starbucks. Starbucks has a goal of ensuring that 100 percent of its coffee is ethically sourced. By this, it means that the farmers who grow the coffee beans it purchases use sustainable farming methods that do not harm the environment and that they treat their employees well and pay them fairly. Starbucks agronomists work directly with

M A NAG E M E N T F O C U S

Sustainability at Umicore In introducing Umicore as the most sustainable multina- tional firm in the world for 2013 on its Global 100 Index, Doug Morrow, vice president of research at Corporate Knights, a Toronto-based media company, said that sus- tainability is “recognizing that a corporation’s long-term in- terests are intellectually and financially consistent with resource efficiency, proactive health and safety practices, and responsible leadership.” “Sustainability is when what is good for a company is also good for the planet, and vice- versa,” added the editor in chief of Corporate Knights, Toby Heaps. Umicore NV, formerly Union Minière until 2001, is a multi- national materials technology company headquartered in Brussels, Belgium. The company was founded in 1989 as a merger of four companies in the mining and smelting indus- tries. Subsequent to the merger, Umicore reshaped itself to focus on technology-related businesses such as refining and recycling of precious metals along with the manufactur- ing of specialized products from precious metals. As a solid and respected company, Umicore has been included as a component of Belgium’s benchmark BEL20 index since its inception in 1991 (BEL20 is the benchmark stock market in- dex of Euronext Brussels, the Brussels Stock Exchange). Umicore’s core business areas or divisions are Cataly- sis, Energy Materials, Performance Materials, and Recy- cling. Catalysis is involved with abatement of global automotive emissions and production of compounds for use in chemicals, life science, and pharmaceutical indus- tries. The materials produced by Energy Materials can be found in a number of applications used in the production

and storage of clean energy. Performance Materials ap- plies its technology and know-how to the unique proper- ties of precious and other metals (to achieve safer products). Recycling treats complex waste streams con- taining precious and other nonferrous metals. Across these four business areas, Umicore clearly de- fines its sustainability objectives and goals, which address market orientation, multiple stakeholders, and corporate social responsibility. The company’s financial objective is to achieve double-digit revenue growth, with the goal of generating an average return on capital employed of more than 15 percent annually. Such a goal is market oriented with a clear, bottom-line financial expectation for perfor- mance. For corporate social responsibility, the focus is on two issues. Environmentally, Umicore focuses on reducing its carbon footprint by 20 percent, reducing the impact of metal emissions on water and air by 20 percent, and in- vesting in tools to better understand and measure life cy- cles of its products. Socially, Umicore focuses on achieving zero lost-time accidents, reducing body concentrations of metals to which employees have exposure, and individual employee development. Umicore also takes a strong stand in its stakeholder management, stating that all of its sites are expected to identify key stakeholders and en- gage with the local community.

Sources: J. Smith, “The World’s Most Sustainable Companies,” Forbes,  January 23, 2013; Umicore’s Sustainability, www.umicore. com/sustainability, accessed March 9, 2014; J. Martens, “Umicore Gains after Maintaining Profit Forecast: Brussels Mover,” Bloomberg Businessweek, July 30, 2013.

farmers in places like Costa Rica and Rwanda to make sure that they use environmentally responsible farming methods. The company also provides loans to farmers to help them upgrade their production methods. As a result of these policies, by 2012 some 93 percent of Starbucks coffee beans were ethically sourced. An important aspect of the sustainable strategies pursued by both Stora Enso and Star- bucks is that they have helped both companies gain a competitive advantage and, there- fore, make more money for their shareholders. In the case of Starbucks, its ethical sourcing policies send a powerful signal to its customers about the kind of company Starbucks wants to be. This resonates well with the company’s customer base and strengthens the Starbucks brand, resulting in more store traffic and higher sales and profits. So even though it may cost Starbucks some money up front to shift to an ethical sourcing policy, the benefits in terms of a more powerful brand outweigh the costs. For another example of a multinational that is pursuing a sustainable strategy, see the Management Focus feature about sustainability at Umicore, a Belgian company. The basic point here is that well-crafted sustainable strategies can be good for sharehold- ers, the environment, suppliers, local communities, employees, and customers. Business

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Ethics, Corporate Social Responsibility, and Sustainability Chapter 5 155

need not be a zero-sum game, where increasing the returns to one stakeholder group (e.g., shareholders) requires the imposition of costs on other stakeholder groups (e.g., the environ- ment, suppliers, employees). As the examples we have given illustrate, it is possible to pursue sustainable strategies that result in a positive-sum game where all stakeholders benefit. To be sure, pursuing such strategies may impose some short-term costs on the multinational as it increases investments in better environmental practices, better employee working condi- tions, and safer products, and as it requires suppliers to adopt similar policies. In the long run, however, there is good evidence that all stakeholders can benefit from such an approach and, indeed, that such an approach may help the company compete more effectively in the global marketplace. Good ethical practices are good for business!

business ethics, p. 131 ethical strategy, p. 131 Foreign Corrupt Practices

Act (FCPA), p. 136 Convention on Combating

Bribery of Foreign Public Officials in International Business Transactions, p. 136

ethical dilemma, p. 139

organizational culture, p. 141 cultural relativism, p. 143 righteous moralist, p. 143 naive immoralist, p. 144 utilitarian approach to ethics, p. 144 Kantian ethics, p. 145 rights theories, p. 145 Universal Declaration of

Human Rights, p. 145

just distribution, p. 146 code of ethics, p. 148 stakeholders, p. 149 internal stakeholders, p. 149 external stakeholders, p. 150 corporate social

responsibility (CSR), p. 152 sustainable strategies, p. 153

Key Terms

C H A P T E R S U M M A R Y

This chapter discussed the source and nature of ethical issues in international businesses, the different philo- sophical approaches to business ethics, and the steps managers can take to ensure that ethical issues are re- spected in international business decisions. The chapter made the following points:

1. The term ethics refers to accepted principles of right or wrong that govern the conduct of a per- son, the members of a profession, or the actions of an organization. Business ethics are the ac- cepted principles of right or wrong governing the conduct of businesspeople, and an ethical strategy is one that does not violate these accepted principles.

2. Ethical issues and dilemmas in international business are rooted in the variations among political systems, law, economic development, and culture from nation to nation.

3. The most common ethical issues in international business involve employment practices, human rights, environmental regulations, corruption, and social responsibility of multinational corporations.

4. Ethical dilemmas are situations in which none of the available alternatives seems ethically acceptable.

5. Unethical behavior is rooted in poor personal ethics, societal culture, the psychological and geographic distances of a foreign subsidiary from the home office, a failure to incorporate ethical issues into strategic and operational decision making, a dysfunctional culture, and failure of leaders to act in an ethical manner.

6. Moral philosophers contend that approaches to business ethics such as the Friedman doctrine, cultural relativism, the righteous moralist, and the naive immoralist are unsatisfactory in im- portant ways.

7. The Friedman doctrine states that the only social responsibility of business is to increase profits, as long as the company stays within the rules of law. Cultural relativism contends that one should adopt the ethics of the culture in which one is doing business. The righteous moralist monolithically applies home-country ethics to a foreign situation, while the naive immoralist believes that if a manager of a multinational sees that firms from other nations are not following ethical norms in a host nation, that manager should not either.

8. Utilitarian approaches to ethics hold that the moral worth of actions or practices is determined

156 Part 2 National Differences

by their consequences, and the best decisions are those that produce the greatest good for the greatest number of people.

9. Kantian ethics state that people should be treated as ends and never purely as means to the ends of others. People are not instruments, like a machine. People have dignity and need to be respected as such.

10. Rights theories recognize that human beings have fundamental rights and privileges that transcend national boundaries and cultures. These rights establish a minimum level of morally acceptable behavior.

11. The concept of justice developed by John Rawls suggests that a decision is just and ethical if people would allow it when designing a social system under a veil of ignorance.

12. To make sure that ethical issues are considered in international business decisions, managers

should (a) favor hiring and promoting people with a well-grounded sense of personal ethics; (b) build an organizational culture and exem- plify leadership behaviors that place a high value on ethical behavior; (c) put decision- making processes in place that require people to consider the ethical dimension of business decisions; (d) establish ethics officers in the organization with responsibility for ethical decision making; (e) be morally courageous and encourage others to do the same; (f) make corporate social responsibility a cornerstone of enterprise policy; and (g) pursue strategies that are sustainable.

13. Multinational corporations that are practicing business-focused sustainability integrate a focus on market orientation, addressing the needs of multiple stakeholders, and adhering to corporate social responsibility principles.

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. A visiting American executive finds that a for- eign subsidiary in a less developed country has hired a 12-year-old girl to work on a factory floor, in violation of the company’s prohibition on child labor. He tells the local manager to re- place the child and tell her to go back to school. The local manager tells the American executive that the child is an orphan with no other means of support, and she will probably become a street child if she is denied work. What should the American executive do?

2. Drawing on John Rawls’s concept of the veil of ignorance, develop an ethical code that will (a) guide the decisions of a large oil multina- tional toward environmental protection and (b) influence the policies of a clothing company in their potential decision of outsourcing its manufacturing operations.

3. Under what conditions is it ethically defensible to outsource production to the developing world where labor costs are lower when such actions also involve laying off long-term employees in the firm’s home country?

4. Do you think facilitating payments (speed pay- ments) should be ethical?

5. A manager from a developing country is over- seeing a multinational’s operations in a country where drug trafficking and lawlessness are rife.

One day, a representative of a local “big man” approaches the manager and asks for a “dona- tion” to help the big man provide housing for the poor. The representative tells the manager that in return for the donation, the big man will make sure that the manager has a productive stay in his country. No threats are made, but the manager is well aware that the big man heads a criminal orga- nization that is engaged in drug trafficking. He also knows that the big man does indeed help the poor in the rundown neighborhood of the city where he was born. What should the manager do?

6. Milton Friedman stated in his famous article in the New York Times in 1970 that “the social responsibility of business is to increase profits.” Do you agree? If not, do you prefer that multinational corporations adopt a focus on corporate social responsibility or sustain- ability practices?

7. Reread the Management Focus on Unocal, and answer the following questions: a. Was it ethical for Unocal to enter into a

partnership with a brutal military dictator- ship for financial gain?

b. What actions could Unocal have taken, short of not investing at all, to safeguard the human rights of people affected by the gas pipeline project?

Ethics, Corporate Social Responsibility, and Sustainability Chapter 5 157

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises:

1. Promoting respect for universal human rights is a central dimension of many countries’ foreign pol- icy. As history has shown, human rights abuses are an important concern worldwide. Some coun- tries are more ready to work with other govern- ments and civil society organizations to prevent abuses of power. Begun in 1977, the annual Country Reports on Human Rights Practices are designed to assess the state of democracy and human rights around the world, call attention to violations, and—where needed—prompt needed changes in U.S. policies toward particular coun- tries. Find the latest annual Country Reports on Human Right Practices for the BRIC countries

(Brazil, China, India, and Russia), and create a table to compare the findings under the “Worker Rights” sections. What commonalities do you see? What differences are there?

2. The use of bribery in the business setting is an im- portant ethical dilemma many companies face both domestically and abroad. The Bribe Payers Index is a study published every three years to assess the likelihood of firms from 28 leading economies to win business overseas by offering bribes. It also ranks industry sectors based on the prevalence of bribery. Compare the five industries thought to have the largest problems with bribery with those five that have the least problems. What patterns do you see? What factors make some industries more conducive to bribery than others?

Bitcoin is an open-source, peer-to-peer digital currency introduced to the world on January 3, 2009, by developer Satoshi Nakamoto. The cryptocurrency is based on a pro- tocol and software that allows instant peer-to-peer transac- tions and worldwide payments with minimal costs. In its few years of existence, bitcoin has seen unprecedented media coverage, a roller-coaster ride of epic spikes and epic plunges, and adopters from major retailers to lemon stands (e.g., Amazon, Target, Victoria’s Secret, and Whole Foods). Bitcoin has also been covered by numerous major news organizations (e.g., ABC, CNBC, Forbes, Fox News, Reuters) as the most popular form of virtual currency. At the same time, ethical concerns exist with this new digital currency. The coupling of no regulations, virtually free movement of value, and a Ponzi scheme–like system have led renowned economist Paul Krugman to suggest that “bitcoin is evil.” At the basic level, Krugman argues that money must be both a medium of exchange and a stable store of value. Krugman argues that it is unclear to him why bitcoin should be a stable store of value. Joining in the discussion, Charlie Stross, the British writer of sci- ence fiction, says that “bitcoin looks like it was designed as a weapon intended to damage central banking and money issuing banks, with a Libertarian political agenda in mind—to damage states’ ability to collect tax and monitor their citizens’ financial transactions.”

What is the difference between bitcoin and normal currency, such as the U.S. dollar? Bitcoin is an unregu- lated peer-to-peer digital currency that is not backed by any other commodity such as gold or silver. Bitcoins ex- ist almost entirely in the digital, online world, although some bitcoins have actually been privately minted. The U.S. dollar, like many other stable currencies, are paper or coin currency issued by a national reserve–type bank (in the United States, it is the Federal Reserve Bank). This means that dollars are really Federal Reserve Notes that are printed or minted at the U.S. Bureau of Engrav- ing and Printing. The dollar is so-called fiat money, which means that dollars derive their value from the U.S. government regulation or law. Interestingly, the United States decided in 2014 that bitcoins will be taxed as property, not currency, for International Revenue Ser- vices (IRS) purposes. The IRS defined bitcoin as a “con- vertible currency that can be used as a medium of exchange, a unit of account, and/or a store of value.” Technically, Bitcoin with a capital B refers to the tech- nology and network associated with the currency, while bitcoin with a lowercase b refers to the actual currency. The philosophy underlying the bitcoin is complete mis- trust in authority or control—basically a perfectly state- less, market-based approach, with no country or region-level bank intervention. It is also very technical.

C L O S I N G C A S E

Bitcoin as an Ethical Dilemma

158 Part 2 National Differences

Bitcoins are generated through a process called “mining.” The mining process involves adding transaction records to bitcoin’s public ledger of past transactions, which is called the block chain (i.e., a chain of blocks). Bitcoin nodes use the block chain to identify legitimate bitcoin transactions. Even in today’s high-tech world, the mining process is intentionally designed to be resource intensive and difficult. This means that the number of blocks found daily by miners remains relatively steady. So, basically, in order to “mine” a bitcoin, a person has to solve a complex mathematical problem using substantial computational power. There’s a twofold reason for this: It controls the supply of bitcoins and incentivizes people to maintain the underlying infrastructure that keeps bitcoins in place. A unique feature of the bitcoin is that the number of new bitcoins that are created is intentionally halved every four years until the year 2140, when it will wind down to zero. So, starting in 2140, no more bitcoins will be added to virtual circulation and they will have reached their maximum of 21 million. Perhaps most people will not worry about the year 2140 just yet, but it does mean that there is, technically, a finite supply of bitcoins. Such a fi- nite number has the potential to adversely affect the value of bitcoins. Economist John Quiggin argues that this has resulted in “the finest example of a pure bubble.” Perhaps more remarkably, bitcoins do not have any real value per se (compared to gold and silver), which means that the coin’s value depends on classical demand- and-supply economics, leading many financial experts to liken bitcoins to a Ponzi scheme, similar to Krugman’s viewpoint. A Ponzi scheme is a fraudulent investment operation that returns payment to its investors from capi- tal paid by new investors rather than from profit earned. (Charles Ponzi was born in Italy, but became known in

the early 1920s as a swindler in North America for his unusual money-making scheme.) Bitcoins have also been the subject of scrutiny by var- ious governments because of concerns that they can be used for illegal activities. Some say the cryptocurrency is unethical because it is allegedly used to buy illegal drugs and guns and to pay for other illegal activities. Addition- ally, given its unique code, once stolen, bitcoins cannot be returned, and there is no central bank or agency that can help catch thieves. But, bitcoins have also attacked the cost of moving money around and have successfully created a simple measure of value that can be very effi- ciently moved around at virtually no cost. Sources: P. Krugman, “Bitcoin Is Evil,” The New York Times, December 28, 2013; U. Goyal, “Bitcoin and the Future of Money,” Informilo, June 5, 2013; D. Leger, “IRS: Bitcoin Is Not a Currency,” USA Today, March 25, 2014.

C a s e D i s c u s s i o n Q u e s t i o n s

1. Do you think bitcoins are approaching being unethical monetary instruments without tech- nically carrying a value similar to “real” money?

2. If bitcoins are used to buy drugs, firearms, or other products that are considered illegal in the country in which the bitcoins are being used, does that make bitcoins unethical?

3. Do you think the bitcoin system is “evil” as Paul Krugman suggests? Is it similar to a Ponzi scheme?

4. Do you think that bitcoins were created as a weapon intended to damage central banking and money-issuing banks?

E n d n o t e s

1. Toy Industry Association Inc. and the NPD Group, 2012, www. toyassociation.org, accessed March 8, 2014.

2. T. Hult, “Market-Focused Sustainability: Market Orientation Plus!,” Journal of the Academy of Marketing Science 39, pp. 1–6, 2011; T. Hult, J. Mena, O. C. Ferrell, and L. Ferrell, “Stakeholder Marketing: A Definition and Conceptual Frame- work,” AMS Review 1 (2011), pp. 44–65.

3. S. Greenhouse, “Nike Shoe Plant in Vietnam Is Called Unsafe for Workers,” The New York Times, November 8, 1997; V. Dobnik, “Chinese Workers Abused Making Nikes, Reeboks,” Seattle Times, September 21, 1997, p. A4.

4. R. K. Massie, Loosing the Bonds: The United States and South Africa in the Apartheid Years (New York: Doubleday, 1997).

5. Not everyone agrees that the divestment trend had much influence on the South African economy. For a counterview see S. H. Teoh, I. Welch, and C. P. Wazzan, “The Effect of Socially Activist In- vesting on the Financial Markets: Evidence from South Africa,” The Journal of Business 72, no. 1 (January 1999), pp. 35–60.

6. Peter Singer, One World: The Ethics of Globalization (New Haven, CT: Yale University Press, 2002).

7. Garrett Hardin, “The Tragedy of the Commons,” Science 162, no. 1 (1968), pp. 243–48.

8. For a summary of the evidence, see S. Solomon, D. Qin, M. Manning, Z. Chen, M. Marquis, K. B. Averyt, M. Tignor, and H. L. Miller, eds., Contribution of Working Group I to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change (Cambridge, UK: Cambridge University Press, 2007).

Ethics, Corporate Social Responsibility, and Sustainability Chapter 5 159

9. J. Everett, D. Neu, and A. S. Rahaman, “The Global Fight against Corruption,” Journal of Business Ethics 65 (2006), pp. 1–18.

10. R. T. De George, Competing with Integrity in International Business (Oxford, UK: Oxford University Press, 1993).

11. Details can be found at www.oecd.org/corruption/ oecdantibriberyconvention.

12. B. Pranab, “Corruption and Development,” Journal of Economic Literature 36 (September 1997), pp. 1320–46.

13. A. Shleifer and R. W. Vishny, “Corruption,” Quarterly Journal of Economics, no. 108 (1993), pp. 599–617; I. Ehrlich and F. Lui, “Bureaucratic Corruption and Endogenous Economic Growth,” Journal of Political Economy 107 (December 1999), pp. 270–92.

14. P. Mauro, “Corruption and Growth,” Quarterly Journal of Eco- nomics, no. 110 (1995), pp. 681–712.

15. D. Kaufman and S. J. Wei, “Does Grease Money Speed up the Wheels of Commerce?,” World Bank policy research working paper, January 11, 2000.

16. Detailed at http://ethics.iit.edu/ecodes/node/3436, accessed March 8, 2014.

17. B. Vitou, R. Kovalevsky, and T. Fox, “Time to Call a Spade a Spade: Facilitation Payments and Why Neither Bans nor Ex- emption Work,” http://thebriberyact.com/2011/02/03/time-to- call-a-spade-a-spade-facilitation-payments-why-neither-bans- nor-exemptions-work, accessed March 8, 2014.

18. This is known as the “when in Rome perspective.” T. Donaldson, “Values in Tension: Ethics Away from Home,” Harvard Business Review, September–October 1996.

19. De George, Competing with Integrity in International Business. 20. For a discussion of the ethics of using child labor, see J. Isern,

“Bittersweet Chocolate: The Legacy of Child Labor in Cocoa Production in Cote d’Ivoire,” Journal of Applied Management and Entrepreneurship 11 (2006), pp. 115–32.

21. S. W. Gellerman, “Why Good Managers Make Bad Ethical Choices,” in Ethics in Practice: Managing the Moral Corpora- tion, ed. K. R. Andrews (Cambridge, MA: Harvard Business School Press, 1989).

22. D. Messick and M. H. Bazerman, “Ethical Leadership and the Psychology of Decision Making,” Sloan Management Review 37 (Winter 1996), pp. 9–20.

23. O. C. Ferrell, J. Fraedrich, and L. Ferrell, Business Ethics, 9th ed. (Mason, OH: Cengage, 2013).

24. B. Scholtens and L. Dam, “Cultural Values and International Differences in Business Ethics,” Journal of Business Ethics, 2007.

25. M. Friedman, “The Social Responsibility of Business Is to Increase Profits,” The New York Times Magazine, September 13, 1970. Re- printed in T. L. Beauchamp and N. E. Bowie, Ethical Theory and Business, 7th ed. (Englewood Cliffs, NJ: Prentice Hall, 2001).

26. Ibid., p. 55. 27. For example, see Donaldson, “Values in Tension: Ethics Away

from Home.” See also N. Bowie, “Relativism and the Moral Obligations of Multinational Corporations,” in T. L. Beauchamp and N. E. Bowie, Ethical Theory and Business, 7th ed. (Englewood Cliffs, NJ: Prentice Hall, 2001).

28. For example, see De George, Competing with Integrity in Inter- national Business.

29. This example is often repeated in the literature on international business ethics. It was first outlined by A. Kelly in “Case Study—

Italian Style Mores,” in T. Donaldson and P. Werhane, Ethical Issues in Business (Englewood Cliffs, NJ: Prentice Hall, 1979).

30. See Beauchamp and Bowie, Ethical Theory and Business. 31. T. Donaldson, The Ethics of International Business (Oxford:

Oxford University Press, 1989). 32. Found at www.un.org/Overview/rights.html. 33. T. Donaldson, The Ethics of International Business. 34. See Chapter 10 in Beauchamp and Bowie, Ethical Theory and

Business.

35. J. Rawls, A Theory of Justice, rev. ed. (Cambridge, MA: Belknap Press, 1999).

36. Found on Unilever’s website, www.unilever.com/aboutus/ purposeandprinciples/ourprinciples/default.aspx.

37. J. Bower and J. Dial, “Jack Welch: General Electrics Revolu- tionary,” Harvard Business School Case 9-394-065, April 1994.

38. For example, see R. E. Freeman and D. Gilbert, Corporate Strategy and the Search for Ethics (Englewood Cliffs, NJ: Prentice Hall, 1988); T. Jones, “Ethical Decision Making by In- dividuals in Organizations,” Academy of Management Review 16 (1991), pp. 366–95; J. R. Rest, Moral Development: Ad- vances in Research and Theory (New York: Praeger, 1986).

39. Freeman and Gilbert, Corporate Strategy and the Search for Ethics; Jones, “Ethical Decision Making by Individuals in Or- ganizations”; Rest, Moral Development.

40. See E. Freeman, Strategic Management: A Stakeholder Approach (Boston: Pitman Press, 1984); C. W. L. Hill and T. M. Jones, “Stakeholder-Agency Theory,” Journal of Management Studies 29 (1992), pp. 131–54; J. G. March and H. A. Simon, Organizations (New York: Wiley, 1958).

41. Hult et al., “Stakeholder Marketing.” 42. Hult, “Market-Focused Sustainability: Market Orientation

Plus!”; Hult et al., “Stakeholder Marketing.” 43. Hill and Jones, “Stakeholder-Agency Theory”; March and Simon,

Organizations.

44. De George, Competing with Integrity in International Business. 45. Ferrell et al., Business Ethics. 46. The code can be accessed at United Technologies website,

www.utc.com/profile/ethics/index.htm. 47. C. Grant, “Whistle Blowers: Saints of Secular Culture,” Jour-

nal of Business Ethics, September 2002, pp. 391–400. 48. “Our Principles,” Unilever’s website, www.unilever.com/aboutus/

purposeandprinciples/ourprinciples/default.aspx, accessed March 9, 2014.

49. S. A. Waddock and S. B. Graves, “The Corporate Social Perfor- mance–Financial Performance Link,” Strategic Management Journal 8 (1997), pp. 303–19; I. Maignan, O. C. Ferrell, and T. Hult, “Corpo- rate Citizenship: Cultural Antecedents and Business Benefits,” Jour- nal of the Academy of Marketing Science 27 (1999), pp. 455–69.

50. Details can be found at BP’s website, www.bp.com. 51. Hult, “Market-Focused Sustainability: Market Orientation Plus!” 52. M. Clarkson, “A Stakeholder Framework for Analyzing and

Evaluating Corporate Social Performance,” Academy of Man- agement Review 20 (1995), pp. 92–117; R. Freeman, Strategic Management: A Stakeholder Approach (Marshfield: Pitman, 1984); T. Hult, J. Mena, O. Ferrell, and L. Ferrell, “Stakeholder Marketing: A Definition and Conceptual Framework,” AMS Review 1 (2011), pp. 44–65.

Credit: ©Federal Reserve Board.

International Trade Theory L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO6 -1 Understand why nations trade with each other.

LO6-2 Summarize the different theories explaining trade flows between nations.

LO6-3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

LO6-4 Explain the arguments of those who maintain that government can play a proactive role in promoting national competitive advantage in certain industries.

LO6-5 Understand the important implications that international trade theory holds for business practice.

part three The Global Trade and Investment Environment

6

Source: © Stephen Morton/Bloomberg/Getty Images

International Trade Theory Chapter 6 161

China and Australia Enter into a Free Trade Agreement

tourist and health care providers to wholly own, build, and operate hotels and hospitals in China.  As for the Chinese, the agreement will eliminate tariffs on imports into Australia of Chinese-manufactured goods including cars, clothes, textiles, and electronic equipment. This will help Chinese companies compete against their South Korean and Japanese rivals in the Australian market place. The deal will also make it easier for Chinese firms to invest directly in Australia. Investments under $1 billion will no longer have to be reviewed by Australia’s Foreign In- vestment Review Board, putting Chinese investors on an equal footing with those from New Zealand and the United States.  When the deal was being negotiated, estimates from economists suggested that it would result in gains in real GDP for Australia of A$150 billion over 20 years, and gains to China of A$131 billion. More recent estimates suggest that the gains to Australia might be quite a bit larger. As for China, because the Chinese economy is so much larger than that of Australia, the direct impact will necessarily be smaller. However, economists believe that by entering into deals such as this, China is trying to inject more competi- tion into the Chinese marketplace, pushing Chinese pro- ducers to become more efficient. In the past China has promoted domestic market–oriented economic reforms under the cover of international trade agreements, most notably prior to the country’s entry into the World Trade Organization in 2001. Although the deal with Australia is much smaller in scale, it fits with this general strategy.

Sources: The Economist Intelligence Unit, “Chinese-Australian FTA Agreed after Ten Years,” November 19, 2014; The Economist, “Are You Being Served?,” December 4, 2014; Victoria Craw and Charis Chang, “Australia-China Free Trade Agreement: What It Means for You,” News.Com.Au, November 17, 2014.

O P E N I N G C A S E On November 18, 2014, Australia and China sealed a free trade agreement after nearly a decade of negotiations. This agreement followed hot on the heels of similar free trade agreements between Australian and South Korea, and Australia and Japan. China is Australia’s biggest trad- ing partner, accounting for nearly 32 percent of Australia’s merchandised exports in 2013 and 15 percent of the coun- try’s imports. During the 2009–2013 period, Australia’s ex- ports to China surged on the back of an increase in trade in raw materials, and particularly iron ore. While the growth in Chinese demand for Australian minerals is expected to slow, proponents of the trade deal argue that it will make it easier for Australian agricultural and service firms to sell into China, thereby helping offset any decline in the growth rate of mineral exports. Under the terms of the deal that now has to be ratified by the Australian Parliament, tariffs on Australian dairy products, which are as high as 20 percent, will be removed within 4 to 11 years. Tariffs on Australian exports of beef, sheep meat, and live cattle will also be phased out over 4 to 9 years. Tariffs on Australian wine exports to China, which currently are as high as 30 percent, will be elimi- nated within 4 years.  Australia’s natural resources sector will also benefit from tariff reductions. Most notably, Chinese tariffs on im- ports of Australian coal will be removed. The agreement also grants Australian service exporters unprecedented access to the Chinese market. Australian financial service firms, including banks, insurance companies, and invest- ment fund managers, will enjoy access to the Chinese market second only to that enjoyed by firms based in Hong Kong. The agreement will also allow Australian

161

Introduction

The free trade agreement between Australia and China that was finalized in November 2014 is an example of the benefits of trade between nations. Assuming that the agreement is ratified, it should boost economic growth in both Australia and China. As tariffs are reduced, Australian firms will have an easier job selling goods and services in China. Similarly, Chinese enterprises will find it easier to do business in Australia. Both sides stand to benefit from this agreement.  Economists have long argued that free trade stimulates economic growth and raises living standards across the board. As the opening case illustrates, the economic argu- ments concerning the benefits of free trade in goods and services are not abstract aca- demic ones. International trade theories have shaped the economic policy of many nations for the past 60 years. They have been the driver behind the formation of the World Trade Organization and regional trade blocs such as the European Union and the North Ameri- can Free Trade Agreement (NAFTA), and they underlie the current push for a free trade deal between the United States and the EU. It is important to understand, therefore, what

162 Part 3 The Global Trade and Investment Environment

these theories are and why they have been so successful in shaping the economic policy of so many nations and the competitive environment in which international businesses compete. This chapter has two goals that go to the heart of the debate over the benefits—and the costs—of free trade. The first is to review a number of theories that explain why it is beneficial for a country to engage in international trade. The second goal is to explain the pattern of international trade that we observe in the world economy. With regard to the pattern of trade, we will be primarily concerned with explaining the pattern of exports and imports of goods and services between countries. The pattern of foreign direct in- vestment between countries is discussed in Chapter 8.

An Overview of Trade Theory

We open this chapter with a discussion of mercantilism. Propagated in the sixteenth and seventeenth centuries, mercantilism advocated that countries should simultaneously en- courage exports and discourage imports. Although mercantilism is an old and largely discredited doctrine, its echoes remain in modern political debate and in the trade policies of many countries. Next, we will look at Adam Smith’s theory of absolute advantage. Proposed in 1776, Smith’s theory was the first to explain why unrestricted free trade is beneficial to a country. Free trade refers to a situation in which a government does not attempt to influence through quotas or duties what its citizens can buy from another coun- try, or what they can produce and sell to another country. Smith argued that the invisible hand of the market mechanism, rather than government policy, should determine what a country imports and what it exports. His arguments imply that such a laissez-faire stance toward trade was in the best interests of a country. Building on Smith’s work are two ad- ditional theories that we review. One is the theory of comparative advantage, advanced by the nineteenth-century English economist David Ricardo. This theory is the intellec- tual basis of the modern argument for unrestricted free trade. In the twentieth century, Ricardo’s work was refined by two Swedish economists, Eli Heckscher and Bertil Ohlin, whose theory is known as the Heckscher-Ohlin theory.

THE BENEFITS OF TRADE

The great strength of the theories of Smith, Ricardo, and Heckscher-Ohlin is that they identify with precision the specific benefits of international trade. Common sense sug- gests that some international trade is beneficial. For example, nobody would suggest that Iceland should grow its own oranges. Iceland can benefit from trade by exchanging some of the products that it can produce at a low cost (fish) for some products that it cannot produce at all (oranges). Thus, by engaging in international trade, Icelanders are able to add oranges to their diet of fish. The theories of Smith, Ricardo, and Heckscher-Ohlin go beyond this commonsense notion, however, to show why it is beneficial for a country to engage in international trade even for products it is able to produce for itself. This is a difficult concept for people to grasp. For example, many people in the United States believe that American consumers should buy products made in the United States by American companies whenever possi- ble to help save American jobs from foreign competition. The same kind of nationalistic sentiments can be observed in many other countries. However, the theories of Smith, Ricardo, and Heckscher-Ohlin tell us that a country’s economy may gain if its citizens buy certain products from other nations that could be produced at home. The gains arise because international trade allows a country to spe- cialize in the manufacture and export of products that can be produced most efficiently in that country, while importing products that can be produced more efficiently in other countries. Thus, it may make sense for the United States to specialize in the production and export of commercial jet aircraft, because the efficient production of commercial jet aircraft requires resources that are abundant in the United States, such as a highly skilled labor force and cutting-edge technological know-how. On the other hand, it may make

LO 6 -1 Understand why nations trade with each other.

International Trade Theory Chapter 6 163

sense for the United States to import textiles from Bangladesh because the efficient pro- duction of textiles requires a relatively cheap labor force—and cheap labor is not abun- dant in the United States. Of course, this economic argument is often difficult for segments of a country’s popu- lation to accept. With their future threatened by imports, U.S. textile companies and their employees have tried hard to persuade the government to limit the importation of textiles by demanding quotas and tariffs. Although such import controls may benefit particular groups, such as textile businesses and their employees, the theories of Smith, Ricardo, and Heckscher-Ohlin suggest that the economy as a whole is hurt by such action. One of the key insights of international trade theory is that limits on imports are often in the in- terests of domestic producers, but not domestic consumers.

T R A D E T U T O R I A L S

In this chapter we discuss benefits and costs associated with free trade, discuss the benefits of international trade, and explain the pattern of international trade in today’s world econ- omy. The general idea is that international trade theories explain why it can be beneficial for a country to engage in trade across country borders even though countries are at different stages of development, have different product needs, and produce different types of prod- ucts. International trade theory assumes that countries—through their governments, laws, and regulations—engage in more or less trade across borders. In reality, the vast majority of trade happens across borders by companies from different countries. As related to this chapter, check out globalEDGE’s “trade tutorials” section where lots of information, data, and tools are compiled related to trading internationally (globaledge.msu.edu/global-resources/ trade-tutorials). The potpourri of trade resources include export tutorials, online course modules, glossary, free trade agreement tariff tool, and much more. The glossary includes lots of terms related to trade. For example, “trade surplus” is defined as a situation in which a country’s exports exceeds its imports (i.e., it represents a net inflow of domestic currency from foreign markets). The opposite is called trade deficit and is considered a net outflow, but how is it really defined—the globalEDGE glossary can help.

THE PATTERN OF INTERNATIONAL TRADE

The theories of Smith, Ricardo, and Heckscher-Ohlin help explain the pattern of interna- tional trade that we observe in the world economy. Some aspects of the pattern are easy to understand. Climate and natural resource endowments explain why Ghana exports cocoa, Brazil exports coffee, Saudi Arabia exports oil, and China exports crawfish. However, much of the observed pattern of international trade is more difficult to explain. For exam- ple, why does Japan export automobiles, consumer electronics, and machine tools? Why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry? Why does Bangladesh export garments? David Ricardo’s theory of comparative advantage offers an explanation in terms of international differences in labor productivity. The more sophisti- cated Heckscher-Ohlin theory emphasizes the interplay between the proportions in which the factors of production (such as land, labor, and capital) are available in different coun- tries and the proportions in which they are needed for producing particular goods. This explanation rests on the assumption that countries have varying endowments of the various factors of production. Tests of this theory, however, suggest that it is a less powerful expla- nation of real-world trade patterns than once thought. One early response to the failure of the Heckscher-Ohlin theory to explain the observed pattern of international trade was the product life-cycle theory. Proposed by Raymond Vernon, this theory suggests that early in their life cycle, most new products are produced in and exported from the country in which they were developed. As a new product becomes

164 Part 3 The Global Trade and Investment Environment

widely accepted internationally, however, production starts in other countries. As a result, the theory suggests, the product may ultimately be exported back to the country of its original innovation.

In a similar vein, during the 1980s economists such as Paul Krugman developed what has come to be known as the new trade theory. New trade theory (for which Krugman won the Nobel Prize in 2008) stresses that in some cases countries specialize in the production and export of particular products not because of underlying differences in factor endow- ments, but because in certain industries the world market can support only a limited number of firms. (This is argued to be the case for the commercial aircraft industry.) In such industries, firms that enter the market first are able to build a competitive advantage that is subsequently difficult to challenge. Thus, the observed pattern of trade between nations may be due in part to the ability of firms within a given nation to capture first-mover advantages. The United States is a major exporter of commer- cial jet aircraft because American firms such as Boeing were first movers in the world market. Boeing built a competitive advantage that has subse- quently been difficult for firms from countries with equally favorable factor endowments to challenge (although Europe’s Airbus has succeeded in doing that). In a work related to the new trade theory, Michael Porter developed a theory referred to as the theory of national competitive advantage. This attempts to explain why particular nations achieve international success in particular industries. In addition to factor endowments, Porter points

out the importance of country factors such as domestic demand and domestic rivalry in explaining a nation’s dominance in the production and export of particular products.

TRADE THEORY AND GOVERNMENT POLICY

Although all these theories agree that international trade is beneficial to a country, they lack agreement in their recommendations for government policy. Mercantilism makes a crude case for government involvement in promoting exports and limiting imports. The theories of Smith, Ricardo, and Heckscher-Ohlin form part of the case for unrestricted free trade. The argument for unrestricted free trade is that both import controls and export incentives (such as subsidies) are self-defeating and result in wasted resources. Both the new trade theory and Porter’s theory of national competitive advantage can be interpreted as justifying some limited government intervention to support the development of certain export-oriented industries. We discuss the pros and cons of this argument, known as strategic trade policy, as well as the pros and cons of the argument for unre- stricted free trade, in Chapter 7.

Mercantilism

The first theory of international trade, mercantilism, emerged in England in the mid- sixteenth century. The principle assertion of mercantilism was that gold and silver were the mainstays of national wealth and essential to vigorous commerce. At that time, gold and silver were the currency of trade between countries; a country could earn gold and silver by export- ing goods. Conversely, importing goods from other countries would result in an outflow of gold and silver to those countries. The main tenet of mercantilism was that it was in a country’s best interests to maintain a trade surplus, to export more than it imported. By doing so, a country would accumulate gold and silver and, consequently, increase its national wealth, prestige, and power. As the English mercantilist writer Thomas Mun put it in 1630:

The ordinary means therefore to increase our wealth and treasure is by foreign trade, wherein we must ever observe this rule: to sell more to strangers yearly than we consume of theirs in value.1

LO 6 -2 Summarize the different theories explaining trade flows between nations.

Switzerland has long had a national competi- tive advantage in the manufacture of watches. Source: © Imaginechina/Corbis Wire/Corbis

TEST PREP Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

International Trade Theory Chapter 6 165

Consistent with this belief, the mercantilist doctrine advocated government intervention to achieve a surplus in the balance of trade. The mercantilists saw no virtue in a large volume of trade. Rather, they recommended policies to maximize exports and minimize imports. To achieve this, imports were limited by tariffs and quotas, while exports were subsidized. The classical economist David Hume pointed out an inherent inconsistency in the mercantilist doctrine in 1752. According to Hume, if England had a balance-of-trade surplus with France (it exported more than it imported), the resulting inflow of gold and silver would swell the domestic money supply and generate inflation in England. In France, however, the outflow of gold and silver would have the opposite effect. France’s money supply would contract, and its prices would fall. This change in relative prices between France and England would encourage the French to buy fewer English goods (because they were becoming more expensive) and the English to buy more French goods (because they were becoming cheaper). The result would be a deterioration in the English balance of trade and an improvement in France’s trade balance, until the English surplus was eliminated. Hence, according to Hume, in the long run no country could sustain a surplus on the balance of trade and so accumulate gold and silver as the mer- cantilists had envisaged. The flaw with mercantilism was that it viewed trade as a zero-sum game. (A zero-sum game is one in which a gain by one country results in a loss by another.) It was left to Adam Smith and David Ricardo to show the shortsightedness of this approach and to demonstrate that trade is a positive-sum game, or a situation in which all countries can benefit. Unfortu- nately, the mercantilist doctrine is by no means dead. Neo-mercantilists equate political power with economic power and economic power with a balance-of-trade surplus. Critics argue that many nations have adopted a neo-mercantilist strategy that is designed to simultaneously boost exports and limit imports.2 For example, critics charge that China long pursued a neo- mercantilist policy, deliberately keeping its currency value low against the U.S. dollar in order to sell more goods to the United States and other developed nations, and thus amass a trade surplus and foreign exchange reserves (see the accompanying Country Focus).

Absolute Advantage

In his 1776 landmark book The Wealth of Nations, Adam Smith attacked the mercantilist assumption that trade is a zero-sum game. Smith argued that countries differ in their abil- ity to produce goods efficiently. In his time, the English, by virtue of their superior manu- facturing processes, were the world’s most efficient textile manufacturers. Due to the combination of favorable climate, good soils, and accumulated expertise, the French had the world’s most efficient wine industry. The English had an absolute advantage in the production of textiles, while the French had an absolute advantage in the production of wine. Thus, a country has an absolute advantage in the production of a product when it is more efficient than any other country at producing it. According to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for those produced by other countries. In Smith’s time, this suggested the English should specialize in the production of textiles, while the French should specialize in the production of wine. England could get all the wine it needed by selling its textiles to France and buying wine in exchange. Similarly, France could get all the textiles it needed by selling wine to England and buy- ing textiles in exchange. Smith’s basic argument, therefore, is that a country should never produce goods at home that it can buy at a lower cost from other countries. Smith demon- strates that, by specializing in the production of goods in which each has an absolute ad- vantage, both countries benefit by engaging in trade. Consider the effects of trade between two countries, Ghana and South Korea. The production of any good (output) requires resources (inputs) such as land, labor, and capi- tal. Assume that Ghana and South Korea both have the same amount of resources and that these resources can be used to produce either rice or cocoa. Assume further that

TEST PREP Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

LO 6 -2 Summarize the different theories explaining trade flows between nations.

166

COUNTRY FOCUS

Is China a Neo-mercantilist Nation? China’s rapid rise in economic power (it is now the world’s second-largest economy) has been built on export-led growth. The country takes raw material imports and, using its cheap labor, converts them to products that it sells to developed nations. For years, the country’s exports have been growing faster than its imports, leading some critics to claim that China is pursuing a neo-mercantilist policy, trying to amass record trade surpluses and foreign cur- rency that will give it economic power over developed na- tions. By late 2013 its foreign exchange reserves exceeded $3.7 trillion, some 60 percent of which were held in U.S.- denominated assets. Observers worry that if China ever decides to sell its holdings of U.S. currency, this could de- press the value of the dollar against other currencies and increase the price of imports into America. Throughout most of the 2000s China’s exports have grown faster than its imports, leading some to argue that China has been limiting imports by pursuing an import substitution policy, encouraging domestic investment in the production of products such as steel, aluminum, and paper, which it had historically imported from other nations. The trade deficit with America has been a particular cause for concern. In 2012, this reached a record $315 billion and it looked set to exceed $340 billion in 2013. At the same time, China long resisted attempts to let its currency float freely against the U.S. dollar. Many claim that China’s currency is too cheap, and that this keeps the prices

of China’s goods artificially low, which fuels the country’s exports. So, is China a neo-mercantilist nation that is deliberately discouraging imports and encouraging exports to increase its trade surplus and accumulate foreign exchange re- serves, which might give it economic power? The jury is out on this issue. Skeptics suggest that going forward, the country will have no choice but to increase its imports of commodities that it lacks, such as oil. They also note that China did start allowing the value of the yuan (China’s cur- rency) to appreciate against the dollar in July 2005, albeit at a slow pace. In July 2005 one U.S. dollar purchased 8.11 yuan. By March 2015, one U.S. dollar purchased 6.16 yuan, a decline of 24 percent. Despite this, China’s trade surplus with the rest of the world remains persistently high and reached a record high of $382 billion in 2014.

Sources: A. Browne, “China’s Wild Swings Can Roil the Global Econ- omy,” The Wall Street Journal, October 24, 2005, p. A2; S. H. Hanke, “Stop the Mercantilists,” Forbes, June 20, 2005, p. 164; G. Dyer and A. Balls, “Dollar Threat as China Signals Shift,” Financial Times, Janu- ary 6, 2006, p. 1; Tim Annett, “Righting the Balance,” The Wall Street Journal, January 10, 2007, p. 15; “China’s Trade Surplus Peaks,” Financial Times, January 12, 2008, p. 1; W. Chong, “China’s Trade Surplus to U.S. to Narrow,” China Daily, December 7, 2009; A. Wang and K. Yao, “China’s Trade Surplus Dips, Taking Heat off Yuan,” Reuters, January 9, 2011; Aaron Back, “China’s Trade Surplus Shrank in ‘11,’” The Wall Street Journal, January 11, 2012; Richard Silk, “China’s Foreign Exchange Reserves Jump Again,” The Wall Street Journal, October 15, 2013.

200 units of resources are available in each country. Imagine that in Ghana it takes 10 re- sources to produce 1 ton of cocoa and 20 resources to produce 1 ton of rice. Thus, Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some com- bination of rice and cocoa between these two extremes. The different combinations that Ghana could produce are represented by the line GG′ in Figure 6.1. This is referred to as Ghana’s production possibility frontier (PPF). Similarly, imagine that in South Korea it takes 40 resources to produce 1 ton of cocoa and 10 resources to produce 1 ton of rice. Thus, South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or some combination between these two extremes. The different combinations available to South Korea are represented by the line KK′ in Figure 6.1, which is South Korea’s PPF. Clearly, Ghana has an absolute advantage in the production of cocoa. (More resources are needed to produce a ton of cocoa in South Korea than in Ghana.) By the same token, South Korea has an absolute advantage in the production of rice. Now consider a situation in which neither country trades with any other. Each coun- try devotes half its resources to the production of rice and half to the production of cocoa. Each country must also consume what it produces. Ghana would be able to pro- duce 10 tons of cocoa and 5 tons of rice (point A in Figure 6.1), while South Korea would be able to produce 10 tons of rice and 2.5 tons of cocoa (point B in Figure 6.1). Without trade, the combined production of both countries would be 12.5 tons of cocoa (10 tons in Ghana plus 2.5 tons in South Korea) and 15 tons of rice (5 tons in Ghana and

International Trade Theory Chapter 6 167

10 tons in South Korea). If each country were to specialize in producing the good for which it had an absolute advantage and then trade with the other for the good it lacks, Ghana could produce 20 tons of cocoa, and South Korea could produce 20 tons of rice. Thus, by specializing, the production of both goods could be increased. Produc- tion of cocoa would increase from 12.5 tons to 20 tons, while production of rice would increase from 15 tons to 20 tons. The increase in production that would result from specialization is therefore 7.5 tons of cocoa and 5 tons of rice. Table 6.1 summarizes these figures.

F I G U R E 6 . 1

The theory of absolute advantage.

5 10 15 200 Rice

K

G20

15

10 A

G'

B

K'

C o

c o

a 5

2.5

Resources Required to Produce 1 Ton of Cocoa and Rice

Cocoa Rice Ghana 10 20

South Korea 40 10

Production and Consumption without Trade

Ghana 10.0 5.0

South Korea 2.5 10.0

Total production 12.5 15.0

Production with Specialization

Ghana 20.0 0.0

South Korea 0.0 20.0

Total production 20.0 20.0

Consumption after Ghana Trades 6 Tons of Cocoa for 6 Tons of South Korean Rice

Ghana 14.0 6.0

South Korea 6.0 14.0

Increase in Consumption as a Result of Specialization and Trade

Ghana 4.0 1.0

South Korea 3.5 4.0

TA B L E 6 . 1

Absolute Advantage and the Gains from Trade

168 Part 3 The Global Trade and Investment Environment

By engaging in trade and swapping 1 ton of cocoa for 1 ton of rice, producers in both countries could consume more of both cocoa and rice. Imagine that Ghana and South Korea swap cocoa and rice on a one-to-one basis; that is, the price of 1 ton of cocoa is equal to the price of 1 ton of rice. If Ghana decided to export 6 tons of cocoa to South Korea and import 6 tons of rice in return, its final consumption after trade would be 14 tons of cocoa and 6 tons of rice. This is 4 tons more cocoa than it could have consumed before specialization and trade and 1 ton more rice. Similarly, South Korea’s final consumption after trade would be 6 tons of cocoa and 14 tons of rice. This is 3.5 tons more cocoa than it could have consumed before specialization and trade and 4 tons more rice. Thus, as a result of specialization and trade, output of both cocoa and rice would be increased, and consumers in both nations would be able to consume more. Thus, we can see that trade is a positive-sum game; it produces net gains for all involved.

Comparative Advantage

David Ricardo took Adam Smith’s theory one step further by exploring what might hap- pen when one country has an absolute advantage in the production of all goods.3 Smith’s theory of absolute advantage suggests that such a country might derive no benefits from international trade. In his 1817 book Principles of Political Economy, Ricardo showed that this was not the case. According to Ricardo’s theory of comparative advantage, it makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries, even if this means buying goods from other countries that it could produce more effi- ciently itself.4 While this may seem counterintuitive, the logic can be explained with a simple example. Assume that Ghana is more efficient in the production of both cocoa and rice; that is, Ghana has an absolute advantage in the production of both products. In Ghana it takes 10 resources to produce 1 ton of cocoa and 13½ resources to produce 1 ton of rice. Thus, given its 200 units of resources, Ghana can produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or any combination in between on its PPF (the line GG′ in Figure 6.2). In South Korea it takes 40 resources to produce 1 ton of cocoa and 20 resources to pro- duce 1 ton of rice. Thus, South Korea can produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or any combination on its PPF (the line KK′ in Figure 6.2). Again assume that without trade, each country uses half its resources to produce rice and half to pro- duce cocoa. Thus, without trade, Ghana will produce 10 tons of cocoa and 7.5 tons of rice (point A in Figure 6.2), while South Korea will produce 2.5 tons of cocoa and 5 tons of rice (point B in Figure 6.2).

LO 6 -2 Summarize the different theories explaining trade flows between nations.

F I G U R E 6 . 2

The theory of comparative advantage.

K

G

A

G'

B

K'

C

5 7.53.75 10 15 200 Rice

20

15

10

C o

c o

a

5

2.5

International Trade Theory Chapter 6 169

In light of Ghana’s absolute advantage in the production of both goods, why should it trade with South Korea? Although Ghana has an absolute advantage in the production of both cocoa and rice, it has a comparative advantage only in the production of cocoa: Ghana can produce 4 times as much cocoa as South Korea, but only 1.5 times as much rice. Ghana is comparatively more efficient at producing cocoa than it is at producing rice. Without trade the combined production of cocoa will be 12.5 tons (10 tons in Ghana and 2.5 in South Korea), and the combined production of rice will also be 12.5 tons (7.5 tons in Ghana and 5 tons in South Korea). Without trade each country must con- sume what it produces. By engaging in trade, the two countries can increase their com- bined production of rice and cocoa, and consumers in both nations can consume more of both goods.

THE GAINS FROM TRADE

Imagine that Ghana exploits its comparative advantage in the production of cocoa to increase its output from 10 tons to 15 tons. This uses up 150 units of resources, leaving the remaining 50 units of resources to use in producing 3.75 tons of rice (point C in Figure 6.2). Meanwhile, South Korea specializes in the production of rice, producing 10 tons. The combined output of both cocoa and rice has now increased. Before special- ization, the combined output was 12.5 tons of cocoa and 12.5 tons of rice. Now it is 15 tons of cocoa and 13.75 tons of rice (3.75 tons in Ghana and 10 tons in South Korea). The source of the increase in production is summarized in Table 6.2. Not only is output higher, but both countries also can now benefit from trade. If Ghana and South Korea swap cocoa and rice on a one-to-one basis, with both countries choosing

Resources Required to Produce 1 Ton of Cocoa and Rice

Cocoa Rice Ghana 10 13.33

South Korea 40 20

Production and Consumption without Trade

Ghana 10.0 7.5

South Korea 2.5 5.0

Total production 12.5 12.5

Production with Specialization

Ghana 15.0 3.75

South Korea 0.0 10.0

Total production 15.0 13.75

Consumption after Ghana Trades 4 Tons of Cocoa for 4 Tons of South Korean Rice

Ghana 11.0 7.75

South Korea 4.0 6.0

Increase in Consumption as a Result of Specialization and Trade

Ghana 1.0 0.25

South Korea 1.5 1.0

TA B L E 6 . 2

Comparative Advantage and the Gains from Trade

170 Part 3 The Global Trade and Investment Environment

to exchange 4 tons of their export for 4 tons of the import, both countries are able to consume more cocoa and rice than they could before specialization and trade (see Table 6.2). Thus, if Ghana exchanges 4 tons of cocoa with South Korea for 4 tons of rice, it is still left with 11 tons of cocoa, which is 1 ton more than it had before trade. The 4 tons of rice it gets from South Korea in exchange for its 4 tons of cocoa, when added to the 3.75 tons it now produces domestically, leave it with a total of 7.75 tons of rice, which is 0.25 ton more than it had before specialization. Similarly, after swapping 4 tons of rice with Ghana, South Korea still ends up with 6 tons of rice, which is more than it had before specializa- tion. In addition, the 4 tons of cocoa it receives in exchange is 1.5 tons more than it pro- duced before trade. Thus, consumption of cocoa and rice can increase in both countries as a result of specialization and trade. The basic message of the theory of comparative advantage is that potential world production is greater with unrestricted free trade than it is with restricted trade. Ricardo’s theory suggests that consumers in all nations can consume more if there are no restrictions on trade. This occurs even in countries that lack an absolute advantage in the production of any good. In other words, to an even greater degree than the theory of absolute advantage, the theory of comparative advantage suggests that trade is a positive- sum game in which all countries that participate realize economic gains. As such, this theory provides a strong rationale for encouraging free trade. So powerful is Ricardo’s theory that it remains a major intellectual weapon for those who argue for free trade.

QUALIFICATIONS AND ASSUMPTIONS

The conclusion that free trade is universally beneficial is a rather bold one to draw from such a simple model. Our simple model includes many unrealistic assumptions:

1. We have assumed a simple world in which there are only two countries and two goods. In the real world, there are many countries and many goods.

2. We have assumed away transportation costs between countries. 3. We have assumed away differences in the prices of resources in different coun-

tries. We have said nothing about exchange rates, simply assuming that cocoa and rice could be swapped on a one-to-one basis.

4. We have assumed that resources can move freely from the production of one good to another within a country. In reality, this is not always the case.

5. We have assumed constant returns to scale; that is, that specialization by Ghana or South Korea has no effect on the amount of resources required to produce one ton of cocoa or rice. In reality, both diminishing and increasing returns to specialization exist. The amount of resources required to produce a good might decrease or increase as a nation specializes in production of that good.

6. We have assumed that each country has a fixed stock of resources and that free trade does not change the efficiency with which a country uses its resources. This static assumption makes no allowances for the dynamic changes in a country’s stock of resources and in the efficiency with which the country uses its resources that might result from free trade.

7. We have assumed away the effects of trade on income distribution within a country. Given these assumptions, can the conclusion that free trade is mutually beneficial be extended to the real world of many countries, many goods, positive transportation costs, volatile exchange rates, immobile domestic resources, nonconstant returns to specializa- tion, and dynamic changes? Although a detailed extension of the theory of comparative advantage is beyond the scope of this book, economists have shown that the basic result derived from our simple model can be generalized to a world composed of many coun- tries producing many different goods.5 Despite the shortcomings of the Ricardian model, research suggests that the basic proposition that countries will export the goods that they are most efficient at producing is borne out by the data.6

LO 6 -3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

International Trade Theory Chapter 6 171

However, once all the assumptions are dropped, the case for unrestricted free trade, while still positive, has been argued by some economists associated with the “new trade theory” to lose some of its strength.7 We return to this issue later in this chapter and in the next when we discuss the new trade theory. In a recent and widely discussed analysis, the Nobel Prize–winning economist Paul Samuelson argued that contrary to the standard interpretation, in certain circumstances the theory of comparative advantage predicts that a rich country might actually be worse off by switching to a free trade regime with a poor nation.8 We consider Samuelson’s critique in the next section.

EXTENSIONS OF THE RICARDIAN MODEL

Let us explore the effect of relaxing three of the assumptions identified earlier in the simple comparative advantage model. Next, we relax the assumptions that resources move freely from the production of one good to another within a country, that there are constant returns to scale, and that trade does not change a country’s stock of resources or the efficiency with which those resources are utilized.

Immobile Resources In our simple comparative model of Ghana and South Korea, we assumed that producers (farmers) could easily convert land from the production of cocoa to rice and vice versa. While this assumption may hold for some agricultural products, resources do not always shift quite so easily from producing one good to another. A certain amount of friction is involved. For example, embracing a free trade regime for an advanced economy such as the United States often implies that the country will produce less of some labor-intensive goods, such as textiles, and more of some knowledge-intensive goods, such as computer software or biotechnology products. Although the country as a whole will gain from such a shift, textile producers will lose. A textile worker in South Carolina is probably not qualified to write software for Microsoft. Thus, the shift to free trade may mean that she becomes unemployed or has to accept another less attractive job, such as working at a fast-food restaurant. Resources do not always move easily from one economic activity to another. The pro- cess creates friction and human suffering too. While the theory predicts that the benefits of free trade outweigh the costs by a significant margin, this is of cold comfort to those who bear the costs. Accordingly, political opposition to the adoption of a free trade re- gime typically comes from those whose jobs are most at risk. In the United States, for example, textile workers and their unions have long opposed the move toward free trade precisely because this group has much to lose from free trade. Governments often ease the transition toward free trade by helping retrain those who lose their jobs as a result. The pain caused by the movement toward a free trade regime is a short-term phenome- non, while the gains from trade once the transition has been made are both significant and enduring.

Diminishing Returns The simple comparative advantage model developed above assumes constant returns to specialization. By constant returns to specialization we mean the units of resources re- quired to produce a good (cocoa or rice) are assumed to remain constant no matter where one is on a country’s production possibility frontier (PPF). Thus, we assumed that it always took Ghana 10 units of resources to produce 1 ton of cocoa. However, it is more realistic to assume diminishing returns to specialization. Diminishing returns to specialization occur when more units of resources are required to produce each additional unit. While 10 units of resources may be sufficient to increase Ghana’s output of cocoa from 12 tons to 13 tons, 11 units of resources may be needed to increase output from 13 to 14 tons, 12 units of re- sources to increase output from 14 tons to 15 tons, and so on. Diminishing returns imply a convex PPF for Ghana (see Figure 6.3), rather than the straight line depicted in Figure 6.2. It is more realistic to assume diminishing returns for two reasons. First, not all re- sources are of the same quality. As a country tries to increase its output of a certain good,

172 Part 3 The Global Trade and Investment Environment

it is increasingly likely to draw on more marginal resources whose productivity is not as great as those initially employed. The result is that it requires ever more resources to pro- duce an equal increase in output. For example, some land is more productive than other land. As Ghana tries to expand its output of cocoa, it might have to utilize increasingly marginal land that is less fertile than the land it originally used. As yields per acre de- cline, Ghana must use more land to produce 1 ton of cocoa. A second reason for diminishing returns is that different goods use resources in differ- ent proportions. For example, imagine that growing cocoa uses more land and less labor than growing rice and that Ghana tries to transfer resources from rice production to cocoa production. The rice industry will release proportionately too much labor and too little land for efficient cocoa production. To absorb the additional resources of labor and land, the cocoa industry will have to shift toward more labor-intensive methods of production. The effect is that the efficiency with which the cocoa industry uses labor will decline, and returns will diminish. Diminishing returns show that it is not feasible for a country to specialize to the degree suggested by the simple Ricardian model outlined earlier. Diminishing returns to specializa- tion suggest that the gains from specialization are likely to be exhausted before specializa- tion is complete. In reality, most countries do not specialize, but instead produce a range of goods. However, the theory predicts that it is worthwhile to specialize until that point where the resulting gains from trade are outweighed by diminishing returns. Thus, the basic con- clusion that unrestricted free trade is beneficial still holds, although because of diminishing returns, the gains may not be as great as suggested in the constant returns case.

Dynamic Effects and Economic Growth The simple comparative advantage model assumed that trade does not change a country’s stock of resources or the efficiency with which it utilizes those resources. This static assump- tion makes no allowances for the dynamic changes that might result from trade. If we relax this assumption, it becomes apparent that opening an economy to trade is likely to generate dynamic gains of two sorts.9 First, free trade might increase a country’s stock of resources as increased supplies of labor and capital from abroad become available for use within the country. For example, this has been occurring in eastern Europe since the early 1990s, with many Western businesses investing significant capital in the former communist countries. Second, free trade might also increase the efficiency with which a country uses its resources. Gains in the efficiency of resource utilization could arise from a number of factors. For example, economies of large-scale production might become available as

LO 6 -3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

F I G U R E 6 . 3

Ghana’s PPF under diminishing returns.

G

G' C

o c

o a

Rice 0

International Trade Theory Chapter 6 173

trade expands the size of the total market available to domestic firms. Trade might make better technology from abroad available to domestic firms; better technology can increase labor productivity or the productivity of land. (The so-called green revolution had this effect on agricultural outputs in developing countries.) Also, opening an economy to foreign competition might stimulate domestic producers to look for ways to increase their efficiency. Again, this phenomenon has arguably been occurring in the once-protected markets of eastern Europe, where many former state monopolies have had to increase the efficiency of their operations to survive in the competitive world market. Dynamic gains in both the stock of a country’s resources and the efficiency with which resources are utilized will cause a country’s PPF to shift outward. This is illustrated in Figure 6.4, where the shift from PPF1 to PPF2 results from the dynamic gains that arise from free trade. As a consequence of this outward shift, the country in Figure 6.4 can produce more of both goods than it did before introduction of free trade. The theory sug- gests that opening an economy to free trade not only results in static gains of the type discussed earlier but also results in dynamic gains that stimulate economic growth. If this is so, then one might think that the case for free trade becomes stronger still, and in gen- eral it does. However, as noted, one of the leading economic theorists of the twentieth century, Paul Samuelson, argued that in some circumstances, dynamic gains can lead to an outcome that is not so beneficial.

The Samuelson Critique Paul Samuelson’s critique looks at what happens when a rich country—the United States—enters into a free trade agreement with a poor country—China—that rapidly improves its productivity after the introduction of a free trade regime (i.e., there is a dynamic gain in the efficiency with which resources are used in the poor country). Samuelson’s model suggests that in such cases, the lower prices that U.S. consumers pay for goods imported from China following the introduction of a free trade regime may not be enough to produce a net gain for the U.S. economy if the dynamic effect of free trade is to lower real wage rates in the United States. As he stated in a New York Times interview, “Being able to purchase groceries 20 percent cheaper at Wal-Mart (due to international trade) does not necessarily make up for the wage losses (in America).”10 Samuelson goes on to note that he is particularly concerned about the ability to off- shore service jobs that traditionally were not internationally mobile, such as software debugging, call-center jobs, accounting jobs, and even medical diagnosis of MRI scans (see the accompanying Country Focus for details). Recent advances in communications

F I G U R E 6 . 4

The influence of free trade on the PPF.

C o

c o

a

Rice 0

PPF2

PPF1

174

COUNTRY FOCUS

Economists have long argued that free trade produces gains for all countries that participate in a free trading system. As the next wave of globalization sweeps through the U.S. economy, many people are wondering if this is true. During the 1980s and 1990s, free trade was associated with the movement of low-skill, blue- collar manufacturing jobs out of rich countries such as the United States and toward low-wage countries—textiles to Costa Rica, athletic shoes to the Philippines, steel to Brazil, electronic products to Thailand, and so on. While many observers bemoaned the “hollowing out” of U.S. manufacturing, economists stated that high-skill and high-wage white-collar jobs associated with the knowledge-based economy would stay in the United States. Computers might be assembled in Thailand, so the argument went, but they would continue to be designed in Silicon Valley by highly skilled U.S. engineers, and software applications would be written in the United States by pro- grammers at Apple, Microsoft, Adobe, Oracle, and the like. Developments over the past several decades have people questioning this assumption. Many American com- panies have been moving white-collar, knowledge-based jobs to developing nations where they can be performed for a fraction of the cost. During the long economic boom of the 1990s, Bank of America had to compete with other organizations for the scarce talents of information technol- ogy specialists, driving annual salaries to more than $100,000. However, with business under pressure during the 2000s, the bank cut nearly 5,000 jobs from its 25,000-strong, U.S.-based information technology work- force. Some of these jobs were transferred to India, where work that costs $100 an hour in the United States could be done for $20 an hour. One beneficiary of Bank of America’s downsizing is  Infosys Technologies Ltd., a Bangalore, India, informa- tion technology firm where 250 engineers now develop information technology applications for the bank. Other

Infosys employees are busy pro- cessing home loan applications for U.S. mortgage companies. Nearby in the offices of another Indian firm, Wipro Ltd., radiolo- gists interpret 30 CT scans a day for Massachusetts General Hos- pital that are sent over the Inter- net. At yet another Bangalore b u s i n e s s , e n g i n e e r s e a r n $10,000 a year designing leading- edge semiconductor chips for Texas Instruments. Nor is India the only beneficiary of these changes.

Some architectural work also is being outsourced to lower-cost locations. Flour Corp., a California-based con- struction company, employs some 1,200 engineers and drafters in the Philippines, Poland, and India to turn layouts of industrial facilities into detailed specifications. For a Saudi Arabian chemical plant Flour is designing, 200 young engineers based in the Philippines earning less than $3,000 a year collaborate in real time over the Internet with elite U.S. and British engineers who make up to $90,000 a year. Why does Flour do this? According to the company, the answer is simple. Doing so reduces the prices of a project by 15 percent, giving the company a cost-based competitive advantage in the global market for construction design. Most disturbing of all for future job growth in the United States, some high-tech start-ups are outsourcing significant work right from inception. For example, Zoho Corporation, a California-based start-up offering online web applications for small businesses, has about 20 employees in the United States and more than 1,000 in India!

Sources: P. Engardio, A. Bernstein, and M. Kripalani, “Is Your Job Next?,” BusinessWeek, February 3, 2003, pp. 50–60; “America’s Pain, India’s Gain,” The Economist, January 11, 2003, p. 57; M. Schroeder and T. Aeppel, “Skilled Workers Mount Opposition to Free Trade, Swaying Politicians,” The Wall Street Journal, October 10, 2003, pp. A1, A11; D. Clark, “New U.S. Fees on Visas Irk Outsources,” The Wall Street Journal, August 16, 2010, p. 6; J. R. Hagerty, “U.S. Loses High Tech Jobs as R&D Shifts to Asia,” The Wall Street Journal, January 18, 2012, p. B1.

Moving U.S. White-Collar Jobs Offshore

Companies like Infosys in India provide many jobs through servicing U.S.-based companies. Source: © Vivek Prakash/Bloomberg/Getty Images

International Trade Theory Chapter 6 175

technology have made this possible, effectively expanding the labor market for these jobs to include educated people in places such as India, the Philippines, and China. When coupled with rapid advances in the productivity of foreign labor due to better education, the effect on middle-class wages in the United States, according to Samuelson, may be similar to mass inward migration into the country: It will lower the market clearing wage rate, perhaps by enough to outweigh the positive benefits of international trade. Having said this, it should be noted that Samuelson concedes that free trade has his- torically benefited rich counties (as data discussed later seem to confirm). Moreover, he notes that introducing protectionist measures (e.g., trade barriers) to guard against the theoretical possibility that free trade may harm the United States in the future may produce a situation that is worse than the disease they are trying to prevent. To quote Samuelson: “Free trade may turn out pragmatically to be still best for each region in comparison to lobbyist-induced tariffs and quotas which involve both a perversion of democracy and non-subtle deadweight distortion losses.”11 One recent study found evidence in support of Samuelson’s thesis. The study looked at every county in the United States for its manufacturers’ exposure to competition from China.12 The researchers found that regions most exposed to China tended not only to lose more manufacturing jobs but also to see overall employment decline. Areas with higher exposure to China also had larger increases in workers receiving unemployment insurance, food stamps, and disability payments. The costs to the economy from the increased government payments amounted to two-thirds of the gains from trade with China. In other words, many of the ways trade with China has helped the United States— such as providing inexpensive goods to U.S. consumers—have been wiped out. Even so, the authors of this study argued that in the long run, free trade is a good thing. They note, however, that the rapid rise of China has resulted in some large adjustment costs that, in the short run, significantly reduce the gains from trade. Other economists have dismissed Samuelson’s fears.13 While not questioning his analy- sis, they note that as a practical matter, developing nations are unlikely to be able to upgrade the skill level of their workforce rapidly enough to give rise to the situation in Samuelson’s model. In other words, they will quickly run into diminishing returns. However, such rebut- tals are at odds with recent data suggesting that Asian countries are rapidly upgrading their educational systems. For example, about 56 percent of the world’s engineering degrees awarded in 2008 were in Asia, compared with 4 percent in the United States!14

Evidence for the Link between Trade and Growth Many economic studies have looked at the relationship between trade and economic growth.15 In general, these studies suggest that as predicted by the standard theory of comparative advantage, countries that adopt a more open stance toward international trade enjoy higher growth rates than those that close their economies to trade. Jeffrey Sachs and Andrew Warner created a measure of how “open” to international trade an economy was and then looked at the relationship between “openness” and economic growth for a sample of more than 100 countries from 1970 to 1990.16 Among other find- ings, they reported:

We find a strong association between openness and growth, both within the group of devel- oping and the group of developed countries. Within the group of developing countries, the open economies grew at 4.49 percent per year, and the closed economies grew at 0.69 percent per year. Within the group of developed economies, the open economies grew at 2.29 percent per year, and the closed economies grew at 0.74 percent per year.17

A study by Wacziarg and Welch updated the Sachs and Warner data through the late 1990s. They found that over the period 1950–1998, countries that liberalized their trade regimes experienced, on average, increases in their annual growth rates of 1.5 percent compared to pre-liberalization times.18 An exhaustive survey of 61 studies published between 1967 and 2009 concluded: “The macroeconomic evidence provides dominant support for the positive and significant effects of trade on output and growth.”19

176 Part 3 The Global Trade and Investment Environment

The message seems clear: Adopt an open economy and embrace free trade, and your nation will be rewarded with higher economic growth rates. Higher growth will raise income levels and living standards. This last point has been confirmed by a study that looked at the relationship between trade and growth in incomes. The study, undertaken by Jeffrey Frankel and David Romer, found that on average, a 1 percentage point increase in the ratio of a country’s trade to its gross domestic product increases income per person by at least 0.5 percent.20 For every 10 percent increase in the importance of international trade in an economy, average income levels will rise by at least 5 percent. Despite the short-term adjustment costs associated with adopting a free trade regime, trade would seem to produce greater economic growth and higher living standards in the long run, just as the theory of Ricardo would lead us to expect.21

Heckscher-Ohlin Theory

Ricardo’s theory stresses that comparative advantage arises from differences in produc- tivity. Thus, whether Ghana is more efficient than South Korea in the production of cocoa depends on how productively it uses its resources. Ricardo stressed labor productivity and argued that differences in labor productivity between nations underlie the notion of comparative advantage. Swedish economists Eli Heckscher (in 1919) and Bertil Ohlin (in 1933) put forward a different explanation of comparative advantage. They argued that comparative advantage arises from differences in national factor endowments.22 By factor endowments they meant the extent to which a country is endowed with such resources as land, labor, and capital. Nations have varying factor endowments, and different factor endowments explain differences in factor costs; specifically, the more abundant a factor, the lower its cost. The Heckscher-Ohlin theory predicts that countries will export those goods that make intensive use of factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce. Thus, the Heckscher-Ohlin theory attempts to explain the pattern of international trade that we observe in the world economy. Like Ricardo’s theory, the Heckscher-Ohlin theory argues that free trade is beneficial. Unlike Ricardo’s theory, however, the Heckscher-Ohlin theory argues that the pattern of international trade is determined by differences in factor endowments, rather than differences in productivity. The Heckscher-Ohlin theory has commonsense appeal. For example, the United States has long been a substantial exporter of agricultural goods, reflecting in part its unusual abundance of arable land. In contrast, China has excelled in the export of goods produced in labor-intensive manufacturing industries. This reflects China’s relative abundance of low-cost labor. The United States, which lacks abundant low-cost labor, has been a primary importer of these goods. Note that it is relative, not absolute, endowments that are important; a country may have larger absolute amounts of land and labor than another country, but be relatively abundant in one of them.

THE LEONTIEF PARADOX

The Heckscher-Ohlin theory has been one of the most influential theoretical ideas in international economics. Most economists prefer the Heckscher-Ohlin theory to Ricardo’s theory because it makes fewer simplifying assumptions. Because of its influence, the theory has been subjected to many empirical tests. Beginning with a famous study published in 1953 by Wassily Leontief (winner of the Nobel Prize in economics in 1973), many of these tests have raised questions about the validity of the Heckscher-Ohlin the- ory.23 Using the Heckscher-Ohlin theory, Leontief postulated that because the United States was relatively abundant in capital compared to other nations, the United States would be an exporter of capital-intensive goods and an importer of labor-intensive goods. To his surprise, however, he found that U.S. exports were less capital intensive than U.S. imports. Because this result was at variance with the predictions of the theory, it has be- come known as the Leontief paradox.

LO 6 -2 Summarize the different theories explaining trade flows between nations.

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International Trade Theory Chapter 6 177

No one is quite sure why we observe the Leontief paradox. One possible explanation is that the United States has a special advantage in producing new products or goods made with innovative technologies. Such products may be less capital intensive than products whose technology has had time to mature and become suitable for mass production. Thus, the United States may be exporting goods that heavily use skilled labor and innova- tive entrepreneurship, such as computer software, while importing heavy manufacturing products that use large amounts of capital. Some empirical studies tend to confirm this.24 Still, tests of the Heckscher-Ohlin theory using data for a large number of countries tend to confirm the existence of the Leontief paradox.25 This leaves economists with a difficult dilemma. They prefer the Heckscher-Ohlin theory on theoretical grounds, but it is a relatively poor predictor of real-world interna- tional trade patterns. On the other hand, the theory they regard as being too limited, Ricardo’s theory of comparative advantage, actually predicts trade patterns with greater accuracy. The best solution to this dilemma may be to return to the Ricardian idea that trade patterns are largely driven by international differences in productivity. Thus, one might argue that the United States exports commercial aircraft and imports textiles not because its factor endowments are especially suited to aircraft manufacture and not suited to textile manufacture, but because the United States is relatively more efficient at producing aircraft than textiles. A key assumption in the Heckscher-Ohlin theory is that technologies are the same across countries. This may not be the case. Differences in technology may lead to differences in productivity, which in turn, drives international trade patterns.26 Thus, Japan’s success in exporting automobiles from the 1970s onward has been based not only on the relative abundance of capital but also on its development of innovative manufacturing technology that enabled it to achieve higher productivity levels in automo- bile production than other countries that also had abundant capital. More recent empirical work suggests that this theoretical explanation may be correct.27 The new research shows that once differences in technology across countries are controlled for, countries do in- deed export those goods that make intensive use of factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce. In other words, once the impact of differences of technology on productivity is controlled for, the Heckscher-Ohlin theory seems to gain predictive power.

The Product Life-Cycle Theory

Raymond Vernon initially proposed the product life-cycle theory in the mid-1960s.28 Vernon’s theory was based on the observation that for most of the twentieth century a very large proportion of the world’s new products had been developed by U.S. firms and sold first in the U.S. market (e.g., mass-produced automobiles, televisions, instant cameras, photocopiers, personal computers, and semiconductor chips). To explain this, Vernon argued that the wealth and size of the U.S. market gave U.S. firms a strong incentive to develop new consumer products. In addition, the high cost of U.S. labor gave U.S. firms an incentive to develop cost-saving process innovations. Just because a new product is developed by a U.S. firm and first sold in the U.S. market, it does not follow that the product must be produced in the United States. It could be pro- duced abroad at some low-cost location and then exported back into the United States. However, Vernon argued that most new products were initially produced in America. Apparently, the pioneering firms believed it was better to keep production facilities close to the market and to the firm’s center of decision making, given the uncertainty and risks inherent in introducing new products. Also, the demand for most new products tends to be based on nonprice factors. Consequently, firms can charge relatively high prices for new prod- ucts, which obviates the need to look for low-cost production sites in other countries. Vernon went on to argue that early in the life cycle of a typical new product, while demand is starting to grow rapidly in the United States, demand in other advanced coun- tries is limited to high-income groups. The limited initial demand in other advanced

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178 Part 3 The Global Trade and Investment Environment

countries does not make it worthwhile for firms in those countries to start producing the new product, but it does necessitate some exports from the United States to those countries. Over time, demand for the new product starts to grow in other advanced countries (e.g., Great Britain, France, Germany, and Japan). As it does, it becomes worthwhile for foreign producers to begin producing for their home markets. In addition, U.S. firms might set up production facilities in those advanced countries where demand is growing. Consequently, production within other advanced countries begins to limit the potential for exports from the United States. As the market in the United States and other advanced nations matures, the product becomes more standardized, and price becomes the main competitive weapon. As this occurs, cost considerations start to play a greater role in the competitive process. Produc- ers based in advanced countries where labor costs are lower than in the United States (e.g., Italy and Spain) might now be able to export to the United States. If cost pressures become intense, the process might not stop there. The cycle by which the United States lost its advantage to other advanced countries might be repeated once more, as develop- ing countries (e.g., Thailand) begin to acquire a production advantage over advanced countries. Thus, the locus of global production initially switches from the United States to other advanced nations and then from those nations to developing countries. The consequence of these trends for the pattern of world trade is that over time the United States switches from being an exporter of the product to an importer of the product as production becomes concentrated in lower-cost foreign locations. 

PRODUCT LIFE-CYCLE THEORY IN THE TWENTY-FIRST CENTURY

Historically, the product life-cycle theory seems to be an accurate explanation of interna- tional trade patterns. Consider photocopiers; the product was first developed in the early 1960s by Xerox in the United States and sold initially to U.S. users. Originally, Xerox exported photocopiers from the United States, primarily to Japan and the advanced countries of western Europe. As demand began to grow in those countries, Xerox entered into joint ventures to set up production in Japan (Fuji-Xerox) and Great Britain (Rank-Xerox). In addition, once Xerox’s patents on the photocopier process expired, other foreign competi- tors began to enter the market (e.g., Canon in Japan and Olivetti in Italy). As a consequence, exports from the United States declined, and U.S. users began to buy some photocopiers from lower-cost foreign sources, particularly Japan. More recently, Japanese companies found that manufacturing costs are too high in their own country, so they have begun to switch production to developing countries such as Thailand. Thus, initially the United States and now other advanced countries (e.g., Japan and Great Britain) have switched from being exporters of photocopiers to importers. This evolution in the pattern of international trade in photocopiers is consistent with the predictions of the product life-cycle theory that mature industries tend to go out of the United States and into low-cost assembly locations. However, the product life-cycle theory is not without weaknesses. Viewed from an Asian or European perspective, Vernon’s argument that most new products are developed and intro- duced in the United States seems ethnocentric and increasingly dated. Although it may be true that during U.S. dominance of the global economy (from 1945 to 1975), most new products were introduced in the United States, there have always been important exceptions. These exceptions appear to have become more common in recent years. Many new products are now first introduced in Japan (e.g., video-game consoles) or South Korea (e.g., Samsung smartphones). Moreover, with the increased globalization and integration of the world economy discussed in Chapter 1, an increasing number of new products (e.g., tablet com- puters, smartphones, and digital cameras) are now introduced simultaneously in the United States and many European and Asian nations. This may be accompanied by globally dis- persed production, with particular components of a new product being produced in those locations around the globe where the mix of factor costs and skills is most favorable (as predicted by the theory of comparative advantage). In sum, although Vernon’s theory may be useful for explaining the pattern of international trade during the period of American global dominance, its relevance in the modern world seems more limited.

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International Trade Theory Chapter 6 179

New Trade Theory

The new trade theory began to emerge in the 1970s when a number of economists pointed out that the ability of firms to attain economies of scale might have important implications for international trade.29 Economies of scale are unit cost reductions associated with a large scale of output. Economies of scale have a number of sources, including the ability to spread fixed costs over a large volume and the ability of large-volume producers to utilize specialized employees and equipment that are more productive than less specialized em- ployees and equipment. Economies of scale are a major source of cost reductions in many industries, from computer software to automobiles and from pharmaceuticals to aerospace. For example, Microsoft realizes economies of scale by spreading the fixed costs of devel- oping new versions of its Windows operating system, which runs to about $10 billion, over the 2 billion or so personal computers on which each new system is ultimately installed. Similarly, automobile companies realize economies of scale by producing a high volume of automobiles from an assembly line where each employee has a specialized task. New trade theory makes two important points: First, through its impact on economies of scale, trade can increase the variety of goods available to consumers and decrease the aver- age cost of those goods. Second, in those industries when the output required to attain econo- mies of scale represents a significant proportion of total world demand, the global market may be able to support only a small number of enterprises. Thus, world trade in certain products may be dominated by countries whose firms were first movers in their production.

INCREASING PRODUCT VARIETY AND REDUCING COSTS

Imagine first a world without trade. In industries where economies of scale are important, both the variety of goods that a country can produce and the scale of production are limited by the size of the market. If a national market is small, there may not be enough demand to enable producers to realize economies of scale for certain products. Accordingly, those products may not be produced, thereby limiting the variety of products available to consum- ers. Alternatively, they may be produced, but at such low volumes that unit costs and prices are considerably higher than they might be if economies of scale could be realized. Now consider what happens when nations trade with each other. Individual national markets are combined into a larger world market. As the size of the market expands due to trade, individual firms may be able to better attain economies of scale. The implication, according to new trade theory, is that each nation may be able to specialize in producing a narrower range of products than it would in the absence of trade, yet by buying goods that it does not make from other countries, each nation can simultaneously increase the variety of goods available to its consumers and lower the costs of those goods—thus trade offers an opportunity for mutual gain even when countries do not differ in their re- source endowments or technology. Suppose there are two countries, each with an annual market for 1 million automobiles. By trading with each other, these countries can create a combined market for 2 million cars. In this combined market, due to the ability to better realize economies of scale, more varieties (models) of cars can be produced, and cars can be produced at a lower average cost, than in either market alone. For example, demand for a sports car may be limited to 55,000 units in each national market, while a total output of at least 100,000 per year may be required to realize significant scale economies. Similarly, demand for a minivan may be 80,000 units in each national market, and again a total output of at least 100,000 per year may be required to realize significant scale economies. Faced with limited domestic market demand, firms in each nation may decide not to produce a sports car, because the costs of doing so at such low volume are too great. Although they may produce minivans, the cost of doing so will be higher, as will prices, than if significant economies of scale had been attained. Once the two countries decide to trade, however, a firm in one nation may specialize in producing sports cars, while a firm in the other nation may produce minivans. The combined demand for 110,000 sports cars and 160,000 minivans allows each firm to realize scale economies. Consumers in this case benefit from having access to a product (sports cars) that was not

LO 6 -2 Summarize the different theories explaining trade flows between nations.

LO 6 -3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

180 Part 3 The Global Trade and Investment Environment

available before international trade and from the lower price for a product (minivans) that could not be produced at the most efficient scale before international trade. Trade is thus mutually beneficial because it allows the specialization of production, the realization of scale economies, the production of a greater variety of products, and lower prices.

ECONOMIES OF SCALE, FIRST-MOVER ADVANTAGES, AND THE PATTERN OF TRADE

A second theme in new trade theory is that the pattern of trade we observe in the world economy may be the result of economies of scale and first-mover advantages. First- mover advantages are the economic and strategic advantages that accrue to early entrants into an industry.30 The ability to capture scale economies ahead of later entrants, and thus benefit from a lower cost structure, is an important first-mover advantage. New trade theory argues that for those products where economies of scale are significant and repre- sent a substantial proportion of world demand, the first movers in an industry can gain a scale-based cost advantage that later entrants find almost impossible to match. Thus, the pattern of trade that we observe for such products may reflect first-mover advantages. Countries may dominate in the export of certain goods because economies of scale are important in their production, and because firms located in those countries were the first to capture scale economies, giving them a first-mover advantage. For example, consider the commercial aerospace industry. In aerospace there are substan- tial scale economies that come from the ability to spread the fixed costs of developing a new jet aircraft over a large number of sales. It has cost Airbus some $15 billion to develop its new superjumbo jet, the 550-seat A380. To recoup those costs and break even, Airbus will have to sell at least 250 A380 planes. If Airbus can sell more than 350 A380 planes, it will apparently be a profitable venture. Total demand over the next 20 years for this class of aircraft is estimated to be between 400 and 600 units. Thus, the global market can probably profitably support only one producer of jet aircraft in the superjumbo category. It follows that the European Union might come to dominate in the export of very large jet aircraft, primarily because a European-based firm, Airbus, was the first to produce a superjumbo jet aircraft and realize scale economies. Other potential producers, such as Boeing, might be shut out of the market because they will lack the scale economies that Airbus will enjoy. By pioneering this market category, Airbus may have captured a first-mover advantage based on scale economies that will be difficult for rivals to match, and that will result in the European Union becoming the leading exporter of very large jet aircraft.

IMPLICATIONS OF NEW TRADE THEORY

New trade theory has important implications. The theory suggests that nations may benefit from trade even when they do not differ in resource endowments or technology. Trade allows a nation to specialize in the production of certain products, attaining scale econo- mies and lowering the costs of producing those products, while buying products that it does not produce from other nations that specialize in the production of other products. By this mechanism, the variety of products available to consumers in each nation is in- creased, while the average costs of those products should fall, as should their price, freeing resources to produce other goods and services. The theory also suggests that a country may predominate in the export of a good simply because it was lucky enough to have one or more firms among the first to produce that good. Because they are able to gain economies of scale, the first movers in an industry may get a lock on the world market that discourages subsequent entry. First-movers’ ability to benefit from increasing returns creates a barrier to entry. In the commercial aircraft industry, the fact that Boeing and Airbus are already in the industry and have the benefits of economies of scale discourages new entry and reinforces the dominance of America and Europe in the trade of midsize and large jet aircraft. This dominance is further reinforced because global demand may not be sufficient to profitably support another producer of midsize and large jet aircraft in the industry. So although Japanese firms

International Trade Theory Chapter 6 181

might be able to compete in the market, they have decided not to enter the industry but to ally themselves as major subcontractors with primary producers (e.g., Mitsubishi Heavy Industries is a major subcontractor for Boeing on the 777 and 787 programs). New trade theory is at variance with the Heckscher-Ohlin theory, which suggests a country will predominate in the export of a product when it is particularly well endowed with those factors used intensively in its manufacture. New trade theorists argue that the United States is a major exporter of commercial jet aircraft not because it is better endowed with the factors of production required to manufacture aircraft, but because one of the first movers in the industry, Boeing, was a U.S. firm. The new trade theory is not at variance with the theory of comparative advantage. Economies of scale increase productivity. Thus, the new trade theory identifies an important source of comparative advantage. This theory is quite useful in explaining trade patterns. Empirical studies seem to sup- port the predictions of the theory that trade increases the specialization of production within an industry, increases the variety of products available to consumers, and results in lower average prices.31 With regard to first-mover advantages and international trade, a study by Harvard business historian Alfred Chandler suggests the existence of first- mover advantages is an important factor in explaining the dominance of firms from certain nations in specific industries.32 The number of firms is very limited in many global industries, including the chemical industry, the heavy construction-equipment industry, the heavy truck industry, the tire industry, the consumer electronics industry, the jet engine industry, and the computer software industry. Perhaps the most contentious implication of the new trade theory is the argument that it generates for government intervention and strategic trade policy.33 New trade theorists stress the role of luck, entrepreneurship, and innovation in giving a firm first-mover advan- tages. According to this argument, the reason Boeing was the first mover in commercial jet aircraft manufacture—rather than firms such as Great Britain’s De Havilland and Hawker Siddeley, or Holland’s Fokker, all of which could have been—was that Boeing was both lucky and innovative. One way Boeing was lucky is that De Havilland shot itself in the foot when its Comet jet airliner, introduced two years earlier than Boeing’s first jet airliner, the 707, was found to be full of serious technological flaws. Had De Havilland not made some serious technological mistakes, Great Britain might have become the world’s leading ex- porter of commercial jet aircraft. Boeing’s innovativeness was demonstrated by its inde- pendent development of the technological know-how required to build a commercial jet airliner. Several new trade theorists have pointed out, however, that Boeing’s R&D was largely paid for by the U.S. government; the 707 was a spin-off from a government-funded military program (the entry of Airbus into the industry was also supported by significant government subsidies). Herein is a rationale for government intervention; by the sophisti- cated and judicious use of subsidies, could a government increase the chances of its do- mestic firms becoming first movers in newly emerging industries, as the U.S. government apparently did with Boeing (and the European Union did with Airbus)? If this is possible, and the new trade theory suggests it might be, we have an economic rationale for a proac- tive trade policy that is at variance with the free trade prescriptions of the trade theories we have reviewed so far. We consider the policy implications of this issue in Chapter 7.

National Competitive Advantage: Porter’s Diamond

Michael Porter, the famous Harvard strategy professor, has also written extensively on international trade.34 Porter and his team looked at 100 industries in 10 nations. Like the work of the new trade theorists, Porter’s work was driven by a belief that existing theories of international trade told only part of the story. For Porter, the essential task was to explain why a nation achieves international success in a particular industry. Why does Japan do so well in the automobile industry? Why does Switzerland excel in the production and export of precision instruments and pharmaceuticals? Why do Germany and the United States

LO 6 -2 Summarize the different theories explaining trade flows between nations.

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182 Part 3 The Global Trade and Investment Environment

do so well in the chemical industry? These questions cannot be answered easily by the Heckscher-Ohlin theory, and the theory of comparative advantage offers only a partial explanation. The theory of comparative advantage would say that Switzerland excels in the production and export of precision instruments because it uses its resources very pro- ductively in these industries. Although this may be correct, this does not explain why Switzerland is more productive in this industry than Great Britain, Germany, or Spain. Porter tries to solve this puzzle. Porter theorizes that four broad attributes of a nation shape the environment in which local firms compete, and these attributes promote or impede the creation of competitive advantage (see Figure 6.5). These attributes are:

∙ Factor endowments—a nation’s position in factors of production, such as skilled labor or the infrastructure necessary to compete in a given industry.

∙ Demand conditions—the nature of home demand for the industry’s product or service. ∙ Related and supporting industries—the presence or absence of supplier indus-

tries and related industries that are internationally competitive. ∙ Firm strategy, structure, and rivalry—the conditions governing how companies

are created, organized, and managed and the nature of domestic rivalry. Porter speaks of these four attributes as constituting the diamond. He argues that firms are most likely to succeed in industries or industry segments where the diamond is most favorable. He also argues that the diamond is a mutually reinforcing system. The effect of one attribute is contingent on the state of others. For example, Porter argues favorable demand conditions will not result in competitive advantage unless the state of rivalry is sufficient to cause firms to respond to them. Porter maintains that two additional variables can influence the national diamond in important ways: chance and government. Chance events, such as major innovations, can reshape industry structure and provide the opportunity for one nation’s firms to supplant another’s. Government, by its choice of policies, can detract from or improve national advantage. For example, regulation can alter home demand conditions, antitrust policies can influence the intensity of rivalry within an industry, and government investments in education can change factor endowments.

FACTOR ENDOWMENTS

Factor endowments lie at the center of the Heckscher-Ohlin theory. While Porter does not propose anything radically new, he does analyze the characteristics of factors of production. He recognizes hierarchies among factors, distinguishing between basic factors (e.g., natural resources, climate, location, and demographics) and advanced factors (e.g., communication infrastructure, sophisticated and skilled labor, research facilities, and

F I G U R E 6 . 5

The determinants of national competitive advantage: Porter’s diamond. Source: Exhibit from “The Com- petitive Advantage of Nations,” by Michael E. Porter, New York: Free Press, 1990 (Republished with a new introduction, 1998), p. 72. Copyright © 1990. Used with permission.

Demand Conditions

Factor Endowments

Related and Supporting Industries

Firm Strategy, Structure, and Rivalry

International Trade Theory Chapter 6 183

technological know-how). He argues that advanced factors are the most significant for competitive advantage. Unlike the naturally endowed basic factors, advanced factors are a product of investment by individuals, companies, and governments. Thus, government investments in basic and higher education, by improving the general skill and knowledge level of the population and by stimulating advanced research at higher education institu- tions, can upgrade a nation’s advanced factors. The relationship between advanced and basic factors is complex. Basic factors can provide an initial advantage that is subsequently reinforced and extended by investment in advanced factors. Conversely, disadvantages in basic factors can create pressures to invest in advanced factors. An obvious example of this phenomenon is Japan, a country that lacks arable land and mineral deposits and yet through investment has built a substan- tial endowment of advanced factors. Porter notes that Japan’s large pool of engineers (reflecting a much higher number of engineering graduates per capita than almost any other nation) has been vital to Japan’s success in many manufacturing industries.

DEMAND CONDITIONS

Porter emphasizes the role home demand plays in upgrading competitive advantage. Firms are typically most sensitive to the needs of their closest customers. Thus, the charac- teristics of home demand are particularly important in shaping the attributes of domesti- cally made products and in creating pressures for innovation and quality. Porter argues that a nation’s firms gain competitive advantage if their domestic consumers are sophis- ticated and demanding. Such consumers pressure local firms to meet high standards of product quality and to produce innovative products. For example, Porter notes that Japan’s sophisticated and knowledgeable buyers of cameras helped stimulate the Japanese camera industry to improve product quality and to introduce innovative models.

RELATED AND SUPPORTING INDUSTRIES

The third broad attribute of national advantage in an industry is the presence of suppliers or related industries that are internationally competitive. The benefits of investments in advanced factors of production by related and supporting industries can spill over into an industry, thereby helping it achieve a strong competitive position internationally. Swedish strength in fabricated steel products (e.g., ball bearings and cutting tools) has drawn on strengths in Sweden’s specialty steel industry. Technological leadership in the U.S. semiconductor industry provided the basis for U.S. success in personal computers and several other technically advanced electronic products. Similarly, Switzerland’s success in pharmaceuticals is closely related to its previous international success in the technologically related dye industry. One consequence of this process is that successful industries within a country tend to be grouped into clusters of related industries. This was one of the most pervasive findings of Porter’s study. One such cluster Porter identified was in the German textile and apparel sector, which included high-quality cotton, wool, synthetic fibers, sewing machine needles, and a wide range of textile machinery. Such clusters are important because valuable knowledge can flow between the firms within a geographic cluster, benefiting all within that cluster. Knowledge flows occur when employees move between firms within a region and when national industry associations bring employees from different companies together for regular conferences or workshops.35

FIRM STRATEGY, STRUCTURE, AND RIVALRY

The fourth broad attribute of national competitive advantage in Porter’s model is the strat- egy, structure, and rivalry of firms within a nation. Porter makes two important points here. First, different nations are characterized by different management ideologies, which either help them or do not help them build national competitive advantage. For example, Porter noted the predominance of engineers in top management at German and Japanese firms. He attributed this to these firms’ emphasis on improving manufacturing pro- cesses and product design. In contrast, Porter noted a predominance of people with

184 Part 3 The Global Trade and Investment Environment

finance backgrounds leading many U.S. firms. He linked this to U.S. firms’ lack of attention to improving manufacturing processes and product design. He argued that the dominance of finance led to an overemphasis on maximizing short-term financial returns. According to Porter, one consequence of these different management ideologies was a relative loss of U.S. competitiveness in those engineering-based industries where manufacturing processes and product design issues are all-important (e.g., the automobile industry). Porter’s second point is that there is a strong association between vigorous domestic rivalry and the creation and persistence of competitive advantage in an industry. Vigorous domestic rivalry induces firms to look for ways to improve efficiency, which makes them better international competitors. Domestic rivalry creates pressures to innovate, to im- prove quality, to reduce costs, and to invest in upgrading advanced factors. All this helps create world-class competitors. Porter cites the case of Japan:

Nowhere is the role of domestic rivalry more evident than in Japan, where it is all-out war- fare in which many companies fail to achieve profitability. With goals that stress market share, Japanese companies engage in a continuing struggle to outdo each other. Shares fluctuate markedly. The process is prominently covered in the business press. Elaborate rankings measure which companies are most popular with university graduates. The rate of new product and process development is breathtaking.36

EVALUATING PORTER’S THEORY

Porter contends that the degree to which a nation is likely to achieve international success in a certain industry is a function of the combined impact of factor endowments, domestic demand conditions, related and supporting industries, and domestic rivalry. He argues that the presence of all four components is usually required for this diamond to boost competi- tive performance (although there are exceptions). Porter also contends that government can influence each of the four components of the diamond—either positively or negatively. Factor endowments can be affected by subsidies, policies toward capital markets, policies toward education, and so on. Government can shape domestic demand through local prod- uct standards or with regulations that mandate or influence buyer needs. Government pol- icy can influence supporting and related industries through regulation and influence firm rivalry through such devices as capital market regulation, tax policy, and antitrust laws. If Porter is correct, we would expect his model to 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. Is he correct? We simply do not know. Porter’s theory has not been subjected to detailed empirical testing. Much about the theory rings true, but the same can be said for the new trade theory, the theory of comparative advantage, and the Heckscher-Ohlin theory. It may be that each of these theories, which complement each other, explains something about the pattern of international trade.

LO 6 - 4 Explain the arguments of those who maintain that government can play a proactive role in promoting national competitive advantage in certain industries.

F O C U S O N M A NAG E R I A L I M P L I C AT I O N S

LOCATION, FIRST-MOVER ADVANTAGES, AND GOVERNMENT POLICY

Why does all this matter for business? There are at least three main implications for international businesses of the material discussed in this chapter: location implications,

first-mover implications, and government policy implications.

Location Underlying most of the theories we have discussed is the notion that different countries have particular advantages in different productive activities.

LO 6 -5 Understand the important implications that international trade theory holds for business practice.

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International Trade Theory Chapter 6 185

Thus, from a profit perspective, it makes sense for a firm to disperse its productive activities to those countries where, according to the theory of international trade, they can be per- formed most efficiently. If design can be performed most efficiently in France, that is where design facilities should be located; if the manufacture of basic components can be per- formed most efficiently in Singapore, that is where they should be manufactured; and if final assembly can be performed most efficiently in China, that is where final assembly should be performed. The result is a global web of productive activities, with different activities being performed in different locations around the globe depending on considerations of compara- tive advantage, factor endowments, and the like. If the firm does not do this, it may find itself at a competitive disadvantage relative to firms that do.

First-Mover Advantages According to the new trade theory, firms that establish a first-mover advantage with regard to the production of a particular new product may subsequently dominate global trade in that product. This is particularly true in industries where the global market can profitably support only a limited number of firms, such as the aerospace market, but early commitments may also seem to be important in less concentrated industries. For the individual firm, the clear message is that it pays to invest substantial financial resources in trying to build a first-mover, or early-mover, advantage, even if that means several years of losses before a new venture becomes profitable. The idea is to preempt the available demand, gain cost advantages related to volume, build an enduring brand ahead of later competitors, and, consequently, establish a long-term sustainable competitive advantage. Although the details of how to achieve this are beyond the scope of this book, many publi- cations offer strategies for exploiting first-mover advantages and for avoiding the traps associated with pioneering a market (first-mover disadvantages).37

Government Policy The theories of international trade also matter to international busi- nesses because firms are major players on the international trade scene. Business firms produce exports, and business firms import the products of other countries. Because of their pivotal role in international trade, businesses can exert a strong influence on government trade policy, lobbying to promote free trade or trade restrictions. The theories of interna- tional trade claim that promoting free trade is generally in the best interests of a country, although it may not always be in the best interest of an individual firm. Many firms recognize this and lobby for open markets. For example, when the U.S. government announced its intention to place a tariff on Japanese imports of liquid crystal display (LCD) screens in the 1990s, IBM and Apple Computer pro- tested strongly. Both IBM and Apple pointed out that (1) Japan was the lowest-cost source of LCD screens; (2) they used these screens in their own laptop computers; and (3) the pro- posed tariff, by increasing the cost of LCD screens, would increase the cost of laptop com- puters produced by IBM and Apple, thus making them less competitive in the world market. In other words, the tariff, designed to protect U.S. firms, would be self-defeating. In response to these pressures, the U.S. government reversed its posture. Unlike IBM and Apple, however, businesses do not always lobby for free trade. In the United States, for example, restrictions on imports of steel have periodically been put into place in response to direct pressure by U.S. firms on the government. In some cases, the government has responded to pressure by getting foreign companies to agree to “voluntary” restrictions on their imports, using the implicit threat of more comprehensive formal trade barriers to get them to adhere to these agreements (historically, this has occurred in the automobile industry). In other cases, the government used what are called “antidumping” actions to justify tariffs on imports from other nations (these mechanisms will be discussed in detail in the next chapter). As predicted by international trade theory, many of these agreements have been self- defeating, such as the voluntary restriction on machine tool imports agreed to in 1985. Shielded from international competition by import barriers, the U.S. machine tool industry had no incentive to increase its efficiency. Consequently, it lost many of its export markets to more efficient foreign competitors. Because of this misguided action, the U.S. machine tool

186 Part 3 The Global Trade and Investment Environment

industry shrunk during the period when the agreement was in force. For anyone schooled in international trade theory, this was not surprising.38

Finally, Porter’s theory of national competitive advantage also contains policy implica- tions. Porter’s theory suggests that it is in the best interest of business for a firm to invest in upgrading advanced factors of production, for example, to invest in better training for its employees and to increase its commitment to research and development. It is also in the best interests of business to lobby the government to adopt policies that have a favorable impact on each component of the national diamond. Thus, according to Porter, businesses should urge government to increase investment in education, infrastructure, and basic re- search (since all these enhance advanced factors) and to adopt policies that promote strong competition within domestic markets (since this makes firms stronger international competi- tors, according to Porter’s findings).

free trade, p. 162 new trade theory, p. 164 mercantilism, p. 164 zero-sum game, p. 165 absolute advantage, p. 165 constant returns to

specialization, p. 171

factor endowments, p. 176 economies of scale, p. 179 first-mover advantages, p. 180 balance-of-payments

accounts, p. 189 current account, p. 189

current account deficit, p. 189

current account surplus, p. 190

capital account, p. 190 financial account, p. 190

Key Terms

C H A P T E R S U M M A R Y

This chapter reviewed a number of theories that explain why it is beneficial for a country to engage in interna- tional trade and explained the pattern of international trade observed in the world economy. The theories of Smith, Ricardo, and Heckscher-Ohlin all make strong cases for unrestricted free trade. In contrast, the mercan- tilist doctrine and, to a lesser extent, the new trade theory can be interpreted to support government intervention to promote exports through subsidies and to limit imports through tariffs and quotas. In explaining the pattern of international trade, this chapter shows that, with the exception of mercantilism, which is silent on this issue, the different theories offer largely complementary explanations. Although no one theory may explain the apparent pattern of international trade, taken together, the theory of comparative advan- tage, the Heckscher-Ohlin theory, the product life-cycle theory, the new trade theory, and Porter’s theory of na- tional competitive advantage do suggest which factors are important. Comparative advantage tells us that pro- ductivity differences are important; Heckscher-Ohlin tells us that factor endowments matter; the product life- cycle theory tells us that where a new product is intro- duced is important; the new trade theory tells us that increasing returns to specialization and first-mover advantages matter; and Porter tells us that all these fac- tors may be important insofar as they affect the four

components of the national diamond. The chapter made the following points:

1. Mercantilists argued that it was in a country’s best interests to run a balance-of-trade surplus. They viewed trade as a zero-sum game, in which one country’s gains cause losses for other countries.

2. The theory of absolute advantage suggests that countries differ in their ability to produce goods efficiently. The theory suggests that a country should specialize in producing goods in areas where it has an absolute advantage and import goods in areas where other countries have abso- lute advantages.

3. The theory of comparative advantage suggests that it makes sense for a country to specialize in producing those goods that it can produce most efficiently, while buying goods that it can produce relatively less efficiently from other countries—even if that means buying goods from other countries that it could produce more efficiently itself.

4. The theory of comparative advantage suggests that unrestricted free trade brings about in- creased world production, that is, that trade is a positive-sum game.

5. The theory of comparative advantage also sug- gests that opening a country to free trade stimu- lates economic growth, which creates dynamic gains from trade. The empirical evidence seems to be consistent with this claim.

6. The Heckscher-Ohlin theory argues that the pattern of international trade is determined by differences in factor endowments. It predicts that countries will export those goods that make intensive use of locally abundant factors and will import goods that make intensive use of factors that are locally scarce.

7. The product life-cycle theory suggests that trade patterns are influenced by where a new product is introduced. In an increasingly integrated global economy, the product life- cycle theory seems to be less predictive than it once was.

8. New trade theory states that trade allows a nation to specialize in the production of certain goods, attaining scale economies and lowering the costs of producing those goods, while buying goods that it does not produce from other nations that are similarly specialized. By this mechanism, the variety of goods available to consumers in each nation is increased, while the average costs of those goods should fall.

9. New trade theory also states that in those indus- tries where substantial economies of scale imply that the world market will profitably support only a few firms, countries may predominate in the export of certain products simply because they had a firm that was a first mover in that industry.

10. Some new trade theorists have promoted the idea of strategic trade policy. The argument is that government, by the sophisticated and judicious use of subsidies, might be able to increase the chances of domestic firms becoming first movers in newly emerging industries.

11. Porter’s theory of national competitive advantage suggests that the pattern of trade is influenced by four attributes of a nation: (a) factor endowments, (b) domestic demand conditions, (c) related and supporting industries, and (d) firm strategy, structure, and rivalry.

12. Theories of international trade are important to an individual business firm primarily because they can help the firm decide where to locate its various production activities.

13. Firms involved in international trade can and do exert a strong influence on government policy toward trade. By lobbying government, business firms can promote free trade or trade restrictions.

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. Mercantilism is a bankrupt theory that has no place in the modern world. Discuss.

2. Is free trade fair? Discuss! 3. Unions in developed nations often oppose

imports from low-wage countries and advocate trade barriers to protect jobs from what they often characterize as “unfair” import competition. Is such competition “unfair”? Do you think that this argument is in the best interests of (a) the unions, (b) the people they represent, and/or (c) the country as a whole?

4. What are the potential costs of adopting a free trade regime? Do you think governments should do anything to reduce these costs? What?

5. Reread the Country Focus “Is China a Neo-mercantilist Nation?”

a. Do you think China is pursuing an economic policy that can be characterized as neo-mercantilist?

b. What should the United States, and other countries, do about this?

6. Reread the Country Focus on moving white- collar jobs offshore.

a. Who benefits from the outsourcing of skilled white-collar jobs to developing nations? Who are the losers?

b. Will developed nations like the United States suffer from the loss of high-skilled and high-paying jobs?

c. Is there a difference between the transfer- ence of high-paying white-collar jobs, such as computer programming and accounting, to developing nations, and low-paying blue- collar jobs? If so, what is the difference, and should government do anything to stop the flow of white- collar jobs out of the country to countries such as India?

7. Drawing upon the new trade theory and Porter’s theory of national competitive advantage, outline the case for government policies that would build national competitive advantage in biotechnology. What kinds of policies would you recommend that the government adopt? Are these policies at vari- ance with the basic free trade philosophy?

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C L O S I N G C A S E

Creating the World's Biggest Free Trade Zone In his February 12, 2013, State of the Union address, President Barack Obama committed the United States to negotiating a free trade deal with the European Union (EU). The proposed agreement is known as the Trans- atlantic Trade and Investment Partnership (TTIP). The United States and the 28 countries that are members of the EU already make up the world’s largest and richest trading partnership, accounting for about 60 percent of global GDP, 33 percent of world trade in goods, and 42 percent of world trade in services. Moreover, both the United States and EU are members of the World Trade Organization, and many trade tariffs between the two economic blocks are already low. Nevertheless, the an- nouncement was greeted with approval on both sides of the Atlantic and, unusually for President Obama, from both sides of the political divide in the United States. The reason for the enthusiasm for the proposed TTIP can be traced to widespread acceptance of the key axiom of international trade theory—trade is a good thing for all countries involved in a free trade agreement. Free trade is a positive-sum game; it is equivalent to the rising tide that lifts all boats. Both the United States and the EU

have struggled with low economic growth, persistently high unemployment, and large government deficits. A new free trade deal could help economies on both sides

8. The world’s poorest countries are at a competitive disadvantage in every sector of their economies. They have little to export. They have no capital; their land is of poor quality; they often have too many people

given available work opportunities; and theyare poorly educated. Free trade cannot possibly be in the interests of such nations. Discuss.

r e s e a r c h t a s k g l o b a l E D G E . m s u . e d u

Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises:

1. The World Trade Organization International Trade Statistics is an annual report that provides comprehensive, comparable, and updated statis- tics on trade in merchandise and commercial services. The report allows an assessment of world trade flows by country, region, and main product or service categories. Using the most recent statistics available, identify the top 10 countries that lead in the export and import of merchandise trade, respectively. Which countries appear in the top 10 in both exports and imports?

Can you explain why these countries appear at the top of both lists?

2. Food in an integral part of understanding different countries, cultures, and lifestyles. You run a chain of high-end premium restaurants in the United States, and you are looking for unique Australian wines you can import. However, you must first identify which Australian suppliers can provide you with premium wines. After searching through the Australian supplier directory, identify three to four companies that can be potential suppliers. Then develop a list of criteria you would need to ask these companies to select which one to work with.

Generic drugs manufactured by Indian firms help the country emerge as a major exporter of pharmaceuticals. Source: © Image Source/Getty Images, RF

188 Part 3 The Global Trade and Investment Environment

of the Atlantic grow faster, thereby reducing unemploy- ment, without costing another dime in government spending. A trade deal is in effect a cost-free stimulus package. How big the economic impact will be remains to be seen. For both the United States and the EU average tar- iffs (taxes) on imported goods are currently close to 3  percent by most measures. Further reduction could nonetheless stimulate additional trade, and there are some areas where tariffs are much higher, notably on ag- ricultural goods. Beyond tariff reductions, there are many nontariff barriers to international trade that could be reduced or eliminated as the result of a deal. One ex- ample is found in the automobile industry, where the EU and United States both employ equally strict but different safety standards. This means that to sell in both the EU and United States, automobile manufacturers must ad- here to two different sets of regulations. Similarly, phar- maceutical firms currently have to submit new drugs to two sets of safety tests, one in the United States and one in the EU. Such regulatory requirements are functionally equivalent to an import tariff insofar as they raise the costs of business and international trade. By some calcu- lations, nontariff barriers such as these are equivalent to a traditional import tariff of 10 to 20 percent. Initial

estimates suggest that a comprehensive and ambitious agreement that covers both tariff and nontariff barriers to trade will boost annual GDP growth by about 0.5 percent per annum on both sides of the Atlantic, producing an additional $200 billion a year in economic activity. Talks on the TTIP began in July 2013 and currently are expected to be completed sometime in 2015. Sources: “Transatlantic Trading,” The Economist, February 2, 2013; Andrew Walker, “EU and US Free Trade Talks Launched,” BBC News, February 13, 2013; Paul Ames, “Parmesan Cheese: Thorn in US-EU Free Trade Deal?,” GlobalPost.com, February 25, 2013; Henry Chu, “U.S., EU Resume Negotiations on Free Trade Agreement,” Los Angeles Times, November 11, 2013.

C a s e D i s c u s s i o n Q u e s t i o n s 1. What are the benefits of the proposed TTIP? 2. Can you think of any drawbacks associated with

the TTIP? 3. Two decades ago when the United States

entered into the North American Free Trade Agreement with Canada and Mexico, there was significant opposition from organized labor and some politicians. There does not seem to be the same level of opposition to the TTIP. Why do you think this is so?

International trade involves the sale of goods and ser- vices to residents in other countries (exports) and the purchase of goods and services from residents in other countries (imports). A country’s balance-of-payments accounts keep track of the payments to and receipts from other countries for a particular time period. These include payments to foreigners for imports of goods and services, and receipts from foreigners for goods and services ex- ported to them. A summary copy of the U.S. balance-of- payments accounts for 2013 is given in Table A.1. In this appendix, we briefly describe the form of the balance-of- payments accounts, and we discuss whether a current ac- count deficit, often a cause of much concern in the popular press, is something to worry about.

BALANCE-OF-PAYMENTS ACCOUNTS

Balance-of-payments accounts are divided into three main sections: the current account, the capital account, and the financial account (to confuse matters, what is now called the capital account until recently was part of the current account, and the financial account used to be called the

Ap p e n d i x : I nt e r n at i o n a l T r a d e a n d t h e B a l a n c e o f P ay m e nt s

capital account). The current account records transac- tions that pertain to four categories, all of which can be seen in Table A.1. The first category, goods, refers to the export or import of physical goods (e.g., agricultural food- stuffs, autos, computers, chemicals). The second category is the export or import of services (e.g., intangible prod- ucts such as banking and insurance services). The third category, primary income receipts or payments, refers to income from foreign investments or payments to foreign investors (e.g., interest and dividend receipts or payments). The third category also includes payments that foreigners have made to U.S. residents for work performed outside the United States, and payments that U.S. entities make to foreign residents. The fourth category, secondary income receipts or payments, refers to the transfer of a good, ser- vice, or asset to the U.S. government or U.S. private enti- ties, or the transfer to a foreign government or entity in the case of payments (this includes tax payments, foreign pen- sion payments, cash transfers, etc.). A current account deficit occurs when a country imports more goods, services, and income than it exports.

International Trade Theory Chapter 6 189

190 Part 3 The Global Trade and Investment Environment

A current account surplus occurs when a country ex- ports more goods, services, and income than it imports. Table A.1 shows that in 2013 the United States ran a cur- rent account deficit of $400.3 billion. This is often a headline-grabbing figure and is widely reported in the news media. In recent years, the U.S. current account deficit has been fairly significant, primarily because America imports far more physical goods than it exports. (The United States typically runs a surplus on trade in services and on income payments.) The 2006 current account deficit of $803 billion was the largest on record and was equivalent to about 6.5 per- cent of the country’s GDP. The deficit has shrunk since then, and the 2013 current account deficit represented just 2.4 percent of GDP. Many people find the fact that the United States runs a persistent deficit on its current account to be disturbing, the common assumption being that high import of goods displaces domestic production,

causes unemployment, and reduces the growth of the U.S. economy. However, the issue is more complex than this. Fully understanding the implications of a large and persistent deficit requires that we look at the rest of the balance-of-payments accounts. The capital account records one-time changes in the stock of assets. As noted earlier, until recently this item was included in the current account. The capital account includes capital transfers, such as debt forgiveness and migrants’ transfers (the goods and financial assets that accompany migrants as they enter or leave the country). In the big scheme of things this is a relatively small figure amounting to $412 million in 2013. The financial account (formerly the capital account) records transactions that involve the purchase or sale of assets. Thus, when a German firm purchases stock in a U.S. company or buys a U.S. bond, the transaction enters the U.S. balance of payments as a credit on the financial

Current Account $ Millions

Exports of goods, services, and income receipts (credits) $ 3,178,744

Goods 1,592,784

Services 687,410

Primary income receipts 780,120

Secondary income receipts 118,429

Imports of goods, services, and income (debits) 3,578,998

Goods 2,294,453

Services 462,134

Primary income payments 580,446

Secondary income payments 241,945

Capital Account Capital transfer receipts 0

Capital transfer debits 412

Financial Account

Net U.S. acquisition of financial assets 644,763

Net U.S. incurrence of liabilities 1,017,699

Net financial derivatives 2,248

Statistical discrepancy 30,008

Balances

Balance on current account −400,254

Balance on capital account −412

Balance on financial account −370,658

TA B L E A . 1

U.S. Balance-of- Payments Accounts, 2013

Source: Bureau of Economic Analysis.

International Trade Theory Chapter 6 191

account. This is because capital is flowing into the coun- try. When capital flows out of the United States, it enters the financial account as a debit. The financial account is comprised of a number of ele- ments. The net U.S. acquisition of financial assets includes the change in foreign assets owned by the U.S. government (e.g., U.S. official reserve assets) and the change in foreign assets owned by private individuals and corporations (including changes in assets owned through foreign direct investment). As can be seen from Table A.1, in 2013 there was a $644.7 billion increase in U.S. ownership of foreign assets, which tells us that the U.S. government and U.S. private entities were purchasing more foreign assets than they were selling. The net U.S. incurrence of liabilities re- fers to the change in U.S. assets owned by foreigners. In 2013 foreigners increased their holdings of U.S. assets by $1,017.7 billion, signifying that foreigners were net acquir- ers of U.S. stocks, bonds (including Treasury bills), and physical assets such as real estate. A basic principle of balance-of-payments accounting is double-entry bookkeeping. Every international transac- tion automatically enters the balance of payments twice— once as a credit and once as a debit. Imagine that you purchase a car produced in Japan by Toyota for $20,000. Because your purchase represents a payment to another country for goods, it will enter the balance of payments as a debit on the current account. Toyota now has the $20,000 and must do something with it. If Toyota deposits the money at a U.S. bank, Toyota has purchased a U.S. asset— a bank deposit worth $20,000—and the transaction will show up as a $20,000 credit on the financial account. Or Toyota might deposit the cash in a Japanese bank in return for Japanese yen. Now the Japanese bank must de- cide what to do with the $20,000. Any action that it takes will ultimately result in a credit for the U.S. balance of payments. For example, if the bank lends the $20,000 to a Japanese firm that uses it to import personal computers from the United States, then the $20,000 must be credited to the U.S. balance-of-payments current account. Or the Japanese bank might use the $20,000 to purchase U.S. government bonds, in which case it will show up as a credit on the U.S. balance-of-payments financial account. Thus, any international transaction automatically gives rise to two offsetting entries in the balance of payments. Because of this, the sum of the current account balance, the capital account, and the financial account balance should always add up to zero. In practice, this does not always oc- cur due to the existence of “statistical discrepancies,” the source of which need not concern us here (note that in 2013, the statistical discrepancy amounted to $30 billion).

DOES THE CURRENT ACCOUNT DEFICIT MATTER?

As discussed earlier, there is some concern when a coun- try is running a deficit on the current account of its balance of payments.39 In recent years, a number of rich

countries, including most notably the United States, have run persistent current account deficits. When a country runs a current account deficit, the money that flows to other countries can then be used by those countries to purchase assets in the deficit country. Thus, when the United States runs a trade deficit with China, the Chinese use the money that they receive from U.S. consumers to purchase U.S. assets such as stocks, bonds, and the like. Put another way, a deficit on the current ac- count is financed by selling assets to other countries; that is, by increasing liabilities on the financial account. Thus, the persistent U.S. current account deficit is being financed by a steady sale of U.S. assets (stocks, bonds, real estate, and whole corporations) to other countries. In short, coun- tries that run current account deficits become net debtors. For example, as a result of financing its current ac- count deficit through asset sales, the United States must deliver a stream of interest payments to foreign bond- holders, rents to foreign landowners, and dividends to foreign stockholders. One might argue that such pay- ments to foreigners drain resources from a country and limit the funds available for investment within the coun- try. Since investment within a country is necessary to stimulate economic growth, a persistent current account deficit can choke off a country’s future economic growth. This is the basis of the argument that persistent deficits are bad for an economy. However, things are not this simple. For one thing, in an era of global capital markets money is efficiently directed toward its highest value uses, and over the past quarter of a century many of the highest value uses of capital have been in the United States. So even though capital is flowing out of the United States in the form of payments to foreigners, much of that capital finds its way right back into the country to fund productive investments in the United States. In short, it is not clear that the current ac- count deficit chokes off U.S. economic growth. In fact, notwithstanding the 2008–2009 recession, the U.S. econ- omy has grown substantially over the past 30 years, de- spite running a persistent current account deficit and despite financing that deficit by selling U.S. assets to foreigners. This is precisely because foreigners reinvest much of the income earned from U.S. assets, and from exports to the United States, right back into the United States. This revisionist view, which has gained in popu- larity in recent years, suggests that a persistent current account deficit might not be the drag on economic growth it was once thought to be.40 Having said this, there is still a nagging fear that at some point the appetite that foreigners have for U.S. as- sets might decline. If foreigners suddenly reduced their investments in the United States, what would happen? In short, instead of reinvesting the dollars that they earn from exports and investment in the United States back into the country, they would sell those dollars for another currency, European euros, Japanese yen, or

192 Part 3 The Global Trade and Investment Environment

Chinese yuan, for example, and invest in euro-, yen-, and yuan-denominated assets instead. This would lead to a fall in the value of the dollar on foreign exchange markets, and that in turn would increase the price of imports, and lower the price of U.S. exports, making them more com- petitive, which should reduce the overall level of the cur- rent account deficit. Thus, in the long run, the persistent U.S. current account deficit could be corrected via a reduction in the value of the U.S. dollar. The concern is

that such adjustments may not be smooth. Rather than a controlled decline in the value of the dollar, the dollar might suddenly lose a significant amount of its value in a very short time, precipitating a “dollar crisis.”41 Because the U.S. dollar is the world’s major reserve currency, and is held by many foreign governments and banks, any dollar crisis could deliver a body blow to the world economy and at the very least trigger a global economic slowdown. That would not be a good thing.

E n d n o t e s

1. H. W. Spiegel, The Growth of Economic Thought (Durham, NC: Duke University Press, 1991).

2. M. Solis, “The Politics of Self-Restraint: FDI Subsidies and Japanese Mercantilism,” The World Economy 26 (February 2003), pp. 153–70.

3. S. Hollander, The Economics of David Ricardo (Buffalo: University of Toronto Press, 1979).

4. D. Ricardo, The Principles of Political Economy and Taxation (Homewood, IL: Irwin, 1967, first published in 1817).

5. For example, R. Dornbusch, S. Fischer, and P. Samuelson, “Comparative Advantage: Trade and Payments in a Ricardian Model with a Continuum of Goods,” American Economic Review 67 (December 1977), pp. 823–39.

6. B. Balassa, “An Empirical Demonstration of Classic Compara- tive Cost Theory,” Review of Economics and Statistics, 1963, pp. 231–38.

7. See P. R. Krugman, “Is Free Trade Passé?,” Journal of Economic Perspectives 1 (Fall 1987), pp. 131–44.

8. P. Samuelson, “Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Globaliza- tion,” Journal of Economic Perspectives 18, no. 3 (Summer 2004), pp. 135–46.

9. P. Samuelson, “The Gains from International Trade Once Again,” Economic Journal 72 (1962), pp. 820–29.

10. S. Lohr, “An Elder Challenges Outsourcing’s Orthodoxy,” The New York Times, September 9, 2004, p. C1.

11. Samuelson, “Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Globaliza- tion,” p. 143.

12. D. H. Autor, D. Dorn, and Gordon H. Hanson, “The China Syndrome: Local Labor Market Effects of Import Competition in the United States,” MIT Working Paper, August 2011.

13. See A. Dixit and G. Grossman, “Samuelson Says Nothing about Trade Policy,” Princeton University, 2004, http://depts. washington.edu/teclass/ThinkEcon/readings/Kalles/ Dixit%20and%20Grossman%20on%20Samuelson.pdf.

14. J. R. Hagerty, “U.S. Loses High Tech Jobs as R&D Shifts to Asia,” The Wall Street Journal, January 18, 2012, p. B1.

15. For example, J. D. Sachs and A. Warner, “Economic Reform and the Process of Global Integration,” Brookings Papers on Economic Activity, 1995, pp. 1–96; J. A. Frankel and D. Romer, “Does Trade Cause Growth?,” American Economic Review 89,

no. 3 (June 1999), pp. 379–99; D. Dollar and A. Kraay, “Trade, Growth and Poverty,” Working Paper, Development Research Group, World Bank, June 2001. Also, for an accessible discus- sion of the relationship between free trade and economic growth, see T. Taylor, “The Truth about Globalization,” Public Interest, Spring 2002, pp. 24–44; D. Acemoglu, S. Johnson, and J. Robinson, “The Rise of Europe: Atlantic Trade, Institu- tional Change and Economic Growth,” American Economic Review 95, no. 3 (2005), pp. 547–79; T. Singh, “Does Interna- tional Trade Cause Economic Growth?,” The World Economy 33, no. 11 (2010), pp. 1517–64.

16. Sachs and Warner, “Economic Reform and the Process of Global Integration.”

17. Ibid., pp. 35–36. 18. R. Wacziarg and K. H. Welch, “Trade Liberalization and

Growth: New Evidence,” National Bureau of Economic Research Working Paper Series, working paper no. 10152, December 2003.

19. Singh, “Does International Trade Cause Economic Growth?” 20. Frankel and Romer, “Does Trade Cause Growth?” 21. A recent skeptical review of the empirical work on the relation-

ship between trade and growth questions these results. See Francisco Rodriguez and Dani Rodrik, “Trade Policy and Economic Growth: A Skeptic’s Guide to the Cross-National Evidence,” National Bureau of Economic Research Working Paper Series, working paper no. 7081, April 1999. Even these authors, however, cannot find any evidence that trade hurts economic growth or income levels.

22. B. Ohlin, Interregional and International Trade (Cambridge, MA: Harvard University Press, 1933). For a summary, see R. W. Jones and J. P. Neary, “The Positive Theory of International Trade,” in Handbook of International Economics, R. W. Jones and P. B. Kenen, eds. (Amsterdam: North Holland, 1984).

23. W. Leontief, “Domestic Production and Foreign Trade: The American Capital Position Re-examined,” Proceedings of the American Philosophical Society 97 (1953), pp. 331–49.

24. R. M. Stern and K. Maskus, “Determinants of the Structure of U.S. Foreign Trade,” Journal of International Economics 11 (1981), pp. 207–44.

25. See H. P. Bowen, E. E. Leamer, and L. Sveikayskas, “Multicountry, Multifactor Tests of the Factor Abundance Theory,” American Economic Review 77 (1987), pp. 791–809.

International Trade Theory Chapter 6 193

26. D. Trefler, “The Case of the Missing Trade and Other Mysteries,” American Economic Review 85 (December 1995), pp. 1029–46.

27. D. R. Davis and D. E. Weinstein, “An Account of Global Factor Trade,” American Economic Review, December 2001, pp. 1423–52.

28. R. Vernon, “International Investments and International Trade in the Product Life Cycle,” Quarterly Journal of Economics, May 1966, pp. 190–207; R. Vernon and L. T. Wells, The Economic Environment of International Business, 4th ed. (Englewood Cliffs, NJ: Prentice Hall, 1986).

29. For a good summary of this literature, see E. Helpman and P. Krugman, Market Structure and Foreign Trade: Increasing Returns, Imperfect Competition, and the International Econ- omy (Boston: MIT Press, 1985). Also see P. Krugman, “Does the New Trade Theory Require a New Trade Policy?,” World Economy 15, no. 4 (1992), pp. 423–41.

30. M. B. Lieberman and D. B. Montgomery, “First-Mover Advan- tages,” Strategic Management Journal 9 (Summer 1988), pp. 41–58; W. T. Robinson and Sungwook Min, “Is the First to Market the First to Fail?,” Journal of Marketing Research 29 (2002), pp. 120–28.

31. J. R. Tybout, “Plant and Firm Level Evidence on New Trade Theories,” National Bureau of Economic Research Working Paper Series, working paper no. 8418, August 2001, www. nber.org); S. Deraniyagala and B. Fine, “New Trade Theory versus Old Trade Policy: A Continuing Enigma,” Cambridge Journal of Economics 25 (November 2001), pp. 809–25.

32. A. D. Chandler, Scale and Scope (New York: Free Press, 1990). 33. Krugman, “Does the New Trade Theory Require a New

Trade Policy?”

34. M. E. Porter, The Competitive Advantage of Nations (New York: Free Press, 1990). For a good review of this book, see R. M. Grant, “Porter’s Competitive Advantage of Nations: An Assessment,” Strategic Management Journal 12 (1991), pp. 535–48.

35. B. Kogut, ed., Country Competitiveness: Technology and the Organizing of Work (New York: Oxford University Press, 1993).

36. Porter, The Competitive Advantage of Nations, p. 121. 37. Lieberman and Montgomery, “First-Mover Advantages.” See

also Robinson and Min, “Is the First to Market the First to Fail?”; W. Boulding and M. Christen, “First Mover Disadvan- tage,” Harvard Business Review, October 2001, pp. 20–21; R. Agarwal and M. Gort, “First Mover Advantage and the Speed of Competitive Entry,” Journal of Law and Economics 44 (2001), pp. 131–59.

38. C. A. Hamilton, “Building Better Machine Tools,” Journal of Commerce, October 30, 1991, p. 8; “Manufacturing Trouble,” The Economist, October 12, 1991, p. 71.

39. P. Krugman, The Age of Diminished Expectations (Cambridge, MA: MIT Press, 1990).

40. D. Griswold, “Are Trade Deficits a Drag on U.S. Economic Growth?,” Free Trade Bulletin, March 12, 2007; O. Blanchard, “Current Account Deficits in Rich Countries,” National Bureau of Economic Research Working Paper Series, working paper no. 12925, February 2007.

41. S. Edwards, “The U.S. Current Account Deficit: Gradual Correction or Abrupt Adjustment?,” National Bureau of Economic Research Working Paper Series, working paper no. 12154, April 2006.

Credit: ©Federal Reserve Board.

Government Policy and International Trade L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO7-1 Identify the policy instruments used by governments to influence international trade flows.

LO7-2 Understand why governments sometimes intervene in international trade.

LO7-3 Summarize and explain the arguments against strategic trade policy.

LO7-4 Describe the development of the world trading system and the current trade issue.

LO7-5 Explain the implications for managers of developments in the world trading system.

part three The Global Trade and Investment Environment

7

Source: © Kuni Takahashi/Bloomberg/Getty Images

U.S. Tariffs on Chinese Solar Panels Benefit Malaysia

protect U.S. jobs. California-based Sun Power, for exam- ple, now manufactures half of its solar panels in Malaysia. Another U.S. producer, First Solar, now has 3,700 employ- ees working at a factory in Malaysia. Some of Europe’s big producers, who lobbied for restrictions on Chinese imports, have also set up production in Malaysia. Hanwha Q Cells, for example, produces 1,100 megawatts a year of panels in Malaysia, and just 200 megawatts in its home market of Germany. As a result of investments like these, production in Malaysia has tripled since 2012. Not everyone is happy about this. Some of the original backers of American trade action against China say that the goal was to create jobs in the United States, not Malay- sia. The Office of the United States Trade Representative has also expressed concern about Malaysia’s tax breaks to foreign investors, and has asked Malaysia to provide details of how they work in order to understand if the tax breaks violate a World Trade Organization ban on export subsidies. For its part, Malaysia has denied breaking any trade rules, and has pointed out that U.S. states routinely give large tax breaks to foreign investors. Notwithstanding these developments, in 2014 the U.S. manufacturer SolarWorld Industries filed a petition with the Commerce Department arguing that loopholes in the 2012 sanctions had allowed some Chinese manufacturers to continue supplying solar panels to the United States at below the cost of production. The Commerce Department agreed, and in mid-2014 it imposed additional import duties ranging from 18.56 to 35.21 percent on imports from certain Chinese companies that had managed to circum- vent the earlier sanctions. For its part, SolarWorld empha- sizes that the additional sanctions will create more jobs in the United States. Consistent with this, the company is investing $400 million in a new manufacturing facility in Oregon. The State of Oregon is supporting this investment with property and business energy tax credits.

Sources: Keith Bradsher, “A Solar Rise in Malaysia,” The New York Times, December 12, 2014; Bloomberg News, “Obama’s Tariffs on China’s Solar Products Will Cost US,” May 16, 2012; Diane Cardwell, “U.S. Imposes Steep Tariffs on Importers of Chinese Solar Panels,” The New York Times, June 3, 2014; SolarWorld Industries website, www.solarworld-usa.com/about-solarworld/locations.

O P E N I N G C A S E In 2009 as the global financial crisis took hold Chinese factories were quickly increasing production of solar pan- els. They were helped by subsidies in the form of large loans from state-owned banks at below-market interest rates, and free or nearly free land from local governments. As their output expanded, prices for solar panels began to plummet. Between 2008 and 2012 prices fell by more than 80 percent. This benefited American consumers, who in- creased their purchases of rooftop solar panels. It also benefited American energy policy, which under the Obama administration had been promoting a shift toward renew- able energy sources and ironically providing subsidies to consumers who installed solar panels on their rooftops. However, the steep price declines hurt American solar panel producers, several of whom went bankrupt. In response, the Coalition for American Solar Manufac- turing petitioned the U.S. Commerce Department for trade sanctions. The coalition argued that unfair govern- ment subsidies to Chinese manufacturers were allowing them to sell solar panels in the United States at below the costs of production. Chinese tactics, they argued, had cost at least 2,000 jobs in the U.S. photovoltaic industry. The U.S. government responded in 2012 by imposing stiff antisubsidies and antidumping duties amounting to about 30 percent of their cost on panels imported from China. The European Union adopted similar trade sanctions, imposing import quotas and minimum selling prices for Chinese panels. What happened next was unexpected. The imposition of duties on imports from China, along with rising labor costs in China, persuaded many multinationals to move their production of solar panels to other locations. The main beneficiary of this action was not the United States or Europe, however; it was Malaysia, where labor costs were comparable to China, electricity was cheap, there was a good supply of English-speaking engineers, and large foreign and domestic investors were given a 10-year exemp- tion from corporate taxes. The investors in Malaysia included several of the American companies that had petitioned the Commerce Department for tariffs on Chinese imports to

195

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Introduction

The review of the classical trade theories of Smith, Ricardo, and Heckscher-Ohlin in Chapter 6 showed that in a world without trade barriers, trade patterns are determined by the relative productivity of different factors of production in different countries. Coun- tries will specialize in products that they can make most efficiently, while importing products that they can produce less efficiently. Chapter 6 also laid out the intellectual case for free trade. Remember, free trade refers to a situation in which a government does not attempt to restrict what its citizens can buy from or sell to another country. As we saw in Chapter 6, the theories of Smith, Ricardo, and Heckscher-Ohlin predict that the consequences of free trade include both static economic gains (because free trade supports a higher level of domestic consumption and more efficient utilization of resources) and dynamic economic gains (because free trade stimulates economic growth and the creation of wealth). This chapter looks at the political reality of international trade. Although many nations are nominally committed to free trade, they tend to intervene in international trade to protect the interests of politically important groups or promote the interests of key domestic producers. The Chinese government appears to have been subsidizing the costs of Chinese solar panel manufacturers to help them gain share in the world marketplace for this strate- gically important industry. The United States (and the European Union) responded by slapping punitive tariffs on solar panels imported from China. Interestingly, however, these tariffs do not seem to have had the desired effect. Far from increasing jobs in the U.S. and EU solar industries, the locus of global production has moved from China to Malaysia, with several manufacturers from the United States and EU setting up operations there. The lesson here is that government intervention in international trade can have unintended consequences. Policymakers would be well advised to think through the impli- cations of their actions before putting policies into practice. This chapter explores the political and economic reasons that governments have for intervening in international trade. When governments intervene, they often do so by restrict- ing imports of goods and services into their nation, while adopting policies that promote domestic production and exports. Normally, their motives are to protect domestic produc- ers. In recent years, social issues have intruded into the decision-making calculus. In the United States, for example, a movement is growing to ban imports of goods from coun- tries that do not abide by the same labor, health, and environmental regulations as the United States. This chapter starts by describing the range of policy instruments that governments use to intervene in international trade. A detailed review of governments’ various political and economic motives for intervention follows. In the third section of this chapter, we consider how the case for free trade stands up in view of the various justifications given for government intervention in international trade. Then we look at the emergence of the modern international trading system, which is based on the General Agreement on Tariffs and Trade (GATT) and its successor, the WTO. The GATT and WTO are the creations of a series of multinational treaties. The final section of this chapter discusses the implications of this material for management practice.

Instruments of Trade Policy

Trade policy uses seven main instruments: tariffs, subsidies, import quotas, voluntary export restraints, local content requirements, administrative policies, and antidumping duties. Tariffs are the oldest and simplest instrument of trade policy. As we shall see later in this chapter, they are also the instrument that the GATT and WTO have been most successful in limiting. A fall in tariff barriers in recent decades has been accompanied by a rise in nontariff barriers, such as subsidies, quotas, voluntary export restraints, and antidumping duties.

LO 7-1 Identify the policy instruments used by governments to influence international trade flows.

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TARIFFS

A tariff is a tax levied on imports (or exports). Tariffs fall into two categories. Specific tariffs are levied as a fixed charge for each unit of a good imported (e.g., $3 per barrel of oil). Ad valorem tariffs are levied as a proportion of the value of the imported good. In most cases, tariffs are placed on imports to protect domestic producers from foreign com- petition by raising the price of imported goods. However, tariffs also produce revenue for the government. Until the income tax was introduced, for example, the U.S. government received most of its revenues from tariffs. The important thing to understand about an import tariff is who suffers and who gains. The government gains, because the tariff increases government revenues. Domestic pro- ducers gain, because the tariff affords them some protection against foreign competitors by increasing the cost of imported foreign goods. Consumers lose because they must pay more for certain imports. For example, in 2002 the U.S. government placed an ad valorem tariff of 8 to 30 percent on imports of foreign steel. The idea was to protect domestic steel producers from cheap imports of foreign steel. The effect, however, was to raise the price of steel products in the United States between 30 and 50 percent. A number of U.S. steel consumers, ranging from appliance makers to automobile companies, objected that the steel tariffs would raise their costs of production and make it more difficult for them to compete in the global marketplace. Whether the gains to the government and domestic producers exceed the loss to consumers depends on various factors, such as the amount of the tariff, the importance of the imported good to domestic consumers, the number of jobs saved in the protected industry, and so on. In the steel case, many argued that the losses to steel consumers apparently outweighed the gains to steel producers. In November 2003, the World Trade Organization declared that the tariffs represented a violation of the WTO treaty, and the United States removed them in December of that year. In general, two conclusions can be derived from economic analysis of the effect of import tariffs.1 First, tariffs are generally pro-producer and anticonsumer. While they protect producers from foreign competitors, this restriction of supply also raises domestic prices. For example, a study by Japanese economists calculated that tariffs on imports of foodstuffs, cosmetics, and chemicals into Japan cost the average Japanese consumer about $890 per year in the form of higher prices. Almost all studies find that import tar- iffs impose significant costs on domestic consumers in the form of higher prices. Second, import tariffs reduce the overall efficiency of the world economy. They reduce efficiency because a protective tariff encourages domestic firms to produce products at home that, in theory, could be produced more efficiently abroad. The consequence is an inefficient utilization of resources. Sometimes tariffs are levied on exports of a product from a country. Export tariffs are less common than import tariffs. In general, export tariffs have two objectives: first, to raise revenue for the government, and second, to reduce exports from a sector, often for political reasons. For example, in 2004 China imposed a tariff on textile exports. The primary objective was to moderate the growth in exports of textiles from China, thereby alleviating tensions with other trading partners.

SUBSIDIES

A subsidy is a government payment to a domestic producer. Subsidies take many forms, including cash grants, low-interest loans, tax breaks, and government equity participation in domestic firms. By lowering production costs, subsidies help domestic producers in two ways: (1) competing against foreign imports and (2) gaining export markets. Agricul- ture tends to be one of the largest beneficiaries of subsidies in most countries. The Euro- pean Union has been paying out about €44 billion annually ($55 billion) in farm subsidies. The farm bill that passed the U.S. Congress in 2007 contained subsidies of $289 billion for the next 10 years. The Japanese also have a long history of supporting inefficient domestic producers with farm subsidies. According to the World Trade Organization, in mid-2000 countries spent some $300 billion on subsidies, $250 billion of which was

spent by 21 developed nations.2 In response to a severe sales slump following the global financial crisis, between mid-2008 and mid-2009, some developed nations gave $45 billion in subsidies to their automobile makers. While the purpose of the subsidies was to help them survive a very difficult economic climate, one of the consequences was to give sub- sidized companies an unfair competitive advantage in the global auto industry. Somewhat ironically given the government bailouts of U.S. auto companies during the global finan- cial crisis, in 2012 the Obama administration filed a complaint with the WTO arguing that the Chinese were illegally subsidizing exports of autos and auto parts. Details are given in the Country Focus feature. The main gains from subsidies accrue to domestic producers, whose international com- petitiveness is increased as a result. Advocates of strategic trade policy (which, as you will recall from Chapter 6, is an outgrowth of the new trade theory) favor subsidies to help domestic firms achieve a dominant position in those industries in which economies of scale are important and the world market is not large enough to profitably support more than a few firms (aerospace and semiconductors are two such industries). According to this argument, subsidies can help a firm achieve a first-mover advantage in an emerging industry (just as U.S. government subsidies, in the form of substantial R&D grants, alleg- edly helped Boeing). If this is achieved, further gains to the domestic economy arise from the employment and tax revenues that a major global company can generate. However, government subsidies must be paid for, typically by taxing individuals and corporations.

COUNTRY FOCUS

Are the Chinese Illegally Subsidizing Auto Exports? In late 2012, during the presidential election campaign, the Obama administration filed a complaint against China with the World Trade Organization. The complaint claims that China is providing export subsidies to its auto and auto parts industries. The subsidies include cash grants for ex- porting, grants for R&D, subsidies to pay interest on loans, and preferential tax treatment. The United States estimates the value of the subsidies to be at least $1 billion between 2009 and 2011. The com- plaint also points out that in the years 2002 through 2011, the value of China’s exports of autos and auto parts increased more than ninefold from $7.4 billion to $69.1 billion. The United States was China’s largest market for exports of auto parts during this period. The United States is assert- ing that, to some degree, this growth may have been helped by subsidies. The complaint goes on to claim that these subsidies have hurt producers of automobiles and auto parts in the United States. This is a large industry in the United States, employing over 800,000 people and generating some $350 billion in sales. While some in the labor movement applauded the move, the response from U.S. auto companies and auto parts producers was muted. One reason for this is that many U.S. producers do business in China and, in all probability, want to avoid retaliation from the Chinese government.

GM, for example, has a joint venture and two wholly owned subsidiaries in China and is doing very well there. In addition, some U.S. producers benefit by purchasing cheap Chinese auto parts, so any retaliatory tariffs imposed on those imports might actually raise their costs. More cynical observers saw the move as nothing more than political theater. The week before the complaint was filed, the Republican presidential candidate, Mitt Romney, had accused the Obama administration of “failing American workers” by not labeling China a currency manipulator. So perhaps the complaint was in part simply another move on the presidential campaign chessboard. In any event, the WTO does not move rapidly, and the case was still under consideration in early 2015. Indeed, in February 2014 the United States expanded its complaint with the WTO against China, arguing that the country had an illegal ex- port subsidy program that includes not only autos and auto parts, but also textile, apparel, and footwear, advanced materials and metals, specialty chemicals, medical prod- ucts, and agriculture.

Sources: James Healey, “U.S. Alleges Unfair China Auto Subsidies in WTO Action,” USA Today, September 17, 2012; M. A. Memoli, “Obama to Tell WTO That China Illegally Subsidizes Auto Imports,” Los Angeles Times, September 17, 2012; Vicki Needham, “US Launches Trade Case against China’s Export Subsidy Program,” The Hill, February 11, 2014.

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Whether subsidies generate national benefits that exceed their national costs is debat- able. In practice, many subsidies are not that successful at increasing the international competitiveness of domestic producers. Rather, they tend to protect the inefficient and promote excess production. One study estimated that if advanced countries abandoned subsidies to farmers, global trade in agricultural products would be 50 percent higher and the world as a whole would be better off by $160 billion.3 Another study estimated that removing all barriers to trade in agriculture (both subsidies and tariffs) would raise world income by $182 billion.4 This increase in wealth arises from the more efficient use of agricultural land.

IMPORT QUOTAS AND VOLUNTARY EXPORT RESTRAINTS

An import quota is a direct restriction on the quantity of some good that may be imported into a country. The restriction is usually enforced by issuing import licenses to a group of individuals or firms. For example, the United States has a quota on cheese imports. The only firms allowed to import cheese are certain trading companies, each of which is allocated the right to import a maximum number of pounds of cheese each year. In some cases, the right to sell is given directly to the governments of exporting countries. Historically, this was the case for textile imports in the United States. However, the international agreement governing the imposition of import quotas on textiles, the Multi-fiber Agreement, expired on January 1, 2005. A common hybrid of a quota and a tariff is known as a tariff rate quota. Under a tariff rate quota, a lower tariff rate is applied to imports within the quota than those over the quota. For example, as illustrated in Figure 7.1, an ad valorem tariff rate of 10 percent might be levied on 1 million tons of rice imports into South Korea, after which an out-of-quota rate of 80 percent might be applied. Thus, South Korea might import 2 million tons of rice, 1 million at a 10 percent tariff rate and another 1 million at an 80 percent tariff. Tariff rate quotas are common in agriculture, where their goal is to limit imports over quota. A variant on the import quota is the voluntary export restraint. A voluntary export restraint (VER) is a quota on trade imposed by the exporting country, typically at the request of the importing country’s government. One of the most famous historical examples is the limitation on auto exports to the United States enforced by Japanese automobile producers in 1981. A response to direct pressure from the U.S. government, this VER limited Japanese imports to no more than 1.68 million vehicles per year. The agreement was revised in 1984 to allow 1.85 million Japanese vehicles per year. The

F I G U R E 7. 1

Hypothetical tariff rate quota.

80%

10%

Tariff Rate % Quota Limit

In quota

Out of quota

2 million1 million Tons of Rice Imported0

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agreement was allowed to lapse in 1985, but the Japanese government indicated its intentions at that time to continue to restrict exports to the United States to 1.85 million vehicles per year.5 In 2012, Brazil imposed what amounts to voluntary export restraints on shipments of vehicles from Mexico to Brazil. The two countries have a decade-old free trade agreement, but a surge in vehicles heading to Brazil from Mexico prompted Brazil to raise its protectionist walls. Mexico has agreed to quotas on Brazil-bound vehicle exports for the next three years.6 Foreign producers agree to VERs because they fear more damaging punitive tariffs or import quotas might follow if they do not. Agree- ing to a VER is seen as a way to make the best of a bad situation by appeasing protec- tionist pressures in a country. As with tariffs and subsidies, both import quotas and VERs benefit domestic producers by limiting import competition. As with all restrictions on trade, quotas do not benefit consumers. An import quota or VER always raises the domestic price of an imported good. When imports are limited to a low percentage of the market by a quota or VER, the price is bid up for that limited foreign supply. The automobile industry VER mentioned earlier increased the price of the limited supply of Japanese imports. According to a study by the U.S. Federal Trade Commission, the automobile VER cost U.S. consumers about $1 billion per year between 1981 and 1985. That $1 billion per year went to Japanese pro- ducers in the form of higher prices.7 The extra profit that producers make when supply is artificially limited by an import quota is referred to as a quota rent. If a domestic industry lacks the capacity to meet demand, an import quota can raise prices for both the domestically produced and the imported good. This happened in the U.S. sugar industry, in which a tariff rate quota system has long limited the amount foreign producers can sell in the U.S. market. According to one study, import quotas have caused the price of sugar in the United States to be as much as 40 percent greater than the world price.8 These higher prices have translated into greater profits for U.S. sugar producers, which have lobbied politicians to keep the lucrative agreement. They argue U.S. jobs in the sugar industry will be lost to foreign producers if the quota sys- tem is scrapped.

LOCAL CONTENT REQUIREMENTS

A local content requirement (LCR) is a requirement that some specific fraction of a good be produced domestically. The requirement can be expressed either in physical terms (e.g., 75 percent of component parts for this product must be produced locally) or in value terms (e.g., 75 percent of the value of this product must be produced locally). Local content regulations have been widely used by developing countries to shift their manufac- turing base from the simple assembly of products whose parts are manufactured else- where into the local manufacture of component parts. They have also been used in developed countries to try to protect local jobs and industry from foreign competition. For example, a little-known law in the United States, the Buy America Act, specifies that government agencies must give preference to American products when putting contracts for equipment out to bid unless the foreign products have a significant price advantage. The law specifies a product as “American” if 51 percent of the materials by value are produced domestically. This amounts to a local content requirement. If a foreign company, or an American one for that matter, wishes to win a contract from a U.S. government agency to provide some equipment, it must ensure that at least 51 percent of the product by value is manufactured in the United States. Local content regulations provide protection for a domestic producer of parts in the same way an import quota does: by limiting foreign competition. The aggregate eco- nomic effects are also the same; domestic producers benefit, but the restrictions on im- ports raise the prices of imported components. In turn, higher prices for imported components are passed on to consumers of the final product in the form of higher final prices. So as with all trade policies, local content regulations tend to benefit producers and not consumers.

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ADMINISTRATIVE POLICIES

In addition to the formal instruments of trade policy, governments of all types some- times use informal or administrative policies to restrict imports and boost exports. Administrative trade policies are bureaucratic rules designed to make it difficult for imports to enter a country. It has been argued that the Japanese are the masters of this trade barrier. In recent decades, Japan’s formal tariff and nontariff barriers have been among the lowest in the world. However, critics charge that the country’s informal ad- ministrative barriers to imports more than compensate for this. For example, at one point the Netherlands exported tulip bulbs to almost every country in the world except Japan. In Japan, customs inspectors insisted on checking every tulip bulb by cutting it vertically down the middle, and even Japanese ingenuity could not put any back to- gether. Federal Express also initially had a tough time expanding its global express shipping services into Japan because Japanese customs inspectors insist on opening a large proportion of express packages to check for pornography, a process that delayed an “express” package for days. As with all instruments of trade policy, administrative instruments benefit producers and hurt consumers, who are denied access to possibly superior foreign products.

ANTIDUMPING POLICIES

In the context of international trade, dumping is variously defined as selling goods in a foreign market at below their costs of production or as selling goods in a foreign market at below their “fair” market value. There is a difference between these two definitions; the fair market value of a good is normally judged to be greater than the costs of produc- ing that good because the former includes a “fair” profit margin. Dumping is viewed as a method by which firms unload excess production in foreign markets. Some dumping may be the result of 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. Once this has been achieved, so the argument goes, the predatory firm can raise prices and earn substantial profits. An example of dumping is given in the opening case. Antidumping policies are designed to punish foreign firms that engage in dumping. The ultimate objective is to protect domestic producers from unfair foreign competi- tion. Although antidumping policies vary from country to country, the majority are similar to those used in the United States. If a domestic producer believes that a foreign firm is dumping production in the U.S. market, it can file a petition with two govern- ment agencies, the Commerce Department and the International Trade Commission (ITC). If a complaint has merit, the Commerce Department may impose an anti- dumping duty on the offending foreign imports (antidumping duties are often called countervailing duties). These duties, which represent a special tariff, can be fairly substantial and stay in place for up to five years. The accompanying Management Fo- cus discusses how a firm, U.S. Magnesium, used antidumping legislation to gain pro- tection from unfair foreign competitors.

The Case for Government Intervention

Now that we have reviewed the various instruments of trade policy that governments can use, it is time to look at the case for government intervention in international trade. Arguments for government intervention take two paths: political and economic. Political arguments for intervention are concerned with protecting the interests of certain groups within a nation (normally producers), often at the expense of other groups (normally consumers), or with achieving some political objective that lies outside the sphere of eco- nomic relationships, such as protecting the environment or human rights. Economic arguments for intervention are typically concerned with boosting the overall wealth of a nation (to the benefit of all, both producers and consumers).

TEST PREP Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

LO 7-2 Understand why governments sometimes intervene in international trade.

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M A NAG E M E N T F O C U S

Protecting U.S. Magnesium In February 2004, U.S. Magnesium, the sole surviving U.S. producer of magnesium, a metal that is primarily used in the manufacture of certain automobile parts and aluminum cans, filed a petition with the U.S. International Trade Commission contending that a surge in imports had caused material dam- age to the U.S. industry’s employment, sales, market share, and profitability. According to U.S. Magnesium, Russian and Chinese producers had been selling the metal at prices sig- nificantly below market value. During 2002 and 2003, imports of magnesium into the United States rose 70 percent, while prices fell by 40 percent, and the market share accounted for by imports jumped to 50 percent from 25 percent. “The United States used to be the largest producer of magnesium in the world,” a U.S. Magnesium spokesperson said at the time of the filing. “What’s really sad is that you can be state of the art and have modern technology, and if the Chinese, who pay people less than 90 cents an hour, want to run you out of business, they can do it. And that’s why we are seeking relief.” During a yearlong investigation, the ITC solicited input from various sides in the dispute. Foreign producers and consumers of magnesium in the United States argued that falling prices for magnesium during 2002 and 2003 simply reflected an imbalance between supply and demand due to additional capacity coming on stream not from Russia or China but from a new Canadian plant that opened in 2001 and from a planned Australian plant. The Canadian plant shut down in 2003, the Australian plant never came on stream, and prices for magnesium rose again in 2004. Magnesium consumers in the United States also argued to the ITC that imposing antidumping duties on foreign imports of magnesium would raise prices in the United States significantly above world levels. A spokesperson for Alcoa, which mixes magnesium with aluminum to make alloys for cans, predicted that if antidumping duties were imposed, high magnesium prices in the United States would force Alcoa to move some production out of the United States.

Alcoa also noted that in 2003, U.S. Magnesium was unable to supply all of Alcoa’s needs, forcing the company to turn to imports. Consumers of magnesium in the automo- bile industry asserted that high prices in the United States would drive engineers to design magnesium out of auto- mobiles, or force manufacturing elsewhere, which would ultimately hurt everyone. The six members of the ITC were not convinced by these arguments. In March 2005, the ITC ruled that both China and Russia had been dumping magnesium in the United States. The government decided to impose duties ranging from 50 percent to more than 140 percent on imports of magnesium from China. Russian producers faced duties ranging from 19 percent to 22 percent. The duties were to be levied for five years, after which the ITC would revisit the situation. The ITC revoked the antidumping order on Russia in February 2011 but decided to continue placing them on Chinese producers, and as of 2014 they are still in place. According to U.S. Magnesium, the favorable ruling would allow the company to reap the benefits of nearly $50 million in investments made in its manufacturing plant and enable the company to boost its capacity by 28 percent by the end of 2005. Commenting on the favorable ruling, a U.S. Magne- sium spokesperson noted, “Once unfair trade is removed from the marketplace we’ll be able to compete with anyone.” U.S. Magnesium’s customers and competitors, however, did not view the situation as one of unfair trade. While the impo- sition of antidumping duties no doubt will help to protect U.S. Magnesium and the 400 people it employs from foreign competition, magnesium consumers in the United States are left wondering if they will be the ultimate losers.

Sources: D. Anderton, “U.S. Magnesium Lands Ruling on Unfair Im- ports,” Desert News, October 1, 2004, p. D10; “U.S. Magnesium and Its Largest Consumers Debate before U.S. ITC,” Platt’s Metals Week, February 28, 2005, p. 2; S. Oberbeck, “U.S. Magnesium Plans Big Utah Production Expansion,” Salt Lake Tribune, March 30, 2005; “US to Keep Anti-dumping Duty on China Pure Magnesium,” Chinadaily.com, September 13, 2012.

POLITICAL ARGUMENTS FOR INTERVENTION

Political arguments for government intervention cover a range of issues, including preserving jobs, protecting industries deemed important for national security, retaliating against unfair foreign competition, protecting consumers from “dangerous” products, furthering the goals of foreign policy, and advancing the human rights of individuals in exporting countries.

Protecting Jobs and Industries Perhaps the most common political argument for government intervention is that it is necessary for protecting jobs and industries from unfair foreign competition. The tariffs

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placed on imports of foreign steel by President George W. Bush in 2002 were designed to do this (many steel producers were located in states that Bush needed to win reelection in 2004). A political motive also underlay establishment of the Common Agricultural Policy (CAP) by the European Union. The CAP was designed to protect the jobs of Europe’s politically powerful farmers by restricting imports and guaranteeing prices. However, the higher prices that resulted from the CAP have cost Europe’s consumers dearly. This is true of many attempts to protect jobs and industries through government intervention. For example, the imposition of steel tariffs in 2002 raised steel prices for American consumers, such as automobile companies, making them less competitive in the global marketplace.

Protecting National Security Countries sometimes argue that it is necessary to protect certain industries because they are important for national security. Defense-related industries often get this kind of atten- tion (e.g., aerospace, advanced electronics, and semiconductors). Although not as com- mon as it used to be, this argument is still made. Those in favor of protecting the U.S. semiconductor industry from foreign competition, for example, argue that semiconductors are now such important components of defense products that it would be dangerous to rely primarily on foreign producers for them. In 1986, this argument helped persuade the federal government to support Sematech, a consortium of 14 U.S. semiconductor compa- nies that accounted for 90 percent of the U.S. industry’s revenues. Sematech’s mission was to conduct joint research into manufacturing techniques that could be parceled out to members. The government saw the venture as so critical that Sematech was specially protected from antitrust laws. Initially, the U.S. government provided Sematech with $100 million per year in subsidies. By the mid-1990s, however, the U.S. semiconductor industry had regained its leading market position, largely through the personal computer boom and demand for microprocessor chips made by Intel. In 1994, the consortium’s board voted to seek an end to federal funding, and since 1996 the consortium has been funded entirely by private money.9

T R A D E L AW

Government policy and international trade is the core focus of Chapter 7. This topic area has far-ranging implications, such as trade policy, free trade, and the world’s international trading system. Basically, we are talking about a lot of legalistic aspects starting at the government level and moving all the way to what organizations and even individuals can and cannot do globally when trading. The globalEDGE section “Trade Law” (globaledge.msu.edu/global- resources/trade-law) is a unique compilation of globalEDGE partner-designed “compendiums of trade laws,” country and region-specific trade law, free online learning modules created for globalEDGE on various aspects of trade law, and much more. One fascinating resource related to trade law is the “A-CAPPP” program (Anti-Counterfeiting and Product Protection Program). A-CAPPP includes counterfeiting-related webinars, presentations, and research- related materials and working papers. Do you know what counterfeiting is? Take a look at the “Trade Law” section of globalEDGE and, especially, the A-CAPPP site to become more familiar with the topic. (Is China really as bad as many think in the international community?)

Retaliating Some argue that governments should use the threat to intervene in trade policy as a bar- gaining tool to help open foreign markets and force trading partners to “play by the rules of the game.” The U.S. government has used the threat of punitive trade sanctions to try to get the Chinese government to enforce its intellectual property laws. Lax enforcement of these laws had given rise to massive copyright infringements in China that had been

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costing U.S. companies such as Microsoft hundreds of millions of dollars per year in lost sales revenues. After the United States threatened to impose 100 percent tariffs on a range of Chinese imports, and after harsh words between officials from the two countries, the Chinese agreed to tighter enforcement of intellectual property regulations.10 If it works, such a politically motivated rationale for government intervention may liberalize trade and bring with it resulting economic gains. It is a risky strategy, however. A country that is being pressured may not back down and instead may respond to the imposition of punitive tariffs by raising trade barriers of its own. This is exactly what the Chinese government threatened to do when pressured by the United States, although it ultimately did back down. If a government does not back down, the results could be higher trade barriers all around and an economic loss to all involved.

Protecting Consumers Many governments have long had regulations to protect consumers from unsafe products. The indirect effect of such regulations often is to limit or ban the importation of such products. For example, in 2003 several countries, including Japan and South Korea, de- cided to ban imports of American beef after a single case of mad cow disease was found in Washington State. The ban was motivated to protect consumers from what was seen to be an unsafe product. Together, Japan and South Korea accounted for about $2 billion of U.S. beef sales, so the ban had a significant impact on U.S. beef producers. After two years, both countries lifted the ban, although they placed stringent requirements on U.S. beef imports to reduce the risk of importing beef that might be tainted by mad cow dis- ease (e.g., Japan required that all beef must come from cattle under 21 months of age). The accompanying Country Focus describes how the European Union banned the sale and importation of hormone-treated beef. The ban was motivated by a desire to protect European consumers from the possible health consequences of eating meat from animals treated with growth hormones.

Furthering Foreign Policy Objectives Governments sometimes use trade policy to support their foreign policy objectives.11 A government may grant preferential trade terms to a country with which it wants to build strong relations. Trade policy has also been used several times to pressure or punish “rogue states” that do not abide by international law or norms. Iraq labored under extensive trade sanctions after the UN coalition defeated the country in the 1991 Gulf War until the 2003 invasion of Iraq by U.S.-led forces. The theory is that such pressure might persuade the rogue state to mend its ways, or it might hasten a change of government. In the case of Iraq, the sanctions were seen as a way of forcing that country to comply with several UN resolutions. The United States has maintained long-running trade sanctions against Cuba (despite the move by the Obama adminis- tration to “normalize” relations with Cuba, these sanctions are still in place). Their principal function is to impoverish Cuba in the hope that the resulting economic hard- ship will lead to the downfall of Cuba’s Communist government and its replacement with a more democratically inclined (and pro-U.S.) regime. The United States has also had trade sanctions in place against Libya and Iran, both of which were accused of supporting terrorist action against U.S. interests and building weapons of mass de- struction. In late 2003, the sanctions against Libya seemed to yield some returns when that country announced it would terminate a program to build nuclear weapons. The U.S. government responded by relaxing those sanctions. Similarly, the U.S. govern- ment used trade sanctions to pressure the Iranian government to halt its alleged nuclear weapons program. Other countries can undermine unilateral trade sanctions. The U.S. sanctions against Cuba, for example, have not stopped other Western countries from trading with Cuba. The U.S. sanctions have done little more than help create a vacuum into which other trading nations, such as Canada and Germany, have stepped.

Protecting Human Rights Protecting and promoting human rights in other countries is an important element of foreign policy for many democracies. Governments sometimes use trade policy to try to improve the human rights policies of trading partners. For example, as discussed in Chapter 5, the U.S. government long had trade sanctions in place against the nation of Myanmar, in no small part due to the poor human rights practices in that nation. In late 2012 the United States said that it would ease trade sanctions against Myanmar

COUNTRY FOCUS

Trade in Hormone-Treated Beef In the 1970s, scientists discovered how to synthesize certain hormones and use them to accelerate the growth rate of livestock animals, reduce the fat content of meat, and in- crease milk production. Bovine somatotropin (BST), a growth hormone produced by cattle, was first synthesized by the biotechnology firm Genentech. Injections of BST could be used to supplement an animal’s own hormone production and increase its growth rate. These hormones became popular among farmers, who found they could cut costs and help satisfy consumer demands for leaner meat. Although these hormones occurred naturally in animals, consumer groups in several countries soon raised concerns about the practice. They argued that the use of hormone supple- ments was unnatural and that the health consequences of consuming hormone-treated meat were unknown but might include hormonal irregularities and cancer. The European Union responded to these concerns in 1989 by banning the importation of hormone-treated meat and the use of growth-promoting hormones in the production of livestock. The ban was controversial because a reason- able consensus existed among scientists that the hormones posed no health risk. Although the EU banned hormone- treated meat, many other countries did not, including big meat-producing countries such as Australia, Canada, New Zealand, and the United States. The use of hormones soon became widespread in these countries. According to trade officials outside the EU, the European ban consti- tuted an unfair restraint on trade. As a result of this ban, exports of meat to the EU fell. For example, U.S. red meat exports to the EU declined from $231 million in 1988 to $98 million in 1994. The complaints of meat exporters were bolstered in 1995 when Codex Alimentarius, the in- ternational food standards body of the UN’s Food and Agriculture Organization and the World Health Organiza- tion, approved the use of growth hormones. In making this decision, Codex reviewed the scientific literature and found no evidence of a link between the consumption of

hormone-treated meat and human health problems, such as cancer. Fortified by such decisions, in 1995 the United States pressed the EU to drop the import ban on hormone- treated beef. The EU refused, citing “consumer concerns about food safety.” In response, Canada and the United States filed formal complaints with the World Trade Organi- zation. They were soon joined by a number of other coun- tries, including Australia and New Zealand. The WTO created a trade panel of three independent experts. After reviewing evidence and hearing from a range of experts and representatives of both parties, the panel in May 1997 ruled that the EU ban on hormone-treated beef was illegal because it had no scientific justification. This ruling left the EU in a difficult position. Legally, the EU had to lift the ban or face punitive sanctions, but the ban had wide public support in Europe. The EU feared that lifting the ban could produce a consumer backlash. Instead the EU did nothing. In February 1999 the United States asked the WTO for permission to impose punitive sanctions on the EU. The WTO responded by allowing the United States to impose punitive tariffs valued at $125 million on EU exports to the United States. The EU decided to accept these tariffs rather than lift the ban on hormone-treated beef. In 2012, the EU struck a deal with the United States that allowed it to keep the ban in place, in return for increasing its import quota of high-quality non-hormone-treated beef from the United States. In response, the United States lifted its puni- tive tariffs on EU food exports, thereby ending one of the longest-running trade disputes in history.

Sources: C. Southey, “Hormones Fuel a Meaty EU Row,” Financial Times, September 7, 1995, p. 2; E. L. Andrews, “In Victory for U.S., European Ban on Treated Beef Is Ruled Illegal,” The New York Times, May 9, 1997, p. A1; R. Baily, “Food and Trade: EU Fear Mongers’ Lethal Harvest,” Los Angeles Times, August 18, 2002, p. M3; Scott Miller, “EU Trade Sanctions Have Dual Edge,” The Wall Street Journal, February 26, 2004, p. A3; G. Reilhac, “Lawmakers Approve Rise in Imports of Hormone Free Beef,” Reuters, March 14, 2012.

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in response to democratic reforms in that country. Similarly, in the 1980s and 1990s, Western governments used trade sanctions against South Africa as a way of pressuring that nation to drop its apartheid policies, which were seen as a violation of basic human rights.

ECONOMIC ARGUMENTS FOR INTERVENTION

With the development of the new trade theory and strategic trade policy (see Chapter 6), the economic arguments for government intervention have undergone a renaissance in recent years. Until the early 1980s, most economists saw little benefit in government inter- vention and strongly advocated a free trade policy. This position has changed at the margins with the development of strategic trade policy, although as we will see in the next section, there are still strong economic arguments for sticking to a free trade stance.

The Infant Industry Argument The infant industry argument is by far the oldest economic argument for government intervention. Alexander Hamilton proposed it in 1792. According to this argument, many developing countries have a potential comparative advantage in manufacturing, but new manufacturing industries cannot initially compete with established industries in devel- oped countries. To allow manufacturing to get a toehold, the argument is that govern- ments should temporarily support new industries (with tariffs, import quotas, and subsidies) until they have grown strong enough to meet international competition. This argument has had substantial appeal for the governments of developing nations during the past 50 years, and the GATT has recognized the infant industry argument as a legitimate reason for protectionism. Nevertheless, many economists remain critical of this argument for two main reasons. First, protection of manufacturing from foreign com- petition does no good unless the protection helps make the industry efficient. In case after case, however, protection seems to have done little more than foster the development of inefficient industries that have little hope of ever competing in the world market. Brazil, for example, built the world’s 10-largest auto industry behind tariff barriers and quotas. Once those barriers were removed in the late 1980s, however, foreign imports soared, and

Even though the United States holds trade sanctions with Cuba, other Western countries continue to trade with the island nation. Source: © Adalberto Roque/AFP/Getty Images

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the industry was forced to face up to the fact that after 30 years of protection, the Brazilian auto industry was one of the world’s most inefficient.12 Second, the infant industry argument relies on an assumption that firms are unable to make efficient long-term investments by borrowing money from the domestic or interna- tional capital market. Consequently, governments have been required to subsidize long- term investments. Given the development of global capital markets over the past 20 years, this assumption no longer looks as valid as it once did. Today, if a developing country has a potential comparative advantage in a manufacturing industry, firms in that country should be able to borrow money from the capital markets to finance the required invest- ments. Given financial support, firms based in countries with a potential comparative advantage have an incentive to endure the necessary initial losses in order to make long-run gains without requiring government protection. Many Taiwanese and South Korean firms did this in industries such as textiles, semiconductors, machine tools, steel, and shipping. Thus, given efficient global capital markets, the only industries that would require govern- ment protection would be those that are not worthwhile.

Strategic Trade Policy Some new trade theorists have proposed the strategic trade policy argument.13 We reviewed the basic argument in Chapter 6 when we considered the new trade theory. The new trade theory argues that in industries in which the existence of substantial economies of scale implies that the world market will profitably support only a few firms, countries may predominate in the export of certain products simply because they have firms that were able to capture first-mover advantages. The long-term dominance of Boeing in the com- mercial aircraft industry has been attributed to such factors. The strategic trade policy argument has two components. First, it is argued that by ap- propriate actions, a government can help raise national income if it can somehow ensure that the firm or firms that gain first-mover advantages in an industry are domestic rather than foreign enterprises. Thus, according to the strategic trade policy argument, a govern- ment should use subsidies to support promising firms that are active in newly emerging in- dustries. Advocates of this argument point out that the substantial R&D grants that the U.S. government gave Boeing in the 1950s and 1960s probably helped tilt the field of competi- tion in the newly emerging market for passenger jets in Boeing’s favor. (Boeing’s first com- mercial jet airliner, the 707, was derived from a military plane.) Similar arguments have been made with regard to Japan’s dominance in the production of liquid crystal display screens (used in computers). Although these screens were invented in the United States, the Japanese government, in cooperation with major electronics companies, targeted this indus- try for research support in the late 1970s and early 1980s. The result was that Japanese firms, not U.S. firms, subsequently captured first-mover advantages in this market. The second component of the strategic trade policy argument is that it might pay a government to intervene in an industry by helping domestic firms overcome the barriers to entry created by foreign firms that have already reaped first-mover advantages. This argument underlies government support of Airbus, Boeing’s major competitor. Formed in 1966 as a consortium of four companies from Great Britain, France, Germany, and Spain, Airbus had less than 5 percent of the world commercial aircraft market when it began production in the mid-1970s. By 2012, it had increased its share to 45 percent, threatening Boeing’s long-term dominance of the market. How did Airbus achieve this? According to the U.S. government, the answer is a $15 billion subsidy from the governments of Great Britain, France, Germany, and Spain.14 Without this subsidy, Airbus would never have been able to break into the world market. If these arguments are correct, they support a rationale for government intervention in international trade. Governments should target technologies that may be important in the future and use subsidies to support development work aimed at commercializing those technologies. Furthermore, government should provide export subsidies until the domestic firms have established first-mover advantages in the world market. Government support may also be justified if it can help domestic firms overcome the first-mover advantages

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enjoyed by foreign competitors and emerge as viable competitors in the world market (as in the Airbus and semiconductor examples). In this case, a combination of home-market protection and export-promoting subsidies may be needed.

The Revised Case for Free Trade

The strategic trade policy arguments of the new trade theorists suggest an economic justi- fication for government intervention in international trade. This justification challenges the rationale for unrestricted free trade found in the work of classic trade theorists such as Adam Smith and David Ricardo. In response to this challenge to economic orthodoxy, a number of economists—including some of those responsible for the development of the new trade theory, such as Paul Krugman—point out that although strategic trade policy looks appealing in theory, in practice it may be unworkable. This response to the strategic trade policy argument constitutes the revised case for free trade.15

RETALIATION AND TRADE WAR

Krugman argues that a strategic trade policy aimed at establishing domestic firms in a dominant position in a global industry is a beggar-thy-neighbor policy that boosts national income at the expense of other countries. A country that attempts to use such policies will probably provoke retaliation. In many cases, the resulting trade war between two or more interventionist governments will leave all countries involved worse off than if a hands-off approach had been adopted in the first place. If the U.S. government were to respond to the Airbus subsidy by increasing its own subsidies to Boeing, for example, the result might be that the subsidies would cancel each other out. In the process, both European and U.S. taxpayers would end up supporting an expensive and pointless trade war, and both Europe and the United States would be worse off. Krugman may be right about the danger of a strategic trade policy leading to a trade war. The problem, however, is how to respond when one’s competitors are already being supported by government subsidies; that is, how should Boeing and the United States re- spond to the subsidization of Airbus? According to Krugman, the answer is probably not to engage in retaliatory action but to help establish rules of the game that minimize the use of trade-distorting subsidies. This is what the World Trade Organization seeks to do.

DOMESTIC POLICIES

Governments do not always act in the national interest when they intervene in the economy; politically important interest groups often influence them. The European Union’s support for the Common Agricultural Policy (CAP), which arose because of the political power of French and German farmers, is an example. The CAP benefits inefficient farmers and the politicians who rely on the farm vote, but not consumers in the EU, who end up paying more for their foodstuffs. Thus, a further reason for not embracing strategic trade policy, according to Krugman, is that such a policy is almost certain to be captured by special- interest groups within the economy, which will distort it to their own ends. Krugman concludes that in the United States,

To ask the Commerce Department to ignore special-interest politics while formulating detailed policy for many industries is not realistic; to establish a blanket policy of free trade, with exceptions granted only under extreme pressure, may not be the optimal policy according to the theory but may be the best policy that the country is likely to get.16

Development of the World Trading System

Strong economic arguments support unrestricted free trade. While many governments have recognized the value of these arguments, they have been unwilling to unilaterally lower their trade barriers for fear that other nations might not follow suit. Consider the

LO 7-3 Summarize and explain the arguments against strategic trade policy.

LO 7- 4 Describe the development of the world trading system and the current trade issue.

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Government Policy and International Trade Chapter 7 209

problem that two neighboring countries, say, Brazil and Argentina, face when deciding whether to lower trade barriers between them. In principle, the government of Brazil might favor lowering trade barriers, but it might be unwilling to do so for fear that Argentina will not do the same. Instead, the government might fear that the Argentineans will take advantage of Brazil’s low barriers to enter the Brazilian market while continuing to shut Brazilian products out of their market through high trade barriers. The Argentinean govern- ment might believe that it faces the same dilemma. The essence of the problem is a lack of trust. Both governments recognize that their respective nations will benefit from lower trade barriers between them, but neither government is willing to lower barriers for fear that the other might not follow.17 Such a deadlock can be resolved if both countries negotiate a set of rules to govern cross-border trade and lower trade barriers. But who is to monitor the governments to make sure they are playing by the trade rules? And who is to impose sanctions on a government that cheats? Both governments could set up an independent body to act as a referee. This referee could monitor trade between the countries, make sure that no side cheats, and impose sanctions on a country if it does cheat in the trade game. While it might sound unlikely that any government would compromise its national sovereignty by submitting to such an arrangement, since World War II an international trading framework has evolved that has exactly these features. For its first 50 years, this framework was known as the General Agreement on Tariffs and Trade (GATT). Since 1995, it has been known as the World Trade Organization. Here, we look at the evolution and workings of the GATT and WTO.

FROM SMITH TO THE GREAT DEPRESSION

As noted in Chapter 5, the theoretical case for free trade dates to the late eighteenth century and the work of Adam Smith and David Ricardo. Free trade as a government policy was first officially embraced by Great Britain in 1846, when the British Parliament repealed the Corn Laws. The Corn Laws placed a high tariff on imports of foreign corn. The objectives of the Corn Laws tariff were to raise government revenues and to protect British corn producers. There had been annual motions in Parliament in favor of free trade since the 1820s when David Ricardo was a member. However, agricultural protec- tion was withdrawn only as a result of a protracted debate when the effects of a harvest failure in Great Britain were compounded by the imminent threat of famine in Ireland. Faced with considerable hardship and suffering among the populace, Parliament narrowly reversed its long-held position. During the next 80 years or so, Great Britain, as one of the world’s dominant trading powers, pushed the case for trade liberalization, but the British government was a voice in the wilderness. Its major trading partners did not reciprocate the British policy of unilateral free trade. The only reason Britain kept this policy for so long was that as the world’s largest exporting nation, it had far more to lose from a trade war than did any other country. By the 1930s, the British attempt to stimulate free trade was buried under the economic rubble of the Great Depression. Economic problems were compounded in 1930 when the U.S. Congress passed the Smoot-Hawley tariff. Aimed at avoiding rising unemployment by protecting domestic industries and diverting consumer demand away from foreign products, the Smoot-Hawley Act erected an enormous wall of tariff barriers. Almost every industry was rewarded with its “made-to-order” tariff. The Smoot-Hawley Act had a damaging ef- fect on employment abroad. Other countries reacted by raising their own tariff barriers. U.S. exports tumbled in response, and the world slid further into the Great Depression.18

1947–1979: GATT, TRADE LIBERALIZATION, AND ECONOMIC GROWTH

Economic damage caused by the beggar-thy-neighbor trade policies that the Smoot-Hawley Act ushered in exerted a profound influence on the economic institutions and ideology of the post–World War II world. The United States emerged from the war both victorious and economically dominant. After the debacle of the Great Depression, opinion in the

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U.S. Congress had swung strongly in favor of free trade. Under U.S. leadership, the GATT was established in 1947. The GATT was a multilateral agreement whose objective was to liberalize trade by eliminating tariffs, subsidies, import quotas, and the like. From its foundation in 1947 until it was superseded by the WTO, the GATT’s membership grew from 19 to more than 120 nations. The GATT did not attempt to liberalize trade restrictions in one fell swoop; that would have been impossible. Rather, tariff reduction was spread over eight rounds. In its early years, the GATT was by most measures very successful. For example, the average tariff declined by nearly 92 percent in the United States between the Geneva Round of 1947 and the Tokyo Round of 1973–1979. Consistent with the theoretical arguments first advanced by Ricardo and reviewed in Chapter 5, the move toward free trade under the GATT appeared to stimulate economic growth.

1980–1993: PROTECTIONIST TRENDS

During the 1980s and early 1990s, the trading system erected by the GATT came under strain as pressures for greater protectionism increased around the world. There were three reasons for the rise in such pressures during the 1980s. First, the economic success of Japan during that time strained the world trading system (much as the success of China has created strains today). Japan was in ruins when the GATT was created. By the early 1980s, however, it had become the world’s second-largest economy and its largest exporter. Japan’s success in such industries as automobiles and semiconductors might have been enough to strain the world trading system. Things were made worse by the widespread perception in the West that despite low tariff rates and subsidies, Japanese markets were closed to imports and foreign investment by administrative trade barriers. Second, the world trading system was strained by the persistent trade deficit in the world’s largest economy, the United States. The consequences of the U.S. deficit included painful adjustments in industries such as automobiles, machine tools, semiconductors, steel, and textiles, where domestic producers steadily lost market share to foreign competitors. The resulting unemployment gave rise to renewed demands in the U.S. Congress for protec- tion against imports. A third reason for the trend toward greater protectionism was that many countries found ways to get around GATT regulations. Bilateral voluntary export restraints (VERs) circumvent GATT agreements, because neither the importing country nor the exporting country complains to the GATT bureaucracy in Geneva—and without a complaint, the GATT bureaucracy can do nothing. Exporting countries agreed to VERs to avoid more damaging punitive tariffs. One of the best-known examples is the automobile VER between Japan and the United States, under which Japanese producers promised to limit their auto imports into the United States as a way of defusing growing trade tensions. According to a World Bank study, 16 percent of the imports of industrialized countries in 1986 were subjected to nontariff trade barriers such as VERs.19

THE URUGUAY ROUND AND THE WORLD TRADE ORGANIZATION

Against the background of rising pressures for protectionism, in 1986 GATT members embarked on their eighth round of negotiations to reduce tariffs, the Uruguay Round (so named because it occurred in Uruguay). This was the most ambitious round of nego- tiations yet. Until then, GATT rules had applied only to trade in manufactured goods and commodities. In the Uruguay Round, member countries sought to extend GATT rules to cover trade in services. They also sought to write rules governing the protection of intel- lectual property, to reduce agricultural subsidies, and to strengthen the GATT’s monitoring and enforcement mechanisms. The Uruguay Round dragged on for seven years before an agreement was reached on December 15, 1993. It went into effect July 1, 1995. The Uruguay Round contained the following provisions:

1. Tariffs on industrial goods were to be reduced by more than one-third, and tariffs were to be scrapped on more than 40 percent of manufactured goods.

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2. Average tariff rates imposed by developed nations on manufactured goods were to be reduced to less than 4 percent of value, the lowest level in modern history.

3. Agricultural subsidies were to be substantially reduced. 4. GATT fair trade and market access rules were to be extended to cover a wide

range of services. 5. GATT rules also were to be extended to provide enhanced protection for patents,

copyrights, and trademarks (intellectual property). 6. Barriers on trade in textiles were to be significantly reduced over 10 years. 7. The World Trade Organization was to be created to implement the GATT

agreement.

The World Trade Organization The WTO acts as an umbrella organization that encompasses the GATT along with two new sister bodies, one on services and the other on intellectual property. The WTO’s General Agreement on Trade in Services (GATS) has taken the lead to ex- tending free trade agreements to services. The WTO’s Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) is an attempt to narrow the gaps in the way intellectual property rights are protected around the world and to bring them under common international rules. WTO has taken over responsibility for arbitrating trade disputes and monitoring the trade policies of member countries. While the WTO operates on the basis of consensus as the GATT did, in the area of dispute settlement, member countries are no longer able to block adoption of arbitration reports. Arbitra- tion panel reports on trade disputes between member countries are automatically ad- opted by the WTO unless there is a consensus to reject them. Countries that have been found by the arbitration panel to violate GATT rules may appeal to a permanent appel- late body, but its verdict is binding. If offenders fail to comply with the recommen- dations of the arbitration panel, trading partners have the right to compensation or, in the last resort, to impose (commensurate) trade sanctions. Every stage of the proce- dure is subject to strict time limits. Thus, the WTO has something that the GATT never had—teeth.20

WTO: EXPERIENCE TO DATE

By 2014, the WTO had 160 members, including China, which joined at the end of 2001, and Russia, which joined in 2012. WTO members collectively account for 98 percent of world trade. Since its formation, the WTO has remained at the forefront of efforts to pro- mote global free trade. Its creators expressed the belief that the enforcement mechanisms granted to the WTO would make it more effective at policing global trade rules than the GATT had been. The great hope was that the WTO might emerge as an effective advocate and facilitator of future trade deals, particularly in areas such as services. The experience so far has been mixed. The WTO talks in Seattle in late 1999, slow progress with the next round of trade talks (the Doha Round), and a shift back toward some limited protectionism following the global financial crisis of 2008–2009 have raised a number of questions about the future direction of the WTO.

WTO as Global Police The first two decades in the life of the WTO suggests that its policing and enforcement mechanisms are having a positive effect.21 Between 1995 and 2014, more than 400 trade disputes between member countries were brought to the WTO.22 This record compares with a total of 196 cases handled by the GATT over almost half a century. Of the cases brought to the WTO, three-fourths have been resolved by informal con- sultations between the disputing countries. Resolving the remainder has involved more formal procedures, but these have been largely successful. In general, countries in- volved have adopted the WTO’s recommendations. The fact that countries are using

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the WTO represents an important vote of confidence in the organization’s dispute resolution procedures.

Expanded Trade Agreements As explained earlier, the Uruguay Round of GATT negotiations extended global trading rules to cover trade in services. The WTO was given the role of brokering future agree- ments to open up global trade in services. The WTO was also encouraged to extend its reach to encompass regulations governing foreign direct investment, something the GATT had never done. Two of the first industries targeted for reform were the global telecommunication and financial services industries. In February 1997, the WTO brokered a deal to get countries to agree to open their telecommunication markets to competition, allowing foreign operators to purchase own- ership stakes in domestic telecommunication providers and establishing a set of common rules for fair competition. Most of the world’s biggest markets—including the United States, European Union, and Japan—were fully liberalized by January 1, 1998, when the pact went into effect. All forms of basic telecommunication service are covered, includ- ing voice telephone, data, and satellite and radio communications. Many telecommunica- tion companies responded positively to the deal, pointing out that it would give them a much greater ability to offer their business customers one-stop shopping—a global, seamless service for all their corporate needs and a single bill. This was followed in December 1997 with an agreement to liberalize cross-border trade in financial services. The deal covered more than 95 percent of the world’s financial services market. Under the agreement, which took effect at the beginning of March 1999, 102 countries pledged to open (to varying degrees) their banking, securities, and insur- ance sectors to foreign competition. In common with the telecommunication deal, the accord covers not just cross-border trade but also foreign direct investment. Seventy countries agreed to dramatically lower or eradicate barriers to foreign direct invest- ment in their financial services sector. The United States and the European Union (with minor exceptions) are fully open to inward investment by foreign banks, insurance, and securities companies. As part of the deal, many Asian countries made important conces- sions that allow significant foreign participation in their financial services sectors for the first time.

THE FUTURE OF THE WTO: UNRESOLVED ISSUES AND THE DOHA ROUND

Since the successes of the 1990s, the World Trade Organization has struggled to make progress on the international trade front. Confronted by a slower growing world economy after 2001, many national governments have been reluctant to agree to a fresh round of policies designed to reduce trade barriers. Political opposition to the WTO has been growing in many nations. As the public face of globalization, some politicians and nongovernmental organizations blame the WTO for a variety of ills, including high unemployment, environmental degradation, poor working conditions in developing nations, falling real wage rates among the lower paid in developed na- tions, and rising income inequality. The rapid rise of China as a dominant trading nation has also played a role here. Like sentiments regarding Japan 20 years ago, many perceive China as failing to play by the international trading rules, even as it embraces the WTO. Against this difficult political backdrop, much remains to be done on the international trade front. Four issues at the forefront of the current agenda of the WTO are antidumping policies, the high level of protectionism in agriculture, the lack of strong protection for intellectual property rights in many nations, and continued high tariff rates on nonagri- cultural goods and services in many nations. We shall look at each in turn before discuss- ing the latest round of talks between WTO members aimed at reducing trade barriers, the Doha Round, which began in 2001 and is still ongoing.

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Antidumping Actions Antidumping actions proliferated during the 1990s. WTO rules allow countries to impose antidumping duties on foreign goods that are being sold cheaper than at home, or below their cost of production, when domestic producers can show that they are being harmed. Unfortunately, the rather vague definition of what constitutes “dumping” has proved to be a loophole that many countries are exploiting to pursue protectionism. Between 1995 and mid-2014, WTO members had reported implementation of some 4,627 antidumping actions to the WTO. India initiated the largest number of antidumping actions, some 715; the EU initiated 457 over the same period, and the United States, 521. China accounted for 1,022 complaints, South Korea for 341, the United States for 257, Taiwan for 258, and Japan for 185. Antidumping actions seem to be concentrated in certain sectors of the economy, such as basic metal industries (e.g., aluminum and steel), chemicals, plastics, and machinery and electrical equipment.23 These sectors account for approximately 70 percent of all antidumping actions reported to the WTO. Since 1995, these four sectors have been characterized by periods of intense competition and excess productive capacity, which have led to low prices and profits (or losses) for firms in those industries. It is not unreasonable, therefore, to hypothesize that the high level of anti- dumping actions in these industries represents an attempt by beleaguered manufacturers to use the political process in their nations to seek protection from foreign competitors, which they claim are engaging in unfair competition. While some of these claims may have merit, the process can become very politicized as representatives of businesses and their employees lobby government officials to “protect domestic jobs from unfair foreign compe- tition,” and government officials, mindful of the need to get votes in future elections, oblige by pushing for antidumping actions. The WTO is clearly worried by the use of antidumping policies, suggesting that it reflects persistent protectionist tendencies and pushing members to strengthen the regulations governing the imposition of antidumping duties.

Protectionism in Agriculture Another focus of the WTO has been the high level of tariffs and subsidies in the agricultural sector of many economies. Tariff rates on agricultural products are generally much higher

Removing barriers to trade and subsidies in agricultural products should benefit consumers. Source: © Mark Elias/Bloomberg/Getty Images

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than tariff rates on manufactured products or services. For example, the average tariff rates on nonagricultural products among developed nations are around 4 percent. On agri- cultural products, however, the average tariff rates are 21.2 percent for Canada, 15.9 percent for the European Union, 18.6 percent for Japan, and 10.3 percent for the United States.24 The implication is that consumers in these countries are paying significantly higher prices than necessary for agricultural products imported from abroad, which leaves them with less money to spend on other goods and services. The historically high tariff rates on agricultural products reflect a desire to protect domestic agriculture and traditional farming communities from foreign competition. In addition to high tariffs, agricultural producers also benefit from substantial subsidies. According to estimates from the Organisation for Economic Co-operation and Develop- ment (OECD), government subsidies on average account for about 17 percent of the cost of agricultural production in Canada, 21 percent in the United States, 35 percent in the European Union, and 59 percent in Japan.25 OECD countries spend more than $300 billion a year in agricultural subsidies. Not surprisingly, the combination of high tariff barriers and subsidies introduces signifi- cant distortions into the production of agricultural products and international trade of those products. The net effect is to raise prices to consumers, reduce the volume of agri- cultural trade, and encourage the overproduction of products that are heavily subsidized (with the government typically buying the surplus). Because global trade in agriculture currently amounts to around 10 percent of total merchandized trade, the WTO argues that removing tariff barriers and subsidies could significantly boost the overall level of trade, lower prices to consumers, and raise global economic growth by freeing consumption and investment resources for more productive uses. According to estimates from the Inter- national Monetary Fund, removal of tariffs and subsidies on agricultural products would raise global economic welfare by $128 billion annually.26 Others suggest gains as high as $182 billion.27 The biggest defenders of the existing system have been the advanced nations of the world, which want to protect their agricultural sectors from competition by low-cost pro- ducers in developing nations. In contrast, developing nations have been pushing hard for reforms that would allow their producers greater access to the protected markets of the developed nations. Estimates suggest that removing all subsidies on agricultural produc- tion alone in OECD countries could return to the developing nations of the world three times more than all the foreign aid they currently receive from the OECD nations.28 In other words, free trade in agriculture could help jump-start economic growth among the world’s poorer nations and alleviate global poverty.

Protection of Intellectual Property Another issue that has become increasingly important to the WTO has been protecting intellectual property. The 1995 Uruguay agreement that established the WTO also contained an agreement to protect intellectual property (the Trade-Related Aspects of Intellectual Property Rights, or TRIPS, agreement). The TRIPS regulations oblige WTO members to grant and enforce patents lasting at least 20 years and copyrights lasting 50 years. Rich countries had to comply with the rules within a year. Poor countries, in which such pro- tection was generally much weaker, had 5 years’ grace, and the very poorest had 10 years. The basis for this agreement was a strong belief among signatory nations that the protec- tion of intellectual property through patents, trademarks, and copyrights must be an essen- tial element of the international trading system. Inadequate protections for intellectual property reduce the incentive for innovation. Because innovation is a central engine of economic growth and rising living standards, the argument has been that a multilateral agreement is needed to protect intellectual property. Without such an agreement it is feared that producers in a country—let’s say, India— might market imitations of patented innovations pioneered in a different country—say, the United States. This can affect international trade in two ways. First, it reduces the export opportunities in India for the original innovator in the United States. Second, to

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the extent that the Indian producer is able to export its pirated imitation to additional countries, it also reduces the export opportunities in those countries for the U.S. inventor. Also, one can argue that because the size of the total world market for the innovator is reduced, its incentive to pursue risky and expensive innovations is also reduced. The net effect would be less innovation in the world economy and less economic growth.

Market Access for Nonagricultural Goods and Services Although the WTO and the GATT have made big strides in reducing the tariff rates on nonagricultural products, much work remains. Although most developed nations have brought their tariff rates on industrial products down to an average of 3.8 percent of value, exceptions still remain. In particular, while average tariffs are low, high tariff rates persist on certain imports into developed nations, which limit market access and economic growth. For example, Australia and South Korea, both OECD countries, still have bound tariff rates of 15.1 percent and 24.6 percent, respectively, on imports of transportation equipment (bound tariff rates are the highest rate that can be charged, which is often, but not always, the rate that is charged). In contrast, the bound tariff rates on imports of transportation equipment into the United States, EU, and Japan are 2.7 percent, 4.8 percent, and 0 percent, respectively. A particular area for concern is high tariff rates on imports of selected goods from developing nations into developed nations. In addition, tariffs on services remain higher than on industrial goods. The average tariff on business and financial services imported into the United States, for example, is 8.2 percent, into the EU it is 8.5 percent, and into Japan it is 19.7 percent.29 Given the rising value of cross-border trade in services, reducing these figures can be expected to yield substantial gains. The WTO would like to bring down tariff rates still further and reduce the scope for the selective use of high tariff rates. The ultimate aim is to reduce tariff rates to zero. Although this might sound ambitious, 40 nations have already moved to zero tariffs on information technology goods, so a precedent exists. Empirical work suggests that fur- ther reductions in average tariff rates toward zero would yield substantial gains. One es- timate by economists at the World Bank suggests that a broad global trade agreement coming out of the current Doha negotiations could increase world income by $263 billion annually, of which $109 billion would go to poor countries.30 Another estimate from the OECD suggests a figure closer to $300 billion annually.31 See the accompanying Country Focus for estimates of the benefits to the American economy from free trade. Looking further out, the WTO would like to bring down tariff rates on imports of non- agricultural goods into developing nations. Many of these nations use the infant industry argument to justify the continued imposition of high tariff rates; however, ultimately these rates need to come down for these nations to reap the full benefits of interna- tional trade. For example, the bound tariff rates of 53.9 percent on imports of transporta- tion equipment into India and 33.6 percent on imports into Brazil, by raising domestic prices, help protect inefficient domestic producers and limit economic growth by reduc- ing the real income of consumers who must pay more for transportation equipment and related services.

A New Round of Talks: Doha In 2001, the WTO launched a new round of talks between member states aimed at further liberalizing the global trade and investment framework. For this meeting, it picked the remote location of Doha in the Persian Gulf state of Qatar. The talks were originally scheduled to last 3 years, although they have already gone on for 12 years and are currently stalled. The Doha agenda includes cutting tariffs on industrial goods and services, phasing out subsidies to agricultural producers, reducing barriers to cross-border investment, and limiting the use of antidumping laws. The talks are currently ongoing. They have been characterized by halting progress punctuated by significant setbacks and missed dead- lines. A September 2003 meeting in Cancún, Mexico, broke down, primarily because

there was no agreement on how to proceed with reducing agricultural subsidies and tariffs; the EU, United States, and India, among others, proved less than willing to reduce tariffs and subsidies to their politically important farmers, while countries such as Brazil and certain West African nations wanted free trade as quickly as possible. In 2004, both the United States and the EU made a determined push to start the talks again. Since then, however, little progress has been made, and the talks are in deadlock, primarily because of disagreements over how deep the cuts in subsidies to agricultural producers should be. As of early 2015, the goal was to reduce tariffs for manufactured and agricultural goods by 60 to 70 percent and to cut subsidies to half of their current level—but getting nations to agree to these goals was proving exceedingly difficult. 

REGIONAL AND BILATERAL TRADE AGREEMENTS

In response to the apparent failure of the Doha Round to progress, many nations have pushed forward with regional or bilateral trade agreements, which are reciprocal trade agreements between two or more partners. For example, as discussed in the open- ing case to Chapter 6, in 2014 Australia and China entered into a bilateral free trade agreement. Similarly, in March 2012 the United States entered into a bilateral free trade agreement with South Korea. Under this agreement, 80 percent of U.S. exports of con- sumer and industrial products became duty free, and 95 percent of bilateral trade in industrial and consumer products will be duty free by 2017. The agreement is esti- mated to boost U.S. GDP by some $10 to $12 billion. The United States is currently negotiating two major regional trade agreements, one with a number of Pacific Rim countries including Australia, New Zealand, Japan, Malaysia, and Chile, and another with the European Union.

COUNTRY FOCUS

Estimating the Gains from Trade for America A study published by the Institute for International Econom- ics tried to estimate the gains to the American economy from free trade. According to the study, due to reductions in tariff barriers under the GATT and WTO since 1947, by 2003 the gross domestic product (GDP) of the United States was 7.3 percent higher than would otherwise be the case. The benefits of that amounted to roughly $1 trillion a year, or $9,000 extra income for each American house- hold per year. The same study tried to estimate what would happen if America concluded free trade deals with all its trading partners, reducing tariff barriers on all goods and services to zero. Using several methods to estimate the impact, the study concluded that additional annual gains of between $450 billion and $1.3 trillion could be realized. This final march to free trade, according to the authors of the study, could safely be expected to raise incomes of the average American household by an additional $4,500 per year. The authors also tried to estimate the scale and cost of employment disruption that would be caused by a move to universal free trade. Jobs would be lost in certain sectors

and gained in others if the country abolished all tariff barri- ers. Using historical data as a guide, they estimated that 226,000 jobs would be lost every year due to expanded trade, although some two-thirds of those losing jobs would find reemployment after a year. Reemployment, however, would be at a wage that was 13 to 14 percent lower. The study concluded that the disruption costs would total some $54 billion annually, primarily in the form of lower lifetime wages to those whose jobs were disrupted as a result of free trade. Offset against this, however, must be the higher economic growth resulting from free trade, which creates many new jobs and raises household incomes, creating another $450 billion to $1.3 trillion annually in net gains to the economy. In other words, the estimated annual gains from trade are far greater than the estimated annual costs associated with job disruption, and more people benefit than lose as a result of a shift to a universal free trade regime.

Sources: S. C. Bradford, P. L. E. Grieco, and G. C. Hufbauer, “The Payoff to America from Global Integration,” in The United States and the World Economy: Foreign Policy for the Next Decade, C. F. Bergsten, ed. (Washington, DC: Institute for International Economics, 2005).

216

Government Policy and International Trade Chapter 7 217

Regional and bilateral trade agreements are designed to capture gain from trade beyond those agreements currently attainable under WTO treaties. Regional and bilateral trade agreements are allowed under WTO rules, and countries entering into these agreements are required to notify the WTO. As of March 2015 some 406 regional or bilateral trade agreements were in force. Reflecting the lack of progress on the Doha Round, the number of such agreements has increased significantly since the early 2000s, when less than 100 were in force.

TEST PREP Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

F O C U S O N M A NAG E R I A L I M P L I C AT I O N S

TRADE BARRIERS, FIRM STRATEGY, AND POLICY IMPLICATIONS

What are the implications for business practice? Why should the international manager care about the political economy of free trade or about the relative merits

of arguments for free trade and protectionism? There are two answers to this question. The first concerns the impact of trade barriers on a firm’s strategy. The second concerns the role that business firms can play in promoting free trade or

trade barriers.

Trade Barriers and Firm Strategy To understand how trade barriers affect a firm’s strategy, consider first the material in Chapter 6. Drawing on the theories of international trade, we discussed how it makes sense for the firm to disperse its various production activities to those countries around the globe where they can be performed most efficiently. Thus, it may make sense for a firm to design and engineer its product in one country, to manufacture components in another, to perform final assembly operations in yet another country, and then export the finished product to the rest of the world. Clearly, trade barriers constrain a firm’s ability to disperse its productive activities in such a manner. First and most obvious, tariff barriers raise the costs of exporting products to a country (or of exporting partly finished products between countries). This may put the firm at a competitive disadvantage to indigenous competitors in that country. In response, the firm may then find it economical to locate production facilities in that country so that it can com- pete on even footing. Second, quotas may limit a firm’s ability to serve a country from loca- tions outside that country. Again, the response by the firm might be to set up production facilities in that country—even though it may result in higher production costs. Such reason- ing was one of the factors behind the rapid expansion of Japanese automaking capacity in the United States during the 1980s and 1990s. This followed the establishment of a VER agreement between the United States and Japan that limited U.S. imports of Japanese automobiles. Third, to conform to local content regulations, a firm may have to locate more produc- tion activities in a given market than it would otherwise. Again, from the firm’s perspec- tive, the consequence might be to raise costs above the level that could be achieved if each production activity were dispersed to the optimal location for that activity. And fi- nally, even when trade barriers do not exist, the firm may still want to locate some pro- duction activities in a given country to reduce the threat of trade barriers being imposed in the future. All these effects are likely to raise the firm’s costs above the level that could be achieved in a world without trade barriers. The higher costs that result need not translate into a significant competitive disadvantage relative to other foreign firms, however, if the countries imposing trade barriers do so to the imported products of all foreign firms, irrespective of their national origin. But when trade barriers are targeted at exports from a particular nation, firms based

LO 7-5 Explain the implications for managers of developments in the world trading system.

218 Part 3 The Global Trade and Investment Environment

in that nation are at a competitive disadvantage to firms of other nations. The firm may deal with such targeted trade barriers by moving production into the country imposing barriers. Another strategy may be to move production to countries whose exports are not targeted by the specific trade barrier. Finally, the threat of antidumping action limits the ability of a firm to use aggressive pric- ing to gain market share in a country. Firms in a country also can make strategic use of antidumping measures to limit aggressive competition from low-cost foreign producers. For example, the U.S. steel industry has been very aggressive in bringing antidumping actions against foreign steelmakers, particularly in times of weak global demand for steel and excess capacity. In 1998 and 1999, the United States faced a surge in low-cost steel imports as a severe recession in Asia left producers there with excess capacity. The U.S. producers filed several complaints with the International Trade Commission. One argued that Japanese producers of hot rolled steel were selling it at below cost in the United States. The ITC agreed and levied tariffs ranging from 18 to 67 percent on imports of certain steel products from Japan (these tariffs are separate from the steel tariffs dis- cussed earlier).32

Policy Implications As noted in Chapter 6, business firms are major players on the interna- tional trade scene. Because of their pivotal role in international trade, firms can and do exert a strong influence on government policy toward trade. This influence can encourage protec- tionism, or it can encourage the government to support the WTO and push for open markets and freer trade among all nations. Government policies with regard to international trade can have a direct impact on business. Consistent with strategic trade policy, examples can be found of government intervention in the form of tariffs, quotas, antidumping actions, and subsidies helping firms and industries establish a competitive advantage in the world economy. In general, however, the argu- ments contained in this chapter and in Chapter 6 suggest that government intervention has three drawbacks. Intervention can be self-defeating because it tends to protect the ineffi- cient rather than help firms become efficient global competitors. Intervention is dangerous; it may invite retaliation and trigger a trade war. Finally, intervention is unlikely to be well executed, given the opportunity for such a policy to be captured by special-interest groups. Does this mean that business should simply encourage government to adopt a laissez-faire free trade policy? Most economists would probably argue that the best interests of international busi- ness are served by a free trade stance, but not a laissez-faire stance. It is probably in the best long-run interests of the business community to encourage the government to aggressively promote greater free trade by, for example, strengthening the WTO. Busi- ness probably has much more to gain from government efforts to open protected mar- kets to imports and foreign direct investment than from government efforts to support certain domestic industries in a manner consistent with the recommendations of strategic trade policy. This conclusion is reinforced by a phenomenon we touched on in Chapter 1—the in- creasing integration of the world economy and internationalization of production that has occurred over the past two decades. We live in a world where many firms of all national origins increasingly depend on globally dispersed production systems for their competi- tive advantage. Such systems are the result of freer trade. Freer trade has brought great advantages to firms that have exploited it and to consumers who benefit from the resulting lower prices. Given the danger of retaliatory action, business firms that lobby their govern- ments to engage in protectionism must realize that by doing so they may be denying themselves the opportunity to build a competitive advantage by constructing a globally dispersed production system. By encouraging their governments to engage in protection- ism, their own activities and sales overseas may be jeopardized if other governments re- taliate. This does not mean a firm should never seek protection in the form of antidumping actions and the like, but it should review its options carefully and think through the larger consequences.

Government Policy and International Trade Chapter 7 219

free trade, p. 196 General Agreement on Tariffs and

Trade (GATT), p. 196 tariff, p. 197 specific tariff, p. 197 ad valorem tariff, p. 197 subsidy, p. 197 import quota, p. 199

tariff rate quota, p. 199 voluntary export restraint

(VER), p. 199 quota rent, p. 200 local content requirement

(LCR), p. 200 administrative trade policies, p. 201 dumping, p. 201

antidumping policies, p. 201 countervailing duties, p. 201 infant industry argument, p. 206 strategic trade policy, p. 207 Smoot-Hawley Act, p. 209 regional or bilateral trade

agreements, p. 216

Key Terms

C H A P T E R S U M M A R Y

This chapter described how the reality of international trade deviates from the theoretical ideal of unrestricted free trade reviewed in Chapter 6. In this chapter, we re- ported the various instruments of trade policy, reviewed the political and economic arguments for government intervention in international trade, reexamined the eco- nomic case for free trade in light of the strategic trade policy argument, and looked at the evolution of the world trading framework. While a policy of free trade may not always be the theoretically optimal policy (given the ar- guments of the new trade theorists), in practice it is prob- ably the best policy for a government to pursue. In particular, the long-run interests of business and con- sumers may be best served by strengthening interna- tional institutions such as the WTO. Given the danger that isolated protectionism might escalate into a trade war, business probably has far more to gain from gov- ernment efforts to open protected markets to imports and foreign direct investment (through the WTO) than from government efforts to protect domestic industries from foreign competition. The chapter made the follow- ing points:

1. Trade policies such as tariffs, subsidies, antidumping regulations, and local content requirements tend to be pro-producer and anticonsumer. Gains accrue to producers (who are protected from foreign competitors), but consumers lose because they must pay more for imports.

2. There are two types of arguments for govern- ment intervention in international trade: politi- cal and economic. Political arguments for intervention are concerned with protecting the interests of certain groups, often at the expense of other groups, or with promoting goals with regard to foreign policy, human rights, consumer protection, and the like. Economic arguments

for intervention are about boosting the overall wealth of a nation.

3. A common political argument for intervention is that it is necessary to protect jobs. However, political intervention often hurts consumers, and it can be self-defeating. Countries some- times argue that it is important to protect cer- tain industries for reasons of national security. Some argue that government should use the threat to intervene in trade policy as a bargain- ing tool to open foreign markets. This can be a risky policy; if it fails, the result can be higher trade barriers.

4. The infant industry argument for government intervention contends that to let manufacturing get a toehold, governments should temporarily support new industries. In practice, however, governments often end up protecting the inefficient.

5. Strategic trade policy suggests that with subsi- dies, government can help domestic firms gain first-mover advantages in global industries where economies of scale are important. Government subsidies may also help domestic firms over- come barriers to entry into such industries.

6. The problems with strategic trade policy are twofold: (a) Such a policy may invite retalia- tion, in which case all will lose, and (b) strategic trade policy may be captured by special- interest groups, which will distort it to their own ends.

7. The GATT was a product of the postwar free trade movement. The GATT was successful in lowering trade barriers on manufactured goods and commodities. The move toward greater free trade under the GATT appeared to stimulate economic growth.

8. The completion of the Uruguay Round of GATT talks and the establishment of the World Trade Organization have strengthened the world trading system by extending GATT rules to services, increasing protection for intellectual property, reducing agricultural subsidies, and enhancing monitoring and enforcement mechanisms.

9. Trade barriers act as a constraint on a firm’s ability to disperse its various production

activities to optimal locations around the globe. One response to trade barriers is to establish more production activities in the protected country.

10. Business may have more to gain from government efforts to open protected markets to imports and foreign direct investment than from govern- ment efforts to protect domestic industries from foreign competition.

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. Do you think governments should consider human rights when granting preferential trading rights to countries? What are the arguments for and against taking such a position?

2. Whose interests should be the paramount concern of government trade policy—the interests of producers (businesses and their employees) or those of consumers?

3. Given the arguments relating to the new trade theory and strategic trade policy, what kind of trade policy should business be pressuring government to adopt?

4. You are an employee of a U.S. firm that pro- duces personal computers in Thailand and then exports them to the United States and other countries for sale. The personal computers were originally produced in Thailand to take

advantage of relatively low labor costs and a skilled workforce. Other possible locations considered at the time were Malaysia and Hong Kong. The U.S. government decides to impose punitive 100 percent ad valorem tariffs on imports of computers from Thailand to punish the country for administrative trade barriers that restrict U.S. exports to Thailand. How should your firm respond? What does this tell you about the use of targeted trade barriers?

5. Reread the Management Focus “Protecting U.S. Magnesium.” Who gains most from the anti- dumping duties levied by the United States on imports of magnesium from China and Russia? Who are the losers? Are these duties in the best national interests of the United States?

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises:

1. You work for a pharmaceutical company that hopes to provide products and services in New Zealand. Yet management’s current knowledge of this country’s trade policies and barriers is limited. After searching a resource that summa- rizes the import and export regulation, outline the most important foreign trade barriers your firm’s managers must keep in mind while devel- oping a strategy for entry into New Zealand’s pharmaceutical market.

2. The number of member nations of the World Trade Organization has increased considerably in recent years. In addition, some nonmember countries have observer status in the WTO. Such status requires accession negotiations to begin within five years of attaining this preliminary position. Visit the WTO’s website to identify a list of current members and observers. Identify the last five countries that joined the WTO as members. Also, examine the list of current ob- server countries. Do you notice anything in particular about the countries that have recently joined or have observer status?

220 Part 3 The Global Trade and Investment Environment

Government Policy and International Trade Chapter 7 221

Back in the 1930s at the height of the Great Depression the U.S. government stepped in to support the U.S. sugar industry with a combination of subsidies, price supports, import quotas, and tariffs. These actions were meant to be temporary, but as of 2015 they are still in place. Under policies approved in the 2008 farm bill, the government guarantees 85 percent of the market for U.S. producers, primarily farmers growing sugar beets and cane. The re- maining 15 percent is allocated for imports from certain countries at a preferential tariff rate. The government also sets a floor price for sugar. If the price falls below the floor, the government steps in to purchase excess supply, driving the price back up again. The surplus is then sold at a loss to producers of ethanol. A significant U.S. sugar harvest in 2013 required the government to spend some $300 million to prop up U.S. sugar prices. As a result of these policies, between 2010 and 2013 the U.S. sugar price has averaged between 64 and 92 percent higher than the world price of sugar. American sugar producers say that the federal pro- grams are necessary to keep big sugar-producing coun- tries like Brazil, India, and Thailand from flooding the U.S. market and driving them out of business. Opponents of the practice include numerous small candy producers. Many of them complain about the high U.S. price for sugar. Increasingly they have responded by moving pro- duction offshore. For example, the Spangler Candy Com- pany, the maker of Dum Dums, has moved 200 jobs from Ohio to Juarez, Mexico, where it makes candy canes that are then imported back into the United States. Similarly, Adams & Brooks, a California-based candy company, has shifted two-thirds of its production across the border to Mexico in response to higher U.S. sugar prices. A recent academic study suggest that the U.S. sugar policies primarily benefit 4,700 sugar producers, while imposing costs of $2.9 to $3.5 billion per annum on U.S. consumers due to higher sugar prices. The same research predicts that removing the support programs would lead to the net creation of 17,000 to 20,000 new jobs in the United States, while dramatically reducing imports of products containing sugar.

Given the benefits of removing sugar support pro- grams, and all the talk about deregulation and reducing the budget deficit in Congress, many observers thought that 2013 would be the year that the sugar programs were finally abandoned. The farm bill was up for renewal, and the sugar support programs were held up as an example of how wasteful government subsidies are. However, sugar producers spent some $20 million on political lobbying between 2011 and 2013. Partly due to their influence, the U.S. Senate voted 54 to 45 against any reform in the sugar programs. The majority included 20 out of 45 Republican senators, most of who publicly rail against this kind of government intervention. Appar- ently, however, political expediency required that they support intervention in this case. Sources: George F. Will, “Congress Needs to Stop Subsidies to Sugar Farmers,” The Washington Post, June 7, 2013; Ron Nixon, “American Candy Makers, Pinched by Inflated Sugar Prices, Look Abroad,” The New York Times, October 30, 2013; J. Beghinand and A. Elobeid, “The Impact of the U.S. Sugar Program Redux,” Iowa State Working Paper 13-WP 538, May 2013, www.card.iastate.edu/publications/dbs/pdffiles/13wp538.pdf.

C a s e D i s c u s s i o n Q u e s t i o n s

1. Who benefits from subsidies to U.S. sugar pro- ducers? Who loses?

2. Do the benefits of U.S. government support to the U.S. sugar industry outweigh the losses?

3. What do you think would happen if the U.S. gov- ernment removed all support for U.S. sugar producers?

4. Government support programs for sugar produc- ers were introduced in the 1930s, yet they are still in place today, long after the original ratio- nale disappeared. What does this tell you about political decisions relating to international trade?

5. If you had the power to make changes here, what would you do, and why?

C L O S I N G C A S E

Sugar Subsidies Drive Candy Makers Abroad

222 Part 3 The Global Trade and Investment Environment

E n d n o t e s

1. For a detailed welfare analysis of the effect of a tariff, see P. R. Krugman and M. Obstfeld, International Economics: Theory and Policy (New York: HarperCollins, 2000), Ch. 8.

2. World Trade Organization, World Trade Report 2006 (Geneva: WTO, 2006).

3. The study was undertaken by Kym Anderson of the University of Adelaide. See “A Not So Perfect Market,” The Economist; Survey of Agriculture and Technology, March 25, 2000, pp. 8–10.

4. K. Anderson, W. Martin, and D. van der Mensbrugghe, “ Distortions to World Trade: Impact on Agricultural Markets and Farm Incomes,” Review of Agricultural Economics 28 (Summer 2006), pp. 168–94.

5. R. W. Crandall, Regulating the Automobile (Washington, DC: Brookings Institution, 1986).

6. J. B. Teece, “Voluntary Export Restraints Are Back; They Didn’t Work the Last Time,” Automotive News, April 23, 2012.

7. Krugman and Obstfeld, International Economics. 8. G. Hufbauer and Z. A. Elliott, Measuring the Costs of

Protectionism in the United States (Washington, DC: Institute for International Economics, 1993).

9. Alan Goldstein, “Sematech Members Facing Dues Increase; 30% Jump to Make Up for Loss of Federal Funding,” Dallas Morning News, July 27, 1996, p. 2F.

10. N. Dunne and R. Waters, “U.S. Waves a Big Stick at Chinese Pirates,” Financial Times, January 6, 1995, p. 4.

11. Peter S. Jordan, “Country Sanctions and the International Business Community,” American Society of International Law Proceedings of the Annual Meeting 20, no. 9 (1997), pp. 333–42.

12. “Brazil’s Auto Industry Struggles to Boost Global Competitive- ness,” Journal of Commerce, October 10, 1991, p. 6A.

13. For reviews, see J. A. Brander, “Rationales for Strategic Trade and Industrial Policy,” in Strategic Trade Policy and the New International Economics, P. R. Krugman, ed. (Cambridge, MA: MIT Press, 1986); P. R. Krugman, “Is Free Trade Passé?,” Journal of Economic Perspectives 1 (1987), pp. 131–44; P. R. Krugman, “Does the New Trade Theory Require a New Trade Policy?,” World Economy 15, no. 4 (1992), pp. 423–41.

14. “Airbus and Boeing: The Jumbo War,” The Economist, June 15, 1991, pp. 65–66.

15. For details see Krugman, “Is Free Trade Passé?”; Brander, “Rationales for Strategic Trade and Industrial Policy.”

16. Krugman, “Is Free Trade Passé?” 17. This dilemma is a variant of the famous prisoner’s dilemma,

which has become a classic metaphor for the difficulty of achieving cooperation between self-interested and mutually suspicious entities. For a good general introduction, see A. Dixit and B. Nalebuff, Thinking Strategically: The Competitive Edge in Business, Politics, and Everyday Life (New York: Norton, 1991).

18. Note that the Smoot-Hawley Act did not cause the Great Depression. However, the beggar-thy-neighbor trade policies that it ushered in certainly made things worse. See J. Bhagwati, Protectionism (Cambridge, MA: MIT Press, 1988).

19. World Bank, World Development Report (New York: Oxford University Press, 1987).

20. Frances Williams, “WTO—New Name Heralds New Powers,” Financial Times, December 16, 1993, p. 5; Frances Williams, “GATT’s Successor to Be Given Real Clout,” Financial Times, April 4, 1994, p. 6.

21. W. J. Davey, “The WTO Dispute Settlement System: The First Ten Years,” Journal of International Economic Law, March 2005, pp. 17–28.

22. Information provided on WTO website, www.wto.org/english/ tratop_e/dispu_e/dispu_status_e.htm.

23. Data at www.wto.org/english/tratop_e/adp_e/adp_e.htm. 24. Annual Report by the Director General 2003 (Geneva: World

Trade Organization, 2003). 25. Ibid. 26. Ibid. 27. Anderson et al., “Distortions to World Trade.” 28. World Trade Organization, Annual Report 2002 (Geneva:

WTO, 2002). 29. S. C. Bradford, P. L. E. Grieco, and G. C. Hufbauer, “The Pay-

off to America from Global Integration,” in The United States and the World Economy: Foreign Policy for the Next Decade, C. F. Bergsten, ed. (Washington, DC: Institute for International Economics, 2005).

30. World Bank, Global Economic Prospects 2005 (Washington, DC: World Bank, 2005).

31. “Doha Development Agenda,” OECD Observer, September 2006, pp. 64–67.

32. “Punitive Tariffs Are Approved on Imports of Japanese Steel,” The New York Times, June 12, 1999, p. A3.

Credit: ©Federal Reserve Board.

Foreign Direct Investment L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO8 -1 Recognize current trends regarding foreign direct investment (FDI) in the world economy.

LO8 -2 Explain the different theories of FDI.

LO8 -3 Understand how political ideology shapes a government’s attitudes toward FDI.

LO8 - 4 Describe the benefits and costs of FDI to home and host countries.

LO8 -5 Explain the range of policy instruments that governments use to influence FDI.

LO8 - 6 Identify the implications for managers of the theory and government policies associated with FDI.

part three The Global Trade and Investment Environment

8

Source: © Fabrice Dimier/Bloomberg/Getty Images

225

Volkswagen in Russia

Toyota had also announced investments of over $1 billion to boost Russian production up to 300,000 units by 2020, and Fiat had indicated that it would make investments to bring its Russian production up to 300,000 as well. In total, foreign carmakers had invested over $5 billion in Russian assembly operations by 2014. Meanwhile, analysts contin- ued to predict that the Russian car market would grow at a healthy pace and exceed that of Germany by 2020. In 2014, however, the market took a sharp turn for the worse. Russia is a major oil producer. Since the mid-2000s much of the country’s economic growth had been powered by high oil prices. In the second half of 2014, however, global oil prices started to fall rapidly as increased produc- tion in America, and weak demand in China, conspired to create a global glut of oil. By early 2015, oil prices had fallen 60 percent from their peak. To make matters worse, following hard on the heals of its hostile takeover of the Crimea Region from Ukraine, Russia had become embroiled in a smoldering civil war in eastern Ukraine. Western nations responded to what they perceived as Russian aggression by imposing sanctions on Russia. Hit by these twin blows, the Russian economy weakened significantly in 2014 and the ruble declined precipitously, losing 50 percent of its value against the U.S. dollar. Suddenly the bright hopes that foreign automakers had for the Russian market seemed to be tarnished. Faced with falling demand, Volkswagen cut production at its Kaluga plant to 120,000 vehicles in 2014, from a planned 150,000. With the new engine plant scheduled to come on line in 2015, and no resolution to Russia’s eco- nomic crisis insight, Volkswagen’s excess capacity prob- lem may get worse. Looking forward, Volkswagen has to decide whether to keep investing in Russia in order to hit the magic 300,000 local output figure by 2020, or to pull back from a market whose future suddenly looks highly uncertain.

Sources: Sarah Sloat, “Volkswagen to Halt Production at Russian Plant for 10 Days,” The Wall Street Journal, September 7, 2014; Clare  Nuttall, “Foreign Car Firms Invest Heavily in Russia,” The Telegraph, April 28, 2011; Staff reporter, “Volkswagen Russia Shows the Way,” Automotive Supply Chain, July 2, 2013; Staff reporter, “Volkswagen Slashes Car Production at Russian Plat,” Reuters, September 7, 2014.

O P E N I N G C A S E In the mid-2000s Volkswagen announced that it would invest directly in automobile production in Russia. The deci- sion to invest was driven by a number of factors. Russia’s economy was growing rapidly at the time, living standards were rising, while the level of car ownership per capita was still low by European standards. This suggested that demand for cars would grow rapidly going forward. Indeed, forecasts predicted that by 2020 Russia would surpass Germany to become the largest car market in Europe. Moreover, Volkswagen’s global rivals, including most no- tably Toyota, General Motors, and Ford, were also invest- ing in production facilities in Russia, so Volkswagen felt that it had to make direct investments in order to avoid being preempted by its rivals. The Russian government also created incentives for carmakers to invest directly in Russian production facilities, allowing them to avoid import tariffs and a punitive tax on imports of parts if they produced at least 25,000 cars in the country. In 2011, the government announced that it would keep tariffs on imported components at 0.3 percent if a foreign automaker built at least 300,000 in the country by 2020, and produced 60 percent of the value of the car locally. Spurred on by such incentives, in 2007 Volkswagen opened a plant in Kaluga, 160 miles southwest of Moscow, to build some of its VW and Skoda car brands. The plant was projected to have a peak capacity of 150,000 units a year and employ 3,000 people. Initially all vehicles at the plant were assembled from semi-knocked-down kits im- ported from Germany. In October 2009, however, the plant launched full-scale production, including welding and painting of vehicles. In October 2011, Volkswagen announced that, together with a local partner, GAZ Group, it would open a second plant near St. Petersburg, as it strove to reach the 300,000 units of local production by 2020. In 2013, Volkswagen made an additional investment in Kaluga when it pledged 300 million euros to build an engine plant near to its assembly operation. The engine plant was slated to open in 2015. All told, by this point Volkswagen had invested over $1 billion in production in Russia. General Motors and

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Introduction

Foreign direct investment (FDI) occurs when a firm invests directly in facilities to pro- duce or market a good or service in a foreign country. According to the U.S. Department of Commerce, FDI occurs whenever a U.S. citizen, organization, or affiliated group takes an interest of 10 percent or more in a foreign business entity. Once a firm undertakes FDI, it becomes a multinational enterprise. The German automobile manufacturer, Volkswagen, which is profiled in the opening case, has long been a multinational enterprise due to its extensive foreign direct investments. These include the investments in Russia that have been made since the mid-2000s.  The opening case suggests some of the reasons why firms undertake FDI. Volkswagen invested in Russia to tap into a market that it thought would grow rapidly. Moreover, direct investment helped circumvent tariff barriers that raised the price of imported cars. The investment was also motivated by a desire to match its global rivals, who were making similar investments in Russia. The case also demonstrates some of the risks associated with FDI. A sharp deterioration in the health of the Russian economy due to plunging oil prices and adverse geopolitical developments has put the profitability of Volkswagen’s Russian investments at risk. Volkswagen now has to decide what to do going forward, and the company’s management is no doubt reviewing its options. Building on the issues raised in the opening case, this chapter begins by looking at the importance of FDI in the world economy. Next, we shall review the theories that have been used to explain why firms like Volkswagen undertake foreign direct investment. The chapter then moves on to look at government policy toward foreign direct investment (you will note that policies adopted by the Russian government were designed to encourage automobile companies to invests directly in Russia). The chapter closes with a section on implications for business.

Foreign Direct Investment in the World Economy

When discussing foreign direct investment, it is important to distinguish between the flow of FDI and the stock of FDI. The flow of FDI refers to the amount of FDI undertaken over a given time period (normally a year). The stock of FDI refers to the total accumulated value of foreign-owned assets at a given time. We also talk of outflows of FDI, meaning the flow of FDI out of a country, and inflows of FDI, the flow of FDI into a country.

TRENDS IN FDI

The past 35 years have seen a marked increase in both the flow and stock of FDI in the world economy. The average yearly outflow of FDI increased from $25 billion in 1975 to $1.4 trillion in 2013 (see Figure 8.1).1 Over the past 30 years the flow of FDI has accelerated faster than the growth in world trade and world output. For example, between 1992 and 2013, the total flow of FDI from all countries increased around ninefold while world trade by value grew fourfold and world output by around 60 percent.2 As a result of the strong FDI flows, by 2013 the global stock of FDI was about $26 trillion. The foreign affili- ates of multinationals had more than $28 trillion in global sales and accounted for one-third of all cross-border trade in goods and services.3 Clearly by any measure, FDI is a very important phenomenon. FDI has grown more rapidly than world trade and world output for several reasons. First, despite the general decline in trade barriers over the past 30 years, firms still fear protectionist pressures. Executives see FDI as a way of circumventing future trade barriers. Second, much of the increase in FDI has been driven by the political and economic changes that have been occurring in many of the world’s developing nations. The general shift toward democratic political institutions and free market economies that we discussed in Chapter 3 has encouraged FDI. Across much of Asia, eastern Europe, and Latin America,

LO 8 -1 Recognize current trends regarding foreign direct investment (FDI) in the world economy.

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economic growth, economic deregulation, privatization programs that are open to foreign investors, and removal of many restrictions on FDI have made these countries more at- tractive to foreign multinationals. According to the United Nations, some 90 percent of the 2,700 changes made worldwide between 1992 and 2009 in the laws governing foreign direct investment created a more favorable environment for FDI.4 The globalization of the world economy is also having a positive effect on the volume of FDI. Many firms see the whole world as their market, and they are undertaking FDI in an attempt to make sure they have a significant presence in many regions of the world. For example, a third of the revenues and as much as 40 percent of the profits of firms in the S&P 500 index are generated abroad. For reasons that we explore later in this book, many firms now believe it is important to have production facilities close to their major customers. This too creates pressure for greater FDI.

THE DIRECTION OF FDI

Historically, most FDI has been directed at the developed nations of the world as firms based in advanced countries invested in the others’ markets (see Figure 8.2). During the 1980s and 1990s, the United States was often the favorite target for FDI inflows. The United States has been an attractive target for FDI because of its large and wealthy domestic markets, its dynamic and stable economy, a favorable political environment, and the openness of the country to FDI. Investors include firms based in Great Britain, Japan, Germany, Holland, and France. Inward investment into the United States remained high during the 2000s and stood at $188 billion in 2013. The developed nations of the European Union have also been recipients of significant FDI inflows, principally from the United States and other member states of the EU. In 2013, inward investment into the EU was $246 billion. The United Kingdom and France have historically been the largest recipi- ents of inward FDI.5 Even though developed nations still account for the largest share of FDI inflows, FDI into developing nations and the transition economies of eastern Europe and the old Soviet Union have increased markedly (see Figure 8.2). Most recent inflows into developing nations have been targeted at the emerging economies of Southeast Asia. Driving much of the increase has been the growing importance of China as a recipient of FDI, which attracted about $60 billion of FDI in 2004 and rose steadily to hit a record $124 billion in 2011 followed by $121 billion in 2013.6 The reasons for the strong flow of investment into China are discussed in the accompanying Country Focus. Latin America is the next

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most important region in the developing world for FDI inflows. In 2013, total inward investments into this region reached $292 billion. Brazil has historically been the top recipient of inward FDI in Latin America. At the other end of the scale, Africa has long received the smallest amount of inward investment, $57 billion in 2013. In recent years, Chinese enterprises have emerged as major investors in Africa, particularly in extraction industries where they seem to be trying to ensure future supplies of valuable raw materials. The inability of Africa to attract greater investment is in part a reflection of the political unrest, armed conflict, and frequent changes in economic policy in the region.7

THE SOURCE OF FDI

Since World War II, the United States has consistently been the largest source country for FDI. Other important source countries include the United Kingdom, France, Germany, the Netherlands, and Japan. Collectively, these six countries accounted for 60 percent of all FDI outflows for 1998–2012 (see Figure 8.3). As might be expected, these countries also predominate in rankings of the world’s largest multinationals.8 These nations dominate

F I G U R E 8 . 2

FDI inflows by region, 1995–2013 ($ billions). Source: Calculated by the author from United Nations World Investment Report, various editions.

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COUNTRY FOCUS

Beginning in late 1978, China’s leadership decided to move the economy away from a centrally planned socialist system to one that was more market driven. The result has been 35 years of sustained high economic growth rates of around 8–10 percent, compounded annually. This growth attracted substantial foreign investment. Starting from a tiny base, foreign investment increased to an annual average rate of $2.7 billion between 1985 and 1990 and then surged to $40 billion annually in the late 1990s, making China the second-biggest recipient of FDI inflows in the world after the United States. The growth has continued, with inward investments into China hitting a record $124 billion in 2013 (with another $74 billion going into Hong Kong). Over the past 20 years, this inflow has resulted in the estab- lishment of more than 300,000 foreign-funded enterprises in China. The total stock of FDI in mainland China grew from almost nothing in 1978 to $957 billion in 2013 (another $1.4 trillion of FDI stock was in Hong Kong). The reasons for this investment are fairly obvious. With a population of more than 1.3 billion people, China repre- sents the world’s largest market. Historically, import tariffs made it difficult to serve this market via exports, so FDI was required if a company wanted to tap into the country’s huge potential. China joined the World Trade Organization in 2001. As a result, average tariff rates on imports have fallen from 15.4 percent to about 8 percent today, and reducing the tariff became a motive for investing in China (although at 8 percent, tariffs are still above the average of 3.5 percent found in many developed nations). Notwithstanding tariff rates, many foreign firms believe that doing business in China requires a substantial presence in the country to build guanxi, the crucial relationship networks (see Chapter 4 for details). Furthermore, a combi- nation of relatively inexpensive labor and tax incentives, particularly for enterprises that establish themselves in special economic zones, makes China an attractive base from which to serve Asian or world markets with exports

(although rising labor costs in China are now making this less important). Less obvious, at least to begin with, was how difficult it would be for foreign firms to do business in China. China may have a huge population, but despite decades of rapid growth, it is still relatively poor. The lack of purchasing power translates into a relatively immature market for many Western consumer goods outside affluent urban areas such as Shanghai. Other problems include a highly regu- lated environment, which can make it problematic to con- duct business transactions, and shifting tax and regulatory regimes. Then there are problems with local joint-venture partners that are inexperienced, opportunistic, or simply operate according to different goals. One U.S. manager explained that when he laid off 200 people to reduce costs, his Chinese partner hired them all back the next day. When he inquired why they had been hired back, the Chinese partner, which was government owned, explained that as an agency of the government, it had an “obligation” to reduce unemployment. To continue to attract foreign investment, in late 2000 the Chinese government had committed itself to invest more than $800 billion in infrastructure projects over 10 years. Further commitments were made in the late 2000s. These investments have improved the nation’s poor highway sys- tem. They have been pursuing a macroeconomic policy that includes an emphasis on maintaining steady economic growth, low inflation, and a stable currency—all of which are attractive to foreign investors. Given these developments, it seems likely that the country will continue to be an impor- tant magnet for foreign investors well into the future.

Sources: Interviews by the author while in China; United Nations, World Investment Report, 2012; Linda Ng and C. Tuan, “Building a Favorable Investment Environment: Evidence for the Facilitation of FDI in China,” The World Economy, 2002, pp. 1095–114; S. Chan and G. Qingyang, “Investment in China Migrates Inland,” Far Eastern Eco- nomic Review, May 2006, pp. 52–57.

Foreign Direct Investment in China

primarily because they were the most developed nations with the largest economies during much of the postwar period and therefore home to many of the largest and best capitalized enterprises. Many of these countries also had a long history as trading nations and natu- rally looked to foreign markets to fuel their economic expansion. Thus, it is no surprise that enterprises based there have been at the forefront of foreign investment trends. That being said, it is noteworthy that Chinese firms have started to emerge as major foreign investors. In 2005, Chinese firms invested some $12 billion internationally. Since

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then, the figure has risen steadily, reaching $101 billion in 2013. Firms based in Hong Kong accounted for another $88 billion of outward FDI in 2013. Much of the outward investment by Chinese firms has been directed at extractive industries in less developed nations (e.g., China has been a major investor in African countries). A major motive for these investments has been to gain access to raw materials, of which China is one of the world’s largest consumers. There are signs, however, that Chinese firms are starting to turn their attention to more advanced nations. In 2012, Chinese firms invested $6.5 billion in the United States, up from $146 million in 2003.9

THE FORM OF FDI: ACQUISITIONS VERSUS GREENFIELD INVESTMENTS

FDI takes on two main forms. The first is a greenfield investment, which involves the establishment of a new operation in a foreign country. The second involves acquiring or merging with an existing firm in the foreign country. UN estimates indicate that some 40 to 80 percent of all FDI inflows were in the form of mergers and acquisitions between 1998 and 2013.10 However, FDI flows into developed nations differ markedly from those into developing nations. In the case of developing nations, only about one-third or less of FDI is in the form of cross-border mergers and acquisitions. The lower percentage of mergers and acquisitions may simply reflect the fact that there are fewer target firms to acquire in developing nations. When contemplating FDI, when do firms prefer to acquire existing assets rather than undertake greenfield investments? We consider this question in depth in Chapter 15. For now, we will make a few basic observations. First, mergers and acquisitions are quicker to execute than greenfield investments. This is an important consideration in the modern business world where markets evolve very rapidly. Many firms apparently believe that if they do not acquire a desirable target firm, then their global rivals will. Second, foreign firms are acquired because those firms have valuable strategic assets, such as brand loyalty, customer relationships, trademarks or patents, distribution systems, production systems, and the like. It is easier and perhaps less risky for a firm to acquire those assets than to build them from the ground up through a greenfield investment. Third, firms make acqui- sitions because they believe they can increase the efficiency of the acquired unit by trans- ferring capital, technology, or management skills (see the next Management Focus on Cemex for an example). However, as we discuss in Chapter 15, there is evidence that many mergers and acquisitions fail to realize their anticipated gains.11

Theories of Foreign Direct Investment

In this section, we review several theories of foreign direct investment. These theories approach the various phenomena of foreign direct investment from three complementary perspectives. One set of theories seeks to explain why a firm will favor direct investment as a means of entering a foreign market when two other alternatives, exporting and licensing, are open to it. Another set of theories seeks to explain why firms in the same industry often undertake foreign direct investment at the same time and why they favor certain locations over others as targets for foreign direct investment. Put differently, these theories attempt to explain the observed pattern of foreign direct investment flows. A third theoretical perspective, known as the eclectic paradigm, attempts to combine the two other perspectives into a single holistic explanation of foreign direct investment (this theoretical perspective is eclectic because the best aspects of other theories are taken and combined into a single explanation).

WHY FOREIGN DIRECT INVESTMENT?

Why do firms go to the trouble of establishing operations abroad through foreign direct investment when two alternatives, exporting and licensing, are available to them for exploit- ing the profit opportunities in a foreign market? Exporting involves producing goods at

LO 8 -2 Explain the different theories of FDI.

TEST PREP Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

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home and then shipping them to the receiving country for sale. Licensing involves granting a foreign entity (the licensee) the right to produce and sell the firm’s product in return for a royalty fee on every unit sold. The question is important, given that a cursory examina- tion of the topic suggests that foreign direct investment may be both expensive and risky compared with exporting and licensing. 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 a dif- ferent culture where the rules of the game may be very different. Relative to indigenous firms, there is a greater probability that a foreign firm undertaking FDI in a country for the first time will make costly mistakes due to its ignorance. When a firm exports, it need not bear the costs associated with FDI, and it can reduce the risks associated with selling abroad by using a native sales agent. Similarly, when a firm allows another enterprise to produce its products under license, the licensee bears the costs or risks. So why do so many firms apparently prefer FDI over either exporting or licensing? The answer can be found by examining the limitations of exporting and licensing as means for capitalizing on foreign market opportunities.

R A N K I N G S

Cross-border investments have been ramped up to a relatively large degree in the last decade. Even with the economic downturn that started in 2008, the world continued to see a great deal of foreign direct investment by companies in the last decade. Now, when the economic prosperity is likely to be better, given that we are removed from those downturn days, the expectation is that more foreign direct investment will be considered by companies. On globalEDGE, there are myriad opportunities to gain more knowledge about foreign direct investment (FDI). The “Rankings” section is a great starting point (globaledge.msu.edu/global- resources/rankings). In this section, globalEDGE features several reports by A.T. Kearney— with one of them squarely centered on foreign direct investment and a “confidence index” for FDI. The companies that participate in the regular study account for more than $2 trillion in annual global revenue! Which countries are in the top three in the investment confidence index, and do you agree that the three countries are the best ones to invest in if you were running a company?

Limitations of Exporting The viability of an exporting strategy is often constrained by transportation costs and trade barriers. When transportation costs are added to production costs, it becomes unprof- itable to ship some products over a large distance. This is particularly true of products that have a low value-to-weight ratio and that can be produced in almost any location. For such products, the attractiveness of exporting decreases, relative to either FDI or licensing. This is the case, for example, with cement. Thus, Cemex, the large Mexican cement maker, has expanded internationally by pursuing FDI, rather than exporting (see the accom- panying Management Focus). For products with a high value-to-weight ratio, however, transportation costs are normally a minor component of total landed cost (e.g., electronic components, personal computers, medical equipment, computer software, etc.) and have little impact on the relative attractiveness of exporting, licensing, and FDI. Transportation costs aside, some firms undertake foreign direct investment as a response to actual or threatened trade barriers such as import tariffs or quotas. By placing tariffs on imported goods, governments can increase the cost of exporting relative to foreign direct investment and licensing. Similarly, by limiting imports through quotas, govern- ments increase the attractiveness of FDI and licensing. For example, the wave of FDI by Japanese auto companies in the United States during the 1980s and 1990s was partly

M A NAG E M E N T F O C U S

Since the early 1990s, Mexico’s largest cement manufacturer, Cemex, has transformed itself from a primarily Mexican operation into the third-largest cement company in the world behind Holcim of Switzerland and Lafarge Group of France. Cemex has long been a powerhouse in Mexico and currently controls more than 60 percent of the market for cement in that country. Cemex’s domestic success has been based in large part on an obsession with efficient manufacturing and a focus on customer service that is tops in the industry. Cemex is a leader in using information technology to match production with consumer demand. The company sells ready-mixed cement that can survive for only about 90 minutes before solidifying, so precise delivery is impor- tant. But Cemex can never predict with total certainty what demand will be on any given day, week, or month. To better manage unpredictable demand patterns, Cemex developed a system of seamless information technology—including truck-mounted global positioning systems, radio transmit- ters, satellites, and computer hardware—that allows it to control the production and distribution of cement like no other company can, responding quickly to unanticipated changes in demand and reducing waste. The results are lower costs and superior customer service, both differenti- ating factors for Cemex. Cemex’s international expansion strategy was driven by a number of factors. First, the company wished to reduce its reliance on the Mexican construction market, which was characterized by very volatile demand. Second, the com- pany realized there was tremendous demand for cement in many developing countries, where significant construc- tion was being undertaken or needed. Third, the company believed that it understood the needs of construction busi- nesses in developing nations better than the established multinational cement companies, all of which were from developed nations. Fourth, Cemex believed that it could create significant value by acquiring inefficient cement companies in other markets and transferring its skills in customer service, marketing, information technology, and production management to those units. The company embarked in earnest on its international expansion strategy in the early 1990s. Initially, Cemex targeted other developing nations, acquiring established cement makers in Venezuela, Colombia, Indonesia, the

Foreign Direct Investment by Cemex Philippines, Egypt, and several other countries. It also purchased two stagnant companies in Spain and turned them around. Bolstered by the success of its Spanish ventures, Cemex began to look for expansion opportuni- ties in developed nations. In 2000, Cemex purchased Houston-based Southland, one of the largest cement companies in the United States, for $2.5 billion. Following the Southland acquisition, Cemex had 56 cement plants in 30 countries, most of which were gained through acqui- sitions. In all cases, Cemex devoted great attention to transferring its technological, management and marketing know-how to acquired units, thereby improving their performance. In 2004, Cemex made another major foreign investment move, purchasing RMC of Great Britain for $5.8 billion. RMC was a huge multinational cement firm with sales of $8 billion, only 22 percent of which were in the United Kingdom, and operations in more than 20 other nations, including many European nations where Cemex had no presence. Finalized in March 2005, the RMC acquisition had transformed Cemex into a global powerhouse in the cement industry with more than $15 billion in annual sales and operations in 50 countries. Only about 15 percent of the company’s sales was now generated in Mexico. Follow- ing the acquisition of RMC, Cemex found that the RMC plant in Rugby was running at only 70 percent of capacity, partly because repeated production problems kept causing a kiln shutdown. Cemex brought in an international team of specialists to fix the problem and quickly increased pro- duction to 90 percent of capacity. Going forward, Cemex has made it clear that it will continue to expand and is eyeing opportunities in the fast-growing economies of China and India where currently it lacks a presence and where its global rivals are already expanding.

Sources: C. Piggott, “Cemex’s Stratospheric Rise,” Latin Finance, March 2001, p. 76; J. F. Smith, “Making Cement a Household Word,” Los Angeles Times, January 16, 2000, p. C1; D. Helft, “Cemex Attempts to Cement Its Future,” The Industry Standard, November 6, 2000; Diane Lindquist, “From Cement to Services,” Chief Executive, November 2002, pp. 48–50; “Cementing Global Success,” Strategic Direct Investor, March 2003, p. 1; M. T. Derham, “The Cemex Surprise,” Latin Finance, November 2004, pp. 1–2; “Holcim Seeks to Acquire Aggregate,” The Wall Street Journal, January 13, 2005, p. 1; J. Lyons, “Cemex Prowls for Deals in Both China and India,” The Wall Street Journal, January 27, 2006, p. C4; S. Donnan, “Cemex Sells 25 Percent Stake in Semen Gresik,” FT.com, May 4, 2006, p. 1.

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driven by protectionist threats from Congress and by quotas on the importation of Japanese cars. For Japanese auto companies, these factors decreased the profitability of exporting and increased that of foreign direct investment. In this context, it is important to under- stand that trade barriers do not have to be physically in place for FDI to be favored over exporting. Often, the desire to reduce the threat that trade barriers might be imposed is enough to justify foreign direct investment as an alternative to exporting.

Limitations of Licensing A branch of economic theory known as internalization theory seeks to explain why firms often prefer foreign direct investment over licensing as a strategy for entering for- eign markets (this approach is also known as the market imperfections approach).12 According to internalization theory, licensing has three major drawbacks as a strategy for exploiting foreign market opportunities. First, licensing may result in a firm’s giving away valuable technological know-how to a potential foreign competitor. For example, in the 1960s, RCA licensed its leading-edge color television technology to a number of Japanese companies, including Matsushita and Sony. At the time, RCA saw licensing as a way to earn a good return from its technological know-how in the Japanese market with- out the costs and risks associated with foreign direct investment. However, Matsushita and Sony quickly assimilated RCA’s technology and used it to enter the U.S. market to compete directly against RCA. As a result, RCA is now a minor player in its home mar- ket, while Matsushita and Sony have a much bigger market share. A second problem is that licensing does not give a firm the tight control over manu- facturing, marketing, and strategy in a foreign country that may be required to maximize its profitability. With licensing, control over manufacturing, marketing, and strategy are granted to a licensee in return for a royalty fee. However, for both strategic and operational reasons, a firm may want to retain control over these functions. The rationale for wanting control over the strategy of a foreign entity is that a firm might want its foreign subsidiary to price and market very aggressively as a way of keeping a foreign competitor in check. Unlike a wholly owned subsidiary, a licensee would probably not accept such an imposition, because it would likely reduce the licensee’s profit, or it might even cause the licensee to take a loss. The rationale for wanting control over the operations of a foreign entity is that the firm might wish to take advantage of differences in factor costs across countries, producing only part of its final product in a given country, while importing other parts from else- where where they can be produced at lower cost. Again, a licensee would be unlikely to accept such an arrangement, since it would limit the licensee’s autonomy. Thus, for these reasons, when tight control over a foreign entity is desirable, foreign direct investment is preferable to licensing. A third problem with licensing arises when the firm’s competitive advantage is based not as much on its products as on the management, marketing, and manufacturing capa- bilities that produce those products. The problem here is that such capabilities are often not amenable to licensing. While a foreign licensee may be able to physically reproduce the firm’s product under license, it often may not be able to do so as efficiently as the firm could itself. As a result, the licensee may not be able to fully exploit the profit potential inherent in a foreign market. For example, consider Toyota, a company whose competitive advantage in the global auto industry is acknowledged to come from its superior ability to manage the overall process of designing, engineering, manufacturing, and selling automobiles—that is, from its management and organizational capabilities. Indeed, Toyota is credited with pioneering the development of a new production process, known as lean production, that enables it to produce higher-quality automobiles at a lower cost than its global rivals.13 Although Toyota could license certain products, its real competitive advantage comes from its manage- ment and process capabilities. These kinds of skills are difficult to articulate or codify; they certainly cannot be written down in a simple licensing contract. They are organization- wide and have been developed over the years. They are not embodied in any one individual

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but instead are widely dispersed throughout the company. Put another way, Toyota’s skills are embedded in its organizational culture, and culture is something that cannot be licensed. Thus, if Toyota were to allow a foreign entity to produce its cars under license, the chances are that the entity could not do so as efficiently as could Toyota. In turn, this would limit the ability of the foreign entity to fully develop the market potential of that product. Such reasoning underlies Toyota’s preference for direct investment in foreign markets, as opposed to allowing foreign automobile companies to produce its cars under license. All of this suggests that when one or more of the following conditions holds, markets fail as a mechanism for selling know-how and FDI is more profitable than licensing: (1) when the firm has valuable know-how that cannot be adequately protected by a licensing contract, (2) when the firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (3) when a firm’s skills and know-how are not amenable to licensing.

Advantages of Foreign Direct Investment It follows that a firm will favor foreign direct investment over exporting as an entry strategy when transportation costs or trade barriers make exporting unattractive. Furthermore, the firm will favor foreign direct investment over licensing (or franchising) when it wishes to maintain control over its technological know-how, or over its operations and business strategy, or when the firm’s capabilities are simply not amenable to licensing, as may often be the case.

THE PATTERN OF FOREIGN DIRECT INVESTMENT

Observation suggests that firms in the same industry often undertake foreign direct invest- ment at about the same time. Also, firms tend to direct their investment activities toward the same target markets. The two theories we consider in this section attempt to explain the patterns that we observe in FDI flows.

Strategic Behavior One theory is based on the idea that FDI flows are a reflection of strategic rivalry between firms in the global marketplace. An early variant of this argument was expounded by F. T. Knickerbocker, who looked at the relationship between FDI and rivalry in oligopo- listic industries.14 An oligopoly is an industry composed of a limited number of large firms (e.g., an industry in which four firms control 80 percent of a domestic market would be defined as an oligopoly). A critical competitive feature of such industries is interde- pendence of the major players: What one firm does can have an immediate impact on the major competitors, forcing a response in kind. By cutting prices, one firm in an oligopoly can take market share away from its competitors, forcing them to respond with similar price cuts to retain their market share. Thus, the interdependence between firms in an oligopoly leads to imitative behavior; rivals often quickly imitate what a firm does in an oligopoly. Imitative behavior can take many forms in an oligopoly. One firm raises prices, and the others follow; one expands capacity, and the rivals imitate lest they be left at a disad- vantage in the future. Knickerbocker argued that the same kind of imitative behavior characterizes FDI. Consider an oligopoly in the United States in which three firms—A, B, and C—dominate the market. Firm A establishes a subsidiary in France. Firms B and C decide that if successful, this new subsidiary may knock out their export business to France and give a first-mover advantage to firm A. Furthermore, firm A might discover some competitive asset in France that it could repatriate to the United States to torment firms B and C on their native soil. Given these possibilities, firms B and C decide to follow firm A and establish operations in France. Studies that have looked at FDI by U.S. firms show that firms based in oligopolistic industries tended to imitate each other’s FDI.15 The same phenomenon has been observed

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with regard to FDI undertaken by Japanese firms.16 For example, Toyota and Nissan responded to investments by Honda in the United States and Europe by undertaking their own FDI in the United States and Europe. Research has also shown that models of strategic behavior in a global oligopoly can explain the pattern of FDI in the global tire industry.17 Knickerbocker’s theory can be extended to embrace the concept of multipoint compe- tition. Multipoint competition arises when two or more enterprises encounter each other in different regional markets, national markets, or industries.18 Economic theory suggests that rather like chess players jockeying for advantage, firms will try to match each other’s moves in different markets to try to hold each other in check. The idea is to ensure that a rival does not gain a commanding position in one market and then use the profits gener- ated there to subsidize competitive attacks in other markets. Although Knickerbocker’s theory and its extensions can help explain imitative FDI behavior by firms in oligopolistic industries, it does not explain why the first firm in an oligopoly decides to undertake FDI rather than to export or license. Internalization theory addresses this phenomenon. The imitative theory also does not address the issue of whether FDI is more efficient than exporting or licensing for expanding abroad. Again, internalization theory addresses the efficiency issue. For these reasons, many economists favor internalization theory as an explanation for FDI, although most would agree that the imitative explanation tells an important part of the story.

THE ECLECTIC PARADIGM

The eclectic paradigm has been championed by the British economist John Dunning.19 Dunning argues that in addition to the various factors discussed earlier, location-spe- cific advantages are also of considerable importance in explaining both the rationale for and the direction of foreign direct investment. By location-specific advantages, Dunning means the advantages that arise from utilizing resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets (such as the firm’s technological, marketing, or manage- ment capabilities). Dunning accepts the argument of internalization theory that it is difficult for a firm to license its own unique capabilities and know-how. Therefore, he argues that combining location-specific assets or resource endowments with the firm’s own unique capabilities often requires foreign direct investment. That is, it requires the firm to establish production facilities where those foreign assets or resource endow- ments are located. An obvious example of Dunning’s arguments are natural resources, such as oil and other minerals, which are by their character specific to certain locations. Dunning sug- gests that to exploit such foreign resources, a firm must undertake FDI. Clearly, this explains the FDI undertaken by many of the world’s oil companies, which have to in- vest where oil is located in order to combine their technological and managerial capa- bilities with this valuable location-specific resource. Another obvious example is valuable human resources, such as low-cost, highly skilled labor. The cost and skill of labor varies from country to country. Because labor is not internationally mobile, ac- cording to Dunning it makes sense for a firm to locate production facilities in those countries where the cost and skills of local labor are most suited to its particular pro- duction processes. However, Dunning’s theory has implications that go beyond basic resources such as minerals and labor. Consider Silicon Valley, which is the world center for the computer and semiconductor industry. Many of the world’s major computer and semiconductor companies—such as Apple Computer, Hewlett-Packard, Oracle, Google, and Intel—are located close to each other in the Silicon Valley region of California. As a result, much of the cutting-edge research and product development in computers and semiconductors occurs there. According to Dunning’s arguments, knowledge being generated in Silicon Valley with regard to the design and manufacture of computers and semiconductors is available

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nowhere else in the world. To be sure, that knowledge is commer- cialized as it diffuses throughout the world, but the leading edge of knowledge generation in the computer and semiconductor in- dustries is to be found in Silicon Valley. In Dunning’s language, this means that Silicon Valley has a location-specific advantage in the generation of knowledge related to the computer and semi- conductor industries. In part, this advantage comes from the sheer concentration of intellectual talent in this area, and in part it arises from a network of informal contacts that allows firms to benefit from each other’s knowledge generation. Economists refer to such knowledge “spillovers” as externalities, and there is a well- established theory suggesting that firms can benefit from such ex- ternalities by locating close to their source.20 Insofar as this is the case, it makes sense for foreign computer and semiconductor firms to invest in research and, perhaps, pro- duction facilities so they too can learn about and utilize valuable

new knowledge before those based elsewhere, thereby giving them a competitive advan- tage in the global marketplace.21 Evidence suggests that European, Japanese, South Korean, and Taiwanese computer and semiconductor firms are investing in the Silicon Valley region precisely because they wish to benefit from the externalities that arise there.22 Others have argued that direct investment by foreign firms in the U.S. biotechnol- ogy industry has been motivated by desires to gain access to the unique location-specific technological knowledge of U.S. biotechnology firms.23 Dunning’s theory, therefore, seems to be a useful addition to those outlined previously, because it helps explain how location factors affect the direction of FDI.24

Political Ideology and Foreign Direct Investment

Historically, political ideology toward FDI within a nation has ranged from a dogmatic radical stance that is hostile to all inward FDI at one extreme to an adherence to the noninterventionist principle of free market economics at the other. Between these two extremes is an approach that might be called pragmatic nationalism.

THE RADICAL VIEW

The radical view traces its roots to Marxist political and economic theory. Radical writers argue that the multinational enterprise (MNE) is an instrument of imperialist domina- tion. They see the MNE as a tool for exploiting host countries to the exclusive benefit of their capitalist-imperialist home countries. They argue that MNEs extract profits from the host country and take them to their home country, giving nothing of value to the host country in exchange. They note, for example, that key technology is tightly con- trolled by the MNE and that important jobs in the foreign subsidiaries of MNEs go to home-country nationals rather than to citizens of the host country. Because of this, ac- cording to the radical view, FDI by the MNEs of advanced capitalist nations keeps the less developed countries of the world relatively backward and dependent on advanced capitalist nations for investment, jobs, and technology. Thus, according to the extreme version of this view, no country should ever permit foreign corporations to undertake FDI, because they can never be instruments of economic development, only of economic domination. Where MNEs already exist in a country, they should be immediately nationalized.25 From 1945 until the 1980s, the radical view was very influential in the world economy. Until the collapse of communism between 1989 and 1991, the countries of eastern Europe were opposed to FDI. Similarly, communist countries elsewhere—such as China, Cambodia, and Cuba—were all opposed in principle to FDI (although, in practice, the Chinese

LO 8 -3 Understand how political ideology shapes a government’s attitudes toward FDI.

Silicon Valley, where Google is based, has long been known as the epicenter of the computer and semi- conductor industry. Source: © Phillip Bond/Alamy

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Foreign Direct Investment Chapter 8 237

started to allow FDI in mainland China in the 1970s). Many socialist countries—particularly in Africa, where one of the first actions of many newly independent states was to nationalize foreign-owned enterprises—also embraced the radical position. Countries whose politi- cal ideology was more nationalistic than socialistic further embraced the radical position. This was true in Iran and India, for example, both of which adopted tough policies restrict- ing FDI and nationalized many foreign-owned enterprises. Iran is a particularly interesting case because its Islamic government, while rejecting Marxist theory, has essentially embraced the radical view that FDI by MNEs is an instrument of imperialism. By the early 1990s, the radical position was in retreat almost everywhere. There seem to be three reasons for this: (1) the collapse of communism in eastern Europe; (2) the generally abysmal economic performance of those countries that embraced the radical position, and a growing belief by many of these countries that FDI can be an important source of technology and jobs and can stimulate economic growth; and (3) the strong economic performance of those developing countries that embraced capitalism rather than radical ideology (e.g., Singapore, Hong Kong, and Taiwan).

THE FREE MARKET VIEW

The free market view traces its roots to classical economics and the international trade theories of Adam Smith and David Ricardo (see Chapter 6). The intellectual case for this view has been strengthened by the internalization explanation of FDI. The free market view argues that international production should be distributed among countries accord- ing to the theory of comparative advantage. Countries should specialize in the production of those goods and services that they can produce most efficiently. Within this frame- work, the MNE is an instrument for dispersing the production of goods and services to the most efficient locations around the globe. Viewed this way, FDI by the MNE increases the overall efficiency of the world economy. Imagine that Dell decided to move assembly operations for many of its personal com- puters from the United States to Mexico to take advantage of lower labor costs in Mexico. According to the free market view, moves such as this can be seen as increasing the over- all efficiency of resource utilization in the world economy. Mexico, due to its lower labor costs, has a comparative advantage in the assembly of PCs. By moving the production of PCs from the United States to Mexico, Dell frees U.S. resources for use in activities in which the United States has a comparative advantage (e.g., the design of computer software, the manufacture of high value-added components such as microprocessors, or basic R&D). Also, consumers benefit because the PCs cost less than they would if they were produced domestically. In addition, Mexico gains from the technology, skills, and capital that the computer company transfers with its FDI. Contrary to the radical view, the free market view stresses that such resource transfers benefit the host country and stimulate its eco- nomic growth. Thus, the free market view argues that FDI is a benefit to both the source country and the host country.

PRAGMATIC NATIONALISM

In practice, many countries have adopted neither a radical policy nor a free market policy toward FDI, but instead a policy that can best be described as pragmatic nationalism.26 The pragmatic nationalist view is that FDI has both benefits and costs. FDI can benefit a host country by bringing capital, skills, technology, and jobs, but those benefits come at a cost. When a foreign company rather than a domestic company produces products, the profits from that investment go abroad. Many countries are also concerned that a foreign- owned manufacturing plant may import many components from its home country, which has negative implications for the host country’s balance-of-payments position. Recognizing this, countries adopting a pragmatic stance pursue policies designed to maximize the national benefits and minimize the national costs. According to this view, FDI should be allowed so long as the benefits outweigh the costs. Japan offers

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an example of pragmatic nationalism. Until the 1980s, Japan’s policy was probably one of the most restrictive among countries adopting a pragmatic nationalist stance. This was due to Japan’s perception that direct entry of foreign (especially U.S.) firms with ample managerial resources into the Japanese markets could hamper the develop- ment and growth of its own industry and technology.27 This belief led Japan to block the majority of applications to invest in Japan. However, there were always exceptions to this policy. Firms that had important technology were often permitted to undertake FDI if they insisted that they would neither license their technology to a Japanese firm nor enter into a joint venture with a Japanese enterprise. IBM and Texas Instruments were able to set up wholly owned subsidiaries in Japan by adopting this negotiating position. From the perspective of the Japanese government, the benefits of FDI in such cases—the stimulus that these firms might impart to the Japanese economy— outweighed the perceived costs. Another aspect of pragmatic nationalism is the tendency to aggressively court FDI believed to be in the national interest by, for example, offering subsidies to foreign MNEs in the form of tax breaks or grants. The countries of the European Union often seem to be competing with each other to attract U.S. and Japanese FDI by offering large tax breaks and subsidies. Britain has been the most successful at attracting Japanese investment in the automobile industry. Nissan, Toyota, and Honda now have major assembly plants in Britain and use the country as their base for serving the rest of Europe—with obvious employment and balance-of-payments benefits for Britain.

SHIFTING IDEOLOGY

Recent years have seen a marked decline in the number of countries that adhere to a radical ideology. Although few countries have adopted a pure free market policy stance, an increas- ing number of countries are gravitating toward the free market end of the spectrum and have liberalized their foreign investment regime. This includes many countries that less than two decades ago were firmly in the radical camp (e.g., the former communist coun- tries of eastern Europe, many of the socialist countries of Africa, and India) and several countries that until recently could best be described as pragmatic nationalists with regard to FDI (e.g., Japan, South Korea, Italy, Spain, and most Latin American countries). One result has been the surge in the volume of FDI worldwide, which, as we noted earlier, has been growing twice as fast as the growth in world trade. Another result has been an increase in the volume of FDI directed at countries that have recently liberalized their FDI regimes, such as China, India, and Vietnam. As a counterpoint, there is some evidence of a shift to a more hostile approach to foreign direct investment in some nations. Venezuela and Bolivia have become increasingly hostile to foreign direct investment. In 2005 and 2006, the governments of both nations unilaterally rewrote contracts for oil and gas exploration, raising the royalty rate that foreign enter- prises had to pay the government for oil and gas extracted in their territories. Following his election victory in 2006, Bolivian president Evo Morales nationalized the nation’s gas fields and stated that he would evict foreign firms unless they agreed to pay about 80 percent of their revenues to the state and relinquish production oversight. In some developed nations, there is increasing evidence of hostile reactions to inward FDI as well. In Europe in 2006, there was a hostile political reaction to the attempted takeover of Europe’s largest steel company, Arcelor, by Mittal Steel, a global company controlled by the Indian entre- preneur Lakshmi Mittal. In mid-2005, China National Offshore Oil Company withdrew a takeover bid for Unocal of the United States after highly negative reaction in Congress about the proposed takeover of a “strategic asset” by a Chinese company. Similarly, as detailed in the accompanying Management Focus, in 2006 a Dubai-owned company withdrew its planned takeover of some operations at six U.S. ports after negative political reactions. So far, these countertrends are nothing more than isolated incidents, but if they become more widespread, the 30-year movement toward lower barriers to cross-border investment could be in jeopardy.

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M A NAG E M E N T F O C U S

DP World and the United States In February 2006, DP World, a ports operator with global reach owned by the government of Dubai, a member of the United Arab Emirates and a staunch U.S. ally, paid $6.8 billion to acquire P&O, a British firm that runs a global network of marine terminals. With P&O came the management opera- tions of six U.S. ports: Miami, Philadelphia, Baltimore, New Orleans, New Jersey, and New York. The acquisition had al- ready been approved by U.S. regulators when it suddenly became front-page news. Upon hearing about the deal, several prominent U.S. senators raised concerns about the acquisition. Their objections were twofold. First, they raised questions about the security risks associated with management operations in key U.S. ports being owned by a foreign enterprise that was based in the Middle East. The implication was that terrorists could somehow take advantage of the ownership arrangement to infiltrate U.S. ports. Second, they were concerned that DP World was a state-owned enterprise and argued that foreign governments should not be in a position of owning key “U.S. strategic assets.” The Bush administration was quick to defend the take- over, stating it posed no threat to national security. Others noted that DP World was a respected global firm with an American chief operating officer and an American- educated chair; the head of the global ports management

operation would also be an American. DP World would not own the U.S. ports in question, just manage them, while security issues would remain in the hands of American customs officials and the U.S. Coast Guard. Dubai was also a member of America’s Container Security Initiative, which allows American customs officials to inspect cargo in foreign ports before it leaves for the United States. Most of the DP World employees at American ports would be U.S. citizens, and any UAE citizen transferred to DP World would be subject to American visa approval. These arguments fell on deaf ears. With several U.S. senators threatening to pass legislation to prohibit foreign ownership of U.S. port operations, DP World bowed to the inevitable and announced it would sell off the right to manage the six U.S. ports for about $750 million. Looking forward, however, DP World stated it would seek an initial public offering in 2007, and the then-private firm would in all probability continue to look for ways to enter the United States. In the words of the firm’s CEO, “This is the world’s largest economy. How can you just ignore it?”

Sources: “Trouble at the Waterfront,” The Economist, February 25, 2006, p. 48; “Paranoia about Dubai Ports Deals Is Needless,” Financial Times, February 21, 2006, p. 16; “DP World: We’ll Be Back,” Traffic World, May 29, 2006, p. 1.

Benefits and Costs of FDI

To a greater or lesser degree, many governments can be considered pragmatic nationalists when it comes to FDI. Accordingly, their policy is shaped by a consideration of the costs and benefits of FDI. Here, we explore the benefits and costs of FDI, first from the perspective of a host (receiving) country and then from the perspective of the home (source) country. In the next section, we look at the policy instruments governments use to manage FDI.

HOST-COUNTRY BENEFITS

The main benefits of inward FDI for a host country arise from resource-transfer effects, employment effects, balance-of-payments effects, and effects on competition and eco- nomic growth.

Resource-Transfer Effects Foreign direct investment can make a positive contribution to a host economy by supplying capital, technology, and management resources that would otherwise not be available and thus boost that country’s economic growth rate. With regard to capital, many MNEs, by virtue of their large size and financial strength, have access to financial resources not available to host-country firms. These funds may

LO 8 - 4 Describe the benefits and costs of FDI to home and host countries.

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be available from internal company sources, or, because of their reputation, large MNEs may find it easier to borrow money from capital markets than host-country firms would.

As for technology, you will recall from Chapter 3 that technology can stimulate economic development and industrialization. Tech- nology can take two forms, both of which are valuable. Technology can be incorporated in a production process (e.g., the technology for discovering, extracting, and refining oil), or it can be incorpo- rated in a product (e.g., personal computers). However, many countries lack the research and development resources and skills required to develop their own indigenous product and process technology. This is particularly true in less developed nations. Such countries must rely on advanced industrialized nations for much of the technology required to stimulate economic growth, and FDI can provide it.

Research supports the view that multinational firms often transfer significant technology when they invest in a foreign country.28 For

example, a study of FDI in Sweden found that foreign firms increased both the labor and total factor productivity of Swedish firms that they acquired, suggesting that significant technology transfers had occurred (technology typically boosts productivity).29 Also, a study of FDI by the Organisation for Economic Co-operation and Development (OECD) found that foreign investors invested significant amounts of capital in R&D in the coun- tries in which they had invested, suggesting that not only were they transferring technology to those countries but they may also have been upgrading existing technology or creating new technology in those countries.30 Foreign management skills acquired through FDI may also produce important benefits for the host country. Foreign managers trained in the latest management techniques can often help improve the efficiency of operations in the host country, whether those operations are acquired or greenfield developments. Beneficial spin-off effects may also arise when local personnel who are trained to occupy managerial, financial, and technical posts in the subsidiary of a foreign MNE leave the firm and help establish indigenous firms. Similar benefits may arise if the superior management skills of a foreign MNE stimulate local suppliers, distributors, and competitors to improve their own management skills.

Employment Effects Another beneficial employment effect claimed for FDI is that it brings jobs to a host country that would otherwise not be created there. The effects of FDI on employment are both direct and indirect. Direct effects arise when a foreign MNE employs a number of host-country citizens. Indirect effects arise when jobs are created in local suppliers as a result of the investment and when jobs are created because of increased local spending by employees of the MNE. The indirect employment effects are often as large as, if not larger than, the direct effects. For example, when Toyota decided to open a new auto plant in France, estimates suggested the plant would create 2,000 direct jobs and perhaps another 2,000 jobs in support industries.31 Cynics argue that not all the “new jobs” created by FDI represent net additions in employ- ment. In the case of FDI by Japanese auto companies in the United States, some argue that the jobs created by this investment have been more than offset by the jobs lost in U.S.-owned auto companies, which have lost market share to their Japanese competitors. As a consequence of such substitution effects, the net number of new jobs created by FDI may not be as great as initially claimed by an MNE. The issue of the likely net gain in employment may be a major negotiating point between an MNE wishing to undertake FDI and the host government. When FDI takes the form of an acquisition of an established enterprise in the host econ- omy as opposed to a greenfield investment, the immediate effect may be to reduce em- ployment as the multinational tries to restructure the operations of the acquired unit to

Job creation is a result of FDI. These French workers assemble cars at Toyota’s Valenciennes manufactur- ing plant. Source: © Philippe Huguen/AFP/Getty Images

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improve its operating efficiency. However, even in such cases, research suggests that once the initial period of restructuring is over, enterprises acquired by foreign firms tend to increase their employment base at a faster rate than domestic rivals. An OECD study found that foreign firms created new jobs at a faster rate than their domestic counterparts.32

Balance-of-Payments Effects FDI’s effect on a country’s balance-of-payments accounts is an important policy issue for most host governments. A country’s balance-of-payments accounts track both its pay- ments to and its receipts from other countries. Governments normally are concerned when their country is running a deficit on the current account of their balance of pay- ments. The current account tracks the export and import of goods and services. A cur- rent account deficit, or trade deficit as it is often called, arises when a country is importing more goods and services than it is exporting. Governments typically prefer to see a cur- rent account surplus than a deficit. The only way in which a current account deficit can be supported in the long run is by selling off assets to foreigners (for a detailed explanation of why this is the case, see the appendix to Chapter 6). For example, the persistent U.S. current account deficit since the 1980s has been financed by a steady sale of U.S. assets (stocks, bonds, real estate, and whole corporations) to foreigners. Because national gov- ernments invariably dislike seeing the assets of their country fall into foreign hands, they prefer their nation to run a current account surplus. There are two ways in which FDI can help a country achieve this goal. First, if the FDI is a substitute for imports of goods or services, the effect can be to improve the current account of the host country’s balance of payments. Much of the FDI by Japanese automobile companies in the United States and Europe, for example, can be seen as substituting for imports from Japan. Thus, the current account of the U.S. balance of payments has improved somewhat because many Japanese companies are now supplying the U.S. market from production facilities in the United States, as opposed to facilities in Japan. Insofar as this has reduced the need to finance a current account deficit by asset sales to foreigners, the United States has clearly benefited. A second potential benefit arises when the MNE uses a foreign subsidiary to export goods and services to other countries. According to a UN report, inward FDI by foreign multinationals has been a major driver of export-led economic growth in a number of de- veloping and developed nations.33 For example, in China exports increased from $26 billion in 1985 to more than $250 billion by 2001 and $1.9 trillion in 2012. Much of this dramatic export growth was due to the presence of foreign multinationals that invested heavily in China during the 1990s.

Effect on Competition and Economic Growth Economic theory tells us that the efficient functioning of markets depends on an adequate level of competition between producers. When FDI takes the form of a greenfield invest- ment, the result is to establish a new enterprise, increasing the number of players in a market and thus consumer choice. In turn, this can increase the level of competition in a national market, thereby driving down prices and increasing the economic welfare of consumers. Increased competition tends to stimulate capital investments by firms in plant, equipment, and R&D as they struggle to gain an edge over their rivals. The long- term results may include increased productivity growth, product and process innovations, and greater economic growth.34 Such beneficial effects seem to have occurred in the South Korean retail sector following the liberalization of FDI regulations in 1996. FDI by large Western discount stores—including Walmart, Costco, Carrefour, and Tesco— seems to have encouraged indigenous discounters such as E-Mart to improve the efficiency of their own operations. The results have included more competition and lower prices, which benefit South Korean consumers. FDI’s impact on competition in domestic markets may be particularly important in the case of services, such as telecommunications, retailing, and many financial services, where exporting is often not an option because the service has to be produced where it is

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delivered.35 For example, under a 1997 agreement sponsored by the World Trade Organiza- tion, 68 countries accounting for more than 90 percent of world telecommunications revenues pledged to start opening their markets to foreign investment and competition and to abide by common rules for fair competition in telecommunications. Before this agreement, most of the world’s telecommunications markets were closed to foreign com- petitors, and in most countries the market was monopolized by a single carrier, which was often a state-owned enterprise. The agreement has dramatically increased the level of competition in many national telecommunications markets, producing two major benefits. First, inward investment has increased competition and stimulated investment in the modernization of telephone networks around the world, leading to better service. Second, the increased competition has resulted in lower prices.

HOST-COUNTRY COSTS

Three costs of FDI concern host countries. They arise from possible adverse effects on competition within the host nation, adverse effects on the balance of payments, and the perceived loss of national sovereignty and autonomy.

Adverse Effects on Competition Host governments sometimes worry that the subsidiaries of foreign MNEs may have greater economic power than indigenous competitors. If it is part of a larger international organization, the foreign MNE may be able to draw on funds generated elsewhere to sub- sidize its costs in the host market, which could drive indigenous companies out of business and allow the firm to monopolize the market. Once the market is monopolized, the foreign MNE could raise prices above those that would prevail in competitive markets, with harm- ful effects on the economic welfare of the host nation. This concern tends to be greater in countries that have few large firms of their own (generally, less developed countries). It tends to be a relatively minor concern in most advanced industrialized nations. In general, while FDI in the form of greenfield investments should increase competi- tion, it is less clear that this is the case when the FDI takes the form of acquisition of an established enterprise in the host nation, as was the case when Cemex acquired RMC in Britain (see the Management Focus). Because an acquisition does not result in a net increase in the number of players in a market, the effect on competition may be neutral. When a foreign investor acquires two or more firms in a host country, and subsequently merges them, the effect may be to reduce the level of competition in that market, create monopoly power for the foreign firm, reduce consumer choice, and raise prices. For ex- ample, in India, Hindustan Lever Ltd., the Indian subsidiary of Unilever, acquired its main local rival, Tata Oil Mills, to assume a dominant position in the bath soap (75 percent) and detergents (30 percent) markets. Hindustan Lever also acquired several local compa- nies in other markets, such as the ice cream makers Dollops, Kwality, and Milkfood. By combining these companies, Hindustan Lever’s share of the Indian ice cream market went from zero in 1992 to 74 percent in 1997.36 However, although such cases are of obvious concern, there is little evidence that such developments are widespread. In many nations, domestic competition authorities have the right to review and block any mergers or acqui- sitions that they view as having a detrimental impact on competition. If such institutions are operating effectively, this should be sufficient to make sure that foreign entities do not monopolize a country’s markets.

Adverse Effects on the Balance of Payments The possible adverse effects of FDI on a host country’s balance-of-payments position are twofold. First, set against the initial capital inflow that comes with FDI must be the sub- sequent outflow of earnings from the foreign subsidiary to its parent company. Such out- flows show up as capital outflow on balance-of-payments accounts. Some governments have responded to such outflows by restricting the amount of earnings that can be repatri- ated to a foreign subsidiary’s home country. A second concern arises when a foreign

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subsidiary imports a substantial number of its inputs from abroad, which results in a debit on the current account of the host country’s balance of payments. One criticism leveled against Japanese-owned auto assembly operations in the United States, for example, is that they tend to import many component parts from Japan. Because of this, the favorable impact of this FDI on the current account of the U.S. balance-of-payments position may not be as great as initially supposed. The Japanese auto companies responded to these criticisms by pledging to purchase 75 percent of their component parts from U.S.-based manufacturers (but not necessarily U.S.-owned manufacturers). When the Japanese auto company Nissan invested in the United Kingdom, Nissan responded to concerns about local content by pledging to increase the proportion of local content to 60 percent and subsequently raising it to more than 80 percent.

Possible Effects on National Sovereignty and Autonomy Some host governments worry that FDI is accompanied by some loss of economic indepen- dence. The concern is that key decisions that can affect the host country’s economy will be made by a foreign parent that has no real commitment to the host country, and over which the host country’s government has no real control. Most economists dismiss such concerns as groundless and irrational. Political scientist Robert Reich has noted that such concerns are the product of outmoded thinking because they fail to account for the growing interdependence of the world economy.37 In a world in which firms from all advanced nations are increasingly investing in each other’s markets, it is not possible for one country to hold another to “economic ransom” without hurting itself.

HOME-COUNTRY BENEFITS

The benefits of FDI to the home (source) country arise from three sources. First, the home country’s balance of payments benefits from the inward flow of foreign earnings. FDI can also benefit the home country’s balance of payments if the foreign subsidiary creates demands for home-country exports of capital equipment, intermediate goods, complementary products, and the like. Second, benefits to the home country from outward FDI arise from employment effects. As with the balance of payments, positive employment effects arise when the foreign subsidiary creates demand for home-country exports. Thus, Toyota’s investment in auto assembly operations in Europe has benefited both the Japanese balance-of-payments position and employment in Japan, because Toyota imports some component parts for its European-based auto assembly operations directly from Japan. Third, benefits arise when the home-country MNE learns valuable skills from its expo- sure to foreign markets that can subsequently be transferred back to the home country. This amounts to a reverse resource-transfer effect. Through its exposure to a foreign market, an MNE can learn about superior management techniques and superior product and process technologies. These resources can then be transferred back to the home country, contributing to the home country’s economic growth rate.38

HOME-COUNTRY COSTS

Against these benefits must be set the apparent costs of FDI for the home (source) country. The most important concerns center on the balance-of-payments and employment effects of outward FDI. The home country’s balance of payments may suffer in three ways. First, the balance of payments suffers from the initial capital outflow required to finance the FDI. This effect, however, is usually more than offset by the subsequent inflow of foreign earnings. Second, the current account of the balance of payments suffers if the purpose of the foreign investment is to serve the home market from a low-cost production location. Third, the current account of the balance of payments suffers if the FDI is a substitute for direct exports. Thus, insofar as Toyota’s assembly operations in the United States are intended to substitute for direct exports from Japan, the current account position of Japan will deteriorate.

244 Part 3 The Global Trade and Investment Environment

With regard to employment effects, the most serious concerns arise when FDI is seen as a substitute for domestic production. This was the case with Toyota’s investments in the United States and Europe. One obvious result of such FDI is reduced home-country employment. If the labor market in the home country is already tight, with little unemploy- ment, this concern may not be that great. However, if the home country is suffering from unemployment, concern about the export of jobs may arise. For example, one objection frequently raised by U.S. labor leaders to the free trade pact among the United States, Mexico, and Canada (see the next chapter) is that the United States would lose hundreds of thousands of jobs as U.S. firms invest in Mexico to take advantage of cheaper labor and then export back to the United States.39

INTERNATIONAL TRADE THEORY AND FDI

When assessing the costs and benefits of FDI to the home country, keep in mind the lessons of international trade theory (see Chapter 6). International trade theory tells us that home- country concerns about the negative economic effects of offshore production may be mis- placed. The term offshore production refers to FDI undertaken to serve the home market. Far from reducing home-country employment, such FDI may actually stimulate economic growth (and hence employment) in the home country by freeing home-country resources to concentrate on activities where the home country has a comparative advan- tage. In addition, home-country consumers benefit if the price of the particular product falls as a result of the FDI. Also, if a company were prohibited from making such invest- ments on the grounds of negative employment effects while its international competitors reaped the benefits of low-cost production locations, it would undoubtedly lose market share to its international competitors. Under such a scenario, the adverse long-run economic effects for a country would probably outweigh the relatively minor balance-of-payments and employment effects associated with offshore production.

Government Policy Instruments and FDI

We have reviewed the costs and benefits of FDI from the perspective of both home coun- try and host country. We now turn our attention to the policy instruments that home (source) countries and host countries can use to regulate FDI.

HOME-COUNTRY POLICIES

Through their choice of policies, home countries can both encourage and restrict FDI by local firms. We look at policies designed to encourage outward FDI first. These include foreign risk insurance, capital assistance, tax incentives, and political pressure. Then we will look at policies designed to restrict outward FDI.

Encouraging Outward FDI Many investor nations now have government-backed insurance programs to cover major types of foreign investment risk. The types of risks insurable through these programs include the risks of expropriation (nationalization), war losses, and the inability to transfer profits back home. Such programs are particularly useful in encouraging firms to undertake invest- ments in politically unstable countries.40 In addition, several advanced countries also have special funds or banks that make government loans to firms wishing to invest in developing countries. As a further incentive to encourage domestic firms to undertake FDI, many countries have eliminated double taxation of foreign income (i.e., taxation of income in both the host country and the home country). Last, and perhaps most significant, a number of investor countries (including the United States) have used their political influence to persuade host countries to relax their restrictions on inbound FDI. For example, in response to direct U.S. pressure, Japan relaxed many of its formal restrictions on inward FDI in the 1980s. Now, in response to further U.S. pressure, Japan has moved toward relaxing its informal barriers to inward FDI. One beneficiary of this trend has been Toys “R” Us,

LO 8 -5 Explain the range of policy instruments that governments use to influence FDI.

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Foreign Direct Investment Chapter 8 245

which, after five years of intensive lobbying by company and U.S. government officials, opened its first retail stores in Japan in December 1991. By 2012, Toys “R” Us had more than 170 stores in Japan, and its Japanese operation, in which Toys “R” Us retained a controlling stake, had a listing on the Japanese stock market.

Restricting Outward FDI Virtually all investor countries, including the United States, have exercised some control over outward FDI from time to time. One policy has been to limit capital outflows out of concern for the country’s balance of payments. From the early 1960s until 1979, for ex- ample, Britain had exchange-control regulations that limited the amount of capital a firm could take out of the country. Although the main intent of such policies was to improve the British balance of payments, an important secondary intent was to make it more dif- ficult for British firms to undertake FDI. In addition, countries have occasionally manipulated tax rules to try to encourage their firms to invest at home. The objective behind such policies is to create jobs at home rather than in other nations. At one time, Britain adopted such policies. The British advanced corporation tax system taxed British companies’ foreign earnings at a higher rate than their domestic earnings. This tax code created an incentive for British companies to invest at home. Finally, countries sometimes prohibit national firms from investing in certain countries for political reasons. Such restrictions can be formal or informal. For example, formal U.S. rules prohibited U.S. firms from investing in countries such as Cuba and Iran, whose political ideology and actions are judged to be contrary to U.S. interests. Similarly, during the 1980s, informal pressure was applied to dissuade U.S. firms from investing in South Africa. In this case, the objective was to pressure South Africa to change its apartheid laws, which happened during the early 1990s.

HOST-COUNTRY POLICIES

Host countries adopt policies designed both to restrict and to encourage inward FDI. As noted earlier in this chapter, political ideology has determined the type and scope of these policies in the past. In the last decade of the twentieth century, many countries moved quickly away from adhering to some version of the radical stance and prohibiting much FDI, and toward a situation where a combination of free market objectives and pragmatic nationalism took hold.

Encouraging Inward FDI It is common for governments to offer incentives to foreign firms to invest in their countries. Such incentives take many forms, but the most common are tax concessions, low-interest loans, and grants or subsidies. Incentives are motivated by a desire to gain from the resource- transfer and employment effects of FDI. They are also motivated by a desire to capture FDI away from other potential host countries. For example, in the mid-1990s, the governments of Britain and France competed with each other on the incentives they offered Toyota to invest in their respective countries. In the United States, state governments often compete with each other to attract FDI. For example, Kentucky offered Toyota an incentive package worth $147 million to persuade it to build its U.S. automobile assembly plants there. The package included tax breaks, new state spending on infrastructure, and low-interest loans.41

Restricting Inward FDI Host governments use a wide range of controls to restrict FDI in one way or another. The two most common are ownership restraints and performance requirements. Ownership restraints can take several forms. In some countries, foreign companies are excluded from specific fields. They are excluded from tobacco and mining in Sweden and from the development of certain natural resources in Brazil, Finland, and Morocco. In other indus- tries, foreign ownership may be permitted although a significant proportion of the equity of the subsidiary must be owned by local investors. Foreign ownership is restricted to

246 Part 3 The Global Trade and Investment Environment

25 percent or less of an airline in the United States. In India, foreign firms were prohib- ited from owning media businesses until 2001, when the rules were relaxed, allowing foreign firms to purchase up to 26 percent of an Indian newspaper. The rationale underlying ownership restraints seems to be twofold. First, foreign firms are often excluded from certain sectors on the grounds of national security or competition. Particularly in less developed countries, the feeling seems to be that local firms might not be able to develop unless foreign competition is restricted by a combination of import tariffs and controls on FDI. This is a variant of the infant industry argument discussed in Chapter 7. Second, ownership restraints seem to be based on a belief that local owners can help maximize the resource-transfer and employment benefits of FDI for the host country. Until the early 1980s, the Japanese government prohibited most FDI but allowed joint ventures between Japanese firms and foreign MNEs if the MNE had a valuable technology. The Japanese government clearly believed such an arrangement would speed up the subse- quent diffusion of the MNE’s valuable technology throughout the Japanese economy. Performance requirements can also take several forms. Performance requirements are controls over the behavior of the MNE’s local subsidiary. The most common performance requirements are related to local content, exports, technology transfer, and local participa- tion in top management. As with certain ownership restrictions, the logic underlying perfor- mance requirements is that such rules help maximize the benefits and minimize the costs of FDI for the host country. Many countries employ some form of performance require- ments when it suits their objectives. However, performance requirements tend to be more common in less developed countries than in advanced industrialized nations.42

INTERNATIONAL INSTITUTIONS AND THE LIBERALIZATION OF FDI

Until the 1990s, there was no consistent involvement by multinational institutions in the governing of FDI. This changed with the formation of the World Trade Organization in 1995. The WTO embraces the promotion of international trade in services. Because many services have to be produced where they are sold, exporting is not an option (e.g., one can- not export McDonald’s hamburgers or consumer banking services). Given this, the WTO has become involved in regulations governing FDI. As might be expected for an institution created to promote free trade, the thrust of the WTO’s efforts has been to push for the liber- alization of regulations governing FDI, particularly in services. Under the auspices of the WTO, two extensive multinational agreements were reached in 1997 to liberalize trade in telecommunications and financial services. Both these agreements contained detailed clauses that require signatories to liberalize their regulations governing inward FDI, essen- tially opening their markets to foreign telecommunications and financial services compa- nies. The WTO has had less success trying to initiate talks aimed at establishing a universal set of rules designed to promote the liberalization of FDI. Led by Malaysia and India, devel- oping nations have so far rejected efforts by the WTO to start such discussions.

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F O C U S O N M A NAG E R I A L I M P L I C AT I O N S

FDI AND GOVERNMENT POLICY Several implications for business are inherent in the material discussed in this chapter.

In this section, we deal first with the implications of the theory and then turn our attention to the implications of government policy.

The Theory of FDI The implications of the theories of FDI for business practice are straightforward. First, the location-specific advantages argument associated with John Dunning does help explain the direction of FDI. However, the location-specific

advantages argument does not explain why firms prefer FDI to licensing or to exporting. In this regard, from both an explanatory and a business perspective, perhaps

LO 8 - 6 Identify the implications for managers of the theory and government policies associated with FDI.

Foreign Direct Investment Chapter 8 247

the most useful theories are those that focus on the limitations of exporting and licensing— that is, internalization theories. These theories are useful because they identify with some preci- sion how the relative profitability of foreign direct investment, exporting, and licensing vary with circumstances. The theories suggest that exporting is preferable to licensing and FDI so long as transportation costs are minor and trade barriers are trivial. As transportation costs or trade barriers increase, exporting becomes unprofitable, and the choice is between FDI and licensing. Because FDI is more costly and more risky than licensing, other things being equal, the theories argue that licensing is preferable to FDI. Other things are seldom equal, however. Although licensing may work, it is not an attractive option when one or more of the following conditions exist: (1) the firm has valuable know-how that cannot be adequately protected by a licensing contract, (2) the firm needs tight control over a foreign entity to maximize its market share and earnings in that country, and (3) a firm’s skills and capabilities are not amenable to licensing. Figure 8.4 presents these considerations as a decision tree. Firms for which licensing is not a good option tend to be clustered in three types of industries:

1. High-technology industries in which protecting firm-specific expertise is of paramount importance and licensing is hazardous.

2. Global oligopolies, in which competitive interdependence requires that multinational firms maintain tight control over foreign operations so that they have the ability to launch coordinated attacks against their global competitors.

F I G U R E 8 . 4

A decision framework. Export

FDI

FDI

FDI

Then License

Low

High

Yes

No

Yes

No

Yes

No

Is Tight Control over Foreign Operation Required?

How High Are Transportation Costs and Tariffs?

Is Know-how Amenable to Licensing?

Can Know-how Be Protected by Licensing Contract?

248 Part 3 The Global Trade and Investment Environment

3. Industries in which intense cost pressures require that multinational firms maintain tight control over foreign operations (so that they can disperse manufacturing to locations around the globe where factor costs are most favorable in order to minimize costs).

Although empirical evidence is limited, the majority seems to support these conjectures.43 In addition, licensing is not a good option if the competitive advantage of a firm is based upon managerial or marketing knowledge that is embedded in the routines of the firm or the skills of its managers, and that is difficult to codify in a “book of blueprints.” This would seem to be the case for firms based in a fairly wide range of industries. Firms for which licensing is a good option tend to be in industries whose conditions are opposite to those just specified. That is, licensing tends to be more common, and more prof- itable, in fragmented, low-technology industries in which globally dispersed manufacturing is not an option. A good example is the fast-food industry. McDonald’s has expanded globally by using a franchising strategy. Franchising is essentially the service-industry version of licensing, although it normally involves much longer-term commitments than licensing. With franchising, the firm licenses its brand name to a foreign firm in return for a percentage of the franchisee’s profits. The franchising contract specifies the conditions that the franchisee must fulfill if it is to use the franchisor’s brand name. Thus, McDonald’s allows foreign firms to use its brand name so long as they agree to run their restaurants on exactly the same lines as McDonald’s restaurants elsewhere in the world. This strategy makes sense for McDonald’s because (1) like many services, fast food cannot be exported; (2) franchising economizes the costs and risks associated with opening up foreign markets; (3) unlike technological know-how, brand names are relatively easy to protect using a contract; (4) there is no compelling reason for McDonald’s to have tight control over franchisees; and (5) McDonald’s know-how, in terms of how to run a fast-food restaurant, is amenable to being specified in a written contract (e.g., the contract specifies the details of how to run a McDonald’s restaurant). Finally, it should be noted that the product life-cycle theory and Knickerbocker’s theory of FDI tend to be less useful from a business perspective. The problem with these two theories is that they are descriptive rather than analytical. They do a good job of describing the historical evolution of FDI, but they do a relatively poor job of identifying the factors that influence the relative profitability of FDI, licensing, and exporting. Indeed, the issue of licens- ing as an alternative to FDI is ignored by both these theories.

Government Policy A host government’s attitude toward FDI should be an important variable in decisions about where to locate foreign production facilities and where to make a foreign direct investment. Other things being equal, investing in countries that have permissive policies toward FDI is clearly preferable to investing in countries that restrict FDI. However, often the issue is not this straightforward. Despite the move toward a free market stance in recent years, many countries still have a rather pragmatic stance toward FDI. In such cases, a firm considering FDI must often negotiate the specific terms of the investment with the country’s government. Such negotiations center on two broad issues. If the host government is trying to attract FDI, the central issue is likely to be the kind of incentives the host government is prepared to offer to the MNE and what the firm will commit in exchange. If the host government is uncertain about the benefits of FDI and might choose to restrict access, the central issue is likely to be the concessions that the firm must make to be allowed to go forward with a proposed investment. To a large degree, the outcome of any negotiated agreement depends on the relative bargaining power of both parties. Each side’s bargaining power depends on three factors:

From the perspective of a firm negotiating the terms of an investment with a host govern- ment, the firm’s bargaining power is high when the host government places a high value on

Foreign Direct Investment Chapter 8 249

what the firm has to offer, the number of comparable alternatives open to the firm is greater, and the firm has a long time in which to complete the negotiations. The converse also holds. The firm’s bargaining power is low when the host government places a low value on what the firm has to offer, the number of comparable alternatives open to the firm is fewer, and the firm has a short time in which to complete the negotiations.44

flow of FDI, p. 226 stock of FDI, p. 226 outflows of FDI, p. 226 inflows of FDI, p. 226 greenfield investment, p. 230 eclectic paradigm, p. 230

exporting, p. 230 licensing, p. 231 internalization theory, p. 233 market imperfections, p. 233 oligopoly, p. 234 multipoint competition, p. 235

location-specific advantages, p. 235 externalities, p. 236 balance-of-payments accounts, p. 241 current account, p. 241 offshore production, p. 244

Key Terms

C H A P T E R S U M M A R Y

FDI to a noninterventionist, free market stance. Between the two extremes is an approach best described as pragmatic nationalism.

7. Benefits of FDI to a host country arise from resource-transfer effects, employment effects, and balance-of-payments effects.

8. The costs of FDI to a host country include adverse effects on competition and balance of payments and a perceived loss of national sovereignty.

9. The benefits of FDI to the home (source) country include improvement in the balance of payments as a result of the inward flow of foreign earnings, positive employment effects when the foreign subsidiary creates demand for home-country exports, and benefits from a reverse resource- transfer effect. A reverse resource-transfer effect arises when the foreign subsidiary learns valuable skills abroad that can be transferred back to the home country.

10. The costs of FDI to the home country include adverse balance-of-payments effects that arise from the initial capital outflow and from the export substitution effects of FDI. Costs also arise when FDI exports jobs abroad.

11. Home countries can adopt policies designed to both encourage and restrict FDI. Host countries try to attract FDI by offering incentives, and try to restrict FDI by dictating ownership restraints and requiring that foreign MNEs meet specific performance requirements.

This chapter reviewed theories that attempt to explain the pattern of FDI between countries and to examine the influence of governments on firms’ decisions to invest in foreign countries. The chapter made the following points:

1. Any theory seeking to explain FDI must explain why firms go to the trouble of acquiring or es- tablishing operations abroad when the alternatives of exporting and licensing are available to them.

2. High transportation costs or tariffs imposed on imports help explain why many firms prefer FDI or licensing over exporting.

3. Firms often prefer FDI to licensing when (a) a firm has valuable know-how that cannot be adequately protected by a licensing contract, (b) a firm needs tight control over a foreign entity in order to maximize its market share and earnings in that country, and (c) a firm’s skills and capabilities are not amenable to licensing.

4. Knickerbocker’s theory suggests that much FDI is explained by imitative behavior by rival firms in an oligopolistic industry.

5. Dunning has argued that location-specific advantages are of considerable importance in explaining the nature and direction of FDI. According to Dunning, firms undertake FDI to exploit resource endowments or assets that are location specific.

6. Political ideology is an important determinant of government policy toward FDI. Ideology ranges from a radical stance that is hostile to

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. In 2008, inward FDI accounted for some 63.7 percent of gross fixed capital formation in Ireland, but only 4.1 percent in Japan (gross fixed capital formation refers to investments in fixed assets such as factories, warehouses, and retail stores). What do you think explains this difference in FDI inflows into the two countries?

2. Compare and contrast these explanations of FDI: internalization theory and Knickerbocker’s theory of FDI. Which theory do you think offers the best explanation of the historical pattern of FDI? Why?

3. What are the strengths of the eclectic theory of FDI? Can you see any shortcomings? How does the eclectic theory influence management practice?

4. Read the Management Focus on Cemex, and then answer the following questions: a. Which theoretical explanation, or explana-

tions, of FDI best explains Cemex’s FDI?

b. What is the value that Cemex brings to a host economy? Can you see any potential drawbacks of inward investment by Cemex in an economy?

c. Cemex has a strong preference for acquisi- tions over greenfield ventures as an entry mode. Why?

5. You are the international manager of a U.S. busi- ness that has just developed a revolutionary new personal computer that can perform the same functions as existing PCs but costs only half as much to manufacture. Several patents protect the unique design of this computer. Your CEO has asked you to formulate a recommendation for how to expand into western Europe. Your options are (a) to export from the United States, (b) to li- cense a European firm to manufacture and market the computer in Europe, or (c) to set up a wholly owned subsidiary in Europe. Evaluate the pros and cons of each alternative, and suggest a course of action to your CEO.

r e s e a r c h t a s k g l o b a l E D G E . m s u . e d u

Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises:

1. The World Investment Report published annu- ally by UNCTAD provides a summary of recent trends in FDI as well as quick access to compre- hensive investment statistics. Identify the table of largest transnational corporations from devel- oping and transition countries. The ranking is based on the foreign assets each corporation owns. Based only at the top 20 companies, pro- vide a summary of the countries and industries represented. Do you notice any common traits from your analysis? Did any industries or coun- tries in the top 20 surprise you? Why?

2. An integral part of successful foreign direct investment is to understand the target market opportunities as well as the nature of the risk inherent in possible investment projects, partic- ularly in developing countries. You work for a company that builds wastewater and sanitation infrastructure in such countries. The Multilat- eral Investment Guarantee Agency (MIGA) provides insurance for risky projects in these markets. Identify the sector brief for the water and wastewater sector, and prepare a report to identify the major risks projects in this sector tend to face and how MIGA can assist in such projects.

For years the economy of Nigeria, Africa’s most populace nation, was held back by political instability, poor gov- ernment policies, a lack of infrastructure, and endemic corruption. This started to change in the 2000s. In halt- ing steps, Nigeria has moved toward a more stable

C L O S I N G C A S E

Foreign Direct Investment in Nigeria democratic form of government. In 2007, for the first time in the history of the country, following general elections there was a peaceful transfer of civilian power. Since then, the government has pursued market-orientated re- forms, including the removal of subsidies, privatization

250 Part 3 The Global Trade and Investment Environment

Foreign Direct Investment Chapter 8 251

of some state run businesses, lower trade barriers, and dereg- ulation. The government has tried to rid itself of corruption, albeit with decidedly mixed success. There has also been some attempt to improve the country’s poor transportation and power infrastructure. The reforms have had a positive impact. The GDP of Nigerian measured in constant 2005 U.S. dollars increased 2.75-fold from $67 billion in 2000 to $183 billion in 2013. When estimates of the “infor- mal” or “black economy” sector are taken into account, the GDP may have been 50 percent larger again in 2013. Since 2004, Nigeria has grown at 7 percent per annum compounded, faster than the West African aver- age. Powering this growth were high oil prices. Nigeria is a significant oil producer, and high oil prices have helped improve government finances, but the industrial and agri- cultural sectors of the economy are also growing. Foreign direct investment emerged as one of the major engines of growth. For years, foreign investors stayed away from Nigeria, scared off by political instability and high levels of corruption, but that too is starting to change. Encouraged by better economic management, and the promise of a large domestic market, inward foreign investment in Nigeria increased from $1.2 billion in 2000 to a peak of almost $9 billion in 2011 before slip- ping to $5.6 billion in 2013. This surge in investment made Nigeria the top destination for FDI in sub-Saharan Africa. Among recent investors has been General Electric, which announced in 2013 that it would put over $1 billion into Nigeria over the next five years. The investments include building a manufacturing plant to support the power generation and oil extraction indus- tries, and a service center for supporting GE equipment. GE believes that its investment will create 2,300 jobs. Foreign retailers will also probably make major in- vestments in distribution infrastructure such as cold stor- age facilities and warehouses. Currently, there is a chronic lack of cold storage facilities in India. Estimates suggest that about 25 to 30 percent of all fruits and veg- etables spoil before they reach the market due to inade- quate cold storage. Similarly, there is a lack of warehousing capacity. A lot of wheat, for example, is simply stored under tarpaulins, where it is at risk of rotting. Such prob- lems raise foods costs to consumers and impose signifi- cant losses on farmers. While the majority of investments are still targeted at Nigeria’s large energy sector, there are signs that this too is beginning to shift. A case in point is Procter &

Gamble, which in 2012 invested $250 million to construct a state of the art plant to manufacture disposable diapers in Nigeria. Explaining the investment, a P&G spokesperson noted that “Nigeria has a very strong, dy- namic and growing population of now over 167 million people with over 40 percent less than 15 years old. By 2050, Nigeria is projected to have the third largest population in the world. This represents a rapidly grow- ing number of consumers and a wonderful oppor tunity to serve.” The P&G spokesperson also indicated that the company would increase its investment if

the government was successful in further lowering import tariffs and consumption taxes, and resolved some of the infrastructure problems that were currently holding back the country. Sources: K. Aderinokun, “Nigeria: We Want to Make Nigeria the Hub of Procter and Gamble’s West African Operations,” All Africa, August 21, 2012; N. Mazen, “General Electric Plans $1 Billion Investment in Nige- Power,” Bloomberg, January 31, 2013; CIA, The World Factbook: Nigeria, updated January 7, 2014; Staff reporter, “Well below Par,” The Economist, November 29, 2014.

C a s e D i s c u s s i o n Q u e s t i o n s 1. What factors held back the flow of FDI into

Nigeria for most of the country’s history as an independent nation?

2. Why did foreign direct investment into Nigeria start to accelerate after the mid-2000s?

3. How do you think FDI might benefit the Nigerian economy? Is there any potential down- side to Nigeria from more FDI?

4. Nigeria is largely dependent on oil exports to drive its economy forward. Given the sharp fall in global oil prices that occurred in 2014, what impact do you think this will have on FDI into Nigeria?

5. Nigeria’s government is currently fighting a vicious insurgency mounted by Boko Haram in the country’s remote and sparsely populated northeast. Should this be of concern to potential foreign investors, most of who invest in the country’s populated southern regions?

6. Imagine that you work for a large consumer products company selling basic household goods. List the pros and cons of investing in Nigeria. Under what circumstances would you recommend investing?

Sharp is a Japanese multinational corporation that has engaged in foreign direct investment in Nigeria. The country of Nigeria has seen a slowdown in FDI in recent years. Source: © Colin C. Hill/Alamy

252 Part 3 The Global Trade and Investment Environment

E n d n o t e s

1. United Nations, World Investment Report, 2013; United Nations Conference on Trade and Investment, “Global Flows of Foreign Direct Investment Exceeding Pre-Crisis Levels in 2011,” Global Investment Trends Monitor, January 24, 2012.

2. World Trade Organization, International Trade Statistics, 2012 (Geneva: WTO, 2012); United Nations, World Investment Report, 2012.

3. United Nations, World Investment Report, 2013. 4. United Nations, World Investment Report, 2010 (New York and

Geneva: United Nations, 2010). 5. United Nations, World Investment Report, 2013; UN Conference

on Trade and Investment, “Global Flows of Foreign Direct Investment.”

6. United Nations, World Investment Report, 2013; UN Conference on Trade and Investment, “Global Flows of Foreign Direct Investment.”

7. United Nations, World Investment Report, 2013. 8. Ibid. 9. M. Caruso-Cabrera, “Chinese Investment in US May Break

Record in 2013,” CNBC, January 2, 2013. 10. United Nations, World Investment Report, 2012. 11. See D. J. Ravenscraft and F. M. Scherer, Mergers, Selloffs and

Economic Efficiency (Washington, DC: Brookings Institution, 1987); A. Seth, K. P. Song, and R. R. Pettit, “Value Creation and Destruction in Cross-Border Acquisitions,” Strategic Management Journal 23 (2002), pp. 921–40.

12. For example, see S. H. Hymer, The International Operations of National Firms: A Study of Direct Foreign Investment (Cambridge, MA: MIT Press, 1976); A. M. Rugman, Inside the Multinationals: The Economics of Internal Markets (New York: Columbia University Press, 1981); D. J. Teece, “Multinational Enterprise, Internal Governance, and Industrial Organization,” American Economic Review 75 (May 1983), pp. 233–38; C. W. L. Hill and W. C. Kim, “Searching for a Dynamic Theory of the Multinational Enterprise: A Transaction Cost Model,” Strategic Management Journal 9 (special issue, 1988), pp. 93–104; A. Verbeke, “The Evolutionary View of the MNE and the Future of Internalization Theory,” Journal of International Business Studies 34 (2003), pp. 498–501; J. H. Dunning, “Some Antecedents of Internalization Theory,” Journal of International Business Studies 34 (2003), pp. 108–28.

13. J. P. Womack, D. T. Jones, and D. Roos, The Machine That Changed the World (New York: Rawson Associates, 1990).

14. The argument is most often associated with F. T. Knickerbocker, Oligopolistic Reaction and Multinational Enterprise (Boston: Harvard Business School Press, 1973).

15. The studies are summarized in R. E. Caves, Multinational Enterprise and Economic Analysis, 2nd ed. (Cambridge, UK: Cambridge University Press, 1996).

16. See R. E. Caves, “Japanese Investment in the US: Lessons for the Economic Analysis of Foreign Investment,” The World Economy 16 (1993), pp. 279–300; B. Kogut and S. J. Chang, “Technological Capabilities and Japanese Direct Investment in the United States,” Review of Economics and Statistics 73 (1991), pp. 401–43; J. Anand and B. Kogut, “Technological Capabilities of Countries, Firm Rivalry, and Foreign Direct Investment,” Journal of International Business Studies, 1997, pp. 445–65.

17. K. Ito and E. L. Rose, “Foreign Direct Investment Location Strategies in the Tire Industry,” Journal of International Business Studies 33 (2002), pp. 593–602.

18. H. Haveman and L. Nonnemaker, “Competition in Multiple Geographical Markets,” Administrative Science Quarterly 45 (2000), pp. 232–67; L. Fuentelsaz and J. Gomez, “Multipoint Competition, Strategic Similarity and Entry into Geographic Markets,” Strategic Management Journal 27 (2006), pp. 447–57.

19. J. H. Dunning, Explaining International Production (London: Unwin Hyman, 1988).

20. P. Krugman. “Increasing Returns and Economic Geography,” Journal of Political Economy 99, no. 3 (1991), pp. 483–99.

21. J. M. Shaver and F. Flyer, “Agglomeration Economies, Firm Heterogeneity, and Foreign Direct Investment in the United States,” Strategic Management Journal 21 (2000), pp. 1175–93.

22. J. H. Dunning and R. Narula, “Transpacific Foreign Direct Investment and the Investment Development Path,” South Carolina Essays in International Business, May 1995.

23. W. Shan and J. Song, “Foreign Direct Investment and the Sourcing of Technological Advantage: Evidence from the Biotechnology Industry,” Journal of International Business Studies, 1997, pp. 267–84.

24. For some additional evidence, see L. E. Brouthers, K. D. Brouthers, and S. Warner, “Is Dunning’s Eclectic Framework Descriptive or Normative?,” Journal of International Business Studies 30 (1999), pp. 831–44.

25. For elaboration, see S. Hood and S. Young, The Economics of the Multinational Enterprise (London: Longman, 1979); P. M. Sweezy and H. Magdoff, “The Dynamics of U.S. Capitalism,” Monthly Review Press, 1972.

26. For an example of this policy as practiced in China, see L. G. Branstetter and R. C. Freenstra, “Trade and Foreign Direct Investment in China: A Political Economy Approach,” Journal of International Economics 58 (December 2002), pp. 335–58.

27. M. Itoh and K. Kiyono, “Foreign Trade and Direct Investment,” in Industrial Policy of Japan, ed. R. Komiya, M. Okuno, and K. Suzumura (Tokyo: Academic Press, 1988).

28. X. J. Zhan and T. Ozawa, Business Restructuring in Asia: Cross Border M&As in Crisis Affected Countries (Copenhagen: Copenhagen Business School, 2000); I. Costa, S. Robles, and

Foreign Direct Investment Chapter 8 253

R. de Queiroz, “Foreign Direct Investment and Technological Capabilities,” Research Policy 31 (2002), pp. 1431–43; B. Potterie and F. Lichtenberg, “Does Foreign Direct Investment Transfer Technology across Borders?,” Review of Economics and Sta- tistics 83 (2001), pp. 490–97; K. Saggi, “Trade, Foreign Direct Investment and International Technology Transfer,” World Bank Research Observer 17 (2002), pp. 191–235.

29. K. M. Moden, “Foreign Acquisitions of Swedish Companies: Effects on R&D and Productivity,” Research Institute of International Economics, 1998, mimeo.

30. “Foreign Friends,” The Economist, January 8, 2000, pp. 71–72. 31. A. Jack, “French Go into Overdrive to Win Investors,” Financial

Times, December 10, 1997, p. 6. 32. “Foreign Friends.” 33. United Nations, World Investment Report, 2014 (New York and

Geneva: United Nations, 2002). 34. R. Ram and K. H. Zang, “Foreign Direct Investment and

Economic Growth,” Economic Development and Cultural Change 51 (2002), pp. 205–25.

35. United Nations, World Investment Report, 2014. 36. United Nations, World Investment Report, 2000 (New York and

Geneva: United Nations, 2000). 37. R. B. Reich, The Work of Nations: Preparing Ourselves for the

21st Century (New York: Knopf, 1991).

38. This idea has been articulated, although not quite in this form, by C. A. Bartlett and S. Ghoshal, Managing across Borders: The Transnational Solution (Boston: Harvard Business School Press, 1989).

39. P. Magnusson, “The Mexico Pact: Worth the Price?,” Business- Week, May 27, 1991, pp. 32–35.

40. C. Johnston, “Political Risk Insurance,” in Assessing Corporate Political Risk, ed. D. M. Raddock (Totowa, NJ: Rowman & Littlefield, 1986).

41. M. Tolchin and S. Tolchin, Buying into America: How Foreign Money Is Changing the Face of Our Nation (New York: Times Books, 1988).

42. L. D. Qiu and Z. Tao, “Export, Foreign Direct Investment and Local Content Requirements,” Journal of Development Economics 66 (October 2001), pp. 101–25.

43. See R. E. Caves, Multinational Enterprise and Economic Analysis (Cambridge, UK: Cambridge University Press, 1982).

44. For a good general introduction to negotiation strategy, see M. H. Bazerman and M. A. Neale, Negotiating Rationally (New York: Free Press, 1992); A. Dixit and B. Nalebuff, Thinking Strategically: The Competitive Edge in Business, Politics, and Everyday Life (New York: Norton, 1991); H. Raiffa, The Art and Science of Negotiation (Cambridge, MA: Harvard University Press, 1982).

Credit: ©Federal Reserve Board.

Regional Economic Integration L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO9 -1 Describe the different levels of regional economic integration.

LO9 -2 Understand the economic and political arguments for regional economic integration.

LO9 -3 Understand the economic and political arguments against regional economic integration.

LO9 - 4 Explain the history, current scope, and future prospects of the world’s most important regional economic agreements.

LO9 -5 Understand the implications for business that are inherent in regional economic integration agreements.

part three The Global Trade and Investment Environment

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255

Regional Trade Pacts Give the Mexican Auto Industry an Edge

they have helped transform Mexico into the fourth-largest auto exporter in the world. Eighty percent of the cars now produced in Mexico are exported to other countries, two- thirds of them to the United States. This unprecedented network of regional trade agreements has given Mexico an important edge when it comes to attracting new invest- ment. For example, when BMW ships cars to Europe from its 20-year-old plant in South Carolina it is hit with a 10 percent import duty. For a $50,000 car, that amounts to $5,000, which is a much bigger factor than differences in labor costs. A factory in Mexico can supply both the U.S. and the EU markets with duty-free automobiles. This was a major factor behind BMW’s 2014 decision to build a new factory in central Mexico rather than the United States, far outweigh- ing the $500 a car labor cost advantage that Mexico cur- rently enjoys over the United States. The new BMW factory will supply the U.S. and EU markets, as well as Latin America. Indeed, because of differences in trade barriers, a car exported from the United States to Brazil costs 55 percent more than one exported from Mexico. As Mexico’s auto industry has grown, auto-part suppliers have also followed manu- facturers to Mexico. The large auto parts supplier Delphi, for example, has 30 factories in Mexico and generates rev- enues of $3 billion in the country. Employment at Delphi’s facilities doubled to 24,000 between 2007 and 2014. Infra- structure has also improved dramatically, and customs clearance at the border is now quick and efficient, which has made managing the supply chain much easier. All of this bodes well for the future of the Mexican auto industry. However, not everyone is happy with what has happened. Some argue that growth in Mexico has come at the expense of factories in the United States, which has had negative impact on employment growth in the U.S. auto industry. When BMW decided to build a factory in central Mexico, for example, it meant that it would not be expanding its  South Carolina plant. The South Carolina plant will continue to operate, and no plants have been closed as a result of the growth of production in Mexico, but it is true that new plants are increasingly being located south of the border.

Sources: Joann Muller, “America’s Car Capital Will Soon Be . . . Mexico,” Forbes, July 20, 2014; Dudley Althaus and William Boston, “Trade Pacts Give Mexico an Edge,” The Wall Street Journal, March 18, 2015; Sonari Glinton, “How NAFTA Drove the Auto Industry South,” NPR, December 8, 2013; Serena Maria Daniels, “Twenty Years after NAFTA, a Mini Detroit Rises in Mexico,” Bridge, September 25, 2014.

O P E N I N G C A S E Mexico’s automobile industry is booming. Bolstered by $19 billion in new investment from foreign carmakers, including Nissan, Honda, Volkswagen, and Mazda, vehicle production doubled between 2009 and 2014 to an esti- mated 3.2 million vehicles. This investment surge has transformed Mexico into the eighth-largest automaker in the world, and it’s not over yet. In 2014 and early 2015 Toyota, Mercedes-Benz, Hyundai-Kia, BMW, and Volkswagen all outlined plans to build new state-of-the-art factories in Mexico. Audi is also constructing a $1.3 billion factory that is slated for producing luxury sport-utility vehicles (SUVs). The Audi factory is scheduled to open in 2016. Taken together, these new factories represent another $20 billion in investment that will push Mexico past Brazil and South Korea to become the sixth-largest car producer in the world by 2020 with an annual output of 4.7 million vehicles (for comparison, the U.S. industry makes some 11.5 million autos a year). The initial stimulus for the dramatic growth of the Mexican auto industry was the establishment of the North American Free Trade Agreement (NAFTA) in 1994. Prior to NAFTA, Mexico’s auto industry was small and protected from foreign competition by high tariff barriers. Car prices in Mexico were two to three times higher than in the United States. Not only were cars in Mexico more expensive, exporting or importing cars and parts was also very tough. Shipments got delayed at the border and were difficult to move around because of poor infrastructure, which is a major problem in an industry where tight logistics is critical. NAFTA removed most tariff and nontariff barriers to trade between Mexico, the United States, and Canada. This initially led to a flood of low-priced auto imports into Mexico from the United States, but it also gave auto manufacturers based in Mexico duty-free access to the large U.S. market next door. With labor costs in Mexico just a fraction of those in the United States, auto manufacturers now had to consider Mexico when planning new plants to serve the North American market. Mexico’s shift to free trade didn’t stop with NAFTA. Mexico spent much of the 2000s hammering out free trade deals with over 40 other countries, including the 28 states of the European Union, Japan, and Brazil. These deals give auto factories based in Mexico duty-free access to markets that contain 60 percent of the world’s economic output, and

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Introduction

The past two decades have witnessed a proliferation of regional trade blocs that promote regional economic integration, agreements among countries in a geographic region to reduce and ultimately remove tariff and nontariff barriers to the free flow of goods, services, and factors or production between each other. World Trade Organization (WTO) members are required to notify the WTO of any regional trade agreements in which they participate. By 2014, nearly all members had notified the WTO of participa- tion in one or more agreements. The total number currently in force is more than 500.1 Consistent with the predictions of international trade theory and particularly the theory of comparative advantage (see Chapter 6), agreements designed to promote freer trade within regions are believed to produce gains from trade for all member countries. The General Agreement on Tariffs and Trade (GATT) and its successor, the World Trade Organization, also seek to reduce trade barriers. However, the WTO has a global perspec- tive and 160 members, which can make reaching an agreement extremely difficult. By entering into regional agreements, groups of countries aim to reduce trade barriers more rapidly than can be achieved under the auspices of the WTO. This has become an increas- ingly important policy approach in recent years given the failure of the WTO to make any progress with its latest round of trade talks, the Doha Round, initiated in 2001 but currently in limbo (see Chapter 7). Given the failure of the Doha Round, national govern- ments have felt that they can better advance their trade agenda through multilateral agreements than through the WTO. Nowhere has the movement toward regional economic integration been more successful than in Europe. On January 1, 1993, the European Union formally removed many barri- ers to doing business across borders within the EU in an attempt to create a single market with 340 million consumers. Today, the EU has a population of more than 500 million and a gross domestic product of more than $18.5 trillion, making it slightly larger than the United States in economic terms. Similar moves toward regional integration are being pursued elsewhere in the world. Canada, Mexico, and the United States have implemented NAFTA. Ultimately, this aims to remove all barriers to the free flow of goods and services among the three countries. While the implementation of NAFTA has resulted in job losses in some sectors of the U.S. economy, in aggregate and consistent with the predictions of international trade theory, most economists argue that the benefits of greater regional trade outweigh any costs (see the opening case). South America too has moved toward regional integration. In 1991, Argentina, Brazil, Paraguay, and Uruguay implemented an agreement known as Mercosur to start reducing barriers to trade between each other, and although progress within Mercosur has been halting, the institution is still in place. There are also active attempts at regional economic integration in Central America, the Andean region of South America, Southeast Asia, and parts of Africa. While the move toward regional economic integration is generally seen as a good thing, some worry that it will lead to a world in which regional trade blocs compete against each other. In this future scenario, free trade will exist within each bloc, but each bloc will protect its market from outside competition with high tariffs. The specter of the EU and NAFTA turning into economic fortresses that shut out foreign producers through high tariff barriers is worrisome to those who believe in unrestricted free trade. If such a situation were to materialize, the resulting decline in trade between blocs could more than offset the gains from free trade within blocs. With these issues in mind, this chapter explores the economic and political debate surrounding regional economic integration, paying particular attention to the eco- nomic and political benefits and costs of integration; reviews progress toward regional economic integration around the world; and maps the important implications of re- gional economic integration for the practice of international business. Before tackling these objectives, we first need to examine the levels of integration that are theoreti- cally possible.

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Levels of Economic Integration

Several levels of economic integration are possible in theory (see Figure 9.1). From least integrated to most integrated, they are a free trade area, a customs union, a common market, an economic union, and, finally, a full political union. In a free trade area, all barriers to the trade of goods and services among member countries are removed. In the theoretically ideal free trade area, no discriminatory tariffs, quotas, subsidies, or administrative impediments are allowed to distort trade between

LO 9 -1 Describe the different levels of regional economic integration.

REGIONAL TRADE AGREEMENTS

Regional economic integration is the focus of Chapter 9, and the value-added portion of globalEDGE that captures the ongoing development of major trade agreements worldwide is called “Regional Trade Agreements” (globaledge.msu.edu/global-resources/regional- trade-agreements). In this section of globalEDGE, the most critical agreements of the some 300 that exist today are included, with direct access to the home pages for each agreement. The landing page for “Regional Trade Agreements” also includes globalEDGE’s own “Trade Bloc Insights,” which takes the user to a wealth of information and data (e.g., overview of each agreement, its history, countries included in the membership, related agreements, online resources, statistics, and an executive summary of what the agreement entails). In Chapter 9, we cover several of the trade agreements to provide an overview of the global marketplace. But, which agreements are not covered in detail in the book and which ones are covered on globalEDGE? (Hint: African trade agreements.) What do you know about, for example, ECOWAS and SADC? How many members are in ECOWAS and SADC, respectively, and are any of them overlapping? When were the treaties (trade agreements) of ECOWAS and SADC started?

Customs Union

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258 Part 3 The Global Trade and Investment Environment

members. Each country, however, is allowed to determine its own trade policies with regard to nonmembers. Thus, for example, the tariffs placed on the products of non- member countries may vary from member to member. Free trade agreements are the most popular form of regional economic integration, accounting for almost 90 percent of regional agreements.2 The most enduring free trade area in the world is the European Free Trade Association (EFTA). Established in January 1960, the EFTA currently joins four countries—Norway, Iceland, Liechtenstein, and Switzerland—down from seven in 1995 (three EFTA mem- bers, Austria, Finland, and Sweden, joined the EU on January 1, 1996). The EFTA was founded by those western European countries that initially decided not to be part of the European Community (the forerunner of the EU). Its original members included Austria, Great Britain, Denmark, Finland, and Sweden, all of which are now members of the EU. The emphasis of the EFTA has been on free trade in industrial goods. Agriculture was left out of the arrangement, each member being allowed to determine its own level of sup- port. Members are also free to determine the level of protection applied to goods coming from outside the EFTA. Other free trade areas include the North American Free Trade Agreement, which we discuss in depth later in the chapter. The customs union is one step farther along the road to full economic and political integration. A customs union eliminates trade barriers between member countries and adopts a common external trade policy. Establishment of a common external trade policy necessitates significant administrative machinery to oversee trade relations with non- members. Most countries that enter into a customs union desire even greater economic integration down the road. The EU began as a customs union, but it has now moved beyond this stage. Other customs unions include the current version of the Andean Community (formerly known as the Andean Pact) among Bolivia, Colombia, Ecuador, and Peru. The Andean Community established free trade between member countries and imposes a common tariff, of 5 to 20 percent, on products imported from outside.3 The next level of economic integration, a common market, has no barriers to trade among member countries, includes a common external trade policy, and allows factors of production to move freely among members. Labor and capital are free to move because there are no restrictions on immigration, emigration, or cross-border flows of capital among member countries. Establishing a common market demands a significant degree of harmony and cooperation on fiscal, monetary, and employment policies. Achieving this degree of cooperation has proved very difficult. For years, the European Union func- tioned as a common market, although it has now moved beyond this stage. Mercosur—the South American grouping of Argentina, Brazil, Paraguay, and Uruguay—hopes to eventu- ally establish itself as a common market. Venezuela was accepted as a full member of Mercosur subject to ratification by the governments of the four existing members. As of early 2015, Paraguay has yet to ratify Venezuela’s membership. An economic union entails even closer economic integration and cooperation than a common market. Like the common market, an economic union involves the free flow of products and factors of production among member countries and the adoption of a com- mon external trade policy, but it also requires a common currency, harmonization of members’ tax rates, and a common monetary and fiscal policy. Such a high degree of integration demands a coordinating bureaucracy and the sacrifice of significant amounts of national sovereignty to that bureaucracy. The EU is an economic union, although an imperfect one because not all members of the EU have adopted the euro, the currency of the EU; differences in tax rates and regulations across countries still remain; and some markets, such as the market for energy, are still not fully deregulated. The move toward economic union raises the issue of how to make a coordinating bu- reaucracy accountable to the citizens of member nations. The answer is through political union in which a central political apparatus coordinates the economic, social, and foreign policy of the member states. The EU is on the road toward at least partial political union. The European Parliament, which is playing an ever more important role in the EU, has been directly elected by citizens of the EU countries since the late 1970s. In addition, the

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Regional Economic Integration Chapter 9 259

Council of Ministers (the controlling, decision-making body of the EU) is composed of government ministers from each EU member. The United States provides an example of even closer political union; in the United States, independent states are effectively com- bined into a single nation. Ultimately, the EU may move toward a similar federal structure.

The Case for Regional Integration

The case for regional integration is both economic and political, and it is typically not accepted by many groups within a country, which explains why most attempts to achieve regional economic integration have been contentious and halting. In this section, we exam- ine the economic and political cases for integration and two impediments to integration. In the next section, we look at the case against integration.

THE ECONOMIC CASE FOR INTEGRATION

The economic case for regional integration is straightforward. We saw in Chapter 6 how economic theories of international trade predict that unrestricted free trade will allow countries to specialize in the production of goods and services that they can produce most efficiently. The result is greater world production than would be possible with trade restrictions. That chapter also revealed how opening a country to free trade stimulates economic growth, which creates dynamic gains from trade. Chapter 8 detailed how foreign direct investment (FDI) can transfer technological, marketing, and managerial know-how to host nations. Given the central role of knowledge in stimulating economic growth, opening a country to FDI also is likely to stimulate economic growth. In sum, economic theories suggest that free trade and investment is a positive-sum game, in which all partici- pating countries stand to gain. Given this, the theoretical ideal is an absence of barriers to the free flow of goods, services, and factors of production among nations. However, as we saw in Chapters 7 and 8, a case can be made for government intervention in international trade and FDI. Because many governments have accepted part or all of the case for intervention, unrestricted free trade and FDI have proved to be only an ideal. Although international institutions such as the WTO have been moving the world toward a free trade regime, success has been less than total. In a world of many nations and many political ideologies, it is very difficult to get all countries to agree to a common set of rules. Against this background, regional economic integration can be seen as an attempt to achieve additional gains from the free flow of trade and investment between countries beyond those attainable under global agreements such as the WTO. It is easier to establish a free trade and investment regime among a limited number of adjacent countries than among the world community. Coordination and policy harmonization problems are largely a function of the number of countries that seek agreement. The greater the number of countries involved, the more perspectives that must be reconciled, and the harder it will be to reach agreement. Thus, attempts at regional economic integration are motivated by a desire to exploit the gains from free trade and investment.

THE POLITICAL CASE FOR INTEGRATION

The political case for regional economic integration also has loomed large in several at- tempts to establish free trade areas, customs unions, and the like. Linking neighboring economies and making them increasingly dependent on each other creates incentives for political cooperation between the neighboring states and reduces the potential for violent conflict. In addition, by grouping their economies, the countries can enhance their politi- cal weight in the world. These considerations underlay the 1957 establishment of the European Community (EC), the forerunner of the EU. Europe had suffered two devastating wars in the first half of the twentieth century, both arising out of the unbridled ambitions of nation-states.

LO 9 -2 Understand the economic and political arguments for regional economic integration.

260 Part 3 The Global Trade and Investment Environment

Those who have sought a united Europe have always had a desire to make another war in Europe unthinkable. Many Europeans also believed that after World War II, the European nation-states were no longer large enough to hold their own in world markets and politics. The need for a united Europe to deal with the United States and the politically alien Soviet Union loomed large in the minds of many of the EC’s founders.4 A long-standing joke in Europe is that the European Commission should erect a statue to Joseph Stalin, for without the aggressive policies of the former dictator of the old Soviet Union, the countries of western Europe may have lacked the incentive to cooperate and form the EC.

IMPEDIMENTS TO INTEGRATION

Despite the strong economic and political arguments in support, integration has never been easy to achieve or sustain for two main reasons. First, although economic integration aids the majority, it has its costs. While a nation as a whole may benefit significantly from a regional free trade agreement, certain groups may lose. Moving to a free trade regime involves painful adjustments. Due to the establishment of NAFTA, some Canadian and U.S. workers in such industries as textiles, which employ low-cost, low-skilled labor, lost their jobs as Canadian and U.S. firms moved production to Mexico. The promise of signifi- cant net benefits to the Canadian and U.S. economies as a whole is little comfort to those who lose as a result of NAFTA. Such groups have been at the forefront of opposition to NAFTA and will continue to oppose any widening of the agreement. A second impediment to integration arises from concerns over national sovereignty. For example, Mexico’s concerns about maintaining control of its oil interests resulted in an agreement with Canada and the United States to exempt the Mexican oil industry from any liberalization of foreign investment regulations achieved under NAFTA. Concerns about national sovereignty arise because close economic integration demands that coun- tries give up some degree of control over such key issues as monetary policy, fiscal policy (e.g., tax policy), and trade policy. This has been a major stumbling block in the EU. To achieve full economic union, the EU introduced a common currency, the euro, controlled by a central EU bank. Although most member states have signed on, Great Britain remains an important holdout. A politically important segment of public opinion in that country opposes a common currency on the grounds that it would require relinquishing control of the country’s monetary policy to the EU, which many British perceive as a bureaucracy run by foreigners. In 1992, the British won the right to opt out of any single currency agreement, and as of 2015, the British government has yet to reverse its decision—and it does not seem likely to do so, given the sovereign debt crisis in Europe and the strains it has placed on the euro (more on this later).

The Case against Regional Integration

Although the tide has been running in favor of regional free trade agreements in recent years, some economists have expressed concern that the benefits of regional integration have been oversold, while the costs have often been ignored.5 They 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 re- placed by low-cost producers within the free trade area. It may also occur when higher- cost external producers are replaced by lower-cost external 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. A regional free trade agreement will benefit the world only if the amount of trade it creates exceeds the amount it diverts. Suppose the United States and Mexico imposed tariffs on imports from all countries, and then they set up a free trade area, scrapping all trade barriers between themselves but maintaining tariffs on imports from the rest of the world. If the United States began to import textiles from Mexico, would this change be for the better? If the United States previously produced all its own textiles at a higher cost than Mexico, then the free trade

LO 9 -3 Understand the economic and political arguments against regional economic integration.

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Regional Economic Integration Chapter 9 261

agreement has shifted production to the cheaper source. According to the theory of compara- tive advantage, trade has been created within the regional grouping, and there would be no decrease in trade with the rest of the world. Clearly, the change would be for the better. If, however, the United States previously imported textiles from Costa Rica, which pro- duced them more cheaply than either Mexico or the United States, then trade has been diverted from a low-cost source—a change for the worse. In theory, WTO rules should ensure that a free trade agreement does not result in trade diversion. These rules allow free trade areas to be formed only if the members set tariffs that are not higher or more restrictive to outsiders than the ones previously in effect. However, as we saw in Chapter 7, GATT and the WTO do not cover some nontariff barriers. As a result, regional trade blocs could emerge whose markets are protected from outside competition by high nontariff barriers. In such cases, the trade diversion effects might outweigh the trade creation effects. The only way to guard against this possibility, according to those concerned about this potential, is to increase the scope of the WTO so it covers nontariff barriers to trade. There is no sign that this is going to occur any- time soon, however, so the risk remains that regional economic integration will result in trade diversion.

Regional Economic Integration in Europe

Europe has two trade blocs—the European Union and the European Free Trade Association. Of the two, the EU is by far the more significant, not just in terms of membership (the EU currently has 28 members; the EFTA has 4), but also in terms of economic and political influence in the world economy. Many now see the EU as an emerging economic and political superpower of the same order as the United States. Accordingly, we will concentrate our attention on the EU.6

EVOLUTION OF THE EUROPEAN UNION

The European Union (EU) is the product of two political factors: (1) the devastation of western Europe during two world wars and the desire for a lasting peace, and (2) the European nations’ desire to hold their own on the world’s political and economic stage. In addition, many Europeans were aware of the potential economic benefits of closer economic integration of the countries. The forerunner of the EU, the European Coal and Steel Community, was formed in 1951 by Belgium, France, West Germany, Italy, Luxembourg, and the Netherlands. Its objective was to remove barriers to intragroup shipments of coal, iron, steel, and scrap metal. With the signing of the Treaty of Rome in 1957, the European Community was established. The name changed again in 1993 when the European Community became the European Union following the ratification of the Maastricht Treaty (discussed later). The Treaty of Rome provided for the creation of a common market. Article 3 of the treaty laid down the key objectives of the new community, calling for the elimination of internal trade barriers and the creation of a common external tariff and requiring member states to abolish obstacles to the free movement of factors of production among the members. To fa- cilitate the free movement of goods, services, and factors of production, the treaty provided for any necessary harmonization of the member states’ laws. Furthermore, the treaty com- mitted the EC to establish common policies in agriculture and transportation. The community grew in 1973, when Great Britain, Ireland, and Denmark joined. These three were followed in 1981 by Greece; in 1986 by Spain and Portugal; and in 1995 by Austria, Finland, and Sweden—bringing the total membership to 15 (East Germany became part of the EC after the reunification of Germany in 1990). Another 10 countries joined the EU on May 1, 2004—8 of them from eastern Europe plus the small Mediter- ranean nations of Malta and Cyprus. Bulgaria and Romania joined in 2007 and Croatia in 2013, bringing the total number of member states to 28 (see Map 9.1). Through these enlargements, the EU has become a global superpower.

LO 9 - 4 Explain the history, current scope, and future prospects of the world’s most important regional economic agreements.

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262 Part 3 The Global Trade and Investment Environment

POLITICAL STRUCTURE OF THE EUROPEAN UNION

The economic policies of the EU are formulated and implemented by a complex and still-evolving political structure. The four main institutions in this structure are the European Commission, the Council of the European Union, the European Parliament, and the Court of Justice.7 The European Commission is responsible for proposing EU legislation, implementing it, and monitoring compliance with EU laws by member states. Headquartered in Brussels, Belgium, it is run by a group of commissioners appointed by each member country for five-year renewable terms. There are 28 commissioners, one from each member state. A president of the commission is chosen by member states, and the president then chooses other members in consultation with the states. The entire commission has to be approved by the European Parliament before it can begin work. The commission has a monopoly in proposing European Union legislation. The commission makes a proposal, which goes to the Council of the European Union and then to the European Parliament. The council cannot legislate without a commission proposal in front of it. The commission is also re- sponsible for implementing aspects of EU law, although in practice much of this must be

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Member states of the European Union in 2013. Source: Copyright © European Union, 1995–2013.

263 Part 3 Part Title

M A NAG E M E N T F O C U S

The European Commission and Intel In May 2009, the European Commission announced that it had imposed a record €1.06 billion ($1.45 billion) fine on Intel for anticompetitive behavior. This fine was the result of an investigation into Intel’s competitive conduct during the period from October 2002 to December 2007. During this time period, Intel’s market share of microprocessor sales to personal computer manufacturers consistently exceeded 70 percent. According to the commission, Intel illegally used its market power to ensure that its major rival, AMD, was at a competitive disadvantage, thereby harming “millions of European consumers.” The commission charged that Intel granted major rebates to PC manufacturers—including Acer, Dell, Hewlett- Packard, Lenovo, and NEC—on the condition that they purchased all or almost all their supplies from Intel. Intel also made payments to some manufacturers in exchange for them postponing, canceling, or putting restrictions on the introduction or distribution of AMD-based products. Intel also apparently made payments to Media Saturn Holdings, the owner of Media Markt chain of superstores,

for only selling Intel-based computers in Germany, Belgium, and other countries. Under the order, Intel had to change its practices imme- diately, pending any appeal. The company was also required to write a bank guarantee for the fine, although that guaran- tee is held in a bank until the appeal process is exhausted. For its part, Intel immediately appealed the ruling. The company insisted that it had never coerced computer makers and retailers with inducements and maintained that Intel had never paid to stop AMD products from reaching the market in Europe. Although Intel acknowledges that it did offer rebates, it claimed that they were never conditional on specific actions by manufacturers and retailers aimed to limit AMD. In June 2014, an EU court rejected Intel’s appeal and upheld the judgment against the company. 

Sources: M. Hachman, “EU Hits Intel with $1.45 Billion Fine for Anti- trust Violations,” PCMAG.com, May 13, 2009; J. Kanter, “Europe Fines Intel $1.45 billion in Antitrust Case,” The New York Times, May 14, 2009; T. Fairless, “EU Court Upholds Record Fine against Intel,” The Wall Street Journal, June 12, 2014.

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delegated to member states. Another responsibility of the commission is to monitor member states to make sure they are complying with EU laws. In this policing role, the commission will normally ask a state to comply with any EU laws that are being broken. If this persua- sion is not sufficient, the commission can refer a case to the Court of Justice. The European Commission’s role in competition policy has become increasingly impor- tant to business in recent years. Since 1990 when the office was formally assigned a role in competition policy, the EU’s competition commissioner has been steadily gaining influ- ence as the chief regulator of competition policy in the member nations of the EU. As with antitrust authorities in the United States, which include the Federal Trade Commission and the Department of Justice, the role of the competition commissioner is to ensure that no one enterprise uses its market power to drive out competitors and monopolize markets. In 2009, for example, the commission fined Intel a record €1.06 billion for abusing its market power in the computer chip market. (See the Management Focus for details.) The previous record for a similar abuse was €497 billion imposed on Microsoft in 2004 for blocking competition in markets for server computers and media software. The commis- sioner also reviews proposed mergers and acquisitions to make sure they do not create a dominant enterprise with substantial market power.8 For example, in 2000 a proposed merger between Time Warner of the United States and EMI of the United Kingdom, both music recording companies, was withdrawn after the commission expressed concerns that the merger would reduce the number of major record companies from five to four and create a dominant player in the $40 billion global music industry. Similarly, the com- mission blocked a proposed merger between two U.S. telecommunication companies, WorldCom and Sprint, because their combined holdings of Internet infrastructure in Europe would give the merged companies so much market power that the commission argued the combined company would dominate that market.

264 Part 3 The Global Trade and Investment Environment

The European Council represents the interests of member states. It is clearly the ulti- mate controlling authority within the EU because draft legislation from the commission can become EU law only if the council agrees. The council is composed of one represen- tative from the government of each member state. The membership, however, varies depending on the topic being discussed. When agricultural issues are being discussed, the agriculture ministers from each state attend council meetings; when transportation is being discussed, transportation ministers attend; and so on. Before 1987, all council issues had to be decided by unanimous agreement among member states. This often led to marathon council sessions and a failure to make progress or reach agreement on commission pro- posals. In an attempt to clear the resulting logjams, the Single European Act formalized the use of majority voting rules on issues that “have as their object the establishment and functioning of a single market.” Most other issues, however, such as tax regulations and immigration policy, still require unanimity among council members if they are to become law. The votes that a country gets in the council are related to the size of the country. For example, Britain, a large country, has 29 votes, whereas Denmark, a much smaller state, has 7 votes. As of 2015, the European Parliament has 754 members and is directly elected by the populations of the member states. The parliament, which meets in Strasbourg, France, is primarily a consultative rather than legislative body. It debates legislation proposed by the commission and forwarded to it by the council. It can propose amendments to that legislation, which the commission and ultimately the council are not obliged to take up but often will. The power of the parliament recently has been increasing, although not by as much as parliamentarians would like. The European Parliament now has the right to vote on the appointment of commissioners as well as veto some laws (such as the EU budget and single-market legislation). One major debate waged in Europe during the past few years is whether the council or the parliament should ultimately be the most powerful body in the EU. Some in Europe expressed concern over the democratic accountability of the EU bureaucracy. One side argued that the answer to this apparent democratic deficit lay in increasing the power of the parliament, while others think that true democratic legitimacy lies with elected governments, acting through the Council of the European Union.9 After significant debate, in December 2007 the member states signed a new treaty, the Treaty of Lisbon, under which the power of the European Parliament was increased. When it took effect in December 2009, for the first time in history the European Parliament was the co-equal legislator for almost all European laws.10 The Treaty of Lisbon also created a new position, a president of the European Council, who serves a 30-month term and represents the nation-states that make up the EU. The Court of Justice, which is comprised of one judge from each country, is the supreme appeals court for EU law. Like commissioners, the judges are required to act as independent officials, rather than as representatives of national interests. The commission or a member country can bring other members to the court for failing to meet treaty obligations. Similarly, member countries, member companies, or member institutions can bring the commission or council to the court for failure to act according to an EU treaty.

THE SINGLE EUROPEAN ACT

The Single European Act was born of a frustration among members that the community was not living up to its promise. By the early 1980s, it was clear that the EC had fallen short of its objectives to remove barriers to the free flow of trade and investment among member countries and to harmonize the wide range of technical and legal standards for doing business. Against this background, many of the EC’s prominent businesspeople mounted an energetic campaign in the early 1980s to end the EC’s economic divisions. The EC responded by creating the Delors Commission. Under the chairperson Jacques Delors, the commission proposed that all impediments to the formation of a single market be eliminated by December 31, 1992. The result was the Single European Act, which became EC law in 1987.

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The Objectives of the Act The purpose of the Single European Act was to have one market in place by December 31, 1992. The act proposed the following changes:11

∙ Remove all frontier controls among EC countries, thereby abolishing delays and reducing the resources required for complying with trade bureaucracy.

∙ Apply the principle of “mutual recognition” to product standards. A standard developed in one EC country should be accepted in another, provided it met basic requirements in such matters as health and safety.

∙ Institute open public procurement to nonnational suppliers, reducing costs directly by allowing lower-cost suppliers into national economies and indirectly by forcing national suppliers to compete.

∙ Lift barriers to competition in the retail banking and insurance businesses, which should drive down the costs of financial services, including borrowing, throughout the EC.

∙ Remove all restrictions on foreign exchange transactions between member countries by the end of 1992.

∙ Abolish restrictions on cabotage—the right of foreign truckers to pick up and deliver goods within another member state’s borders—by the end of 1992. Estimates suggested this would reduce the cost of haulage within the EC by 10 to 15 percent.

All those changes were expected to lower the costs of doing business in the EC, but the single-market program was also expected to have more complicated supply-side effects. For example, the expanded market was predicted to give EC firms greater opportunities to exploit economies of scale. In addition, it was thought that the increase in competitive intensity brought about by removing internal barriers to trade and investment would force EC firms to become more efficient. To signify the importance of the Single European Act, the European Community also decided to change its name to the European Union once the act took effect.

Impact The Single European Act has had a significant impact on the EU economy.12 The act pro- vided the impetus for the restructuring of substantial sections of European industry. Many firms have shifted from national to pan-European production and distribution systems in an attempt to realize scale economies and better compete in a single market. The results have included faster economic growth than would otherwise have been the case. However, more than 20 years after the formation of a single market, the reality still falls short of the ideal. An example is given in the accompanying Country Focus, which describes the slow progress toward establishing a fully functioning single market for fi- nancial services in the EU. Thus, although the EU is undoubtedly moving toward a single marketplace, established legal, cultural, and language differences among nations mean that implementation has been uneven.

THE ESTABLISHMENT OF THE EURO

In February 1992, EC members signed the Maastricht Treaty, which committed them to adopting a common currency by January 1, 1999.13 The euro is now used by 19 of the 28 member states of the European Union; these 19 states are members of what is often referred to as the euro zone. It encompasses 330 million EU citizens and includes the powerful economies of Germany and France. Many of the countries that joined the EU on May 1, 2004, and the two that joined in 2007, originally planned to adopt the euro when they fulfilled certain economic criteria—a 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). However, the events surrounding the EU sovereign

COUNTRY FOCUS

Creating a Single Market in Financial Services The European Union in 1999 embarked upon an ambitious action plan to create a single market in financial services by January 1, 2005. Launched a few months after the euro, the EU’s single currency, the goal was to dismantle barriers to cross-border activity in financial services, creating a continentwide market for banking services, insurance services, and investment products. In this vision of a single Europe, a citizen of France might use a German firm for basic banking services, borrow a home mortgage from an Italian institution, buy auto insurance from a Dutch enter- prise, and keep her savings in mutual funds managed by a British company. Similarly, an Italian firm might raise capital from investors across Europe and use a German firm as its lead underwriter to issue stock for sale through stock exchanges in London and Frankfurt. One main benefit of a single market, according to its ad- vocates, would be greater competition for financial services, which would give consumers more choices, lower prices, and require financial service firms in the EU to become more efficient, thereby increasing their global competitiveness. Another major benefit would be the creation of a single Eu- ropean capital market. The increased liquidity of a larger capital market would make it easier for firms to borrow funds, lowering their cost of capital (the price of money) and stimu- lating business investment in Europe, which would create more jobs. A European Commission study suggested that the creation of a single market in financial services would in- crease the EU’s gross domestic product by 1.1 percent a year, creating an additional €130 billion in wealth over a decade. Total business investment would increase by 6 percent an- nually in the long run, private consumption by 0.8 percent, and total employment by 0.5 percent a year. Creating a single market has been anything but easy. The financial markets of different EU member states histori- cally have been segmented from each other, and each has its own regulatory framework. In the past, EU financial services firms rarely did business across national borders because of a host of different national regulations with regard to taxation, oversight, accounting information, cross-border

takeovers, and the like—all of which had to be harmonized. To complicate matters, long-standing cultural and linguistic barriers complicated the move toward a single market. While in theory an Italian might benefit by being able to purchase homeowners insurance from a British company, in practice he might be predisposed to purchase it from a local enterprise, even if the price were higher. By 2014, the EU had made significant progress. More than 40 measures designed to create a single market in fi- nancial services had become EU law, and others were in the pipeline. The new rules embraced issues as diverse as the conduct of business by investment firms, stock ex- changes, and banks; disclosure standards for listing com- panies on public exchanges; and the harmonization of accounting standards across nations. However, there had also been some significant setbacks. Most notably, legisla- tion designed to make it easier for firms to make hostile cross-border acquisitions was defeated, primarily due to opposition from German members of the European Parlia- ment, making it more difficult for financial service firms to build pan-European operations. In addition, national gov- ernments have still reserved the right to block even friendly cross-border mergers between financial service firms. The critical issue now is enforcement of the rules that have been put in place. Some believe that it will be years before the full benefits of the new regulations become apparent. In the meantime, the changes may impose significant costs on financial institutions as they attempt to deal with the new raft of regulations.

Sources: C. Randzio-Plath, “Europe Prepares for a Single Financial Market,” Intereconomic, May–June 2004, pp. 142–46; T. Buck, D. Hargreaves, and P. Norman, “Europe’s Single Financial Market,” Financial Times, January 18, 2005, p. 17; “The Gate-Keeper,” The Economist, February 19, 2005, p. 79; P. Hofheinz, “A Capital Idea: The European Union Has a Grand Plan to Make Its Financial Markets More Efficient,” The Wall Street Journal, October 14, 2002, p. R4; “Banking on McCreevy: Europe’s Single Market,” The Economist, November 26, 2005, p. 91; The European Commission, “A New Financial System for Europe; Financial Reform at the Service of Growth; State of Play,” http://ec.europa.eu/internal_market/publications/docs/ financial-reform-for-growth_en.pdf.

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debt crisis of 2010–2012 persuaded many of these countries to put their plans on hold, at least for the time being (further details provided later). Establishment of the euro was an amazing political feat with few historical precedents. It required participating national governments to give up their own currencies and na- tional control over monetary policy. Governments do not routinely sacrifice national sov- ereignty for the greater good, indicating the importance that the Europeans attach to the euro. By adopting the euro, the EU has created the second most widely traded currency in

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the world after that of the U.S. dollar. Some believe that the euro could come to rival the dollar as the most important currency in the world. Three long-term EU members—Great Britain, Denmark, and Sweden—are still sitting on the sidelines. The countries agreeing to the euro locked their exchange rates against each other January 1, 1999. Euro notes and coins were not actually issued until January 1, 2002. In the interim, national currencies circulated in each participating state. However, in each country the national currency stood for a defined amount of euros. After January 1, 2002, euro notes and coins were issued and the national currencies were taken out of circulation. By mid-2002, all prices and routine economic transactions within the euro zone were in euros.

Benefits of the Euro Europeans decided to establish a single currency in the EU for a number of reasons. First, they believe that businesses and individuals realize significant savings from having to handle one currency, rather than many. These savings come from lower foreign exchange and hedging costs. For example, people going from Germany to France no longer have to pay a commission to a bank to change German deutsche marks into French francs. Instead, they are able to use euros. According to the European Commission, such savings amount to 0.5 percent of the European Union’s GDP. Second, and perhaps more important, the adoption of a common currency makes it easier to compare prices across Europe. This has been increasing competition because it has become easier for consumers to shop around. For example, if a German finds that cars sell for less in France than Germany, he may be tempted to purchase from a French car dealer rather than his local car dealer. Alternatively, traders may engage in arbitrage to exploit such price differentials, buying cars in France and reselling them in Germany. The only way that German car dealers will be able to hold onto business in the face of such competitive pressures will be to reduce the prices they charge for cars. As a conse- quence of such pressures, the introduction of a common currency has led to lower prices, which translates into substantial gains for European consumers. Third, faced with lower prices, European producers have been forced to look for ways to reduce their production costs to maintain their profit margins. The introduction of a common currency, by increasing competition, has produced long-run gains in the economic efficiency of European companies. Fourth, the introduction of a common currency has given a boost to the development of a highly liquid pan-European capital market. Over time, the development of such a capital market should lower the cost of capital and lead to an increase in both the level of investment and the efficiency with which investment funds are allocated. This could be especially helpful to smaller companies that have historically had difficulty borrowing money from domestic banks. For example, the capital market of Portugal is very small and illiquid, which makes it extremely difficult for bright Portuguese entrepreneurs with a good idea to borrow money at a reasonable price. However, in theory, such companies can now tap a much more liquid pan-European capital market. Finally, the development of a pan-European, euro-denominated capital market will increase the range of investment options open to both individuals and institutions. For example, it will now be much easier for individuals and institutions based in, let’s say, Holland to invest in Italian or French companies. This will enable European investors to better diversify their risk, which again lowers the cost of capital, and should also increase the efficiency with which capital resources are allocated.14

Costs of the Euro The drawback, for some, of a single currency is that national authorities have lost control over monetary policy. Thus, it is crucial to ensure that the EU’s monetary policy is well managed. The Maastricht Treaty called for establishment of the independent European Central Bank (ECB), similar in some respects to the U.S. Federal Reserve, with a clear mandate to manage monetary policy so as to ensure price stability. The ECB, based in Frankfurt, is meant to be independent from political pressure—although critics question this. Among other things, the ECB sets interest rates and determines monetary policy across the euro zone.

268 Part 3 The Global Trade and Investment Environment

The implied loss of national sovereignty to the ECB underlies the decision by Great Britain, Denmark, and Sweden to stay out of the euro zone. Many in these countries are suspicious of the ECB’s ability to remain free from political pressure and to keep inflation under tight control. In theory, the design of the ECB should ensure that it remains free of political pres- sure. The ECB is modeled on the German Bundesbank, which historically has been the most independent and successful central bank in Europe. The Maastricht Treaty prohib- its the ECB from taking orders from politicians. The executive board of the bank, which consists of a president, vice president, and four other members, carries out policy by issuing instructions to national central banks. The policy itself is determined by the governing council, which consists of the executive board plus the central bank gover- nors from the 17 euro zone countries. The governing council votes on interest rate changes. Members of the executive board are appointed for eight-year nonrenewable terms, insulating them from political pressures to get reappointed. Nevertheless, the jury is still out on the issue of the ECB’s independence, and it will take some time for the bank to establish its credentials. According to critics, another drawback of the euro is that the EU is not what econo- mists would call an optimal currency area. In an optimal currency area, similarities in the underlying structure of economic activity make it feasible to adopt a single currency and use a single exchange rate as an instrument of macroeconomic policy. Many of the European economies in the euro zone, however, are very dissimilar. For example, Finland and Portugal have different wage rates, tax regimes, and business cycles, and they may react very differently to external economic shocks. A change in the euro exchange rate that helps Finland may hurt Portugal. Obviously, such differences complicate macroeco- nomic policy. For example, when euro economies are not growing in unison, a common monetary policy may mean that interest rates are too high for depressed regions and too low for booming regions. One way of dealing with such divergent effects within the euro zone is for the EU to engage in fiscal transfers, taking money from prosperous regions and pumping it into depressed regions. Such a move, however, opens a political can of worms. Would the citizens of Germany forgo their “fair share” of EU funds to create jobs for underemployed Greece workers? Not surprisingly, there is strong political opposition to such practices.

The Euro Experience Since its establishment January 1, 1999, the euro has had a volatile trading history against the world’s major currency, the U.S. dollar. After starting life in 1999 at €1 = $1.17, the euro steadily fell until it reached a low of €1 = $0.83 in October 2000, leading critics to claim the euro was a failure. A major reason for the fall in the euro’s value was that interna- tional investors were investing money in booming U.S. stocks and bonds and taking money out of Europe to finance this investment. In other words, they were selling euros to buy dol- lars so that they could invest in dollar-denominated assets. This increased the demand for dollars and decreased the demand for the euro, driving the value of the euro down. The fortunes of the euro began improving in late 2001 when the dollar weakened; the cur- rency stood at a robust all-time high of €1 = $1.54 in early March 2008. One reason for the rise in the value of the euro was that the flow of capital into the United States stalled as the U.S. financial markets fell during 2007 and 2008. Many investors were now taking money out of the United States by selling dollar-denominated assets such as U.S. stocks and bonds and purchasing euro-denominated assets. Falling demand for U.S. dollars and rising demand for euros translated into a fall in the value of the dollar against the euro. Furthermore, in a vote of confidence in both the euro and the ability of the ECB to manage monetary policy within the euro zone, many foreign central banks added more euros to their supply of foreign currencies. In the first three years of its life, the euro never reached the 13 percent of global reserves made up by the deutsche mark and other former euro zone currencies. The euro didn’t jump that hurdle until early 2002, but by 2011 it stood at 26.3 percent.15

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Since 2008 however, the euro has weakened, reflecting persistent concerns over slow economic growth and large budget deficits among several EU member states, particularly Greece, Portugal, Ireland, Italy, and Spain. During the 2000s, all these governments had sharply increased their government debt to finance public spending. Government debt as a percentage of GDP hit record levels in many of these nations. By 2010, private investors became increasingly concerned that these nations would not be able to service their sov- ereign debt, particularly given the economic slowdown following the 2008–2009 global financial crisis. They sold off government bonds of troubled nations, driving down bond prices and driving up the cost of government borrowing (bond prices and interest rates are inversely related). This led to fears that several national governments, particularly Greece, might default on their sovereign debt, plunging the euro zone into an economic crisis. To try and stave off such a sovereign debt crisis, in May 2010 the euro zone nations and the International Monetary Fund (IMF) agreed to a €110 billion bailout package to help rescue Greece. In November 2010, the EU and IMF agreed to a bailout package for Ireland of €85 billion; in May 2011, euro zone countries and the IMF instituted a €78 bil- lion bailout plan for Portugal. In return for these loans, all three countries had to agree to sharp reductions in government spending, which meant slower economic growth and high unemployment until government debt was reduced to more sustainable levels. While Italy and Spain did not request bailout packages, both countries were forced by falling bond prices to institute austerity programs that required big reductions in government spending. The euro zone nations also set up a permanent bailout fund—the European Stability Mechanism—worth about €500 billion, which was designed to restore confi- dence in the euro. As detailed in the next Country Focus, by 2012 Greece had been granted two more bailout packages in an attempt to forestall a full-blown default on pay- ment of its sovereign debt. As might be expected, the economic turmoil led to a decline in the value of the euro. By early 2014, the dollar-euro exchange rate stood at €1 = $1.08, significantly below its 2008 level but still somewhat better than the exchange rate in early 2000. The euro also declined by 20 to 30 percent against most of the world’s other major currencies between late 2008 and early 2015.

The weakened value of the euro against the U.S. dollar has been a cause for concern among many nations. Source: © Martin Leissl/Bloomberg/Getty Images

COUNTRY FOCUS

The Greek Sovereign Debt Crisis When the euro was established, some critics worried that free-spending countries in the euro zone (such as Italy and Greece) might borrow excessively, running up large public- sector deficits that they could not finance. This would then rock the value of the euro, requiring their more sober brethren, such as Germany or France, to step in and bail out the profligate nation. In 2010, this worry became a real- ity as a financial crisis in Greece hit the value of the euro.

The financial crisis had its roots in a decade of free spending by the Greek government, which ran up a high level of debt to finance extensive spending in the public sector. Much of the spending increase could be character- ized as an attempt by the government to buy off powerful interest groups in Greek society, from teachers and farmers to public-sector employees, rewarding them with high pay and extensive benefits. To make matters worse, the gov- ernment misled the international community about the level of its indebtedness. In October 2009, a new government took power and quickly announced that the 2009 public- sector deficit, which had been projected to be around 5  percent, would actually be 12.7 percent. The previous government had apparently been cooking the books.

This shattered any faith that international investors might have had in the Greek economy. Interest rates on Greek gov- ernment debt quickly surged to 7.1 percent, about 4 percent- age points higher than the rate on German bonds. Two of the three international rating agencies also cut their ratings on Greek bonds and warned that further downgrades were likely. The main concern now was that the Greek government might not be able to refinance some €20 billion of debt that would mature in April or May 2010. A further concern was that the Greek government might lack the political willpower to make the large cuts in public spending necessary to bring down the deficit and restore investor confidence.

Nor was Greece alone in having large public-sector deficits. Three other euro zone countries—Spain, Portugal, and Ireland—also had large debt loads, and interest rates on their bonds surged as investors sold out. This raised the specter of financial contagion, with large-scale defaults among the weaker members of the euro zone. If this did occur, the EU and IMF would most certainly have to step in and rescue the troubled nations. With this possibility, once considered very remote, investors started to move money out of euros, and the value of the euro started to fall on the foreign exchange market.

Recognizing that the unthinkable might happen—and that without external help, Greece might default on its govern- ment debt, pushing the EU and the euro into a major crisis—in

May 2010 the euro zone countries, led by Germany, along with the IMF agreed to lend Greece up to €110 billion. These loans were judged sufficient to cover Greece’s financing needs for three years. In exchange, the Greek government agreed to implement a series of strict austerity measures. These included tax increases, major cuts in public-sector pay, reductions in benefits enjoyed by public-sector employees (e.g., the retirement age was increased to 65 from 61, and limits were placed on pensions), and reductions in the num- ber of public-sector enterprises from 6,000 to 2,000. How- ever, the Greek economy contracted so fast in 2010 and 2011 that tax revenues plunged. By the end of 2011, the Greek economy was almost 29 percent smaller than it had been in 2005, while unemployment approached 20 percent. The contracting tax base limited the ability of the government to pay down debt. By early 2012, yields on 10-year Greek gov- ernment debt reached 34 percent, indicating that many inves- tors now expected Greece to default on its sovereign debt. This forced the Greek government to seek further aid from the euro zone countries and the IMF. As a condition for a fresh €130 billion bailout plan, the Greek government had to get holders of Greek government bonds to agree to the big- gest sovereign debt restructuring in history, In effect, bond- holders agreed to write off 53.5 percent of the debt they held. 

While the Greek government did not technically default on its sovereign debt, to many it seemed as if the EU and IMF had orchestrated an orderly partial default. By early 2014, it looked as if the Greek economy had finally turned a corner and was on the way to recovery. Yields on 10-year bonds had fallen below 8 percent, and the government was running a budget surplus before interest payments. However, things took a turn for the worse in 2014 when it became clear that despite eco- nomic progress, Greece did not have the funds to repay its creditors on time, and would have to issue new bonds in order to do so. Following a decision to call a snap election, in Janu- ary 2015 a radical left-wing “anti-bailout” party was swept into power. The financial minister of the new government sug- gested that Greece should default on its scheduled debt re- payments to its largest creditor, Germany. This initiated a crisis in the euro zone, and helped precipitate a sharp decline in the value of the euro against the U.S. dollar. As of the time of writ- ing, the crisis is ongoing and discussions are taking place about rescheduling Greece’s debt payments.

Sources: “A Very European Crisis,” The Economist, February 6, 2010, pp. 75–77; L. Thomas, “Is Debt Trashing the Euro?,” The New York Times, February 7, 2010, pp. 1, 7; “Bite the Bullet,” The Economist, Jan- uary 15, 2011, pp. 77–79; “The Wait Is Over,” The Economist, March 17, 2012, pp. 83–84; “Aegean Stables,” The Economist, January 11, 2014.

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More troubling perhaps for the long-run success of the euro, many of the newer EU nations that had committed to adopting the euro put their plans on hold. Countries like Poland and the Czech Republic had no desire to join the euro zone and then have their taxpayers help bail out the profligate governments of countries like Italy and Greece. To compound matters, the sovereign debt crisis had exposed a deep flaw in the euro zone—it was difficult for fiscally more conservative nations like Germany to limit profligate spending by the governments of other nations that might subsequently create strains and impose costs on the entire euro zone. The Germans in particular found themselves in the unhappy position of having to underwrite loans to bail out the governments of Greece, Portugal, and Ireland. This started to erode support for the euro in the stronger EU states. To try to correct this flaw, 25 of the then 27 countries in the EU signed a fiscal pact in January 2012 that made it more difficult for member states to break tight new rules on government deficits (the UK and Czech Republic abstained, Croatia joined in 2013). Whether such actions will be sufficient to get the euro back on track remains to be seen.

ENLARGEMENT OF THE EUROPEAN UNION

A major issue facing the EU has been that of enlargement. Enlargement of the EU into eastern Europe has been a possibility since the collapse of communism at the end of the 1980s, and by the end of the 1990s, 13 countries had applied to become EU members. To qualify for EU membership, the applicants had to privatize state assets, deregulate mar- kets, restructure industries, and tame inflation. They also had to enshrine complex EU laws into their own systems, establish stable democratic governments, and respect human rights.16 In December 2002, the EU formally agreed to accept the applications of 10 coun- tries, and they joined May 1, 2004. The new members included the Baltic countries, the Czech Republic, and the larger nations of Hungary and Poland. The only new members not in eastern Europe were the Mediterranean island nations of Malta and Cyprus. Their inclu- sion in the EU expanded the union to 25 states, stretching from the Atlantic to the borders of Russia; added 23 percent to the landmass of the EU; brought 75 million new citizens into the EU, building an EU with a population of 450 million people; and created a single continental economy with a GDP of close to €11 trillion. In 2007, Bulgaria and Romania joined, and in 2013 Croatia joined, bringing total membership to 28 nations. The new members were not able to adopt the euro for several years, and free move- ment of labor among the new and existing members was prohibited until then. Consistent with theories of free trade, the enlargement should create added benefits for all members. However, given the small size of the eastern European economies (together they amount to only 5 percent of the GDP of current EU members), the initial impact will probably be small. The biggest notable change might be in the EU bureaucracy and decision-making processes, where budget negotiations among 28 nations are bound to prove more prob- lematic than negotiations among 15 nations. Left standing at the door is Turkey. Turkey, which has long lobbied to join the union, presents the EU with some difficult is- sues. The country has had a customs union with the EU since 1995, and about half its international trade is already with the EU. However, full membership has been denied because of con- cerns over human rights issues (particularly Turkish policies to- ward its Kurdish minority). In addition, some on the Turkish side suspect the EU is not eager to let a primarily Muslim nation of 74 million people, which has one foot in Asia, join the EU. The EU formally indicated in December 2002 that it would allow the Turkish application to proceed with no further delay in December 2004 if the country improved its human rights record to the satis- faction of the EU. In December 2004, the EU agreed to allow Turkey to start accession talks in October 2005, but those talks are not moving along rapidly, and at this point, it is unclear when the nation will join.

Croatia is the 28th nation to join the EU. Source: © Frederik Florin/AFP/Getty Images

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272 Part 3 The Global Trade and Investment Environment

Regional Economic Integration in the Americas

No other attempt at regional economic integration comes close to the EU in its boldness or its potential implications for the world economy, but regional economic integration is on the rise in the Americas. The most significant attempt is the North American Free Trade Agreement. In addition to NAFTA, several other trade blocs are in the offing in the Americas (see Map 9.2), the most significant of which appear to be the Andean Commu- nity and Mercosur. Also, negotiations are under way to establish a hemispherewide Free Trade Area of the Americas (FTAA), although currently they seem to be stalled.

THE NORTH AMERICAN FREE TRADE AGREEMENT

The governments of the United States and Canada in 1988 agreed to enter into a free trade agreement, which took effect January 1, 1989. The goal of the agreement was to eliminate all tariffs on bilateral trade between Canada and the United States by 1998. This was followed in 1991 by talks among the United States, Canada, and Mexico aimed at establishing a North American Free Trade Agreement (NAFTA) for the three countries. The talks concluded in August 1992 with an agreement in principle, and the following year the agreement was ratified by the governments of all three countries. The agreement became law January 1, 1994.17

LO 9 - 4 Explain the history, current scope, and future prospects of the world’s most important regional economic agreements.

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NAFTA’S Contents The contents of NAFTA include the following:

∙ Abolition by 2004 of tariffs on 99 percent of the goods traded among Mexico, Canada, and the United States.

∙ Removal of most barriers on the cross-border flow of services, allowing financial institutions, for example, unrestricted access to the Mexican market by 2000.

∙ Protection of intellectual property rights. ∙ Removal of most restrictions on foreign direct investment among the three member

countries, although special treatment (protection) will be given to Mexican energy and railway industries, American airline and radio communications industries, and Canadian culture.

∙ Application of national environmental standards, provided such standards have a scientific basis. Lowering of standards to lure investment is described as being inappropriate.

∙ Establishment of two commissions with the power to impose fines and remove trade privileges when environmental standards or legislation involving health and safety, minimum wages, or child labor are ignored.

The Case for NAFTA Proponents of NAFTA have argued that the free trade area should be viewed as an op- portunity to create an enlarged and more efficient productive base for the entire region. Advocates acknowledge that one effect of NAFTA would be that some U.S. and Cana- dian firms would move production to Mexico to take advantage of lower labor costs. (In 2004, the average hourly labor cost in Mexico was still one-tenth of that in the United States and Canada.) Movement of production to Mexico, they argued, was most likely to occur in low-skilled, labor-intensive manufacturing industries where Mexico might have a comparative advantage. Advocates of NAFTA argued that many would benefit from such a trend. Mexico would benefit from much-needed inward investment and employ- ment. The United States and Canada would benefit because the increased incomes of the Mexicans would allow them to import more U.S. and Canadian goods, thereby increasing demand and making up for the jobs lost in industries that moved production to Mexico. U.S. and Canadian consumers would benefit from the lower prices of products made in Mexico. In addition, the international competitiveness of U.S. and Canadian firms that moved production to Mexico to take advantage of lower labor costs would be enhanced, enabling them to better compete with Asian and European rivals.

The Case against NAFTA Those who opposed NAFTA claimed that ratification would be followed by a mass exodus of jobs from the United States and Canada into Mexico as employers sought to profit from Mexico’s lower wages and less strict environmental and labor laws. According to one ex- treme opponent, Ross Perot, up to 5.9 million U.S. jobs would be lost to Mexico after NAFTA in what he famously characterized as a “giant sucking sound.” Most economists, however, dismissed these numbers as being absurd and alarmist. They argued that Mexico would have to run a bilateral trade surplus with the United States of close to $300 billion for job loss on such a scale to occur—and $300 billion was the size of Mexico’s GDP. In other words, such a scenario seemed implausible. More sober estimates of the impact of NAFTA ranged from a net creation of 170,000 jobs in the United States (due to increased Mexican demand for U.S. goods and services) and an increase of $15 billion per year to the joint U.S. and Mexican GDP, to a net loss of 490,000 U.S. jobs. To put these numbers in perspective, employment in the U.S. economy was predicted to grow by 18 million from 1993 to 2003. As most economists repeatedly stressed, NAFTA would have a small impact on both Canada and the United States. It

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could hardly be any other way, because the Mexican economy was only 5 percent of the size of the U.S. economy. Signing NAFTA required the largest leap of economic faith from Mexico rather than Canada or the United States. Falling trade barriers would expose Mexican firms to highly efficient U.S. and Canadian competitors that, when compared to the average Mexican firm, had far greater capital resources, access to highly educated and skilled workforces, and much greater technological sophistication. The short-run outcome was likely to be painful economic restructuring and unemployment in Mexico. But advo- cates of NAFTA claimed there would be long-run dynamic gains in the efficiency of Mexican firms as they adjusted to the rigors of a more competitive marketplace. To the extent that this occurred, they argued, Mexico’s economic growth rate would accelerate, and Mexico might become a major market for Canadian and U.S. firms.18 Environmentalists also voiced concerns about NAFTA. They pointed to the sludge in the Rio Grande and the smog in the air over Mexico City and warned that Mexico could degrade clean air and toxic waste standards across the continent. They pointed out that the lower Rio Grande was the most polluted river in the United States and that, with NAFTA, chemical waste and sewage would increase along its course from El Paso, Texas, to the Gulf of Mexico. There was also opposition in Mexico to NAFTA from those who feared a loss of na- tional sovereignty. Mexican critics argued that their country would be dominated by U.S. firms that would not really contribute to Mexico’s economic growth, but instead would use Mexico as a low-cost assembly site while keeping their high-paying, high-skilled jobs north of the border.

NAFTA: The Results Studies of NAFTA’s impact suggest its initial effects were at best muted, and both advocates and detractors may have been guilty of exaggeration.19 On average, studies indicate that NAFTA’s overall impact has been small but positive.20 From 1993 to 2005, trade among NAFTA’s partners grew by 250 percent.21 Today, Canada and Mexico are now among the top three trading partners of the United States (the other is China), suggesting the econo- mies of the three NAFTA nations have become more closely integrated. In 1990, U.S. trade with Canada and Mexico accounted for about a quarter of total U.S. trade. By 2005, the figure was close to one-third. Canada’s trade with its NAFTA partners increased from about 70 percent to more than 80 percent of all Canadian foreign trade between 1993 and 2005, while Mexico’s trade with NAFTA increased from 66 percent to 80 percent over the same period. America’s trade with Mexico increased 506 percent between 1993 and 2012, com- pared with 279 percent for non-NAFTA countries. All three countries also experienced strong productivity growth since 1993. In Mexico, labor productivity has increased by 50 percent since 1993, and the passage of NAFTA may have contributed to this. However, estimates suggest that employment effects of NAFTA have been small. The most pessimistic estimates suggest the United States lost 110,000 jobs per year due to NAFTA between 1994 and 2000—and many economists dispute this figure—which is tiny compared to the more than 2 million jobs a year created in the United States during the same period. Perhaps the most significant impact of NAFTA has not been economic, but political. Many observers credit NAFTA with helping create the background for increased political stability in Mexico. For most of the post-NAFTA period, Mexico has been viewed as a stable democratic nation with a steadily growing economy, something that is beneficial to the United States, which shares a 2,000-mile border with the country.22 However, recent events have cast a cloud over Mexico’s future. In late 2006, newly elected Mexican presi- dent Felipe Calderón initiated a crackdown on Mexico’s increasingly powerful drug car- tels (whose main business has been the illegal trafficking of drugs across the border into the United States). Calderón sent 6,500 troops into the Mexican state of Michoacan to end escalating drug violence there. The cartels responded by escalating their own violence, and the country is now gripped in what amounts to an all-out war. Fueled by the lucrative business of selling drugs to the United States and armed with guns purchased in the United States, the cartels have been fighting each other and the Mexican authorities in an increasingly brutal conflict that claimed more than 60,000 lives since 2006.23

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Enlargement One issue confronting NAFTA is that of enlargement. A number of other Latin American countries have indicated their desire to eventually join NAFTA. The governments of both Canada and the United States are adopting a wait-and-see attitude with regard to most countries. Getting NAFTA approved was a bruising political experience, and neither gov- ernment is eager to repeat the process soon. Nevertheless, the Canadian, Mexican, and U.S. governments began talks in 1995 regarding Chile’s possible entry into NAFTA. However, these talks yielded little progress, partly because of political opposition in the U.S. Congress to expanding NAFTA. December 2002, however, the United States and Chile did sign a bilateral free trade pact.

THE ANDEAN COMMUNITY

Bolivia, Chile, Ecuador, Colombia, and Peru signed an agreement in 1969 to create the An- dean Pact. The Andean Community was largely based on the EU model, but was far less successful at achieving its stated goals. The integration steps begun in 1969 included an in- ternal tariff reduction program, a common external tariff, a transportation policy, a common industrial policy, and special concessions for the smallest members, Bolivia and Ecuador. By the mid-1980s, the Andean Pact had all but collapsed and had failed to achieve any of its stated objectives. There was no tariff-free trade among member countries, no com- mon external tariff, and no harmonization of economic policies. Political and economic problems seem to have hindered cooperation among member countries. The countries of the Andean Pact have had to deal with low economic growth, hyperinflation, high unem- ployment, political unrest, and crushing debt burdens. In addition, the dominant political ideology in many of the Andean countries during this period tended toward the radical- socialist end of the political spectrum. Because such an ideology is hostile to the free market economic principles on which the Andean Pact was based, progress toward closer integration could not be expected. The tide began to turn in the late 1980s when, after years of economic decline, the gov- ernments of Latin America began to adopt free market economic policies. In 1990, the heads of the five current members of the Andean Community—Bolivia, Ecuador, Peru, Colombia, and Venezuela—met in the Galápagos Islands. The resulting Galápagos Decla- ration effectively relaunched the Andean Pact, which was renamed the Andean Commu- nity in 1997. The declaration’s objectives included the establishment of a free trade area by 1992, a customs union by 1994, and a common market by 1995. This last milestone has not been reached. A customs union was implemented in 1995—although Peru opted out and Bolivia received preferential treatment until 2003. The Andean Community now operates as a customs union. In December 2005, it signed an agreement with Mercosur to restart stalled negotiations on the creation of a free trade area between the two trading blocs. Those negotiations are proceeding at a slow pace. In late 2006, Venezuela withdrew from the Andean Community as part of that country’s attempts to join Mercosur.

MERCOSUR

Mercosur originated in 1988 as a free trade pact between Brazil and Argentina. The mod- est reductions in tariffs and quotas accompanying this pact reportedly helped bring about an 80 percent increase in trade between the two countries in the late 1980s.24 This success encouraged the expansion of the pact in March 1990 to include Paraguay and Uruguay. In 2006, the pact was further expanded when Venezuela joined Mercosur, although it may take years for Venezuela to become fully integrated into the pact. As of early 2014, Paraguay had yet to ratify the agreement allowing Venezuela to become a full member of Mercosur. The initial aim of Mercosur was to establish a full free trade area by the end of 1994 and a common market sometime thereafter. In December 1995, Mercosur’s members agreed to a five-year program under which they hoped to perfect their free trade area and move toward a full customs union—something that has yet to be achieved.25 For its first eight years or so, Mercosur seemed to be making a positive contribution to the economic growth rates of its member states. Trade among the four core members quadrupled

276 Part 3 The Global Trade and Investment Environment

between 1990 and 1998. The combined GDP of the four member states grew at an annual average rate of 3.5 percent between 1990 and 1996, a performance that is significantly better than the four attained during the 1980s.26 However, Mercosur had its critics, including Alexander Yeats, a senior economist at the World Bank, who wrote a stinging critique.27 According to Yeats, the trade diversion effects of Mercosur outweigh its trade creation effects. Yeats pointed out that the fastest-growing items in intra-Mercosur trade were cars, buses, agricultural equipment, and other capital- intensive goods that are produced relatively inefficiently in the four member countries. In other words, Mercosur countries, insulated from outside competition by tariffs that run as high as 70 percent of value on motor vehicles, are investing in factories that build products that are too expensive to sell to anyone but themselves. The result, according to Yeats, is that Mercosur countries might not be able to compete globally once the group’s external trade barriers come down. In the meantime, capital is being drawn away from more effi- cient enterprises. In the near term, countries with more efficient manufacturing enterprises lose because Mercosur’s external trade barriers keep them out of the market. Mercosur hit a significant roadblock in 1998 when its member states slipped into reces- sion and intrabloc trade slumped. Trade fell further in 1999 following a financial crisis in Brazil that led to the devaluation of the Brazilian real, which immediately made the goods of other Mercosur members 40 percent more expensive in Brazil, their largest export market. At this point, progress toward establishing a full customs union all but stopped. Things dete- riorated further in 2001 when Argentina, beset by economic stresses, suggested the customs union be temporarily suspended. Argentina wanted to suspend Mercosur’s tariff so that it could abolish duties on imports of capital equipment, while raising those on consumer goods to 35 percent (Mercosur had established a 14 percent import tariff on both sets of goods). Brazil agreed to this request, effectively halting Mercosur’s quest to become a fully function- ing customs union.28 Hope for a revival arose in 2003 when new Brazilian president Lula da Silva announced his support for a revitalized and expanded Mercosur modeled after the EU with a larger membership, a common currency, and a democratically elected Mercosur par- liament.29 In 2010, the members of Mercosur did agree on a common customs code to avoid outside goods having to pay tariffs more than once, an important step toward achieving a full customs union. Since 2010, however, Mercosur has made little forward progress, and the jury is still out on whether it will become a fully functioning customs union.

CENTRAL AMERICAN COMMON MARKET, CAFTA, AND CARICOM

Two other trade pacts in the Americas have not made much progress. In the early 1960s, Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua attempted to set up a Central American Common Market. It collapsed in 1969 when war broke out between Honduras and El Salvador after a riot at a soccer match between teams from the two countries. Since then, the member countries have made some progress toward reviving their agreement (the five founding members were joined by the Dominican Republic). The proposed common market was given a boost in 2003 when the United States signaled its intention to enter into bilateral free trade negotiations with the group. These culminated in a 2004 agreement to establish a free trade agreement between the six countries and the United States. Known as the Central America Free Trade Agreement (CAFTA), the aim is to lower trade barriers between the United States and the six countries for most goods and services. A customs union was to have been created in 1991 between the English-speaking Caribbean countries under the auspices of the Caribbean Community. Referred to as CARICOM, it was established in 1973. However, it repeatedly failed to progress toward economic integration. A formal commitment to economic and monetary union was ad- opted by CARICOM’s member states in 1984, but since then little progress has been made. In October 1991, the CARICOM governments failed, for the third consecutive time, to meet a deadline for establishing a common external tariff. Despite this, CARI- COM expanded to 15 members by 2005. In early 2006, six CARICOM members estab- lished the Caribbean Single Market and Economy (CSME). Modeled on the EU’s

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single market, CSME’s goal is to lower trade barriers and harmonize macroeconomic and monetary policy between member states.30

FREE TRADE AREA OF THE AMERICAS

At a hemispherewide Summit of the Americas in December 1994, a Free Trade Area of the Americas (FTAA) was proposed. It took more than three years for the talks to start, but in April 1998, 34 heads of state traveled to Santiago, Chile, for the second Summit of the Americas, where they formally inaugurated talks to establish an FTAA by January 1, 2005—something that didn’t occur. The continuing talks have addressed a wide range of economic, political, and environmental issues related to cross-border trade and invest- ment. Although both the United States and Brazil were early advocates of the FTAA, support from both countries seems to be mixed at this point. Because the United States and Brazil have the largest economies in North and South America, respectively, strong U.S. and Brazilian support is a precondition for establishment of the free trade area. The major stumbling blocks so far have been twofold. First, the United States wants its southern neighbors to agree to tougher enforcement of intellectual property rights and lower manufacturing tariffs, which they do not seem to be eager to embrace. Second, Brazil and Argentina want the United States to reduce its subsidies to U.S. agricultural producers and scrap tariffs on agricultural imports, which the U.S. government does not seem inclined to do. For progress to be made, most observers agree that the United States and Brazil have to first reach an agreement on these crucial issues.31 If the FTAA is even- tually established, it will have major implications for cross-border trade and investment flows within the hemisphere. The FTAA would open a free trade umbrella over 850 mil- lion people, who accounted for some $18 trillion in GDP in 2008. Currently, however, FTAA is very much a work in progress, and the progress has been slow. The most recent attempt to get talks going again, in November 2005 at a summit of 34 heads of state from North and South America, failed when opponents, led by Venezuela’s populist president Hugo Chávez, blocked efforts by the Bush administration to set an agenda for further talks on FTAA. In voicing his opposition, the late Chávez condemned the U.S. free trade model as a “perversion” that would unduly benefit the United States to the detriment of poor people in Latin America, who Chávez claimed have not benefited from free trade details.32 Such views make it unlikely that there will be much progress establishing an FTAA in the near term.

Regional Economic Integration Elsewhere

Numerous attempts at regional economic integration have been tried throughout Asia and Africa. However, few exist in anything other than name. Perhaps the most significant is the Association of Southeast Asian Nations (ASEAN). In addition, the Asia-Pacific Economic Cooperation (APEC) forum has recently emerged as the seed of a potential free trade region.

ASSOCIATION OF SOUTHEAST ASIAN NATIONS

Formed in 1967, the Association of Southeast Asian Nations (ASEAN) includes Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, and Vietnam. Laos, Myanmar, Vietnam, and Cambodia have all joined recently, creating a re- gional grouping of 600 million people with a combined GDP of some $2 trillion (see Map 9.3). The basic objective of ASEAN is to foster freer trade among member countries and to achieve cooperation in their industrial policies. Progress so far has been limited, however. Until recently, only 5 percent of intra-ASEAN trade consisted of goods whose tariffs had been reduced through an ASEAN preferential trade arrangement. This may be chang- ing. In 2003, an ASEAN Free Trade Area (AFTA) among the six original members of ASEAN came into full effect. The AFTA has cut tariffs on manufacturing and agricul- tural products to less than 5 percent. However, there are some significant exceptions to this tariff reduction. Malaysia, for example, refused to bring down tariffs on imported

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278 Part 3 The Global Trade and Investment Environment

cars until 2005 and then agreed to lower the tariff only to 20 percent, not the 5 percent called for under the AFTA. Malaysia wanted to protect Proton, an inefficient local car- maker, from foreign competition. Similarly, the Philippines has refused to lower tariff rates on petrochemicals, and rice, the largest agricultural product in the region, will re- main subject to higher tariff rates until at least 2020.33 Notwithstanding such issues, ASEAN and AFTA are at least progressing toward es- tablishing a free trade zone. Vietnam joined the AFTA in 2006, Laos and Myanmar in 2008, and Cambodia in 2010. The goal was to reduce import tariffs among the six origi- nal members to zero by 2010 and to do so by 2015 for the newer members (although im- portant exceptions to that goal, such as tariffs on rice, will persist). ASEAN signed a free trade agreement with China that removes tariffs on 90 percent of traded goods. This went into effect January 1, 2010. Trade between China and ASEAN members more than tripled during the first decade of the twenty-first century, and this agreement should spur further growth.34

ASIA-PACIFIC ECONOMIC COOPERATION

The Asia-Pacific Economic Cooperation (APEC) was founded in 1990 at the suggestion of Australia. APEC currently has 21 member states, including such economic power- houses as the United States, Japan, and China (see Map 9.4). Collectively, the member

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states account for about 54 percent of the world’s GNP, 54 percent of world trade. The stated aim of APEC is to increase multilateral cooperation in view of the economic rise of the Pacific nations and the growing interdependence within the region. U.S. support for APEC was also based on the belief that it might prove a viable strategy for heading off any moves to create Asian groupings from which it would be excluded. Interest in APEC was heightened considerably in November 1993 when the heads of APEC member states met for the first time at a two-day conference in Seattle. Debate before the meeting speculated on the likely future role of APEC. One view was that APEC should commit itself to the ultimate formation of a free trade area. Such a move would transform the Pacific Rim from a geographic expression into the world’s largest free trade area. An- other view was that APEC would produce no more than hot air and lots of photo opportuni- ties for the leaders involved. As it turned out, the APEC meeting produced little more than some vague commitments from member states to work together for greater economic inte- gration and a general lowering of trade barriers. However, member states did not rule out the possibility of closer economic cooperation in the future.35 The heads of state have met again on a number of occasions. However, the vague plan committed APEC to doing no more than holding further talks, which is all that has been accomplished to date.

REGIONAL TRADE BLOCS IN AFRICA

African countries have been experimenting with regional trade blocs for half a century. There are now nine trade blocs on the African continent. Many countries are members of more than one group. Although the number of trade groups is impressive, progress to- ward the establishment of meaningful trade blocs has been slow.

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Many of these groups have been dormant for years. Significant political turmoil in sev- eral African nations has persistently impeded any meaningful progress. Also, deep suspi- cion 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. Given the preva- lence of this argument, it has been hard to establish free trade areas or customs unions. The most recent attempt to reenergize the free trade movement in Africa occurred in early 2001, when Kenya, Uganda, and Tanzania, member states of the East African Com- munity (EAC), committed themselves to relaunching their bloc, 24 years after it col- lapsed. The three countries, with 80 million inhabitants, intend to establish a customs union, regional court, legislative assembly, and, eventually, a political federation. Their program includes cooperation on immigration, road and telecommunication net- works, investment, and capital markets. However, while local business leaders welcomed the relaunch as a positive step, they were critical of the EAC’s failure in practice to make progress on free trade. At the EAC treaty’s signing in November 1999, members gave themselves four years to negotiate a customs union, with a draft slated for the end of 2001. But that fell far short of earlier plans for an immediate free trade zone, shelved after Tanzania and Uganda, fearful of Kenyan competition, expressed concerns that the zone could create imbalances similar to those that contributed to the breakup of the first com- munity.36 Nevertheless, in 2005 the EAC did start to implement a customs union. In 2007, Burundi and Rwanda joined the EAC. The EAC established a common market in 2010 and is now striving toward an eventual goal of monetary union.

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F O C U S O N M A NAG E R I A L I M P L I C AT I O N S

REGIONAL ECONOMIC INTEGRATION THREATS Currently, the most significant developments in regional economic integration are oc-

curring in the EU and NAFTA. Although some of the Latin American trade blocs, ASEAN, and the proposed FTAA may have economic significance in the future,

developments in the EU and NAFTA currently have more profound implications for business practice. Accordingly, in this section we concentrate on the business implications of those two groups. Similar conclusions, however, could be drawn

with regard to the creation of a single market anywhere in the world.

Opportunities The creation of a single market through regional economic integration offers significant opportunities because markets that were formerly protected from foreign competi- tion are increasingly open. Additional opportunities arise from the inherent lower costs of do- ing business in a single market—as opposed to 28 national markets in the case of the EU or 3 national markets in the case of NAFTA. Free movement of goods across borders, harmonized product standards, and simplified tax regimes make it possible for firms based in the EU and the NAFTA countries to realize potentially significant cost economies by centralizing produc- tion in those EU and NAFTA locations where the mix of factor costs and skills is optimal. Rather than producing a product in each of the 28 EU countries or the 3 NAFTA countries, a firm may be able to serve the whole EU or North American market from a single location. This location must be chosen carefully, of course, with an eye on local factor costs and skills. Even after the removal of barriers to trade and investment, enduring differences in culture and competitive practices often limit the ability of companies to realize cost economies by cen- tralizing production in key locations and producing a standardized product for a single multiple- country market. Consider the case of Atag Holdings NV, a Dutch maker of kitchen appliances.37 Atag thought it was well placed to benefit from the single market, but found it tough going. Atag’s plant is just 1 mile from the German border and near the center of the EU’s population. The company thought it could cater to both the “potato” and “spaghetti” belts—marketers’ terms for consumers in northern and southern Europe—by producing two main product lines and

LO 9 -5 Understand the implications for business that are inherent in regional economic integration agreements.

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selling these standardized “euro-products” to “euro-consumers.” The main benefit of doing so is the economy of scale derived from mass production of a standardized range of products. Atag quickly discovered that the “euro-consumer” was a myth. Consumer preferences vary much more across nations than Atag had thought. Consider ceramic cooktops: Atag planned to mar- ket just 2 varieties throughout the EU but found it needed 11. Belgians, who cook in huge pots, require extra-large burners. Germans like oval pots and burners to fit. The French need small burners and very low temperatures for simmering sauces and broths. Germans like oven knobs on the top; the French want them on the front. Most Germans and French prefer black and white ranges; the British demand a range of colors including peach, pigeon blue, and mint green.

Threats Just as the emergence of single markets creates opportunities for business, it also presents a number of threats. For one thing, the business environment within each grouping has become more competitive. The lowering of barriers to trade and investment among coun- tries has led to increased price competition throughout the EU and NAFTA. Over time, price differentials across nations will decline in a single market. This is a direct threat to any firm doing business in EU or NAFTA countries. To survive in the tougher single-market environment, firms must take advantage of the opportunities offered by the creation of a single market to rational- ize their production and reduce their costs. Otherwise, they will be at a severe disadvantage. A further threat to firms outside these trading blocs arises from the likely long-term im- provement in the competitive position of many firms within the areas. This is particularly rel- evant in the EU, where many firms have historically been limited by a high-cost structure in their ability to compete globally with North American and Asian firms. The creation of a sin- gle market and the resulting increased competition in the EU produced serious attempts by many EU firms to reduce their cost structure by rationalizing production. This transformed many EU companies into more efficient global competitors. The message for non-EU busi- nesses is that they need to respond to the emergence of more capable European competi- tors by reducing their own cost structures. Another threat to firms outside of trading areas is the threat of being shut out of the single market by the creation of a “trade fortress.” The charge that regional economic integration might lead to a fortress mentality is most often leveled at the EU. Although the free trade phi- losophy underpinning the EU theoretically argues against the creation of any fortress in Europe, occasional signs indicate the EU may raise barriers to imports and investment in certain “politi- cally sensitive” areas, such as autos. Non-EU firms might be well advised, therefore, to set up their own EU operations. This could also occur in the NAFTA countries, but it seems less likely. Finally, the emerging role of the European Commission in competition policy suggests the EU is increasingly willing and able to intervene and impose conditions on companies proposing mergers and acquisitions. This is a threat insofar as it limits the ability of firms to pursue the corporate strategy of their choice. The commission may require significant con- cessions from businesses as a precondition for allowing proposed mergers and acquisitions to proceed. While this constrains the strategic options for firms, it should be remembered that in taking such action, the commission is trying to maintain the level of competition in Europe’s single market, which should benefit consumers.

regional economic integration, p. 256

free trade area, p. 257 European Free Trade

Association (EFTA), p. 258 customs union, p. 258 common market, p. 258 economic union, p. 258 political union, p. 258 trade creation, p. 260 trade diversion, p. 260

European Union (EU), p. 261 Treaty of Rome, p. 261 European Commission, p. 262 European Council, p. 264 European Parliament, p. 264 Treaty of Lisbon, p. 264 Court of Justice, p. 264 Maastricht Treaty, p. 265 optimal currency area, p. 268 North American Free Trade

Agreement (NAFTA), p. 272

Andean Community, p. 275 Mercosur, p. 275 Central American Common

Market, p. 276 Central America Free Trade

Agreement (CAFTA), p. 276 CARICOM, p. 276 Caribbean Single Market and

Economy (CSME), p. 276 Association of Southeast Asian

Nations (ASEAN), p. 277

Key Terms

282 Part 3 The Global Trade and Investment Environment

C H A P T E R S U M M A R Y

This chapter pursued three main objectives: to examine the economic and political debate surrounding regional economic integration; to review the progress toward re- gional economic integration in Europe, the Americas, and elsewhere; and to distinguish the important impli- cations of regional economic integration for the prac- tice of international business. The chapter made the following points:

1. A number of levels of economic integration are possible in theory. In order of increasing inte- gration, they include a free trade area, a cus- toms union, a common market, an economic union, and full political union.

2. In a free trade area, barriers to trade among member countries are removed, but each coun- try determines its own external trade policy. In a customs union, internal barriers to trade are re- moved, and a common external trade policy is adopted. A common market is similar to a cus- toms union, except that a common market also allows factors of production to move freely among countries. An economic union involves even closer integration, including the establish- ment of a common currency and the harmoniza- tion of tax rates. A political union is the logical culmination of attempts to achieve ever-closer economic integration.

3. Regional economic integration is an attempt to achieve economic gains from the free flow of trade and investment between neighboring countries.

4. Integration is not easily achieved or sustained. Although integration brings benefits to the ma- jority, it is never without costs for the minority. Concerns over national sovereignty often slow or stop integration attempts.

5. Regional integration will not increase eco- nomic welfare if the trade creation effects in the free trade area are outweighed by the trade diversion effects.

6. The Single European Act sought to create a true single market by abolishing administrative bar- riers to the free flow of trade and investment among EU countries.

7. Seventeen EU members now use a common cur- rency, the euro. The economic gains from a common currency come from reduced exchange costs, reduced risk associated with currency fluctuations, and increased price competition within the EU.

8. Increasingly, the European Commission is tak- ing an activist stance with regard to competition policy, intervening to restrict mergers and acqui- sitions that it believes will reduce competition in the EU.

9. Although no other attempt at regional economic integration comes close to the EU in terms of potential economic and political significance, various other attempts are being made in the world. The most notable include NAFTA in North America, the Andean Community and Mercosur in Latin America, ASEAN in South- east Asia, and perhaps APEC.

10. The creation of single markets in the EU and North America means that many markets that were formerly protected from foreign competi- tion are now more open. This creates major investment and export opportunities for firms within and outside these regions.

11. The free movement of goods across borders, the harmonization of product standards, and the sim- plification of tax regimes make it possible for firms based in a free trade area to realize potentially enormous cost economies by centralizing produc- tion in those locations within the area where the mix of factor costs and skills is optimal.

12. The lowering of barriers to trade and investment among countries within a trade group will proba- bly be followed by increased price competition.

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. NAFTA has produced significant net benefits for the Canadian, Mexican, and U.S. economies. Discuss.

2. What are the economic and political arguments for regional economic integration? Given these arguments, why don’t we see more substantial examples of integration in the world economy?

3. What in general was the effect of the creation of a single market and a single currency within the EU on competition within the EU? Why?

4. Do you think it is correct for the European Com- mission to restrict mergers between American companies that do business in Europe? (For ex- ample, the European Commission vetoed the

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proposed merger between WorldCom and Sprint, both U.S. companies, and it carefully reviewed the merger between AOL and Time Warner, again both U.S. companies.)

5. What were the causes of the 2010–2012 sover- eign debt crisis in the EU? What does this crisis tell us about the weaknesses of the euro? Do you think the euro will survive the sover- eign debt crisis?

6. How should a U.S. firm that currently exports only to ASEAN countries respond to the creation of a single market in this regional grouping?

7. How should a firm with self-sufficient production facilities in several ASEAN countries respond

to the creation of a single market? What are the constraints on its ability to respond in a manner that minimizes production costs?

8. After a promising start, Mercosur, the major Latin American trade agreement, has faltered and made little progress since 2000. What problems are hurting Mercosur? What can be done to solve these problems?

9. Would establishment of a Free Trade Area of the Americas (FTAA) be good for the two most ad- vanced economies in the hemisphere, the United States and Canada? How might the establish- ment of the FTAA affect the strategy of North American firms?

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises:

1. The World Trade Organization maintains a data- base of regional trade agreements. You can search this database to identify all agreements that a spe- cific country participates in. Search the database to identify the trade agreements that Japan cur- rently participates in. What patterns do you see? Which region (or regions) of the world does Japan seem to be focusing on in its trade endeavors?

2. Your company has assigned you with the task of investigating the various trade blocs in Africa to see if your company can benefit from these trade agreements while expanding into African mar- kets. The first trade bloc you come across is COMESA. Prepare a short executive summary for your company, explaining the level of integration the bloc has currently achieved, the level it as- pires to accomplish, and the relationships it has with other African trade blocs.

When the North American Free Trade Agreement (NAFTA) went into effect in December 1992 and tariffs on imported tomatoes were dropped U.S. tomato producers in Florida feared that they would lose business to lower-cost producers in Mexico. So they lobbied the gov- ernment to set a minimum floor price for tomatoes imported from Mexico. The idea was to stop Mexi- can producers from cutting prices below the floor to gain share in the U.S. market. In 1996 the United States and Mexico agreed on a basic floor price of 21.69 cents a pound. At the time, both sides declared

themselves to be happy with the deal. As it turns out, the deal didn’t offer much protection for U.S. to- mato growers. In 1992, the year be- fore NAFTA was passed, Mexican producers exported 800 million pounds of tomatoes to the United States. By 2011 they were exporting 2.8 billion pounds of tomatoes, an increase of 3.5-fold. The value of Mexican tomato exports almost tri- pled over the same period to $2 bil- lion. In contrast, tomato production in Florida has fallen by 41 percent since NAFTA went into effect. Florida growers complained that they could not compete against low

C L O S I N G C A S E

Tomato Wars

Tomato farming is an important business glob- ally. Tomatoes originated in the South American Andes, near where Peru is today, and were used early on by the Aztecs in southern Mexico as a food. Source: © Joe Raedle/Getty Images

284 Part 3 The Global Trade and Investment Environment

wages and lax environmental oversight in Mexico. They also alleged that Mexican growers were dumping tomatoes in the U.S. market at below the cost of production, with the goal of driving U.S. producers out of business. In 2012, Florida growers petitioned the U.S. Department of Com- merce to scrap the 1996 minimum price agreement, which would then free them up to file an antidumping case against Mexican producers. In September 2012 the Commerce Department announced a preliminary decision to scrap the agreement. At first glance, it looked as if the Florida grow- ers were going to get their way. It soon became apparent, however, that the situation was more complex than appeared at first glance. More than 370 business and trade groups in the United States—from small family-run importers to meat and vegetable producers and Wal-Mart Stores—wrote or signed letters to the Commerce Depart- ment in favor of continuing the 1996 agreement.

Among the letter writers was Kevin Ahern, the CEO of Ahern Agribusiness in San Diego. His company sells about $20 million a year in tomato seeds and transplants to Mexican farmers. In a letter sent to the New York Times, Ahern noted that “yes, Mexico produces their tomatoes on average at a lower cost than Florida; that’s what we call competitive advantage.” Without the agreement Ahern claimed that his business would suffer. Another U.S. com- pany, NatureSweet Ltd., grows cherry and grape tomatoes under 1,200 acres of greenhouses in Mexico for the American market. It employs 5,000 people, although all but 100 work in Mexico. The CEO, Bryant Ambelang, said that his company couldn’t survive without NAFTA. In his view, Mexican-grown tomatoes were more competitive because of lower labor costs, good weather, and more than a decade of investment in greenhouse technology. In a sim- ilar vein, Scott DeFife, a representative of the U.S. National Restaurant Association, stated, “people want tomato-based dishes all the time. . . . You plan over the course of the year where you are going to get your supply in the winter, spring, fall.” Without tomatoes from Mexico, a winter freeze in Florida, for example, would send prices shooting up, he said. Faced with a potential backlash from U.S. importers, and U.S. producers with interests in Mexico, the

Commerce Department pulled back from its initial con- clusion that the agreement should be scrapped. Instead, in early 2013 it reached an agreement with Mexican grow- ers to raise the minimum floor price from 21.69 cents a pound to 31 cents a pound. The new agreement also es- tablished even higher prices for specialty tomatoes and tomatoes grown in controlled environments. This was clearly aimed at Mexican growers, who have invested billions to grow tomatoes in greenhouses. Florida tomatoes are largely picked green and treated with gas to change their color. Sources: E. Malkin, “Mexico Finds Unlikely Allies in Trade Fight,” The New York Times, December 25, 2012, p. B1; S. Strom, “United States and Mexico Reach Tomato Deal, Averting a Trade War,” The New York Times, February 3, 2013; J. Margolis, “NAFTA 20 Years After: Florida’s Tomato Growers Struggling,” The World, December 1, 2012.

C a s e D i s c u s s i o n Q u e s t i o n s

1. Was the establishment of a minimum floor price for tomatoes consistent with the free trade principles enshrined in NAFTA?

2. Why despite the establishment of a minimum floor price have imports from Mexico grown over the years?

3. Who benefits from the importation of tomatoes grown in Mexico? Who suffers?

4. Do you think that Mexican producers were dump- ing tomatoes in the United States?

5. Was the Commerce Department right to establish a new minimum floor price, rather than scrap the agreement and file an antidumping suit? Who would have benefited from an antidumping suit against Mexican tomato producers? Who would have suffered?

6. What do you think will be the impact of the new higher floor price? Who benefits from the higher floor price? Who suffers?

7. What do you think is the optimal government policy response here? Explain your answer.

E n d n o t e s

1. Information taken from World Trade Organization website and current as of April 2012, www.wto.org.

2. Ibid. 3. The Andean Community has been through a number of changes

since its inception. The latest version was established in 1991. See “Free-Trade Free for All,” The Economist, January 4, 1991, p. 63.

4. D. Swann, The Economics of the Common Market, 6th ed. (London: Penguin Books, 1990).

5. See J. Bhagwati, “Regionalism and Multilateralism: An Over- view,” Columbia University Discussion Paper 603, Department of Economics, Columbia University, New York; A. de la Torre and M. Kelly, “Regional Trade Arrangements,” Occasional

Regional Economic Integration Chapter 9 285

Paper 93, Washington, DC: International Monetary Fund, March 1992; J. Bhagwati, “Fast Track to Nowhere,” The Econo- mist, October 18, 1997, pp. 21–24; Jagdish Bhagwati, Free Trade Today (Princeton and Oxford: Princeton University Press, 2002); and B. K. Gordon, “A High Risk Trade Policy,” Foreign Affairs 82 no. 4 (July–August 2003), pp. 105–15.

6. N. Colchester and D. Buchan, Europower: The Essential Guide to Europe’s Economic Transformation in 1992 (London: The Econo- mist Books, 1990); Swann, Economics of the Common Market.

7. Swann, Economics of the Common Market; Colchester and Buchan, Europower; “The European Union: A Survey,” The Economist, October 22, 1994; “The European Community: A Survey,” The Economist, July 3, 1993; and the European Union website at http://europa.eu.int.

8. E. J. Morgan, “A Decade of EC Merger Control,” International Journal of Economics and Business, November 2001, pp. 451–73.

9. “The European Community: A Survey,” 1993. 10. Tony Barber, “The Lisbon Reform Treaty,” FT.com, December

13, 2007. 11. “One Europe, One Economy,” The Economist, November 30,

1991, pp. 53–54; “Market Failure: A Survey of Business in Europe,” The Economist, June 8, 1991, pp. 6–10.

12. Alan Riley, “The Single Market Ten Years On,” European Pol- icy Analyst, December 2002, pp. 65–72.

13. See C. Wyploze, “EMU: Why and How It Might Happen,” Journal of Economic Perspectives 11 (1997), pp. 3–22; M. Feldstein, “The Political Economy of the European Economic and Monetary Union,” Journal of Economic Perspectives 11 (1997), pp. 23–42.

14. “One Europe, One Economy”; and Feldstein, “The Political Economy of the European Economic and Monetary Union.”

15. “Euro Still the World’s Second Reserve Currency,” Economic Times, July 22, 2011.

16. Details regarding conditions of membership and the progres- sion of enlargement negotiations can be found at http://europa. eu/pol/enlarg/index_en.htm.

17. “What Is NAFTA?,” Financial Times, November 17, 1993, p. 6; S. Garland, “Sweet Victory,” BusinessWeek, November 29, 1993, pp. 30–31.

18. “NAFTA: The Showdown,” The Economist, November 13, 1993, pp. 23–36.

19. N. C. Lustog, “NAFTA: Setting the Record Straight,” The World Economy, 1997, pp. 605–14; and G. C. Hufbauer and J. J. Schott, NAFTA Revisited: Achievements and Challenges (Washington, DC: Institute for International Economics, 2005).

20. W. Thorbecke and C. Eigen-Zucchi, “Did NAFTA Cause a Giant Sucking Sound?,” Journal of Labor Research, Fall 2002, pp. 647–58; G. Gagne, “North American Free Trade, Canada,

and U.S. Trade Remedies: An Assessment after Ten Years,” The World Economy, 2000, pp. 77–91; Hufbauer and Schott, NAFTA Revisited; J. Romalis, “NAFTA’s and Custfa’s Impact on International Trade,” Review of Economics and Statistics 98, no. 3 (2007), pp. 416–35; “NAFTA at 20: Ready to Take Off Again?,” The Economist, January 4, 2014.

21. All trade figures from U.S. Department of Commerce Trade Stat Express website at http://tse.export.gov/.

22. J. Cavanagh et al., “Happy Ever NAFTA?,” Foreign Policy, September–October 2002, pp. 58–65.

23. “Mexican Daily: Nearly 60,000 Drug War Deaths under Calderon,” Fox News Latino, November 1, 2012.

24. “The Business of the American Hemisphere,” The Economist, August 24, 1991, pp. 37–38.

25. “NAFTA Is Not Alone,” The Economist, June 18, 1994, pp. 47–48.

26. “Murky Mercosur,” The Economist, July 26, 1997, pp. 66–67. 27. See M. Philips, “South American Trade Pact under Fire,” The

Wall Street Journal, October 23, 1996, p. A2; A. J. Yeats, Does Mercosur’s Trade Performance Justify Concerns about the Global Welfare-Reducing Effects of Free Trade Arrangements? Yes! (Washington, DC: World Bank, 1996); and D. M. Leipziger et al., “Mercosur: Integration and Industrial Policy,” The World Economy, 1997, pp. 585–604.

28. “Another Blow to Mercosur,” The Economist, March 31, 2001, pp. 33–34.

29. “Lula Lays Out Mercosur Rescue Mission,” Latin America Newsletters, February 4, 2003, p. 7.

30. “CARICOM Single Market Begins,” EIU Views, February 3, 2006.

31. M. Esterl, “Free Trade Area of the Americas Stalls,” The Economist, January 19, 2005, p. 1.

32. M. Moffett and J. D. McKinnon, “Failed Summit Casts Shadow on Global Trade Talks,” The Wall Street Journal, November 7, 2005, p. A1.

33. “Every Man for Himself: Trade in Asia,” The Economist, November 2, 2002, pp. 43–44.

34. L. Gooch, “Asian Free-Trade Zone Raises Hopes,” The New York Times, January 1, 2010, p. B3.

35. “Aimless in Seattle,” The Economist, November 13, 1993, pp. 35–36.

36. M. Turner, “Trio Revives East African Union,” Financial Times, January 16, 2001, p. 4.

37. T. Horwitz, “Europe’s Borders Fade,” The Wall Street Journal, May 18, 1993, pp. A1, A12; “A Singular Market,” The Economist, October 22, 1994, pp. 10–16; and “Something Dodgy in Europe’s Single Market,” The Economist, May 21, 1994, pp. 69–70.

Credit: ©Federal Reserve Board.

The Foreign Exchange Market L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO10 -1 Describe the functions of the foreign exchange market.

LO10-2 Understand what is meant by spot exchange rates.

LO10-3 Recognize the role that forward exchange rates play in insuring against foreign exchange risk.

LO10-4 Understand the different theories explaining how currency exchange rates are determined and their relative merits.

LO10-5 Identify the merits of different approaches toward exchange rate forecasting.

LO10-6 Compare and contrast the differences among translation, transaction, and economic exposure, and what managers can do to manage each type of exposure.

part four The Global Monetar y System

10

Source: © Ekasit Wangprasert/Alamy, RF

287

Subaru’s Sales Boom Thanks to the Weaker Yen

As a consequence, the price of yen in terms of dollars fell. By October 2014, 1 dollar bought 115 yen, representing a 43 percent fall in the value of the yen since 2012.    For Subaru, the depreciation in the value of the yen has given it a pricing advantage and driven a sales boom. De- mand for Subaru cars in the United States has been so strong that the automaker has been struggling to keep up. The profits of Subaru’s parent company, Fuji Heavy Indus- tries, have surged. In February 2015, Fuji announced that it would earn record operating profits of around ¥410 billion ($3.5 billion) for the financial year ending March 2015. Subaru’s profit margin has increased to 14.4 percent, com- pared with 5.6 percent for Honda, a company that is heav- ily dependent on U.S. production.  Despite its current pricing advantage, Subaru is still moving to increase its U.S. production. It plans to expand its sole plant in the United States, in Indiana, by March 2017, with a goal of making 310,000 cars a year, up from 200,000 currently. When asked why it is doing this, Subaru’s man- agement note that the yen will not stay weak against the dollar forever, and it is wise to expand local production as a hedge against future increases in the value of the yen. 

Sources: Chang-Ran Kim, “Subaru-maker, Fuji Heavy Lifts Profit View on Rosy US Sales, Weak Yen,” Reuters, February 3, 2015; Yoko Kubota, “Why Subaru’s Profit Is Surging,” The Wall Street Journal, No- vember 14, 2014; Doron Levin, “Subaru Profit Soaring on Weaker Yen,” Market Watch, November 15, 2014. 

O P E N I N G C A S E For the Japanese carmaker Subaru a sharp fall in the value of yen against the U.S. dollar has turned a problem— the lack of U.S. production—into an unexpected sales boom. Subaru, which is a niche player in the global auto industry, has long bucked the trend among its Japanese rivals of establishing significant manufacturing facilities in the North American market. Instead, the company has chosen to concentrate most of its manufacturing in Japan in order to achieve economies of scale at its home plants, exporting its production to the United States. Subaru still makes 80 percent of its vehicles at home, compared with 21 percent for Honda. Back in 2012 this strategy was viewed as something of a liability. In those days, 1 U.S. dollar bought only 80 Japa- nese yen. The strong yen meant that Subaru cars were being priced out of the U.S. market. Japanese companies like Honda and Toyota, which had substantial production in the United States, gained business at Subaru’s ex- pense. But from 2012 onward, with Japan mired in reces- sion and consumer prices falling, the country’s central bank repeatedly cut interest rates in an attempt to stimu- late the economy. As interest rates fell in Japan, investors moved money out of the country, selling yen and buying the U.S. dollar. They used those dollars to invest in U.S. stocks and bonds where they anticipated a greater return.

Introduction

Like many enterprises in the global economy, the Japanese carmaker Subaru is affected by changes in the value of currencies on the foreign exchange market. As described in the opening case, Subaru’s revenues and profits are helped when the Japanese yen is weak against the U.S. dollar, and vice versa. The case illustrates that what happens in the for- eign exchange market can have a fundamental impact on the sales, profits, and strategy of an enterprise. Accordingly, it is very important for managers to understand how the for- eign exchange works, and what the impact of changes in currency exchange rates might be for their enterprise.

This chapter has three main objectives. The first is to explain how the foreign ex- change market works. The second is to examine the forces that determine exchange rates and to discuss the degree to which it is possible to predict future exchange rate move- ments. The third objective is to map the implications for international business of ex- change rate movements. This chapter is the first of three that deal with the international monetary system and its relationship to international business. The next chapter explores the institutional structure of the international monetary system. The institutional struc- ture is the context within which the foreign exchange market functions. As we shall see, changes in the institutional structure of the international monetary system can exert a profound influence on the development of foreign exchange markets.

288 Part 4 The Global Monetary System

The foreign exchange market is a market for converting the currency of one country into that of another country. An exchange rate is simply the rate at which one currency is converted into another. For example, Toyota uses the foreign exchange market to con- vert the dollars it earns from selling cars in the United States into Japanese yen. Without the foreign exchange market, international trade and international investment on the scale that we see today would be impossible; companies would have to resort to barter. The foreign exchange market is the lubricant that enables companies based in countries that use different currencies to trade with each other.

We know from earlier chapters that international trade and investment have their risks. Some of these risks exist because future exchange rates cannot be perfectly predicted. The rate at which one currency is converted into another can change over time. For example, at the start of 2001, one U.S. dollar bought 1.065 euros, but by early 2014 one U.S. dollar bought only 0.74 euro. The dollar had fallen sharply in value against the euro. This made American goods cheaper in Europe, boosting export sales. At the same time, it made Eu- ropean goods more expensive in the United States, which hurt the sales and profits of Eu- ropean companies that sold goods and services to the United States. The pricing advantage enjoyed by U.S. companies, however, disappeared during the second half of 2014 and early 2015 as economic weakness in Europe, and a stronger U.S. economy, resulted in a sharp fall in the value of the euro. By March 2015, one U.S. dollar bought 0.92 euro. Rapid changes in currency values such as these often take managers by surprise, and if they have not hedged against the possible risk, sales and profits can be significantly impacted. 

One function of the foreign exchange market is to provide some insurance against the risks that arise from such volatile changes in exchange rates, commonly referred to as foreign exchange risk. Although the foreign exchange market offers some insurance against foreign exchange risk, it cannot provide complete insurance. It is not unusual for international businesses to suffer losses (or gains) because of unpredicted changes in ex- change rates. Currency fluctuations can make seemingly profitable trade and investment deals unprofitable, and vice versa.

We begin this chapter by looking at the functions and the form of the foreign exchange market. This includes distinguishing among spot exchanges, forward exchanges, and cur- rency swaps. Then we consider the factors that determine exchange rates. We also look at how foreign trade is conducted when a country’s currency cannot be exchanged for other currencies, that is, when its currency is not convertible. The chapter closes with a discus- sion of these things in terms of their implications for business.

D ATA B A S E O F I N T E R N AT I O N A L B U S I N E S S S TAT I S T I C S

With Chapter 10, we begin a two-chapter series focused on issues related to what we call the “global money system.” The broad topics that are covered include the foreign exchange market and international monetary system. These are critically important topics that can have a signifi- cant effect on how companies operate globally. Oftentimes, companies have to deal with exchange rates, monetary systems, and the capital market on both country and regional levels. But the influences of countries on the regional and global money system are significant (i.e., countries set the tone for the parameters of the foreign exchange market and the international monetary system). The globalEDGE Database of International Business Statistics (DIBS) includes time-series data beginning in the 1990s until today and covers more than 200 countries and more than 5,000 data variables. Countries, regions, and the world use these types of data points to drive the global money system, and everyone who is interested in better understand- ing the global capital market needs to know about them! Register on globalEDGE to gain ac- cess to the DIBS database right now; students have free access to DIBS!

The Foreign Exchange Market Chapter 10 289

The Functions of the Foreign Exchange Market

The foreign exchange market serves two main functions. The first is to convert the cur- rency of one country into the currency of another. The second is to provide some insur- ance against foreign exchange risk, or the adverse consequences of unpredictable changes in exchange rates.1

CURRENCY CONVERSION

Each country has a currency in which the prices of goods and services are quoted. In the United States, it is the dollar ($); in Great Britain, the pound (£); in France, Germany, and the other 17 members of the euro zone it is the euro (€); in Japan, the yen (¥); and so on. In general, within the borders of a particular country, one must use the national currency. A U.S. tourist cannot walk into a store in Edinburgh, Scotland, and use U.S. dollars to buy a bottle of Scotch whisky. Dollars are not recognized as legal tender in Scotland; the tourist must use British pounds. Fortunately, the tourist can go to a bank and exchange her dollars for pounds. Then she can buy the whisky.

When a tourist changes one currency into another, she is participating in the foreign ex- change market. The exchange rate is the rate at which the market converts one currency into another. For example, an exchange rate of €1 = $1.30 specifies that 1 euro buys 1.30 U.S. dollars. The exchange rate allows us to compare the relative prices of goods and services in different countries. Our U.S. tourist wishing to buy a bottle of Scotch whisky in Edinburgh may find that she must pay £30 for the bottle, knowing that the same bottle costs $45 in the United States. Is this a good deal? Imagine the current pound/dollar exchange rate is £1.00 = $2.00 (i.e., one British pound buys $2.00). Our intrepid tourist takes out her calculator and converts £30 into dollars. (The calculation is 30 × 2.) She finds that the bottle of Scotch costs the equivalent of $60. She is surprised that a bottle of Scotch whisky could cost less in the United States than in Scotland (alcohol is taxed heavily in Great Britain).

Tourists are minor participants in the foreign exchange market; companies engaged in international trade and investment are major ones. International businesses have four main uses of foreign exchange markets. First, the payments a company receives for its exports, the income it receives from foreign investments, or the income it receives from licensing agreements with foreign firms may be in foreign cur- rencies. To use those funds in its home country, the company must con- vert them to its home country’s currency. Consider the Scotch distillery that exports its whisky to the United States. The distillery is paid in dollars, but because those dollars cannot be spent in Great Britain, they must be converted into British pounds. Similarly, Toyota sells its cars in the United States for dollars; it must convert the U.S. dollars it re- ceives into Japanese yen to use them in Japan.

Second, international businesses use foreign exchange markets when they must pay a foreign company for its products or services in its coun- try’s currency. For example, Dell buys many of the components for its computers from Malaysian firms. The Malaysian companies must be paid in Malaysia’s currency, the ringgit, so Dell must convert money from dollars into ringgit to pay them.

Third, international businesses also use foreign exchange markets when they have spare cash that they wish to invest for short terms in money markets. For example, consider a U.S. company that has $10 mil- lion it wants to invest for three months. The best interest rate it can earn on these funds in the United States may be 2 percent. Investing in a South Korean money market account, however, may earn 6 percent. Thus, the company may change its $10 million into Korean won and invest it in South Korea. Note, however, that the rate of return it earns

LO 10 -1 Describe the functions of the foreign exchange market.

Every time tourists change money in a foreign country they are participating in the foreign exchange market. Source: © Ed Brown/Alamy

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on this investment depends not only on the Korean interest rate but also on the changes in the value of the Korean won against the dollar in the intervening period.

Currency speculation is another use of foreign exchange markets. Currency speculation typically involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates. Consider again a U.S. company with $10 million to invest for three months. Suppose the company suspects that the U.S. dollar is overvalued against the Japanese yen. That is, the company expects the value of the dollar to depreciate (fall) against that of the yen. Imagine the current dollar/yen exchange rate is $1 = ¥120. The company exchanges its $10 million into yen, receiving ¥1.2 billion ($10 million × 120 = ¥1.2 billion). Over the next three months, the value of the dollar depreciates against the yen until $1 = ¥100. Now the company exchanges its ¥1.2 billion back into dollars and finds that it has $12 million. The company has made a $2 million profit on currency speculation in three months on an initial investment of $10 million! In general, however, companies should beware, for speculation by definition is a very risky business. The company cannot know for sure what will happen to exchange rates. While a speculator may profit handsomely if his speculation about future currency movements turns out to be correct, he can also lose vast amounts of money if he turns out to be wrong.

A kind of speculation that has become more common in recent years is known as the carry trade. The carry trade involves borrowing in one currency where interest rates are low and then using the proceeds to invest in another currency where interest rates are high. For example, if the interest rate on borrowings in Japan is 1 percent, but the interest rate on deposits in American banks is 6 percent, it can make sense to borrow in Japanese yen, con- vert the money into U.S. dollars, and deposit it in an American bank. The trader can make a 5 percent margin by doing so, minus the transaction costs associated with changing one currency into another. The speculative element of this trade is that its success is based on a belief that there will be no adverse movement in exchange rates (or interest rates for that matter) that will make the trade unprofitable. However, if the yen were to rapidly increase in value against the dollar, then it would take more U.S. dollars to repay the original loan, and the trade could fast become unprofitable. The dollar/yen carry trade was actually very significant during the mid-2000s, peaking at more than $1 trillion in 2007, when some 30 percent of trade on the Tokyo foreign exchange market was related to the carry trade.2 This carry trade declined in importance during 2008–2009 because interest rate differen- tials were falling as U.S. rates came down, making the trade less profitable.

INSURING AGAINST FOREIGN EXCHANGE RISK

A second function of the foreign exchange market is to provide insurance against foreign exchange risk, which is the possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm. When a firm insures itself against foreign exchange risk, it is engaging in hedging. To explain how the market performs this function, we must first distinguish among spot exchange rates, forward exchange rates, and currency swaps.

Spot Exchange Rates When two parties agree to exchange currency and execute the deal immediately, the transaction is referred to as a spot exchange. Exchange rates governing such “on the spot” trades are referred to as spot exchange rates. The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day. Thus, when our U.S. tourist in Edinburgh goes to a bank to convert her dollars into pounds, the exchange rate is the spot rate for that day.

Spot exchange rates are reported on a real-time basis on many financial websites. An exchange rate can be quoted in two ways: as the amount of foreign currency one U.S. dollar will buy or as the value of a dollar for one unit of foreign currency. Thus, on March 26, 2015, at 12:30 p.m., Eastern Standard Time, one U.S. dollar bought €0.0.92, and one euro bought $1.09.

Spot rates change continually, often on a minute-by-minute basis (although the magnitude of changes over such short periods is usually small). The value of a currency is determined

LO 10 -2 Understand what is meant by spot exchange rates.

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by the interaction between the demand and supply of that currency relative to the demand and supply of other currencies. For example, if lots of people want U.S. dollars and dol- lars are in short supply, and few people want British pounds and pounds are in plentiful supply, the spot exchange rate for converting dollars into pounds will change. The dollar is likely to appreciate against the pound (or the pound will depreciate against the dollar). Imagine the spot exchange rate is £1 = $2.00 when the market opens. As the day pro- gresses, dealers demand more dollars and fewer pounds. By the end of the day, the spot exchange rate might be £1 = $1.98. Each pound now buys fewer dollars than at the start of the day. The dollar has appreciated, and the pound has depreciated.

Forward Exchange Rates Changes in spot exchange rates can be problematic for an international business. For ex- ample, a U.S. company that imports high-end cameras from Japan knows that in 30 days it must pay yen to a Japanese supplier when a shipment arrives. The company will pay the Japanese supplier ¥200,000 for each camera, and the current dollar/yen spot exchange rate is $1 = ¥120. At this rate, each camera costs the importer $1,667 (i.e., 1,667 = 200,000/120). The importer knows she can sell the camera the day they arrive for $2,000 each, which yields a gross profit of $333 on each ($2,000 − $1,667). However, the im- porter will not have the funds to pay the Japanese supplier until the cameras are sold. If, over the next 30 days, the dollar unexpectedly depreciates against the yen, say, to $1 = ¥95, the importer will still have to pay the Japanese company ¥200,000 per camera, but in dollar terms that would be equivalent to $2,105 per camera, which is more than she can sell the cameras for. A depreciation in the value of the dollar against the yen from $1 = ¥120 to $1 = ¥95 would transform a profitable deal into an unprofitable one.

To insure or hedge against this risk, the U.S. importer might want to engage in a for- ward exchange. A forward exchange occurs when two parties agree to exchange cur- rency and execute the deal at some specific date in the future. Exchange rates governing such future transactions are referred to as forward exchange rates. For most major currencies, forward exchange rates are quoted for 30 days, 90 days, and 180 days into the future. In some cases, it is possible to get forward exchange rates for several years into the future. Returning to our camera importer example, let us assume the 30-day forward exchange rate for converting dollars into yen is $1 = ¥110. The importer enters into a 30-day forward exchange transaction with a foreign exchange dealer at this rate and is guaranteed that she will have to pay no more than $1,818 for each camera (1,818 = 200,000/110). This guarantees her a profit of $182 per camera ($2,000 − $1,818). She also insures herself against the possibility that an unanticipated change in the dollar/yen ex- change rate will turn a profitable deal into an unprofitable one.

In this example, the spot exchange rate ($1 = ¥120) and the 30-day forward rate ($1 = ¥110) differ. Such differences are normal; they reflect the expectations of the foreign exchange market about future currency movements. In our example, the fact that $1 bought more yen with a spot exchange than with a 30-day forward exchange indicates foreign exchange dealers expected the dollar to depreciate against the yen in the next 30 days. When this occurs, we say the dollar is selling at a discount on the 30-day forward market (i.e., it is worth less than on the spot market). Of course, the opposite can also occur. If the 30-day forward exchange rate were $1 = ¥130, for example, $1 would buy more yen with a forward exchange than with a spot exchange. In such a case, we say the dollar is selling at a premium on the 30-day forward market. This reflects the foreign exchange dealers’ expectations that the dollar will appreciate against the yen over the next 30 days.

In sum, when a firm enters into a forward exchange contract, it is taking out insurance against the possibility that future exchange rate movements will make a transaction un- profitable by the time that transaction has been executed. Although many firms routinely enter into forward exchange contracts to hedge their foreign exchange risk, there are some spectacular examples of what happens when firms don’t take out this insurance. An example is given in the accompanying Management Focus, which explains how a failure to fully insure against foreign exchange risk cost Volkswagen dearly.

LO 10 -3 Recognize the role that forward exchange rates play in insuring against foreign exchange risk.

M A NAG E M E N T F O C U S

In January 2004, Volkswagen, Europe’s largest carmaker, reported a 95 percent drop in 2003 fourth-quarter profits, which slumped from €1.05 billion to a mere €50 million. For all of 2003, Volkswagen’s operating profit fell by 50 percent from the record levels attained in 2002. Although the profit slump had multiple causes, two factors were the focus of much attention—the sharp rise in the value of the euro against the dollar during 2003 and Volkswagen’s decision to hedge only 30 percent of its foreign currency exposure, as opposed to the 70 percent it had traditionally hedged. In total, currency losses due to the dollar’s rise are estimated to have reduced Volkswagen’s operating profits by some €1.2 billion ($1.5 billion). The rise in the value of the euro during 2003 took many companies by surprise. Since its introduction January 1, 1999, when it became the currency unit of 12 members of the European Union, the euro had recorded a volatile trading history against the U.S. dollar. In early 1999, the exchange rate stood at €1 = $1.17, but by October 2000 it had slumped to €1 = $0.83. Although it recovered, reach- ing parity of €1 = $1.00 in late 2002, few analysts predicted a rapid rise in the value of the euro against the dollar dur- ing 2003. As so often happens in the foreign exchange markets, the experts were wrong; by late 2003, the ex- change rate stood at €1 = $1.25. For Volkswagen, which made cars in Germany and exported them to the United States, the fall in the value of the dollar against the euro during 2003 was devastating. To understand what hap- pened, consider a Volkswagen Jetta built in Germany for export to the United States.

Volkswagen’s Hedging Strategy Volkswagen could have insured against this adverse movement in exchange rates by entering the foreign exchange market in late 2002 and buying a forward contract for dollars at an exchange rate of around $1 = €1 (a forward contract gives the holder the right to exchange one currency for another at some point in the future at a predetermined exchange rate). Called hedging, the financial strategy of buy- ing forward guarantees that at some future point, such as 180 days, Volkswagen would have been able to exchange the dollars it got from selling Jettas in the United States into euros at $1 = €1, irrespective of what the actual exchange rate was at that time. In 2003, such a strategy would have been good for Volkswagen. However, hedging is not without its costs. For one thing, if the euro had declined in value against the dollar, instead of appreciating as it did, Volkswagen would have made even more profit per car in euros by not hedging (a dollar at the end of 2003 would have bought more euros than a dollar at the end of 2002). For another thing, hedging is expensive because foreign exchange dealers will charge a high commission for selling currency forward. Volkswagen decided to hedge just 30 percent of its anticipated U.S. sales in 2003 through forward contracts, rather than the 70 percent it had historically hedged. The decision cost the company more than €1 billion. For 2004, the company reverted back to hedging 70 percent of its foreign currency exposure.

Sources: Mark Landler, “As Exchange Rates Swing, Car Makers Try to Duck,” The New York Times, January 17, 2004, pp. B1, B4; N. Boudette, “Volkswagen Posts 95% Drop in Net,” The Wall Street Journal, February 19, 2004, p. A3; “Volkswagen’s Financial Mechanic,” Corporate Finance, June 2003, p. 1.

Currency Swaps The preceding discussion of spot and forward exchange rates might lead you to conclude that the option to buy forward is very important to companies engaged in international trade— and you would be right. According to the most recent data, forward instruments account for almost two-thirds of all foreign exchange transactions, while spot exchanges account for about one-third.3 However, the vast majority of these forward exchanges are not forward exchanges of the type we have been discussing, but rather a more sophisticated instrument known as currency swaps.

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 busi- nesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange risk. A common kind of swap is spot against forward. Consider a company such as Apple Computer. Apple assembles laptop computers in the United States, but the screens

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are made in Japan. Apple also sells some of the finished laptops in Japan. So, like many companies, Apple both buys from and sells to Japan. Imagine Apple needs to change $1 million into yen to pay its supplier of laptop screens today. Apple knows that in 90 days it will be paid ¥120 million by the Japanese importer that buys its finished laptops. It will want to convert these yen into dollars for use in the United States. Let us say today’s spot exchange rate is $1 = ¥120 and the 90-day forward exchange rate is $1 = ¥110. Apple sells $1 million to its bank in return for ¥120 million. Now Apple can pay its Japanese supplier. At the same time, Apple enters into a 90-day forward exchange deal with its bank for converting ¥120 million into dollars. Thus, in 90 days Apple will receive $1.09 million (¥120 million/ 110 = $1.09 million). Because the yen is trading at a premium on the 90-day forward market, Apple ends up with more dollars than it started with (although the opposite could also occur). The swap deal is just like a conventional forward deal in one important respect: It enables Apple to insure itself against foreign exchange risk. By engaging in a swap, Apple knows today that the ¥120 million payment it will receive in 90 days will yield $1.09 million.

The Nature of the Foreign Exchange Market

The foreign exchange market is not located in any one place. It is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems. When companies wish to convert currencies, they typically go through their own banks rather than entering the market directly. The foreign exchange market has been growing at a rapid pace, reflecting a general growth in the volume of cross-border trade and invest- ment (see Chapter 1). In March 1986, the average total value of global foreign exchange trading was about $200 billion per day. By April 2013, the last date for which we have solid data, it had hit $5.3 trillion a day.4 The most important trading centers are London (37 percent of activity), New York (18 percent of activity), and Zurich, Tokyo, and Singapore (all with around 5 to 6 percent of activity).5 Major secondary trading centers include Frankfurt, Paris, Hong Kong, and Sydney.

London’s dominance in the foreign exchange market is due to both history and geography. As the capital of the world’s first major industrial trading nation, London had become the world’s largest center for international banking by the end of the nineteenth century, a position it has retained. Today, London’s central position between Tokyo and Singapore to the east and New York to the west has made it the critical link between the East Asian and New York markets. Due to the particular differences in time zones, London opens soon after Tokyo closes for the night and is still open for the first few hours of trading in New York.6

Two features of the foreign exchange market are of particular note. The first is that the market never sleeps. Tokyo, London, and New York are all shut for only 3 hours out of every 24. During these 3 hours, trading continues in a number of minor centers, particularly San Francisco and Sydney, Australia. The second feature of the market is the integration of the various trading centers. High-speed computer linkages among trading centers around the globe have effectively created a single market. The integration of financial centers implies there can be no significant difference in exchange rates quoted in the trading centers. For example, if the yen/dollar exchange rate quoted in London at 3 p.m. is ¥120 = $1, the yen/dollar exchange rate quoted in New York at the same time (10 a.m. New York time) will be identical. If the New York yen/dollar exchange rate were ¥125 = $1, a dealer could make a profit through arbitrage, buying a currency low and selling it high. For example, if the prices differed in London and New York as given, a dealer in New York could take $1 million and use that to purchase ¥125 million. She could then immediately sell the ¥125 million for dollars in London, where the transaction would yield $1.041666 million, allowing the trader to book a profit of $41,666 on the transaction. If all dealers tried to cash in on the opportunity, however, the demand for yen in New York would rise, resulting in an appreciation of the yen against the dollar such that the price differential between

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New York and London would quickly disappear. Because foreign exchange dealers are always watching their computer screens for arbitrage opportunities, the few that arise tend to be small, and they disappear in minutes.

Another feature of the foreign exchange market is the important role played by the U.S. dollar. Although a foreign exchange transaction can involve any two currencies, most transactions involve dollars on one side. This is true even when a dealer wants to sell a nondollar currency and buy another. A dealer wishing to sell Korean won for Brazilian real, for example, will usually sell the won for dollars and then use the dollars to buy real. Although this may seem a roundabout way of doing things, it is actually cheaper than trying to find a holder of real who wants to buy won. Because the volume of international transactions involving dollars is so great, it is not hard to find dealers who wish to trade dollars for won or real.

Due to its central role in so many foreign exchange deals, the dollar is a vehicle currency. In 2013, 87 percent of all foreign exchange transactions involved dollars on one side of the transaction. After the dollar, the most important vehicle currencies were the euro (33 percent), the Japanese yen (23 percent), and the British pound (12 percent)—reflecting the historical importance of these trading entities in the world economy.

Economic Theories of Exchange Rate Determination

At the most basic level, exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another. For example, if the demand for dollars outstrips the supply of them and if the supply of Japanese yen is greater than the demand for them, the dollar/yen exchange rate will change. The dollar will appreciate against the yen (the yen will depreciate against the dollar). However, while differences in relative demand and supply explain the determination of exchange rates, they do so only in a superficial sense. This simple explanation does not reveal what factors underlie the demand for and supply of a currency. Nor does it tell us when the demand for dollars will exceed the supply (and vice versa) or when the supply of Japanese yen will exceed demand for them (and vice versa). Neither does it show under what conditions a currency is in demand or under what conditions it is not demanded. In this section, we will review eco- nomic theory’s answers to these questions. This will give us a deeper understanding of how exchange rates are determined.

If we understand how exchange rates are determined, we may be able to forecast ex- change rate movements. Because future exchange rate movements influence export oppor- tunities, the profitability of international trade and investment deals, and the price competitiveness of foreign imports, this is valuable information for an international business. Unfortunately, there is no simple explanation. The forces that determine exchange rates are complex, and no theoretical consensus exists, even among academic economists who study the phenomenon every day. Nonetheless, most economic theories of exchange rate movements seem to agree that three factors have an important impact on future exchange rate movements in a country’s currency: the country’s price inflation, its interest rate, and market psychology.7

PRICES AND EXCHANGE RATES

To understand how prices are related to exchange rate movements, we first need to discuss an economic proposition known as the law of one price. Then we will discuss the theory of purchasing power parity (PPP), which links changes in the exchange rate between two countries’ currencies to changes in the countries’ price levels.

The Law of One Price The law of one price states that in competitive markets free of transportation costs and barriers to trade (such as tariffs), identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency.8 For example,

LO 10 - 4 Understand the different theories explaining how currency exchange rates are determined and their relative merits.

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The Foreign Exchange Market Chapter 10 295

if the exchange rate between the British pound and the dollar is £1 = $2, a jacket that retails for $80 in New York should sell for £40 in London (because $80/$2 = £40). Consider what would happen if the jacket cost £30 in London ($60 in U.S. currency). At this price, it would pay a trader to buy jackets in London and sell them in New York (an example of arbitrage). The company initially could make a profit of $20 on each jacket by purchasing it for £30 ($60) in London and selling it for $80 in New York (we are assuming away transportation costs and trade barriers). However, the increased demand for jackets in London would raise their price in London, and the increased supply of jackets in New York would lower their price there. This would continue until prices were equalized. Thus, prices might equalize when the jacket cost £35 ($70) in London and $70 in New York (assuming no change in the exchange rate of £1 = $2).

Purchasing Power Parity If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. By comparing the prices of identical products in different currencies, it would be possible to determine the “real” or PPP exchange rate that would exist if markets were efficient. (An efficient market has no impediments to the free flow of goods and services, such as trade barriers.)

A less extreme version of the PPP theory states that given relatively efficient mar- kets—that is, markets in which few impediments to international trade exist—the price of a “basket of goods” should be roughly equivalent in each country. To express the PPP theory in symbols, let P$ be the U.S. dollar price of a basket of particular goods and P¥ be the price of the same basket of goods in Japanese yen. The PPP theory predicts that the dollar/yen exchange rate, E$/¥, should be equivalent to

E$/ ¥ = P$/P¥ Thus, if a basket of goods costs $200 in the United States and ¥20,000 in Japan, PPP theory predicts that the dollar/yen exchange rate should be $200/¥20,000 or $0.01 per Japanese yen (i.e., $1 = ¥100).

Every year, the newsmagazine The Economist publishes its own version of the PPP theorem, which it refers to as the “Big Mac Index.” The Economist has selected McDonald’s Big Mac as a proxy for a “basket of goods” because it is produced according to more or less the same recipe in about 120 countries. The Big Mac PPP is the exchange rate that would have hamburgers costing the same in each country. According to The Economist, comparing a country’s actual exchange rate with the one predicted by the PPP theorem based on relative prices of Big Macs is a test of whether a currency is undervalued or not. This is not a totally serious exercise, as The Economist admits, but it does provide a use- ful illustration of the PPP theorem.

To calculate the index, The Economist converts the price of a Big Mac in a country into dollars at current exchange rates and divides that by the average price of a Big Mac in America. According to the PPP theorem, the prices should be the same. If they are not, it implies that the currency is either overvalued against the dollar or undervalued. For example, in January 2015, the average price of a Big Mac in the United States was $4.79, while it was $5.21 in Brazil, $6.30 in Norway, and $2.77 in China. This suggests that the Brazilian real is overvalued by 8.7 percent and the Norwegian krona by 31.5 percent, while the Chinese currency is undervalued by 42.2 percent!

The next step in the PPP theory is to argue that the exchange rate will change if relative prices change. For example, imagine there is no price inflation in the United States, while prices in Japan are increasing by 10 percent a year. At the beginning of the year, a basket of goods costs $200 in the United States and ¥20,000 in Japan, so the dollar/yen exchange rate, according to PPP theory, should be $1 = ¥100. At the end of the year, the basket of goods still costs $200 in the United States, but it costs ¥22,000 in Japan. PPP theory predicts that the exchange rate should change as a result. More precisely, by the end of the year:

E$/ ¥ = $ 200/¥22,000

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Thus, ¥1 = $0.0091 (or $1 = ¥110). Because of 10 percent price inflation, the Japanese yen has depreciated by 10 percent against the dollar. One dollar will buy 10 percent more yen at the end of the year than at the beginning.

Money Supply and Price Inflation In essence, PPP theory predicts that changes in relative prices will result in a change in exchange rates. Theoretically, a country in which price inflation is running wild should expect to see its currency depreciate against that of countries in which inflation rates are lower. If we can predict what a country’s future inflation rate is likely to be, we can also predict how the value of its currency relative to other currencies—its exchange rate—is likely to change. The growth rate of a country’s money supply determines its likely future inflation rate.9 Thus, in theory at least, we can use information about the growth in money supply to forecast exchange rate movements.

Inflation is a monetary phenomenon. It occurs when the quantity of money in circula- tion rises faster than the stock of goods and services—that is, when the money supply increases faster than output increases. Imagine what would happen if everyone in the country was suddenly given $10,000 by the government. Many people would rush out to spend their extra money on those things they had always wanted—new cars, new furni- ture, better clothes, and so on. There would be a surge in demand for goods and services. Car dealers, department stores, and other providers of goods and services would respond to this upsurge in demand by raising prices. The result would be price inflation.

A government increasing the money supply is analogous to giving people more money. An increase in the money supply makes it easier for banks to borrow from the govern- ment and for individuals and companies to borrow from banks. The resulting increase in credit causes increases in demand for goods and services. Unless the output of goods and services is growing at a rate similar to that of the money supply, the result will be infla- tion. This relationship has been observed time after time in country after country.

So now we have a connection between the growth in a country’s money supply, price inflation, and exchange rate movements. Put simply, when the growth in a country’s money supply is faster than the growth in its output, price inflation is fueled. The PPP theory tells us that a country with a high inflation rate will see depreciation in its cur- rency exchange rate. In one of the clearest historical examples, in the mid-1980s, Bolivia experienced hyperinflation—an explosive and seemingly uncontrollable price inflation in which money loses value very rapidly. Table 10.1 presents data on Bolivia’s money supply, inflation rate, and its peso’s exchange rate with the U.S. dollar during the period of hyperinflation. The exchange rate is actually the “black market” exchange rate, be- cause the Bolivian government prohibited converting the peso to other currencies during the period. The data show that the growth in money supply, the rate of price inflation,

and the depreciation of the peso against the dollar all moved in step with each other. This is just what PPP theory and monetary economics predict. Between April 1984 and July 1985, Bolivia’s money supply increased by 17,433 percent, prices increased by 22,908 percent, and the value of the peso against the dollar fell by 24,662 percent! In October 1985, the Bolivian government in- stituted a dramatic stabilization plan—which included the intro- duction of a new currency and tight control of the money supply—and by 1987 the country’s annual inflation rate was down to 16 percent.10

Another way of looking at the same phenomenon is that an in- crease in a country’s money supply, which increases the amount of currency available, changes the relative demand-and-supply con- ditions in the foreign exchange market. If the U.S. money supply is growing more rapidly than U.S. output, dollars will be relatively more plentiful than the currencies of countries where monetary growth is closer to output growth. As a result of this relative

Women shop at an outdoor market in La Paz, Boliva. Bolivia’s inflation rate is much lower today than it was in 1985, but must be carefully monitored. Source: © Noah Friedman-Rudovsky/Bloomberg/Getty Images

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increase in the supply of dollars, the dollar will depreciate on the foreign exchange mar- ket against the currencies of countries with slower monetary growth.

Government policy determines whether the rate of growth in a country’s money supply is greater than the rate of growth in output. A government can increase the money supply simply by telling the country’s central bank to issue more money. Gov- ernments tend to do this to finance public expenditure (building roads, paying govern- ment workers, paying for defense, etc.). A government could finance public expenditure by raising taxes, but because nobody likes paying more taxes and because politicians do not like to be unpopular, they have a natural preference for expanding the money supply. Unfortunately, there is no magic money tree. The result of excessive growth in money supply is typically price inflation. However, this has not stopped governments around the world from expanding the money supply, with predictable results. If an international business is attempting to predict future movements in the value of a country’s currency on the foreign exchange market, it should examine that country’s policy toward monetary growth. If the government seems committed to controlling the rate of growth in money supply, the country’s future inflation rate may be low (even if the current rate is high) and its currency should not depreciate too much on the foreign exchange market. If the government seems to lack the political will to con- trol the rate of growth in money supply, the future inflation rate may be high, which is

TA B L E 1 0 . 1

Macroeconomic Data for Bolivia, April 1984 to October 1985

Source: From Juan-Antonio Morales, “Inflation Stabilization in Bolivia” in Inflation Stabili- zation: The Experience of Israel, Argentina, Brazil, Bolivia, and Mexico, ed. Michael Bruno et al. (Cambridge, MA: MIT Press, 1988).

Price Level Exchange Money Supply Relative to 1982 Rate (pesos Month (billions of pesos) (average = 1) per dollar) 1984

April 270 21.1 3,576

May 330 31.1 3,512

June 440 32.3 3,342

July 599 34.0 3,570

August 718 39.1 7,038

September 889 53.7 13,685

October 1,194 85.5 15,205

November 1,495 112.4 18,469

December 3,296 180.9 24,515

1985

January 4,630 305.3 73,016

February 6,455 863.3 141,101

March 9,089 1,078.6 128,137

April 12,885 1,205.7 167,428

May 21,309 1,635.7 272,375

June 27,778 2,919.1 481,756

July 47,341 4,854.6 885,476

August 74,306 8,081.0 1,182,300

September 103,272 12,647.6 1,087,440

October 132,550 12,411.8 1,120,210

298

likely to cause its currency to depreciate. Historically, many Latin American govern- ments have fallen into this latter category, including Argentina, Bolivia, and Brazil. More recently, many of the newly democratic states of eastern Europe made the same mistake. In late 2010, when the U.S. Federal Reserve decided to promote growth by expanding the U.S. money supply using a technique known as quantitative easing, crit- ics charged that this too would lead to inflation and a decline in the value of the U.S. dollar on foreign exchange markets, but are they right? For a discussion of this, see the accompanying Country Focus.

COUNTRY FOCUS

Quantitative Easing, Inflation, and the Value of the U.S. Dollar In fall 2010, the U.S. Federal Reserve decided to expand the U.S. money supply by entering the open market and purchasing $600 billion in U.S. government bonds from bondholders, a technique known as quantitative easing. Where did the $600 billion come from? The Fed simply created new bank reserves and used this cash to pay for the bonds. It had, in effect, printed money. The Fed took this action in an attempt to stimulate the U.S. economy, which, in the aftermath of the 2008–2009 global financial crisis, was struggling with low economic growth and high unemploy- ment rates. The Fed had already tried to stimulate the econ- omy by lowering short-term interest rates, but these were already close to zero, so it decided to lower medium- to longer-term rates; its tool for doing this was to pump $600  billion into the economy, increasing the supply of money and lowering its price, the interest rate. The Fed pursued further rounds of quantitative easing in 2011 through to 2013. In 2014, with the U.S. economy getting stronger and unemployment falling below 6 percent, the Fed progressively reduced its bond buying program. It ended the program in October 2014. By that time the Fed had effectively pumped more than $3.5 trillion into the U.S. economy.  Critics were quick to attack the Fed’s moves. Many claimed that the policy of expanding the money supply would fuel inflation and lead to a decline in the value of the U.S. dollar on the foreign exchange market. Some even called the policy a deliberate attempt by the Fed to debase the value of the U.S. currency, thereby driving down its value and promoting U.S. exports, which if true would be a form of mercantilism. However, these charges may be unfounded for two reasons. First, at the time, the core U.S. inflation rate was the lowest in 50 years. In fact, the Fed actually feared the risk of deflation (a persistent fall in prices), which is a very damaging phenomenon. When prices are falling, people

hold off their purchases because they know that goods will be cheaper tomorrow than they are today. This can result in a collapse in aggregate demand and high unem- ployment. The Fed felt that a little inflation—say, 2 percent per year—might be a good thing. Second, U.S. economic growth had been weak, unemployment was high, and there was excess productive capacity in the economy. Consequently, if the injection of money into the economy did stimulate demand, this would not translate into price inflation because the first response of businesses would be to expand output to utilize their excess capacity. Defenders of the Fed argued that the important point, which the critics seemed to be missing, was that expanding the money supply leads to only higher price inflation when unemployment is relatively low and there is not much excess capacity in the economy, a situation that did not exist in fall 2010. As for the currency market, its reaction was muted. At the beginning of November 2010, just be- fore the Fed announced its policy, the index value of the dollar against a basket of other major currencies stood at 98.6. At the end of January 2013, it stood at 99.1—little changed. In short, currency traders did not seem to be selling off the dollar or reflecting worries about high infla- tion rates. By early 2015, with the program over, there was no sign of a surge in price inflation in the U.S. economy. Indeed, inflation rates remained near historic lows. Moreover, far from weakening, the U.S. dollar had increased in value against most currencies, and the index value stood at 117. The Fed, it would seem, had been right and the critics were wrong. 

Sources: P. Wallsten and S. Reddy, “Fed’s Bond Buying Plan Ignites Growing Criticism,” The Wall Street Journal, November 15, 2010; S.  Chan, “Under Attack, the Fed Defends Policy of Buying Bonds,” International Herald Tribune, November 17, 2010; “What QE Means for the World; Positive Sum Currency Wars,” The Econo- mist, February 14, 2013.

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Empirical Tests of PPP Theory PPP theory predicts that exchange rates are determined by relative prices and that changes in relative prices will result in a change in exchange rates. A country in which price infla- tion is running wild should expect to see its currency depreciate against that of countries with lower inflation rates. This is intuitively appealing, but is it true in practice? There are several good examples of the connection between a country’s price inflation and ex- change rate position (such as Bolivia). However, extensive empirical testing of PPP theory has yielded mixed results.11 While PPP theory seems to yield relatively accurate predic- tions in the long run, it does not appear to be a strong predictor of short-run movements in exchange rates covering time spans of five years or less.12 In addition, the theory seems to best predict exchange rate changes for countries with high rates of inflation and under- developed capital markets. The theory is less useful for predicting short-term exchange rate movements between the currencies of advanced industrialized nations that have rela- tively small differentials in inflation rates.

The failure to find a strong link between relative inflation rates and exchange rate movements has been referred to as the purchasing power parity puzzle. Several factors may explain the failure of PPP theory to predict exchange rates more accurately.13 PPP theory assumes away transportation costs and barriers to trade. In practice, these factors are significant, and they tend to create significant price differentials between countries. Transportation costs are certainly not trivial for many goods. Moreover, as we saw in Chapter 7, governments routinely intervene in international trade, creating tariff and non- tariff barriers to cross-border trade. Barriers to trade limit the ability of traders to use arbitrage to equalize prices for the same product in different countries, which is required for the law of one price to hold. Government intervention in cross-border trade, by violat- ing the assumption of efficient markets, weakens the link between relative price changes and changes in exchange rates predicted by PPP theory.

PPP theory may not hold if many national markets are dominated by a handful of mul- tinational enterprises that have sufficient market power to be able to exercise some influ- ence over prices, control distribution channels, and differentiate their product offerings between nations.14 In fact, this situation seems to prevail in a number of industries. In such cases, dominant enterprises may be able to exercise a degree of pricing power, set- ting different prices in different markets to reflect varying demand conditions. This is referred to as price discrimination. For price discrimination to work, arbitrage must be limited. According to this argument, enterprises with some market power may be able to control distribution channels and therefore limit the unauthorized resale (arbitrage) of products purchased in another national market. They may also be able to limit resale (arbitrage) by differentiating otherwise identical products among nations along some line, such as design or packaging.

For example, even though the version of Microsoft Office sold in China may be less expensive than the version sold in the United States, the use of arbitrage to equalize prices may be limited because few Americans would want a version that was based on Chinese characters. The design differentiation between Microsoft Office for China and for the United States means that the law of one price would not work for Microsoft Of- fice, even if transportation costs were trivial and tariff barriers between the United States and China did not exist. If the inability to practice arbitrage were widespread enough, it would break the connection between changes in relative prices and exchange rates predicted by the PPP theorem and help explain the limited empirical support for this theory.

Another factor of some importance is that governments also intervene in the foreign exchange market in attempting to influence the value of their currencies. We look at why and how they do this in Chapter 11. For now, the important thing to note is that govern- ments regularly intervene in the foreign exchange market, and this further weakens the link between price changes and changes in exchange rates. One more factor explaining the failure of PPP theory to predict short-term movements in foreign exchange rates is the

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impact of investor psychology and other factors on currency purchasing decisions and exchange rate movements. We discuss this issue in more detail later in this chapter.

INTEREST RATES AND EXCHANGE RATES

Economic theory tells us that interest rates reflect expectations about likely future infla- tion rates. In countries where inflation is expected to be high, interest rates also will be high, because investors want compensation for the decline in the value of their money. This relationship was first formalized by economist Irvin Fisher and is referred to as the Fisher effect. The Fisher effect states that a country’s “nominal” interest rate (i) is the sum of the required “real” rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent (I). More formally,

i = r + I

For example, if the real rate of interest in a country is 5 percent and annual inflation is expected to be 10 percent, the nominal interest rate will be 15 percent. As predicted by the Fisher effect, a strong relationship seems to exist between inflation rates and interest rates.15

We can take this one step further and consider how it applies in a world of many coun- tries and unrestricted capital flows. When investors are free to transfer capital between countries, real interest rates will be the same in every country. If differences in real inter- est rates did emerge between countries, arbitrage would soon equalize them. For exam- ple, if the real interest rate in Japan was 10 percent and only 6 percent in the United States, it would pay investors to borrow money in the United States and invest it in Japan. The resulting increase in the demand for money in the United States would raise the real interest rate there, while the increase in the supply of foreign money in Japan would lower the real interest rate there. This would continue until the two sets of real interest rates were equalized.

It follows from the Fisher effect that if the real interest rate is the same worldwide, any difference in interest rates between countries reflects differing expectations about infla- tion rates. Thus, if the expected rate of inflation in the United States is greater than that in Japan, U.S. nominal interest rates will be greater than Japanese nominal interest rates.

Because we know from PPP theory that there is a link (in theory at least) between in- flation and exchange rates, and because interest rates reflect expectations about inflation, it follows that there must also be a link between interest rates and exchange rates. This link is known as the international Fisher effect. The international Fisher effect (IFE) 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 the two countries. Stated more formally, the change in the spot exchange rate between the United States and Japan, for example, can be modeled as follows:

S1 − S2 × 100 = i$ − i¥S2 where i$ and i¥ are the respective nominal interest rates in the United States 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. If the U.S. nominal interest rate is higher than Japan’s, reflecting greater expected inflation rates, the value of the dollar against the yen should fall by that interest rate differential in the future. So if the interest rate in the United States is 10 per- cent and in Japan it is 6 percent, we would expect the value of the dollar to depreciate by 4 percent against the Japanese yen.

Do interest rate differentials help predict future currency movements? The evidence is mixed; as in the case of PPP theory, in the long run, there seems to be a relationship be- tween interest rate differentials and subsequent changes in spot exchange rates. However, considerable short-run deviations occur. Like PPP, the international Fisher effect is not a good predictor of short-run changes in spot exchange rates.16

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INVESTOR PSYCHOLOGY AND BANDWAGON EFFECTS

Empirical evidence suggests that neither PPP theory nor the international Fisher effect is particularly good at explaining short-term movements in exchange rates. One reason may be the impact of investor psychology on short-run exchange rate movements. Evidence reveals that various psychological factors play an important role in determining the ex- pectations of market traders as to likely future exchange rates.17 In turn, expectations have a tendency to become self-fulfilling prophecies.

A particularly famous example of this mechanism occurred in September 1992 when the international financier George Soros made a huge bet against the British pound. Soros borrowed billions of pounds, using the assets of his investment funds as collateral, and immediately sold those pounds for German deutsche marks (this was before the advent of the euro). This technique, known as short selling, can earn the speculator enormous profits if he can subsequently buy back the pounds he sold at a much better exchange rate and then use those pounds, purchased cheaply, to repay his loan. By selling pounds and buying deutsche marks, Soros helped start pushing down the value of the pound on the foreign exchange markets. More importantly, when Soros started shorting the British pound, many foreign exchange traders, knowing Soros’s reputation, jumped on the bandwagon and did likewise. This triggered a classic bandwagon effect with traders moving as a herd in the same direction at the same time. As the bandwagon effect gained momentum, with more traders selling British pounds and purchasing deutsche marks in expectation of a decline in the pound, their expectations became a self-fulfilling prophecy. Massive selling forced down the value of the pound against the deutsche mark. In other words, the pound de- clined in value not so much because of any major shift in macroeconomic fundamentals, but because investors followed a bet placed by a major speculator, George Soros.

According to a number of studies, investor psychology and bandwagon effects play an important role in determining short-run exchange rate movements.18 However, these effects can be hard to predict. Investor psychology can be influenced by political factors and by microeconomic events, such as the investment decisions of individual firms, many of which are only loosely linked to macroeconomic fundamentals, such as relative inflation rates. Also, bandwagon effects can be both triggered and exacerbated by the idiosyncratic behav- ior of politicians. Something like this seems to have occurred in Southeast Asia during 1997 when, one after another, the currencies of Thailand, Malaysia, South Korea, and Indonesia lost between 50 and 70 percent of their value against the U.S. dollar in a few months.

SUMMARY OF EXCHANGE RATE THEORIES

Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates. They are poor predictors of short-run changes in exchange rates, however, perhaps because of the im- pact of psychological factors, investor expectations, and bandwagon effects on short-term currency movements. This information is useful for an international business. Insofar as the long-term profitability of foreign investments, export opportunities, and the price competitiveness of foreign imports are all influenced by long-term movements in ex- change rates, international businesses would be advised to pay attention to countries’ differing monetary growth, inflation, and interest rates. International businesses that en- gage in foreign exchange transactions on a day-to-day basis could benefit by knowing some predictors of short-term foreign exchange rate movements. Unfortunately, short- term exchange rate movements are difficult to predict.

Exchange Rate Forecasting

A company’s need to predict future exchange rate variations raises the issue of whether it is worthwhile for the company to invest in exchange rate forecasting services to aid deci- sion making. Two schools of thought address this issue. The efficient market school argues that forward exchange rates do the best possible job of forecasting future spot

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LO 10 -5 Identify the merits of different approaches toward exchange rate forecasting.

302 Part 4 The Global Monetary System

exchange rates, and, therefore, investing in forecasting services would be a waste of money. The other school of thought, the inefficient market school, argues that companies can improve the foreign exchange market’s estimate of future exchange rates (as con- tained in the forward rate) by investing in forecasting services. In other words, this school of thought does not believe the forward exchange rates are the best possible predictors of future spot exchange rates.

THE EFFICIENT MARKET SCHOOL

Forward exchange rates represent market participants’ collective predictions of likely spot exchange rates at specified future dates. If forward exchange rates are the best pos- sible predictor of future spot rates, it would make no sense for companies to spend addi- tional money trying to forecast short-run exchange rate movements. Many economists believe the foreign exchange market is efficient at setting forward rates.19 An efficient market is one in which prices reflect all available public information. (If forward rates reflect all available information about likely future changes in exchange rates, a company cannot beat the market by investing in forecasting services.)

If the foreign exchange market is efficient, forward exchange rates should be unbiased predictors of future spot rates. This does not mean the predictions will be accurate in any specific situation. It means inaccuracies will not be consistently above or below future spot rates; they will be random. Many empirical tests have addressed the efficient market hypothesis. Although most of the early work seems to confirm the hypothesis (suggesting that companies should not waste their money on forecasting services) some studies have challenged it.20 There is some evidence that forward rates are not unbiased predictors of future spot rates, and that more accurate predictions of future spot rates can be calculated from publicly available information.21

THE INEFFICIENT MARKET SCHOOL

Citing evidence against the efficient market hypothesis, some economists believe the for- eign exchange market is inefficient. 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.

If this is true, it may be worthwhile for international businesses to invest in forecasting services (as many do). The belief is that professional exchange rate forecasts might pro- vide better predictions of future spot rates than forward exchange rates do. However, the track record of professional forecasting services is not that good.22 For example, forecast- ing services did not predict the 1997 currency crisis that swept through Southeast Asia, nor did they predict the rise in the value of the dollar that occurred during late 2008, a period when the United States fell into a deep financial crisis that some thought would lead to a decline in the value of the dollar (it appears that the dollar rose because it was seen as a relatively safe currency in a time when many nations were experiencing eco- nomic trouble).

APPROACHES TO FORECASTING

Assuming the inefficient market school is correct that the foreign exchange market’s es- timate of future spot rates can be improved, on what basis should forecasts be prepared? Here again, there are two schools of thought. One adheres to fundamental analysis, while the other uses technical analysis.

Fundamental Analysis Fundamental analysis draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements. The variables contained in these models typically include those we have discussed, such as relative money supply growth rates, inflation rates, and interest rates. In addition, they may include variables related to bal- ance-of-payments positions.

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Running a deficit on a balance-of-payments current account (a country is importing more goods and services than it is exporting) creates pressures that may result in the de- preciation of the country’s currency on the foreign exchange market.23 Consider what might happen if the United States was running a persistent current account balance-of- payments deficit (as it has been). Because the United States would be importing more than it was exporting, people in other countries would be increasing their holdings of U.S. dollars. If these people were willing to hold their dollars, the dollar’s exchange rate would not be influenced. However, if these people converted their dollars into other currencies, the supply of dollars in the foreign exchange market would increase (as would demand for the other currencies). This shift in demand and supply would create pressures that could lead to the depreciation of the dollar against other currencies.

This argument hinges on whether people in other countries are willing to hold dollars. This depends on such factors as U.S. interest rates, the return on holding other dollar- denominated assets such as stocks in U.S. companies, and, most important, inflation rates. So, in a sense, the balance-of-payments situation is not a fundamental predictor of future exchange rate movements. But what makes financial assets such as stocks and bonds attractive? The answer is prevailing interest rates and inflation rates, both of which affect underlying economic growth and the real return to holding U.S. financial assets. Given this, we are back to the argument that the fundamental determinants of exchange rates are monetary growth, inflation rates, and interest rates.

Technical Analysis Technical analysis uses price and volume data to determine past trends, which are ex- pected to continue into the future. This approach does not rely on a consideration of economic fundamentals. Technical analysis is based on the premise that there are analyz- able market trends and waves and that previous trends and waves can be used to predict future trends and waves. Since there is no theoretical rationale for this assumption of predictability, many economists compare technical analysis to fortune-telling. Despite this skepticism, technical analysis has gained favor in recent years.24

Currency Convertibility

Until this point, we have assumed that the currencies of various countries are freely con- vertible into other currencies. Due to government restrictions, a significant number of currencies are not freely convertible into other currencies. A country’s currency is said to be freely convertible when the country’s government allows both residents and nonresi- dents to purchase unlimited amounts of a foreign currency with it. A currency is said to be externally convertible when only nonresidents may convert it into a foreign currency without any limitations. A currency is nonconvertible when neither residents nor non- residents are allowed to convert it into a foreign currency.

Free convertibility is not universal. Many countries place some restrictions on their resi- dents’ ability to convert the domestic currency into a foreign currency (a policy of external convertibility). Restrictions range from the relatively minor (such as restricting the amount of foreign currency they may take with them out of the country on trips) to the major (such as restricting domestic businesses’ ability to take foreign currency out of the country). Ex- ternal convertibility restrictions can limit domestic companies’ ability to invest abroad, but they present few problems for foreign companies wishing to do business in that country. For example, even if the Japanese government tightly controlled the ability of its residents to convert the yen into U.S. dollars, all U.S. businesses with deposits in Japanese banks may at any time convert all their yen into dollars and take them out of the country. Thus, a U.S. company with a subsidiary in Japan is assured that it will be able to convert the profits from its Japanese operation into dollars and take them out of the country.

Serious problems arise, however, under a policy of nonconvertibility. This was the prac- tice of the former Soviet Union, and it continued to be the practice in Russia for several

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304 Part 4 The Global Monetary System

years after the collapse of the Soviet Union. When strictly applied, nonconvertibility means that although a U.S. company doing business in a country such as Russia may be able to generate significant ruble profits, it may not convert those rubles into dollars and take them out of the country. Obviously this is not desirable for international business.

Governments limit convertibility to preserve their foreign exchange reserves. A coun- try needs an adequate supply of these reserves to service its international debt commit- ments and to purchase imports. Governments typically impose convertibility restrictions on their currency when they fear that free convertibility will lead to a run on their foreign exchange reserves. This occurs when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency—a phenomenon generally referred to as capital flight. Capital flight is most likely to occur when the value of the domestic currency is depreciating rapidly because of hyperinflation or when a country’s economic prospects are shaky in other respects. Under such circumstances, both residents and non- residents tend to believe that their money is more likely to hold its value if it is converted into a foreign currency and invested abroad. Not only will a run on foreign exchange re- serves limit the country’s ability to service its international debt and pay for imports, but it will also lead to a precipitous depreciation in the exchange rate as residents and non- residents unload their holdings of domestic currency on the foreign exchange markets (thereby increasing the market supply of the country’s currency). Governments fear that the rise in import prices resulting from currency depreciation will lead to further in- creases in inflation. This fear provides another rationale for limiting convertibility.

Companies can deal with the nonconvertibility problem by engaging in countertrade. Countertrade refers to a range of barter-like agreements by which goods and services can be traded for other goods and services. Countertrade can make sense when a country’s cur- rency is nonconvertible. For example, consider the deal that General Electric struck with the Romanian government when that country’s currency was nonconvertible. When General Electric won a contract for a $150 million generator project in Romania, it agreed to take payment in the form of Romanian goods that could be sold for $150 million on international markets. In a similar case, the Venezuelan government negotiated a contract with Caterpil- lar under which Venezuela would trade 350,000 tons of iron ore for Caterpillar heavy con- struction equipment. Caterpillar subsequently traded the iron ore to Romania in exchange for Romanian farm products, which it then sold on international markets for dollars.25

How important is countertrade? Twenty years ago, a large number of nonconvertible currencies existed in the world, and countertrade was quite significant. However, in recent years many governments have made their currencies freely convertible, and the percentage of world trade that involves countertrade is probably significantly below 10 percent.26

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F O C U S O N M A NAG E R I A L I M P L I C AT I O N S

FOREIGN EXCHANGE RATE RISK Compare and contrast the differences among translation, transaction, and economic

exposure, and what managers can do to manage each type of exposure. This chapter contains a number of clear implications for business. First, it is critical

that international businesses understand the influence of exchange rates on the profitability of trade and investment deals. Adverse changes in exchange rates can make apparently profitable deals unprofitable. As noted, the risk introduced into

international business transactions by changes in exchange rates is referred to as foreign exchange risk. Foreign exchange risk is usually divided into three main cate-

gories: transaction exposure, translation exposure, and economic exposure.

Transaction Exposure Transaction exposure is the extent to which the income from indi- vidual transactions is affected by fluctuations in foreign exchange values. Such exposure

LO 10 - 6 Compare and contrast the differences among translation, transaction, and economic exposure, and what managers can do to manage each type of exposure.

The Foreign Exchange Market Chapter 10 305

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. For example, suppose in 2004 an American airline agreed to purchase 10 Airbus 330 aircraft for €120 million each for a total price of €1.20 billion, with delivery scheduled for 2008 and payment due then. When the contract was signed in 2004 the dollar/euro exchange rate stood at $1 = €1.10, so the American airline anticipated paying $1.09 billion for the 10 aircraft when they were delivered (€1.2 billion/1.1 = $1.09 billion). However, imagine that the value of the dollar depreciates against the euro over the intervening period, so that a dollar buys only €0.80 in 2008 when payment is due ($1 = €0.80). Now the total cost in U.S. dollars is $1.5 billion (€1.2 billion/ 0.80 = $1.5 billion), an increase of $0.41 billion! The transaction exposure here is $0.41 billion, which is the money lost due to an adverse movement in exchange rates between the time when the deal was signed and when the aircraft were paid for.

Translation Exposure Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company. Translation exposure is con- cerned with the present measurement of past events. The resulting accounting gains or losses are said to be unrealized—they are “paper” gains and losses—but they are still impor- tant. Consider a U.S. firm with a subsidiary in Mexico. If the value of the Mexican peso depre- ciates significantly against the dollar, this would substantially reduce the dollar value of the Mexican subsidiary’s equity. In turn, this would reduce the total dollar value of the firm’s eq- uity reported in its consolidated balance sheet. This would raise the apparent leverage of the firm (its debt ratio), which could increase the firm’s cost of borrowing and potentially limit its access to the capital market. Similarly, if an American firm has a subsidiary in the Euro- pean Union, and if the value of the euro depreciates rapidly against that of the dollar over a year, this will reduce the dollar value of the euro profit made by the European subsidiary, resulting in negative translation exposure. In fact, many U.S. firms suffered from significant negative translation exposure in Europe during 2000, precisely because the euro did de- preciate rapidly against the dollar. In 2002–2007, the euro rose in value against the dollar. This positive translation exposure boosted the dollar profits of American multinationals with significant operations in Europe. Between mid-2014 and early 2015, the euro slumped in value against the dollar, compressing the dollar profits of American multinationals with sig- nificant European exposure. 

Economic Exposure Economic exposure is the extent to which a firm’s future international earning power is affected by changes in exchange rates. Economic exposure is concerned with the long-run effect of changes in exchange rates on future prices, sales, and costs. This is distinct from transaction exposure, which is concerned with the effect of exchange rate changes on individual transactions, most of which are short-term affairs that will be executed within a few weeks or months. Consider the effect of wide swings in the value of the dollar on many U.S. firms’ international competitiveness. The rapid rise in the value of the dollar on the foreign exchange market in the 1990s hurt the price competitiveness of many U.S. pro- ducers in world markets. U.S. manufacturers that relied heavily on exports saw their export volume and world market share decline. The reverse phenomenon occurred in 2000–2009, when the dollar declined against most major currencies. The fall in the value of the dollar helped increase the price competitiveness of U.S. manufacturers in world markets. Between mid-2014 and early 2015 the dollar increased significantly in value against most major cur- rencies, decreasing the price competitiveness of U.S. exporters. 

Reducing Translation and Transaction Exposure A number of tactics can help firms minimize their transaction and translation exposure. These tactics primarily protect short-term cash flows from adverse changes in exchange rates. We have already discussed two of these tactics at length in the chapter, entering into forward exchange rate contracts and buying swaps. In addition to buying forward and using swaps, firms can minimize their foreign ex- change exposure through leading and lagging payables and receivables—that is, paying suppliers and collecting payment from customers early or late depending on expected

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exchange rate movements. A lead strategy involves attempting to collect foreign currency receivables (payments from customers) early when a foreign currency is expected to depre- ciate and paying foreign currency payables (to suppliers) before they are due when a cur- rency is expected to appreciate. A lag strategy involves delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate. Leading and lagging involve accelerating payments from weak-currency to strong-currency countries and delaying inflows from strong-currency to weak-currency countries. Lead and lag strategies can be difficult to implement, however. The firm must be in a posi- tion to exercise some control over payment terms. Firms do not always have this kind of bargaining power, particularly when they are dealing with important customers who are in a position to dictate payment terms. Also, because lead and lag strategies can put pressure on a weak currency, many governments limit leads and lags. For example, some countries set 180 days as a limit for receiving payments for exports or making payments for imports.

Reducing Economic Exposure Reducing economic exposure requires strategic choices that go beyond the realm of financial management. The key to reducing economic exposure is to distribute the firm’s productive assets to various locations so the firm’s long-term financial well-being is not severely affected by adverse changes in exchange rates. This is a strategy that firms both large and small sometimes pursue. For example, during the 2000s fearing that the euro would continue to strengthen against the U.S. dollar, some European firms that did significant business in the United States set up local production facilities in that market to ensure that a rising euro does not put them at a competitive disadvantage relative to their local rivals. Similarly, Toyota has production plants distributed around the world in part to make sure that a rising yen does not price Toyota cars out of local markets. Caterpillar has also pursued this strategy, setting up factories around the world that can act as a hedge against the possibility that a strong dollar will price Caterpillar’s exports out of foreign mar- kets. In 2008, 2009, and 2014–2015, all periods of dollar strength, this real hedge proved to be very useful.

Other Steps for Managing Foreign Exchange Risk A firm needs to develop a mechanism for ensuring it maintains an appropriate mix of tactics and strategies for minimizing its foreign exchange exposure. Although there is no universal agreement as to the components of this mechanism, a number of common themes stand out.27 First, central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies. Many companies have set up in-house foreign exchange centers. Although such centers may not be able to execute all foreign exchange deals—particularly in large, complex multinationals where myriad transactions may be pursued simultaneously— they should at least set guidelines for the firm’s subsidiaries to follow. Second, firms should distinguish between, on one hand, transaction and translation ex- posure and, on the other, economic exposure. Many companies seem to focus on reducing their transaction and translation exposure and pay scant attention to economic exposure, which may have more profound long-term implications.28 Firms need to develop strategies for dealing with economic exposure. For example, Stanley Black & Decker, the maker of power tools, has a strategy for actively managing its economic risk. The key to Stanley Black & Decker’s strategy is flexible sourcing. In response to foreign exchange movements, Stanley Black & Decker can move production from one location to another to offer the most competitive pricing. Stanley Black & Decker manufactures in more than a dozen locations around the world—in Europe, Australia, Brazil, Mexico, and Japan. More than 50 percent of the company’s productive assets are based outside North America. Although each of Stanley Black & Decker’s factories focuses on one or two products to achieve economies of scale, there is considerable overlap. On average, the company runs its factories at no more than 80 percent capacity, so most are able to switch rapidly from producing one product to producing another or to add a product. This allows a factory’s production to be changed in response to foreign exchange movements. For example, if the dollar depreciates

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against other currencies, the amount of imports into the United States from overseas subsid- iaries can be reduced and the amount of exports from U.S. subsidiaries to other locations can be increased.29

Third, the need to forecast future exchange rate movements cannot be overstated, though, as we saw earlier in the chapter, this is a tricky business. No model comes close to perfectly predicting future movements in foreign exchange rates. The best that can be said is that in the short run, forward exchange rates provide the best predictors of exchange rate movements, and in the long run, fundamental economic factors—particularly relative inflation rates—should be watched because they influence exchange rate movements. Some firms attempt to forecast exchange rate movements in-house; others rely on outside forecasters. However, all such forecasts are imperfect attempts to predict the future. Fourth, firms need to establish good reporting systems so the central finance function (or in-house foreign exchange center) can regularly monitor the firm’s exposure positions. Such reporting systems should enable the firm to identify any exposed accounts, the exposed position by currency of each account, and the time periods covered. Finally, on the basis of the information it receives from exchange rate forecasts and its own regular reporting systems, the firm should produce monthly foreign exchange exposure reports. These reports should identify how cash flows and balance sheet elements might be affected by forecasted changes in exchange rates. The reports can then be used by man- agement as a basis for adopting tactics and strategies to hedge against undue foreign ex- change risks. Surprisingly, some of the largest and most sophisticated firms don’t take such precaution- ary steps, exposing themselves to very large foreign exchange risks. Thus, as we have seen in this chapter, Volkswagen suffered significant losses during the early 2000s due to a fail- ure to adequately hedge its foreign exchange exposure.

foreign exchange market, p. 288 exchange rate, p. 288 foreign exchange risk, p. 289 currency speculation, p. 290 carry trade, p. 290 spot exchange rate, p. 290 forward exchange, p. 291 forward exchange rate, p. 291 currency swap, p. 292

arbitrage, p. 293 law of one price, p. 294 efficient market, p. 295 Fisher effect, p. 300 international Fisher effect

(IFE), p. 300 bandwagon effect, p. 301 inefficient market, p. 302 freely convertible currency, p. 303

externally convertible currency, p. 303 nonconvertible currency, p. 303 capital flight, p. 304 countertrade, p. 304 transaction exposure, p. 304 translation exposure, p. 305 economic exposure, p. 305 lead strategy, p. 306 lag strategy, p. 306

Key Terms

C H A P T E R S U M M A R Y

This chapter explained how the foreign exchange market works, examined the forces that determine exchange rates, and then discussed the implications of these factors for in- ternational business. Given that changes in exchange rates can dramatically alter the profitability of foreign trade and investment deals, this is an area of major interest to interna- tional business. The chapter made the following points:

1. One function of the foreign exchange market is to convert the currency of one country into the currency of another. A second function of the

foreign exchange market is to provide insurance against foreign exchange risk.

2. The spot exchange rate is the exchange rate at which a dealer converts one currency into another currency on a particular day.

3. Foreign exchange risk can be reduced by using forward exchange rates. A forward exchange rate is an exchange rate governing future transactions. Foreign exchange risk can also be reduced by engaging in currency swaps. A swap

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is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.

4. The law of one price holds that in competitive markets that are free of transportation costs and barriers to trade, identical products sold in differ- ent countries must sell for the same price when their price is expressed in the same currency.

5. Purchasing power parity (PPP) theory states the price of a basket of particular goods should be roughly equivalent in each country. PPP theory predicts that the exchange rate will change if relative prices change.

6. The rate of change in countries’ relative prices depends on their relative inflation rates. A country’s inflation rate seems to be a function of the growth in its money supply.

7. The PPP theory of exchange rate changes yields relatively accurate predictions of long-term trends in exchange rates, but not of short-term movements. The failure of PPP theory to predict exchange rate changes more accurately may be due to transportation costs, barriers to trade and investment, and the impact of psychological factors such as bandwagon effects on market movements and short-run exchange rates.

8. Interest rates reflect expectations about infla- tion. In countries where inflation is expected to be high, interest rates also will be high.

9. 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.

10. The most common approach to exchange rate forecasting is fundamental analysis. This relies on variables such as money supply growth, inflation rates, nominal interest rates, and balance-of-payments positions to predict future changes in exchange rates.

11. In many countries, the ability of residents and nonresidents to convert local currency into a foreign currency is restricted by government policy. A government restricts the convertibility of its currency to protect the country’s foreign exchange reserves and to halt any capital flight.

12. Nonconvertibility of a currency makes it very difficult to engage in international trade and investment in the country. One way of coping with the nonconvertibility problem is to engage in countertrade—to trade goods and services for other goods and services.

13. The three types of exposure to foreign ex- change risk are transaction exposure, translation exposure, and economic exposure.

14. Tactics that insure against transaction and translation exposure include buying forward, using currency swaps, and leading and lagging payables and receivables.

15. Reducing a firm’s economic exposure requires strategic choices about how the firm’s productive assets are distributed around the globe.

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. The interest rate on South Korean government securities with one-year maturity is 4 percent, and the expected inflation rate for the coming year is 2 percent. The interest rate on U.S. government securities with one-year maturity is 7 percent, and the expected rate of inflation is 5 percent. The current spot exchange rate for Korean won is $1 = W1,200. Forecast the spot exchange rate one year from today. Explain the logic of your answer.

2. Two countries, Great Britain and the United States, produce just one good: beef. Suppose the price of beef in the United States is $2.80 per pound and in Britain it is £3.70 per pound.

a. According to PPP theory, what should the dollar/pound spot exchange rate be?

b. Suppose the price of beef is expected to rise to $3.10 in the United States and to £4.65 in Britain. What should the one-year forward dollar/pound exchange rate be?

c. Given your answers to parts a and b, and given that the current interest rate in the United States is 10 percent, what would you expect the current interest rate to be in Britain?

3. Reread the Management Focus on Volkswagen; then answer the following questions:

a. Why do you think management at Volkswagen decided to hedge only 30 percent of the automaker’s foreign currency exposure in 2003? What would have happened if it had hedged 70 percent of exposure?

b. Why do you think the value of the U.S. dollar declined against that of the euro in 2003?

c. Apart from hedging through the foreign ex- change market, what else can Volkswagen do to reduce its exposure to future declines in the value of the U.S. dollar against the euro?

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4. You manufacture wine goblets. In mid-June, you receive an order for 10,000 goblets from Japan. Payment of ¥400,000 is due in mid-December. You expect the yen to rise from its present rate of $1 = ¥130 to $1 = ¥100 by December. You can borrow yen at 6 percent a year. What should you do?

5. You are the CFO of a U.S. firm whose wholly owned subsidiary in Mexico manufactures

component parts for your U.S. assembly operations. The subsidiary has been financed by bank borrowings in the United States. One of your analysts told you that the Mexican peso is expected to depreciate by 30 percent against the dollar on the foreign exchange markets over the next year. What actions, if any, should you take?

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises:

1. One of your company’s essential suppliers is located in Japan. Your company needs to make a 1 million Japanese yen payment in six months. Considering that your company primarily operates in U.S. dollars, you are assigned the task of deciding on a strategy to minimize your transaction exposure. Identify the spot and forward exchange rates be- tween the two currencies. What factors influence your decision to use each? Which one would you choose? How many dollars must you spend to acquire the amount of yen required?

2. Sometimes, analysts use the price of specific products in different locations to compare cur- rency valuation and purchasing power. For ex- ample, The Economist’s Big Mac Index compares the purchasing power parity of many countries based on the price of a Big Mac. Using Google, locate the latest edition of this index that is accessible. Identify the five countries (and their currencies) with the lowest purchasing power parity according to this classification. Which currencies, if any, are overvalued?

For many years Brazil was a country battered by persis- tently high inflation. As a result the value of its currency, the real, depreciated steadily against the U.S. dollar. This changed in the early 2000s when the Brazilian govern- ment was successful in bringing down annual inflation rates into the single digits. Lower inflation, coupled with policies that paved the way for the expansion of the Brazilian economy, resulted in a steady appreciation of the real against the U.S. dollar. In May 2004, 1 real bought $0.3121; by August 2008, 1 real bought $0.65, an appreciation of more than 100 percent. The appreciation of the real against the dollar was a mixed bag for Embraer, the world’s largest manufacturer of regional jets of up to 110 seats and one of Brazil’s most prominent industrial companies. Embraer purchases many of the parts that go into its jets, including the en- gines and electronics, from U.S. manufacturers. As the real appreciated against the dollar, these parts cost less when translated into reals, which benefited Embraer’s

profit margins. However, the company also prices its air- craft in U.S. dollars, as do all manufacturers in the global market for commercial jet aircraft. So, as the real appreci- ated against the dollar, Embraer’s dollar revenues were compressed when exchanged back into reals. To try and deal with the impact of currency apprecia- tion on its revenues, in the mid-2000s Embraer started to hedge against future appreciation of the real by buying forward contracts (forward contracts give the holder the right to exchange one currency—in this case dollars—for another—in this case reals—at some point in the future at a predetermined exchange rate). If the real had continued to appreciate, this would have been a great strategy for Embraer because the company could have locked in the rate at which sales made in dollars were exchanged back into reals. Unfortunately for Embraer, as the global finan- cial crisis unfolded in 2008, investors fled to the dollar, which they viewed as a safe haven, and the real depreci- ated against the dollar. Between August 2008 and

C L O S I N G C A S E

Embraer and the Wild Ride of the Brazilian Real

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November 2008, the value of the real fell by almost 40  percent against the dollar. But for the hedging, this depreciation would have actually increased Embraer’s revenues in reals. Embraer, however, had locked itself into a much higher real/dollar exchange rate, and the company was forced to take a $121 million loss on what was essentially a bad currency bet. Since the shock of 2008, Embraer has cut back on currency hedging, and most of its dollar sales and pur- chases are not hedged. This makes Embraer’s sales rev- enues very sensitive to the real/dollar exchange rate. By 2010, the Brazilian real was once more appreciating against the U.S. dollar, which pressured Embraer’s reve- nues. By 2012, however, the Brazilian economy was stagnating, while inflation was starting to increase again. This led to a sustained fall in the value of the real, which fell from 1 real = $0.644 in July 2011 to 1 real = $0.40 by January 2014, a depreciation of 38 percent. What was bad for the Brazilian currency, however, was good for Embraer, whose stock price surged to the highest price since February 2008 on speculation that the decline on the real would lead to a boost in Embraer’s revenues when expressed in reals. Sources: D. Godoy, “Embraer Rallies as Brazilian Currency Weakens,” Bloomberg, May 31, 2013; K. Kroll, “Embraer Fourth Quarter Profits Plunge 44% on Currency Woes,” Cleveland.com, March 27, 2009; “A Fall from Grace: Brazil’s Mediocre Economy,” The Economist,

June 8, 2013; “Brazil’s Economy: The Deterioration,” The Economist, December 7, 2013.

C a s e D i s c u s s i o n Q u e s t i o n s

1. What does the recent economic history of Brazil tell you about the relationship between price in- flation and exchange rates? What other factors might determine exchange rates for the Brazilian real?

2. Is a decline in value of the real against the U.S. dollar good for Embraer, bad for Embraer, or a mixed bag? Explain your answer.

3. What kind of foreign exchange rate risks is Em- braer exposed to? Can Embraer reduce these risks? How?

4. Do you think Embraer’s decision to try and hedge against further appreciation of the real in the early 2000s was a good decision? What was the alternative? 

5. Since 2008 Embraer has significantly reduced its dollar hedging operations. Is this wise?  

6. Between mid-2014 and early 2015 the real depreciated significantly against the U.S. dollar. What do you think the impact was on Embraer?

E n d n o t e s

1. For a good general introduction to the foreign exchange market, see R. Weisweiller, How the Foreign Exchange Market Works (New York: New York Institute of Finance, 1990). A detailed description of the economics of foreign exchange markets can be found in P. R. Krugman and M. Obstfeld, International Economics: Theory and Policy (New York: HarperCollins, 1994).

2. “The Domino Effect,” The Economist, July 5, 2008, p. 85. 3. Bank for International Settlements, Tri-annual Central Bank

Survey of Foreign Exchange and Derivatives Market Activity, April 2013 (Basle, Switzerland: BIS, September 2013).

4. Ibid. 5. Ibid. 6. M. Dickson, “Capital Gain: How London Is Thriving as It

Takes on the Global Competition,” Financial Times, March 27, 2006, p. 11.

7. For a comprehensive review, see M. Taylor, “The Economics of Exchange Rates,” Journal of Economic Literature 33 (1995), pp. 13–47.

8. Krugman and Obstfeld, International Economics. 9. M. Friedman, Studies in the Quantity Theory of Money

(Chicago: University of Chicago Press, 1956). For an accessible explanation, see M. Friedman and R. Friedman, Free to Choose (London: Penguin Books, 1979), chap. 9.

10. Juan-Antonio Morales, “Inflation Stabilization in Bolivia,” in Inflation Stabilization: The Experience of Israel, Argentina, Brazil, Bolivia, and Mexico, ed. Michael Bruno et al. (Cambridge, MA: MIT Press, 1988); and The Economist, World Book of Vital Statistics (New York: Random House, 1990).

11. For reviews and various articles, see H. J. Edison, J. E. Gagnon, and W. R. Melick, “Understanding the Empirical Literature on Purchasing Power Parity,” Journal of International Money and Finance 16 (February 1997), pp. 1–18; J. R. Edison, “Multi- country Evidence on the Behavior of Purchasing Power Parity under the Current Float,” Journal of International Money and Finance 16 (February 1997), pp. 19–36; K. Rogoff, “The Pur- chasing Power Parity Puzzle,” Journal of Economic Literature 34 (1996), pp. 647–68; D. R. Rapach and M. E. Wohar, “Testing

The Foreign Exchange Market Chapter 10 311

the Monetary Model of Exchange Rate Determination: New Evidence from a Century of Data,” Journal of International Economics, December 2002, pp. 359–85; M. P. Taylor, “Purchas- ing Power Parity,” Review of International Economics, August 2003, pp. 436–56.

12. M. Obstfeld and K. Rogoff, “The Six Major Puzzles in Interna- tional Economics,” National Bureau of Economic Research Working Paper Series, paper no. 7777, July 2000.

13. Ibid. 14. See M. Devereux and C. Engel, “Monetary Policy in the Open

Economy Revisited: Price Setting and Exchange Rate Flexibility,” National Bureau of Economic Research Working Paper Series, paper no. 7665, April 2000. See also P. Krugman, “Pricing to Market When the Exchange Rate Changes,” in Real Financial Economics, ed. S. Arndt and J. Richardson (Cambridge, MA: MIT Press, 1987).

15. For a summary of the evidence, see the survey by Taylor, “The Economics of Exchange Rates.”

16. R. E. Cumby and M. Obstfeld, “A Note on Exchange Rate Expectations and Nominal Interest Differentials: A Test of the Fisher Hypothesis,” Journal of Finance, June 1981, pp. 697–703; and L. Coppock and M. Poitras, “Evaluating the Fisher Effect in Long Term Cross Country Averages,” International Review of Economics and Finance 9 (2000), pp. 181–203.

17. Taylor, “The Economics of Exchange Rates.” See also R. K. Lyons, The Microstructure Approach to Exchange Rates (Cambridge, MA: MIT Press, 2002).

18. See H. L. Allen and M. P. Taylor, “Charts, Noise, and Fundamentals in the Foreign Exchange Market,” Economic Journal 100 (1990), pp. 49–59; T. Ito, “Foreign Exchange Rate Expectations: Micro Survey Data,” American Economic Review 80 (1990), pp. 434–49; and T. F. Rotheli, “Bandwagon Effects and Run Patterns in Exchange Rates,” Journal of International Financial Markets, Money and Institutions 12, no. 2 (2002), pp. 157–66.

19. For example, see E. Fama, “Forward Rates as Predictors of Future Spot Rates,” Journal of Financial Economics, October 1976, pp. 361–77.

20. L. Kilian and M. P. Taylor, “Why Is It So Difficult to Beat the Random Walk Forecast of Exchange Rates?,” Journal of Inter- national Economics 20 (May 2003), pp. 85–103; and R. M. Levich, “The Efficiency of Markets for Foreign Exchange,” in International Finance, ed. G. D. Gay and R. W. Kold (Richmond, VA: Robert F. Dane, Inc., 1983).

21. J. Williamson, The Exchange Rate System (Washington, DC: Institute for International Economics, 1983); and R. H. Clarida, L. Sarno, M. P. Taylor, and G. Valente, “The Out of Sample Success of Term Structure Models as Exchange Rate Predictors,” Journal of International Economics 60 (May 2003), pp. 61–84.

22. Kilian and Taylor, “Why Is It So Difficult to Beat the Random Walk Forecast of Exchange Rates?”

23. Rogoff, “The Purchasing Power Parity Puzzle.” 24. C. Engel and J. D. Hamilton, “Long Swings in the Dollar: Are

They in the Data and Do Markets Know It?,” American Eco- nomic Review, September 1990, pp. 689–713.

25. J. R. Carter and J. Gagne, “The Do’s and Don’ts of Interna- tional Countertrade,” Sloan Management Review, Spring 1988, pp. 31–37.

26. D. S. Levine, “Got a Spare Destroyer Lying Around?,” World Trade 10 (June 1997), pp. 34–35; and Dan West, “Countertrade,” Business Credit, April 2001, pp. 64–67.

27. For details on how various firms manage their foreign exchange exposure, see the articles contained in the special foreign exchange issue of Business International Money Report, December 18, 1989, pp. 401–12.

28. Ibid. 29. S. Arterian, “How Black & Decker Defines Exposure,”

Business International Money Report, December 18, 1989, pp. 404, 405, 409.

Credit: ©Federal Reserve Board.

The International Monetary System L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO11-1 Describe the historical development of the modern global monetary system.

LO11-2 Explain the role played by the World Bank and the IMF in the international monetary system.

LO11-3 Compare and contrast the differences between a fixed and a floating exchange rate system.

LO11-4 Identify exchange rate regimes used in the world today and why countries adopt different exchange rate regimes.

LO11-5 Understand the debate surrounding the role of the IMF in the management of financial crises.

LO11-6 Explain the implications of the global monetary system for currency management and business strategy.

part four The Global Monetar y System

11

Source: © Brendan Hoffman/Getty Images

313

The IMF and Ukraine’s Economic Crisis

In an attempt to pull Ukraine out of an economic tail spin, in April 2014 the IMF pledged to contribute $17 billion in loans to the country over two years, of which about $5 bil- lion was disbursed in 2014. It wasn’t enough. The currency continued to lose value, inflation increased, unemployment rose, and the economy shrank. In early March 2015, the IMF deepened its involvement in the country, putting together a package of additional financial support. The IMF agreed to a four-year deal to loan $17.5 billion to Ukraine. The deal was expected to unlock another $20 billion in loans from the United States and the European Union. In return for these funds, which were to be used to sup- port the value of the hryvina in foreign exchange markets, Ukraine had to agree to a raft of policies imposed at the bequest of the IMF. The country agreed to maintain a free floating exchange rate and to pursue a tight monetary policy aimed at restoring price stability. The state-owned natural gas company, Naftogaz, was also required to increase its prices by as much as 200 percent. Naftogaz had been buy- ing natural gas at market prices from Russia, and selling it at deeply subsidized prices to Ukrainians. This money-losing transaction had been financed by issuing debt, which the government could no longer service. Ukraine also agreed to cut spending on unemployment and disability insurance. The IMF believed that while these austerity policies would result in the economy shrinking by a further 5 percent in 2015, the economy would start growing again in 2016.

Sources: Andrew Mayeda, “IMF Approves Ukraine Aid Package of about $17.5 Billion,” Bloomberg Business, March 11, 2015; Staff re- porter, “IMF Signs Off on $17.5 Billion Loan for Ukraine in Second At- tempt to Stave Off Bankruptcy,” Reuters, March 11, 2015; Staff reporter, “The New Greece in the East,” The Economist, March 12, 2015.

O P E N I N G C A S E Back in late 2013, then-president of Ukraine Viktor Yanukovych suspended preparations for the implementa- tion of a trade agreement with the European Union, opting instead for closer ties with Russia. Yanukovych’s decision resulted in mass protests in the capital city Kiev and else- where in western Ukraine, where closer ties with the West were seen as a necessary counterbalance to the growing influence of its powerful neighbor to the east, the increas- ingly autocratic Russia of Vladimir Putin. These protests ultimately led to Yanukovych’s ousting from office in Febru- ary 2014. Following his removal, unrest enveloped the largely Russian-speaking provinces of eastern and south- ern Ukraine from which he had drawn his support. In March 2014, the autonomous region of Crimea was annexed by Russia, while a civil war between the new Ukrainian gov- ernment and pro-Russian separatists developed in eastern Ukraine. The result was an economic disaster for Ukraine. In 2014 the country’s GDP shrank by nearly 10 percent. The currency, the hryvina, fell by more than 50 percent against other currencies. As the costs of imports rose, inflation jumped from 1 to 25 percent. In a desperate attempt to support the value of its currency, Ukraine’s central bank bought hryvina on the foreign exchange market, selling its foreign currency reserves to do so. Ukraine’s foreign ex- change reserves declined from more than $16 billion in mid-2014 to under $6 billion by early 2015. Moreover, the country was facing debt repayments of at least $10 billion and gas import bills from Russia, while its own banking sys- tem was shattered.

Introduction

What happened in Ukraine goes to the heart of the subject matter covered in this chapter. Here, we look at the international monetary system, and its role in determining exchange rates. The international monetary system refers to the institutional arrangements that govern exchange rates. In Chapter 10, we assumed the foreign exchange market was the primary institution for determining exchange rates and the impersonal market forces of demand and supply determined the relative value of any two currencies (i.e., their exchange rate). Furthermore, we explained that the demand and supply of currencies is influenced by their respective countries’ relative inflation rates and interest rates. When the foreign ex- change market determines the relative value of a currency, we say that the country is adher- ing to a floating exchange rate regime. Four of the world’s major trading currencies—the U.S. dollar, the European Union’s euro, the Japanese yen, and the British pound—are all free to float against each other. Thus, their exchange rates are determined by market forces and fluctuate against each other day to day, if not minute to minute. Similarly, as noted in the opening case, the Ukrainian currency, the hryvina, is also free to float against other currencies. However, the exchange rates of many currencies are not determined by the free play of market forces; other institutional arrangements are adopted.

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Many of the world’s developing nations peg their currencies, primarily to the dollar or the euro. A pegged exchange rate means the value of the currency is fixed relative to a reference currency, such as the U.S. dollar, and then the exchange rate between that currency and other currencies is determined by the reference currency exchange rate. Other countries, while not adopting a formal pegged rate, try to hold the value of their currency within some range against an important reference currency such as the U.S. dollar, or a “basket” of currencies. This is often referred to as a dirty-float system. It is a float because in theory, the value of the currency is determined by market forces, but it is a dirty float (as opposed to a clean float) because the central bank of a country will intervene in the foreign exchange market to try to maintain the value of its currency if it depreciates too rapidly against an important reference currency. This has been the policy adopted by the Chinese since July 2005. The value of the Chinese currency, the yuan, has been linked to a basket of other currencies—including the dollar, yen, and euro— and it is allowed to vary in value against individual currencies, but only within limits. Still other countries have operated with a fixed exchange rate, in which the values of a set of currencies are fixed against each other at some mutually agreed-on exchange rate. Before the introduction of the euro in 1999, several member states of the European Union operated with fixed exchange rates within the context of the European Monetary System (EMS). For a quarter of a century after World War II, the world’s major indus- trial nations participated in a fixed exchange rate system. Although this system collapsed in 1973, some still argue that the world should attempt to reestablish it.

G L O B A L E D G E B L O G

The international monetary system captures our attention because here we are talking about the institutional arrangements that govern exchange rates, and this is a tricky business where countries have leverage to influence their country’s currency value but do not neces- sarily always use it. The options for how the value, or “rate,” is set for a currency are many: floating exchange rate, pegged exchange rate, dirty float, and fixed exchange rate are the ones covered in Chapter 11. We start the chapter by some history related to the “gold stan- dard,” a practice that takes us back to ancient times. Technically, no country uses the gold standard any longer but many, including the United States, hold substantial gold reserves. The international monetary system depends on a lot of variables (see the globalEDGE Data- base of International Business Statistics which we covered in Chapter 10); today, these vari- ables also include “behavioral” (perception) issues in addition to hard, concrete data. The globalEDGE Blog has been a favored “international business” vehicle to stay current on important topics, often related to monetary issues. Check out the globalEDGE Blog (globaledge.msu.edu/blog), see what is covered on monetary issues, and engage with people from around the world on issues that are of interest to you.

This chapter explains how the international monetary system works and points out its implications for international business. To understand how the system works, we must re- view its evolution. We begin with a discussion of the gold standard and its breakup during the 1930s. Then we discuss the 1944 Bretton Woods conference. The Bretton Woods con- ference also created two major international institutions that play a role in the international monetary system—the International Monetary Fund (IMF) and the World Bank. The IMF was given the task of maintaining order in the international monetary system; the World Bank’s role was to promote development. Today, both these institutions continue to play major roles in the world economy and in the international monetary system. As we saw in the opening case, the IMF has stepped in to help Ukraine navigate its way through an economic crisis caused by political turmoil and a civil war in eastern Ukraine. The Bretton

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Woods system of fixed exchange rates collapsed in 1973. Since then, the world has oper- ated with a mixed system in which some currencies are allowed to float freely, but many are either managed by government intervention or pegged to another currency. Finally, we discuss the implications of all this material for international business. We will see how the exchange rate policy adopted by a government can have an important impact on the outlook for business operations in a given country. We also look at how the policies adopted by the IMF can have an impact on the economic outlook for a country and, accordingly, on the costs and benefits of doing business in that country.

The Gold Standard

The gold standard had its origin in the use of gold coins as a medium of exchange, unit of account, and store of value—a practice that dates to ancient times. When international trade was limited in volume, payment for goods purchased from another country was typically made in gold or silver. However, as the volume of international trade expanded in the wake of the Industrial Revolution, a more convenient means of financing interna- tional trade was needed. Shipping large quantities of gold and silver around the world to finance international trade seemed impractical. The solution adopted was to arrange for payment in paper currency and for governments to agree to convert the paper currency into gold on demand at a fixed rate.

MECHANICS OF THE GOLD STANDARD

Pegging currencies to gold and guaranteeing convertibility is known as the gold standard. By 1880, most of the world’s major trading nations, including Great Britain, Germany, Japan, and the United States, had adopted the gold standard. Given a common gold standard, the value of any currency in units of any other currency (the exchange rate) was easy to determine. For example, under the gold standard, one U.S. dollar was defined as equivalent to 23.22 grains of “fine” (pure) gold. Thus, one could, in theory, demand that the U.S. government convert that one dollar into 23.22 grains of gold. Because there are 480 grains in an ounce, one ounce of gold cost $20.67 (480/23.22). The amount of a currency needed to purchase one ounce of gold was referred to as the gold par value. The British pound was valued at 113 grains of fine gold. In other words, one ounce of gold cost £4.25 (480/113). From the gold par values of pounds and dollars, we can calculate what the exchange rate was for converting pounds into dollars; it was £1 = $4.87 (i.e., $20.67/£4.25).

STRENGTH OF THE GOLD STANDARD

The great strength claimed for the gold standard was that it contained a powerful mechanism for achieving balance-of-trade equilibrium by all countries.1 A country is said to be in balance-of-trade equilibrium when the income its residents earn from exports is equal to the money its residents pay to other countries for imports (the cur- rent account of its balance of payments is in balance). Suppose there are only two coun- tries in the world, Japan and the United States. Imagine Japan’s trade balance is in surplus because it exports more to the United States than it imports from the United States. Japanese exporters are paid in U.S. dollars, which they exchange for Japanese yen at a Japanese bank. The Japanese bank submits the dollars to the U.S. government and demands payment of gold in return. (This is a simplification of what would occur, but it will make our point.) Under the gold standard, when Japan has a trade surplus, there is a net flow of gold from the United States to Japan. These gold flows automatically reduce the U.S. money supply and swell Japan’s money supply. As we saw in Chapter 10, there is a close connec- tion between money supply growth and price inflation. An increase in money supply will raise prices in Japan, while a decrease in the U.S. money supply will push U.S. prices

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downward. The rise in the price of Japanese goods will decrease demand for these goods, while the fall in the price of U.S. goods will increase demand for these goods. Thus, Japan will start to buy more from the United States, and the United States will buy less from Japan, until a balance-of-trade equilibrium is achieved. This adjustment mechanism seems so simple and attractive that even today, nearly 80  years after the final collapse of the gold standard, some people believe the world should return to a gold standard.

THE PERIOD BETWEEN THE WARS: 1918–1939

The gold standard worked reasonably well from the 1870s until the start of World War I in 1914, when it was abandoned. During the war, several governments financed part of their massive military expenditures by printing money. This resulted in inflation, and by the war’s end in 1918, price levels were higher everywhere. The United States returned to the gold standard in 1919, Great Britain in 1925, and France in 1928. Great Britain returned to the gold standard by pegging the pound to gold at the prewar gold parity level of £4.25 per ounce, despite substantial inflation between 1914 and 1925. This priced British goods out of foreign markets, which pushed the country into a deep depression. When foreign holders of pounds lost confidence in Great Britain’s commit- ment to maintaining its currency’s value, they began converting their holdings of pounds into gold. The British government saw that it could not satisfy the demand for gold with- out seriously depleting its gold reserves, so it suspended convertibility in 1931. The United States followed suit and left the gold standard in 1933 but returned to it in 1934, raising the dollar price of gold from $20.67 per ounce to $35.00 per ounce. Because more dollars were needed to buy an ounce of gold than before, the implication was that the dollar was worth less. This effectively amounted to a devaluation of the dollar relative to other currencies. Thus, before the devaluation, the pound/dollar exchange rate was £1 = $4.87, but after the devaluation it was £1 = $8.24. By reducing the price of U.S. exports and increasing the price of imports, the government was trying to create employment in the United States by boosting output (the U.S. government was basically using the ex- change rate as an instrument of trade policy—something it now accuses China of doing). However, a number of other countries adopted a similar tactic, and in the cycle of com- petitive devaluations that soon emerged, no country could win. The net result was the shattering of any remaining confidence in the system. With coun- tries devaluing their currencies at will, one could no longer be certain how much gold a currency could buy. Instead of holding onto another country’s currency, people often tried to change it into gold immediately, lest the country devalue its currency in the intervening period. This put pressure on the gold reserves of various countries, forcing them to suspend gold convertibility. By the start of World War II in 1939, the gold standard was dead.

The Bretton Woods System

In 1944, at the height of World War II, representatives from 44 countries met at Bretton Woods, New Hampshire, to design a new international monetary system. With the col- lapse of the gold standard and the Great Depression of the 1930s fresh in their minds, these statesmen were determined to build an enduring economic order that would facili- tate postwar economic growth. There was consensus that fixed exchange rates were de- sirable. In addition, the conference participants wanted to avoid the senseless competitive devaluations of the 1930s, and they recognized that the gold standard would not ensure this. The major problem with the gold standard as previously constituted was that no mul- tinational institution could stop countries from engaging in competitive devaluations. The agreement reached at Bretton Woods established two multinational institutions— the International Monetary Fund (IMF) and the World Bank. The task of the IMF would be to maintain order in the international monetary system and that of the World Bank would be to promote general economic development. The Bretton Woods agreement also

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LO 11 -2 Explain the role played by the World Bank and the IMF in the international monetary system.

The International Monetary System Chapter 11 317

called for a system of fixed exchange rates that would be policed by the IMF. Under the agreement, all countries were to fix the value of their currency in terms of gold but were not required to exchange their currencies for gold. Only the dollar remained convertible into gold—at a price of $35 per ounce. Each country decided what it wanted its exchange rate to be vis-à-vis the dollar and then calculated the gold par value of the currency based on that selected dollar exchange rate. All participating countries agreed to try to maintain the value of their currencies within 1 percent of the par value by buying or selling curren- cies (or gold) as needed. For example, if foreign exchange dealers were selling more of a country’s currency than demanded, that country’s government would intervene in the foreign exchange markets, buying its currency in an attempt to increase demand and maintain its gold par value. Another aspect of the Bretton Woods agreement was a commitment not to use devalu- ation as a weapon of competitive trade policy. However, if a currency became too weak to defend, a devaluation of up to 10 percent would be allowed without any formal approval by the IMF. Larger devaluations required IMF approval.

THE ROLE OF THE IMF

The IMF Articles of Agreement were heavily influenced by the worldwide financial collapse, competitive devaluations, trade wars, high unemployment, hyperinflation in Germany and elsewhere, and general economic disintegration that occurred between the two world wars. The aim of the Bretton Woods agreement, of which the IMF was the main custodian, was to try to avoid a repetition of that chaos through a combination of discipline and flexibility.

Discipline A fixed exchange rate regime imposes discipline in two ways. First, the need to maintain a fixed exchange rate puts a brake on competitive devaluations and brings stability to the world trade environment. Second, a fixed exchange rate regime imposes monetary disci- pline on countries, thereby curtailing price inflation. For example, consider what would happen under a fixed exchange rate regime if Great Britain rapidly increased its money supply by printing pounds. As explained in Chapter 10, the increase in money supply would lead to price inflation. Given fixed exchange rates, inflation would make British goods uncompetitive in world markets, while the prices of imports would become more attractive in Great Britain. The result would be a widening trade deficit in Great Britain, with the country importing more than it exports. To correct this trade imbalance under a fixed exchange rate regime, Great Britain would be required to restrict the rate of growth in its money supply to bring price inflation back under control. Thus, fixed exchange rates are seen as a mechanism for controlling inflation and imposing economic discipline on countries.

Flexibility Although monetary discipline was a central objective of the Bretton Woods agreement, it was recognized that a rigid policy of fixed exchange rates would be too inflexible. It would probably break down just as the gold standard had. In some cases, a country’s at- tempts to reduce its money supply growth and correct a persistent balance-of-payments deficit could force the country into recession and create high unemployment. The archi- tects of the Bretton Woods agreement wanted to avoid high unemployment, so they built limited flexibility into the system. Two major features of the IMF Articles of Agreement fostered this flexibility: IMF lending facilities and adjustable parities. The IMF stood ready to lend foreign currencies to members to tide them over during short periods of balance-of-payments deficits, when a rapid tightening of monetary or fiscal policy would hurt domestic employment. A pool of gold and currencies contributed by IMF members provided the resources for these lending operations. A persistent bal- ance-of-payments deficit can lead to a depletion of a country’s reserves of foreign

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currency, forcing it to devalue its currency. By providing deficit-laden countries with short-term foreign currency loans, IMF funds would buy time for countries to bring down their inflation rates and reduce their balance-of-payments deficits. The belief was that such loans would reduce pressures for devaluation and allow for a more orderly and less painful adjustment. Countries were to be allowed to borrow a limited amount from the IMF without adher- ing to any specific agreements. However, extensive drawings from IMF funds would require a country to agree to increasingly stringent IMF supervision of its macroeco- nomic policies. Heavy borrowers from the IMF must agree to monetary and fiscal condi- tions set down by the IMF, which typically included IMF-mandated targets on domestic money supply growth, exchange rate policy, tax policy, government spending, and so on. The system of adjustable parities allowed for the devaluation of a country’s currency by more than 10 percent if the IMF agreed that a country’s balance of payments was in “fundamental disequilibrium.” The term fundamental disequilibrium was not defined in the IMF’s Articles of Agreement, but it was intended to apply to countries that had suf- fered permanent adverse shifts in the demand for their products. Without devaluation, such a country would experience high unemployment and a persistent trade deficit until the domestic price level had fallen far enough to restore a balance-of-payments equilib- rium. The belief was that devaluation could help sidestep a painful adjustment process in such circumstances.

THE ROLE OF THE WORLD BANK

The official name for the World Bank is the International Bank for Reconstruction and Development (IBRD). When the Bretton Woods participants established the World Bank, the need to reconstruct the war-torn economies of Europe was foremost in their minds. The bank’s initial mission was to help finance the building of Europe’s economy by pro- viding low-interest loans. As it turned out, the World Bank was overshadowed in this role by the Marshall Plan, under which the United States lent money directly to European nations to help them rebuild. So the bank turned its attention to development and began lending money to third-world nations. In the 1950s, the bank concentrated on public- sector projects. Power stations, road building, and other transportation investments were much in favor. During the 1960s, the bank also began to lend heavily in support of agri- culture, education, population control, and urban development. The bank lends money under two schemes. Under the IBRD scheme, money is raised through bond sales in the international capital market. Borrowers pay what the bank calls a market rate of interest—the bank’s cost of funds plus a margin for expenses. This “mar- ket” rate is lower than commercial banks’ market rate. Under the IBRD scheme, the bank offers low-interest loans to risky customers whose credit rating is often poor, such as the governments of underdeveloped nations. A second scheme is overseen by the International Development Association (IDA), an arm of the bank created in 1960. Resources to fund IDA loans are raised through sub- scriptions from wealthy members such as the United States, Japan, and Germany. IDA loans go only to the poorest countries. Borrowers have up to 50 years to repay at an inter- est rate of less than 1 percent a year. The world’s poorest nations receive grants and interest- free loans.

The Collapse of the Fixed Exchange Rate System

The system of fixed exchange rates established at Bretton Woods worked well until the late 1960s, when it began to show signs of strain. The system finally collapsed in 1973, and since then we have had a managed-float system. To understand why the system collapsed, one must appreciate the special role of the U.S. dollar in the system. As the only currency that could be converted into gold, and as the currency that served as the reference point for

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LO 11 -1 Describe the historical development of the modern global monetary system.

The International Monetary System Chapter 11 319

all others, the dollar occupied a central place in the system. Any pressure on the dollar to devalue could wreak havoc with the system, and that is what occurred. Most economists trace the breakup of the fixed exchange rate system to the U.S. mac- roeconomic policy package of 1965–1968.2 To finance both the Vietnam conflict and his welfare programs, President Lyndon Johnson backed an increase in U.S. government spending that was not financed by an increase in taxes. Instead, it was financed by an increase in the money supply, which led to a rise in price inflation from less than 4 per- cent in 1966 to close to 9 percent by 1968. At the same time, the rise in government spending had stimulated the economy. With more money in their pockets, people spent more—particularly on imports—and the U.S. trade balance began to deteriorate. The increase in inflation and the worsening of the U.S. foreign trade position gave rise to speculation in the foreign exchange market that the dollar would be devalued. Things came to a head in spring 1971 when U.S. trade figures showed that for the first time since 1945, the United States was importing more than it was exporting. This set off massive purchases of German deutsche marks in the foreign exchange market by speculators who guessed that the mark would be revalued against the dollar. On a single day, May 4, 1971, the Bundesbank (Germany’s central bank) had to buy $1 billion to hold the dollar/ deutsche mark exchange rate at its fixed exchange rate given the great demand for deutsche marks. On the morning of May 5, the Bundesbank purchased another $1 billion during the first hour of foreign exchange trading! At that point, the Bundesbank faced the inevitable and allowed its currency to float. In the weeks following the decision to float the deutsche mark, the foreign exchange market became increasingly convinced that the dollar would have to be devalued. How- ever, devaluation of the dollar was no easy matter. Under the Bretton Woods provisions, any other country could change its exchange rates against all currencies simply by fixing its dollar rate at a new level. But as the key currency in the system, the dollar could be devalued only if all countries agreed to simultaneously revalue against the dollar. Many countries did not want this, because it would make their products more expensive relative to U.S. products. To force the issue, President Nixon announced in August 1971 that the dollar was no longer convertible into gold. He also announced that a new 10 percent tax on imports would remain in effect until U.S. trading partners agreed to revalue their currencies against the dollar. This brought the trading partners to the bargaining table, and in De- cember 1971 an agreement was reached to devalue the dollar by about 8 percent against foreign currencies. The import tax was then removed. The problem was not solved, how- ever. The U.S. balance-of-payments position continued to deteriorate throughout 1973, while the nation’s money supply continued to expand at an inflationary rate. Speculation continued to grow that the dollar was still overvalued and that a second devaluation would be necessary. In anticipation, foreign exchange dealers began converting dollars to deutsche marks and other currencies. After a massive wave of speculation in February 1973, which culminated with European central banks spending $3.6 billion on March 1 to try to prevent their currencies from appreciating against the dollar, the foreign ex- change market was closed. When the foreign exchange market reopened March 19, the currencies of Japan and most European countries were floating against the dollar, al- though many developing countries continued to peg their currency to the dollar, and many do to this day. At that time, the switch to a floating system was viewed as a tempo- rary response to unmanageable speculation in the foreign exchange market. But it is now more than 40 years since the Bretton Woods system of fixed exchange rates collapsed, and the temporary solution looks permanent. The Bretton Woods system had an Achilles’ heel: The system could not work if its key currency, the U.S. dollar, was under speculative attack. The Bretton Woods system could work only as long as the U.S. inflation rate remained low and the United States did not run a balance-of-payments deficit. Once these things occurred, the system soon became strained to the breaking point.

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The Floating Exchange Rate Regime

The floating exchange rate regime that followed the collapse of the fixed exchange rate system was formalized in January 1976 when IMF members met in Jamaica and agreed to the rules for the international monetary system that are in place today.

THE JAMAICA AGREEMENT

The Jamaica meeting revised the IMF’s Articles of Agreement to reflect the new reality of floating exchange rates. The main elements of the Jamaica agreement include the following:

∙ Floating rates were declared acceptable. IMF members were permitted to enter the foreign exchange market to even out “unwarranted” speculative fluctuations.

∙ Gold was abandoned as a reserve asset. The IMF returned its gold reserves to members at the current market price, placing the proceeds in a trust fund to help poor nations. IMF members were permitted to sell their own gold reserves at the market price.

∙ Total annual IMF quotas—the amount member countries contribute to the IMF—were increased to $41 billion. (Since then, they have been increased to $767 billion, while the membership of the IMF has been expanded to include 188 countries. Non-oil-exporting, less developed countries were given greater access to IMF funds.)

EXCHANGE RATES SINCE 1973

Since March 1973, exchange rates have become much more volatile and less predictable than they were between 1945 and 1973.3 This volatility has been partly due to a number of unexpected shocks to the world monetary system, including:

∙ The oil crisis in 1971, when the Organization of the Petroleum Exporting Countries (OPEC) quadrupled the price of oil. The harmful effect of this on the U.S. inflation rate and trade position resulted in a further decline in the value of the dollar.

∙ The loss of confidence in the dollar that followed a sharp rise in the U.S. inflation rate in 1977–1978.

∙ The oil crisis of 1979, when OPEC once again increased the price of oil dramatically—this time it was doubled.

∙ The unexpected rise in the dollar between 1980 and 1985, despite a deteriorating balance-of-payments picture.

∙ The rapid fall of the U.S. dollar against the Japanese yen and German deutsche mark between 1985 and 1987, and against the yen between 1993 and 1995.

∙ The partial collapse of the European Monetary System in 1992. ∙ The 1997 Asian currency crisis, when the Asian currencies of several coun-

tries—including South Korea, Indonesia, Malaysia, and Thailand—lost between 50 and 80 percent of their value against the U.S. dollar in a few months.

∙ The global financial crisis of 2008–2010 and the sovereign debt crisis in the European Union during 2010–2011.

Figure 11.1 summarizes how the value of the U.S. dollar has fluctuated against an in- dex of trading currencies between January 1973 and February 2015. (The index, which was set equal to 100 in March 1973, is a weighted average of the foreign exchange values of the U.S. dollar against a basket of other currencies.) An interesting phenomenon in Fig- ure 11.1 is the rapid rise in the value of the dollar between 1980 and 1985 and its subse- quent fall between 1985 and 1988. A similar, though less pronounced, rise and fall in the value of the dollar occurred between 1995 and 2012. You will also notice a sharp uptick

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in the value of the dollar between mid-2014 and early 2015. We briefly discuss the rise and fall of the dollar during these periods, because this tells us something about how the international monetary system has operated in recent years.4 The rise in the value of the dollar between 1980 and 1985 occurred when the United States was running a large and growing trade deficit, importing substantially more than it exported. Conventional wisdom would suggest that the increased supply of dollars in the foreign exchange market as a result of the trade deficit should lead to a reduction in the value of the dollar, but as shown in Figure 11.1, it increased in value. Why? A number of favorable factors overcame the unfavorable effect of a trade deficit. Strong economic growth in the United States attracted heavy inflows of capital from foreign in- vestors seeking high returns on capital assets. High real interest rates attracted foreign investors seeking high returns on financial assets. At the same time, political turmoil in other parts of the world, along with relatively slow economic growth in the developed countries of Europe, helped create the view that the United States was a good place to in- vest. These inflows of capital increased the demand for dollars in the foreign exchange market, which pushed the value of the dollar upward against other currencies. The fall in the value of the dollar between 1985 and 1988 was caused by a combination of government intervention and market forces. The rise in the dollar, which priced U.S. goods out of foreign markets and made imports relatively cheap, had contributed to a dis- mal trade picture. In 1985, the United States posted a then-record-high trade deficit of more than $160 billion. This led to growth in demands for protectionism in the United States. In September 1985, the finance ministers and central bank governors of the so-called Group of Five major industrial countries (Great Britain, France, Japan, Germany, and the United States) met at the Plaza Hotel in New York and reached what was later referred to as the Plaza Accord. They announced that it would be desirable for most major currencies to ap- preciate vis-à-vis the U.S. dollar and pledged to intervene in the foreign exchange markets, selling dollars, to encourage this objective. The dollar had already begun to weaken during summer 1985, and this announcement further accelerated the decline.

F I G U R E 1 1 . 1

Major currencies dollar index, 1973–2015. Source: Data from www.federalreserve.gov/releases/H10/summary/indexn_m.htm.

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The dollar continued to decline until 1987. The governments of the Group of Five began to worry that the dollar might decline too far, so the finance ministers of the Group of Five met in Paris in February 1987 and reached a new agreement known as the Louvre Accord. They agreed that exchange rates had been realigned sufficiently and pledged to support the stability of exchange rates around their current levels by intervening in the foreign exchange markets when necessary to buy and sell currency. Although the dollar continued to decline for a few months after the Louvre Accord, the rate of decline slowed, and by early 1988 the decline had ended. Except for a brief speculative flurry around the time of the Persian Gulf War in 1991, the dollar was relatively stable for the first half of the 1990s. However, in the late 1990s, the dollar again began to appreciate against most major currencies, including the euro after its introduction, even though the United States was still running a significant balance- of-payments deficit. Once again, the driving force for the appreciation in the value of the dollar was that foreigners continued to invest in U.S. financial assets, primar- ily stocks and bonds, and the inflow of money drove up the value of the dollar on foreign exchange markets. The inward investment was due to a belief that U.S. financial assets offered a favorable rate of return. By 2002, however, foreigners had started to lose their appetite for U.S. stocks and bonds, and the inflow of money into the United States slowed. Instead of reinvesting dol- lars earned from exports to the United States in U.S. financial assets, they exchanged those dollars for other currencies, particularly euros, to invest them in non-dollar-denom- inated assets. One reason for this was the continued growth in the U.S. trade deficit, which hit a record $791 billion in 2005 (by 2011 it had fallen to $540 billion). Although the U.S. trade deficits had been hitting records for decades, this deficit was the largest ever when measured as a percentage of the country’s GDP (6.3 percent of GDP in 2005). The record deficit meant that even more dollars were flowing out of the United States into foreign hands, and those foreigners were less inclined to reinvest those dollars in the United States at a rate required to keep the dollar stable. This growing reluctance of for- eigners to invest in the United States was in turn due to several factors. First, there was a slowdown in U.S. economic activity during 2001–2002. Second, the U.S. government’s budget deficit expanded rapidly after 2001. This led to fears that ultimately the budget deficit would be financed by an expansionary monetary policy that could lead to higher price inflation. Third, from 2003 onward, U.S. government officials began to “talk down” the value of the dollar, in part because the administration believed that a cheaper dollar would increase exports and reduce imports, thereby improving the U.S. balance of trade position.5 Foreigners saw this as a signal that the U.S. government would not intervene in the foreign exchange markets to prop up the value of the dollar, which increased their reluctance to reinvest dollars earned from export sales in U.S. financial assets. As a result of these factors, demand for dollars weakened, and the value of the dollar slid on the for- eign exchange markets—hitting an index value of 80.5 in June 2011, the lowest value since the index began in 1973. Some believe that it could resume its fall in coming years, particularly if large holders of U.S. dollars, such as oil-producing states and China, decide to diversify their foreign exchange holdings (see the accompanying Country Focus for a discussion of this possibility with respect to oil-producing states). Interestingly, from mid-2008 through early 2009, the dollar staged a moderate rally against major currencies, despite the fact that the American economy was suffering from a serious financial crisis. The reason seems to be that despite America’s problems, things were even worse in many other countries, and foreign investors saw the dollar as a safe haven and put their money in low-risk U.S. assets, particularly low-yielding U.S. govern- ment bonds. This rally faltered in mid-2009 as investors became worried about the level of U.S. indebtedness.  However, between 2014 and early 2015 the dollar yet again increased significantly in value, primarily because of the strength of the U.S. economy, which had emerged from the great financial crisis of 2008–2009 in better shape than any other major developed nation, with higher economic growth rates and lower levels of unemployment.

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COUNTRY FOCUS

The U.S. Dollar, Oil Prices, and Recycling Petrodollars Between 2004 and 2008, global oil prices surged. They peaked at $147 a barrel in July 2008, up from about $20 in 2001, before falling sharply back to a $34 to $48 range by early 2009. From 2010 onward they increased again, ris- ing to over $100 a barrel in early 2014, before falling back to around $50 a barrel by early 2015. The rise was due to a combination of greater-than-expected demand for oil, particularly from rapidly developing giants such as China and India; tight supplies; and perceived geopolitical risks in the Middle East, the world’s largest oil-producing region. The fall since mid-2014 is due to the combination of a weak global economy and rapidly increasing production from shale oil fields in the United States. The surge in oil prices between 2004 and 2009 was a windfall for oil-producing countries. Collectively, they earned around $700 billion in oil revenues in 2005, and well over $1 trillion in 2007 and 2008—some 64 percent of which went to members of OPEC. Saudi Arabia, the world’s largest oil producer, reaped a major share. Be- cause oil is priced in U.S. dollars, the rise in oil prices translated into a substantial increase in the dollar holdings of oil producers (the dollars earned from the sale of oil are often referred to as petrodollars). In essence, rising oil prices represent a net transfer of dollars from oil consum- ers in countries such as the United States to oil producers in Russia, Saudi Arabia, and Venezuela. What did they do with these dollars? One option for producing countries was to spend their petrodollars on public-sector infrastructure, such as health services, education, roads, and telecommunica- tions systems. Among other things, this could boost eco- nomic growth in those countries and pull in foreign imports, which would help counterbalance the trade sur- pluses enjoyed by oil producers and support global eco- nomic growth. Spending did indeed pick up in many oil-producing countries. However, according to the IMF, OPEC members spent only about 40 percent of their windfall profits from higher oil prices in 2002–2007 (an

exception was Venezuela, whose leader, Hugo Chávez, was on a spending spree until his death in early 2013). The last time oil prices increased sharply in 1979, oil pro- ducers significantly ramped up spending on infrastruc- ture, only to find themselves saddled with excessive debt when oil prices collapsed a few years later. This time they were more cautious—an approach that seems wise given the rapid fall in oil prices during late 2008 and again in late 2014. Another option was for oil producers to invest a good chunk of the dollars they earned from oil sales in dollar- denominated assets, such as U.S. bonds, stocks, and real estate. This did happen. OPEC members in particular fun- neled dollars back into U.S. assets, mostly low-risk govern- ment bonds. The implication is that by recycling their petrodollars, oil producers helped finance the large and growing current account deficit of the United States, enabling it to pay its large oil import bill. A third possibility for oil producers was to invest in non-dollar-denominated assets, including European and Japanese bonds and stocks. This, too, happened. Also, some OPEC investors had purchased not just small equity positions but entire companies. In 2005, for example, Dubai International Capital purchased the Tussauds Group, a British theme-park firm, and DP World of Dubai purchased P&O, Britain’s biggest port and ferries group. Despite examples such as these, the bulk of petrodollars appear to have been recycled into dollar-denominated assets. In part, this was be- cause U.S. interest rates increased throughout 2004–2007 and in part because the United States was viewed as a safe haven in economically troubled times. However, if the flow of petrodollars should dry up, which could occur if oil prices continue to decline in 2015–2016, the value of the dollar could fall significantly.

Sources: “Recycling the Petrodollars; Oil Producers’ Surpluses,” The Economist, November 12, 2005, pp. 101–02; S. Johnson, “Dollar’s Rise Aided by OPEC Holdings,” Financial Times, December 5, 2005, p. 17; “The Petrodollar Puzzle,” The Economist, June 9, 2007, p. 86.

This review tells us that in recent history both market forces and government interven- tion have determined the value of the dollar. Under a floating exchange rate regime, mar- ket forces have produced a volatile dollar exchange rate. Governments have sometimes responded by intervening in the market—buying and selling dollars—in an attempt to limit the market’s volatility and to correct what they see as overvaluation (in 1985) or

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potential undervaluation (in 1987) of the dollar. In addition to direct intervention, statements from government officials have frequently influenced the value of the dollar. The dollar may not have declined by as much as it did in 2004, for example, had not U.S. govern- ment officials publicly ruled out any action to stop the decline. Paradoxically, a signal not to intervene can affect the market. The frequency of government intervention in the foreign exchange market explains why the current system is sometimes thought of as a managed-float system or a dirty-float system.

Fixed versus Floating Exchange Rates

The breakdown of the Bretton Woods system has not stopped the debate about the relative merits of fixed versus floating exchange rate regimes. Disappointment with the system of floating rates in recent years has led to renewed debate about the merits of fixed exchange rates. This section reviews the arguments for fixed and floating exchange rate regimes.6 We discuss the case for floating rates before studying why many critics are disappointed with the experience under floating exchange rates and yearn for a system of fixed rates.

THE CASE FOR FLOATING EXCHANGE RATES

The case in support of floating exchange rates has three main elements: monetary policy autonomy, automatic trade balance adjustments, and economic recovery following a se- vere economic crisis.

Monetary Policy Autonomy It is argued that under a fixed system, a country’s ability to expand or contract its money supply as it sees fit is limited by the need to maintain exchange rate parity. Monetary expansion can lead to inflation, which puts downward pressure on a fixed exchange rate (as predicted by the PPP theory; see Chapter 10). Similarly, monetary contraction re- quires high interest rates (to reduce the demand for money). Higher interest rates lead to an inflow of money from abroad, which puts upward pressure on a fixed exchange rate. Thus, to maintain exchange rate parity under a fixed system, countries were limited in their ability to use monetary policy to expand or contract their economies. Advocates of a floating exchange rate regime argue that removal of the obligation to maintain exchange rate parity would restore monetary control to a government. If a gov- ernment faced with unemployment wanted to increase its money supply to stimulate do- mestic demand and reduce unemployment, it could do so unencumbered by the need to maintain its exchange rate. While monetary expansion might lead to inflation, this would lead to a depreciation in the country’s currency. If PPP theory is correct, the resulting currency depreciation on the foreign exchange markets should offset the effects of infla- tion. Although under a floating exchange rate regime, domestic inflation would have an impact on the exchange rate, it should have no impact on businesses’ international cost competitiveness due to exchange rate depreciation. The rise in domestic costs should be exactly offset by the fall in the value of the country’s currency on the foreign exchange markets. Similarly, a government could use monetary policy to contract the economy without worrying about the need to maintain parity.

Trade Balance Adjustments Under the Bretton Woods system, if a country developed a permanent deficit in its bal- ance of trade (importing more than it exported) that could not be corrected by domestic policy, this would require the IMF to agree to currency devaluation. Critics of this system argue that the adjustment mechanism works much more smoothly under a floating exchange rate regime. They argue that if a country is running a trade deficit, the imbal- ance between the supply and demand of that country’s currency in the foreign exchange

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LO 11 -3 Compare and contrast the differences between a fixed and a floating exchange rate system.

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markets (supply exceeding demand) will lead to depreciation in its exchange rate. In turn, by making its exports cheaper and its imports more expensive, exchange rate depreciation should correct the trade deficit.

Crisis Recovery Advocates of floating exchange rates also argue that exchange rate adjustments can help a country to deal with economic crises. When a country is hit by a severe economic cri- sis, its currency typically declines on foreign exchange markets. The reason for this is that investors respond to the crisis by taking their money out of the country, selling the local currency, and driving down its value. At some point, however, the currency be- comes so cheap that it starts to stimulate exports. This is what occurred in Iceland after the krona lost 50 percent of its value against the U.S. dollar and euro following a banking crisis in 2008. By 2009 exports of fish and aluminum from Iceland were booming, which helped pull the Icelandic economy out of a recession. A similar process occurred in South Korean after the 1997 Asian banking crisis. The value of the South Korean won plunged to 1,700 per dollar from around 800. In turn, the cheap won helped South Korea increase its exports and resulted in an export-led economic recovery. On the other hand, in both countries the declining value of the currency did raise import prices and led to an increase in inflation, so there is a price that has to be paid for an export-led recovery due to falling currency values. A contrast can be drawn with the recent situation in Greece, where the economy im- ploded following the 2008–2009 global financial crisis, and has struggled to recover. Part of the problem in Greece is that it gave up its own currency to adopt the euro in 2001, and the euro has remained quite strong—thus Greece cannot rely on a falling local currency to boost exports and stimulate economic recovery.

THE CASE FOR FIXED EXCHANGE RATES

The case for fixed exchange rates rests on arguments about monetary discipline, specu- lation, uncertainty, and the lack of connection between the trade balance and exchange rates.

Monetary Discipline We have already discussed the nature of monetary discipline inherent in a fixed exchange rate system when we discussed the Bretton Woods system. The need to maintain fixed exchange rate parity ensures that governments do not expand their money supplies at in- flationary rates. While advocates of floating rates argue that each country should be al- lowed to choose its own inflation rate (the monetary autonomy argument), advocates of fixed rates argue that governments all too often give in to political pressures and expand the monetary supply far too rapidly, causing unacceptably high price inflation. A fixed exchange rate regime would ensure that this does not occur.

Speculation Critics of a floating exchange rate regime also argue that speculation can cause fluctua- tions in exchange rates. They point to the dollar’s rapid rise and fall during the 1980s, which they claim had nothing to do with comparative inflation rates and the U.S. trade deficit, but everything to do with speculation. They argue that when foreign exchange dealers see a currency depreciating, they tend to sell the currency in the expectation of future depreciation regardless of the currency’s longer-term prospects. As more traders jump on the bandwagon, the expectations of depreciation are realized. Such destabilizing speculation tends to accentuate the fluctuations around the exchange rate’s long-run value. It can damage a country’s economy by distorting export and import prices. Thus, advocates of a fixed exchange rate regime argue that such a system will limit the destabi- lizing effects of speculation.

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Uncertainty Speculation also adds to the uncertainty surrounding future currency movements that characterizes floating exchange rate regimes. The unpredictability of exchange rate movements in the post–Bretton Woods era has made business planning difficult, and it adds risk to exporting, importing, and foreign investment activities. Given a volatile ex- change rate, international businesses do not know how to react to the changes—and often they do not react. Why change plans for exporting, importing, or foreign investment after a 6 percent fall in the dollar this month, when the dollar may rise 6 percent next month? This uncertainty, according to the critics, dampens the growth of international trade and investment. They argue that a fixed exchange rate, by eliminating such uncertainty, pro- motes the growth of international trade and investment. Advocates of a floating system reply that the forward exchange market ensures against the risks associated with ex- change rate fluctuations (see Chapter 10), so the adverse impact of uncertainty on the growth of international trade and investment has been overstated.

Trade Balance Adjustments and Economic Recovery Those in favor of floating exchange rates argue that floating rates help adjust trade imbal- ances and can assist with economic recovery after a crisis. Critics question the closeness of the link between the exchange rate, the trade balance and economic growth. They claim trade deficits are determined by the balance between savings and investment in a country, not by the external value of its currency.7 They argue that depreciation in a cur- rency will lead to inflation (due to the resulting increase in import prices). This inflation, they state, will wipe out any apparent gains in cost competitiveness that arise from cur- rency depreciation. In other words, a depreciating exchange rate will not boost exports and reduce imports, as advocates of floating rates claim; it will simply boost price infla- tion. In support of this argument, those who favor fixed rates point out that the 40 percent drop in the value of the dollar between 1985 and 1988 did not correct the U.S. trade defi- cit. In reply, advocates of a floating exchange rate regime argue that between 1985 and 1992, the U.S. trade deficit fell from more than $160 billion to about $70 billion, and they attribute this in part to the decline in the value of the dollar. Moreover, the experience of countries like South Korea and Iceland seems to suggest that floating rates can help a country recover from a severe economic crisis.

WHO IS RIGHT?

Which side is right in the vigorous debate between those who favor a fixed exchange rate and those who favor a floating exchange rate? Economists cannot agree. Business, as a major player on the international trade and investment scene, has a large stake in the reso- lution of the debate. Would international business be better off under a fixed regime, or are flexible rates better? The evidence is not clear. However, a fixed exchange rate regime modeled along the lines of the Bretton Woods system probably will not work. Speculation ultimately broke the system, a phenomenon that advocates of fixed rate regimes claim is associated with floating exchange rates! Nevertheless, a different kind of fixed exchange rate system might be more enduring and might foster the stability that would facilitate more rapid growth in international trade and investment. In the next section, we look at potential models for such a system and the problems with such systems.

Exchange Rate Regimes in Practice

Governments around the world pursue a number of different exchange rate policies. These range from a pure “free float” where the exchange rate is determined by market forces to a pegged system that has some aspects of the pre-1973 Bretton Woods system of fixed exchange rates. Some 21 percent of the IMF’s members allow their currency to float

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LO 11 - 4 Identify exchange rate regimes used in the world today and why countries adopt different exchange rate regimes.

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freely. Another 23 percent intervene in only a limited way (the so-called managed float). A further 5 percent of IMF members now have no separate legal tender of their own (this figure excludes the European Union countries that have adopted the euro). These are typi- cally smaller states, mostly in Africa or the Caribbean, that have no domestic currency and have adopted a foreign currency as legal tender within their borders, typically the U.S. dollar or the euro. The remaining countries use more inflexible systems, including a fixed peg arrangement (43 percent) under which they peg their currencies to other curren- cies, such as the U.S. dollar or the euro, or to a basket of currencies. Other countries have adopted a system under which their exchange rate is allowed to fluctuate against other currencies within a target zone (an adjustable peg system). In this section, we look more closely at the mechanics and implications of exchange rate regimes that rely on a currency peg or target zone.

PEGGED EXCHANGE RATES

Under a pegged exchange rate regime, a country will peg the value of its currency to that of a major currency so that, for example, as the U.S. dollar rises in value, its own currency rises too. Pegged exchange rates are popular among many of the world’s smaller nations. As with a full fixed exchange rate regime, the great virtue claimed for a pegged exchange rate is that it imposes monetary discipline on a country and leads to low inflation. For example, if Belize pegs the value of the Belizean dollar to that of the U.S. dollar so that US$1 = B$1.97, then the Belizean government must make sure the inflation rate in Belize is similar to that in the United States. If the Belizean inflation rate is greater than the U.S. inflation rate, this will lead to pressure to devalue the Belizean dollar (i.e., to alter the peg). To maintain the peg, the Belizean government would be required to rein in inflation. Of course, for a pegged exchange rate to impose monetary discipline on a country, the coun- try whose currency is chosen for the peg must also pursue sound monetary policy. Evidence shows that adopting a pegged exchange rate regime moderates inflationary pressures in a country. An IMF study concluded that countries with pegged exchange rates had an average annual inflation rate of 8 percent, compared with 14 percent for intermediate regimes and 16 percent for floating regimes.8 However, many countries operate with only a nominal peg and in practice are willing to devalue their currency rather than pursue a tight monetary policy. It can be very difficult for a smaller country to maintain a peg against another currency if capital is flowing out of the country and for- eign exchange traders are speculating against the currency. Something like this occurred in 1997 when a combination of adverse capital flows and currency speculation forced several Asian countries, including Thailand and Malaysia, to abandon pegs against the U.S. dollar and let their currencies float freely. Malaysia and Thailand would not have been in this position had they dealt with a number of problems that began to arise in their economies during the 1990s, including excessive private-sector debt and expanding current account trade deficits.

CURRENCY BOARDS

Hong Kong’s experience during the 1997 Asian currency crisis added a new dimension to the debate over how to manage a pegged exchange rate. During late 1997, when other Asian currencies were collapsing, Hong Kong maintained the value of its currency against the U.S. dollar at about $1 = HK$7.80 despite several concerted speculative attacks. Hong Kong’s currency board has been given credit for this success. A country that introduces a currency board commits itself to converting its domestic currency on demand into another currency at a fixed exchange rate. To make this commitment credible, the currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100 percent of the domestic currency issued. The system used in Hong Kong means its currency must be fully backed by the U.S. dollar at the specified exchange rate. This is still not a true fixed exchange rate regime, because the U.S. dollar, and by extension the Hong Kong dollar, floats against other currencies, but it has some features of a fixed exchange rate regime.

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Under this arrangement, the currency board can issue additional domestic notes and coins only when there are foreign exchange reserves to back it. This limits the ability of the government to print money and, thereby, create inflationary pressures. Under a strict currency board system, interest rates adjust automatically. If investors want to switch out of domestic currency into, for example, U.S. dollars, the supply of domestic currency will shrink. This will cause interest rates to rise until it eventually becomes attractive for in- vestors to hold the local currency again. In the case of Hong Kong, the interest rate on three-month deposits climbed as high as 20 percent in late 1997, as investors switched out of Hong Kong dollars and into U.S. dollars. The dollar peg held, however, and interest rates declined again. Since its establishment in 1983, the Hong Kong currency board has weathered several storms, including the latest. This success persuaded several other countries in the devel- oping world to consider a similar system. Argentina introduced a currency board in 1991 (but abandoned it in 2002), and Bulgaria, Estonia, and Lithuania have all gone down this road in recent years. Despite interest in the arrangement, however, critics are quick to point out that currency boards have their drawbacks.9 If local inflation rates remain higher than the inflation rate in the country to which the currency is pegged, the curren- cies of countries with currency boards can become uncompetitive and overvalued (this is what happened in the case of Argentina, which had a currency board). Also, under a cur- rency board system, government lacks the ability to set interest rates. Interest rates in Hong Kong, for example, are effectively set by the U.S. Federal Reserve. In addition, economic collapse in Argentina in 2001 and the subsequent decision to abandon its cur- rency board dampened much of the enthusiasm for this mechanism of managing ex- change rates.

Crisis Management by the IMF

Many observers initially believed that the collapse of the Bretton Woods system in 1973 would diminish the role of the IMF within the international monetary system. The IMF’s original function was to provide a pool of money from which members could borrow, short term, to adjust their balance-of-payments position and maintain their exchange rate. Some believed the demand for short-term loans would be considerably diminished under a floating exchange rate regime. A trade deficit would presumably lead to a decline in a country’s exchange rate, which would help reduce imports and boost exports. No tempo- rary IMF adjustment loan would be needed. Consistent with this, after 1973, most indus- trialized countries tended to let the foreign exchange market determine exchange rates in response to demand and supply. Since the early 1970s, the rapid development of global capital markets has generally allowed developed countries such as Great Britain and the United States to finance their deficits by borrowing private money, as opposed to drawing on IMF funds. Despite these developments, the activities of the IMF have expanded over the past 30 years. By 2014, the IMF had 188 members, 52 of which had some kind of IMF pro- gram in place. In 1997, the institution implemented its largest rescue packages until that date, committing more than $110 billion in short-term loans to three troubled Asian coun- tries—South Korea, Indonesia, and Thailand. This was followed by additional IMF res- cue packages in Turkey, Russia, Argentina, and Brazil. IMF loans increased again in late 2008 as the global financial crisis took hold. Between 2008 and 2010, the IMF made more than $100 billion in loans to troubled economies such as Latvia, Greece, and Ire- land. In April 2009, in response to the growing financial crisis, major IMF members agreed to triple the institution’s resources from $250 billion to $750 billion, thereby giv- ing the IMF the financial leverage to act aggressively in times of global financial crisis. The IMF’s activities have expanded because periodic financial crises have continued to hit many economies in the post–Bretton Woods era. The IMF has repeatedly lent money to nations experiencing financial crises, requesting in return that the governments

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LO 11 -5 Understand the debate surrounding the role of the IMF in the management of financial crises.

The International Monetary System Chapter 11 329

enact certain macroeconomic policies (see the opening case on Ukraine for an example). Critics of the IMF claim these policies have not always been as beneficial as the IMF might have hoped and, in some cases, may have made things worse. Following the IMF loans to several Asian economies, these criticisms reached new levels, and a vigor- ous debate was waged as to the appropriate role of the IMF. In this section, we discuss some of the main challenges the IMF has had to deal with over the past three decades and review the ongoing debate over the role of the IMF.

FINANCIAL CRISES IN THE POST–BRETTON WOODS ERA

A number of broad types of financial crises have occurred over the past 30 years, many of which have required IMF involvement. 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 to defend the prevailing exchange rate. This happened in Brazil in 2002, and the IMF stepped in to help stabilize the value of the Brazilian currency on foreign exchange markets by lending it foreign currency. A banking crisis refers to a loss of confidence in the banking system that leads to a run on banks, as individuals and companies withdraw their deposits. This is what happened in Iceland in 2008. A foreign debt crisis is a situation in which a country cannot service its foreign debt obligations, whether private-sector or government debt. This happened to Greece, Ireland, and Portugal in 2010. These crises tend to have common underlying macroeconomic causes: high relative price inflation rates, a widening current account deficit, excessive expansion of domestic borrowing, high government deficits, and asset price inflation (such as sharp increases in stock and property prices).10 At times, elements of currency, banking, and debt crises may be present simultaneously, as in the 1997 Asian crisis, the 2000–2002 Argentinean crisis, and the 2010 crisis in Ireland. To assess the frequency of financial crises, the IMF looked at the macroeconomic performance of a group of 53 countries from 1975 to 1997 (22 of these countries were developed nations, and 31 were developing countries).11 The IMF found there had been 158 currency crises, including 55 episodes in which a country’s currency declined by more than 25 percent. There were also 54 banking crises. The IMF’s data suggest that developing nations were more than twice as likely to experience currency and banking crises as developed nations. It is not surprising, therefore, that most of the IMF’s loan activities since the mid-1970s have been targeted toward developing nations. The nearby Country Focus gives a detailed look at the development of one currency crisis, that in Mexico during 1995. In 1997, several Asian currencies started to fall sharply as international investors came to the realization that there was a speculative investment bubble in the region. They took their money out of local currencies, changing it into U.S. dollars, and those currencies started to fall precipitously. The currency declines started in Thailand and then, in a process of contagion, quickly spread to other countries in the region. Stabiliz- ing those currencies required massive help from the IMF. In the case of South Korea, local enterprises had built up huge debt loads as they invested heavily in new industrial capacity. By 1997, they found they had too much industrial capacity and could not gen- erate the income required to service their debt. South Korean banks and companies had also made the mistake of borrowing in dollars, much of it in the form of short-term loans that would come due within a year. Thus, when the Korean won started to decline in fall 1997 in sympathy with the problems elsewhere in Asia, South Korean companies saw their debt obligations balloon. Several large companies were forced to file for bankruptcy. This triggered a decline in the South Korean currency and stock market that was difficult to halt. With its economy on the verge of collapse, the South Korean government requested $20 billion in standby loans from the IMF on November 21. As the negotiations

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COUNTRY FOCUS

The Mexican Currency Crisis of 1995 The Mexican peso had been pegged to the dollar since the early 1980s when the International Monetary Fund made it a condition for lending money to the Mexican gov- ernment to help bail the country out of a 1982 financial cri- sis. Under the IMF-brokered arrangement, the peso had been allowed to trade within a tolerance band of plus or minus 3 percent against the dollar. The band was also per- mitted to “crawl” down daily, allowing for an annual peso depreciation of about 4 percent against the dollar. The IMF believed that the need to maintain the exchange rate within a fairly narrow trading band would force the Mexi- can government to adopt stringent financial policies to limit the growth in the money supply and contain inflation. Until the early 1990s, it looked as if the IMF policy had worked. However, the strains were beginning to show by 1994. Since the mid-1980s, Mexican producer prices had risen 45 percent more than prices in the United States, and yet there had not been a corresponding adjustment in the exchange rate. By late 1994, Mexico was running a $17 billion trade deficit, which amounted to some 6 per- cent of the country’s gross domestic product, and there had been an uncomfortably rapid expansion in public- and private-sector debt. Despite these strains, Mexican gov- ernment officials had been stating publicly they would sup- port the peso’s dollar peg at around $1 = 3.5 pesos by adopting appropriate monetary policies and by interven- ing in the currency markets if necessary. Encouraged by such statements, $64 billion of foreign investment money poured into Mexico between 1990 and 1994 as corpora- tions and money managers sought to take advantage of the booming economy. However, many currency traders concluded the peso would have to be devalued, and they began to dump pe- sos on the foreign exchange market. The government

tried to hold the line by buying pesos and selling dollars, but it lacked the foreign currency reserves required to halt the speculative tide (Mexico’s foreign exchange reserves fell from $6 billion at the beginning of 1994 to less than $3.5 billion at the end of the year). In mid-December 1994, the Mexican government abruptly announced a devalua- tion. Immediately, much of the short-term investment money that had flowed into Mexican stocks and bonds over the previous year reversed its course as foreign in- vestors bailed out of peso-denominated financial assets. This exacerbated the sale of the peso and contributed to the rapid 40 percent drop in its value. The IMF stepped in again, this time arm in arm with the U.S. government and the Bank for International Settle- ments. Together, the three institutions pledged close to $50 billion to help Mexico stabilize the peso and to re- deem $47 billion of public- and private-sector debt that was set to mature in 1995. Of this amount, $20 billion came from the U.S. government and another $18 billion came from the IMF (which made Mexico the largest recipient of IMF aid up to that point). Without the aid package, Mexico would probably have defaulted on its debt obligations, and the peso would have gone into free fall. As is normal in such cases, the IMF insisted on tight monetary policies and further cuts in public spending, both of which helped push the country into a deep recession. However, the re- cession was relatively short-lived, and by 1997 the country was once more on a growth path, had pared down its debt, and had paid back the $20 billion borrowed from the U.S. government ahead of schedule.

Sources: P. Carroll and C. Torres, “Mexico Unveils Program of Harsh Fiscal Medicine,” The Wall Street Journal, March 10, 1995, pp. A1, A6; “Putting Mexico Together Again,” The Economist, February 4, 1995, p. 65.

progressed, it became apparent that South Korea was going to need far more than $20 billion. On December 3, 1997, the IMF and South Korean government reached a deal to lend $55 billion to the country. The agreement with the IMF called for the South Koreans to open their economy and banking system to foreign investors. South Korea also pledged to restrain Korea’s largest enterprises, the chaebol, by reducing their share of bank financing and requiring them to publish consolidated financial statements and undergo annual independent external audits. On trade liberalization, the IMF said South Korea would comply with its commitments to the World Trade Organization to eliminate trade-related subsidies and restrictive import licensing and

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would streamline its import certification procedures, all of which should open the South Korean economy to greater foreign competition.12

EVALUATING THE IMF’S POLICY PRESCRIPTIONS

By 2014, the IMF was committing loans to more than 50 countries that were struggling with economic and/or currency crises. All IMF loan packages come with conditions at- tached. Until very recently, the IMF has insisted on a combination of tight macroeco- nomic policies, including cuts in public spending, higher interest rates, and tight monetary policy. It has also often pushed for the deregulation of sectors formerly protected from domestic and foreign competition, privatization of state-owned assets, and better finan- cial reporting from the banking sector. These policies are designed to cool overheated economies by reining in inflation and reducing government spending and debt. This set of policy prescriptions has come in for tough criticisms from many observers, and the IMF itself has started to change its approach.13

Inappropriate Policies One criticism is that the IMF’s traditional policy prescriptions represent a “one-size-fits-all” approach to macroeconomic policy that is inappropriate for many countries. In the case of the 1997 Asian crisis, critics argue that the tight macroeconomic policies imposed by the IMF were not well suited to countries that are suffering not from excessive government spending and inflation, but from a private-sector debt crisis with deflationary undertones.14 In South Korea, for example, the government had been running a budget surplus for years (it was 4 percent of South Korea’s GDP in 1994–1996), and inflation was low at about 5 percent. South Korea had the second-strongest financial position of any country in the Organisation for Economic Co-operation and Development. Despite this, critics say, the IMF insisted on applying the same policies that it applies to countries suffering from high inflation. The IMF required South Korea to maintain an inflation rate of 5 percent. However, given the collapse in the value of its currency and the subsequent rise in price for imports such as oil, critics claimed inflationary pressures would inevitably

Christine Lagarde heads the IMF. © Stephen Jaffe/IMF/Handout/Getty Images News/Getty Images

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increase in South Korea. So to hit a 5 percent inflation rate, the South Koreans would be forced to apply an unnecessarily tight monetary policy. Short-term interest rates in South Korea did jump from 12.5 to 21 percent immediately after the country signed its initial deal with the IMF. Increasing interest rates made it even more difficult for companies to service their already excessive short-term debt obligations, and critics used this as evi- dence to argue that the cure prescribed by the IMF may actually increase the probability of widespread corporate defaults, not reduce them. At the time the IMF rejected this criticism. According to the IMF, the central task was to rebuild confidence in the won. Once this was achieved, the won would recover from its oversold levels, reducing the size of South Korea’s dollar-denominated debt burden when expressed in won, making it easier for companies to service their debt. The IMF also ar- gued that by requiring South Korea to remove restrictions on foreign direct investment, foreign capital would flow into the country to take advantage of cheap assets. This, too, would increase demand for the Korean currency and help improve the dollar/won ex- change rate. South Korea did recover fairly quickly from the crisis, supporting the position of the IMF. While the economy contracted by 7 percent in 1998, by 2000 it had rebounded and grew at a 9 percent rate (measured by growth in GDP). Inflation, which peaked at 8 per- cent in 1998, fell to 2 percent by 2000, and unemployment fell from 7 to 4 percent over the same period. The won hit a low of $1 = W1,812 in early 1998, but by 2000 was back to an exchange rate of around $1 = W1,200, at which it seems to have stabilized.

Moral Hazard A second criticism of the IMF is that its rescue efforts are exacerbating a problem known to economists as moral hazard. Moral hazard arises when people behave recklessly be- cause they know they will be saved if things go wrong. Critics point out that many Japa- nese and Western banks were far too willing to lend large amounts of capital to overleveraged Asian companies during the boom years of the 1990s. These critics argue that the banks should now be forced to pay the price for their rash lending policies, even if that means some banks must close.15 Only by taking such drastic action, the argument goes, will banks learn the error of their ways and not engage in rash lending in the future. By providing support to these countries, the IMF is reducing the probability of debt de- fault and in effect bailing out the banks whose loans gave rise to this situation. This argument ignores two critical points. First, if some Japanese or Western banks with heavy exposure to the troubled Asian economies were forced to write off their loans due to widespread debt default, the impact would have been difficult to contain. The fail- ure of large Japanese banks, for example, could have triggered a meltdown in the Japa- nese financial markets. That would almost inevitably lead to a serious decline in stock markets around the world, which was the very risk the IMF was trying to avoid by step- ping in with financial support. Second, it is incorrect to imply that some banks have not had to pay the price for rash lending policies. The IMF insisted on the closure of banks in South Korea, Thailand, and Indonesia after the 1997 Asian financial crisis. Foreign banks with short-term loans outstanding to South Korean enterprises have been forced by circumstances to reschedule those loans at interest rates that do not compensate for the extension of the loan maturity.

Lack of Accountability The final criticism of the IMF is that it has become too powerful for an institution that lacks any real mechanism for accountability.16 The IMF has determined macroeconomic policies in those countries, yet according to critics such as noted economist Jeffrey Sachs, the IMF, with a staff of less than 1,000, lacks the expertise required to do a good job. Evidence of this, according to Sachs, can be found in the fact that the IMF was singing the praises of the Thai and South Korean governments only months before both countries lurched into crisis. Then the IMF put together a draconian program for South Korea without having deep

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knowledge of the country. Sachs’s solution to this problem is to reform the IMF so it makes greater use of outside experts and its operations are open to greater outside scrutiny.

Observations As with many debates about international economics, it is not clear which side is correct about the appropriateness of IMF policies. There are cases where one can argue that IMF policies had been counterproductive or only had limited success. For example, one might question the success of the IMF’s involvement in Turkey given that the country has had to implement some 18 IMF programs since 1958! But the IMF can also point to some nota- ble accomplishments, including its success in containing the Asian crisis, which could have rocked the global international monetary system to its core, and its actions in 2008– 2010 to contain the global financial crisis, quickly stepping in to rescue Iceland, Ireland, Greece, and Latvia. Similarly, many observers give the IMF credit for its deft handling of politically difficult situations, such as the Mexican peso crisis, and for successfully pro- moting a free market philosophy. Several years after the IMF’s intervention, the Asian economy of Asia recovered. Cer- tainly they all averted the kind of catastrophic implosion that might have occurred had the IMF not stepped in, and although some countries still faced considerable problems, it is not clear that the IMF should take much blame for this. The IMF cannot force countries to adopt the policies required to correct economic mismanagement. While a government may commit to taking corrective action in return for an IMF loan, internal political problems may make it difficult for a government to act on that commitment. In such cases, the IMF is caught between a rock and a hard place, because if it decided to withhold money, it might trigger financial collapse and the kind of contagion that it seeks to avoid. Finally, it is notable that in recent years the IMF has started to change its policies. In response to the global financial crisis of 2008–2009, the IMF began to urge countries to adopt policies that included fiscal stimulus and monetary easing—the direct opposite of what the fund traditionally advocated. Some economists in the fund are also now arguing that higher inflation rates might be a good thing, if the consequence is greater growth in aggregate demand, which would help pull nations out of recessionary conditions. The IMF, in other words, is starting to display the very flexibility in policy responses that its critics claim it lacks. While the traditional policy of tight controls on fiscal policy and tight monetary policy targets might be appropriate for countries suffering from high in- flation rates, the Asian economic crisis and the 2008–2009 global financial crisis were caused not by high inflation rates but by excessive debt, and the IMF’s “new approach” seems tailored to deal with this.17

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F O C U S O N M A NAG E R I A L I M P L I C AT I O N S

CURRENCY MANAGEMENT, BUSINESS STRATEGY, AND GOVERNMENT RELATIONS

The implications for international businesses of the material discussed in this chapter fall into three main areas: currency management, business strategy, and corpo-

rate–government relations.

Currency Management An obvious implication with regard to currency manage- ment is that companies must recognize that the foreign exchange market does not

work quite as depicted in Chapter 10. The current system is a mixed system in which a combination of government intervention and speculative activity can drive the foreign ex- change market. Companies engaged in significant foreign exchange activities need to be aware of this and to adjust their foreign exchange transactions accordingly. For example, the

LO 11 - 6 Explain the implications of the global monetary system for currency management and business strategy.

334 Part 4 The Global Monetary System

currency management unit of Caterpillar claims it made millions of dollars in the hours follow- ing the announcement of the Plaza Accord by selling dollars and buying currencies that it expected to appreciate on the foreign exchange market following government intervention. Under the present system, speculative buying and selling of currencies can create very volatile movements in exchange rates (as exhibited by the rise and fall of the dollar during the 1980s and the Asian currency crisis of the late 1990s). Contrary to the predictions of the purchasing power parity theory (see Chapter 10), exchange rate movements during the 1980s and 1990s often did not seem to be strongly influenced by relative inflation rates. In- sofar as volatile exchange rates increase foreign exchange risk, this is not good news for business. On the other hand, as we saw in Chapter 10, the foreign exchange market has developed a number of instruments, such as the forward market and swaps, that can help ensure against foreign exchange risk. Not surprisingly, use of these instruments has in- creased markedly since the breakdown of the Bretton Woods system in 1973.

Business Strategy The volatility of the current global exchange rate regime presents a co- nundrum for international businesses. Exchange rate movements are difficult to predict, and yet their movement can have a major impact on a business’s competitive position. For a detailed example, see the accompanying Management Focus on Airbus. Faced with uncer- tainty about the future value of currencies, firms can utilize the forward exchange market, which Airbus has done. However, the forward exchange market is far from perfect as a pre- dictor of future exchange rates (see Chapter 10). It is also difficult if not impossible to get adequate insurance coverage for exchange rate changes that might occur several years in the future. The forward market tends to offer coverage for exchange rate changes a few months—not years—ahead. Given this, it makes sense to pursue strategies that will increase the company’s strategic flexibility in the face of unpredictable exchange rate movements— that is, to pursue strategies that reduce the economic exposure of the firm (which we first discussed in Chapter 10). Maintaining strategic flexibility can take the form of dispersing production to different lo- cations around the globe as a real hedge against currency fluctuations (this seems to be what Airbus has considered). Consider the case of Daimler-Benz, Germany’s export-oriented automobile and aerospace company. In June 1995, the company stunned the German busi- ness community when it announced it expected to post a severe loss in 1995 of about $720 million. The cause was Germany’s strong currency, which had appreciated by 4 per- cent against a basket of major currencies since the beginning of 1995 and had risen by more than 30 percent against the U.S. dollar since late 1994. By mid-1995, the exchange rate against the dollar stood at $1 = DM1.38. Daimler’s management believed it could not make money with an exchange rate under $1 = DM1.60. Daimler’s senior managers concluded the appreciation of the mark against the dollar was probably permanent, so they decided to move substantial production outside of Germany and increase purchasing of foreign com- ponents. The idea was to reduce the vulnerability of the company to future exchange rate movements. Even before the company’s acquisition of Chrysler Corporation in 1998, the Mercedes-Benz division planned to produce 10 percent of its cars outside Germany by 2000, mostly in the United States. Similarly, the move by Japanese automobile companies to expand their productive capacity in the United States and Europe can be seen in the con- text of the increase in the value of the yen between 1985 and 1995, which raised the price of Japanese exports. For the Japanese companies, building production capacity overseas was a hedge against continued appreciation of the yen (as well as against trade barriers). Another way of building strategic flexibility and reducing economic exposure involves contracting out manufacturing. This allows a company to shift suppliers from country to country in response to changes in relative costs brought about by exchange rate move- ments. However, this kind of strategy may work only for low-value-added manufacturing (e.g., textiles), in which the individual manufacturers have few if any firm-specific skills that contribute to the value of the product. It may be less appropriate for high-value-added man- ufacturing, in which firm-specific technology and skills add significant value to the product (e.g., the heavy equipment industry) and in which switching costs are correspondingly high.

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M A NAG E M E N T F O C U S

Airbus and the Euro Airbus had reason to celebrate in 2003; for the first time in  the company’s history, it delivered more commercial jet  aircraft than long-time rival Boeing. Airbus delivered 305 planes in 2003, compared to Boeing’s 281. The cele- bration, however, was muted because the strength of the euro against the U.S. dollar was casting a cloud over the company’s future. Airbus, which is based in Toulouse, France, prices planes in dollars, just as Boeing has always done. But more than half of Airbus’ costs are in euros. So as the dollar drops in value against the euro—and it dropped by more than 50 percent between 2002 and the end of 2009—Airbus’ costs rise in proportion to its reve- nue, squeezing profits in the process. In the short run, the fall in the value of the dollar against the euro did not hurt Airbus. The company fully hedged its dollar exposure in 2005 and was mostly hedged for 2006. However, anticipating that the dollar would stay weak against the euro, Airbus started to take other steps to re- duce its economic exposure to a strong European cur- rency. Recognizing that raising prices is not an option given the strong competition from Boeing, Airbus decided to focus on reducing its costs. As a step toward doing this, Airbus is giving U.S. suppliers a greater share of work on new aircraft models, such as the A380 superjumbo and the A350. It is also shifting supply work on some of its older models from European to American-based suppliers. This will increase the proportion of its costs that are in dol- lars, making profits less vulnerable to a rise in the value of the euro and reducing the costs of building an aircraft when they are converted back into euros. In addition, Airbus is pushing its European-based sup- pliers to start pricing in U.S. dollars. Because the costs of many suppliers are in euros, the suppliers are finding that to comply with Airbus’ wishes, they too have to move more work to the United States, or to countries whose currency is pegged to the U.S. dollar. Thus, one large French-based

supplier, Zodiac, has announced that it was considering acquisitions in the United States. Not only is Airbus push- ing suppliers to price components for commercial jet air- craft in dollars, but the company is also requiring suppliers to its A400M program, a military aircraft that will be sold to European governments and priced in euros, to price com- ponents in U.S. dollars. Beyond these steps, the CEO of EADS, Airbus’ parent company, has publicly stated it might be prepared to assemble aircraft in the United States if that helps win important U.S. contracts. While this strategy made good sense for years, it worked against Airbus be- tween mid-2014 and 2015 as the dollar rose rapidly against the euro.

Sources: D. Michaels, “Airbus Deliveries Top Boeing’s; but Several Obstacles Remain,” The Wall Street Journal, January 16, 2004, p. A9; J. L. Gerondeau, “Airbus Eyes U.S. Suppliers as Euro Gains,” Seattle Times, February 21, 2004, p. C4; “Euro’s Gains Create Worries in Eu- rope,” Houston Chronicle.com, January 13, 2004, p. 3; K. Done, “Soft Dollar and A380 Hitches Lead to EADS Losses,” Financial Times, No- vember 9, 2006, p. 32.

For high-value-added manufacturing, switching suppliers will lead to a reduction in the value that is added, which may offset any cost gains arising from exchange rate fluctuations. The roles of the IMF and the World Bank in the current international monetary system also have implications for business strategy. Increasingly, the IMF has been acting as the macro- economic police of the world economy, insisting that countries seeking significant borrow- ings adopt IMF-mandated macroeconomic policies. These policies typically include anti-inflationary monetary policies and reductions in government spending. In the short run,

Wings are assembled at the Airbus SAS factory in Broughton, UK. Completed wings are transported to Toulouse, France, or Hamburg, Germany, for final assembly. Source: © Christopher Furlong/Getty Images News/Getty Images

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such policies usually result in a sharp contraction of demand. International businesses sell- ing or producing in such countries need to be aware of this and plan accordingly. In the long run, the kind of policies imposed by the IMF can promote economic growth and an expan- sion of demand, which create opportunities for international business.

Corporate–Government Relations As major players in the international trade and investment environment, businesses can influence government policy toward the international mone- tary system. For example, intense government lobbying by U.S. exporters helped convince the U.S. government that intervention in the foreign exchange market was necessary. With this in mind, business can and should use its influence to promote an international monetary system that facilitates the growth of international trade and investment. Whether a fixed or floating regime is optimal is a subject for debate. However, exchange rate volatility such as the world experienced during the 1980s and 1990s creates an environment less conducive to international trade and investment than one with more stable exchange rates. Therefore, it would seem to be in the interests of international business to promote an international monetary system that minimizes volatile exchange rate movements, particularly when those movements are unrelated to long-run economic fundamentals.

international monetary system, p. 313

floating exchange rate, p. 313 pegged exchange rate, p. 314 dirty-float system, p. 314 fixed exchange rate, p. 314

European Monetary System (EMS), p. 314

gold standard, p. 315 gold par value, p. 315 balance-of-trade equilibrium, p. 315 managed-float system, p. 324

currency board, p. 327 currency crisis, p. 329 banking crisis, p. 329 foreign debt crisis, p. 329 moral hazard, p. 332

Key Terms

C H A P T E R S U M M A R Y

This chapter explained the workings of the international monetary system and pointed out its implications for inter- national business. The chapter made the following points:

1. The gold standard is a monetary standard that pegs currencies to gold and guarantees convert- ibility to gold. It was thought that the gold stan- dard contained an automatic mechanism that contributed to the simultaneous achievement of a balance-of-payments equilibrium by all coun- tries. The gold standard broke down during the 1930s as countries engaged in competitive devaluations.

2. The Bretton Woods system of fixed exchange rates was established in 1944. The U.S. dollar was the central currency of this system; the value of every other currency was pegged to its value. Significant exchange rate devaluations were allowed only with the permission of the IMF. The role of the IMF was to maintain order in the

international monetary system (a) to avoid a repetition of the competitive devaluations of the 1930s and (b) to control price inflation by imposing monetary discipline on countries.

3. The fixed exchange rate system collapsed in 1973, primarily due to speculative pressure on the dollar following a rise in U.S. inflation and a growing U.S. balance-of-trade deficit.

4. Since 1973, the world has operated with a float- ing exchange rate regime, and exchange rates have become more volatile and far less predict- able. Volatile exchange rate movements have helped reopen the debate over the merits of fixed and floating systems.

5. The case for a floating exchange rate regime claims (a) such a system gives countries auton- omy regarding their monetary policy and (b) floating exchange rates facilitate smooth adjustment of trade imbalances.

governments and by requiring them to adopt certain macroeconomic policies.

9. An important debate is occurring over the appropriateness of IMF-mandated macroeco- nomic policies. Critics charge that the IMF often imposes inappropriate conditions on developing nations that are the recipients of its loans.

10. The current managed-float system of exchange rate determination has increased the impor- tance of currency management in international businesses.

11. The volatility of exchange rates under the current managed-float system creates both opportunities and threats. One way of re- sponding to this volatility is for companies to build strategic flexibility and limit their economic exposure by dispersing production to different locations around the globe by con- tracting out manufacturing (in the case of low- value-added manufacturing) and other means.

6. The case for a fixed exchange rate regime claims (a) the need to maintain a fixed exchange rate imposes monetary discipline on a country; (b) floating exchange rate regimes are vulnerable to speculative pressure; (c) the uncertainty that accompanies floating exchange rates dampens the growth of international trade and investment; and (d) far from correcting trade imbalances, depreciating a currency on the foreign exchange market tends to cause price inflation.

7. In today’s international monetary system, some countries have adopted floating exchange rates; some have pegged their currency to another currency such as the U.S. dollar; and some have pegged their currency to a basket of other currencies, allowing their currency to fluctuate within a zone around the basket.

8. In the post–Bretton Woods era, the IMF has continued to play an important role in helping countries navigate their way through financial crises by lending significant capital to embattled

The International Monetary System Chapter 11 337

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. Why did the gold standard collapse? Is there a case for returning to some type of gold standard? What is it?

2. What opportunities might current IMF lending policies to developing nations create for interna- tional businesses? What threats might they create?

3. Do you think the standard IMF policy prescrip- tions of tight monetary policy and reduced gov- ernment spending are always appropriate for developing nations experiencing a currency cri- sis? How might the IMF change its approach? What would the implications be for international businesses?

4. Debate the relative merits of fixed and floating exchange rate regimes. From the perspective of an international business, what are the most im- portant criteria in a choice between the systems? Which system is the more desirable for an inter- national business?

5. Imagine that Canada, the United States, and Mexico decide to adopt a fixed exchange rate system. What would be the likely consequences of such a system for (a) international businesses and (b) the flow of trade and investment among the three countries?

6. Reread the Country Focus on the U.S. dollar, oil prices, and recycling petrodollars; then answer the following questions: What will happen to the value of the U.S. dollar if oil producers decide to invest most of their earn- ings from oil sales in domestic infrastructure projects?

7. What factors determine the relative attractive- ness of dollar-, euro-, and yen- denominated as- sets to oil producers flush with petrodollars? What might lead them to direct more funds to- ward non-dollar-denominated assets?

8. What will happen to the value of the U.S. dollar if OPEC members decide to invest more of their petrodollars toward non-dollar-denominated assets, such as euro-denominated stocks and bonds?

9. In addition to oil producers, China is also accumulating a large stock of dollars, currently estimated to total $1.4 trillion. What would happen to the value of the dollar if China and oil-producing nations all shifted out of dollar- denominated assets at the same time? What would be the consequence for the U.S. economy?

When the global financial crisis hit in 2008, tiny Ice- land suffered more than most. The country’s three big- gest banks had been expanding at a breakneck pace since 2000 when the government privatized the bank- ing sector. With a population of around 320,000, Ice- land was too small for the banking sector’s ambitions, so the banks started to expand into other Scandinavian countries and the UK. They entered local mortgage markets, purchased foreign financial institutions, and opened foreign branches, attracting depositors by offer- ing high interest rates. The expansion was financed by debt, much of it structured as short-term loans that had to be regularly refinanced. By early 2008, the three banks held debts that amounted to almost six times the value of the entire economy of Iceland! So long as they could periodically refinance this debt, it was not a prob- lem. However, in 2008, global financial markets im- ploded following the bankruptcy of Lehman Brothers and the collapse of the U.S. housing market. In the af- termath, financial markets froze. The Icelandic banks found that they could not refinance their debt, and they faced bankruptcy. The Icelandic government lacked the funds to bail out the banks, so it decided to let the big three fail. In quick succession the local stock market plunged 90 percent and unemployment increased ninefold. The krona, Iceland’s currency, plunged on foreign exchange markets, pushing

C L O S I N G C A S E

The IMF and Iceland’s Economic Recovery up the price of imports, and inflation soared to 18 per- cent. Iceland appeared to be in free fall. The economy shrank by almost 7 percent in 2009 and another 4 percent in 2010. To stem the decline, the government secured $10 bil- lion in loans from the International Monetary Fund (IMF) and other countries. The Icelandic government stepped in to help local depositors, seizing the domestic assets of the Icelandic banks and using IMF and other loans to backstop deposit guarantees. Far from imple- menting austerity measures to solve the crisis, the Icelandic government looked for ways to shore up con- sumer spending. For example, the government provided means-tested subsidies to reduce the mortgage interest expenses of borrowers. The idea was to stop domestic consumer spending from imploding and further depressing the economy. With the financial system stabilized, thanks to the IMF and other foreign loans, what happened next is an object lesson in the value of having a floating currency. The fall in the value of the krona helped boost Iceland’s exports, such as fish and aluminum, while depressing de- mand for costly imports, such as automobiles. By 2009 the krona was worth half as much against the U.S. dollar and euro as it was in 2007 before the crisis. Iceland’s exports surged and imports slumped. While the high cost of imports did stoke inflation, booming exports started

338 Part 4 The Global Monetary System

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises:

1. The Global Financial Stability Report is a semiannual report published by the International Capital Markets division of the International Monetary Fund (IMF). The report includes an assessment of the risks facing the global finan- cial markets. Locate and download the latest report to get an overview of the most important issues currently under discussion. Also, down- load a report from five years ago. How do issues from five years ago compare with financial issues identified in the current report?

2. An important element to understanding the inter- national monetary system is keeping updated on current growth trends worldwide. A German col- league told you yesterday that Deutsche Bank Re- search provides an effective way to stay informed on important topics in international finance from a European perspective. One area of focus for the site is emerging markets and economic and finan- cial challenges faced by these markets. Find an emerging market research report for analysis. On which emerging market region did you choose to focus? What are the key takeaways from your chosen report?

The International Monetary System Chapter 11 339

to pump money back into the Icelandic economy. In 2011 the economy grew again at a 3.1 percent annual rate. This was followed by 2.7 percent growth in 2012 and 4 percent growth in 2013, while unemployment fell from a high of nearly 10 percent to 4.4 percent at the end of 2013. Sources: Charles Forelle, “In European Crisis, Iceland Emerges as an Is- land of Recovery,” The Wall Street Journal, May 19, 2012, pp. A1, A10; “Coming in from the Cold,” The Economist, December 16, 2010; Charles Duxbury, “Europe Gets Cold Shoulder in Iceland,” The Wall Street Jour- nal, April 26, 2012; “Iceland,” The World Factbook 2013 (Washington, DC: Central Intelligence Agency, 2013).

C a s e D i s c u s s i o n Q u e s t i o n s

1. What were the main causes of Iceland’s economic troubles in 2008?

2. Was Iceland facing a classic currency crisis, or was this a banking crisis?

3. How did Iceland recover from its 2008–2009 cri- sis? What are the important lessons to draw from this case?

4. Iceland did not implement the austerity policies that are so often associated with IMF loans, and yet the economy recovered. Does this suggest that austerity policies do not work?

E n d n o t e s

1. The argument goes back to eighteenth-century philosopher Da- vid Hume. See D. Hume, “On the Balance of Trade,” reprinted in The Gold Standard in Theory and in History, ed. B. Eichen- green (London: Methuen, 1985).

2. R. Solomon, The International Monetary System, 1945–1981 (New York: Harper & Row, 1982).

3. International Monetary Fund, World Economic Outlook, 2005 (Washington, DC: IMF, May 2005).

4. For an extended discussion of the dollar exchange rate in the 1980s, see B. D. Pauls, “US Exchange Rate Policy: Bretton Woods to the Present,” Federal Reserve Bulletin, November 1990, pp. 891–908.

5. R. Miller, “Why the Dollar Is Giving Way,” BusinessWeek, De- cember 6, 2004, pp. 36–37.

6. For a feel for the issues contained in this debate, see P. Krugman, Has the Adjustment Process Worked? (Washington, DC: Institute for International Economics, 1991); “Time to Tether Currencies,” The Economist, January 6, 1990, pp. 15–16; P. R. Krugman and M. Obstfeld, International Economics: Theory and Policy (New York: HarperCollins, 1994); J. Shelton, Money Meltdown (New York: Free Press, 1994); S. Edwards, “Exchange Rates and the Political Economy of Macroeconomic Discipline,” American Economic Review 86, no. 2 (May 1996), pp. 159–63.

7. The argument is made by several prominent economists, partic- ularly Stanford’s Robert McKinnon. See R. McKinnon, “An

International Standard for Monetary Stabilization,” Policy Analyses in International Economics 8 (1984). The details of this argument are beyond the scope of this book. For a rela- tively accessible exposition, see P. Krugman, The Age of Di- minished Expectations (Cambridge, MA: MIT Press, 1990).

8. A. R. Ghosh and A. M. Gulde, “Does the Exchange Rate Regime Matter for Inflation and Growth?,” Economic Issues, no. 2 (1997).

9. “The ABC of Currency Boards,” The Economist, November 1, 1997, p. 80.

10. International Monetary Fund, World Economic Outlook, 1998 (Washington, DC: IMF, 1998).

11. Ibid. 12. T. S. Shorrock, “Korea Starts Overhaul; IMF Aid Hits $55 Bil-

lion,” Journal of Commerce, December 8, 1997, p. 3A. 13. See J. Sachs, “Economic Transition and Exchange Rate

Regime,” American Economic Review 86, no. 92 (May 1996), pp. 147–52; J. Sachs, “Power unto Itself,” Financial Times, December 11, 1997, p. 11.

14. Sachs, “Power unto Itself.” 15. Martin Wolf, “Same Old IMF Medicine,” Financial Times,

December 9, 1997, p. 12. 16. Sachs, “Power unto Itself.” 17. “New Fund, Old Fundamentals,” The Economist, May 2, 2009,

p. 78.

Credit: ©Federal Reserve Board.

The Global Capital Market L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO12-1 Describe the benefits of the global capital market.

LO12-2 Identify why the global capital market has grown so rapidly.

LO12-3 Understand the risks associated with the globalization of capital markets.

LO12-4 Compare and contrast the benefits and risks associated with the Eurocurrency market, the global bond market, and the global equity market.

LO12-5 Understand how foreign exchange risks affect the cost of capital.

part four The Global Monetar y System

12

Source: © ChinaFotoPress/Getty Images

341

Alibaba’s Record-Setting IPO

in a timely manner, Alibaba made inquiries to the New York Stock Exchange (NYSE) and the U.S. Securities and Exchange Commission (SEC). The NYSE and SEC indi- cated that they would have no problem with Alibaba’s partners retaining control over more than half of all board seats.  Alibaba realized that an offering on the NYSE would have other advantages, beyond retaining control of the board. The NYSE is the largest and most liquid exchange in the world. The recent successful IPO of Facebook and Twitter had demonstrated that U.S. investors had an ap- petite for Internet offerings. Demand for Alibaba shares was expected to be high, raising the possibility that Alibaba might have a record-setting IPO. Moreover, if its shares were listed on the NYSE, this might make it easier for Alibaba to subsequently use those shares to acquire U.S. and other foreign enterprises, giving Alibaba a bigger global footprint.  The biggest obstacle standing in the way of a U.S. list- ing was the Chinese government–imposed limits on for- eign ownership of Chinese technology businesses. Alibaba was able to circumvent these limits by establishing a complex corporate structure in which investors would actually own shares in a Cayman Island entity, Alibaba Group Holdings, which has contractual rights to all of the earnings of Alibaba China, but no ownership interest in the Chinese entity, which would continue to be owned by Ma and his partners. The IPO took place on the NYSE on September 18, 2014. The initial offering price was $68 a share, but demand was so strong that Alibaba’s shares opened at $92.70. The IPO raised $25 billion for Alibaba, $6 billion more than originally estimated, and valued the company at  $231 billion, making it the largest IPO in history.

Sources: S. D. Solomon, “Alibaba Investors Will Buy a Risky Corpo- rate Structure,” The New York Times, May 6, 2014; T. Demos and J. Osawa, “Alibaba Debut Makes a Splash,” The Wall Street Jour- nal, September 19, 2014; D. Thomas and E. Barreto, “Alibaba’s Choice of US IPO Spurred by Rivals, Hong Kong Impass,” Reuters, March 19, 2014.

O P E N I N G C A S E In 2013 senior managers at Alibaba, China’s largest e-commerce enterprise, decided that it was time to take the company public and offer its shares for sale to retail and institutional investors. Alibaba was founded in 1999 by a former English teacher, Jack Ma, with just $60,000 in capital. Often described as a fusion of Amazon and eBay, by 2013 Alibaba was already the world’s largest online e-commerce company. In 2012, transactions at its online sites totaled $248 billion, more than those of Amazon and eBay combined. Driven by rapid growth in China’s online shopping market, projections called for the company to reach online sales of $713 billion by 2017.  Ma and his colleagues had several motives for the IPO. First, they wanted to raise capital to finance the infrastruc- ture investment required at a company that was growing at breakneck speed. Second, publicly traded shares would give Alibaba a currency that it could use to acquire other enterprises (by offering its shares in exchange for the shares of an acquired company). Third, a public market in Alibaba shares would be a major liquidity event for the large number of Alibaba employees who held stock in the enterprise. It would enable them to more easily sell shares in order to raise cash for other purchases.  Initially, Alibaba considered doing an IPO in Hong Kong. The choice made sense. Hong Kong has a large and liquid stock market that attracts investors from all over the world. However, while Hong Kong is part of China, it retains its own legal system. Hong Kong’s stock exchange has a “one share one vote” requirement. Ma and his colleagues were opposed to this. Even though they would hold only a minority of shares after the IPO, they wanted to retain the ability to nominate more than half of the company’s board of directors, ensuring that they maintained control over the management of the enterprise.  Alibaba entered into negotiations with the Hong Kong stock exchange to see if the rules could be changed, but to no avail. As it became increasingly apparently that the Hong Kong exchange was unwilling to change its rules

Introduction

The opening case illustrates just how global capital markets have become in the mod- ern era. Thirty years ago, the idea that the initial public offering of a fast-growing Chinese company would take place not on the Shanghai or the Hong Kong Stock Ex- changes, but on the New York Stock Exchange, seemed highly unlikely. Today, it is commonplace for a corporation such as Alibaba to list its shares on foreign exchanges, and to borrow equity and debt capital from whichever sources offer the most attractive terms, irrespective of the nationality of the investors or lenders. We have moved from a world in which national capital markets were segmented from each other by regula- tory barriers to capital flow, toward a world in which the capital market is becoming

342 Part 4 The Global Monetary System

truly global. This has clear benefits for corporations, as is clear from the Alibaba case, but it also comes with some risks.

This chapter looks at the global market for capital. We begin by studying the benefits associated with the globalization of capital markets. This is followed by a more detailed look at the growth of the international capital market and the macroeconomic risks associated with such growth. Next, we review three important segments of the global capital market: the Eurocurrency market, the international bond market, and the interna- tional equity market. As usual, we close the chapter by pointing out some of the implications for the practice of international business.

Benefits of the Global Capital Market

Although this section is about the global capital market, it opens by discussing the func- tions of a generic capital market. Then we look at the limitations of domestic capital markets and discuss the benefits of using global capital markets.

FUNCTIONS OF A GENERIC CAPITAL MARKET

Capital markets bring together those who want to invest money and those who want to borrow money (see Figure 12.1). Those who want to invest money include corporations with surplus cash, individuals, and nonbank financial institutions (e.g., pension funds, insurance companies). Those who want to borrow money include individuals, compa- nies, and governments. Between these two groups are the market makers. Market mak- ers are the financial service companies that connect investors and borrowers, either directly or indirectly. They include commercial banks (e.g., Citi, U.S. Bank) and invest- ment banks (e.g., Goldman Sachs).

Commercial banks perform an indirect connection function. They take cash depos- its from corporations and individuals and pay them a rate of interest in return. They then lend that money to borrowers at a higher rate of interest, making a profit from the difference in interest rates (commonly referred to as the interest rate spread). Invest- ment banks perform a direct connection function. They bring investors and borrowers together and charge commissions for doing so. For example, Goldman Sachs may act as a stockbroker for an individual who wants to invest some money. Its personnel will advise her as to the most attractive purchases and buy stock on her behalf, charging a fee for the service.

Capital market loans to corporations are either equity loans or debt loans. An equity loan is made when a corporation sells stock to investors (as Alibaba did in its 2014 NYSE IPO; see the opening case). The money the corporation receives in return for its stock can be used to purchase plants and equipment, fund R&D projects, pay wages, and so on. A share of stock gives its holder a claim to a firm’s profit stream. Ultimately, the corpora- tion honors this claim by paying dividends to the stockholders (although many fast-grow- ing young corporations do not start to issue dividends until the business has matured and growth rate slows). The amount of the dividends is not fixed in advance. Rather, it is de- termined by management based on how much profit the corporation is making. Investors purchase stock both for their dividend yield and in anticipation of gains in the price of the

LO 12-1 Describe the benefits of the global capital market.

Investors: Companies Individuals Institutions

Market Makers: Commercial Bankers Investment Bankers

Borrowers: Individuals Companies Governments

F I G U R E 1 2 . 1

The main players in the generic capital market.

The Global Capital Market Chapter 12 343

stock, which in theory reflects future dividend yields. Stock prices increase when a cor- poration is projected to have greater earnings in the future, which increases the probabil- ity that it will raise future dividend payments.

A debt loan requires the corporation to repay a predetermined portion of the loan amount (the sum of the principal plus the specified interest) at regular intervals regardless of how much profit it is making. Management has no discretion as to the amount it will pay investors. Debt loans include cash loans from banks and funds raised from the sale of corporate bonds to investors. When an investor purchases a corporate bond, he purchases the right to receive a specified fixed stream of income from the corporation for a speci- fied number of years (i.e., until the bond maturity date). The maturity period of debt loans vary from the very long term, such as 20 years, to extremely short-term loans, including those with a maturity of just one day.

G L O S S A R Y

Our International Business textbook covers what is commonly referred to as a “survey” of topics in international business. As such, the book includes a lot of terms, definitions, and technical language associated with international business and worldwide trade. One such chapter topic that covers a lot of important details is this chapter on global capital markets. While our goal is to provide readers of the textbook with state-of-the-art knowledge, every possible term and definition that may be important when conducting international business around the world cannot be covered in our textbook (due to space and volume of terms). Instead, globalEDGE provides several hundred relevant terms and definitions. They may become valuable to better understand certain scenarios in our book as well as, most impor- tantly, to better understand practical scenarios that you may encounter in the workplace. As related to Chapter 12 (and also all other chapters), check out globalEDGE’s glossary section at globaledge.msu.edu/reference-desk/glossary. View the glossary, definitions, and breadth of terminology as a quick-examination of your understanding of the main issues in interna- tional business.

ATTRACTIONS OF THE GLOBAL CAPITAL MARKET

A global capital market benefits both borrowers and investors. It benefits borrowers by increasing the supply of funds available for borrowing and by lowering the cost of capital. It benefits investors by providing a wider range of investment opportunities, thereby allowing them to build portfolios of international investments that diversify their risks.

The Borrower’s Perspective: Lower Cost of Capital In a purely domestic capital market, the pool of investors is limited to residents of the country. This places an upper limit on the supply of funds available to borrowers. In other words, the liquidity of the market is limited. A global capital market, with its much larger pool of investors, provides a larger supply of funds for borrowers to draw on.

Perhaps the most important drawback of the limited liquidity of a purely domestic capital market is that the cost of capital tends to be higher than it is in a global market. The cost of capital is the price of borrowing money, which is the rate of return that bor- rowers must pay investors. This is the interest rate on debt loans and the dividend yield and expected capital gains on equity loans. In a purely domestic market, the limited pool of investors implies that borrowers must pay more to persuade investors to lend them their money. The larger pool of investors in an international market implies that borrow- ers will be able to pay less.

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The argument is illustrated in Figure 12.2, using Deutsche Telekom as an example (see the Management Focus for details). Deutsche Telekom raised over $13 billion by simulta- neously offering shares for sales in Frankfurt, New York, London, and Tokyo. The verti- cal axis in Figure 12.2 is the cost of capital (the price of borrowing money), and the horizontal axis is the amount of money available at varying interest rates. The Deutsche Telekom demand curve for borrowings is DD. Note that the Deutsche Telekom demand for funds varies with the cost of capital; the lower the cost of capital, the more money Deutsche Telekom will borrow. (Money is just like anything else; the lower its price, the more of it people can afford.) The supply curve of funds available in the German capital market is SSG, and the funds available in the global capital market is represented by SSI. Note that Deutsche Telekom can borrow more funds more cheaply on the global capital market. As Figure 12.2 illustrates, the greater pool of resources in the global capital mar- ket—the greater liquidity—both lowers the cost of capital and increases the amount Deutsche Telekom can borrow. Thus, the advantage of a global capital market to borrow- ers is that it lowers the cost of capital.

Problems of limited liquidity are not restricted to less developed nations, which natu- rally tend to have smaller domestic capital markets. In recent decades, even very large enterprises based in some of the world’s most advanced industrialized nations have tapped the international capital markets in their search for greater liquidity and a lower cost of capital, such as Germany’s Daimler and Deutsche Telekom.1

The Investor’s Perspective: Portfolio Diversification By using the global capital market, investors have a much wider range of investment op- portunities than in a purely domestic capital market. The most significant consequence of this choice is that investors can diversify their portfolios internationally, thereby reducing their risk to less than what could be achieved in a purely domestic capital market. We consider how this works in the case of stock holdings, although the same argument could be made for bond holdings.

Consider an investor who buys stock in a biotech firm that has not yet produced a new product. Imagine the price of the stock is very volatile—investors are buying and selling the stock in large numbers in response to information about the firm’s prospects. Such stocks are risky investments; investors may win big if the firm produces a marketable

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M A NAG E M E N T F O C U S

Deutsche Telekom Taps the Global Capital Market Based in the world’s third-largest industrial economy, Deutsche Telekom is one of the world’s largest telephone companies. Until late 1996, the German government wholly owned the company. However, in the mid-1990s, the Ger- man government formulated plans to privatize the utility, selling shares to the public. The privatization effort was driven by two factors: (1) a realization that state-owned enterprises tend to be inherently inefficient and (2) the impending deregulation of the European Union tele- communications industry in 1998, which promised to expose Deutsche Telekom to foreign competition for the first time. Deutsche Telekom realized that, to become more competitive, it needed massive investments in new telecommunications infrastructure, including fiber optics and wireless, lest it start losing share in its home market to more efficient competitors such as AT&T and British Tele- com after 1998. Financing such investments from state sources would have been difficult even under the best of circumstances and almost impossible in the late 1990s, when the German government was trying to limit its bud- get deficit to meet the criteria for membership in the Euro- pean monetary union. With the active encouragement of the government, Deutsche Telekom hoped to finance its investments in capital equipment through the sale of shares to the public. From a financial perspective, the privatization looked anything but easy. In 1996, Deutsche Telekom was valued at about $60 billion. If it maintained this valuation as a private company, it would dwarf all others listed on the German stock market. However, many analysts doubted there was anything close to $60 billion available in Germany for investment in Deutsche Telekom stock. One problem was that there was no tradition of retail stock investing in Germany. In 1996, only 1 in 20 German citizens owned shares, compared with 1 in every 4 or 5 in the United States and Great Britain. This lack of retail interest in stock ownership makes for a relatively illiquid stock market. Nor did banks,

the traditional investors in company stocks in Germany, seem enthused about underwriting such a massive privati- zation effort. A further problem was that a wave of privati- zations was already sweeping through Germany and the rest of Europe, so Deutsche Telekom would have to com- pete with many other state-owned enterprises for inves- tors’ attention. Given these factors, probably the only way that Deutsche Telekom could raise $60 billion through the German capital market would have been by promising investors a dividend yield that would raise the company’s cost of capital above levels that could be serviced profitably. Deutsche Telekom managers concluded they had to privatize the company in stages and sell a substantial por- tion of Deutsche Telekom stock to foreign investors. The company’s plans called for an initial public offering (IPO) of 623 million shares of Deutsche Telekom stock, represent- ing 25 percent of the company’s total value, for about $18.50 per share. With a total projected value in excess of $13 billion, even this “limited” sale of Deutsche Telekom represented the largest IPO in European history and the second largest in the world after the 1987 sale of shares in Japan’s telephone monopoly, NTT, for $15.6 billion. Con- cluding there was no way the German capital market could absorb even this partial sale of Deutsche Telekom equity, the managers of the company decided to simultaneously list shares and offer them for sale in Frankfurt (where the German stock exchange is located), New York, and Tokyo, attracting investors from all over the world. The IPO was successfully executed in November 1996 and raised $13.3 billion for the company.

Sources: J. O. Jackson, “The Selling of the Big Pink,” Time, Decem- ber 2, 1996, p. 46; S. Ascarelli, “Privatization Is Worrying Deutsche Telekom,” The Wall Street Journal, February 3, 1995, p. A1; “Plunging into Foreign Markets, The Economist, September 17, 1994, pp. 86–87; A. Raghavan and M. R. Sesit, “Financing Boom: Foreign Firms Raise More and More Money in the U.S. Market,” The Wall Street Journal, October 5, 1993, p. A1.

product; but investors may also lose all their money if the firm fails to come up with a product that sells. Investors can guard against the risk associated with holding this stock by buying other firms’ stocks, particularly those weakly or negatively correlated with the biotech stock. By holding a variety of stocks in a diversified portfolio, the losses incurred when some stocks fail to live up to their promise are offset by the gains enjoyed when other stocks exceed their promise.

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As an investor increases the number of stocks in her portfolio, the portfolio’s risk declines. At first this decline is rapid. Soon, however, the rate of decline falls off and asymptotically approaches the systematic risk of the market. Systematic risk refers to movements in a stock portfolio’s value that are attributable to macroeconomic forces af- fecting all firms in an economy, rather than factors specific to an individual firm. The systematic risk is the level of nondiversifiable risk in an economy. Data from a classic study by Solnik2 suggested that a fully diversified U.S. portfolio is only about 27 percent as risky as a typical individual stock.

By diversifying a portfolio internationally, an investor can reduce the level of risk even further because the movements of stock market prices across countries are not per- fectly correlated. For example, one study looked at the correlation between three stock market indexes. The Standard & Poor’s 500 (S&P 500) summarized the movement of large U.S. stocks. The Morgan Stanley Capital International Europe, Australia, and Far East Index (EAFE) summarized stock market movements in other developed nations. The third index, the International Finance Corporation Global Emerging Markets Index (IFC), summarized stock market movements in less developed “emerging economies.” From 1981 to 1994, the correlation between the S&P 500 and EAFE indexes was 0.45, suggesting they moved together only about 20 percent of the time (i.e., 0.45 × 0.45 = 0.2025). The correlation between the S&P 500 and IFC indexes was even lower at 0.32, suggesting they moved together only a little over 10 percent of the time.3 Other studies have confirmed that despite casual observations, different national stock markets appear to be only moderately correlated. One study found that between 1972 and 2000 the aver- age pair-wise correlation between the world’s four largest equity markets in the United States, United Kingdom, Germany, and Japan was 0.475, suggesting that these markets moved in tandem only about 22 percent of the time (0.475 × 0.472 = 0.22 or 22 percent of shared variance).4

The relatively low correlation between the movement of stock markets in different countries reflects two basic factors. First, countries pursue different macroeconomic poli- cies and face different economic conditions, so their stock markets respond to different forces and can move in different ways. For example, in 1997, the stock markets of several Asian countries, including South Korea, Malaysia, Indonesia, and Thailand, lost more than 50 percent of their value in response to the Asian financial crisis, while at the same time the S&P 500 increased in value by over 20 percent. Second, some stock markets are still somewhat segmented from each other by capital controls—that is, by restrictions on cross-border capital flows (although as noted earlier, such restrictions are declining rap- idly). The most common restrictions include limits on the amount of a firm’s stock that a foreigner can own and limits on the ability of a country’s citizens to invest their money outside that country. For example, until recently it was difficult for foreigners to own more than 30 percent of the equity of South Korean enterprises. Such barriers to cross- border capital flows limit the ability of capital to roam the world freely in search of the highest risk-adjusted return. Consequently, at any one time there may be too much capital invested in some markets and too little in others. This will tend to produce differences in rates of return across stock markets.5 The implication is that by diversifying a portfolio to include foreign stocks, an investor can reduce the level of risk below that incurred by holding only domestic stocks.

According to the classic study by Bruno Solnik,6 a fully diversified portfolio that contains stocks from many countries is less than half as risky as a fully diversified port- folio that contains only U.S. stocks. Solnik found that a fully diversified portfolio of international stocks is only about 12 percent as risky as a typical individual stock, whereas a fully diversified portfolio of U.S. stocks is about 27 percent as risky as a typical indi- vidual stock.

There is a perception, increasingly common among investment professionals, that the growing integration of the global economy and the emergence of the global capital mar- ket have increased the correlation between different stock markets, reducing the benefits

The Global Capital Market Chapter 12 347

of international diversification.7 Today, it is argued, if the U.S. economy enters a reces- sion, and the U.S. stock market declines rapidly, other markets follow suit. Indeed, this is what seems to have occurred in 2008 and 2009 as the financial crisis that started in the United States swept around the world. Another study by Solnik suggests there may be some truth to this assertion, but the rate of integration is not occurring as rapidly as the popular perception would lead one to believe. Solnik and his associate looked at the correlation between 15 major stock markets in developed countries between 1971 and 1998. They found that on average, the correlation of monthly stock market returns increased from 0.66 in 1971 to 0.75 in 1998, indicating some convergence over time, but that “the regression results were weak,” which suggests that this “average” relationship was not strong and that there was considerable variation among countries.8 Similarly, a more recent study confirmed this basic finding, suggesting that even today, most of the time a portfolio equally diversified across all available markets can reduce portfolio risk to about 35 percent of the volatility associated with a single market (i.e., a 65 percent reduction in risk).9

The implication here is that international portfolio diversification can still reduce risk. Moreover, the correlation between stock market movements in developed and emerging markets seems to be lower, and the rise of stock markets in developing nations, such as China, has given international investors many more opportunities for international port- folio diversification.10

The risk-reducing effects of international portfolio diversification would be greater were it not for the volatile exchange rates associated with the current floating exchange rate regime. Floating exchange rates introduce an additional element of risk into investing in foreign assets. As we have said repeatedly, adverse exchange rate movements can transform otherwise profitable investments into unprofitable investments. The uncer- tainty engendered by volatile exchange rates may be acting as a brake on the otherwise rapid growth of the international capital market.

GROWTH OF THE GLOBAL CAPITAL MARKET

According to data from the Bank for International Settlements, the global capital market is growing at a rapid pace.11 There seem to be two factors driving this growth—advances in information technology and deregulation by governments.

Information Technology Financial services is an information-intensive industry. It draws on large volumes of information about markets, risks, exchange rates, interest rates, creditworthiness, and so on. It uses this information to make decisions about what to invest where, how much to charge borrowers, how much interest to pay to depositors, and the value and riski- ness of a range of financial assets including corporate bonds, stocks, government secu- rities, and currencies.

Because of this information intensity, the financial services industry has been revolu- tionized more than any other industry by advances in information technology since the 1970s. The growth of international communications technology has facilitated instanta- neous communication between any two points on the globe. At the same time, rapid advances in data processing capabilities have allowed market makers to absorb and process large volumes of information from around the world. According to one study, because of these technological developments, the real cost of recording, transmitting, and processing information fell by 95 percent between 1964 and 1990.12 With the rapid rise of the Inter- net and the massive increase in computing power that we have seen since 1990, it seems likely that the cost of recording, transmitting, and processing information has fallen by a similar amount since 1990 and is now trivial.

Such developments have facilitated the emergence of an integrated international capi- tal market. It is now technologically possible for financial services companies to engage

LO 12-2 Identify why the global capital market has grown so rapidly.

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in 24-hour-a-day trading, whether it is in stocks, bonds, foreign exchange, or any other financial asset. Due to advances in communications and data processing technology, the international capital market never sleeps. San Francisco closes one hour before Tokyo opens, but during this period trading continues in New Zealand.

The integration facilitated by technology has a dark side.13 “Shocks” that occur in one financial center now spread around the globe very quickly. As discussed in the closing case, the financial crisis that began in the United States in 2008 quickly spread around the globe. However, most market participants would argue that the benefits of an integrated global capital market far outweigh any potential costs. Moreover, despite the fact that shocks in national financial markets do seem to spill over into other markets, on average the correlation between movements in national equity markets remains relatively low, sug- gesting that such shocks may have a relatively moderate long-term impact outside their home market.14

Deregulation In country after country, financial services has historically been the most tightly regu- lated of all industries. Governments around the world have traditionally kept other countries’ financial service firms from entering their capital markets. In some cases, they have also restricted the overseas expansion of their domestic financial services firms. In many countries, the law has also segmented the domestic financial services industry. In the United States, for example, until the late 1990s commercial banks were prohibited from performing the functions of investment banks, and vice versa. Histori- cally, many countries have limited the ability of foreign investors to purchase signifi- cant equity positions in domestic companies. They have also limited the amount of foreign investment that their citizens could undertake. In the 1970s, for example, capi- tal controls made it very difficult for a British investor to purchase American stocks and bonds.

Many of these restrictions have been crumbling since the early 1980s. In part, this has been a response to the development of the Eurocurrency market, which from the begin- ning was outside national control. (This is explained later in the chapter.) It has also been a response to pressure from financial services companies, which have long wanted to operate in a less regulated environment. Increasing acceptance of the free market ideol- ogy associated with an individualistic political philosophy also has a lot to do with the global trend toward the deregulation of financial markets (see Chapter 2). Whatever the reason, deregulation in a number of key countries has undoubtedly facilitated the growth of the international capital market.

The trend began in the United States in the late 1970s and early 1980s with a series of changes that allowed foreign banks to enter the U.S. capital market and domestic banks to expand their operations overseas. In Great Britain, the so-called Big Bang of October 1986 removed barriers that had existed between banks and stockbrokers and allowed foreign financial service companies to enter the British stock market. Restric- tions on the entry of foreign securities houses have been relaxed in Japan, and Japanese banks are now allowed to open international banking facilities. In France, the “Little Bang” of 1987 opened the French stock market to outsiders and to foreign and domestic banks. In Germany, foreign banks are now allowed to lend and manage foreign euro issues, subject to reciprocity agreements.15 All of this has enabled financial services companies to transform themselves from primarily domestic companies into global operations with major offices around the world—a prerequisite for the development of a truly international capital market. As we saw in Chapter 8, in late 1997 the World Trade Organization brokered a deal that removed many of the restrictions on cross- border trade in financial services. This deal facilitated further growth in the size of the global capital market.

In addition to the deregulation of the financial services industry, many countries begin- ning in the 1970s started to dismantle capital controls, loosening both restrictions on in- ward investment by foreigners and outward investment by their own citizens and

The Global Capital Market Chapter 12 349

corporations. By the 1980s, this trend spread from developed nations to the emerging economies of the world as countries across Latin America, Asia, and eastern Europe started to dismantle decades-old restrictions on capital flows.

The trends toward deregulation of financial services and removal of capital controls were still firmly in place until 2008. However, the global financial crisis of 2008–2009 prompted many to wonder if deregulation had gone too far, and it focused attention on the need for new regulations to govern certain sectors of the financial services industry, including the hedge funds, which operate largely outside of existing regulatory bound- aries. (Hedge funds are private investment funds that position themselves to make “long bets” on assets that they think will increase in value and “short bets” on assets that they think will decline in value.) Given the benefits associated with the globaliza- tion of capital, notwithstanding the current contraction, over the long term the growth of the global capital market can be expected to continue. While most commentators see this as a positive development, some believe the globalization of capital holds inherent serious risks.

GLOBAL CAPITAL MARKET RISKS

Some analysts are concerned that due to deregulation and reduced controls on cross- border capital flows, individual nations are becoming more vulnerable to speculative capital flows. They see this as having a destabilizing effect on national economies.16 Harvard economist Martin Feldstein, for example, has argued that most of the capital that moves internationally is pursuing temporary gains, and it shifts in and out of countries as quickly as conditions change.17 He distinguishes between this short-term capital, or “hot money,” and “patient money” that would support long-term cross-border capital flows. To Feldstein, patient money is still relatively rare, primarily because although capital is free to move internationally, its owners and managers still prefer to keep most of it at home. Feldstein supports his arguments with statistics that demonstrate that although vast amounts of money flows through the foreign exchange markets every day, “when the dust settles, most of the savings done in each country stays in that country.”18 Feldstein argues that the lack of patient money is due to the relative paucity of information that investors have about foreign investments. In his view, if investors had better information about foreign assets, the global capital market would work more efficiently and be less subject to short-term speculative capital flows. Feldstein claims that Mexico’s economic prob- lems in the mid-1990s were the result of too much hot money flowing in and out of the country and too little patient money. This example is reviewed in detail in the accompa- nying Country Focus.

A lack of information about the fundamental quality of foreign investments may encourage speculative flows in the global capital market. Faced with a lack of quality information, investors may react to dramatic news events in foreign nations and pull their money out too quickly. Despite advances in information technology, it is still dif- ficult for investors to get access to the same quantity and quality of information about foreign investment opportunities that they can get about domestic investment opportu- nities. This information gap is exacerbated by different accounting conventions in dif- ferent countries, which makes the direct comparison of cross-border investment opportunities difficult for all but the most sophisticated investor (see Chapter 17 for details). For example, historically German accounting principles have been different from those found in the United States and presented quite a different picture of the health of a company. Thus, when the Germany company Daimler-Benz translated its German financial accounts into U.S.-style accounts in 1993, as it had to do to be listed on the New York Stock Exchange, it found that while it had made a profit of $97 mil- lion under German rules, under U.S. rules it had lost $548 million!19 However, in the 2000s there has been rapid movement toward harmonization of different national accounting standards, which is certainly improving the quality of information available to investors (see Chapter 20 for details).

LO 12-3 Understand the risks associated with the globalization of capital markets.

COUNTRY FOCUS

Did the Global Capital Markets Fail Mexico? In early 1994, soon after passage of the North American Free Trade Agreement (NAFTA), Mexico was widely admired among the international community as a shining example of a developing country with a bright economic future. Since the late 1980s, the Mexican government had pursued sound mon- etary, budget, tax, and trade policies. By historical standards, inflation was low, the country was experiencing solid eco- nomic growth, and exports were booming. This robust picture attracted capital from foreign investors; between 1991 and 1993, foreigners invested more than $75 billion in the Mexican economy, more than in any other developing nation. If there was a blot on Mexico’s economic report card, it was the country’s growing current account (trade) deficit. Mexican exports were booming but so were its imports. In the 1989–1990 period, the current account deficit was equivalent to about 3 percent of Mexico’s gross domestic product. In 1991 it increased to 5 percent, and by 1994 it was running at an annual rate of over 6 percent. Bad as this might seem, it is not unsustainable and should not bring an economy crashing down. The United States has been running a current account deficit for decades with apparently little in the way of ill effects. A current account deficit will not be a problem for a country as long as for- eign investors take the money they earn from trade with that country and reinvest it within the country. This has been the case in the United States for years, and during the early 1990s, it was occurring in Mexico too. Thus, com- panies such as Ford took the pesos they earned from ex- ports to Mexico and reinvested those funds in productive capacity in Mexico, building auto plants to serve the future needs of the Mexican market and to export elsewhere. Unfortunately for Mexico, much of the $25 billion annual inflow of capital it received during the early 1990s was not the kind of patient long-term money that Ford was putting into Mexico. Rather, according to economist Martin Feldstein, much of the inflow was short-term capital that could flee if eco- nomic conditions changed for the worse. This is what seems to have occurred. In February 1994, the U.S. Federal Reserve began to increase U.S. interest rates. This led to a rapid fall in U.S. bond prices. At the same time, the yen began to appreci- ate sharply against the U.S. dollar. These events resulted in large losses for many managers of short-term capital, such as hedge fund managers and banks, which had been betting on exactly the opposite happening. Many hedge funds had been betting that interest rates would fall, bond prices would rise, and the dollar would appreciate against the yen.

Faced with large losses, money managers tried to re- duce the riskiness of their portfolios by pulling out of risky situations. About the same time, events took a turn for the worse in Mexico. An armed uprising in the southern state of Chiapas, the assassination of the leading candidate in the presidential election campaign, and an accelerating inflation rate all helped produce a feeling that Mexican in- vestments were riskier than had been assumed. Money managers began to pull many of their short-term invest- ments out of the country. As hot money flowed out, the Mexican government re- alized it could not continue to count on capital inflows to finance its current account deficit. The government had as- sumed the inflow was mainly composed of patient, long- term money. In reality, much of it appeared to be short-term money. As money flowed out of Mexico, the Mexican gov- ernment had to commit more foreign reserves to defend- ing the value of the peso against the U.S. dollar, which was pegged at 3.5 to the dollar. Currency speculators entered the picture and began to bet against the Mexican govern- ment by selling pesos short. Events came to a head in De- cember 1994 when the Mexican government was essentially forced by capital flows to abandon its support for the peso. Over the next month, the peso lost 40 per- cent of its value against the dollar, the government was forced to introduce an economic austerity program, and the Mexican economic boom came to an abrupt end. According to Martin Feldstein, the Mexican economy was brought down not by currency speculation on the foreign exchange market but by a lack of long-term patient money. He argued that Mexico offered, and still offers, many attrac- tive long-term investment opportunities, but because of the lack of information on long-term investment opportunities in Mexico, most of the capital flowing into the country from 1991 to 1993 was short-term, speculative money, the flow of which could quickly be reversed. If foreign investors had better information, Feldstein argued, Mexico should have been able to finance its current account deficit from inward capital flows because patient capital would naturally gravitate toward attractive Mexican investment opportunities.

Sources: Martin Feldstein, “Global Capital Flows: Too Little, Not Too Much,” The Economist, June 24, 1995, pp. 72–73; R. Dornbusch, “We Have Salinas to Thank for the Peso Debacle,” BusinessWeek, January 16, 1995, p. 20; P. Carroll and C. Torres, “Mexico Unveils Program of Harsh Fiscal Medicine,” The Wall Street Journal, March 10, 1995, pp. A1, A6. See also Martin Feldstein and Charles Horioka, “Domestic Savings and International Capital Flows,” Economic Journal 90 (1980), pp. 314–29.

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Given the problems created by differences in the quantity and quality of informa- tion, many investors have yet to venture into the world of cross-border investing, and those that do are prone to reverse their decision on the basis of limited (and perhaps inaccurate) information. However, if the international capital market continues to grow, financial intermediaries likely will increasingly provide quality information about foreign investment opportunities. Better information should increase the so- phistication of investment decisions and reduce the frequency and size of speculative capital flows. Although concerns about the volume of “hot money” sloshing around in the global capital market increased as a result of the Asian financial crisis, IMF research suggests there has not been an increase in the volatility of financial markets since the 1970s.20

The Eurocurrency Market

A Eurocurrency is any currency banked outside its country of origin. Eurodollars, which account for about two-thirds of all Eurocurrencies, are dollars banked outside the United States. Other important Eurocurrencies include the Euro-yen, the Euro-pound, and the Euro-euro! The term Eurocurrency is actually a misnomer because a Eurocurrency can be created anywhere in the world; the persistent Euro- prefix reflects the European origin of the market. The Eurocurrency market has been an important and relatively low-cost source of funds for international businesses.

GENESIS AND GROWTH OF THE MARKET

The Eurocurrency market was born in the mid-1950s when eastern European holders of dollars, including the former Soviet Union, were afraid to deposit their holdings of dollars in the United States lest they be seized by the U.S. government to settle U.S. residents’ claims against business losses resulting from the Communist takeover of  eastern Europe.21 These countries deposited many of their dollar holdings in Europe, particularly in London. Additional dollar deposits came from various western European central banks and from companies that earned dollars by exporting to the United States. These two groups deposited their dollars in London banks, rather than U.S. banks, because they were able to earn a higher rate of interest (which will be explained).

The Eurocurrency market received a major push in 1957 when the British government prohibited British banks from lending British pounds to finance non-British trade, a busi- ness that had been very profitable for British banks. British banks began financing the same trade by attracting dollar deposits and lending dollars to companies engaged in in- ternational trade and investment. Because of this historical event, London became, and has remained, the leading center of Eurocurrency trading.

The Eurocurrency market received another push in the 1960s when the U.S. govern- ment enacted regulations that discouraged U.S. banks from lending to non-U.S. residents. Would-be dollar borrowers outside the United States found it increasingly difficult to borrow dollars in the United States to finance international trade, so they turned to the Eurodollar market to obtain the necessary dollar funds.

The U.S. government changed its policies after the 1973 collapse of the Bretton Woods system (see Chapter 11), removing an important impetus to the growth of the Eurocur- rency market. However, another political event, the oil price increases engineered by OPEC in the 1973–1974 and 1979–1980 periods, gave the market another big shove. As a result of the oil price increases, the Arab members of OPEC accumulated huge amounts of dollars. They were afraid to place their money in U.S. banks or their European branches, lest the U.S. government attempt to confiscate them. (Iranian assets in U.S. banks and their European branches were frozen by President Carter in 1979 after Ameri- cans were taken hostage at the U.S. embassy in Tehran; their fear was not unfounded.)

TEST PREP Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

LO 12- 4 Compare and contrast the benefits and risks associated with the Eurocurrency market, the global bond market, and the global equity market.

352 Part 4 The Global Monetary System

Instead, these countries deposited their dollars with banks in London, further increasing the supply of Eurodollars.

Although these various political events contributed to the growth of the Eurocurrency market, they alone were not responsible for it. The market grew because it offered real financial advantages—initially to those who wanted to deposit dollars or borrow dollars and later to those who wanted to deposit and borrow other currencies. We now look at the source of these financial advantages.

ATTRACTIONS OF THE EUROCURRENCY MARKET

The main factor that makes the Eurocurrency market attractive to both depositors and borrowers is its lack of government regulation. This allows banks to offer higher inter- est rates on Eurocurrency deposits than on deposits made in the home currency, mak- ing Eurocurrency deposits attractive to those who have cash to deposit. The lack of regulation also allows banks to charge borrowers a lower interest rate for Eurocur- rency borrowings than for borrowings in the home currency, making Eurocurrency loans attractive for those who want to borrow money. In other words, the spread be- tween the Eurocurrency deposit rate and the Eurocurrency lending rate is less than the spread between the domestic deposit and lending rates (see Figure 12.3). To under- stand why this is so, we must examine how government regulations raise the costs of domestic banking.

Domestic currency deposits are regulated in all industrialized countries. Such regula- tions ensure that banks have enough liquid funds to satisfy demand if large numbers of domestic depositors should suddenly decide to withdraw their money. All countries oper- ate with certain reserve requirements. For example, each time a U.S. bank accepts a de- posit in dollars, it must place some fraction of that deposit in a non-interest-bearing account at a Federal Reserve Bank as part of its required reserves. Similarly, each time a British bank accepts a deposit in pounds sterling, it must place a certain fraction of that deposit with the Bank of England.

Banks are given much more freedom in their dealings in foreign currencies, however. For example, the British government does not impose reserve requirement restrictions on deposits of foreign currencies within its borders. Nor are the London branches of U.S. banks subject to U.S. reserve requirement regulations, provided those deposits are pay- able only outside the United States. This gives Eurobanks a competitive advantage.

For example, suppose a bank based in New York faces a 10 percent reserve require- ment. According to this requirement, if the bank receives a $100 deposit, it can lend out

Domestic Lending Rate

Domestic Deposit Rate

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Rate of Interest

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Interest rate spreads in domestic and Eurocurrency markets.

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no more than $90 of that, and it must place the remaining $10 in a non-interest-bearing account at a Federal Reserve bank. Suppose the bank has annual operating costs of $1 per $100 of deposits and that it charges 10 percent interest on loans. The highest interest the New York bank can offer its depositors and still cover its costs is 8 percent per year. Thus, the bank pays the owner of the $100 deposit (0.08 × $100 =) $8, earns (0.10 × $90 =) $9 on the fraction of the deposit it is allowed to lend, and just covers its operating costs.

In contrast, a Eurobank can offer a higher interest rate on dollar deposits and still cover its costs. The Eurobank, with no reserve requirements regarding dollar deposits, can lend out all of a $100 deposit. Therefore, it can earn 0.10 × $100 = $10 at a loan rate of 10 percent. If the Eurobank has the same operating costs as the New York bank ($1 per $100 deposit), it can pay its depositors an interest rate of 9 percent, a full percent- age point higher than that paid by the New York bank, and still cover its costs. That is, it can pay out 0.09 × $100 = $9 to its depositor, receive $10 from the borrower, and be left with $1 to cover operating costs. Alternatively, the Eurobank might pay the depositor 8.5 percent (which is still above the rate paid by the New York bank), charge borrowers 9.5 percent (still less than the New York bank charges), and cover its operating costs. Thus, the Eurobank has a competitive advantage vis-à-vis the New York bank in both its deposit rate and its loan rate.

Clearly, there are strong financial motivations for companies to use the Eurocurrency market. By doing so, they receive a higher interest rate on deposits and pay less for loans. Given this, the surprising thing is not that the Euromarket has grown rapidly but that it hasn’t grown even faster. Why do any depositors hold deposits in their home currency when they could get better yields in the Eurocurrency market?

DRAWBACKS OF THE EUROCURRENCY MARKET

The Eurocurrency market has two drawbacks. First, when depositors use a regulated banking system, they know that the probability of a bank failure that would cause them to lose their deposits is very low. Regulation maintains the liquidity of the banking sys- tem. In an unregulated system such as the Eurocurrency market, the probability of a bank failure that would cause depositors to lose their money is greater (although, in absolute terms, still low). Thus, the lower interest rate received on home-country deposits reflects the costs of insuring against bank failure. Some depositors are more comfortable with the security of such a system and are willing to pay the price.

Second, borrowing funds internationally can expose a company to foreign exchange risk. For example, consider a U.S. company that uses the Eurocurrency market to borrow Euro-pounds—perhaps because it can pay a lower interest rate on Euro-pound loans than on dollar loans. Imagine, however, that the British pound subsequently appreciates against the dollar. This would increase the dollar cost of repaying the Euro-pound loan and thus the company’s cost of capital. This possibility can be insured against by using the forward exchange market (as we saw in Chapter 10), but the forward exchange market does not offer perfect insurance. Consequently, many companies borrow funds in their domestic currency to avoid foreign exchange risk, even though the Eurocurrency markets may offer more attractive interest rates.

The Global Bond Market

The global bond market has grown rapidly over the last four decades. Bonds are an im- portant means of financing for many companies. The most common kind of bond is a fixed-rate bond. The investor who purchases a fixed-rate bond receives a fixed set of cash payoffs. Each year until the bond matures, the investor gets an interest payment, and then at maturity he gets back the face value of the bond.

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354 Part 4 The Global Monetary System

International bonds are of two types: foreign bonds and Eurobonds. Foreign bonds are sold outside the borrower’s country and are denominated in the currency of the coun- try in which they are issued. Thus, when Dow Chemical issues bonds in Japanese yen and sells them in Japan, it is issuing foreign bonds. Many foreign bonds have nicknames; foreign bonds sold in the United States are called Yankee bonds, foreign bonds sold in Japan are Samurai bonds, and foreign bonds sold in Great Britain are bulldogs. Compa- nies will issue international bonds if they believe that it will lower their cost of capital. For example, during the late 1990s and early 2000s many companies issued Samurai bonds in Japan to take advantage of the very low interest rates in Japan. In early 2001, 10-year Japanese government bonds yielded 1.24 percent, compared with 5 percent for comparable U.S. government bonds. Against this background, companies found that they could raise debt at a cheaper rate in Japan than the United States.

Eurobonds are normally underwritten by an international syndicate of banks and placed in countries other than the one in whose currency the bond is denominated. For example, a bond may be issued by a German corporation, denominated in U.S. dollars, and sold to investors outside the United States by an international syndicate of banks. Eurobonds are routinely issued by multinational corporations, large domestic corpora- tions, sovereign governments, and international institutions. They are usually offered simultaneously in several national capital markets, but not in the capital market of the country, nor to residents of the country, in whose currency they are denominated. Histori- cally, Eurobonds accounted for the lion’s share of international bond issues, but increas- ingly they are being eclipsed by foreign bonds.

ATTRACTIONS OF THE EUROBOND MARKET

Three features of the Eurobond market make it an appealing alternative to most major domestic bond markets, specifically:

∙ An absence of regulatory interference. ∙ Less stringent disclosure requirements than in most domestic bond markets. ∙ A favorable tax status.

Regulatory Interference National governments often impose controls on domestic and foreign issuers of bonds denominated in the local currency and sold within their national boundaries. These con- trols tend to raise the cost of issuing bonds. However, government limitations are gener- ally less stringent for securities denominated in foreign currencies and sold to holders of those foreign currencies. Eurobonds fall outside the regulatory domain of any single na- tion. As such, they can often be issued at a lower cost to the issuer.

Disclosure Requirements Eurobond market disclosure requirements tend to be less stringent than those of several national governments. For example, if a firm wishes to issue dollar-denominated bonds within the United States, it must first comply with SEC disclosure requirements. The firm must disclose detailed information about its activities, the salaries and other compensa- tion of its senior executives, stock trades by its senior executives, and the like. In addition, the issuing firm must submit financial accounts that conform to U.S. accounting stan- dards. For non-U.S. firms, redoing their accounts to make them consistent with U.S. stan- dards can be very time-consuming and expensive. Therefore, many firms have found it cheaper to issue Eurobonds, including those denominated in dollars, than to issue dollar- denominated bonds within the United States.

Favorable Tax Status Before 1984, U.S. corporations issuing Eurobonds were required to withhold for U.S. income tax up to 30 percent of each interest payment to foreigners. This did not encourage

The Global Capital Market Chapter 12 355

foreigners to hold bonds issued by U.S. corporations. Similar tax laws were operational in many countries at that time, and they limited market demand for Eurobonds. U.S. laws were revised in 1984 to exempt from any withholding tax foreign holders of bonds issued by U.S. corporations. As a result, U.S. corporations found it feasible for the first time to sell Eurobonds directly to foreigners. Repeal of the U.S. laws caused other governments—including those of France, Germany, and Japan—to liberalize their tax laws likewise to avoid outflows of capital from their markets. The consequence was an upsurge in demand for Eurobonds from investors who wanted to take advantage of their tax benefits.

The Global Equity Market

Historically substantial regulatory barriers separated national equity markets from each other. Not only was it often difficult to take capital out of a country and invest it elsewhere, but corporations also frequently lacked the ability to list their shares on stock markets outside their home nations. These regulatory barriers made it difficult for a corporation to attract significant equity capital from foreign investors. These barriers tumbled fast during the 1980s and 1990s. The global equity market enabled firms to attract capital from inter- national investors, to list their stock on multiple exchanges, and to raise funds by issuing equity or debt around the world. For example, in 1994 Daimler-Benz, Germany’s largest industrial company, raised $300 million by issuing new shares not in Germany but in Singapore.22 Similarly, in 1996 the German telecommunications provider Deutsche Telekom raised some $13.3 billion by simultaneously listing its shares for sale on stock exchanges in Frankfurt, London, New York, and Tokyo. These German companies elected to raise equity through foreign markets because they reasoned that their domestic capital market was too small to supply the requisite funds at a reasonable cost. To lower their cost of capital, they tapped into the large and highly liquid global capital market.

More recently, many Chinese companies have been raising equity capital through for- eign stock issues. In 2010, a record 39 Chinese companies issued stock through the New York Stock Exchange, giving them access to more capital at a lower cost than would have been possible if they had just issued stock in China.23 In 2014 in what was the largest IPO ever, the Chinese Internet company Alibaba raised equity capital in the New York Stock Exchange (see the opening case). Of course, the other side of the coin is that if foreign entities are going to issue stock in New York, London, or another major foreign market, they also have to adhere to the stringent requirements for financial reporting that are com- mon in those markets.

Although we have talked about the growth of the global equity market, strictly speak- ing there is no international equity market in the sense that there are international cur- rency and bond markets. Rather, many countries have their own domestic equity markets in which corporate stock is traded. The largest of these domestic equity markets are to be found in the United States, Great Britain, Japan, and Hong Kong. Although each domes- tic equity market is still dominated by investors who are citizens of that country and companies incorporated in that country, developments are internationalizing the world equity market. Investors are investing heavily in foreign equity markets to diversify their portfolios. Facilitated by deregulation and advances in information technology, this trend seems to be here to stay.

An interesting consequence of the trend toward international equity investment is the internationalization of corporate ownership. Today it is still generally possible to talk about U.S. corporations, British corporations, and Japanese corporations, primarily be- cause the majority of stockholders (owners) of these corporations are of the respective nationality. However, this is changing. Increasingly, U.S. citizens are buying stock in companies incorporated abroad, and foreigners are buying stock in companies incorpo- rated in the United States. Looking into the future, Robert Reich has mused about “the coming irrelevance of corporate nationality.”24

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356 Part 4 The Global Monetary System

A second development internationalizing the world equity market is that companies with historic roots in one nation are broadening their stock ownership by listing their stock in the equity markets of other nations. The reasons are primarily financial. Listing stock on a foreign market is often a prelude to issuing stock in that market to raise capital. The idea is to tap into the liquidity of foreign markets, thereby increasing the funds avail- able for investment and lowering the firm’s cost of capital. (The relationship between li- quidity and the cost of capital was discussed earlier in the chapter.) Firms also often list their stock on foreign equity markets to facilitate future acquisitions of foreign compa- nies. Other reasons for listing a company’s stock on a foreign equity market are that the company’s stock and stock options can be used to compensate local management and employees, it satisfies the desire for local ownership, and it increases the company’s vis- ibility with local employees, customers, suppliers, and bankers. Although firms based in developed nations were the first to start listing their stock on foreign exchanges, increas- ingly firms from developing countries who find their own growth limited by an illiquid domestic capital market are exploiting this opportunity.

Foreign Exchange Risk and the Cost of Capital

While a firm can borrow funds at a lower cost in the global capital market than in the domestic capital market, foreign exchange risk complicates this picture under a floating exchange rate regime. Adverse movements in foreign exchange rates can substantially increase the cost of foreign currency loans, which is what happened to many Asian com- panies during the 1997–1998 Asian financial crisis.

Consider a South Korean firm that wants to borrow 1 billion Korean won for one year to fund a capital investment project. The company can borrow this money from a Korean bank at an interest rate of 10 percent, and at the end of the year pay back the loan plus interest, for a total of W1.10 billion. Or the firm could borrow dollars from an international bank at a 6 percent interest rate. At the prevailing exchange rate of $1 = W1,000, the firm would bor- row $1 million and the total loan cost would be $1.06 million, or W1.06 billion. By borrow- ing dollars, the firm could reduce its cost of capital by 4 percent, or W40 million. However, this saving is predicated on the assumption that during the year of the loan, the dollar/won exchange rate stays constant. Instead, imagine that the won depreciates sharply against the U.S. dollar during the year and ends the year at $1 = W1,500. (This occurred in late 1997 when the won declined in value from $1 = 1,000 to $1 = W1,500 in two months.) The firm still has to pay the international bank $1.06 million at the end of the year, but now this costs the company W1.59 billion (i.e., $1.06 million × 1,500). As a result of the depreciation in the value of the won, the cost of borrowing in U.S. dollars has soared from 6 percent to 59 per- cent, a huge rise in the firm’s cost of capital. Although this may seem like an extreme ex- ample, it happened to many South Korean firms in 1997 at the height of the Asian financial crisis. Not surprisingly, many of them were pushed into technical default on their loans.

Unpredictable movements in exchange rates can inject risk into foreign currency bor- rowing, making something that initially seems less expensive ultimately much more ex- pensive. The borrower can hedge against such a possibility by entering into a forward contract to purchase the required amount of the currency being borrowed at a predeter- mined exchange rate when the loan comes due (see Chapter 10 for details). Although this will raise the borrower’s cost of capital, the added insurance limits the risk involved in such a transaction. Unfortunately, many Asian borrowers did not hedge their dollar-de- nominated short-term debt, so when their currencies collapsed against the dollar in 1997, many saw a sharp increase in their cost of capital.

When a firm borrows funds from the global capital market, it must weigh the benefits of a lower interest rate against the risks of an increase in the real cost of capital due to adverse exchange rate movements. Although using forward exchange markets may lower foreign exchange risk with short-term borrowings, it cannot remove the risk. Most important, the forward exchange market does not provide adequate coverage for long-term borrowings.

TEST PREP Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

LO 12-5 Understand how foreign exchange risks affect the cost of capital.

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The Global Capital Market Chapter 12 357

C H A P T E R S U M M A R Y

This chapter explained the functions and form of the global capital market and defined the implications of these for international business practice. This chapter made the following points:

1. The function of a capital market is to bring those who want to invest money together with those who want to borrow money.

2. Relative to a domestic capital market, the global capital market has a greater supply of funds available for borrowing, and this makes for a lower cost of capital for borrowers.

3. Relative to a domestic capital market, the global capital market allows investors to diversify portfolios of holdings internationally, thereby reducing risk.

4. The growth of the global capital market during recent decades can be attributed to advances in information technology, the widespread deregulation of financial services, and the

relaxation of regulations governing cross- border capital flows.

5. A Eurocurrency is any currency banked outside its country of origin. The lack of government regulations makes the Eurocurrency market attractive to both depositors and borrowers. Due to the absence of regulation, the spread between the Eurocurrency deposit and lending rates is less than the spread between the domestic deposit and lending rates. This gives Eurobanks a competitive advantage.

6. The global bond market has two classifications: the foreign bond market and the Eurobond market. Foreign bonds are sold outside of the borrower’s country and are denominated in the currency of the country in which they are issued. A Eurobond issue is normally under- written by an international syndicate of banks and placed in countries other than the one

hedge fund, p. 349 Eurocurrency, p. 351

foreign bonds, p. 354 Eurobonds, p. 354

Key Terms

F O C U S O N M A NAG E R I A L I M P L I C AT I O N S 

GROWTH OF THE GLOBAL CAPITAL MARKET The implications of the material discussed in this chapter for international business are

quite straightforward but no less important for being obvious. The growth of the global capital market has created opportunities for international businesses that

wish to borrow and/or invest money. On the borrowing side, by using the global capital market, firms can often borrow funds at a lower cost than is possible in a purely domestic capital market. This conclusion holds no matter what form of bor-

rowing a firm uses—equity, bonds, or cash loans. The lower cost of capital on the global market reflects its greater liquidity and the general absence of government

regulation. Government regulation tends to raise the cost of capital in most domestic capital markets. The global market, being transnational, escapes regulation. Balanced against this, however, is the foreign exchange risk associated with borrowing in a foreign currency. On the investment side, the growth of the global capital market is providing opportunities for firms, institutions, and individuals to diversify their investments to limit risk. By holding a diverse portfolio of stocks and bonds in different nations, an investor can reduce total risk to a lower level than can be achieved in a purely domestic setting. Once again, however, for- eign exchange risk is a complicating factor.

in whose currency the bond is denominated. Eurobonds account for the lion’s share of inter- national bond issues.

7. The Eurobond market is an attractive way for companies to raise funds due to the absence of regulatory interference, less stringent disclo- sure requirements, and Eurobonds’ favorable tax status.

8. Foreign investors are investing in other countries’ equity markets to reduce risk by diversifying their stock holdings among nations.

9. Many companies are now listing their stock in the equity markets of other nations, primarily as a prelude to issuing stock in those markets to raise additional capital. Other reasons for listing stock in another country’s exchange are to facilitate future stock swaps; to enable the company to use its stock and stock options for compensating local management and

employees; to satisfy local ownership desires; and to increase the company’s visibility among its local employees, customers, suppliers, and bankers.

10. When borrowing funds from the global capital market, companies must weigh the benefits of a lower interest rate against the risks of greater real costs of capital due to adverse exchange rate movements.

11. One major implication of the global capital market for international business is that compa- nies can often borrow funds at a lower cost of capital in the international capital market than they can in the domestic capital market.

12. The global capital market provides greater op- portunities for businesses and individuals to build a truly diversified portfolio of interna- tional investments in financial assets, which lowers risk.

358 Part 4 The Global Monetary System

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. Why has the global capital market grown so rap- idly in recent decades? Do you think this growth will continue throughout the next decade? Why or why not?

2. In 2008–2009, the world economy retrenched in the wake of a global financial crisis. Did the glo- balization of capital markets contribute to this crisis? If so, what can be done to stop global financial contagion in the future?

3. A firm based in Mexico has found that its growth is restricted by the limited liquidity of the Mexican capital market. List the firm’s options for raising money on the global capital market. Discuss the pros and cons of each option, and make a recommendation. How might your recommended options be affected if the Mexican peso depreciates significantly on the foreign ex- change markets over the next two years?

4. Happy Company wants to raise $2 million with debt financing. The funds are needed

to finance working capital, and the firm will repay them with interest in one year. Happy Company’s treasurer is considering three options:

a. Borrowing U.S. dollars from Security Pacific Bank at 8 percent.

b. Borrowing British pounds from Midland Bank at 14 percent.

c. Borrowing Japanese yen from Sanwa Bank at 5 percent.

If Happy borrows foreign currency, it will not cover it; that is, it will simply change foreign currency for dollars at today’s spot rate and buy the same foreign currency a year later at the spot rate then in effect. Happy Company estimates the pound will depreciate by 5 percent relative to the dollar and the yen will appreciate 3 percent relative to the dollar in the next year. From which bank should Happy Company borrow?

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises:

1. The top management team of your not-for- profit organization would like to find out more about investing in environmentally responsible companies in Europe. FTSE develops various

indexes for the global financial markets. A series of indexes, called ESG, cover social, environ- mental, and good governance standards. One of these is the Environmental Europe 40 Index. Download the index’s factsheet for your analysis. Evaluate the top 10 companies, countries, and

The Global Capital Market Chapter 12 359

industries represented in this index. What patterns do you see?

2. The Bureau of Economic Analysis is an agency of the U.S. Department of Commerce. It lists data about the U.S. economic accounts, includ- ing current investment positions and the amount

of direct investment by multinational corpora- tions in the United States and abroad. Prepare a brief report regarding the direct investments of other countries in the United States. Include in your report the leading countries in foreign direct investment.

For decades cross-border capital flows—including lend- ing, foreign direct investment flows, and purchases of equities and bonds—advanced relentlessly, reflecting the increasing integration of national capital markets into one single massive global system. Cross-border capital flows surged from $0.5 trillion in 1980 to a peak of $11.8 tril- lion in 2007; and then they collapsed. By 2012 cross- border capital flows had retreated to $4.6 trillion, 60 per- cent below their former peak. The global capital market, it seemed, was in retreat. To understand why, we have to go back to 2008, when a major crisis swept through the global capital market that very nearly froze the financial pipes that lu- bricate the wheels of the global economy. Financial in- stitutions and corporations around the world routinely lend and borrow trillions of dollars between themselves. Most banks and corporations issue unsecured notes known as commercial paper with a fixed maturity of be- tween 1 and 270 days. This is a way for those firms to get access to cash to meet short-term obligations, such as meeting payroll and paying suppliers. Because the notes are unsecured, and not backed by any specific as- sets, only banks and corporations with excellent credit ratings are able to sell their commercial paper at a rea- sonable price. This price is set with reference to the London Interbank Offered Rate (LIBOR). The LIBOR is the rate at which banks lend to each other. In normal times, the LIBOR rate is very close to the rate charged by national central banks, such as the U.S. Federal Re- serve for the dollar. Early in 2008 banks in several countries had started to run into trouble as it became clear that the value of the mortgage-backed securities that they held was col- lapsing. This was due to a fall in housing prices, and rising default rates on mortgages, most notably in the United States and Great Britain, where lenders had written increasingly risky mortgages over the preceding few years. These mortgages were bundled into securi- ties and then sold to other financial institutions. Also,

many institutions held complex derivatives, the value of which was tied to the underlying value of mortgage- backed securities. Now these institutions were facing large write-offs on their portfolios of mortgage-backed securities and the associated derivatives. One of these institutions, Lehman Brothers, had taken aggressive po- sitions in the market for mortgage-backed securities. In September 2008 the firm collapsed into bankruptcy af- ter the U.S. government decided not to step in and save the company. The bankruptcy of Lehman sent shock waves through the global financial markets. In effect, the U.S. govern- ment had stated it was prepared to let large financial in- stitutions fail. Immediately, banks reduced their short-term loans. They did this for two reasons. First, they felt a need to hoard cash because they no longer knew the value of the mortgage-backed securities they held on their own balance sheets. Second, they were afraid to lend to other banks because those banks might fail and they might not get their money back. As a result, LIBOR rates quickly spiked. The dollar rate, for example, had been 0.2 percent above the rate on three-month U.S. Treasury bills in 2007, which is a  normal spread. However, the spread increased to 3.3 percent by late 2008, raising the cost of short-term borrowing some 16-fold. Many corporations found that they could not raise capital at a reasonable price. Money market funds, which in normal times are large buyers of commercial paper, fled to ultra-safe assets, such as U.S. Treasury bills. This pushed the yield on three-month Treasury bills down to historic lows, and also led to a sharp rise in the value of the U.S. dollar. In essence, the financial plumbing of the global economy was freezing up. If nothing was done about it, many firms would be unable to borrow to service their short term financing needs. They would rapidly become in- solvent and a wave of bankruptcies could sweep around the globe, plunging the world into a serious recession, or even a depression.

C L O S I N G C A S E

Declining Cross-Border Capital Flows—Retreat or Reset?

360 Part 4 The Global Monetary System

At this point several national governments stepped into the breach. The U.S. Federal Reserve entered the commercial paper market, setting up a fund to purchase commercial paper at rates close to the rates for U.S. Treasury bills. Central banks in Japan, Great Britain, and the European Union took similar action. Once partici- pants in the global capital markets saw that national gov- ernments were willing to enter the commercial paper market, they too started to ease their lending restrictions, and LIBOR rates started to fall again. The U.S. govern- ment established the Troubled Asset Relief Program (TARP), allowing the U.S. Treasury to purchase or in- sure up to $700 billion in “troubled assets.” Under TARP the government began to inject capital into troubled banks by purchasing assets from them that were difficult to value, such as mortgage-backed securities. This sig- naled there would be no more bankruptcies such as Lehman’s. This too helped unfreeze the market for com- mercial paper. A major crisis had been averted, but only just. Although the $700 billion price tag for TARP stunned people, most of the money lent to banks under TARP was quickly paid back with interest, and by late 2012 estimates suggest that the total cost to the taxpayer would be close to $24 billion. Five years after the crisis hit, the global capital mar- ket had still not fully recovered from its 2007 peak. Does this signal a retreat from the globalization of capi- tal, or merely a reset? Most observers believe the latter is the case. Since 2008 the world economy has grown slowly, and economic troubles persist in many regions, particularly Europe, where several national govern- ments are burdened with high levels of sovereign debt that limits their ability to deal with persistently slow growth and high unemployment. Notwithstanding this, the world economy continues to become more inte- grated, propelled by stronger growth in some develop- ing nations, and as this process unfolds, global capital

markets will inevitably start to expand again to support cross-border trade in goods and services, as well as cross-border investments. Sources: Susan Lund et al., “Financial Globalization: Retreat or Reset?,” McKinsey Global Institute, March 2013; “Blocked Pipes,” The Econo- mist, October 4, 2008, pp. 73–75; “On Life Support,” The Economist, October 4, 2008, pp. 77–78; M. Boyle, “The Fed’s Commercial Paper Chase,” BusinessWeek, October 8, 2008, p. 5; M. Gordon, “TARP Bailout Costs to Taxpayers Expected to Be Lower,” Christian Science Monitor, December 17, 2012.

C a s e D i s c u s s i o n Q u e s t i o n s

1. Do you think that something like the financial crisis that occurred in 2007–2008 could happen again? If it did, what would the impact be on the ability of firms to raise capital to fund invest- ments, and on the global economy? 

2. In retrospect,were central banks justified in step- ping in as aggressively as they did to shore up the global financial system? If they had not done so, and instead let more large financial institutions fail, what would have been the consequence? 

3. How can the risk of occurrence of crises such as the 2007–2008 global financial crisis be miti- gated in the future? 

4. Why do you think that global capital flows were still significantly below their 2007 peak five years after the crisis hit? What are the implications of this for the ability of multinational firms to fi- nance their investments by raising outside capital? 

5. What actions do you think a multinational firm can take to limit the impact of future crises in the global financial system on the ability of the enter- prise to raise capital to pay its short-term bills and fund long-term investments? 

E n d n o t e s

1. D. Waller, “Daimler in $250m Singapore Placing,” Financial Times, May 10, 1994.

2. B. Solnik, “Why Not Diversify Internationally Rather Than Domestically?” Financial Analysts Journal, July 1974, p. 17.

3. C. G. Luck and R. Choudhury, “International Equity Diversifi- cation for Pension Funds,” Journal of Investing 5, no. 2 (1996), pp. 43–53.

4. W. N. Goetzmann, L. Li, and K. G. Rouwenhorst, “Long Term Global Market Correlations,” The Journal of Business, January 2005, pp. 78–126.

5. Ian Domowitz, Jack Glen, and Ananth Madhavan, “Market Segmentation and Stock Prices: Evidence from an Emerging Market,” Journal of Finance 3, no. 3 (1997), pp. 1059–68.

The Global Capital Market Chapter 12 361

6. Solnik, “Why Not Diversify Internationally Rather Than Domestically?”

7. A. Lavine, “With Overseas Markets Now Moving in Sync with U.S. Markets, It’s Getting Harder to Find True Diversification Abroad,” Financial Planning, December 1, 2000, pp. 37–40.

8. B. Solnik and J. Roulet. “Dispersion as Cross Sectional Corre- lation,” Financial Analysts Journal 56, no. 1 (2000), pp. 54–61.

9. Goetzmann et al., “Long Term Global Market Correlations.” 10. Ibid. 11. Bank for International Settlements, BIS Quarterly Review,

March 2013. 12. T. F. Huertas, “U.S. Multinational Banking: History and Pros-

pects,” in Banks as Multinationals, ed. G. Jones (London: Routledge, 1990).

13. G. J. Millman, The Vandals’ Crown (New York: Free Press, 1995).

14. Goetzmann et al., “Long Term Global Market Correlations.” 15. P. Dicken, Global Shift: The Internationalization of Economic

Activity (London: Guilford Press, 1992).

16. Ibid. 17. Martin Feldstein, “Global Capital Flows: Too Little, Not Too

Much,” The Economist, June 24, 1995, pp. 72–73. 18. Ibid., p. 73. 19. D. Duffy and L. Murry, “The Wooing of American Investors,”

The Wall Street Journal, February 25, 1994, p. A14. 20. International Monetary Fund, World Economic Outlook

(Washington, DC: IMF, 1998). 21. C. Schenk, “The Origins of the Eurodollar Market in London,

1955–1963,” Explorations in Economic History 35 (1998), pp. 221–39.

22. Waller, “Daimler in $250m Singapore Placing.” 23. L. Spears and C. Vannucci, “China’s Latest American IPOs

Slump as Offerings Increase to Annual Record,” Bloomberg Businessweek, December 6, 2010.

24. R. Reich, The Work of Nations (New York: Knopf, 1991).

Credit: ©Federal Reserve Board.

The Strategy of International Business L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO13 -1 Explain the concept of strategy.

LO13-2 Recognize how firms can profit by expanding globally.

LO13-3 Understand how pressures for cost reductions and pressures for local responsiveness influence strategic choice.

LO13-4 Identify and choosing the different strategies for competing globally.

part five The Strategy and Structure of International Business

13

© Peter Foley/Bloomberg/Getty Images

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IKEA’s Global Strategy

A global network of more than 1,050 suppliers based in 53 countries manufactures most of the 12,000 or so prod- ucts that IKEA sells. IKEA itself focuses on the design of products and works closely with suppliers to bring down manufacturing costs. Developing a new product line can be a painstaking process that takes years. IKEA’s design- ers will develop a prototype design (a small couch, for ex- ample), look at the price that rivals charge for a similar piece, and then work with suppliers to figure out a way to cut prices by 40 percent without compromising on quality. IKEA also manufactures about 10 percent of what it sells in-house and uses the knowledge gained to help its sup- pliers improve their productivity, thereby lowering costs across the entire supply chain. Look a little closer, however, and you will see subtle dif- ferences between the IKEA offerings in North America, Eu- rope, and China. In North America, sizes are different to reflect the American demand for bigger beds, furnishings, and kitchenware. This adaptation to local tastes and pref- erences was the result of a painful learning experience for IKEA. When the company first entered the United States in the late 1980s, it thought that consumers would flock to its stores the same way that they had in western Europe. At first they did, but they didn’t buy as much, and sales fell short of expectations. IKEA discovered that its European- style sofas were not big enough, wardrobe drawers were not deep enough, glasses were too small, and kitchens didn’t fit U.S. appliances. So the company set about rede- signing its offerings to better match American tastes and was rewarded with accelerating sales growth. Lesson learned, when IKEA entered China in the 2000s, it made adaptations to the local market. The store layout reflects the layout of many Chinese apartments, where most people live, and because many Chinese apartments have balconies, IKEA’s Chinese stores include a balcony section. IKEA has also had to shift its locations in China, where car ownership lags behind that in Europe and North America. In the West, IKEA stores are located in suburban areas and have lots of parking space. In China, stores are located near public transportation, and IKEA of- fers a delivery service so that Chinese customers can get their purchases home.

Sources: D. L. Yohn, “How IKEA Designs Its Brand Success,” Forbes, June 10, 2015; J. Kane, “The 21 Emotional Stages of Shopping at IKEA, From Optimism to Total Defeat,” The Huffington Post, May 6, 2015; J. Leland, “How the Disposable Sofa Conquered America,” The New York Times Magazine, October 5, 2005, p. 45; “The Secret of IKEA’s Success,” The Economist, February 24, 2011; B. Torekull, Leading by Design: The IKEA Story (New York: HarperCollins, 1998); P. M. Miller, “IKEA with Chinese Characteristics,” Chinese Business Review, July– August 2004, pp. 36–69.

O P E N I N G C A S E Walk into an IKEA store anywhere in the world, and you would recognize it instantly. Global strategy standardiza- tion is rampant! The warehouse-type stores all sell the same broad range of affordable home furnishings, kitch- ens, accessories, and food. Most of the products are in- stantly recognizable as IKEA merchandise, with their clean yet tasteful lines and functional design. With a heritage from Sweden (IKEA was founded in 1943 as a mail order company and the first store opened in Sweden in 1958), the outside of the store will be wrapped in the blue and yellow colors of the Swedish flag. IKEA had sales of about $34 billion in 2014 and some 147,000 employees. Interest- ingly, IKEA is responsible for about 1 percent of the world’s commercial-product wood consumption. The IKEA name comes from its founder—the acronym consists of the founder’s initials from his first and last names (Ingvar Kamprad) along with the first initials of the farm where he grew up (Elmtaryd) and his hometown in Sweden (Agunnaryd). Overall, Sweden has 20 IKEA stores, which is only fewer than in Germany (49 IKEA stores), United States (42), France (32), and Italy (21). Spain also has 20 stores. With 351 stores in 46 countries, IKEA is the largest furniture retailer in the world. Basically, the furniture market is one of the least global markets, with local tastes, needs, and interests much different than for many other products across industries. The largest IKEA store is in Gwangmyeong, South Korea, at some 640,000 square feet). The IKEA store itself will be laid out as a maze that re- quires customers to walk through every department be- fore they reach the checkout stations. The stores are often structured as a one-way layout, leading customers coun- terclockwise along what IKEA calls “the long natural way.” This “way” is designed to encourage customers to see the store in its entirety. Cut-off points and shortcuts exist but are not easy to figure out. It is even difficult to get back out after having a meal in the famous IKEA restaurant with its Swedish food (meatballs anyone?). Immediately before the checkout, there is an in-store warehouse where customers can pick up the items they purchased. The furniture is all packed flat for ease of trans- portation, and requires assembly by the customer. Value is stressed to a great extent (the price customers pay for the quality furniture they get). If you look at customers in the store, you will see that many of them are in there 20s and 30s. IKEA sells to the same basic customers worldwide: young, upwardly mobile people who are looking for taste- ful yet inexpensive “disposable” furniture of a certain qual- ity standard for the price they are willing to pay.

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Introduction

The primary concern thus far in this book has been with aspects of the larger environ- ment in which international businesses compete. As described in the preceding chap- ters, this environment has included the different political, economic, and cultural institutions found in nations; the international trade and investment framework; and the international monetary system. Now, our focus shifts from the so-called macro envi- ronment to the firm itself and, in particular, to the actions managers can take to com- pete more effectively as an international business. This chapter looks at how firms can increase their revenue (and profitability) by expanding their operations in foreign mar- kets. We discuss the different strategies that firms pursue when competing internation- ally, consider the pros and cons of these strategies, and study the various factors that affect a firm’s choice of strategy. Key issues in this global strategy chapter are value creation and global value chains.

The strategy of furniture retailer IKEA, which was discussed in the opening case, gives us a preview of some of the key issues discussed in this chapter. IKEA’s business- level strategy is to target young, upwardly mobile people and offer them affordable, taste- fully designed furniture and accessories. IKEA differentiates its offering by design. At the same time, the company does everything it can to lower the costs of the products it sells, thereby enabling it to underprice its rivals and still make good profits. IKEA devel- oped its basic formula for competing first in Sweden and then in the other countries in Scandinavia in the 1950s and 1960s. This formula, or business model, includes self-ser- vice warehouse-type stores, a mazelike store layout that funnels customers through every department and maximizes impulse purchases, the design of furniture so that it can be flat-packed, an in-store warehouse, and so on.

IKEA initially expanded into other countries by using exactly the same segmenta- tion strategy and retailing formula and selling the same set of products. We refer to such a standardized approach as a global strategy. One of its great virtues is that it can help a company attain a low-cost position through the realization of economies of scale. However, as the opening case makes clear, while this worked in the western European region, it did not work in North America where IKEA had to adapt its product design to the tastes and preferences of North American consumers. In other words, IKEA found that it needed to localize some of its offerings. As we shall see in this chapter, there is often a tension between the desire to standardize a product offering in order to attain low costs and the need to localize the offering to better match the tastes and preferences of local consumers, which can make it more difficult to attain scale econo- mies and raise costs.

Strategy and the Firm

When we talk about strategy and the firm, we refer to the firm in the most common way as a way to organize activities. This means that the firm can also be called multinational enterprise, multinational corporation, an international business, international organiza- tion, global company, and so on. Throughout this chapter and throughout the book, we use a variety of these terminologies in largely the same context.

Also, before we discuss the strategies that managers in the multinational enterprise can pursue, we need to review some basic principles of strategy. A firm’s strategy can be defined as the actions that managers take to attain the goals of the firm. For most firms, the preeminent goal is to maximize the value of the firm for its owners and its shareholders (subject to the very important constraint that this is done in a legal, ethi- cal, and socially responsible manner—see Chapter 5 for details). To maximize the value of a firm, managers must pursue strategies that increase the profitability of the enterprise and its rate of profit growth over time (see Figure 13.1). Profitability can be measured in a number of ways, but for consistency, we define it as the rate of return

LO 13 -1 Explain the concept of strategy.

The Strategy of International Business Chapter 13 365

that the firm makes on its invested capital (ROIC), which is calculated by dividing the net profits of the firm by total invested capital.1 Profit growth is measured by the percentage increase in net profits over time. In general, higher profitability and a higher rate of profit growth will increase the value of an enterprise and thus the returns garnered by its owners, the shareholders.2

Managers can increase the profitability of the firm by pursuing strategies that lower costs or by pursuing strategies that add value to the firm’s products, which enables the firm to raise prices. Managers can increase the rate at which the firm’s profits grow over time by pursuing strategies to sell more products in existing markets or by pursuing strat- egies to enter new markets. As we shall see, expanding internationally can help managers boost the firm’s profitability and increase the rate of profit growth over time.

VALUE CREATION

The way to increase the profitability of a firm is to create more value. The amount of value a firm creates is generally measured by the difference between its costs of produc- tion and the quality that consumers perceive in its products. In general, the more value customers place on a firm’s products, the higher the price the firm can charge for those products. However, the price a firm charges for a good or service is typically less than the value placed on that good or service by the customer. This is because the customer cap- tures some of that value in the form of what economists call a consumer surplus.3 The customer is able to do this because the firm is competing with other firms for the cus- tomer’s business, so the firm must charge a lower price than it could were it a monopoly supplier. Also, it is normally impossible to segment the market to such a degree that the firm can charge each customer a price that reflects that individual’s assessment of the value of a product, which economists refer to as a customer’s reservation price. For these reasons, the price that gets charged tends to be less than the value placed on the product by many customers.

Figure 13.2 illustrates these concepts. The value of a product to an average con- sumer is V; the average price that the firm can charge a consumer for that product given competitive pressures and its ability to segment the market is P; and the average unit cost of producing that product is C (C comprises all relevant costs, including the firm’s cost of capital). The firm’s profit per unit sold (p) is equal to P – C, while the consumer surplus per unit is equal to V – P (another way of thinking of the consumer surplus is as “value for the money”; the greater the consumer surplus, the greater the value for the

Profitability

Profit Growth

Reduce Costs

Add Value and Raise Prices

Sell More in Existing Markets

Enter New Markets

Enterprise Valuation

F I G U R E 1 3 . 1

Determinants of enterprise value.

366 Part 5 The Strategy and Structure of International Business

money the consumer gets). The firm makes a profit so long as P is greater than C, and its profit will be greater the lower C is relative to P. The difference between V and P is in part determined by the intensity of competitive pressure in the marketplace; the lower the intensity of competitive pressure, the higher the price charged relative to V.4 In general, the higher the firm’s profit per unit sold, the greater its profitability, all else being equal.

The firm’s value creation is measured by the difference between V and C (V – C); a company creates value by converting inputs that cost C into a product on which consum- ers place a value of V. A company can create more value (V – C) either by lowering pro- duction costs, C, or by making the product more attractive through superior design, styling, functionality, features, reliability, after-sales service, and the like, so that con- sumers place a greater value on it (V increases) and, consequently, are willing to pay a higher price (P increases). This discussion suggests that a firm has high profits when it creates more value for its customers and does so at a lower cost. We refer to a strategy that focuses primarily on lowering production costs as a low-cost strategy. We refer to a strategy that focuses primarily on increasing the attractiveness of a product as a differen- tiation strategy.5

Michael Porter has argued that low cost and differentiation are two basic strategies for creating value and attaining a competitive advantage in an industry.6 According to Porter, superior profitability goes to those firms that can create superior value, and the way to create superior value is to drive down the cost structure of the business and/or differenti- ate the product in some way so that consumers value it more and are prepared to pay a premium price. Superior value creation relative to rivals does not necessarily require a firm to have the lowest-cost structure in an industry, or to create the most valuable prod- uct in the eyes of consumers. However, it does require that the gap between value (V) and cost of production (C) be greater than the gap attained by competitors.

STRATEGIC POSITIONING

Porter notes that it is important for a firm to be explicit about its choice of strategic emphasis with regard to value creation (differentiation) and low cost, and to configure its internal operations to support that strategic emphasis.7 Figure 13.3 illustrates his point. The convex curve in Figure 13.3 is what economists refer to as an efficiency frontier. The efficiency frontier shows all of the different positions that a firm can adopt with regard to adding value to the product (V) and low cost (C) assuming that its internal operations are configured efficiently to support a particular position (note that the horizontal axis in Figure 13.3 is reverse scaled—moving along the axis to the right implies lower costs). The efficiency frontier has a convex shape because of diminish- ing returns. Diminishing returns imply that when a firm already has significant value built into its product offering, increasing value by a relatively small amount requires significant additional costs. The converse also holds, when a firm already has a

V – P

P – C

C

V P

C

V – C

V = value of product to an average consumer

P = price per unit

C = cost of production per unit

V – P = consumer surplus per unit

P – C = profit per unit sold

V – C = value created per unit

F I G U R E 1 3 . 2

Value creation.

The Strategy of International Business Chapter 13 367

low-cost structure, it has to give up a lot of value in its product offering to get addi- tional cost reductions.

Figure 13.3 plots three hotel firms with a global presence that cater to international travelers, Four Seasons, Marriott International, and Starwood (Starwood owns the Sheraton and Westin chains). Four Seasons positions itself as a luxury chain and empha- sizes the value of its product offering, which drives up its costs of operations. Marriott and Starwood are positioned more in the middle of the market. Both emphasize sufficient value to attract international business travelers, but are not luxury chains like Four Sea- sons. In Figure 13.3, Four Seasons and Marriott are shown to be on the efficiency fron- tier, indicating that their internal operations are well configured to their strategy and run efficiently. Starwood is inside the frontier, indicating that its operations are not running as efficiently as they might be and that its costs are too high. This implies that Starwood is less profitable than Four Seasons and Marriott and that its managers must take steps to improve the company’s performance.

Porter emphasizes that it is very important for management to decide where the com- pany wants to be positioned with regard to value (V) and cost (C), to configure operations accordingly, and to manage them efficiently to make sure the firm is operating on the efficiency frontier. However, not all positions on the efficiency frontier are viable. In the international hotel industry, for example, there might not be enough demand to support a chain that emphasizes very low cost and strips all the value out of its product offering (see Figure 13.3). International travelers are relatively affluent and expect a degree of comfort (value) when they travel away from home.

A central tenet of the basic strategy paradigm is that to maximize its profitability, a firm must do three things: (a) pick a position on the efficiency frontier that is viable in the sense that there is enough demand to support that choice; (b) configure its internal opera- tions, such as manufacturing, marketing, logistics, information systems, human resources, and so on, so that they support that position; and (c) make sure that the firm has the right organization structure in place to execute its strategy. The strategy, operations, and orga- nization of the firm must all be consistent with each other if it is to attain a competitive advantage and garner superior profitability. By operations we mean the different value creation activities a firm undertakes, which we review next.

THE FIRM AS A VALUE CHAIN

The operations of a firm can be thought of as a value chain composed of a series of distinct value creation activities, including production, marketing and sales, materi- als management, R&D, human resources, information systems, and the firm infra- structure. We can categorize these value creation activities, or operations, as primary

F I G U R E 1 3 . 3

Strategic choice in the international hotel industry.

Low Cost (C)High Cost

Four Seasons

Starwood Marriott

Efficiency Frontier

Strategic Choices in This Area Not Viable in International Hotel Industry

In cr

ea se

d Va

lu e/

D iff

er en

tia tio

n (V

)

368 Part 5 The Strategy and Structure of International Business

activities and support activities (see Figure 13.4).8 As noted, if a firm is to implement its strategy efficiently, and position itself on the efficiency frontier shown in Fig- ure 13.3, it must manage these activities effectively and in a manner that is consistent with its strategy.

Primary Activities Primary activities have to do with the design, creation, and delivery of the product; its marketing; and its support and after-sale service. Following normal practice, in the value chain illustrated in Figure 13.4, the primary activities are divided into four functions: re- search and development, production, marketing and sales, and customer service.

Research and development (R&D) is concerned with the design of products and pro- duction processes. Although we think of R&D as being associated with the design of physical products and production processes in manufacturing enterprises, many service companies also undertake R&D. For example, banks compete with each other by devel- oping new financial products and new ways of delivering those products to customers. Online banking and smart debit cards are two examples of product development in the banking industry. Earlier examples of innovation in the banking industry included auto- mated teller machines, credit cards, and debit cards. Through superior product design, R&D can increase the functionality of products, which makes them more attractive to consumers (raising V). Alternatively, R&D may result in more efficient production pro- cesses, thereby cutting production costs (lowering C). Either way, the R&D function can create value.

Production is concerned with the creation of a good or service. For physical prod- ucts, when we talk about production, we generally mean manufacturing. Thus, we can talk about the production of an automobile. For services such as banking or health care, “production” typically occurs when the service is delivered to the customer (for exam- ple, when a bank originates a loan for a customer, it is engaged in “production” of the loan). For a retailer such as Walmart, “production” is concerned with selecting the merchandise, stocking the store, and ringing up the sale at the cash register. For MTV, production is concerned with the creation, programming, and broadcasting of content, such as music videos and thematic shows. The production activity of a firm creates value by performing its activities efficiently so lower costs result (lower C) and/or by performing them in such a way that a higher-quality product is produced (which results in higher V).

F I G U R E 1 3 . 4

The value chain. Support Activities

Company Infrastructure

Information Systems Logistics Human Resources

R&D Production Marketing and Sales

Customer Service

Primary Activities

The Strategy of International Business Chapter 13 369

The marketing and sales functions of a firm can help create value in several ways. Through brand positioning and advertising, the marketing function can increase the value (V) that consumers perceive to be contained in a firm’s product. If these create a favor- able impression of the firm’s product in the minds of consumers, they increase the price that can be charged for the firm’s product. For example, Ford produced a high-value ver- sion of its Ford Expedition SUV. Sold as the Lincoln Navigator and priced around $10,000 higher, the Navigator has the same body, engine, chassis, and design as the Expedition, but through skilled advertising and marketing, supported by some fairly minor features changes (e.g., more accessories and the addition of a Lincoln-style engine grille and nameplate), Ford has fostered the perception that the Navigator is a “luxury SUV.” This marketing strategy has increased the perceived value (V) of the Navigator relative to the Expedition and enables Ford to charge a higher price for the car (P).

Marketing and sales can also create value by discovering consumer needs and com- municating them back to the R&D function of the company, which can then design prod- ucts that better match those needs. For example, the allocation of research budgets at Pfizer, the world’s largest pharmaceutical company, is determined by the marketing func- tion’s assessment of the potential market size associated with solving unmet medical needs. Thus, Pfizer is currently directing significant monies to R&D efforts aimed at finding treatments for Alzheimer’s disease, principally because marketing has identified the treatment of Alzheimer’s as a major unmet medical need in nations around the world where the population is aging.

The role of the enterprise’s service activity is to provide after-sale service and support. This function can create a perception of superior value (V) in the minds of consumers by solving customer problems and supporting customers after they have purchased the prod- uct. Caterpillar, the U.S.-based manufacturer of heavy earthmoving equipment, can get spare parts to any point in the world within 24 hours, thereby minimizing the amount of downtime its customers have to suffer if their Caterpillar equipment malfunctions. This is an extremely valuable capability in an industry where downtime is very expensive. It has helped to increase the value that customers associate with Caterpillar products and thus the price that Caterpillar can charge.

G L O B A L E D G E B U S I N E S S R E V I E W

In Chapter 13, we are bringing you closer to running a globally oriented company based on the issues we have covered on country differences,  global trade and investment environment, and the global money system. This is where many of you will “make your money” as strategic  decision makers in corporations. This also means you need to know what is current, important, and strategic in the global marketplace; your company’s products or services; and your company’s uniqueness in satisfying the needs and wants of customers. The globalEDGE Business Review (gBR) is a leading source for cutting- edge global business knowledge with a main target audience of business executives (globaledge.msu.edu/gbr). Note that gBR complements the overall globalEDGE site con- tent by publishing cutting-edge articles dealing with a variety of international business issues facing managers in different world areas, industries, and management functions. With 1.5 million active users and millions more visitors to the site and some 30,000 sub- scribers, gBR reaches farther and has more impact and visibility than any business jour- nal in international business. One gBR article is titled “From Domestic to International to Global Sourcing.” Based on this article, how much should a company engage in “interna- tional/global purchasing activities” versus “domestic purchasing only” to best operate a global strategy?

370 Part 5 The Strategy and Structure of International Business

Support Activities The support activities of the value chain provide inputs that allow the primary activities to occur (see Figure 13.4). In terms of attaining a competitive advantage, support activi- ties can be as important as, if not more important than, the primary activities of the firm. Consider information systems; these systems refer to the electronic systems for managing inventory, tracking sales, pricing products, selling products, dealing with customer ser- vice inquiries, and so on. Information systems, when coupled with the communications features of the Internet, can alter the efficiency and effectiveness with which a firm man- ages its other value creation activities. Dell, for example, has used its information systems to attain a competitive advantage over rivals. When customers place an order for a Dell product over the firm’s website, that information is immediately transmitted, via the In- ternet, to suppliers, who then configure their production schedules to produce and ship that product so that it arrives at the right assembly plant at the right time. These systems have reduced the amount of inventory that Dell holds at its factories to under two days, which is a major source of cost savings.

The logistics function controls the transmission of physical materials through the value chain, from procurement through production and into distribution. The effi- ciency with which this is carried out can significantly reduce cost (lower C), thereby creating more value. The combination of logistics systems and information systems is a particularly potent source of cost savings in many enterprises, such as Dell, where information systems tell Dell on a real-time basis where in its global logistics network parts are, when they will arrive at an assembly plant, and thus how production should be scheduled.

The human resource function can help create more value in a number of ways. It en- sures that the company has the right mix of skilled people to perform its value creation activities effectively. The human resource function also ensures that people are ade- quately trained, motivated, and compensated to perform their value creation tasks. In a multinational enterprise, one of the things human resources can do to boost the competi- tive position of the firm is to take advantage of its transnational reach to identify, recruit, and develop a cadre of skilled managers, regardless of their nationality, who can be groomed to take on senior management positions. They can find the very best, wherever they are in the world. Indeed, the senior management ranks of many multinationals are becoming increasingly diverse, as managers from a variety of national backgrounds have ascended to senior leadership positions. Japan’s Sony, for example, is now headed not by a Japanese national, but by Howard Stringer, a Welshman.

The final support activity is the company infrastructure, or the context within which all the other value creation activities occur. The infrastructure includes the organization structure, control systems, and culture of the firm. Because top management can exert considerable influence in shaping these aspects of a firm, top management should also be viewed as part of the firm’s infrastructure. Through strong leadership, top management can consciously shape the infrastructure of a firm and through that the performance of all its value creation activities.

Global Expansion, Profitability, and Profit Growth

Expanding globally allows firms to increase their profitability and rate of profit growth in ways not available to purely domestic enterprises.9 Firms that operate internationally are able to:

1. Expand the market for their domestic product offerings by selling those products in international markets.

2. Realize location economies by dispersing individual value creation activities to those locations around the globe where they can be performed most efficiently and effectively.

TEST PREP Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

LO 13 -2 Recognize how firms can profit by expanding globally.

The Strategy of International Business Chapter 13 371

3. Realize greater cost economies from experience effects by serving an expanded global market from a central location, thereby reducing the costs of value creation.

4. Earn a greater return by leveraging any valuable skills developed in foreign oper- ations and transferring them to other entities within the firm’s global network of operations.

As we will see, however, a firm’s ability to increase its profitability and profit growth by pursuing these strategies is constrained by the need to customize its product offering, marketing strategy, and business strategy to differing national conditions, that is, by the imperative of localization.

EXPANDING THE MARKET: LEVERAGING PRODUCTS AND COMPETENCIES

A company can increase its growth rate by taking goods or services developed at home and selling them internationally. Almost all multinationals started out doing just this. For example, Procter & Gamble developed most of its best-selling products (such as Pampers disposable diapers and Ivory soap) in the United States and subsequently sold them around the world. Likewise, although Microsoft developed its software in the United States, from its earliest days the company has always focused on selling that software in international markets. Automobile companies such as Volkswagen and Toyota also grew by developing products at home and then selling them in international markets. The re- turns from such a strategy are likely to be greater if indigenous competitors in the nations that a company enters lack comparable products. Thus, Toyota increased its profits by entering the large automobile markets of North America and Europe, offering products that were different from those offered by local rivals (Ford and GM) by their superior quality and reliability.

The success of many multinational companies that expand in this manner is based not just upon the goods or services that they sell in foreign nations, but also upon the core competencies that underlie the development, production, and marketing of those goods or services. The term core competence refers to skills within the firm that competitors cannot easily match or imitate.10 These skills may exist in any of the firm’s value creation activities—production, marketing, R&D, human resources, logistics, general manage- ment, and so on. Such skills are typically expressed in product offerings that other firms find difficult to match or imitate. Core competencies are the bedrock of a firm’s competi- tive advantage. They enable a firm to reduce the costs of value creation and/or to create perceived value in such a way that premium pricing is possible. For example, Toyota has a core competence in the production of cars. It is able to produce high-quality, well-de- signed cars at a lower delivered cost than any other firm in the world. The competencies that enable Toyota to do this seem to reside primarily in the firm’s production and logis- tics functions.11 Similarly, IKEA has a core competence in the design of stylish and af- fordable furniture that can be manufactured at a low cost and flat-packed, McDonald’s has a core competence in managing fast-food operations (it seems to be one of the most skilled firms in the world in this industry), and Procter & Gamble has a core competence in developing and marketing name-brand consumer products (it is one of the most skilled firms in the world in this business.

Because core competencies are, by definition, the source of a firm’s competitive advantage, the successful global expansion by manufacturing companies such as Toy- ota and P&G was based not just on leveraging products and selling them in foreign markets, but also on the transfer of core competencies to foreign markets where indige- nous competitors lacked them. The same can be said of companies engaged in the service sectors of an economy, such as financial institutions, retailers like IKEA, restaurant chains, and hotels. Expanding the market for their services often means replicating their business model in foreign nations (albeit with some changes to account for local differ- ences, which we will discuss in more detail shortly). Firms like Starbucks and IKEA, for example, expanded rapidly outside their home markets of the United States and Sweden

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by taking the basic business model that they developed at home and using that as a blueprint for establishing international operations.

LOCATION ECONOMIES

Earlier chapters revealed that countries differ along a range of dimensions, including the economic, political, legal, and cultural, and that these differences can either raise or lower the costs of doing business in a country. The theory of international trade also teaches that due to differences in factor costs, certain countries have a comparative advantage in the production of certain products. Japan might excel in the production of automobiles and consumer electronics; the United States in the production of computer software, pharmaceuticals, biotechnology products, and financial services.12 For a firm that is try- ing to survive in a competitive global market, this implies that trade barriers and trans- portation costs permitting, the firm will benefit by basing each value creation activity it performs at that location where economic, political, and cultural conditions, including relative factor costs, are most conducive to the performance of that activity.

Firms that pursue such a strategy can realize what we refer to as location economies, which are the economies that arise from performing a value creation activity in the opti- mal location for that activity, wherever in the world that might be (transportation costs and trade barriers permitting). Locating a value creation activity in the optimal location for that activity can have one of two effects. It can lower the costs of value creation and help the firm achieve a low-cost position, and/or it can enable a firm to differentiate its product offering from those of competitors. In terms of Figure 13.2, it can lower C and/or increase V (which in general supports higher pricing), both of which boost the profitabil- ity of the enterprise.

For an example of how this works in an international business, consider ClearVision Optical, a manufacturer and distributor of eyewear. Started by David Glassman, the firm now generates annual gross revenues of more than $100 million. Not exactly small, but no corporate giant either, ClearVision is a multinational firm with production facilities on three continents and customers around the world. ClearVision began its move toward becoming a multinational when its sales were still less than $20 million. At the time, the U.S. dollar was very strong, and this made U.S.-based manufacturing expensive. Low- priced imports were taking an ever-larger share of the U.S. eyewear market, and Clear- Vision realized it could not survive unless it also began to import. Initially the firm bought from independent overseas manufacturers, primarily in Hong Kong. However, the firm became dissatisfied with these suppliers’ product quality and delivery. As Clear- Vision’s volume of imports increased, Glassman decided the best way to guarantee quality and delivery was to set up ClearVision’s own manufacturing operation overseas. Accord- ingly, ClearVision found a Chinese partner, and together they opened a manufacturing facility in Hong Kong, with ClearVision being the majority shareholder.

The choice of the Hong Kong location was influenced by its combination of low labor costs, a skilled workforce, and tax breaks given by the Hong Kong government. The firm’s objective at this point was to lower production costs by locating value creation ac- tivities at an appropriate location. After a few years, however, the increasing industrial- ization of Hong Kong and a growing labor shortage had pushed up wage rates to the extent that it was no longer a low-cost location. In response, Glassman and his Chinese partner moved part of their manufacturing to a plant in mainland China to take advantage of the lower wage rates there. Again, the goal was to lower production costs. The parts for eyewear frames manufactured at this plant were shipped to the Hong Kong factory for final assembly and then distributed to markets in North and South America. The Hong Kong factory now employs 80 people and the Chinese plant between 300 and 400.

At the same time, ClearVision was looking for opportunities to invest in foreign eye- wear firms with reputations for fashionable design and high quality. Its objective was not to reduce production costs but to launch a line of high-quality differentiated, “designer” eyewear. ClearVision did not have the design capability in-house to support such a line,

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but Glassman knew that certain foreign manufacturers did. As a result, ClearVision in- vested in factories in Japan, France, and Italy, holding a minority shareholding in each case. These factories now supply eyewear for ClearVision’s Status Eye division, which markets high-priced designer eyewear.13

Thus, to deal with a threat from foreign competition, ClearVision adopted a strategy intended to lower its cost structure (lower C): shifting its production from a high-cost location, the United States, to a low-cost location, first Hong Kong and later China. Then ClearVision adopted a strategy intended to increase the perceived value of its product (increase V) so it could charge a premium price (P). Reasoning that premium pricing in eyewear depended on superior design, its strategy involved investing capital in French, Italian, and Japanese factories that had reputations for superior design. In sum, ClearVision’s strategies included some actions intended to reduce its costs of creating value and other actions intended to add perceived value to its product through differen- tiation. The overall goal was to increase the value created by ClearVision and thus the profitability of the enterprise. To the extent that these strategies were successful, the firm should have attained a higher profit margin and greater profitability than if it had remained a U.S.-based manufacturer of eyewear.

Creating a Global Web Generalizing from the ClearVision example, one result of this kind of thinking is the creation of a global web of value creation activities, with different stages of the value chain being dispersed to those locations around the globe where perceived value is maxi- mized or where the costs of value creation are minimized.14 Consider Lenovo’s ThinkPad laptop computers (Lenovo is the Chinese computer company that purchased IBM’s per- sonal computer operations in 2005).15 This product is designed in the United States by engineers because Lenovo believes that the United States is the best location in the world to do the basic design work. The case, keyboard, and hard drive are made in Thailand; the display screen and memory in South Korea; the built-in wireless card in Malaysia; and the microprocessor in the United States.

In each case, these components are manufactured and sourced from the optimal loca- tion given current factor costs. These components are then shipped to an assembly opera- tion in China, where the product is assembled before being shipped to the United States for final sale. Lenovo assembles the ThinkPad in Mexico because managers have calcu- lated that due to low labor costs, the costs of assembly can be minimized there. The mar- keting and sales strategy for North America is developed by Lenovo personnel in the United States, primarily because managers believe that due to their knowledge of the lo- cal marketplace, U.S. personnel add more value to the product through their marketing efforts than personnel based elsewhere.

In theory, a firm that realizes location economies by dispersing each of its value cre- ation activities to its optimal location should have a competitive advantage vis-à-vis a firm that bases all of its value creation activities at a single location. It should be able to better differentiate its product offering (thereby raising perceived value, V) and lower its cost structure (C) than its single-location competitor. In a world where competitive pres- sures are increasing, such a strategy may become an imperative for survival.

Some Caveats Introducing transportation costs and trade barriers complicates this picture. Due to favor- able factor endowments, New Zealand may have a comparative advantage for automobile assembly operations, but high transportation costs would make it an uneconomical loca- tion from which to serve global markets. Another caveat concerns the importance of as- sessing political and economic risks when making location decisions. Even if a country looks very attractive as a production location when measured against all the standard criteria, if its government is unstable or totalitarian, the firm might be advised not to base production there. (Political risk is discussed in Chapter 2.) Similarly, if the government

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appears to be pursuing inappropriate economic policies that could lead to foreign ex- change risk, that might be another reason for not basing production in that location, even if other factors look favorable.

EXPERIENCE EFFECTS

The experience curve refers to systematic reductions in production costs that have been observed to occur over the life of a product.16 A number of studies have observed that a product’s production costs decline by some quantity about each time cumulative output doubles. The relationship was first observed in the aircraft industry, where each time cumulative output of airframes was doubled, unit costs typically declined to 80 percent of their previous level.17 Thus, production cost for the fourth airframe would be 80 percent of production cost for the second airframe, the eighth airframe’s produc- tion costs 80 percent of the fourth’s, the sixteenth’s 80 percent of the eighth’s, and so on. Figure 13.5 illustrates this experience curve relationship between unit production costs and cumulative output (the relationship is for cumulative output over time, and not output in any one period, such as a year). Two things explain this: learning effects and economies of scale.

Learning Effects Learning effects refer to cost savings that come from learning by doing. Labor, for ex- ample, learns by repetition how to carry out a task, such as assembling airframes, most efficiently. Labor productivity increases over time as individuals learn the most efficient ways to perform particular tasks. Equally important in new production facilities, manage- ment typically learns how to manage the new operation more efficiently over time. Hence, production costs decline due to increasing labor productivity and management efficiency, which increases the firm’s profitability.

Learning effects tend to be more significant when a technologically complex task is repeated because there is more that can be learned about the task. Thus, learning effects will be more significant in an assembly process involving 1,000 complex steps than in one of only 100 simple steps. No matter how complex the task, however, learning effects typically disappear after a while. It has been suggested that they are important only dur- ing the startup period of a new process and that they cease after two or three years.18 Any decline in the experience curve after such a point is due to economies of scale.

Economies of Scale Economies of scale refer to the reductions in unit cost achieved by producing a large volume of a product. Attaining economies of scale lowers a firm’s unit costs and increases

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its profitability. Economies of scale have a number of sources. One is the ability to spread fixed costs over a large volume.19 Fixed costs are the costs required to set up a production facility, develop a new product, and the like. They can be substantial. For example, the fixed cost of establishing a new production line to manufacture semiconductor chips now exceeds $1 billion. Similarly, according to one estimate, developing a new drug and bringing it to market costs about $800 million and takes about 12 years.20 The only way to recoup such high fixed costs may be to sell the product worldwide, which reduces aver- age unit costs by spreading fixed costs over a larger volume. The more rapidly that cumu- lative sales volume is built up, the more rapidly fixed costs can be amortized over a large production volume, and the more rapidly unit costs will fall.

Second, a firm may not be able to attain an efficient scale of production unless it serves global markets. In the automobile industry, for example, an efficiently scaled fac- tory is one designed to produce about 200,000 units a year. Automobile firms would prefer to produce a single model from each factory since this eliminates the costs associ- ated with switching production from one model to another. If domestic demand for a particular model is only 100,000 units a year, the inability to attain a 200,000-unit output will drive up average unit costs. By serving international markets as well, however, the firm may be able to push production volume up to 200,000 units a year, thereby reaping greater scale economies, lowering unit costs, and boosting profitability.

Finally, as global sales increase the size of the enterprise, so its bargaining power with suppliers increases, which may allow it to attain economies of scale in purchasing, bar- gaining down the cost of key inputs and boosting profitability that way. For example, Walmart has used its enormous sales volume as a lever to bargain down the price it pays suppliers for merchandise sold through its stores.

Strategic Significance The strategic significance of the experience curve is clear. Moving down the experience curve allows a firm to reduce its cost of creating value (to lower C in Figure 13.2) and increase its profitability. The firm that moves down the experience curve most rapidly will have a cost advantage vis-à-vis its competitors. Firm A in Figure 13.5, because it is farther down the experience curve, has a clear cost advantage over firm B.

Many of the underlying sources of experience-based cost economies are plant-based. This is true for most learning effects as well as for the economies of scale derived by spreading the fixed costs of building productive capacity over a large output, attaining an efficient scale of output, and utilizing a plant more intensively. Thus, one key to pro- gressing downward on the experience curve as rapidly as possible is to increase the volume produced by a single plant as rapidly as possible. Because global markets are larger than domestic markets, a firm that serves a global market from a single location is likely to build accumulated volume more quickly than a firm that serves only its home market or that serves multiple markets from multiple production locations. Thus, serving a global market from a single location is consistent with moving down the experience curve and establishing a low-cost position. In addition, to get down the experience curve rapidly, a firm may need to price and market aggressively so demand will expand rap- idly. It will also need to build sufficient production capacity for serving a global market. Also, the cost advantages of serving the world market from a single location will be even more significant if that location is the optimal one for performing the particular value creation activity.

Once a firm has established a low-cost position, it can act as a barrier to new competi- tion. Specifically, an established firm that is well down the experience curve, such as firm A in Figure 13.5, can price so that it is still making a profit while new entrants, which are farther up the curve, are suffering losses. Intel is one of the masters of this kind of strategy. The costs of building a state-of-the-art facility to manufacture microproces- sors are so large (now around $5 billion) that to make this investment pay Intel must pursue experience curve effects, serving world markets from a limited number of plants to maximize the cost economies that derive from scale and learning effects.

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LEVERAGING SUBSIDIARY SKILLS

Implicit in our earlier discussion of core competencies is the idea that valuable skills are developed first at home and then transferred to foreign operations. However, for more mature multinationals that have already established a network of subsidiary op- erations in foreign markets, the development of valuable skills can just as well occur in foreign subsidiaries.21 Skills can be created anywhere within a multinational’s global network of operations, wherever people have the opportunity and incentive to try new ways of doing things. The creation of skills that help lower the costs of production, or enhance perceived value and support higher product pricing, is not the monopoly of the corporate center.

Leveraging the skills created within subsidiaries and applying them to other opera- tions within the firm’s global network may create value. McDonald’s increasingly is finding that its foreign franchisees are a source of valuable new ideas. Faced with slow growth in France, its local franchisees have begun to experiment not only with the menu but also with the layout and theme of restaurants. Gone are the ubiquitous golden arches; gone too are many of the utilitarian chairs and tables and other plastic features of the fast-food giant. Many McDonald’s restaurants in France now have hardwood floors, exposed brick walls, and even armchairs. Half of the 1,200 or so outlets in France have been upgraded to a level that would make them unrecognizable to an American. The menu too has been changed to include premier sandwiches, such as chicken on focaccia bread, priced some 30 percent higher than the average hamburger. In France at least, the strategy seems to be working. Following the change, increases in same-store sales rose from 1 percent annually to 3.4 percent. Impressed with the im- pact, McDonald’s executives are considering similar changes at other McDonald’s res- taurants in markets where same-store sales growth is sluggish, including the United States.22 Another example of a multinational firm leveraging subsidiary skills is given in the next Management Focus feature.

For the managers of the multinational enterprise, this phenomenon creates impor- tant new challenges. First, they must have the humility to recognize that valuable skills that lead to competencies can arise anywhere within the firm’s global network, not just at the corporate center. Second, they must establish an incentive system that encour- ages local employees to acquire new skills. This is not as easy as it sounds. Creating new skills involves a degree of risk. Not all new skills add value. For every valuable idea created by a McDonald’s subsidiary in a foreign country, there may be several failures. The management of the multinational must install incentives that encourage employees to take the necessary risks. The company must reward people for successes and not sanction them unnecessarily for taking risks that did not pan out. Third, man- agers must have a process for identifying when valuable new skills have been created in a subsidiary. And finally, they need to act as facilitators, helping transfer valuable skills within the firm.

PROFITABILITY AND PROFIT GROWTH SUMMARY

We have seen how firms that expand globally can increase their profitability and profit growth by entering new markets where indigenous competitors lack similar competen- cies, by lowering costs and adding value to their product offering through the attainment of location economies, by exploiting experience curve effects, and by transferring valu- able skills between their global network of subsidiaries. For completeness it should be noted that strategies that increase profitability may also expand a firm’s business, and thus enable it to attain a higher rate of profit growth. For example, by simultaneously re- alizing location economies and experience effects, a firm may be able to produce a more highly valued product at a lower unit cost, thereby boosting profitability. The increase in the perceived value of the product may also attract more customers, thereby increasing revenues and profits as well. Furthermore, rather than raising prices to reflect the higher perceived value of the product, the firm’s managers may elect to hold prices low in order

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Leveraging Subsidiary Skills at ArcelorMittal ArcelorMittal is the world’s largest steelmaker with 222,000 employees in 60 countries and more than 100 steelmaking facilities. Early on, ArcelorMittal perfected a deceptively simple strategy—buy rundown steel mills, cut costs, lay off excess workers, take actions to improve pro- ductivity, particularly through automation, and transform the acquisition into a profitable enterprise. It worked again and again all around the world. More recently, he has kept the productivity gains coming by pursuing a strategy known in the company as “twinning.” Mittal “twins” pairs of mills—usually of a similar size, age, product mix, and output level—against each other. The weaker mill is told to copy the practices of the stronger mill, while the stronger mill is told to keep its edge. Managers are summoned to regular meetings to compare their perfor- mance and to look for ways of improving the productivity of the weaker mill. In one example, a poorly performing plant in Burns Har- bor, Indiana, was twinned with a high-performing mill in Gent, Belgium. The Burns Harbor mill had been acquired by ArcelorMittal in 2008. Over 100 engineers and manag- ers were flown from Burns Harbor to Gent and told to look at everything the Belgians did and copy them. The Bel- gium mill was one of the most efficient of its kind in the world, with work hours per ton of steel produced coming in at 1.25, versus an industry average of 2.0. The Americans quickly realized that Gent’s high perfor- mance was not due to lower pay—in fact, total pay plus benefits was higher in Gent than at Burns Harbor. Rather,

the Belgium mill had adopted a number of processes that increased productivity. For example, in Gent a computer coordinates the movement and processing of iron and steel slabs, whereas in Burns Harbor the same work was done by workers relying on phone calls and paper. Em- ployees at Gent had also made a number of modifications to reduce waste. They developed a specially designed nozzle attached to a huge hose that was used to remove flakes from hot steel. Placed at a more efficient angle, the same amount of surface impurities could be removed with less water. Welders at Gent also cut coils of steel to order, which  kept waste to a minimum as well. By adopting the improvements pioneered in Gent, em- ployees at Burns Harbor found that they were able to sig- nificantly increase productivity. For example, by adopting the same computer software that the Gent workers had developed, employees at Burns Harbor were able to in- crease the average number of cauldrons of molten steel they made each day from 42 to 50. As a result of improve- ments such as these, employee productivity at Burns Harbor, measured by work hours per ton of steel pro- duced, increased from around 2.0 to 1.32 in 2012. By lever- aging the skills developed at Gent, and applying them to the Burns Harbor steel mill, ArcelorMittal had boosted the performance of the acquired company, creating consider- able value in the process and guaranteeing the future of the Burns Harbor mill.

Source: J. W. Miller, “Indiana Steel Mill Revived with Lessons from Abroad,” The Wall Street Journal, May 21, 2012.

TEST PREP Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

LO 13 -3 Understand how pressures for cost reductions and pressures for local responsiveness influence strategic choice.

to increase global market share and attain greater scale economies (in other words, they may elect to offer consumers better “value for money”). Such a strategy could increase the firm’s rate of profit growth even further, since consumers will be attracted by prices that are low relative to value. The strategy might also increase profitability if the scale economies that result from market share gains are substantial. In sum, managers need to keep in mind the complex relationship between profitability and profit growth when making strategic decisions about pricing.

Cost Pressures and Pressures for Local Responsiveness

Firms that compete in the global marketplace typically face two types of competitive pressure that affect their ability to realize location economies and experience effects, and to leverage products and transfer competencies and skills within the enterprise. They face pressures for cost reductions and pressures to be locally responsive (see Figure 13.6).23 These competitive pressures place conflicting demands on a firm.

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Responding to pressures for cost reductions requires that a firm try to minimize its unit costs. But responding to pressures to be locally responsive requires that a firm differ- entiate its product offering and marketing strategy from country to country in an effort to accommodate the diverse demands arising from national differences in consumer tastes and preferences, business practices, distribution channels, competitive condi- tions, and government policies. Because differentiation across countries can involve significant duplication and a lack of product standardization, it may raise costs.

While some enterprises, such as firm A in Figure 13.6, face high pressures for cost reductions and low pressures for local responsiveness, and others, such as firm B, face low pressures for cost reductions and high pressures for local responsiveness, many com- panies are in the position of firm C. They face high pressures for both cost reductions and local responsiveness. Dealing with these conflicting and contradictory pressures is a dif- ficult strategic challenge, primarily because being locally responsive tends to raise costs.

PRESSURES FOR COST REDUCTIONS

In competitive global markets, international businesses often face pressures for cost re- ductions. Responding to pressures for cost reduction requires a firm to try to lower the costs of value creation. A manufacturer, for example, might mass-produce a standard- ized product at the optimal location in the world, wherever that might be, to realize economies of scale, learning effects, and location economies. Alternatively, a firm might outsource certain functions to low-cost foreign suppliers in an attempt to reduce costs. A service business such as a bank might respond to cost pressures by moving some back- office functions, such as information processing, to developing nations where wage rates are lower.

Pressures for cost reduction can be particularly intense in industries producing com- modity-type products where meaningful differentiation on nonprice factors is difficult and price is the main competitive weapon. This tends to be the case for products that serve universal needs. Universal needs exist when the tastes and preferences of consum- ers in different nations are similar if not identical. This is the case for conventional com- modity products such as bulk chemicals, petroleum, steel, sugar, and the like. It also tends to be the case for many industrial and consumer products, for example, handheld calculators, semiconductor chips, personal computers, and liquid crystal display screens. Pressures for cost reductions are also intense in industries where major competitors are

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based in low-cost locations, where there is persistent excess capacity and where consum- ers are powerful and face low switching costs. The liberalization of the world trade and investment environment in recent decades, by facilitating greater international competi- tion, has generally increased cost pressures.24

PRESSURES FOR LOCAL RESPONSIVENESS

Pressures for local responsiveness arise from national differences in consumer tastes and preferences, infrastructure, accepted business practices, and distribution channels, and from host-government demands. Responding to pressures to be locally responsive re- quires a firm to differentiate its products and marketing strategy from country to country to accommodate these factors, all of which tends to raise the firm’s cost structure.

Differences in Customer Tastes and Preferences Strong pressures for local responsiveness emerge when customer tastes and preferences differ significantly between countries, as they often do for deeply embedded historic or cultural reasons. In such cases, a multinational’s products and marketing message have to be customized to appeal to the tastes and preferences of local customers. This typically creates pressure to delegate production and marketing responsibilities and functions to a firm’s overseas subsidiaries.

For example, the automobile industry in the 1990s moved toward the creation of “world cars.” The idea was that global companies such as General Motors, Ford, and Toyota would be able to sell the same basic vehicle the world over, sourcing it from cen- tralized production locations. If successful, the strategy would have enabled automobile companies to reap significant gains from global scale economies. However, this strategy frequently ran aground on the hard rocks of consumer reality. Consumers in different automobile markets seem to have different tastes and preferences, and demand different types of vehicles. North American consumers show a strong demand for pickup trucks. This is particularly true in the South and West where many families have a pickup truck as a second or third car. But in European countries, pickup trucks are seen purely as util- ity vehicles and are purchased primarily by firms rather than individuals. As a conse- quence, the product mix and marketing message needs to be tailored to consider the different nature of demand in North America and Europe.

Some have argued that customer demands for local customization are on the decline worldwide.25 According to this argument, modern communications and transport tech- nologies have created the conditions for a convergence of the tastes and preferences of consumers from different nations. The result is the emergence of enormous global markets for standardized consumer products. The worldwide acceptance of Subway sandwiches, McDonald’s hamburgers, Coca-Cola, Gap clothes, Apple iPhones, and Microsoft’s Xbox, all of which are sold globally as standardized products, are often cited as evidence of the increasing homogeneity of the global marketplace.

However, this argument may not hold in many consumer goods markets. Significant differences in consumer tastes and preferences still exist across nations and cultures. Managers in international businesses do not yet have the luxury of being able to ignore these differences, and they may not for a long time to come. For an example of a company that has discovered how important pressures for local responsiveness can still be, read the accompanying Management Focus on MTV Networks.

Differences in Infrastructure and Traditional Practices Pressures for local responsiveness arise from differences in infrastructure or traditional practices among countries, creating a need to customize products accordingly. Fulfilling this need may require the delegation of manufacturing and production functions to for- eign subsidiaries. For example, in North America, consumer electrical systems are based on 110 volts, whereas in some European countries, 240-volt systems are standard. Thus, domestic electric appliances have to be customized for this difference in infrastructure.

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Local Responsiveness at MTV Networks MTV Networks has become a symbol of globalization. Es- tablished in 1981, the U.S.-based TV network has been expanding outside its North American base since 1987 when it opened MTV Europe. Today MTV Networks fig- ures that every second of every day over 2 million peo- ple are watching MTV around the world, the majority outside the United States. Despite its international suc- cess, MTV’s global expansion got off to a weak start. In the 1980s, when the main programming fare was still mu- sic videos, it piped a single feed across Europe almost entirely composed of American programming with English-speaking veejays. Naively, the network’s U.S. managers thought Europeans would flock to the American programming. But while viewers in Europe shared a com- mon interest in a handful of global superstars, their tastes turned out to be surprisingly local. After losing share to local competitors, who focused more on local tastes, MTV changed its strategy in the 1990s. It broke its ser- vice into “feeds” aimed at national or regional markets. While MTV Networks exercises creative control over these different feeds, and while all the channels have the same familiar frenetic look and feel of MTV in the United

States, a significant share of the programming and con- tent is now local. Although a lot of programming ideas still originate in the United States, with staples such as the Real World having equivalents in different countries, an increasing share of programming is local in conception. In Italy, MTV Kitchen combines cooking with a music countdown. Erotica airs in Brazil and features a panel of youngsters discussing sex. The Indian channel produces 21 homegrown shows hosted by local veejays who speak “Hinglish,” a city-bred version of Hindi and English. Many feeds still feature music videos by locally popular performers. This localization push reaped big benefits for MTV, allowing the network to capture viewers back from local imitators.

Sources: M. Gunther, “MTV’s Passage to India,” Fortune, August 9, 2004, pp. 117–122; B. Pulley and A. Tanzer, “Sumner’s Gemstone,” Forbes, February 21, 2000, pp. 107–11; K. Hoffman, “Youth TV’s Old Hand Prepares for the Digital Challenge,” Financial Times, February 18, 2000, p. 8; presentation by Sumner M. Redstone, chair and CEO, Viacom Inc., delivered to Salomon Smith Barney 11th Annual Global Entertainment Media, Telecommunications Conference, Scottsdale, AZ, January 8, 2001, archived at www.viacom.com; Viacom 10K State- ment, 2005.

Although many national differences in infrastructure are rooted in history, some are quite recent. For example, in the wireless telecommunications industry different techni- cal standards exist in different parts of the world. A technical standard known as GSM is common in Europe, and an alternative standard, CDMA, is more common in the United States and parts of Asia. Equipment designed for GSM will not work on a CDMA net- work, and vice versa. Thus, companies such as Nokia, Motorola, and Samsung, which manufacture wireless handsets and infrastructure such as switches, need to customize their product offering according to the technical standard prevailing in a given country.

Differences in Distribution Channels A firm’s marketing strategies may have to be responsive to differences in distribution channels among countries, which may necessitate the delegation of marketing functions to national subsidiaries. In the pharmaceutical industry, for example, the British and  Japanese distribution systems are radically different from the U.S. system. British and Japanese doctors will not accept or respond favorably to a U.S.-style high-pressure sales force. Thus, pharmaceutical companies have to adopt different marketing practices in Britain and Japan compared with the United States—soft sell versus hard sell. Simi- larly, Poland, Brazil, and Russia all have similar per capita income on a purchasing power parity basis, but there are big differences in distribution systems across the three coun- tries. In Brazil, supermarkets account for 36 percent of food retailing, in Poland for 18 percent, and in Russia for less than 1 percent.26 These differences in channels require that companies adapt their own distribution and sales strategy.

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Host-Government Demands Economic and political demands imposed by host-country governments may require local responsiveness. For example, pharmaceutical companies are subject to local clinical testing, registration procedures, and pricing restrictions, all of which make it necessary that the man- ufacturing and marketing of a drug should meet local requirements. Because governments and government agencies control a significant proportion of the health care budget in most countries, they are in a powerful position to demand a high level of local responsiveness.

More generally, threats of protectionism, economic nationalism, and local content rules (which require that a certain percentage of a product should be manufactured lo- cally) dictate that international businesses manufacture locally. For example, consider Bombardier, the Canadian-based manufacturer of railcars, aircraft, jet boats, and snow- mobiles. Bombardier has 12 railcar factories across Europe. Critics of the company argue that the resulting duplication of manufacturing facilities leads to high costs and helps explain why Bombardier makes lower profit margins on its railcar operations than on its other business lines. In reply, managers at Bombardier argue that in Europe, informal rules with regard to local content favor people who use local workers. To sell railcars in Germany, they claim, you must manufacture in Germany. The same goes for Belgium, Austria, and France. To try to address its cost structure in Europe, Bombardier has cen- tralized its engineering and purchasing functions, but it has no plans to centralize manufacturing.27

Rise of Regionalism Traditionally, we have tended to think of pressures for local responsiveness as being de- rived from national differences in tastes and preferences, infrastructure, and the like. While this is still often the case, there is also a tendency toward the convergence of tastes, preferences, infrastructure, distribution channels, and host-government demands with a broader region that is composed of two or more nations.28 We tend to see this when there are strong pressures for convergence due to, for example, a shared history and culture or the establishment of a trading block where there are deliberate attempts to harmonize trade policies, infrastructure, regulations, and the like.

The most obvious example of a region is the European Union, and particularly the euro zone countries within that trade block, where there are institutional forces that are pushing toward convergence (see Chapter 9 for details). The creation of a single EU market—with a single currency, common business regulations, standard infrastructure, and so on—cannot help but result in the reduction of certain national differences among countries within the EU and the creation of one regional rather than several national markets. Indeed, at the economic level at least, that is the explicit intent of the EU.

Another example of regional convergence is North America, which includes the United States, Canada, and to some extent in some product markets, Mexico. Canada and the United States share history, language, and much of their culture, and both are members of NAFTA. Mexico is clearly different in many regards, but its proximity to the United States, along with its membership in NAFTA, implies that for some product markets (e.g., automobiles) it might be reasonable to consider Mexico as part of a relatively homoge- neous regional market. We might also talk about the Latin America region, where shared Spanish history, cultural heritage, and language (with the exception of Brazil, which was colonized by the Portuguese) means that national differences are somewhat moderated. It can also be argued that Greater China, which includes the city-states of Hong Kong and Singapore along with Taiwan, is a coherent region, as is much of the Middle East, where a strong Arab culture and shared history may limit national differences. Similarly, Russia and some of the former states of the Soviet Union, such as Belarus and Ukraine, might be considered part of a larger regional market, at least for some products.

Taking a regional perspective is important because it may suggest that localization at the regional rather than the national level is the appropriate strategic response. For example, rather than produce cars for each national market within the Europe or North America, it

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makes far more sense for car manufacturers to build cars for the European or North Ameri- can regions. The ability to standardize product offering within a region allows for the at- tainment of greater scale economies, and hence lower costs, than if each nation had to have its own offering. At the same time, this perspective should not be pushed too far. There are still deep and profound cultural differences among the United Kingdom, France, Germany, and Italy—all members of the EU—that may in turn require some degree of local custom- ization at the national level. Managers must thus make a judgment call about the appropri- ate level of aggregation given (1) the product market they are looking at and (2) the nature of national differences and trends for regional convergence. What might make sense for automobiles, for example, might not be appropriate for packaged food products.

Choosing a Strategy

Pressures for local responsiveness imply that it may not be possible for a firm to realize the full benefits from economies of scale, learning effects, and location economies. It may not be possible to serve the global marketplace from a single low-cost location, pro- ducing a globally standardized product, and marketing it worldwide to attain the cost re- ductions associated with experience effects. The need to customize the product offering to local conditions may work against the implementation of such a strategy.

For example, as noted automobile firms have found that Japanese, American, and Eu- ropean consumers demand different kinds of cars, and this necessitates producing prod- ucts that are customized for regional markets. In response, firms such as Honda, Ford, and Toyota are pursuing a strategy of establishing top-to-bottom design and production facilities in each of these regions so that they can better serve local demands. Although

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LO 13 - 4 Identify the different strategies for competing globally and their pros and cons.

McDonald’s tweaks its menu from nation to nation to bet- ter appeal to local tastes and preferences. Source: © Pradeep Paliwal/ Demotix/Demotix/Corbis

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such customization brings benefits, it also limits the ability of a firm to realize significant scale economies and location economies.

In addition, pressures for local responsiveness imply that it may not be possible to le- verage skills and products associated with a firm’s core competencies wholesale from one nation to another. Concessions often have to be made to local conditions. Despite being depicted as “poster child” for the proliferation of standardized global products, even McDonald’s has found that it has to customize its product offerings (i.e., its menu) to ac- count for national differences in tastes and preferences.

How do differences in the strength of pressures for cost reductions versus those for lo- cal responsiveness affect a firm’s choice of strategy? Firms typically choose among four main strategic postures when competing internationally. These can be characterized as a global standardization strategy, a localization strategy, a transnational strategy, and an international strategy.29 The appropriateness of each strategy varies given the extent of pressures for cost reductions and local responsiveness. Figure 13.7 illustrates the condi- tions under which each of these strategies is most appropriate.

GLOBAL STANDARDIZATION STRATEGY

Firms that pursue a global standardization strategy focus on increasing profitability and profit growth by reaping the cost reductions that come from economies of scale, learning effects, and location economies; that is, their strategic goal is to pursue a low- cost strategy on a global scale. The production, marketing, and R&D activities of firms pursuing a global standardization strategy are concentrated in a few favorable locations. Firms pursuing a global standardization strategy try not to customize their product offer- ing and marketing strategy to local conditions because customization involves shorter production runs and the duplication of functions, which tend to raise costs. Instead, they prefer to market a standardized product worldwide so that they can reap the maximum benefits from economies of scale and learning effects. They also tend to use their cost advantage to support aggressive pricing in world markets.

This strategy makes most sense when there are strong pressures for cost reductions and demands for local responsiveness are minimal. Increasingly, these conditions prevail in many industrial goods industries, whose products often serve universal needs. In the semiconductor industry, for example, global standards have emerged, creating enormous demands for standardized global products. Accordingly, companies such as Intel, Texas

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Instruments, and Motorola all pursue a global standardization strategy. However, these conditions are not always found in many consumer goods markets, where demands for local responsiveness remain high. The strategy is inappropriate when demands for local responsiveness can remain high.

LOCALIZATION STRATEGY

A localization strategy focuses on increasing profitability by customizing the firm’s goods or services so that they provide a good match to tastes and preferences in different national markets. Localization is most appropriate when there are substantial differences across nations with regard to consumer tastes and preferences, and where cost pressures are not too intense. By customizing the product offering to local demands, the firm in- creases the value of that product in the local market. On the downside, because it involves some duplication of functions and smaller production runs, customization limits the ability of the firm to capture the cost reductions associated with mass-producing a standardized product for global consumption. The strategy may make sense, however, if the added value associated with local customization supports higher pricing, which enables the firm to re- coup its higher costs, or if it leads to substantially greater local demand, enabling the firm to reduce costs through the attainment of some scale economies in the local market.

At the same time, firms still have to keep an eye on costs. Firms pursuing a localiza- tion strategy still need to be efficient and, whenever possible, to capture some scale econ- omies from their global reach. As noted earlier, many automobile companies have found that they have to customize some of their product offerings to local market demands—for example, producing large pickup trucks for U.S. consumers and small, fuel-efficient cars for Europeans and Japanese. At the same time, these multinationals try to get some scale economies from their global volume by using common vehicle platforms and components across many different models, and manufacturing those platforms and components at ef- ficiently scaled factories that are optimally located. By designing their products in this way, these companies have been able to localize their product offering, yet simultane- ously capture some scale economies, learning effects, and location economies.

TRANSNATIONAL STRATEGY

We have argued that a global standardization strategy makes most sense when cost pressures are intense, and demands for local responsiveness are limited. Conversely, a localization strat- egy makes most sense when demands for local responsiveness are high, but cost pressures are moderate or low. What happens, however, when the firm simultaneously faces both strong cost pressures and strong pressures for local responsiveness? How can managers balance the competing and inconsistent demands such divergent pressures place on the firm? According to some researchers, the answer is to pursue what has been called a transnational strategy.

Two of these researchers, Christopher Bartlett and Sumantra Ghoshal, argue that in today’s global environment, competitive conditions are so intense that to survive, firms must do all they can to respond to pressures for cost reductions and local responsiveness. They must try to realize location economies and experience effects, to leverage products internationally, to transfer core competencies and skills within the company, and to si- multaneously pay attention to pressures for local responsiveness.30 Bartlett and Ghoshal note that in the modern multinational enterprise, core competencies and skills do not re- side just in the home country but can develop in any of the firm’s worldwide operations. Thus, they maintain that the flow of skills and product offerings should not be all one way, from home country to foreign subsidiary. Rather, the flow should also be from for- eign subsidiary to home country and from foreign subsidiary to foreign subsidiary. Trans- national enterprises, in other words, must also focus on leveraging subsidiary skills.

In essence, firms that pursue a transnational strategy are trying to simultaneously achieve low costs through location economies, economies of scale, and learning effects; differentiate their product offering across geographic markets to account for local differ- ences; and foster a multidirectional flow of skills between different subsidiaries in the

The Strategy of International Business Chapter 13 385

firm’s global network of operations. As attractive as this may sound in theory, the strat- egy is not an easy one to pursue since it places conflicting demands on the company. Differentiating the product to respond to local demands in different geographic markets raises costs, which runs counter to the goal of reducing costs. Companies such as 3M and ABB (one of the world’s largest engineering conglomerates) have tried to embrace a transnational strategy and found it difficult to implement.

How best to implement a transnational strategy is one of the most complex questions that large multinationals are grappling with today. Few if any enterprises have perfected this stra- tegic posture. But some clues as to the right approach can be derived from a number of com- panies. For an example, consider the case of Caterpillar. The need to compete with low-cost competitors such as Komatsu of Japan forced Caterpillar to look for greater cost economies. However, variations in construction practices and government regulations across countries mean that Caterpillar also has to be responsive to local demands. Therefore, Caterpillar con- fronted significant pressures for cost reductions and for local responsiveness.

To deal with cost pressures, Caterpillar redesigned its products to use many identical components and invested in a few large-scale component manufacturing facilities, sited at favorable locations, to fill global demand and realize scale economies. At the same time, the company augments the centralized manufacturing of components with assembly plants in each of its major global markets. At these plants, Caterpillar adds local product features, tailoring the finished product to local needs. Thus, Caterpillar is able to realize many of the benefits of global manufacturing while reacting to pressures for local responsiveness by differentiating its product among national markets.31 Caterpillar started to pursue this strategy in the 1980s and by the 2000s had succeeded in doubling output per employee, significantly reducing its overall cost structure in the process. Meanwhile, Komatsu and Hitachi, which are still wedded to a Japan-centric global strategy, have seen their cost ad- vantages evaporate and have been steadily losing market share to Caterpillar.

Changing a firm’s strategic posture to build an organization capable of supporting a transnational strategy is a complex and challenging task. Some would say it is too com- plex, because the strategy implementation problems of creating a viable organization structure and control systems to manage this strategy are immense.

INTERNATIONAL STRATEGY

Sometimes it is possible to identify multinational firms that find themselves in the fortu- nate position of being confronted with low cost pressures and low pressures for local re- sponsiveness. Many of these enterprises have pursued an international strategy, taking products first produced for their domestic market and selling them internationally with only minimal local customization. The distinguishing feature of many such firms is that they are selling a product that serves universal needs, but they do not face significant competitors, and thus unlike firms pursuing a global standardization strategy, they are not confronted with pressures to reduce their cost structure. Xerox found itself in this position in the 1960s after its invention and commercialization of the photocopier. The technology underlying the photocopier was protected by strong patents, so for several years Xerox did not face competitors—it had a monopoly. The product serves universal needs, and it was highly valued in most developed nations. Thus, Xerox was able to sell the same basic product the world over, charging a relatively high price for that product. Since Xerox did not face direct competitors, it did not have to deal with strong pressures to minimize its cost structure.

Enterprises pursuing an international strategy have followed a similar developmental pattern as they expanded into foreign markets. They tend to centralize product development functions such as R&D at home. However, they also tend to establish manufacturing and marketing functions in each major country or geographic region in which they do business. The resulting duplication can raise costs, but this is less of an issue if the firm does not face strong pressures for cost reductions. Although they may undertake some local customiza- tion of product offering and marketing strategy, this tends to be rather limited in scope.

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M A NAG E M E N T F O C U S

Evolution of Strategy at Procter & Gamble Founded in 1837, Cincinnati-based Procter & Gamble has long been one of the world’s most international compa- nies. Today P&G is a global colossus in the consumer products business with annual sales in excess of $80 bil- lion, some 54 percent of which are generated outside the United States. P&G sells more than 300 brands—including Ivory soap, Tide, Pampers, IAMS pet food, Crisco, and Folgers—to consumers in 180 countries. Historically the strategy at P&G was well established. The company devel- oped new products in Cincinnati and then relied on semi- autonomous foreign subsidiaries to manufacture, market, and distribute those products in different nations. In many cases, foreign subsidiaries had their own production facili- ties and tailored the packaging, brand name, and market- ing message to local tastes and preferences. For years this strategy delivered a steady stream of new products and reliable growth in sales and profits. By the 1990s, how- ever, profit growth at P&G was slowing. The essence of the problem was simple; P&G’s costs were too high because of extensive duplication of manu- facturing, marketing, and administrative facilities in different national subsidiaries. The duplication of assets made sense in the world of the 1960s, when national markets were seg- mented from each other by barriers to cross-border trade. Products produced in Great Britain, for example, could not be sold economically in Germany due to high tariff duties levied on imports into Germany. By the 1980s, however, barriers to cross-border trade were falling rapidly world- wide and fragmented national markets were merging into larger regional or global markets. Also, the retailers through which P&G distributed its products were growing larger and more global, such as Walmart, Tesco from the United Kingdom, and Carrefour from France. These emerging global retailers were demanding price discounts from P&G. In the 1990s P&G embarked on a major reorganization in an attempt to control its cost structure and recognize the

new reality of emerging global markets. The company shut down some 30 manufacturing plants around the globe, laid off 13,000 employees, and concentrated production in fewer plants that could better realize economies of scale and serve regional markets. It wasn’t enough! Profit growth remained sluggish so in 1999 P&G launched its second re- organization of the decade. Named “Organization 2005,” the goal was to transform P&G into a truly global company. The company tore up its old organization, which was based on countries and regions, and replaced it with one based on seven self-contained global business units, ranging from baby care to food products. Each business unit was given complete responsibility for generating profits from its prod- ucts, and for manufacturing, marketing, and product devel- opment. Each business unit was told to rationalize production, concentrating it in fewer larger facilities; to try to build global brands wherever possible, thereby eliminating marketing differences between countries; and to accelerate the development and launch of new products. P&G an- nounced that as a result of this initiative, it would close an- other 10 factories and lay off another 15,000 employees, mostly in Europe where there was still extensive duplication of assets. The annual cost savings were estimated to be about $800 million. P&G planned to use the savings to cut prices and increase marketing spending in an effort to gain market share, and thus further lower costs through the at- tainment of scale economies. This time the strategy seemed to be working. For most of the 2000s P&G reported strong growth in both sales and profits. Significantly, P&G’s global competitors, such as Unilever, Kimberly-Clark, and Colgate- Palmolive, were struggling during the same time period.

Sources: J. Neff, “P&G Outpacing Unilever in Five-Year Battle,” Adver- tising Age, November 3, 2003, pp. 1–3; G. Strauss, “Firm Restructuring into Truly Global Company,” USA Today, September 10, 1999, p. B2; Procter & Gamble 10K Report, 2005; M. Kolbasuk McGee, “P&G Jump-Starts Corporate Change,” Information Week, November 1, 1999, pp. 30–34.

Ultimately, in most firms that pursue an international strategy, the head office retains fairly tight control over marketing and product strategy.

Other firms that have pursued this strategy include Procter & Gamble and Microsoft. Historically, Procter & Gamble developed innovative new products in Cincinnati and then transferred them wholesale to local markets (see the accompanying Management Focus). Similarly, the bulk of Microsoft’s product development work occurs in Redmond, Wash- ington, where the company is headquartered. Although some localization work is under- taken elsewhere, this is limited to producing foreign-language versions of popular Microsoft programs.

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THE EVOLUTION OF STRATEGY

The Achilles’ heel of the international strategy is that over time, competitors inevitably emerge, and if managers do not take proactive steps to reduce their firm’s cost structure, it will be rapidly outflanked by efficient global competitors. This is exactly what happened to Xerox. Japanese companies such as Canon ultimately invented their way around Xerox’s patents, produced their own photocopiers in very efficient manufacturing plants, priced them below Xerox’s products, and rapidly took global market share from Xerox. In the final analysis, Xerox’s demise was not due to the emergence of competitors, for ultimately that was bound to occur, but due to its failure to proactively reduce its cost structure in advance of the emergence of efficient global competitors. The message in this story is that an international strategy may not be viable in the long term, and to survive, firms need to shift toward a global standardiza- tion strategy or a transnational strategy in advance of competitors (see Figure 13.8).

The same can be said about a localization strategy. Localization may give a firm a competitive edge, but if it is simultaneously facing aggressive competitors, the company will also have to reduce its cost structure, and the only way to do that may be to shift toward a transnational strategy. This is what Procter & Gamble has been doing (see the accompanying Management Focus). Thus, as competition intensifies, international and localization strategies tend to become less viable, and managers need to direct their companies toward either a global standardization strategy or a transnational strategy.

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Changes in strategy over time.

strategy, p. 364 profitability, p. 364 profit growth, p. 365 value creation, p. 366 operations, p. 367 core competence, p. 371

location economies, p. 372 global web, p. 373 experience curve, p. 374 learning effects, p. 374 economies of scale, p. 374 universal needs, p. 378

global standardization strategy, p. 383

localization strategy, p. 384 transnational strategy, p. 384 international strategy, p. 385

Key Terms

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C H A P T E R S U M M A R Y

This chapter reviewed basic principles of strategy and the various ways in which firms can profit from global expansion, and it looked at the strategies that firms competing globally can adopt. The chapter made the following points:

1. A strategy can be defined as the actions that managers take to attain the goals of the firm. For most multinational corporations, especially publicly traded firms, the preeminent goal is to maximize shareholder value. Maximizing shareholder value requires firms to focus on increasing their profitability and the growth rate of profits over time.

2. International expansion may enable a firm to earn greater returns by transferring the product offerings derived from its core com petencies to markets where indigenous competitors lack those product offerings and competencies.

3. It may pay a firm to base each value creation activity it performs at that location where factor conditions are most conducive to the perfor- mance of that activity. We refer to this strategy as focusing on the attainment of location economies.

4. By rapidly building sales volume for a stan- dardized product, international expansion can assist a firm in moving down the experience curve by realizing learning effects and econo- mies of scale.

5. A multinational firm can create additional value by identifying valuable skills created within its foreign subsidiaries and leveraging those skills within its global network of operations. These leverage issues are part of the firm’s global value chains.

6. The best strategy for a firm to pursue often depends on a consideration of the pressures for cost reductions and for local responsiveness.

7. Firms pursuing an international strategy transfer the products derived from core competencies to foreign markets while under- taking some limited local customization.

8. Firms pursuing a localization strategy customize their product offering, marketing strategy, and business strategy to national conditions.

9. Firms pursuing a global standardization strategy focus on reaping the cost reductions that come from experience curve effects and location economies.

10. Many industries are now so competitive that firms must adopt a transnational strategy. This involves a simultaneous focus on reducing costs, transferring skills and products, and boosting local responsive- ness. Implementing such a strategy may not be easy.

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. In a world of zero transportation costs, no trade barriers, and significant differences between nations with regard to factor conditions, firms must expand internationally if they are to survive. Discuss.

2. Plot the position of the following firms on Fig- ure 13.6: Procter & Gamble, IBM, Apple, Coca- Cola, Dow Chemical, Intel, and McDonald’s. In each case justify your answer.

3. In what kind of industries does a localiza- tion strategy make sense? When does a global standardization strategy make most sense?

4. Reread the Management Focus on Procter & Gam- ble, and then answer the following questions:

a. What strategy was Procter & Gamble pursuing when it first entered foreign markets in the period up until the 1980s?

b. Why do you think this strategy became less viable in the 1990s?

c. What strategy does P&G appear to be moving toward? What are the benefits of this strategy? What are the potential risks associated with it?

5. What do you see as the main organiza- tional problems that are likely to be associated with implementation of a transnational strategy?

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises:

1. Your company, a white goods manufacturer (primarily major kitchen appliances) based in the United States, has decided to pursue interna- tional expansion opportunities in sub-Saharan Africa. To achieve some economies of scale, your strategy is to minimize local adaptation. Focusing on a comparison of two sub-Saharan African countries of your choice, prepare an executive summary that features aspects of the product where standardization will simply not

be possible and adaptation to local conditions will be essential.

2. A. T. Kearney publishes an annual study to help retailers prioritize their global development strate- gies by ranking the retail expansion attractiveness of emerging countries based on a particular set of criteria. Find the latest version of this Global Re- tail Development Index. What criteria are used to identify the attractiveness of the retail environment in emerging countries? Categorize the top 10 coun- tries by world region. Are there any of these coun- tries that surprise you? Why or why not?

Global strategy is multidimensional and can include a va- riety of “levers” depending on the company and its situa- tion (e.g., products, industry, country markets). One global strategy framework that has been used extensively for a couple of decades is the framework presented by George Yip and Tomas Hult in Total Global Strategy (2012). It includes five dimensions, or levers, that drive how local or global a company is in the marketplace. Ba- sically, setting strategy for a multinational corporation

requires strategic decision choices along these five levers. Based on Yip and Hult, the five global strategy levers are:

Market participation involves the choice of countries in which to operate and the level of activity that the company decides to engage at in each country. Products/services involve the extent to which a multi- national business offers the same or different prod- ucts/services in different countries.

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80 90

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Products/Services Market Participation

Supply Chain Management

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Supply chain management, in this context, involves the choice of where to locate each of the operational activities that constitute the entire supply chain. Marketing involves the extent to which a multina- tional business uses the same marketing mix (e.g., brand names, advertising, and other marketing ele- ments in different countries). Competitive moves involve the extent to which a multinational business makes competitive moves in different countries as part of a global competitive strategy.

Tomas Hult along with coauthors David Closs and David Frayer examined a number of companies and their allocation of effort with respect to each of the five global strategy levers. Ten of those companies are illustrated here. For example, Mercedes is found to emphasize mak- ing global competitive moves vis-à-vis its competitors as its most important strategic lever and decision choice. Marketing is important for ABB. The services offered and the markets in which American Express participates drive its strategy globally. Microsoft appears reasonably well balanced in its approach to global strategy making. The other companies also adopt unique strategic posi- tions for the five global strategy levers. Sources: G. S. Yip and G. T. M. Hult, Total Global Strategy (Boston: Pearson Prentice Hall, 2012); G. T. M. Hult, “A Focus on International Competitiveness,” Journal of the Academy of Marketing Science 40 (2012), pp. 195–201; T. Hult, D. Closs, and D. Frayer, Global Supply Chain Management:

Leveraging Processes, Measurement, and Tools for Strategic Corporate Advan- tage (New York: McGraw-Hill, 2014); J. K. Johanson and G. S. Yip, “Ex- ploiting Globalization Potential: U.S. and Japanese Strategies,” Strategic Management Journal 15 (1994), pp. 579–601; G. S. Yip, “Global Strategy . . . in a World of Nations?,” Sloan Management Review 31 (1989), pp. 29–41.

C a s e D i s c u s s i o n Q u e s t i o n s

1. Which global strategy lever do you think is the most universally important across companies, and why? Which is the least important, and why?

2. Do you think your answers in question 1 will change over time; if so, how?

3. FedEx emphasizes supply chain management the least in driving its corporate global strategy. But, it is viewed as a supply chain company—perhaps even a transportation company. Why do you think the other global strategy levers are more important for FedEx?

4. Microsoft is known for making competitive moves globally but competitive moves are its least emphasized strategy lever; why do you think that is the case?

5. If you could work for one of the 10 companies shown in the bar chart based on their global strategy makeup, which company would it be, and why?

E n d n o t e s

1. More formally, ROIC = Net profit after tax ÷ Capital, where capital includes the sum of the firm’s equity and debt. This way of calculating profitability is highly correlated with return on assets.

2. T. Copeland, T. Koller, and J. Murrin, Valuation: Measuring and Managing the Value of Companies (New York: Wiley, 2000).

3. The concept of consumer surplus is an important one in economics. For a more detailed exposition, see D. Besanko, D. Dranove, and M. Shanley, Economics of Strategy (New York: Wiley, 1996).

4. However, P = V only in the special case where the company has a perfect monopoly, and where it can charge each customer a unique price that reflects the value of the product to that cus- tomer (i.e., where perfect price discrimination is possible). More generally, except in the limiting case of perfect price discrimina- tion, even a monopolist will see most consumers capture some of the value of a product in the form of a consumer surplus.

5. This point is central to the work of M. E. Porter, Competitive Advantage (New York: Free Press, 1985). See also chap. 4 in P. Ghemawat, Commitment: The Dynamic of Strategy (New York: Free Press, 1991).

6. M. E. Porter, Competitive Strategy (New York: Free Press, 1980).

7. M. E. Porter, “What Is Strategy?,” Harvard Business Review, On-point Enhanced Edition article, February 1, 2000.

8. Porter, Competitive Advantage. 9. Empirical evidence does seem to indicate that, on average, in-

ternational expansion is linked to greater firm profitability. For some examples, see M. A. Hitt, R. E. Hoskisson, and H. Kim, “International Diversification, Effects on Innovation and Firm Performance,” Academy of Management Journal 40, no. 4 (1997), pp. 767–98; S. Tallman and J. Li, “Effects of Interna- tional Diversity and Product Diversity on the Performance of Multinational Firms,” Academy of Management Journal 39, no. 1 (1996), pp. 179–96.

The Strategy of International Business Chapter 13 391

10. This concept has been popularized by G. Hamel and C. K. Prahalad, Competing for the Future (Boston: Harvard Business School Press, 1994). The concept is grounded in the resource-based view of the firm; for a summary, see J. B. Barney, “Firm Resources and Sustained Competitive Advantage,” Journal of Management 17 (1991), pp. 99–120; K. R. Conner, “A Historical Comparison of Resource-Based Theory and Five Schools of Thought within Industrial Organization Economics: Do We Have a New Theory of the Firm?,” Journal of Manage- ment 17 (1991), pp. 121–54.

11. J. P. Womack, D. T. Jones, and D. Roos, The Machine That Changed the World (New York: Rawson Associates, 1990).

12. M. E. Porter, The Competitive Advantage of Nations (New York: Free Press, 1990).

13. Example is based on C. S. Trager, “Enter the Mini-multinational,” Northeast International Business, March 1989, pp. 13–14.

14. See R. B. Reich, The Work of Nations (New York: Knopf, 1991); P. J. Buckley and N. Hashai, “A Global System View of Firm Boundaries,” Journal of International Business Studies, January 2004, pp. 33–50.

15. D. Barboza, “An Unknown Giant Flexes Its Muscles,” The New York Times, December 4, 2004, pp. B1, B3.

16. G. Hall and S. Howell, “The Experience Curve from an Econo- mist’s Perspective,” Strategic Management Journal 6 (1985), pp. 197–212.

17. A. A. Alchain, “Reliability of Progress Curves in Airframe Production,” Econometrica 31 (1963), pp. 697–98.

18. Hall and Howell, “The Experience Curve from an Economist’s Perspective.”

19. For a full discussion of the source of scale economies, see D. Besanko, D. Dranove, and M. Shanley, Economics of Strategy (New York: Wiley, 1996).

20. This estimate was provided by the Pharmaceutical Manufactur- ers Association.

21. See J. Birkinshaw and N. Hood, “Multinational Subsidiary Evolution: Capability and Charter Change in Foreign Owned Subsidiary Companies,” Academy of Management Review 23 (October 1998), pp. 773–95; A. K. Gupta and V. J. Govindarajan, “Knowledge Flows within Multinational Corporations,” Strategic Management Journal 21 (2000), pp. 473–96;

V. J. Govindarajan and A. K. Gupta, The Quest for Global Dominance (San Francisco: Jossey-Bass, 2001); T. S. Frost, J. M. Birkinshaw, and P. C. Ensign, “Centers of Excellence in Multinational Corporations,” Strategic Management Journal 23 (2002), pp. 997–1018; U. Andersson, M. Forsgren, and U. Holm, “The Strategic Impact of External Networks,” Strategic Manage- ment Journal 23 (2002), pp. 979–96.

22. S. Leung, “Armchairs, TVs and Espresso: Is It McDonald’s?,” The Wall Street Journal, August 30, 2002, pp. A1, A6.

23. C. K. Prahalad and Yves L. Doz, The Multinational Mission: Balancing Local Demands and Global Vision (New York: Free Press, 1987). Also see J. Birkinshaw, A. Morrison, and J. Hulland, “Structural and Competitive Determinants of a Global Integra- tion Strategy,” Strategic Management Journal 16 (1995), pp. 637–55; P. Ghemawat, Redefining Global Strategy (Boston: Harvard Business School Press, 2007).

24. Prahalad and Doz, The Multinational Mission. Prahalad and Doz actually talk about local responsiveness rather than local customization.

25. T. Levitt, “The Globalization of Markets,” Harvard Business Review, May–June 1983, pp. 92–102.

26. W. W. Lewis. The Power of Productivity (Chicago: University of Chicago Press, 2004).

27. C. J. Chipello, “Local Presence Is Key to European Deals,” The Wall Street Journal, June 30, 1998, p. A15.

28. For an extended discussion see G. S. Yip and G. Tomas M. Hult, Total Global Strategy (Boston: Pearson, 2012); A. M. Rugman and A. Verbeke, “A Perspective on Regional and Global Strategies of Multinational Enterprises,” Journal of International Business Studies 35, no. 1 (2004), pp. 3–18; C. A. Bartlett and S. Ghoshal, Managing across Borders (Boston: Harvard Business School Press, 1989).

29. Bartlett and Ghoshal, Managing across Borders. 30. Ibid. Pankaj Ghemawat makes a similar argument, although he

does not use the term transnational. See Ghemawat, Redefin- ing Global Strategy.

31. T. Hout, M. E. Porter, and E. Rudden, “How Global Companies Win Out,” Harvard Business Review, September–October 1982, pp. 98–108.

Credit: ©Federal Reserve Board.

The Organization of International Business L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO14 -1 Explain what is meant by organizational architecture.

LO14 -2 Describe the different organizational choices that can be made in an international business.

LO14 -3 Explain how organization can be matched to strategy to improve the performance of an international business.

LO14 - 4 Discuss what is required for an international business to change its organization so that it better matches its strategy.

part five The Strategy and Structure of International Business

14

Source: © Xu congjun/AP Images

393

P&G—Strength in Architecture

With the organizational size and product line breadth come both industry responsibility and business opportu- nity (see Chapter 5 on ethics, corporate social responsi- bility, and sustainability for a discussion of combining industry and business opportunities). P&G says that “our responsibility is to be an ethical corporate citizen” and the company articulates this in its Purpose Statement: “We will provide branded products and services of supe- rior quality and value that improve the lives of the world’s consumers, now and for generations to come. As a result, consumers will reward us with leadership sales, profit and value creation, allowing our people, our sharehold- ers and the communities in which we live and work to prosper.” As P&G continues to streamline its product assortment, it focuses heavily on its Selling and Market Operations (SMOs) as a mechanism to reach global customers in all four of its industry-based sectors. P&G views the SMOs as more of a name change from its old Market Development Organizations to a structure that supports each of the four industry sectors with “superior, effective and efficient selling, distribution, shelving, pricing execution and merchandising— every day, every week—in every store.” The SMOs are staffed with employees representing 140 different nation- alities. At the same time, fewer than 1 percent of job appli- cants actually get a job offer from P&G. There is strength in architecture (structure, people, incentives and control, culture, processes) at P&G.

Sources: “Global Structure and Governance,” www.pg.com, accessed June 21, 2015; J. Neff, “Biggest Ad Spender P&G Has New North America Media Chief,” Advertising Age, January 15, 2015; “Around 100 Brands to Be Dropped by Procter and Gamble to Boost Sales,” Cincinnati News.Net, August 1, 2014; S. Ng, “P&G CEO Lafley Lays Groundwork for Exit,” The Wall Street Journal, April 13, 2015.

O P E N I N G C A S E Procter & Gamble Company, more well known simply as P&G, is a force in the global marketplace. P&G is the biggest U.S. advertiser at some $5 billion annually, and it spends a staggering $9 billion annually worldwide on advertisement. Beyond ad spending, P&G is also the world’s largest maker of household products. It is a very large company with more than $80 billion in annual sales and with a net worth (some- times referred to as “market capitalization”) greater than the gross domestic product (GDP) of most countries. P&G markets products in more than 180 countries. Geographically, these 180 countries are divided into the core markets of Asia; Europe; India, the Middle East, and Africa; Latin America; and North America. The company sells products to about 5 billion of the world’s 7 billion people. P&G organizes its many products into four industry-based sectors: (1) Baby, Feminine and Family Care; (2) Beauty, Hair and Personal Care; (3) Fabric and Home Care; and (4) Health and Grooming. In fact, P&G states that “we have made P&G’s organization structure an important part of our capability to grow . . . it combines global scale benefits with a local focus to win with consumers and retail customers in each country where P&G products are sold.” To best serve the global markets, P&G decided in 2014 that it would cut around 100 brands from its portfolio and focus on its core remaining 80 brands, which generated 95 percent of the company’s profits. Alan “A.G.” Lafley, then the company’s board chair, president, and CEO, said, “this will be a much simpler, much less complex company of leading brands that’s easier to manage and operate.” In the middle of 2015, the company was about halfway through cutting the announced 100 brands (including well- known names like Duracell batteries).

Introduction

The story of P&G, which is profiled in the opening case, is similar to that of many multi- nationals over the past several decades. Originally P&G pursued a localization strategy (see Chapter 13). It implemented this strategy through strong Market Development Orga- nizations. By the mid-2000s, however, this organizational structure was not working well. In response, P&G changed the strategy name to Selling and Market Operations (SMOs). The SMOs represent more than just a name change. They clarify the work P&G needs to do in the global marketplace. As outlined in the opening case, the focus is on superior, effective, and efficient selling, distribution, shelving, pricing execution, and merchandising. As of 2014, P&G is structured into four industry-based sectors (Baby, Feminine and Family Care; Beauty, Hair and Personal Care; Fabric and Home Care; and Health and Grooming) and five SMOs (Asia; Europe; India, the Middle East, and Africa; Latin America; and North America).

In response, P&G reorganized to give more power, responsibility, and accountability to the global business SMOs. At the same time, P&G continued to recognize the importance

394 Part 5 The Strategy and Structure of International Business

of countries for purposes of culturally interfacing with customers and ensuring coop- eration on local projects, but management wanted to make sure that ultimately country operations served the best interests of the overall global business. By making these changes, P&G was trying to reap the gains from globalization, particularly with regard to realizing the scale and location economies that come from optimally configuring the global value chain for a business while continuing to recognize the importance of local responsiveness. In the language of the last chapter, P&G was shifting its organization to try and become more of a transnational enterprise; it was moving from a localization strategy to a transnational strategy, and the change in organization reflected this.

As suggested by the P&G example, this chapter is concerned with identifying the orga- nizational architecture that international businesses use to manage and direct their global operations. By organizational architecture we mean the totality of a firm’s organization, including formal organizational structure, control systems and incentives, processes, orga- nizational culture, and people. The core argument outlined in this chapter is that superior enterprise profitability requires three conditions to be fulfilled. First, the different elements of a firm’s organizational architecture must be internally consistent. For example, the control and incentive systems used in the firm must be consistent with the structure of the enterprise. Second, the organizational architecture must match or fit the strategy of the firm—strategy and architecture must be consistent.1 For example, if a firm is pursuing a global standardization strategy but has the wrong kind of organizational architecture in place, it is unlikely that it will be able to execute that strategy effectively and poor perfor- mance may result. The strategy and architecture of the firm must not only be consistent with each other but also make sense given the competitive conditions prevailing in the firm’s markets—strategy, architecture, and competitive environment must all be consis- tent. For example, a firm pursuing a localization strategy might have the right kind of organizational architecture in place for that strategy. However, if it competes in markets where cost pressures are intense and demands for local responsiveness are low, it will still have inferior performance because a global standardization strategy is more appropriate in such an environment.

To explore the issues illustrated by examples such as P&G, this chapter opens by discuss- ing in more detail the concepts of organizational architecture and fit. Next, it turns to a more detailed exploration of various components of architecture—structure, control systems and incentives, organizational culture, and processes—and explains how these compo- nents must be internally consistent. (We discuss the “people” component of architecture in Chapter 19, where we discuss human resource strategy in the multinational firm.) After reviewing the various components of architecture, we look at the ways in which architec- ture can be matched to strategy and the competitive environment to achieve high perfor- mance. The chapter closes with a discussion of organizational change, for as the P&G example illustrates, periodically firms have to change their organization so that it matches new strategic and competitive realities.

Organizational Architecture

As noted in the introduction, the term organizational architecture refers to the totality of a firm’s organization, including formal organizational structure, control systems and incen- tives, organizational culture, processes, and people.2 Figure 14.1 illustrates these different elements. By organizational structure, we mean three things: First, the formal division of the organization into subunits such as product divisions, national operations, and func- tions (most organizational charts display this aspect of structure); second, the location of decision-making responsibilities within that structure (e.g., centralized or decentralized); and third, the establishment of integrating mechanisms to coordinate the activities of subunits, including cross-functional teams and pan-regional committees.

Control systems are the metrics used to measure the performance of subunits and make judgments about how well managers are running those subunits. For example, historically

LO 14 -1 Explain what is meant by organizational architecture.

The Organization of International Business Chapter 14 395

Unilever measured the performance of national operating subsidiary companies according to profitability—profitability was the metric. Incentives are the devices used to reward appropriate managerial behavior. Incentives are very closely tied to performance metrics. For example, the incentives of a manager in charge of a national operating subsidiary might be linked to the performance of that company. Specifically, she might receive a bonus if her subsidiary exceeds its performance targets.

Processes are the manner in which decisions are made and work is performed within the organization. Examples are the processes for formulating strategy, for deciding how to allocate resources within a firm, or for evaluating the performance of managers and giving feedback. Processes are conceptually distinct from the location of decision-making responsibilities within an organization, although both involve decisions. While the CEO might have ultimate responsibility for deciding what the strategy of the firm should be (i.e., the decision-making responsibility is centralized), the process he or she uses to make that decision might include the solicitation of ideas and criticism from lower-level managers.

Organizational culture refers to the norms and value systems that are shared among the employees of an organization. Just as societies have cultures (see Chapter 4 for details), so do organizations. Organizations can be viewed as societies of individuals who come together to perform collective tasks. They have their own distinctive patterns of culture and subculture.3 As we shall see, organizational culture can have a profound impact on how a firm performs. Finally, by people we mean not only the employees of the organi- zation but also the strategy used to recruit, compensate, and retain those individuals and the type of people that they are in terms of their skills, values, and orientation (discussed in depth in Chapter 19).

As illustrated by the arrows in Figure 14.1, the various components of an organization’s architecture are not independent of each other: Each component shapes, and is shaped by, other components of architecture. An obvious example is the strategy regarding people. This can be used proactively to hire individuals whose internal values are consistent with those that the firm wishes to emphasize in its organizational culture. Thus, the people component of architecture can be used to reinforce (or not) the prevailing culture of the organization. For example, Unilever has historically made an effort to hire managers who were sociable and placed a high value on consensus and cooperation, values that the enter- prise wished to emphasize in its own culture.4 P&G has made a concerted effort to hire people from countries in which it has operations; some 140 nationalities are represented in P&G’s workforce compared with the 180 countries in which it sells products. If a firm is going to maximize its profitability, it must pay close attention to achieving internal consistency between the various components of its architecture.

F I G U R E 1 4 . 1

Organizational architecture.

Processes Incentives

and Controls

Structure

People

Culture

TEST PREP Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

396 Part 5 The Strategy and Structure of International Business

Organizational Structure

Organizational structure can be thought of in terms of three dimensions: (1) vertical differ- entiation, which refers to the location of decision-making responsibilities within a structure; (2) horizontal differentiation, which refers to the formal division of the organization into subunits; and (3) integrating mechanisms, which are mechanisms for coordinating subunits.

VERTICAL DIFFERENTIATION: CENTRALIZATION AND DECENTRALIZATION

A firm’s vertical differentiation determines where in its hierarchy the decision-making power is concentrated.5 Are production and marketing decisions centralized in the offices of upper-level managers, or are they decentralized to lower-level managers? Where does the responsibility for R&D decisions lie? Are important strategic and financial decisions pushed down to operating units, or are they concentrated in the hands of top management? And so on. There are arguments for both centralization and decentralization.

Arguments for Centralization There are four main arguments for centralization. First, centralization can facilitate coordina- tion and integration of operations. For example, consider a firm that has a component manu- facturing operation in Taiwan and an assembly operation in Mexico. The activities of these two operations may need to be coordinated to ensure a smooth flow of products from the component operation to the assembly operation. This might be achieved by centralizing pro- duction scheduling at the firm’s head office. Second, centralization can help ensure that deci- sions are consistent with organizational objectives. When decisions are decentralized to lower-level managers, those managers may make decisions at variance with top manage- ment’s goals. Centralization of important decisions minimizes the chance of this occurring.

Third, by concentrating power and authority in one individual or a management team, centralization can give top-level managers the means to bring about needed major organi- zational changes. Fourth, centralization can avoid the duplication of activities that occurs when similar activities are carried on by various subunits within the organization. For example, many international firms centralize their R&D functions at one or two locations to ensure that R&D work is not duplicated. Production activities may be centralized at key locations for the same reason.

LO 14 -2 Describe the different organizational choices that can be made in an international business.

G L O B A L E D G E B U S I N E S S B E AT

globalEDGE has partnered with the Michigan Business Network to offer a radio show called globalEDGE Business Beat (gBB). gBB is available worldwide to more than 200 countries via globalEDGE.msu.edu. Charles W. L. Hill is a regular guest on the radio show, which is hosted by Tomas Hult (both authors of this textbook). globalEDGE Business Beat covers inter- views and discussions with a wide range of global leaders in business, government, and academe to spread the word about the latest thoughts, tools, and markets to succeed globally. Oftentimes, these interviews focus on the best organizational architecture for companies to develop to succeed globally. For example, top leaders from large organizations such as Domino’s, Saatchi and Saatchi X, and the U.S. Department of Commerce have been featured. But focus is also placed on small and medium-sized companies and their globalization efforts. Additionally, there is a segment where Tomas Hult reports on what companies are currently doing to be globally competitive and what they plan to do in the next 5 to 20 years to stay competitive (with topics representing each of the chapters in this textbook). The pod- casts are available on globalEDGE (see globaledge.msu.edu/get-connected/globaledge- business-beat for podcasts and air times).

The Organization of International Business Chapter 14 397

Arguments for Decentralization There are five main arguments for decentralization. First, top management can become overburdened when decision-making authority is centralized, and this can result in poor decisions. Decentralization gives top management time to focus on critical issues by del- egating more routine issues to lower-level managers. Second, motivational research favors decentralization. Behavioral scientists have long argued that people are willing to give more to their jobs when they have a greater degree of individual freedom and control over their work.

Third, decentralization permits greater flexibility—more rapid response to environ- mental changes—because decisions do not have to be “referred up the hierarchy” unless they are exceptional in nature. Fourth, decentralization can result in better decisions. In a decentralized structure, decisions are made closer to the spot by individuals who (pre- sumably) have better information than managers several levels up in a hierarchy (for an example of decentralization to achieve this goal, see the Management Focus on Walmart’s international division). Fifth, decentralization can increase control. Decentralization can be used to establish relatively autonomous, self-contained subunits within an organiza- tion. Subunit managers can then be held accountable for subunit performance. The more responsibility subunit managers have for decisions that impact subunit performance, the fewer excuses they have for poor performance.

Strategy and Centralization in an International Business The choice between centralization and decentralization is not absolute. Frequently it makes sense to centralize some decisions and to decentralize others, depending on the type of decision and the firm’s strategy. Decisions regarding overall firm strategy, major financial expenditures, financial objectives, and legal issues are typically centralized at the firm’s headquarters. However, operating decisions, such as those relating to produc- tion, marketing, R&D, and human resource management, may or may not be centralized depending on the firm’s strategy.

Consider firms pursuing a global standardization strategy. They must decide how to disperse the various value creation activities around the globe so location and experience economies can be realized. The head office must make the decisions about where to lo- cate R&D, production, marketing, and so on. In addition, the globally dispersed web of value creation activities that facilitates a global strategy must be coordinated. All of this creates pressures for centralizing some operating decisions.

In contrast, the emphasis on local responsiveness in firms pursuing a localization strat- egy creates strong pressures for decentralizing operating decisions to foreign subsidiar- ies. Firms pursuing an international strategy also tend to maintain centralized control over their core competencies and to decentralize other decisions to foreign subsidiaries. Typically, such firms centralize control over R&D in their home country, but decentralize operating decisions to foreign subsidiaries. For example, Microsoft Corporation, which fits the international mode, centralizes its product development activities (where its core competencies lie) at its Redmond, Washington, headquarters and decentralizes marketing activities to various foreign subsidiaries. Thus, while products are developed at home, managers in the various foreign subsidiaries have significant latitude for formulating strategies to market those products in their particular settings.6

The situation in firms pursuing a transnational strategy is more complex. The need to realize location and experience curve economies requires some degree of centralized control over global production centers. However, the need for local responsiveness dic- tates the decentralization of many operating decisions, particularly for marketing, to for- eign subsidiaries. Thus, in firms pursuing a transnational strategy, some operating decisions are relatively centralized, while others are relatively decentralized. In addition, global learning based on the multidirectional transfer of skills between subsidiaries, and between subsidiaries and the corporate center, is a central feature of a firm pursuing a transnational strategy. The concept of global learning is predicated on the notion that

M A NAG E M E N T F O C U S

When Walmart started to expand internationally in the early 1990s, it decided to set up an international division to over- see the process. The international division was based in Bentonville, Arkansas, at the company headquarters. Today the international division oversees operations for Walmart as the largest global retailer in the world of 6,400 retail units under 65 banners in 27 countries that collectively generate more than $136 billion in sales (2015). Some 800,000 Walmart employees (“associates”) work in these international positions to serve more than 100 million customers weekly. In terms of reporting structure, the division is divided into

Walmart International three regions—Europe, Asia, and the Americas—with the CEO of each region reporting to the CEO of the international division, who in turn reports to the CEO of Walmart. Initially, the senior management of the international divi- sion exerted tight centralized control over merchandising strategy and operations in different countries. The reason- ing was straightforward: Walmart’s managers wanted to make sure that international stores copied the format for stores, merchandising, and operations that had served the company so well in the United States. They believed, naively perhaps, that centralized control over merchandis- ing strategy and operations was the way to make sure this was the case. By the late 1990s, with the international division ap- proaching $20 billion in sales, Walmart’s managers con- cluded this centralized approach was not serving them well. Country managers had to get permission from their superiors in Bentonville before changing strategy and operations, and this was slowing decision making. Central- ization also produced information overload at the head- quarters, and led to some poor decisions. Walmart found that managers in Bentonville were not necessarily the best ones to decide on store layout in Mexico, merchandising strategy in Argentina, or compensation policy in the United Kingdom. The need to adapt merchandising strategy and operations to local conditions argued strongly for greater decentralization.Source: © Kpzfoto/Alamy

foreign subsidiaries within a multinational firm have significant freedom to develop their own skills and competencies. Only then can these be leveraged to benefit other parts of the organization. A substantial degree of decentralization is required if subsidiaries are going to have the freedom to do this. For this reason too, the pursuit of a transnational strategy requires a high degree of decentralization.7

HORIZONTAL DIFFERENTIATION: THE DESIGN OF STRUCTURE

Horizontal differentiation is concerned with how the firm decides to divide itself into subunits.8 The decision is normally made on the basis of function, type of business, or geographic area. In many firms, just one of these predominates, but more complex solu- tions are adopted in others. This is particularly likely in the case of multinational firms, where the conflicting demands to organize the company around different products (to realize location and experience curve economies) and different national markets (to remain locally responsive) must be reconciled.

The Structure of Domestic Firms Most firms begin with no formal structure and are run by a single entrepreneur or a small team of individuals. As they grow, the demands of management become too

398

The pivotal event that led to a change in policy at Walmart was the company’s 1999 acquisition of Britain’s ASDA supermarket chain. The ASDA acquisition added a mature and successful $14 billion operation to Walmart’s in- ternational division. The company realized that it was not appropriate for managers in Bentonville to be making all- important decisions for ASDA. Accordingly, over the next few months John Menzer, then CEO of the international division, reduced the number of staff members located in Bentonville that were devoted to international operations by 50 percent. Country leaders were given greater re- sponsibility, especially in the area of merchandising and operations. In Menzer’s own words, “We were at the point where it was time to break away a little bit. . . . You can’t run the world from one place. The countries have to drive the business. . . . The change has sent a strong message [to country managers] that they no longer have to wait for approval from Bentonville.” Although Walmart has now decentralized decisions within the international division, it is still struggling to find the right formula for managing global procurement. Ide- ally, the company would like to centralize procurement in Bentonville so that it could use its enormous purchasing power to bargain down the prices it pays suppliers. As a practical matter, however, this has not been easy to attain given that the product mix in Walmart stores has to be tailored to conditions prevailing in the local market. Cur- rently, significant responsibility for procurement remains at the country and regional level. However, Walmart would like to have a global procurement strategy such that it can negotiate on a global basis with key suppliers and can

simultaneously introduce new merchandise into its stores around the world. As merchandising and operating decisions have been decentralized, the international division has in- creasingly taken on a new role—that of identifying best practices and transferring them between countries. For example, the division has developed a knowledge man- agement system whereby stores in one country, let’s say Argentina, can quickly communicate pictures of items, sales data, and ideas on how to market and pro- mote products to stores in another country, such as Japan. The division is also starting to move personnel between stores in different countries as a way of facilitating the flow of best practices across national borders. The divi- sion is continuously trying to be innovative and move Walmart away from its U.S.-centric mentality and by leveraging ideas implemented in foreign operations to improve the efficiency and effectiveness of Walmart’s operations. This is stressed by Walmart International’s president and CEO David Cheesewright who said that “international is a growth engine for Walmart and to suc- ceed we must focus on being in good businesses and running them well.”

Sources: M. Troy, “Wal-Mart Braces for International Growth with Personnel Moves,” DSN Retailing Today, February 9, 2004, pp. 5–7; “Division Heads Let Numbers Do the Talking,” DSN Retailing Today, June 21, 2004, pp. 26–28; “The Division That Defines the Future,” DSN Retailing Today, June 2001, pp. 4–7; Walmart 2013 annual report. “Innovating for Customers All Around the World,” http://news.walmart. com/executive-viewpoints/innovating- for- our-customers-all- around-the-world, accessed June 21, 2015.

great for one individual or a small team to handle. At this point the organization is split into functions reflecting the firm’s value creation activities (e.g., production, marketing, R&D, sales). These functions are typically coordinated and controlled by top management (see Figure 14.2). Decision making in this functional structure tends to be centralized.

Buying Units Plants Branch Sales Units Accounting Units

Purchasing Manufacturing Marketing Finance

Top Management

F I G U R E 1 4 . 2

A typical functional structure.

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400 Part 5 The Strategy and Structure of International Business

Further horizontal differentiation may be required if the firm significantly diversi- fies its product offering, which takes the firm into different business areas. For exam- ple, Dutch multinational Philips Electronics NV began as a lighting company, but diversification took the company into consumer electronics (e.g., visual and audio equipment), industrial electronics (integrated circuits and other electronic compo- nents), and medical systems (MRI scanners and ultrasound systems). In such circum- stances, a functional structure can be too clumsy. Problems of coordination and control arise when different business areas are managed within the framework of a functional structure.9 For one thing, it becomes difficult to identify the profitability of each dis- tinct business area. For another, it is difficult to run a functional department, such as production or marketing, if it is supervising the value creation activities of several busi- ness areas.

To solve the problems of coordination and control, at this stage most firms switch to a product divisional structure (see Figure 14.3). With a product divisional structure, each division is responsible for a distinct product line (business area). Thus, Philips created divisions for lighting, consumer electronics, industrial electronics, and medical systems. Each product division is set up as a self-contained, largely autonomous entity with its own functions. The responsibility for operating decisions is typically decentralized to product divisions, which are then held accountable for their performance. Headquarters is responsible for the overall strategic development of the firm and for the financial control of the various divisions.

The International Division When firms initially expand abroad, they often group all their international activities into an international division. This has tended to be the case for firms organized on the basis of functions and for firms organized on the basis of product divisions. Regardless of the firm’s domestic structure, its international division tends to be organized on geography. Figure 14.4 illustrates this for a firm whose domestic organization is based on product divisions.

Many manufacturing firms expanded internationally by exporting the product manufactured at home to foreign subsidiaries to sell. Thus, in the firm illustrated in Figure 14.4, the subsidiaries in countries 1 and 2 would sell the products manufactured by divisions A, B, and C. In time, however, it might prove viable to manufacture the prod- uct in each country, and so production facilities would be added on a country-by-country basis. For firms with a functional structure at home, this might mean replicating the func- tional structure in every country in which the firm does business. For firms with a divi- sional structure, this might mean replicating the divisional structure in every country in which the firm does business.

Buying Units Plants Branch Sales Units Accounting Units

Department Purchasing

Department Marketing

Department Manufacturing

Department Finance

Division Product Line B Division Product Line CDivision Product Line A

Headquarters

F I G U R E 1 4 . 3

A typical product divisional structure.

The Organization of International Business Chapter 14 401

This structure has been widely used; according to a Harvard study, 60 percent of all firms that have expanded internationally have initially adopted it. A good example of a company that uses this structure is Walmart, which created an international division in 1993 to manage its global expansion (Walmart’s international division is profiled in the Management Focus). Despite its popularity, an international division structure can give rise to problems.10 The dual structure it creates contains inherent potential for conflict and coordination problems between domestic and foreign operations. One problem with the structure is that the heads of foreign subsidiaries are not given as much voice in the organization as the heads of domestic functions (in the case of functional firms) or divi- sions (in the case of divisional firms). Rather, the head of the international division is presumed to be able to represent the interests of all countries to headquarters. This effectively relegates each country’s manager to the second tier of the firm’s hierarchy, which is inconsistent with a strategy of trying to expand internationally and build a true multinational organization.

Another problem is the implied lack of coordination between domestic operations and foreign operations, which are isolated from each other in separate parts of the structural hierarchy. This can inhibit the worldwide introduction of new products, the transfer of core competencies between domestic and foreign operations, and the consolidation of global production at key locations so as to realize location and experience curve economies.

As a result of such problems, many firms that continue to expand internationally aban- don this structure and adopt one of the worldwide structures discussed next. The two initial choices are a worldwide product divisional structure, which tends to be adopted by diversified firms that have domestic product divisions, and a worldwide area structure, which tends to be adopted by undiversified firms whose domestic structures are based on functions. These two alternative paths of development are illustrated in Figure 14.5. The model in the figure is referred to as the international structural stages model and was developed by John Stopford and Louis Wells.11

F I G U R E 1 4 . 4

One company’s international division structure.

Country 1

General Manager (Product A, B, and/or C)

Country 2

General Manager (Product A, B, and/or C)

Functional units

Functional units

Headquarters

Domestic Division

General Manager Product Line A

Domestic Division

General Manager Product Line B

Domestic Division

General Manager Product Line C

International Division

General Manager Area Line

402 Part 5 The Strategy and Structure of International Business

Worldwide Area Structure A worldwide area structure tends to be favored by firms with a low degree of diversifica- tion and a domestic structure based on functions (see Figure 14.6). Under this structure, the world is divided into geographic areas. An area may be a country (if the market is large enough) or a group of countries. Each area tends to be a self-contained, largely autonomous entity with its own set of value creation activities (e.g., its own production, marketing, R&D, human resources, and finance functions). Operations authority and strategic decisions relat- ing to each of these activities are typically decentralized to each area, with headquarters re- taining authority for the overall strategic direction of the firm and financial control.

This structure facilitates local responsiveness. Because decision-making responsibili- ties are decentralized, each area can customize product offerings, marketing strategy, and business strategy to the local conditions. However, this structure encourages fragmenta- tion of the organization into highly autonomous entities. This can make it difficult to transfer core competencies and skills between areas and to realize location and experi- ence curve economies. In other words, the structure is consistent with a localization strat- egy, but may make it difficult to realize gains associated with global standardization. Firms structured on this basis may encounter significant problems if local responsiveness is less critical than reducing costs or transferring core competencies for establishing a competitive advantage.

F I G U R E 1 4 . 5

The international structural stages model.

F I G U R E 1 4 . 6

A worldwide area structure.

Foreign Product Diversity

Foreign Sales as a Percentage of Total Sales

Alternate Paths of Development

Worldwide Product Division Global Matrix

("Grid")

Area DivisionInternational

Division

North American Area

Latin American Area

European Area

Headquarters

Middle Eastern– African Area

Far East Area

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Worldwide Product Divisional Structure A worldwide product division structure tends to be adopted by firms that are reason- ably diversified and, accordingly, originally had domestic structures based on product di- visions. As with the domestic product divisional structure, each division is a self-contained, largely autonomous entity with full responsibility for its own value creation activities. The headquarters retains responsibility for the overall strategic development and finan- cial control of the firm (see Figure 14.7).

Underpinning the organization is a belief that the value creation activities of each product division should be coordinated by that division worldwide. Thus, the worldwide product divisional structure is designed to help overcome the coordination problems that arise with the international division and worldwide area structures. This structure pro- vides an organizational context that enhances the consolidation of value creation activi- ties at key locations necessary for realizing location and experience curve economies. It also facilitates the transfer of core competencies within a division’s worldwide operations and the simultaneous worldwide introduction of new products. The main problem with the structure is the limited voice it gives to area or country managers, since they are seen as subservient to product division managers. The result can be a lack of local responsive- ness, which, as Chapter 13 showed, can lead to performance problems.

Global Matrix Structure Both the worldwide area structure and the worldwide product divisional structure have strengths and weaknesses. The worldwide area structure facilitates local responsiveness, but it can inhibit the realization of location and experience curve economies and the transfer of core competencies between areas. The worldwide product division structure provides a better framework for pursuing location and experience curve economies and for transferring core competencies, but it is weak in local responsiveness. Other things being equal, this suggests that a worldwide area structure is more appropriate if the firm is pursuing a localization strategy, while a worldwide product divisional structure is more appropriate for firms pursuing global standardization or international strategies. However, as we saw in Chapter 13, other things are not equal. As Bartlett and Ghoshal have argued, to survive in some industries, firms must adopt a transnational strategy. That is, they must focus simultaneously on realizing location and experience curve econ- omies, on local responsiveness, and on the internal transfer of core competencies (world- wide learning).12

F I G U R E 1 4 . 7

A worldwide product divisional structure.

Functional Units Functional Units

Headquarters

Worldwide Product Group or Division A

Worldwide Product Group or Division B

Worldwide Product Group or Division C

Area 1

(Domestic)

Area 2

(International)

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Some firms have attempted to cope with the conflicting demands of a transnational strategy by using a matrix structure. In the classic global matrix structure, horizontal differentiation proceeds along two dimensions: product division and geographic area (see Figure 14.8). The philosophy is that responsibility for operating decisions pertaining to a particular product should be shared by the product division and the various areas of the firm. Thus, the nature of the product offering, the marketing strategy, and the business strategy to be pursued in area 1 for the products produced by division A are determined by conciliation between division A and area 1 management. It is believed that this dual decision-making responsibility should enable the firm to simultaneously achieve its par- ticular objectives. In a classic matrix structure, giving product divisions and geographic areas equal status within the organization reinforces the idea of dual responsibility. Indi- vidual managers thus belong to two hierarchies (a divisional hierarchy and an area hierarchy) and have two bosses (a divisional boss and an area boss).

ABB (Asea Brown Boveri), a large multinational corporation operating in robotics and the power and automation technology areas, was one of the initial “global matrix” com- panies. After the merger of Swedish Asea with the Swiss Brown Boveri to create ABB, the company strategically opted to create a global matrix structure to leverage synergies and to be a truly “global” company. Inspiration for the global matrix came from the 1960s and U.S. president John F. Kennedy’s space program (National Aeronautics and Space Administration, or NASA), which instituted a matrix organization to create syner- gies in energy, creativity, and decision making, and also Dow Chemical’s early entry into this form of global matrix structure (see the accompanying Management Focus). How- ever, ABB has since reorganized several times in search of an optimal organizational architecture. Oftentimes, as ABB has found out, running a company as an organizational global matrix is perhaps founded in structure and authoritative linkages across company hierarchy but its success in reality depends on people’s knowledge and skills to make the global matrix work.

The reality of the global matrix structure is that it often does not work as well as the theory predicts. In practice, the matrix often is clumsy and bureaucratic. It can require so many meetings that it is difficult to get any work done. The need to get an area and a product division to reach a decision can slow decision making and produce an inflexible organization unable to respond quickly to market shifts or to innovate. The dual-hierarchy structure can lead to conflict and perpetual power struggles between the areas and the product divisions, catching many managers in the middle. To make matters worse, it

Headquarters

Area 1 Area 2 Area 3

Product Division A

Product Division B

Product Division C

Manager Here Belongs to Division B and Area 2

F I G U R E 1 4 . 8

A global matrix structure.

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can prove difficult to ascertain accountability in this structure. When all critical deci- sions are the product of negotiation between divisions and areas, one side can always blame the other when things go wrong. As a manager in one global matrix structure, re- flecting on a failed product launch, said to the author, “Had we been able to do things our way, instead of having to accommodate those guys from the product division, this would never have happened.” (A manager in the product division expressed similar sentiments.) The result of such finger-pointing can be that accountability is compromised, conflict is enhanced, and headquarters loses control over the organization. (See the accompanying Management Focus on Dow Chemical for an example of the problems associated with a matrix structure.)

In light of these problems, many firms that pursue a transnational strategy have tried to build “flexible” matrix structures based more on enterprisewide management knowledge networks, and a shared culture and vision, than on a rigid hierarchical arrangement. Within such companies the informal structure plays a greater role than the formal structure. We discuss this issue when we consider informal integrating mechanisms in the next section.

INTEGRATING MECHANISMS

The previous section explained that firms divide themselves into subunits. One way of co- ordinating these subunits is through centralization. If the coordination task is complex, however, centralization may not be very effective. Higher-level managers responsible for achieving coordination can soon become overwhelmed by the volume of work required to coordinate the activities of various subunits, particularly if the subunits are large, diverse, and/or geographically dispersed. When this is the case, firms look toward integrating mech- anisms, both formal and informal, to help achieve coordination. This section introduces the various integrating mechanisms that international businesses can use. But first, we explore the need for coordination in international firms and some impediments to coordination.

Strategy and Coordination in the International Business The need for coordination between subunits varies with the strategy of the firm.13 The need for coordination is lowest in firms pursuing a localization strategy, is higher in in- ternational companies, higher still in global companies, and highest of all in transna- tional companies. Firms pursuing a localization strategy are primarily concerned with local responsiveness. Such firms are likely to operate with a worldwide area structure in which each area has considerable autonomy and its own set of value creation functions. Because each area is established as a stand-alone entity, the need for coordination be- tween areas is minimized.

The need for coordination is greater in firms pursuing an international strategy and trying to profit from the transfer of core competencies and skills between units at home and abroad. Coordination is necessary to support the transfer of skills and product offer- ings between units. The need for coordination is also great in firms trying to profit from location and experience curve economies, that is, in firms pursuing global standardiza- tion strategies. Achieving location and experience curve economies involves dispersing value creation activities to various locations around the globe. The resulting global web of activities must be coordinated to ensure the smooth flow of inputs into the value chain, the smooth flow of semifinished products through the value chain, and the smooth flow of finished products to markets around the world.

The need for coordination is greatest in transnational firms, which simultaneously pursue location and experience curve economies, local responsiveness, and the multidi- rectional transfer of core competencies and skills among all the firm’s subunits (referred to as global learning). As with a global standardization strategy, coordination is required to ensure the smooth flow of products through the global value chain. As with an interna- tional strategy, coordination is required for ensuring the transfer of core competencies to subunits. However, the transnational goal of achieving multidirectional transfer of com- petencies requires much greater coordination than in firms pursuing an international

strategy. In addition, a transnational strategy requires coordination between foreign sub- units and the firm’s globally dispersed value creation activities (e.g., production, R&D, marketing) to ensure that any product offering and marketing strategy is sufficiently cus- tomized to local conditions.

Impediments to Coordination Managers of the various subunits have different orientations, partly because they have different tasks. For example, production managers are typically concerned with produc- tion issues such as capacity utilization, cost control, and quality control, whereas market- ing managers are concerned with marketing issues such as pricing, promotions, distribution, and market share. These differences can inhibit communication between the managers. Quite simply, these managers often do not even “speak the same language.” There may also be a lack of respect between subunits (e.g., marketing managers “looking down on” production managers, and vice versa), which further inhibits the communication required to achieve cooperation and coordination.

Differences in subunits’ orientations also arise from their differing goals. For exam- ple, worldwide product divisions of a multinational firm may be committed to cost goals that require global production of a standardized product, whereas a foreign subsidiary

M A NAG E M E N T F O C U S

A select few companies are major players globally in the chemical industry. These companies include Dow Chemi- cal, BASF, Bayer, DuPont, ExxonMobil, Formosa, Mitsubishi, and Shell. It is an industry that often takes heavy invest- ment, knowledge, and skills. At the same time, the barri- ers to the free flow of chemical products between nations largely disappeared several decades ago. This along with the commodity nature of most bulk chemicals has ush- ered in a prolonged period of intense price competition among the companies in the industry. In such a competi- tive environment, the company that wins the competitive race is the one with the lowest costs. The Dow Chemical Company, usually referred to as just Dow (which is the same as its stock symbol),   was long among the cost leaders. For years, beginning in the 1970s, Dow’s managers in- sisted that part of the credit should be placed at the feet of its “matrix” organization. Dow’s organizational matrix had three interacting elements: functions (e.g., R&D, manufacturing, marketing), businesses (e.g., ethylene, plastics, pharmaceuticals), and geography (e.g., Spain, Germany, Brazil). Managers’ job titles incorporated all three elements—for example, plastics marketing manager for Spain—and most managers reported to at least two bosses. The plastics marketing manager in Spain might report to both the head of the worldwide plastics business

Dow—(Failed) Early Global Matrix Adopter and the head of the Spanish operations. The intent of the matrix was to make Dow operations responsive to both local market needs and corporate objectives. Thus, the plastics business might be charged with minimizing Dow’s global plastics production costs, while the Spanish opera- tion might be charged with determining how best to sell plastics in the Spanish market. When Dow introduced this matrix structure as one of the first large multinational corporations to do so, the re- sults were less than promising; multiple reporting chan- nels led to confusion and conflict. The large number of bosses made for an unwieldy bureaucracy. The overlap- ping responsibilities resulted in turf battles and a lack of accountability. Area managers disagreed with managers overseeing business sectors about which plants should be built and where. In short, the structure didn’t work. In- stead of abandoning the structure, however, Dow decided to see if it could be made more flexible. After all, Dow wanted to draw on its people’s knowledge and skills in the fullest manner possible, and a matrix structure would do just that it thought. Dow’s decision to keep its matrix structure was prompted by its move into the pharmaceuticals industry. The company realized that the pharmaceutical business is very different from the bulk chemicals business. In bulk chemicals, the big returns come from achieving

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may be committed to increasing its market share in its country, which will require a non- standard product. These different goals can lead to conflict.

Such impediments to coordination are not unusual in any firm, but they can be particu- larly problematic in the multinational enterprise with its profusion of subunits at home and abroad. Differences in subunit orientation are often reinforced in multinationals by the separations of time zone, distance, and nationality between managers of the subunits.

Formal Integrating Mechanisms The formal mechanisms used to integrate subunits vary in complexity from simple direct contact and liaison roles, to teams, to a matrix structure (see Figure 14.9). In general, the greater the need for coordination, the more complex the formal integrating mechanisms need to be.14

Direct contact between subunit managers is the simplest integrating mechanism. By this “mechanism,” managers of the various subunits simply contact each other whenever they have a common concern. Direct contact may not be effective if the managers have differing orientations that act to impede coordination, as pointed out in the previous subsection.

Liaison roles are a bit more complex. When the volume of contacts between subunits increases, coordination can be improved by giving a person in each subunit responsibility

economies of scale in production. This dictates estab- lishing large plants in key locations from which regional or global markets can be served. But in pharmaceuticals, regulatory and marketing requirements for drugs vary so much from country to country that local needs are far more important than reducing manufacturing costs through scale economies. A high degree of local re- sponsiveness is essential. Dow realized its pharmaceuti- cal business would never thrive if it were managed by the same priorities as its mainstream chemical operations. Accordingly, instead of abandoning its matrix, Dow decided to make it more flexible so it could better accom- modate the different businesses, each with its own priorities, within a single management system. A small team of senior executives at headquarters helped set the priorities for each type of business. After priorities were identified for each business sector, one of the three ele- ments of the matrix—function, business, or geographic area—was given primary authority in decision making. Which element took the lead varied according to the type of decision and the market or location in which the company was competing. Such flexibility required that all employees understand what was occurring in the rest of the matrix. Although this may seem confusing, for years Dow claimed this flexible system worked well and credited much of its success to the quality of the decisions it facilitated. By the mid-1990s, however, Dow had refocused its business on the chemicals industry, divesting itself of

its pharmaceutical activities where the company’s performance had been unsatisfactory. Reflecting the change in corporate strategy, in 1995 Dow decided to abandon its matrix structure in favor of a more stream- lined structure based on global business divisions. The change was also driven by the realization that the matrix structure was just too complex and costly to manage in the intense competitive environment of the 1990s, particularly given the company’s renewed focus on its commodity chemicals where competitive advan- tage often went to the low-cost producer. As Dow’s then CEO put it in a 1999 interview, “We were an orga- nization that was matrixed and depended on teamwork, but there was no one in charge. When things went well, we didn’t know whom to reward; and when things went poorly, we didn’t know whom to blame. So we cre- ated a global divisional structure, and cut out layers of management. There used to be 11 layers of manage- ment between me and the lowest-level employees, now there are five.” In short, Dow ultimately found that a matrix structure was unsuited to a company that was competing in very cost-competitive global industries, and it had to abandon its matrix to drive down operat- ing costs.

Sources: “Dow Draws Its Matrix Again, and Again, and Again,” The Economist, August 5, 1989, pp. 55–56; “Dow Goes for Global Struc- ture,” Chemical Marketing Reporter, December 11, 1995, pp. 4–5; R. M. Hodgetts, “Dow Chemical CEO William Stavropoulos on Structure and Decision Making,” Academy of Management Executive, November 1999, pp. 29–35.

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for coordinating with another subunit on a regular basis. Through these roles, the people involved establish a permanent relationship. This helps attenuate the impediments to coordination discussed in the previous subsection.

When the need for coordination is greater still, firms tend to use temporary or perma- nent teams composed of individuals from the subunits that need to achieve coordination. They typically coordinate product development and introduction, but they are useful when any aspect of operations or strategy requires the cooperation of two or more sub- units. Product development and introduction teams are typically composed of personnel from R&D, production, and marketing. The resulting coordination aids the development of products that are tailored to consumer needs and that can be produced at a reasonable cost (design for manufacturing).

When the need for integration is very high, firms may institute a matrix structure, in which all roles are viewed as integrating roles. The structure is designed to facilitate maximum integration among subunits. The most common matrix in multinational firms is based on geographic areas and worldwide product divisions. This achieves a high level of integration between the product divisions and the areas so that, in theory, the firm can pay close attention to both local responsiveness and the pursuit of location and experience curve economies.

In some multinationals, the matrix is more complex still, structuring the firm into geographic areas, worldwide product divisions, and functions, all of which report directly to headquarters. Thus, within a company such as Dow Chemical before it abandoned its matrix in the mid-1990s (see the Management Focus), each manager belonged to three hierarchies. For example, a plastics marketing manager in Spain was a member of the Spanish subsidiary, the plastics product division, and the marketing function. In addition to facilitating local responsiveness and location and experience curve economies, such a matrix fosters the transfer of core competencies within the organization. This occurs be- cause core competencies tend to reside in functions (e.g., R&D, marketing). A structure such as this in theory facilitates the transfer of competencies existing in functions from division to division and from area to area.

However, as discussed earlier, such matrix solutions to coordination problems in mul- tinational enterprises can quickly become bogged down in a bureaucratic tangle that cre- ates as many problems as it solves. Matrix structures tend to be bureaucratic, inflexible, and characterized by conflict rather than the hoped-for cooperation. For such a structure to work, it needs to be flexible and to be supported by informal integrating mechanisms.15 The knowledge and skills of people are typically more important than the structural re- porting lines in the global matrix hierarchy. Integration and coordination via a matrix organization structure should not override the flexibility to make decisions based on peo- ple’s knowledge and skills.

F I G U R E 1 4 .9

Formal integrating mechanisms.

Direct Contact

Liaison Roles

Teams

Matrix Structures

Increasing Complexity of Integrating Mechanism

The Organization of International Business Chapter 14 409

Informal Integrating Mechanism: Knowledge Networks In attempting to alleviate or avoid the problems associated with formal integrating mecha- nisms in general, and matrix structures in particular, firms with a high need for integration have been experimenting with an informal integrating mechanism: knowledge networks that are supported by an organizational culture that values teamwork and cross-unit coop- eration.16 A knowledge network is a network for transmitting information within an orga- nization that is based not on formal organizational structure, but on informal contacts between managers within an enterprise and on distributed information systems.17 The great strength of such a network is that it can be used as a nonbureaucratic conduit for knowledge flows within a multinational enterprise.18 For a network to exist, managers at different locations within the organization must be linked to each other at least indirectly. For example, Figure 14.10 shows the simple network relationships between seven manag- ers within a multinational firm. Managers A, B, and C all know each other personally, as do managers D, E, and F. Although manager B does not know manager F personally, they are linked through common acquaintances (managers C and D). Thus, we can say that managers A through F are all part of the network, and also that manager G is not.

Imagine manager B is a marketing manager in Spain and needs to know the solution to a technical problem to better serve an important European customer. Manager F, an R&D manager in the United States, has the solution to manager B’s problem. Manager B mentions her problem to all of her contacts, including manager C, and asks if they know of anyone who might be able to provide a solution. Manager C asks manager D, who tells manager F, who then calls manager B with the solution. In this way, coordination is achieved informally through the network, rather than by formal integrating mechanisms such as teams or a matrix structure.

For such a network to function effectively, however, it must embrace as many manag- ers as possible. For example, if manager G had a problem similar to manager B’s, he would not be able to utilize the informal network to find a solution; he would have to re- sort to more formal mechanisms. Establishing companywide knowledge networks is dif- ficult, and although network enthusiasts speak of networks as the “glue” that binds multinational companies together, it is far from clear how successful firms have been at building companywide networks. Two techniques being used to establish networks are information systems and management development policies.

Firms are using their distributed computer and telecommunications information sys- tems to provide the foundation for informal knowledge networks.19 Electronic mail, video- conferencing, high-bandwidth data systems, and web-based search engines make it much easier for managers scattered over the globe to get to know each other, to identify contacts that might help solve a particular problem, and to publicize and share best practices within the organization. Walmart, for example, now uses its intranet system to communicate ideas about merchandising strategy between stores located in different countries.

F I G U R E 1 4 . 1 0

A simple management network.

A

B

F

E G

C D

410 Part 5 The Strategy and Structure of International Business

Firms are also using their management development programs to build informal net- works. Tactics include rotating managers through various subunits on a regular basis so they build their own informal network and using management education programs to bring managers of subunits together in a single location so they can become acquainted.

Knowledge networks by themselves may not be sufficient to achieve coordination if subunit managers persist in pursuing subgoals that are at variance with companywide goals. For a knowledge network to function properly—and for a formal matrix structure to work also—managers must share a strong commitment to the same goals. To appreci- ate the nature of the problem, consider again the case of manager B and manager F. As before, manager F hears about manager B’s problem through the network. However, solv- ing manager B’s problem would require manager F to devote considerable time to the task. Insofar as this would divert manager F away from his own regular tasks—and the pursuit of subgoals that differ from those of manager B—he may be unwilling to do it. Thus, manager F may not call manager B, and the informal network would fail to provide a solution to manager B’s problem.

To eliminate this flaw, the organization’s managers must adhere to a common set of norms and values that override differing subunit orientations.20 In other words, the firm must have a strong organizational culture that promotes teamwork and cooperation. When this is the case, a manager is willing and able to set aside the interests of his own subunit when doing so benefits the firm as a whole. If manager B and manager F are committed to the same organizational norms and value systems, and if these organiza- tional norms and values place the interests of the firm as a whole above the interests of any individual subunit, manager F should be willing to cooperate with manager B on solving her subunit’s problems.

Integrating Mechanisms Summary The message contained in this section on integrating mechanisms is crucial to understand- ing the problems of managing the multinational firm. Multinationals need integration— particularly if they are pursuing global standardization, international, or transnational strategies—but it can be difficult to achieve due to the impediments to coordination dis- cussed. Firms traditionally have tried to achieve coordination by adopting formal integrat- ing mechanisms. These do not always work, however, since they tend to be bureaucratic and do not necessarily address the problems that arise from differing subunit orientations. This is particularly likely with a complex matrix structure, and yet, a complex matrix structure is required for simultaneously achieving location and experience curve econo- mies, local responsiveness, and the multidirectional transfer of core competencies within the organization. The solution to this dilemma seems twofold. First, the firm must try to establish an informal knowledge network that can do much of the work previously under- taken by a formal matrix structure. Second, the firm must build a common culture. Neither of these partial solutions, however, is easy to achieve.21

Control Systems and Incentives

A major task of a firm’s leadership is to control the various subunits of the firm—whether they be defined on the basis of function, product division, or geographic area—to ensure their actions are consistent with the firm’s overall strategic and financial objectives. Firms achieve this with various control and incentive systems. In this section, we first review the various types of control systems firms use to control their subunits. We briefly discuss incentive systems. Then we look at how the appropriate control and incentive systems vary according to the strategy of the multinational enterprise.

TYPES OF CONTROL SYSTEMS

Four main types of control systems are used in multinational firms: personal controls, bureaucratic controls, output controls, and cultural controls. In most firms, all four are used, but their relative emphasis varies with the strategy of the firm.

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Personal Controls Personal control  is control achieved by personal contact with subordinates. This type of control tends to be most widely used in small firms, where it is seen in the direct supervi- sion of subordinates’ actions. However, it also structures the relationships between man- agers at different levels in multinational enterprises. For example, the CEO may use a great deal of personal control to influence the behavior of his or her immediate subordi- nates, such as the heads of worldwide product divisions or major geographic areas. In turn, these heads may use personal control to influence the behavior of their subordi- nates, and so on down through the organization. Jack Welch, the legendary CEO of General Electric who retired in 2001, had regular one-on-one meetings with the heads of all of GE’s major businesses (most of which are international).22 He used these meetings to probe the managers about the strategy, structure, and financial performance of their operations. In doing so, he essentially exercised personal control over these managers and, undoubtedly, over the strategies that they favored.

Bureaucratic Controls Bureaucratic control is control achieved through a system of rules and procedures that directs the actions of subunits. The most important bureaucratic controls in subunits within multinational firms are budgets and capital spending rules. Budgets are essentially a set of rules for allocating a firm’s financial resources. A subunit’s budget specifies with some precision how much the subunit may spend. Headquarters uses budgets to influence the behavior of subunits. For example, the R&D budget normally specifies how much cash the R&D unit may spend on product development. R&D managers know that if they spend too much on one project, they will have less to spend on other projects, so they modify their behavior to stay within the budget. Most budgets are set by negotiation between headquarters management and subunit management. Headquarters management can encourage the growth of certain subunits and restrict the growth of others by manipu- lating their budgets.

Capital spending rules require headquarters management to approve any capital ex- penditure by a subunit that exceeds a certain amount. A budget allows headquarters to specify the amount a subunit can spend in a given year, and capital spending rules give headquarters additional control over how the money is spent. Headquarters can be ex- pected to deny approval for capital spending requests that are at variance with overall firm objectives and to approve those that are congruent with firm objectives.

Output Controls Output control involves setting goals for subunits to achieve and expressing those goals in terms of relatively objective performance metrics such as profitability, productivity, growth, market share, and quality. The performance of subunit managers is then judged by their ability to achieve the goals.23 If goals are met or exceeded, subunit managers will be rewarded. If goals are not met, top management will normally intervene to find out why and take appropriate corrective action. Thus, control is achieved by comparing ac- tual performance against targets and intervening selectively to take corrective action. Subunits’ goals depend on their role in the firm. Self-contained product divisions or na- tional subsidiaries are typically given goals for profitability, sales growth, and market share. Functions are more likely to be given goals related to their particular activity. Thus, R&D will be given product development goals, production will be given productiv- ity and quality goals, marketing will be given market share goals, and so on.

As with budgets, goals are normally established through negotiation between subunits and headquarters. Generally, headquarters tries to set goals that are challenging but real- istic, so subunit managers are forced to look for ways to improve their operations but are not so pressured that they will resort to dysfunctional activities to do so (such as short-run profit maximization). Output controls foster a system of “management by exception,” in that so long as subunits meet their goals, they are left alone. If a subunit fails to attain its goals, however, headquarters managers are likely to ask some tough questions. If they

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don’t get satisfactory answers, they are likely to intervene proactively in a subunit, replac- ing top management and looking for ways to improve efficiency.

Cultural Controls Cultural control exists when employees “buy into” the norms and value systems of the firm. When this occurs, employees tend to control their own behavior, which reduces the need for direct supervision. In a firm with a strong culture, self-control can reduce the need for other control systems. We discuss organizational culture later. McDonald’s actively promotes organizational norms and values, referring to its franchisees and sup- pliers as partners and emphasizing its long-term commitment to them. This commitment is not just a public relations exercise; it is backed by actions, including a willingness to help suppliers and franchisees improve their operations by providing capital and/or man- agement assistance when needed. In response, McDonald’s franchisees and suppliers are integrated into the firm’s culture and thus become committed to helping McDonald’s succeed. One result is that McDonald’s can devote less time than would otherwise be necessary to controlling its franchisees and suppliers.

INCENTIVE SYSTEMS

Incentives refer to the devices used to reward appropriate employee behavior. Many em- ployees receive incentives in the form of annual bonus pay. Incentives are usually closely tied to the performance metrics used for output controls. For example, setting targets linked to profitability might be used to measure the performance of a subunit, such as a global product division. To create positive incentives for employees to work hard to ex- ceed those targets, they may be given a share of any profits above those targeted. If a subunit has set a goal of attaining a 15 percent return on investment and it actually attains a 20 percent return, unit employees may be given a share in the profits generated in ex- cess of the 15 percent target in the form of bonus pay.

We return to the topic of incentive systems in Chapter 19 when we discuss human re- source strategy in the multinational firm. For now, however, several important points need to be made. First, the type of incentive used often varies depending on the employ- ees and their tasks. Incentives for employees working on the factory floor may be very different from the incentives used for senior managers. The incentives used must be matched to the type of work being performed. The employees on the factory floor of a manufacturing plant may be broken into teams of 20 to 30 individuals, and they may have their bonus pay tied to the ability of their team to hit or exceed targets for output and product quality. In contrast, the senior managers of the plant may be rewarded according to metrics linked to the output of the entire operation. The basic principle is to make sure the incentive scheme for an individual employee is linked to an output target that he or she has some control over and can influence. The individual employees on the factory floor may not be able to exercise much influence over the performance of the entire op- eration, but they can influence the performance of their team, so incentive pay is tied to output at this level.

Second, the successful execution of strategy in the multinational firm often requires significant cooperation between managers in different subunits. For example, as noted earlier, some multinational firms operate with matrix structures where a country subsid- iary might be responsible for marketing and sales in a nation, while a global product divi- sion might be responsible for manufacturing and product development. The managers of these different units need to cooperate closely with each other if the firm is to be success- ful. One way of encouraging the managers to cooperate is to link incentives to perfor- mance at a higher level in the organization. Thus, the senior managers of the country subsidiaries and global product divisions might be rewarded according to the profitability of the entire firm. The thinking here is that boosting the profitability of the entire firm requires managers in the country subsidiaries and product divisions to cooperate with each other on strategy implementation, and linking incentive systems to the next level up

The Organization of International Business Chapter 14 413

in the hierarchy encourages this. Most firms use a formula for incentives that links a por- tion of incentive pay to the performance of the subunit in which a manager or employee works and a portion to the performance of the entire firm, or some other higher-level or- ganizational unit. The goal is to encourage employees to improve the efficiency of their unit and to cooperate with other units in the organization.

Third, the incentive systems used within a multinational enterprise often have to be adjusted to account for national differences in institutions and culture. Incentive systems that work in the United States might not work, or even be allowed, in other countries. For example, Lincoln Electric, a leader in the manufacture of arc welding equipment, has used an incentive system for its employees based on piecework rates in its American fac- tories (under a piecework system, employees are paid according to the amount they pro- duce). While this system has worked very well in the United States, Lincoln has found that the system is difficult to introduce in other countries. In some countries, such as Germany, piecework systems are illegal, while in others the prevailing national culture is antagonistic to a system where performance is so closely tied to individual effort.

Finally, it is important for managers to recognize that incentive systems can have un- intended consequences. Managers need to carefully think through exactly what behavior certain incentives encourage. For example, if employees in a factory are rewarded solely on the basis of how many units of output they produce, with no attention paid to the qual- ity of that output, they may produce as many units as possible to boost their incentive pay, but the quality of those units may be poor.

CONTROL SYSTEMS, INCENTIVES, AND STRATEGY IN THE INTERNATIONAL BUSINESS

The key to understanding the relationship between international strategy, control sys- tems, and incentive systems is the concept of performance ambiguity.

Performance Ambiguity Performance ambiguity exists when the causes of a subunit’s poor performance are not clear. This is not uncommon when a subunit’s performance is partly dependent on the performance of other subunits, that is, when there is a high degree of interdependence between subunits within the organization. Consider the case of a French subsidiary of a U.S. firm that depends on another subsidiary, a manufacturer based in Italy, for the prod- ucts it sells. The French subsidiary is failing to achieve its sales goals, and the U.S. man- agement asks the managers to explain. They reply that they are receiving poor-quality goods from the Italian subsidiary. The U.S. management asks the managers of the Italian operation what the problem is. They reply that their product quality is excellent—the best in the industry, in fact—and that the French simply don’t know how to sell a good prod- uct. Who is right, the French or the Italians? Without more information, top management cannot tell. Because they are dependent on the Italians for their product, the French have an alibi for poor performance. U.S. management needs to have more information to deter- mine who is correct. Collecting this information is expensive and time-consuming and will divert attention away from other issues. In other words, performance ambiguity raises the costs of control.

Consider how different things would be if the French operation were self-contained, with its own manufacturing, marketing, and R&D facilities. The French operation would lack a convenient alibi for its poor performance; the French managers would stand or fall on their own merits. They could not blame the Italians for their poor sales. The level of performance ambiguity, therefore, is a function of the interdependence of subunits in an organization.

Strategy, Interdependence, and Ambiguity Now let us consider the relationships between strategy, interdependence, and perfor- mance ambiguity. In firms pursuing a localization strategy, each national operation is a

414 Part 5 The Strategy and Structure of International Business

stand-alone entity and can be judged on its own merits. The level of performance ambigu- ity is low. In an international firm, the level of interdependence is somewhat higher. Inte- gration is required to facilitate the transfer of core competencies and skills. Since the success of a foreign operation is partly dependent on the quality of the competency trans- ferred from the home country, performance ambiguity can exist.

In firms pursuing a global standardization strategy, the situation is still more complex. Recall that in a pure global firm the pursuit of location and experience curve economies leads to the development of a global web of value creation activities. Many of the activi- ties in a global firm are interdependent. A French subsidiary’s ability to sell a product does depend on how well other operations in other countries perform their value creation activities. Thus, the levels of interdependence and performance ambiguity are high in global companies.

The level of performance ambiguity is highest of all in transnational firms. Transna- tional firms suffer from the same performance ambiguity problems that global firms do. In addition, since they emphasize the multidirectional transfer of core competen- cies, they also suffer from the problems characteristic of firms pursuing an interna- tional strategy. The extremely high level of integration within transnational firms implies a high degree of joint decision making, and the resulting interdependencies create plenty of alibis for poor performance. There is lots of room for finger-pointing in transnational firms.

Implications for Control and Incentives The arguments of the previous section, along with the implications for the costs of con- trol, are summarized in Table 14.1. The costs of control can be defined as the amount of time top management must devote to monitoring and evaluating subunits’ performance. This is greater when the amount of performance ambiguity is greater. When performance ambiguity is low, management can use output controls and a system of management by exception; when it is high, managers have no such luxury. Output controls do not provide totally unambiguous signals of a subunit’s efficiency when the performance of that sub- unit is dependent on the performance of another subunit within the organization. Thus, management must devote time to resolving the problems that arise from performance ambiguity, with a corresponding rise in the costs of control.

Table 14.1 reveals a paradox. We saw in Chapter 13 that a transnational strategy is desirable because it gives a firm more ways to profit from international expansion than do localization, international, and global standardization strategies. But now we see that due to the high level of interdependence, the costs of controlling transnational firms are higher than the costs of controlling firms that pursue other strategies. Unless there is some way of reducing these costs, the higher profitability associated with a transnational strategy could be canceled out by the higher costs of control. The same point, although to a lesser extent, can be made with regard to firms pursuing a global standardization strat- egy. Although firms pursuing a global standardization strategy can reap the cost benefits of location and experience curve economies, they must cope with a higher level of perfor- mance ambiguity, and this raises the costs of control (in comparison with firms pursuing an international or localization strategy).

TA B L E 1 4 . 1

Interdependence, Performance Ambiguity, and the Costs of Control for the Four International Business Strategies

Performance Costs of Strategy Interdependence Ambiguity Control Localization Low Low Low

International Moderate Moderate Moderate

Global High High High

Transnational Very high Very high Very high

The Organization of International Business Chapter 14 415

This is where control systems and incentives come in. When we survey the systems that corporations use to control their subunits, we find that irrespective of their strategy, multinational firms all use output and bureaucratic controls. However, in firms pursuing either global or transnational strategies, the usefulness of output controls is limited by substantial performance ambiguities. As a result, these firms place greater emphasis on cultural controls. Cultural control—by encouraging managers to want to assume the orga- nization’s norms and value systems—gives managers of interdependent subunits an in- centive to look for ways to work out problems that arise between them. The result is a reduction in finger-pointing and, accordingly, in the costs of control. The development of cultural controls may be a precondition for the successful pursuit of a transnational strat- egy and perhaps of a global strategy as well.24 As for incentives, the material discussed earlier suggests that the conflict between different subunits can be reduced and the poten- tial for cooperation enhanced if incentive systems are tied in some way to a higher level in the hierarchy. When performance ambiguity makes it difficult to judge the perfor- mance of subunits as stand-alone entities, linking the incentive pay of senior managers to the entity to which both subunits belong can reduce the resulting problems.

Processes

Processes, defined as the manner in which decisions are made and work is performed within the organization, can be found at many different levels within an organization.25 There are processes for formulating strategy, processes for allocating resources, pro- cesses for evaluating new-product ideas, processes for handling customer inquiries and complaints, processes for improving product quality, processes for evaluating employee performance, and so on. Often, the core competencies or valuable skills of a firm are embedded in its processes. Efficient and effective processes can lower the costs of value creation and add additional value to a product. For example, the global success of many Japanese manufacturing enterprises in the 1980s was based in part on their early adop- tion of processes for improving product quality and operating efficiency, including total quality management and just-in-time inventory systems. Today, the competitive success of General Electric can in part be attributed to a number of processes that have been widely promoted within the company. These include the company’s Six Sigma process for quality improvement, its process for “digitalization” of business (using corporate in- tranets and the Internet to automate activities and reduce operating costs), and its process for idea generation, referred to within the company as “workouts,” where managers and employees get together for intensive sessions over several days to identify and commit to ideas for improving productivity.

An organization’s processes can be summarized by means of a flow chart, which illus- trates the various steps and decision points involved in performing work. Many processes cut across functions, or divisions, and require cooperation between individuals in differ- ent subunits. For example, product development processes require employees from R&D, manufacturing, and marketing to work together in a cooperative manner to make sure new products are developed with market needs in mind and designed in such a way that they can be manufactured at a low cost. Because they cut across organizational boundaries, performing processes effectively often requires the establishment of formal integrating mechanisms and incentives for cross-unit cooperation.

A detailed consideration of the nature of processes and strategies for process improve- ment and reengineering is beyond the scope of this book. However, it is important to make two basic remarks about managing processes, particularly in the context of an in- ternational business.26 The first is that in a multinational enterprise, many processes cut not only across organizational boundaries, embracing several different subunits, but also across national boundaries. Designing a new product may require the cooperation of R&D personnel located in California, production people located in Taiwan, and market- ing located in Europe, America, and Asia. The chances of pulling this off are greatly

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416 Part 5 The Strategy and Structure of International Business

enhanced if the processes are embedded in an organizational culture that promotes coop- eration between individuals from different subunits and nations, if the incentive systems of the organization explicitly reward such cooperation, and if formal and informal inte- grating mechanisms are used to facilitate coordination between subunits.

Second, it is particularly important for a multinational enterprise to recognize that valuable new processes that might lead to a competitive advantage can be developed any- where within the organization’s global network of operations.27 New processes may be developed by a local operating subsidiary in response to conditions pertaining to its mar- ket. Those processes might then have value to other parts of the multinational enterprise. The ability to create valuable processes matters, but it is also important to leverage those processes. This requires both formal and informal integrating mechanisms such as knowledge networks.

Organizational Culture

Chapter 4 applied the concept of culture to countries. Culture, however, is also a social construct ascribed to societies, including organizations.28 Thus, we can speak of organiza- tional culture and subcultures. The basic definition of culture remains the same, whether we are applying it to a macro (large) society such as a country, or subcultures within coun- tries, or a micro (small) society such as an organization or one of its subunits. Culture re- fers to a system of values and norms that are shared among people. Values are abstract ideas about what a group believes to be good, right, and desirable. Norms mean the social rules and guidelines that prescribe appropriate behavior in particular situations.

Values and norms express themselves as the behavior patterns or style of an organiza- tion that new employees are automatically encouraged to follow by their fellow employees. Although an organization’s culture is rarely static, it tends to change relatively slowly. Cultural changes often come from doing something or behaving a certain way over time. Seldom do we adopt a cultural change, and then behaviors ensue without having ever been done before. Instead, repeated behaviors lead to revised values and norms, which, in turn, emphasize the new cultural makeup (whether it be at the country or organizational level).

CREATING AND MAINTAINING ORGANIZATIONAL CULTURE

An organization’s culture comes from several sources. First, there seems to be wide agreement that founders or important leaders can have a profound impact on an organiza- tion’s culture, often imprinting their own values on the culture.29 A famous example of a strong founder effect concerns the Japanese firm Matsushita. Konosuke Matsushita’s al- most Zen-like personal business philosophy was codified in the “Seven Spiritual Values” of Matsushita that all new employees still learn today. These values are (1) national ser- vice through industry, (2) fairness, (3) harmony and cooperation, (4) struggle for better- ment, (5) courtesy and humility, (6) adjustment and assimilation, and (7) gratitude. A leader does not have to be the founder to have a profound influence on organizational culture. Jack Welch is widely credited with having changed the culture of GE when he first became CEO, primarily by emphasizing a countercultural set of values, such as risk taking, entrepreneurship, stewardship, and boundaryless behavior. It is more difficult for a leader, however forceful, to change an established organizational culture than it is to create one from scratch in a new venture. A blank slate on culture allows for the estab- lishment of desired values and norms, while an existing culture and any change desired often results from implemented behaviors over time.

Another important influence on organizational culture is the broader social culture of the nation where the firm was founded and/or has significant operations. In the United States, for example, the competitive ethic of individualism looms large and there is enor- mous social stress on producing winners. Many American firms find ways of rewarding and motivating individuals so that they see themselves as winners.30 The values of American firms often reflect the values of American culture. Similarly, the cooperative values found in many Japanese firms have been argued to reflect the values of traditional Japanese society,

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The Organization of International Business Chapter 14 417

with its emphasis on group cooperation, reciprocal obligations, and harmony.31 Thus, although it may be a generalization, there may be something to the argument that organizational culture is influenced by national culture. This influence is particularly tricky in countries that are by design going through significant culture change (e.g., many eastern European countries). For example, China is more and more moving toward a market-based economy, while still having significant influence from the Communist system; such an economy can create inconsistent cultural makeups for companies, especially foreign com- panies trying to operate in China.

A third influence on organizational culture is the history of the enterprise, which over time may come to shape the values of the or- ganization. In the language of historians, organizational culture is the path-dependent product of where the organization has been through time. For example, Koninklijke Philips Electronics NV, the Dutch multinational, long operated with a culture that placed a high value on the independence of national operating companies. This culture was shaped by the history of the company. During World War II, the Netherlands was occupied by the Germans. With the head office in occupied territories, power was devolved by default to various for- eign operating companies, such as Philips’ subsidiaries in the United States and Great Britain. After the war ended, these subsidiaries con- tinued to operate in a highly autonomous fashion. A belief that this was the right thing to do became a core value of the company.

Decisions that subsequently result in high performance tend to be- come institutionalized in the values of a firm. In the 1920s, 3M was primarily a manufacturer of sandpaper. Richard Drew, who was a young laboratory assistant at the time, came up with what he thought would be a great new product—a glue-covered strip of paper, which he called “sticky tape.” Drew saw applications for the product in the automobile industry, where it could be used to mask parts of a vehicle during painting. He presented the idea to the company’s president, William McKnight. An unimpressed McKnight suggested that Drew drop the research. Drew didn’t; instead he developed the “sticky tape” and then went out and got endorsements from potential customers in the auto industry. Armed with this information, he approached McKnight again. A chastened McKnight re- versed his position and gave Drew the go-ahead to start developing what was to become one of 3M’s main product lines—sticky tape—a business it dominates to this day.32 From then on, McKnight emphasized the importance of giving researchers at 3M free rein to explore their own ideas and experiment with product offerings. This soon became a core value at 3M and was enshrined in the company’s famous “15 percent rule,” which stated that re- searchers could spend 15 percent of the company time working on ideas of their own choos- ing. Today, new employees are often told the Drew story, which is used to illustrate the value of allowing individuals to explore their own ideas.

Culture is maintained by a variety of mechanisms. These include (1) hiring and pro- motional practices of the organization, (2) reward strategies, (3) socialization processes, and (4) communication strategy. The goal is to recruit people whose values are consistent with those of the company. To further reinforce values, a company may promote indi- viduals whose behavior is consistent with the core values of the organization. Merit re- view processes may also be linked to a company’s values, which further reinforces cultural norms.

Socialization can be formal, such as training programs that educate employees in the core values of the organization. Informal socialization may be friendly advice from peers or bosses or may be implicit in the actions of peers and superiors toward new employees. As for communication strategy, many companies with strong cultures devote a lot of atten- tion to framing their key values in corporate mission statements, communicating them often to employees, and using them to guide difficult decisions. Stories and symbols are often used to reinforce important values (e.g., the Drew and McKnight story at 3M).

The Post-it Note was an idea that stuck. Innovation continues to be a hallmark of 3M to this day. Source: © BananaStock/Jupiterimages, RF

418 Part 5 The Strategy and Structure of International Business

ORGANIZATIONAL CULTURE AND PERFORMANCE IN THE INTERNATIONAL BUSINESS

Management authors often talk about “strong cultures.”33 In a strong culture, almost all managers share a relatively consistent set of values and norms that have a clear impact on the way work is performed. New employees adopt these values very quickly, and employees that do not fit in with the core values tend to leave. In such a culture, a new executive is just as likely to be corrected by his subordinates as by his superiors if he violates the values and norms of the organizational culture. Firms with a strong culture are normally seen by out- siders as having a certain style or way of doing things. Lincoln Electric, featured in the ac- companying Management Focus, is an example of a firm with a strong culture.

Strong does not necessarily mean good. A culture can be strong but bad. The culture of the Nazi Party in Germany was certainly strong, but it was most definitely not good. Nor does it follow that a strong culture leads to high performance. One study found that in the 1980s General Motors had a “strong culture,” but it was a strong culture that discouraged lower-level employees from demonstrating initiative and taking risks, which the authors argued was dysfunctional and led to low performance at GM.34 Also, a strong culture might be beneficial at one point, leading to high performance, but inappropriate at another time. The appropriateness of the culture depends on the context. In the 1980s, when IBM was performing very well, several management authors sang the praises of its strong cul- ture, which among other things placed a high value on consensus-based decision making.35 These authors argued that such a decision-making process was appropriate given the sub- stantial financial investments that IBM routinely made in new technology. However, this process turned out to be a weakness in the fast-moving computer industry of the late 1980s and 1990s. Consensus-based decision making was slow, bureaucratic, and not particularly conducive to corporate risk taking. While this was fine in the 1970s, IBM needed rapid decision making and entrepreneurial risk taking in the 1990s, but its culture discouraged such behavior. IBM found itself outflanked by then-small enterprises such as Microsoft.

One study concluded that firms that exhibited high performance over a prolonged pe- riod tended to have strong but adaptive cultures. According to this study, in an adaptive culture most managers care deeply about and value customers, stockholders, and employ- ees. They also strongly value people and processes that create useful change in a firm.36 While this is interesting, it does reduce the issue to a very high level of abstraction; after all, what company would say that it doesn’t care deeply about customers, stockholders, and employees? A somewhat different perspective is to argue that the culture of the firm must match the rest of the architecture of the organization, the firm’s strategy, and the demands of the competitive environment for superior performance to be attained. All these elements must be consistent with each other.

Lincoln Electric provides another useful example (see the Management Focus). Lincoln competes in a business that is very competitive, where cost minimization is a key source of competitive advantage. Lincoln’s culture and incentive systems both encourage employees to strive for high levels of productivity, which translates into the low costs that are critical for Lincoln’s success. The Lincoln example also demonstrates another important point for international businesses: A culture that leads to high performance in the firm’s home nation may not be easy to impose on foreign subsidiaries! Lincoln’s culture has clearly helped the firm achieve superior performance in the U.S. market, but this same culture is very “Ameri- can” in its form and difficult to implement in other countries. The managers and employees of several of Lincoln’s European subsidiaries found the culture to be alien to their own val- ues and were reluctant to adopt it. The result was that Lincoln found it very difficult to replicate in foreign markets the success it has had in the United States. Lincoln compounded the problem by acquiring established enterprises that already had their own organizational culture. Thus, in trying to impose its culture on foreign operating subsidiaries, Lincoln had to deal with two problems: how to change the established organizational culture of those units, and how to introduce an organizational culture whose key values might be alien to the values held by members of that society. These problems are not unique to Lincoln; many international businesses have to deal with exactly the same problems.

M A NAG E M E N T F O C U S

Lincoln Electric and Culture Lincoln Electric is one of the leading global manufactur- ers of welding products, arc welding equipment, welding consumables, plasma and oxy-fuel cutting equipment and robotic welding systems. Lincoln’s success has been based on extremely high levels of employee productivity. The company attributes its productivity to a strong orga- nizational culture and an incentive scheme based on piecework. Lincoln’s organizational culture dates back to James Lincoln, who in 1907 joined the company that his brother had established a few years earlier. Lincoln had a strong respect for the ability of the individual and be- lieved that, correctly motivated, ordinary people could achieve extraordinary performance. He emphasized that Lincoln should be a meritocracy where people were rewarded for their individual effort. Strongly egalitarian, Lincoln removed barriers to communication between “workers” and “managers,” practicing an open-door pol- icy. He made sure that all who worked for the company were treated equally; for example, everyone ate in the same cafeteria, there were no reserved parking places for “managers,” and so on. Lincoln also believed that any gains in productivity should be shared with consumers in the form of lower prices, with employees in the form of higher pay, and with shareholders in the form of higher dividends. The organizational culture that grew out of James Lin- coln’s beliefs was reinforced by the company’s incentive system. Production workers receive no base salary but are paid according to the number of pieces they produce. The piecework rates at the company enable an employee working at a normal pace to earn an income equivalent to the average wage for manufacturing workers in the area where a factory is based. Workers have responsibility for the quality of their output and must repair any defects spotted by quality inspectors before the pieces are in- cluded in the piecework calculation. Since 1934, produc- tion workers have been awarded a semiannual bonus based on merit ratings. These ratings are based on objec- tive criteria (such as an employee’s level and quality of out- put) and subjective criteria (such as an employee’s attitudes toward cooperation and his or her dependability). These systems give Lincoln’s employees an incentive to

work hard and to generate innovations that boost produc- tivity, for doing so influences their level of pay. Lincoln’s factory workers have been able to earn a base pay that often exceeds the average manufacturing wage in the area by more than 50 percent and receive a bonus on top of this that in good years could double their base pay. De- spite high employee compensation, the workers are so productive that Lincoln has a lower cost structure than its competitors. While this organizational culture and set of incentives works well in the United States, where it is compatible with the individualistic culture of the country, it did not translate easily into foreign operations. Early on, Lincoln expanded aggressively into Europe and Latin America, acquiring a number of local arc welding manufacturers. Lincoln left lo- cal managers in place, believing that they knew local con- ditions better than Americans. However, the local managers had little working knowledge of Lincoln’s strong organizational culture and were unable or unwilling to im- pose that culture on their units, which had their own long- established organizational cultures. Nevertheless, Lincoln told local managers to introduce its incentive systems in acquired companies. They frequently ran into legal and cultural roadblocks. In many countries, piecework is viewed as an exploi- tive compensation system that forces employees to work ever harder. In Germany, where Lincoln made an acquisi- tion, it is illegal. In Brazil, a bonus paid for more than two years becomes a legal entitlement! In many other coun- tries, both managers and workers were opposed to the idea of piecework. Lincoln found that many European workers valued extra leisure more highly than extra in- come and were not prepared to work as hard as their American counterparts. Many of the acquired companies were also unionized, and the local unions vigorously op- posed the introduction of piecework. As a result, Lincoln was not able to replicate the high level of employee pro- ductivity that it had achieved in the United States, and its expansion pulled down the performance of the entire company.

Sources: J. O’Connell, “Lincoln Electric: Venturing Abroad,” Harvard Business School Case No. 9-398-095, April 1998; www.lincolnelectric.com.

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The solution Lincoln has adopted is to establish new subsidiaries, rather than acquiring and trying to transform an enterprise with its own culture. It is much easier to establish a set of values in a new enterprise than it is to change the values of an established enterprise. A second solution is to devote a lot of time and attention to transmitting the firm’s organi- zational culture to its foreign operations. This was something Lincoln originally omitted. Other firms make this an important part of their strategy for internationalization.

The need for a common organizational culture that is the same across a multinational’s global network of subsidiaries probably varies with the strategy of the firm. Shared norms and values can facilitate coordination and cooperation between individuals from different subunits.37 A strong common culture may lead to goal congruence and can attenuate the problems that arise from interdependence, performance ambiguities, and conflict among managers from different subsidiaries. As noted earlier, a shared culture may help infor- mal integrating mechanisms such as knowledge networks to operate more effectively. As such, a common culture may be of greater value in a multinational that is pursuing a strategy that requires cooperation and coordination between globally dispersed subsidiar- ies. This suggests that it is more important to have a common culture in firms employing a transnational strategy than a localization strategy, with global and international strate- gies falling between these two extremes.

Synthesis: Strategy and Architecture

Chapter 13 identified four basic strategies that multinational firms pursue: localization, international, global, and transnational. So far in this chapter we have looked at several aspects of organizational architecture, and we have discussed the interrelationships between these dimensions and strategies. Now it is time to synthesize this material.

LOCALIZATION STRATEGY

Firms pursuing a localization strategy focus on local responsiveness. Table 14.2 shows that such firms tend to operate with worldwide area structures, within which operating decisions are decentralized to functionally self-contained country subsidiaries. The need for coordination between subunits (areas and country subsidiaries) is low. This suggests that firms pursuing a localization strategy do not have a high need for integrating mecha- nisms, either formal or informal, to knit together different national operations. The lack

LO 14 -3 Explain how organization can be matched to strategy to improve the performance of an international business.

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TA B L E 1 4 . 2

A Synthesis of Strategy, Structure, and Control Systems

Strategy

Structure Global and Controls Localization International Standardization Transnational Vertical differentiation Decentralized Core competency Some centralization Mixed more centralized; centralization and rest decentralized decentralization

Horizontal Worldwide Worldwide Worldwide Informal matrix differentiation area structure product divisions product divisions

Need for coordination Low Moderate High Very high

Integrating mechanisms None Few Many Very many

Performance ambiguity Low Moderate High Very high

Need for cultural controls Low Moderate High Very high

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of interdependence implies that the level of performance ambiguity in such enterprises is low, as (by extension) are the costs of control. Thus, headquarters can manage foreign operations by relying primarily on output and bureaucratic controls and a policy of man- agement by exception. Incentives can be linked to performance metrics at the level of country subsidiaries. Since the need for integration and coordination is low, the need for common processes and organizational culture is also quite low. Were it not for the fact that these firms are unable to profit from the realization of location and experience curve economies, or from the transfer of core competencies, their organizational simplicity would make this an attractive strategy.

INTERNATIONAL STRATEGY

Firms pursuing an international strategy attempt to create value by transferring core competencies from home to foreign subsidiaries. If they are diverse, as most of them are, these firms operate with a worldwide product division structure. Headquarters normally maintains centralized control over the source of the firm’s core competency, which is most typically found in the R&D and/or marketing functions of the firm. All other oper- ating decisions are decentralized within the firm to subsidiary operations in each country (which in diverse firms report to worldwide product divisions).

The need for coordination is moderate in such firms, reflecting the need to transfer core competencies. Thus, although such firms operate with some integrating mecha- nisms, they are not that extensive. The relatively low level of interdependence that results translates into a relatively low level of performance ambiguity. These firms can generally get by with output and bureaucratic controls and with incentives that are focused on per- formance metrics at the level of country subsidiaries. The need for a common organiza- tional culture and common processes is not that great. An important exception to this is when the core skills or competencies of the firm are embedded in processes and culture, in which case the firm needs to pay close attention to transferring those processes and associated culture from the corporate center to country subsidiaries. Overall, although the organization required for an international strategy is more complex than that of firms pursuing a localization strategy, the increase in the level of complexity is not that great.

GLOBAL STANDARDIZATION STRATEGY

Firms pursuing a global standardization strategy focus on the realization of location and experience curve economies. If they are diversified, as many of them are, these firms operate with a worldwide product division structure. To coordinate the firm’s globally dispersed web of value creation activities, headquarters typically maintains ultimate con- trol over most operating decisions. In general, such firms are more centralized than enter- prises pursuing a localization or international strategy. Reflecting the need for coordination of the various stages of the firms’ globally dispersed value chains, the need for integra- tion in these firms also is high. Thus, these firms tend to operate with an array of formal and informal integrating mechanisms. The resulting interdependencies can lead to sig- nificant performance ambiguities. As a result, in addition to output and bureaucratic con- trols, firms pursuing a global standardization strategy tend to stress the need to build a strong organizational culture that can facilitate coordination and cooperation. They also tend to use incentive systems that are linked to performance metrics at the corporate level, giving the managers of different operations a strong incentive to cooperate with each other to increase the performance of the entire corporation. On average, the organi- zation of such firms is more complex than that of firms pursuing a localization or inter- national strategy.

TRANSNATIONAL STRATEGY

Firms pursuing a transnational strategy focus on the simultaneous attainment of location and experience curve economies, local responsiveness, and global learning (the multidirec- tional transfer of core competencies or skills). These firms may operate with matrix-type

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structures in which both product divisions and geographic areas have significant influence. The need to coordinate a globally dispersed value chain and to transfer core competencies creates pressures for centralizing some operating decisions (particularly production and R&D). At the same time, the need to be locally responsive creates pressures for decentral- izing other operating decisions to national operations (particularly marketing). Conse- quently, these firms tend to mix relatively high degrees of centralization for some operating decisions with relative high degrees of decentralization for other operating decisions.

The need for coordination is high in transnational firms. This is reflected in the use of an array of formal and informal integrating mechanisms, including formal matrix struc- tures and informal management networks. The high level of interdependence of subunits implied by such integration can result in significant performance ambiguities, which raise the costs of control. To reduce these, in addition to output and bureaucratic controls, firms pursuing a transnational strategy need to cultivate a strong culture and to establish incentives that promote cooperation between subunits.

ENVIRONMENT, STRATEGY, ARCHITECTURE, AND PERFORMANCE

Underlying the scheme outlined in Table 14.2 is the notion that a “fit” between strategy and architecture is necessary for a firm to achieve high performance. For a firm to suc- ceed, two conditions must be fulfilled. First, the firm’s strategy must be consistent with the environment in which the firm operates. We discussed this issue in Chapter 13 and noted that in some industries a global standardization strategy is most viable, in others an international or transnational strategy may be most viable, and in still others a localiza- tion strategy may be most viable. Second, the firm’s organizational architecture must be consistent with its strategy.

If the strategy does not fit the environment, the firm is likely to experience significant performance problems. If the architecture does not fit the strategy, the firm is also likely to experience performance problems. Therefore, to survive, a firm must strive to achieve a fit of its environment, its strategy, and its organizational architecture. For example, consider Koninklijke Philips NV. For reasons rooted in the history of the firm, Philips operated until recently with an organization typical of an enterprise pursuing localiza- tion; operating decisions were decentralized to largely autonomous foreign subsidiaries. Historically, electronics markets were segmented from each other by high trade barriers, so an organization consistent with a localization strategy made sense. However, by the mid-1980s, the industry in which Philips competed had been revolutionized by declining trade barriers, technological change, and the emergence of low-cost Japanese competitors that utilized a global strategy. To survive, Philips needed to adopt a global standardization strategy itself. The firm recognized this and tried to adopt a global posture, but it did little to change its organizational architecture. The firm nominally adopted a matrix structure based on worldwide product divisions and national areas. In reality, however, the national areas continued to dominate the organization, and the product divisions had little more than an advisory role. As a result, Philips’ architecture did not fit the strategy, and by the early 1990s Philips was losing money. It was only after four years of wrench- ing change and large losses that Philips was finally able to tilt the balance of power in its matrix toward the product divisions. By the mid-1990s, the fruits of this effort to realign the company’s strategy and architecture with the demands of its operating environment finally showed up in improved financial performance.38

Organizational Change

Multinational firms periodically have to alter their architecture so that it conforms to the changes in the environment in which they are competing and the strategy they are pursu- ing. To be profitable, Philips had to alter its strategy and architecture so that both matched the demands of the competitive environment in the electronics industry, which had shifted from localization toward a global industry. While a detailed consideration of

LO 14 - 4 Discuss what is required for an international business to change its organization so that it better matches its strategy.

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The Organization of International Business Chapter 14 423

organizational change is beyond the scope of this book, a few comments are warranted regarding the sources of organization inertia and the strategies and tactics for implement- ing organizational change.

ORGANIZATIONAL INERTIA

Organizations are difficult to change. Within most organizations are strong inertia forces. These forces come from a number of sources. One source of inertia is the exist- ing distribution of power and influence within an organization.39 The power and influ- ence enjoyed by individual managers are in part a function of their role in the organizational hierarchy, as defined by structural position. By definition, most substan- tive changes in an organization require a change in structure and, by extension, a change in the distribution of power and influence within the organization. Some individuals will see their power and influence increase as a result of organizational change, and some will see the converse. For example, Philips decided to increase the roles and re- sponsibilities of its global product divisions and decrease the roles and responsibilities of its foreign subsidiary companies to combat organizational inertia. This meant the managers running the global product divisions saw their power and influence increase, while the managers running the foreign subsidiary companies saw their power and in- fluence decline. As might be expected, some managers of foreign subsidiary companies did not like this change and resisted it, which slowed the pace of change. Those whose power and influence are reduced as a consequence of organizational change can be ex- pected to resist it, primarily by arguing that the change might not work. To the extent that they are successful, this constitutes a source of organizational inertia that might slow or stop change.

Another source of organizational inertia is the existing culture, as expressed in norms and value systems. Value systems reflect deeply held beliefs, and as such, they can be very hard to change. If the formal and informal socialization mechanisms within an orga- nization have been emphasizing a consistent set of values for a prolonged period, and if hiring, promotion, and incentive systems have all reinforced these values, then suddenly announcing that those values are no longer appropriate and need to be changed can pro- duce resistance and dissonance among employees. For example, Philips historically placed a very high value on local autonomy. The changes the company decided to make implied a reduction in the autonomy enjoyed by foreign subsidiaries, which was counter to the established values of the company and thus resisted.

Organizational inertia might also derive from senior managers’ preconceptions about the appropriate business model or paradigm. When a given paradigm has worked well in the past, managers might have trouble accepting that it is no longer appropriate. At Philips, granting considerable autonomy to foreign subsidiaries had worked very well in the past, allowing local managers to tailor product and business strategy to the condi- tions prevailing in a given country. Since this paradigm had worked so well, it was dif- ficult for many managers to understand why it no longer applied. Consequently, they had difficulty accepting a new business model and tended to fall back on their established paradigm and ways of doing things. This change required managers to let go of long- held assumptions about what worked and what didn’t work, which was something many of them couldn’t do.

Institutional constraints might also act as a source of inertia. National regulations in- cluding local content rules and policies pertaining to layoffs might make it difficult for a multinational to alter its global value chain. A multinational might wish to take control for manufacturing away from local subsidiaries, transfer that control to global product divisions, and consolidate manufacturing at a few choice locations. However, if local content rules (see Chapter 7) require some degree of local production and if regulations regarding layoffs make it difficult or expensive for a multinational to close operations in a country, a multinational may find that these constraints make it very difficult to adopt the most effective strategy and architecture.

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IMPLEMENTING ORGANIZATIONAL CHANGE

Although all organizations suffer from inertia, the complexity and global spread of many multinationals might make it particularly difficult for them to change their strategy and architecture to match new organizational realities. Yet at the same time, the trend toward globalization in many industries has made it more critical than ever that many multina- tionals do just that. In industry after industry, declining barriers to cross-border trade and investment have led to a change in the nature of the competitive environment. Cost pres- sures have increased, requiring multinationals to respond by streamlining their opera- tions to realize economic benefits associated with location and experience curve economies and with the transfer of competencies and skills within the organization. Local responsiveness remains an important source of differentiation as well. To survive in this emerging competitive environment, multinationals must change not only their strategy but also their architecture so that it matches strategy in discriminating ways. The basic principles for successful organizational change can be summarized as follows: (1) unfreeze the organization through shock therapy, (2) move the organization to a new state through proactive change in the architecture, and (3) refreeze the organization in its new state.

Unfreezing the Organization Because of inertia forces, incremental change is often no change. Those whose power is threatened by change can too easily resist incremental change. This leads to the big bang theory of change, which maintains that effective change requires taking bold action early to “unfreeze” the established culture of an organization and to change the distribution of power and influence. Shock therapy to unfreeze the organization might include the closure of plants deemed uneconomic or the announcement of a dramatic structural reorganiza- tion. It is also important to realize that change will not occur unless senior managers are committed to it. Senior managers must clearly articulate the need for change so employ- ees understand both why it is being pursued and the benefits that will flow from success- ful change. Senior managers must also practice what they preach and take the necessary bold steps. If employees see senior managers preaching the need for change but not changing their own behavior or making substantive changes in the organization, they will soon lose faith in the change effort, which then will flounder.

Moving to the New State Once an organization has been unfrozen, it must be moved to its new state. Movement requires taking action—closing operations; reorganizing the structure; reassigning re- sponsibilities; changing control, incentive, and reward systems; redesigning processes; and letting people go who are seen as an impediment to change. In other words, movement requires a substantial change in the form of a multinational’s organizational architecture so that it matches the desired new strategic posture. For movement to be successful, it must be done with sufficient speed. Involving employees in the change effort is an excel-

lent way to get them to appreciate and buy into the needs for change and to help with rapid movement. For example, a firm might delegate substantial responsi- bility for designing operating processes to lower-level employees. If enough of their recommendations are then acted on, the employees will see the conse- quences of their efforts and consequently buy into the notion that change is really occurring.

Refreezing the Organization Refreezing the organization takes longer. It may require that a new culture be established while the old one is being dismantled. Thus, refreezing requires that employees be socialized into the new way of doing things. Companies will often use management education programs to achieve this. At General Electric, where longtime CEO Jack Welch instituted a major change in the culture of the

Jack Welch, General Electric’s legend- ary former CEO, set a benchmark for embracing change. Source: © Erik Freeland/Corbis News/Corbis

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company, management education programs were used as a proactive tool to communicate new values to organization members. On their own, however, management education pro- grams are not enough. Hiring policies must be changed to reflect the new realities, with an emphasis on hiring individuals whose own values are consistent with that of the new culture the firm is trying to build. Similarly, control and incentive systems must be consis- tent with the new realities of the organization, or change will never take. Senior manage- ment must recognize that changing culture takes a long time. Any letup in the pressure to change may allow the old culture to reemerge as employees fall back into familiar ways of doing things. The communication task facing senior managers, therefore, is a long- term endeavor that requires managers to be relentless and persistent in their pursuit of change. One striking feature of Jack Welch’s two-decade tenure at GE, for example, is that he never stopped pushing his change agenda. It was a consistent theme of his tenure. He was always thinking up new programs and initiatives to keep pushing the culture of the organization along the desired trajectory.

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organizational architecture, p. 394 organizational structure, p. 394 control systems, p. 394 incentives, p. 395 processes, p. 395 organizational culture, p. 395 people, p. 395

vertical differentiation, p. 396 horizontal differentiation, p. 396 integrating mechanisms, p. 396 international division, p. 400 worldwide area structure, p. 402 worldwide product division

structure, p. 403

global matrix structure, p. 404 knowledge network, p. 409 personal control, p. 411 bureaucratic control, p. 411 output controls, p. 411 cultural controls, p. 412 performance ambiguity, p. 413

Key Terms

C H A P T E R S U M M A R Y

This chapter identified the organizational architecture that can be used by multinational enterprises to manage and direct their global operations. A central theme of the chapter was that different strategies require different ar- chitectures; strategy is implemented through architec- ture. To succeed, a firm must match its architecture to its strategy in discriminating ways. Firms whose architec- ture does not fit their strategic requirements will experi- ence performance problems. It is also necessary for the different components of architecture to be consistent with each other. The chapter made the following points:

1. Organizational architecture refers to the totality of a firm’s organization, including formal orga- nizational structure, control systems and incen- tives, processes, organizational culture, and people.

2. Superior enterprise profitability requires three conditions to be fulfilled: the different elements of a firm’s organizational architecture must be internally consistent, the organizational architec- ture must fit the strategy of the firm, and the strategy and architecture of the firm must be consistent with competitive conditions prevailing in the firm’s markets.

3. Organizational structure means three things: the formal division of the organization into subunits (horizontal differentiation), the location of deci- sion-making responsibilities within that structure (vertical differentiation), and the establishment of integrating mechanisms.

4. Control systems are the metrics used to measure the performance of subunits and make judg- ments about how well managers are running those subunits.

5. Incentives refer to the devices used to reward appropriate employee behavior. Many employees receive incentives in the form of annual bonus pay. Incentives are usually closely tied to the performance metrics used for output controls.

6. Processes refer to the manner in which decisions are made and work is performed within the orga- nization. Processes can be found at many differ- ent levels within an organization. The core competencies or valuable skills of a firm are of- ten embedded in its processes. Efficient and ef- fective processes can help lower the costs of value creation and add additional value to a product.

7. Organizational culture refers to a system of val- ues and norms that is shared among employees. Values and norms express themselves as the be- havior patterns or style of an organization that new employees are automatically encouraged to follow by their fellow employees.

8. Firms pursuing different strategies must adopt a different architecture to implement those strate- gies successfully. Firms pursuing localization, global, international, and transnational strategies

all must adopt an organizational architecture that matches their strategy.

9. While all organizations suffer from inertia, the complexity and global spread of many multina- tionals might make it particularly difficult for them to change their strategy and architecture to match new organizational realities. At the same time, the trend toward globalization in many in- dustries has made it more critical than ever that many multinationals do just that.

C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. “The choice of strategy for a multinational firm must depend on a comparison of the benefits of that strategy (in terms of value creation) with the costs of implementing it (as defined by organiza- tional architecture necessary for implementa- tion). On this basis, it may be logical for some firms to pursue a localization strategy, others a global or international strategy, and still others a transnational strategy.” Is this statement correct?

2. Discuss this statement: “An understanding of the causes and consequences of performance ambi- guity is central to the issue of organizational design in multinational firms.”

3. Describe the organizational architecture that a transnational firm might adopt to reduce the costs of control.

4. What is the most appropriate organizational architecture for a firm that is competing in an industry where a global strategy is most appropriate?

5. If a firm is changing its strategy from an interna- tional to a transnational strategy, what are the most important challenges it is likely to face in implementing this change? How can the firm overcome these challenges?

6. Reread the Management Focus on Walmart In- ternational; then answer the following questions: a. Why did the centralization of decisions at

the headquarters of Walmart’s international division create problems for the company’s

different national operations? Has Walmart’s response been appropriate?

b. Do you think that having an international division is the best structure for managing Walmart’s foreign operations? What prob- lems might arise with this structure? What other structure might work?

7. Reread the Management Focus on Dow Chemical; then answer the following questions: a. Why did Dow first adopt a matrix structure?

What were the problems with this structure? Do you think these problems are typical of matrix structures?

b. What drove the shift away from the matrix structure for companies such as Dow and ABB? Does Dow’s structure now make sense given the nature of its businesses and the competitive environment it competes in?

8. Reread the Management Focus on Lincoln Electric; then answer the following questions: a. To what extent is the organizational culture

of Lincoln Electric aligned with the firm’s strategy?

b. How was the culture at Lincoln Electric created and nurtured over time?

c. Why did Lincoln Electric’s culture and incentive systems work well in the United States? Why did it not take in other nations?

426 Part 5 The Strategy and Structure of International Business

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises:

1. Fortune conducts an annual survey and pub- lishes the rankings of the world’s most admired companies. Locate the most recent ranking

available, and focus on the factors used to deter- mine which companies are most admired. Pre- pare an executive summary of the strategic and organizational success factors for a company of your choice.

Established in 1891 in Eindhoven, the Netherlands, Koninklijke Philips NV is one of the world’s oldest multi- national companies. The company began making lighting products and over time diversified into a range of businesses that included domestic appliances, consumer electronics, and health care products. From the beginning, the small Dutch domestic market created pressures for Philips to look to foreign markets for growth. Some argue that this is the case for most European companies and, thus, the many companies from Europe that are globally competitive. By the start of World War II, Philips already had a global presence. During the war, the Netherlands was oc- cupied by Germany. By necessity, the company’s national organizations in countries such as Australia, Brazil, Can- ada, United Kingdom, and the United States gained con- siderable autonomy during this period.  After the war, a structure based on strong national organizations remained in place. Each national organization was in essence a self- contained entity that was responsible for much of its own manufacturing, marketing, and sales. Most R&D activi- ties, however, were centralized at Philips’ headquarters in Eindhoven. Reflecting this, several product divisions were created. Based in Eindhoven, the product divisions devel- oped technologies and products, which were then made and sold by the different national organizations. During this period, the career track of most senior managers at Philips involved significant postings in various national organizations around the world (a career development practice often seen still in multinational corporations). For several decades this organizational arrangement worked well. It allowed Philips to customize its product offerings, sales, and marketing efforts to the conditions that existed in different national markets. By the 1970s, however, flaws were appearing in the approach. The structure involved significant duplication of activities around the world, particularly in manufacturing, which created an intrinsically high-cost structure. When trade barriers were high, this did not matter so much, but the significance of its effect became important when trade barriers were starting to fall and competitors came in to

the marketplace. These competitors included Sony and Matsushita from Japan, General Electric from the United States, and Samsung from South Korea. Each of these competitors gained market share by serving increasingly global markets from centralized production facilities where they could achieve greater scale economies and hence lower costs. Philips’ response was to try to tilt the balance of power in its structure away from national organizations and toward product divisions. International production centers were established under the direction of the prod- uct divisions. The national organizations, however, re- mained responsible for local marketing and sales, and they often maintained control over some local produc- tion facilities. One problem Philips faced in trying to change its structure at this time was that most senior managers had come up through the national organiza- tions. Consequently, they were loyal to them and tended to protect their autonomy. Despite several reorganization efforts, the national or- ganizations remained a strong influence at Philips until the 1990s. In the mid-1990s Cor Boonstra became CEO.

C L O S I N G C A S E

Koninklijke Philips NV

2. You work at a European-based pharmaceutical company that is planning to expand operations to other parts of the world. To design the structure of the organization as it expands internationally, management has requested additional informa- tion on the pharmaceutical sector worldwide.

Use the Industry Profiles section on the global- EDGE site to prepare a risk assessment of the food and beverage industry that can help man- agement gain a better understanding of the exter- nal environment in foreign markets.

The headquarters of Philips NV in Eindhoven, Netherlands. Source: © Sander Koning/Corbis Wire/Corbis

The Organization of International Business Chapter 14 427

428 Part 5 The Strategy and Structure of International Business

He famously described the company’s organizational structure as a “plate of spaghetti” and asked how Philips could compete when the company had 350 subsidiaries around the world and significant duplication of manufac- turing and marketing efforts across nations. Boonstra in- stituted a radical reorganization. He replaced the company’s 21 product divisions with just 7 global busi- ness divisions, making them responsible for global prod- uct development, production, and marketing. The heads of the divisions reported directly to him, while the na- tional organizations reported to the divisions. The national organizations remained responsible for local sales and local marketing efforts, but after this reorganization they finally lost their historic sway on the company. Philips, however, continued to underperform its global rivals. By 2008, Gerard Kleisterlee, who succeeded Boonstra as CEO in 2001, decided Philips was still not sufficiently focused on global markets. He reorganized yet again, this time around just three global divisions, health care, lighting, and consumer lifestyle (which included the company’s electronics businesses). These are also the three divisions that are in place under the most recent CEO, Frans van Houten, who became the CEO of Philips in 2011. The slogan for the health care division is “creating the future of healthcare.” Philips is a global leader in the health care domain. It is guided by the understanding that there is a patient in the center of everything it does in the field of health care, and its focus is on creating the ideal experience for all patients around the world, young and old. Philips Lighting is about “enhancing lives with light” by delivering innovative and energy-efficient solu- tions. The Consumer Lifestyle division is dedicated to “helping people achieve a healthier and better life.”

The three divisions are responsible for product strat- egy, global marketing, and shifting of production to low- cost locations (or outsourcing production). The divisions also took over some sales responsibilities, particularly dealing with global retail chains such as Walmart, Tesco, and Carrefour. To accommodate national differences, however, some sales and marketing activities remained located at the national organizations. Sources: C. A. Bartlett, “Philips versus Matsushita: The Competitive Battle Continues,” Harvard Business School Case, December 11, 2009; “Philips Communicates Vision 2010 Strategic Plan,” Philips press re- lease, September 10, 2007.

C a s e D i s c u s s i o n Q u e s t i o n s

1. Why did Philips’ organizational structure make sense early on in its existence? Why did this structure start to create problems for the company later on?

2. What was Philips trying to achieve by tilting the balance of power in its structure away from national organizations and toward the product divisions? Why was this hard to achieve?

3. What was the point of the organizational changes made by Cor Boonstra? What was he trying to achieve? Do you agree with Frans van Houten’s decision to keep the same three divi- sions when he became CEO in 2011?

4. In 2008 Philips reorganized yet again, now down from 21 divisions to 9 divisions and sub- sequently just 3 divisions. Why do you think it did this? What is it trying to achieve?

E n d n o t e s

1. This has long been a central theme of the strategic management literature. See, for example, C. W. L. Hill and R. E. Hoskisson, “Strategy and Structure in the Multiproduct Firm,” Academy of Management Review, 1987, pp. 331–41. Also see J. Wolf and W. G. Egelhoff, “A Reexamination and Extension of International Strategy Structure Theory,” Strategic Management Journal 23 (2002), pp. 181–90.

2. D. Naidler, M. Gerstein, and R. Shaw, Organization Architecture (San Francisco: Jossey-Bass, 1992).

3. G. Morgan, Images of Organization (Beverly Hills, CA: Sage, 1986).

4. “Unilever: A Networked Organization,” Harvard Business Re- view, November–December 1996, p. 138.

5. The material in this section draws on John Child, Organizations (London: Harper & Row, 1984).

6. Allan Cane, “Microsoft Reorganizes to Meet Market Chal- lenges,” Financial Times, March 16, 1994, p. 1. Interviews by Charles Hill.

7. For research evidence that is related to this issue, see J. Birkinshaw, “Entrepreneurship in the Multinational Corporation: The Char- acteristics of Subsidiary Initiatives,” Strategic Management Journal 18 (1997), pp. 207–29; J. Birkinshaw, N. Hood, and S. Jonsson, “Building Firm Specific Advantages in Multinational Corporations: The Role of Subsidiary Initiatives,” Strategic Man- agement Journal 19 (1998), pp. 221–41; I. Bjorkman, W. Barner- Rasussen, and L. Li, “Managing Knowledge Transfer in MNCs: The Impact of Headquarters Control Mechanisms,” Journal of International Business 35 (2004), pp. 443–60.

8. For more detail, see S. M. Davis, “Managing and Organizing Multinational Corporations,” in C. A. Bartlett and S. Ghoshal,

The Organization of International Business Chapter 14 429

Transnational Management (Homewood, IL: Richard D. Irwin, 1992). Also see Wolf and Egelhoff, “A Reexamination and Ex- tension of International Strategy Structure Theory.”

9. A. D. Chandler, Strategy and Structure: Chapters in the History of the Industrial Enterprise (Cambridge, MA: MIT Press, 1962).

10. Davis, “Managing and Organizing Multinational Corporations.”

11. J. M. Stopford and L. T. Wells, Strategy and Structure of the Multinational Enterprise (New York: Basic Books, 1972).

12. C. A. Bartlett and S. Ghoshal, Managing across Borders (Boston: Harvard Business School Press, 1989).

13. Ibid.; A. McDonnell, P. Gunnigle, and J. Lavelle, “Learning Transfer in Multinational Companies,” Human Resource Man- agement Journal, 2010, pp. 23–43.

14. See J. R. Galbraith, Designing Complex Organizations (Read- ing, MA: Addison-Wesley, 1977).

15. M. Goold and A. Campbell, “Structured Networks: Towards the Well Designed Matrix,” Long Range Planning, October 2003, pp. 427–60.

16. Bartlett and Ghoshal, Managing across Borders; F. V. Guterl, “Goodbye, Old Matrix,” Business Month, February 1989, pp. 32–38; Bjorkman et al., “Managing Knowledge Transfer in MNCs”; M. T. Hansen and B. Lovas, “How Do Multinational Companies Leverage Technological Competencies?,” Strategic Management Journal, 2004, pp. 801–22.

17. M. S. Granovetter, “The Strength of Weak Ties,” American Journal of Sociology 78 (1973), pp. 1360–80.

18. A. K. Gupta and V. J. Govindarajan, “Knowledge Flows within Multinational Corporations,” Strategic Management Journal 21, no. 4 (2000), pp. 473–96; V. J. Govindarajan and A. K. Gupta, The Quest for Global Dominance (San Francisco: Jossey-Bass, 2001); U. Andersson, M. Forsgren, and U. Holm, “The Strategic Impact of External Networks: Subsidiary Per- formance and Competence Development in the Multinational Corporation,” Strategic Management Journal 23 (2002), pp. 979–96.

19. For examples, see W. H. Davidow and M. S. Malone, The Vir- tual Corporation (New York: HarperCollins, 1992).

20. W. G. Ouchi, “Markets, Bureaucracies, and Clans,” Adminis- trative Science Quarterly 25 (1980), pp. 129–44.

21. For some empirical work that addresses this issue, see T. P. Murtha, S. A. Lenway, and R. P. Bagozzi, “Global Mind Sets and Cognitive Shift in a Complex Multinational Corporation,” Strategic Management Journal 19 (1998), pp. 97–114.

22. J. Welch and J. Byrne, Jack: Straight from the Gut (Warner Books: New York, 2001).

23. C. W. L. Hill, M. E. Hitt, and R. E. Hoskisson, “Cooperative versus Competitive Structures in Related and Unrelated Diver- sified Firms,” Organization Science 3 (1992), pp. 501–21.

24. Murtha et al., “Global Mind Sets.” 25. M. Hammer and J. Champy, Reengineering the Corporation

(New York: Harper Business, 1993). 26. T. Kostova, “Transnational Transfer of Strategic Organizational

Practices: A Contextual Perspective,” Academy of Management Review 24, no. 2 (1999), pp. 308–24.

27. Andersson et al., “The Strategic Impact of External Networks.” 28. E. H. Schein, “What Is Culture?,” in P. J. Frost et al., Reframing

Organizational Culture (Newbury Park, CA: Sage, 1991). 29. E. H. Schein, Organizational Culture and Leadership, 2nd ed.

(San Francisco: Jossey-Bass, 1992). 30. G. Morgan, Images of Organization (Beverly Hills, CA: Sage,

1986). 31. R. Dore, British Factory, Japanese Factory (London: Allen &

Unwin, 1973). 32. M. Dickson, “Back to the Future,” Financial Times, May 30,

1994, p. 7. 33. See J. P. Kotter and J. L. Heskett, Corporate Culture and Per-

formance (New York: Free Press, 1992); M. L. Tushman and C. A. O’Reilly, Winning through Innovation (Boston: Harvard Business School Press, 1997).

34. Kotter and Heskett, Corporate Culture and Performance. 35. The classic song of praise was produced by T. Peters and

R. H. Waterman, In Search of Excellence (New York: Harper & Row, 1982). Ironically, IBM’s decline began shortly after Peters and Waterman’s book was published.

36. Kotter and Heskett, Corporate Culture and Performance. 37. Bartlett and Ghoshal, Managing across Borders. 38. See F. J. Aguilar and M. Y. Yoshino, “The Philips Group:

1987,” Howard Business School Case No. 388-050, 1987; “Philips Fights Flab,” The Economist, April 7, 1990, pp. 73–74; R. Van de Krol, “Philips Wins Back Old Friends,” Financial Times, July 14, 1995, p. 14.

39. J. Pfeffer, Managing with Power: Politics and Influence within Organizations (Boston: Harvard Business School Press, 1992).

Credit: ©Federal Reserve Board.

Entry Strategy and Strategic Alliances L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO15 -1 Explain the three basic decisions that firms contemplating foreign expansion must make: which markets to enter, when to enter those markets, and on what scale.

LO15-2 Compare and contrast the different modes that firms use to enter foreign markets.

LO15-3 Identify the factors that influence a firm’s choice of entry mode.

LO15-4 Recognize the pros and cons of acquisitions versus greenfield ventures as an entry strategy.

LO15-5 Evaluate the pros and cons of entering into strategic alliances.

part five The Strategy and Structure of International Business

15

Source: © EyesWideOpen/Getty Images

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Starbucks’ Foreign Entry Strategy

After Japan, the company embarked on an aggressive foreign investment program. In 1998, it purchased Seattle Coffee, a British coffee chain with 60 retail stores, for $84 million. An American couple, originally from Seattle, had started Seattle Coffee with the intention of establishing a Starbucks- like chain in Britain. In the late 1990s, Starbucks opened stores in Taiwan, Singapore, Thailand, New Zealand, South Korea, Malaysia, and—most significantly—China. In Asia, Starbucks’ most common strategy was to license its format to a local operator in return for initial licensing fees and royalties on store revenues. As in Japan, Starbucks insisted on an intensive employee-training program and strict speci- fications regarding the format and layout of the store. By 2002, Starbucks was pursuing an aggressive expan- sion in mainland Europe. As its first entry point, Starbucks chose Switzerland. Drawing on its experience in Asia, the company entered into a joint venture with a Swiss com- pany, Bon Appetit Group, Switzerland’s largest food ser- vice company. Bon Appetit was to hold a majority stake in the venture, and Starbucks would license its format to the Swiss company using a similar agreement to those it had used successfully in Asia. This was followed by a joint ven- ture in other countries. United Kingdom leads the charge in Europe with 808 Starbucks stores. By 2014, Starbucks emphasized the rapid growth of its operations in China, where it had 1,716 stores and planned to roll out another 500 in three years. The success of Starbucks in China has been attributed to a smart partnering strategy. China is not one homogeneous market; the cul- ture of northern China is very different from that of the east, consumer spending power inland is not on par with that of the big coastal cities. To deal with this complexity, Starbucks entered into three different joint ventures: in the north with Beijong Mei Da coffee, in the east with Taiwan- based UniPresident, and in the south with Hong Kong– based Maxim’s Caterers. Each partner bought different strengths and local expertise that helped the company gain insights into the tastes and preferences of local Chi- nese customers, and to adapt accordingly. Starbucks now believes that China will become its second-largest market after the United States by 2020.

Sources: Starbucks 10K, various years; C. McLean, “Starbucks Set to Invade Coffee-Loving Continent,” Seattle Times, October 4, 2000, p.  E1; J. Ordonez, “Starbucks to Start Major Expansion in Over- seas Market,” The Wall Street Journal, October 27, 2000, p. B10; S. Homes and D. Bennett, “Planet Starbucks,” BusinessWeek, Sep- tember 9, 2002, pp.  99–110; “Starbucks Outlines International Growth Strategy,” Business Wire, October 14, 2004; A. Yeh, “Starbucks Aims for New Tier in China,” Financial Times, February 14, 2006, p. 17; C. Matlack, “Will Global Growth Help Starbucks?,” Business- Week, July 2, 2008; H. H. Wang, “Five Things Starbucks Did to Get China Right,” Forbes, July 10, 2012.

O P E N I N G C A S E Forty years ago, Starbucks was a single store in Seattle’s Pike Place Market selling premium-roasted coffee. Today, it is a global roaster and retailer of coffee with some 21,536 stores, 43 percent of which are in 63 countries outside the United States. China (1,716 stores), Canada (1,330 stores), Japan (1,079 stores), and United Kingdom (808 stores) are large markets internationally for Starbucks. Starbucks set out on its current course in the 1980s when the company’s director of marketing, Howard Schultz, came back from a trip to Italy enchanted with the Italian coffeehouse experience. Schultz, who later became CEO, persuaded the company’s owners to experiment with the coffeehouse format—and the Starbucks experi- ence was born. The strategy was to sell the company’s own premium roasted coffee and freshly brewed espresso-style coffee beverages, along with a variety of pastries, coffee accessories, teas, and other products, in a tastefully designed coffeehouse setting. From the outset, the company focused on selling “a third place experience,” rather than just the coffee. The formula led to spectacular success in the United States, where Starbucks went from obscurity to one of the best-known brands in the country in a decade. Thanks to Starbucks, coffee stores became places for relaxation, chatting with friends, reading the newspaper, holding business meetings, or (more recently) browsing the web. In 1995, with 700 stores across the United States, Starbucks began exploring foreign market opportunities. The first target market was Japan. The company estab- lished a joint venture with a local retailer, Sazaby Inc. Each company held a 50 percent stake in the venture, Starbucks Coffee of Japan. Starbucks initially invested $10 million in this venture, its first foreign direct investment. The Starbucks format was then licensed to the venture, which was charged with taking over responsibility for growing Starbucks’ presence in Japan. To make sure the Japanese operations replicated the “Starbucks experience” in North America, Starbucks trans- ferred some employees to the Japanese operation. The li- censing agreement required all Japanese store managers and employees to attend training classes similar to those given to U.S. employees. The agreement also required that stores adhere to the design parameters established in the United States. In 2001, the company introduced a stock option plan for all Japanese employees, making it the first company in Japan to do so. Skeptics doubted that Starbucks would be able to replicate its North American success overseas, but by June of 2015 Starbucks’ had some 1,079 stores and a profitable business in Japan.

432 Part 5 The Strategy and Structure of International Business

Introduction

This chapter is concerned with three closely related topics: (1) the decision of which for- eign markets to enter, when to enter them, and on what scale; (2) the choice of entry mode; and (3) the role of strategic alliances. Any firm contemplating foreign expansion must first struggle with the issue of which foreign markets to enter and the timing and scale of entry. The choice of which markets to enter should be driven by an assessment of relative long-run growth and profit potential.  For example, enticed by its long-term growth potential, Starbucks entered China in 1999. In number of stores, China is the sec- ond most important market after the United States, ahead of Canada, Japan, and United Kingdom. And China continues to be a strategic market entry focus for Starbucks, with the company planning several hundred more store openings in the near future. 

The choice of mode for entering a foreign market is another major issue with which international businesses must wrestle. The various modes for serving foreign markets are exporting, licensing or franchising to host-country firms, establishing joint ventures with a host-country firm, setting up a new wholly owned subsidiary in a host country to serve its market, and acquiring an established enterprise in the host nation to serve that market. Each of these options has advantages and disadvantages. The magnitude of the advan- tages and disadvantages associated with each entry mode is determined by a number of factors, including transport costs, trade barriers, political risks, economic risks, business risks, costs, and firm strategy. The optimal entry mode varies by situation, depending on these factors. Thus, whereas some firms may best serve a given market by exporting, other firms may better serve the market by setting up a new wholly owned subsidiary or by acquiring an established enterprise.

Starbucks, for example, seems to have had a preference for entering into joint ventures with local partners and then licensing its format to the joint venture. Starbucks has done this in order to benefit from its joint-venture partners’ local expertise, which has helped the company better configure its store format and menu to the tastes and preferences of local customers. In China, for example, its partners urged Starbucks to capitalize on the tea-drinking culture of the country by using popular local ingredients such as green tea. This helped get consumers through the door, and once they frequented the stores, they quickly developed a taste for Starbucks coffee.

The final topic of this chapter is strategic alliances. Strategic alliances are coopera- tive agreements between potential or actual competitors. The term is often used to em- brace a variety of agreements between actual or potential competitors including cross-shareholding deals, licensing arrangements, formal joint ventures, and informal cooperative arrangements. The motives for entering strategic alliances are varied, but they often include market access, hence the overlap with the topic of entry mode.

I N T E R A C T I V E R A N K I N G S

Entering foreign markets is the focus of Chapter 15. The selection of country markets to choose from is getting larger for many product categories as more countries see their popu- lations’ growing purchasing power. With more than 200 countries in the world, the data are overwhelming, and even the starting point for analysis is not always an easy decision. The Interactive Rankings on globalEDGE can serve as a great pictorial view of the world on some 50 important variables in categories covering the economy, energy, government, health, infrastructure, labor, people, and trade and investment (globaledge.msu.edu/tools-and-data/ interactive-rankings). Active data maps such as the Interactive Rankings maps are a good starting point for analysis to evaluate data for a specific country as well as the countries around in a region. This allows for a focus on entry into one market now and a strategy for expansion later on to nearby countries with similar characteristics. Which are the top three countries for Internet users?

Entry Strategy and Strategic Alliances Chapter 15 433

Basic Entry Decisions

A firm contemplating foreign expansion must make three basic decisions: which markets to enter, when to enter those markets, and on what scale.1

WHICH FOREIGN MARKETS?

There are now more than 200 countries in the world, and they do not all hold the same profit potential for a firm contemplating foreign expansion. Ultimately, the choice must be based on an assessment of a nation’s long-run profit potential. This potential is a func- tion of several factors, many of which we have studied in earlier chapters. Chapters 2 and 3 looked in detail at the economic and political factors that influence the potential attrac- tiveness of a foreign market. The attractiveness of a country as a potential market for an international business depends on balancing the benefits, costs, and risks associated with doing business in that country.

Chapters 2 and 3 also noted that the long-run economic benefits of doing business in a country are a function of factors such as the size of the market (in terms of demograph- ics), the present wealth (purchasing power) of consumers in that market, and the likely future wealth of consumers, which depends on economic growth rates. While some mar- kets are very large when measured by number of consumers (e.g., China, India, Brazil, Russia, and Indonesia), one must also look at living standards and economic growth. On this basis, China and India, while relatively poor, are growing so rapidly that they are attrac- tive targets for inward investment. Alternatively, weak growth in Indonesia implies that this populous nation is a far less attractive target for inward investment. As we saw in Chapters 2 and 3, likely future economic growth rates appear to be a function of a free market system and a country’s capacity for growth (which may be greater in less devel- oped nations). Also, the costs and risks associated with doing business in a foreign coun- try are typically lower in economically advanced and politically stable democratic nations, and they are greater in less developed and politically unstable nations.

The discussion in Chapters 2 and 3 suggests that, other things being equal, the bene- fit–cost–risk trade-off is likely to be most favorable in politically stable developed and developing nations that have free market systems, and where there is not a dramatic up- surge in either inflation rates or private-sector debt. The trade-off is likely to be least favorable in politically unstable developing nations that operate with a mixed or com- mand economy or in developing nations where speculative financial bubbles have led to excess borrowing.

Another important factor is the value an international business can create in a foreign market. This depends on the suitability of its product offering to that market and the nature of indigenous competition.2 If the international business can offer a product that has not been widely available in that market and that satisfies an unmet need, the value of that product to consumers is likely to be much greater than if the international busi- ness simply offers the same type of product that indigenous competitors and other for- eign entrants are already offering. Greater value translates into an ability to charge higher prices and/or to build sales volume more rapidly. By considering such factors, a firm can rank countries in terms of their attractiveness and long-run profit potential. Preference is then given to entering markets that rank highly. For example, Tesco, the large British grocery chain, has been aggressively expanding its foreign operations, pri- marily by focusing on emerging markets that lack strong indigenous competitors (see the accompanying Management Focus).

TIMING OF ENTRY

Once attractive markets have been identified, it is important to consider the timing of entry. Entry is early when an international business enters a foreign market before other foreign firms and late when it enters after other international businesses have already established themselves. The advantages frequently associated with entering a market early are commonly known as first-mover advantages.3 One first-mover advantage is

LO 15 -1 Explain the three basic decisions that firms contemplating foreign expansion must make: which markets to enter, when to enter those markets, and on what scale.

M A NAG E M E N T F O C U S

Tesco, founded in 1919 by Jack Cohen, is a British multina- tional grocery and merchandise retailer. It is the largest grocery retailer in the United Kingdom, with a 28 percent share of the local market, and the second-largest retailer in the world after Walmart measured by revenue. In 2014, Tesco had sales of more than $72 billion, more than 500,000 employees, and 6,784 stores. In its home market of the United Kingdom (with a headquarters in Chestnut, Hertfordshire, England), the company’s strengths are reputed to come from strong competencies in marketing and store site selection, lo- gistics and inventory management, and its own label product offerings. By the early 1990s, these competen- cies had already given the company a leading position in the United Kingdom. The company was generating strong free cash flows, and senior managers had to de- cide how to use that cash. One strategy they settled on was overseas expansion. As they looked at international markets, they soon con- cluded the best opportunities were not in established markets, such as those in North America and western Europe, where strong local competitors already existed, but in the emerging markets of eastern Europe and Asia where there were few capable competitors but strong un- derlying growth trends.  Tesco’s first international foray was into Hungary in 1994, when it acquired an initial 51 percent stake in Global, a 43-store, state-owned grocery

Tesco’s International Growth Strategy chain. By 2015, Tesco was the market leader in Hungary, with more than 200 stores and additional openings planned. In 1995, Tesco acquired 31 stores in Poland from Stavia; a year later it added 13 stores purchased from

Tesco is the largest grocery retailer in the United Kingdom, and the second-largest retailer worldwide after Walmart.

Source: © Guang Niu/Getty Images

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the ability to preempt rivals and capture demand by establishing a strong brand name. This desire has driven the rapid expansion by Tesco into developing nations (see the Man- agement Focus). A second advantage is the ability to build sales volume in that country and ride down the experience curve ahead of rivals, giving the early entrant a cost advan- tage over later entrants. This cost advantage may enable the early entrant to cut prices below that of later entrants, thereby driving them out of the market. A third advantage is the ability of early entrants to create switching costs that tie customers into their products or services. Such switching costs make it difficult for later entrants to win business.

There can also be disadvantages associated with entering a foreign market before other international businesses. These are often referred to as first-mover disadvantages.4 These disadvantages may give rise to pioneering costs, costs that an early entrant has to bear that a later entrant can avoid. Pioneering costs arise when the business system in a foreign coun- try is so different from that in a firm’s home market that the enterprise has to devote consid- erable effort, time, and expense to learning the rules of the game. Pioneering costs include the costs of business failure if the firm, due to its ignorance of the foreign environment, makes major mistakes. A certain liability is associated with being a foreigner, and this lia- bility is greater for foreign firms that enter a national market early.5 Research seems to

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Kmart in the Czech Republic and Slovakia; and the follow- ing year it entered the Republic of Ireland. Tesco now has more than 450 stores in Poland, some 80 stores in the Czech Republic, more than 120 stores in Slovakia, and more than 100 stores in Ireland. Tesco’s Asian expansion began in 1998 in Thailand when it purchased 75 percent of Lotus, a local food retailer with 13 stores. Building on that base, Tesco had more than 380 stores in Thailand by 2015. In 1999, the company en- tered South Korea when it partnered with Samsung to de- velop a chain of hypermarkets. This was followed by entry into Taiwan in 2000, Malaysia in 2002, Japan in 2003, and China in 2004. The move into China came after three years of careful research and discussions with potential partners. Like many other Western companies, Tesco was attracted to the Chinese market by its large size and rapid growth. In the end, Tesco settled on a 50–50 joint venture with Hymall, a hypermarket chain that is controlled by Ting Hsin, a Taiwanese group, which had been operating in China for six years. In 2014, Tesco combined its 131 stores in China in a joint venture with the state-run China Re- sources Enterprise (CRE) and its nearly 3,000 stores. Tesco owns 20 percent of the joint venture. As a result of these moves, by 2015 Tesco generated sales of $26 billion outside the United Kingdom (its UK an- nual revenues were $46 billion). The addition of international stores has helped make Tesco the second-largest company in the global grocery market behind only Walmart (Tesco is also behind Carrefour of France if profits are used). Of the three, however, Tesco may be the most successful interna- tionally. By 2015, all its foreign ventures were making money.

In explaining the company’s success, Tesco’s managers have detailed a number of important factors. First, the company devotes considerable attention to transferring its  core capabilities in retailing to its new ventures. At the same time, it does not send in an army of expatriate managers to run local operations, preferring to hire local managers and support them with a few operational experts from the United Kingdom. Second, the company believes that its partnering strategy in Asia has been a great asset. Tesco has teamed up with good companies that have a deep understanding of the markets in which they are partici- pating but that lack Tesco’s financial strength and retailing capabilities. Consequently, both Tesco and its partners have brought useful assets to the venture, increasing the proba- bility of success. As the venture becomes established, Tesco has typically increased its ownership stake in its part- ner. For example, by 2015 Tesco owned 100 percent of Homeplus, its South Korean hypermarket chain, but when the venture was established Tesco owned 51 percent. Third, the company has focused on markets with good growth po- tential but that lack strong indigenous competitors, which provides Tesco with ripe ground for expansion.

Sources: P. N. Child, “Taking Tesco Global,” The McKenzie Quarterly, no. 3 (2002); H. Keers, “Global Tesco Sets Out Its Stall in China,” Daily Telegraph, July 15, 2004, p. 31; K. Burgess, “Tesco Spends Pounds 140m on Chinese Partnership,” Financial Times, July 15, 2004, p. 22; J. McTaggart, “Industry Awaits Tesco Invasion,” Progressive Grocer, March 1, 2006, pp. 8–10; Tesco’s annual reports, archived at www. tesco.com; P. Sonne, “Five Years and $1.6 Billion Later, Tesco Decides to Quit US,” The Wall Street Journal, December 6, 2012; “Tesco Set to Push Ahead in the United States,” The Wall Street Journal, October 6, 2010, p. 19.

confirm that the probability of survival increases if an international business enters a na- tional market after several other foreign firms have already done so.6 The late entrant may benefit by observing and learning from the mistakes made by early entrants.

Pioneering costs also include the costs of promoting and establishing a product offer- ing, including the costs of educating customers. These can be significant when the product being promoted is unfamiliar to local consumers. In contrast, later entrants may be able to ride on an early entrant’s investments in learning and customer education by watching how the early entrant proceeded in the market, by avoiding costly mistakes made by the early entrant, and by exploiting the market potential created by the early entrant’s investments in customer education. For example, KFC introduced the Chinese to American-style fast food, but a later entrant, McDonald’s, has capitalized on the market in China.

An early entrant may be put at a severe disadvantage, relative to a later entrant, if regu- lations change in a way that diminishes the value of an early entrant’s investments. This is a serious risk in many developing nations where the rules that govern business prac- tices are still evolving. Early entrants can find themselves at a disadvantage if a subse- quent change in regulations invalidates prior assumptions about the best business model for operating in that country.

436 Part 5 The Strategy and Structure of International Business

SCALE OF ENTRY AND STRATEGIC COMMITMENTS

Another issue that an international business needs to consider when contemplating mar- ket entry is the scale of entry. Entering a market on a large scale involves the commitment of significant resources and implies rapid entry. Consider the entry of the Dutch insur- ance company ING into the U.S. insurance market in 1999. ING had to spend several billion dollars to acquire its U.S. operations. Not all firms have the resources necessary to enter on a large scale, and even some large firms prefer to enter foreign markets on a small scale and then build slowly as they become more familiar with the market.

The consequences of entering on a significant scale—entering rapidly—are associated with the value of the resulting strategic commitments.7 A strategic commitment has a long-term impact and is difficult to reverse. Deciding to enter a foreign market on a sig- nificant scale is a major strategic commitment. Strategic commitments, such as rapid large-scale market entry, can have an important influence on the nature of competition in a market. For example, by entering the U.S. financial services market on a significant scale, ING signaled its commitment to the market. This will have several effects. On the positive side, it will make it easier for the company to attract customers and distributors (such as insurance agents). The scale of entry gives both customers and distributors rea- sons for believing that ING will remain in the market for the long run. The scale of entry may also give other foreign institutions considering entry into the United States pause; now they will have to compete not only against indigenous institutions in the United States but also against an aggressive and successful European institution. On the negative side, by committing itself heavily to one country, the United States, ING may have fewer resources available to support expansion in other desirable markets, such as Japan. The commitment to the United States limits the company’s strategic flexibility.

As suggested by the ING example, significant strategic commitments are neither un- ambiguously good nor bad. Rather, they tend to change the competitive playing field and unleash a number of changes, some of which may be desirable and some of which will not be. It is important for a firm to think through the implications of large-scale entry into a market and act accordingly. Of particular relevance is trying to identify how actual and potential competitors might react to large-scale entry into a market. Also, the large- scale entrant is more likely than the small-scale entrant to be able to capture first-mover advantages associated with demand preemption, scale economies, and switching costs.

The value of the commitments that flow from rapid large-scale entry into a foreign market must be balanced against the resulting risks and lack of flexibility associated with significant commitments. But strategic inflexibility can also have value. A famous ex- ample from military history illustrates the value of inflexibility. When Hernán Cortés landed in Mexico, he ordered his men to burn all but one of his ships. Cortés reasoned that by eliminating their only method of retreat, his men had no choice but to fight hard to win against the Aztecs—and ultimately they did.8

Balanced against the value and risks of the commitments associated with large-scale entry are the benefits of a small-scale entry. Small-scale entry allows a firm to learn about a foreign market while limiting the firm’s exposure to that market. Small-scale entry is a way to gather information about a foreign market before deciding whether to enter on a significant scale and how best to enter. By giving the firm time to collect information, small-scale entry reduces the risks associated with a subsequent large-scale entry. But the lack of commitment associated with small-scale entry may make it more difficult for the small-scale entrant to build market share and to capture first-mover or early-mover advan- tages. The risk-averse firm that enters a foreign market on a small scale may limit its po- tential losses, but it may also miss the chance to capture first-mover advantages.

MARKET ENTRY SUMMARY

There are no “right” decisions here, just decisions that are associated with different levels of risk and reward. Entering a large developing nation such as China or India before most other international businesses in the firm’s industry, and entering on a large scale, will be

Entry Strategy and Strategic Alliances Chapter 15 437

associated with high levels of risk. In such cases, the liability of being foreign is in- creased by the absence of prior foreign entrants whose experience can be a useful guide. At the same time, the potential long-term rewards associated with such a strategy are great. The early large-scale entrant into a major developing nation may be able to capture significant first-mover advantages that will bolster its long-run position in that market.9 In contrast, entering developed nations such as Australia or Canada after other international businesses in the firm’s industry, and entering on a small scale to first learn more about those markets, will be associated with much lower levels of risk. However, the potential long-term rewards are also likely to be lower because the firm is essentially forgoing the opportunity to capture first-mover advantages and because the lack of commitment sig- naled by small-scale entry may limit its future growth potential.

This section has been written largely from the perspective of a business based in a developed country considering entry into foreign markets. Christopher Bartlett and Sumantra Ghoshal have pointed out the ability that businesses based in developing na- tions have to enter foreign markets and become global players.10 Although such firms tend to be late entrants into foreign markets, and although their resources may be limited, Bartlett and Ghoshal argue that such late movers can still succeed against well-estab- lished global competitors by pursuing appropriate strategies. In particular, Bartlett and Ghoshal argue that companies based in developing nations should use the entry of foreign multinationals as an opportunity to learn from these competitors by benchmarking their operations and performance against them. Furthermore, they suggest the local company may be able to find ways to differentiate itself from a foreign multinational, for example, by focusing on market niches that the multinational ignores or is unable to serve effec- tively if it has a standardized global product offering. Having improved its performance through learning and differentiated its product offering, the firm from a developing na- tion may then be able to pursue its own international expansion strategy. Even though the firm may be a late entrant into many countries, by benchmarking and then differentiating itself from early movers in global markets, the firm from the developing nation may still be able to build a strong international business presence. A good example of how this can work is given in the accompanying Management Focus, which looks at how Jollibee, a Philippines-based fast-food chain, has started to build a global presence in a market dom- inated by U.S. multinationals such as McDonald’s and KFC.

Entry Modes

Once a firm decides to enter a foreign market, the question arises as to the best mode of entry. Firms can use six different modes to enter foreign markets: exporting, turnkey proj- ects, licensing, franchising, establishing joint ventures with a host-country firm, or setting up a new wholly owned subsidiary in the host country. Each entry mode has advantages and disadvantages. Managers need to consider these carefully when deciding which to use.11

EXPORTING

Many manufacturing firms begin their global expansion as exporters and only later switch to another mode for serving a foreign market. We take a close look at the mechan- ics of exporting in Chapter 16. Here we focus on the advantages and disadvantages of exporting as an entry mode.

Advantages Exporting has two distinct advantages. First, it avoids the often substantial costs of estab- lishing manufacturing operations in the host country. Second, exporting may help a firm achieve experience curve and location economies (see Chapter 13). By manufacturing the product in a centralized location and exporting it to other national markets, the firm may realize substantial scale economies from its global sales volume. This is how many Japa- nese automakers made inroads into the U.S. market.

TEST PREP Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

LO 15 -2 Compare and contrast the different modes that firms use to enter foreign markets.

Disadvantages Exporting has a number of drawbacks. First, exporting from the firm’s home base may not be appropriate if lower-cost locations for manufacturing the product can be found abroad (i.e., if the firm can realize location economies by moving production elsewhere). Thus, particularly for firms pursuing global or transnational strategies, it may be prefer- able to manufacture where the mix of factor conditions is most favorable from a value creation perspective and to export to the rest of the world from that location. This is not so much an argument against exporting as an argument against exporting from the firm’s home country. Many U.S. electronics firms have moved some of their manufacturing to the Far East because of the availability of low-cost, highly skilled labor there. They then export from that location to the rest of the world, including the United States.

M A NAG E M E N T F O C U S

Jollibee Foods Corporation, abbreviated JFC and more popularly known as Jollobee, is one of the Philippines’ phenomenal business success stories. Jollibee, which stands for “Jolly Bee,” began operations in 1975 as a two- branch ice cream parlor. It later expanded its menu to in- clude hot sandwiches and other meals. Encouraged by early success, Jollibee Foods Corporation was incorpo- rated in 1978, with a network that had grown to seven outlets. In 1981, when Jollibee had 11 stores, McDonald’s began to open stores in Manila. Many observers thought Jollibee would have difficulty competing against McDonald’s. However, Jollibee saw this as an opportunity to learn from a very successful global competitor. Jollibee benchmarked its performance against that of McDonald’s and started to adopt operational systems similar to those used at McDonald’s to control its quality, cost, and ser- vice at the store level. This helped Jollibee improve its performance. As it came to better understand McDonald’s business model, Jollibee began to look for a weakness in McDonald’s global strategy. Jollibee executives concluded that McDonald’s fare was too standardized for many locals and that the local firm could gain share by tailoring its menu to local tastes. Jollibee’s hamburgers were set apart by a se- cret mix of spices blended into the ground beef to make the burgers sweeter than those produced by McDonald’s, appealing more to Philippine tastes. It also offered local fare, including various rice dishes, pineapple burgers, and banana langka and peach mango pies for desserts. By pursuing this strategy, Jollibee maintained a leadership position over the global giant. By 2015, Jollibee had over 801 stores in the Philippines for its Jollibee brand and some 2,040 total stores across all of its brands (e.g., Jollibee,

The Jollibee Phenomenon Chowking, Greenwich, Red Ribbon, Mang INasal, and Burger King), a market share of more than 60 percent, and revenues in excess of $600 million. McDonald’s, in con- trast, had about 400 stores. The international expansion started in the mid-1980s. Jollibee’s initial ventures were into neighboring Asian countries such as Indonesia, where it pursued the strategy of localiz- ing the menu to better match local tastes, thereby differenti- ating itself from McDonald’s. In 1987, Jollibee entered the Middle East, where a large contingent of expatriate Filipino workers provided a ready-made market for the company. The strategy of focusing on expatriates worked so well that in the late 1990s Jollibee decided to enter another foreign market where there was a large Filipino population—the United States. Between 1999 and 2012, Jollibee opened 25 stores in the United States, 20 of which are in California. Even though many believe the U.S. fast-food market is satu- rated, the stores have performed well. While the initial clien- tele was strongly biased toward the expatriate Filipino community, where Jollibee’s brand awareness is high, non- Filipinos increasingly are coming to the restaurant. In the San Francisco store, which has been open the longest, more than half the customers are now non-Filipino. Today, Jollibee has some 500 international stores and a potentially bright future as a niche player in a market that has histori- cally been dominated by U.S. multinationals.

Sources: “Jollibee Battles Burger Giants in US Market,” Philippine Daily Inquirer, July 13, 2000; M. Ballon, “Jollibee Struggling to Expand in U.S.,” Los Angeles Times, September 16, 2002, p. C1; J. Hookway, “Burgers and Beer,” Far Eastern Economic Review, December 2003, pp. 72–74; S. E. Lockyer, “Coming to America,” Nation’s Restaurant News, February 14, 2005, pp. 33–35; Erik de la Cruz, “Jollibee to Open 120 New Stores This Year, Plans India,” Inquirer Money, July 5, 2006 (business.inquirer.net); www.jollibee.com.ph.

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A second drawback to exporting is that high transport costs can make exporting un- economical, particularly for bulk products. One way of getting around this is to manufac- ture bulk products regionally. This strategy enables the firm to realize some economies from large-scale production and at the same time to limit its transport costs. For example, many multinational chemical firms manufacture their products regionally, serving sev- eral countries from one facility.

Another drawback is that tariff barriers can make exporting uneconomical. Similarly, the threat of tariff barriers by the host-country government can make it very risky. A fourth drawback to exporting arises when a firm delegates its marketing, sales, and ser- vice in each country where it does business to another company. This is a common ap- proach for manufacturing firms that are just beginning to expand internationally. The other company may be a local agent, or it may be another multinational with extensive international distribution operations. Local agents often carry the products of competing firms and so have divided loyalties. In such cases, the local agent may not do as good a job as the firm would if it managed its marketing itself. Similar problems can occur when another multinational takes on distribution.

The way around such problems is to set up wholly owned subsidiaries in foreign na- tions to handle local marketing, sales, and service. By doing this, the firm can exercise tight control over marketing and sales in the country while reaping the cost advantages of manufacturing the product in a single location or a few choice locations.

TURNKEY PROJECTS

Firms that specialize in the design, construction, and start-up of turnkey plants are com- mon in some industries. In a turnkey project, the contractor agrees to handle every detail of the project for a foreign client, including the training of operating personnel. At com- pletion of the contract, the foreign client is handed the “key” to a plant that is ready for full operation—hence, the term turnkey. This is a means of exporting process technology to other countries. Turnkey projects are most common in the chemical, pharmaceutical, petroleum-refining, and metal-refining industries, all of which use complex, expensive production technologies.

Advantages The know-how required to assemble and run a technologically complex process, such as refining petroleum or steel, is a valuable asset. Turnkey projects are a way of earning great economic returns from that asset. The strategy is particularly useful where foreign direct investment (FDI) is limited by host-government regulations. For example, the gov- ernments of many oil-rich countries have set out to build their own petroleum-refining industries, so they restrict FDI in their oil-refining sectors. But because many of these countries lack petroleum-refining technology, they gain it by entering into turnkey proj- ects with foreign firms that have the technology. Such deals are often attractive to the selling firm because without them, they would have no way to earn a return on their valu- able know-how in that country. A turnkey strategy can also be less risky than conven- tional FDI. In a country with unstable political and economic environments, a longer-term investment might expose the firm to unacceptable political and/or economic risks (e.g., the risk of nationalization or of economic collapse).

Disadvantages Three main drawbacks are associated with a turnkey strategy. First, the firm that enters into a turnkey deal will have no long-term interest in the foreign country. This can be a disadvantage if that country subsequently proves to be a major market for the output of the process that has been exported. One way around this is to take a minority equity in- terest in the operation. Second, the firm that enters into a turnkey project with a foreign enterprise may inadvertently create a competitor. For example, many of the Western

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firms that sold oil-refining technology to firms in Saudi Arabia, Kuwait, and other Gulf states now find themselves competing with these firms in the world oil market. Third, if the firm’s process technology is a source of competitive advantage, then selling this tech- nology through a turnkey project is also selling competitive advantage to potential and/or actual competitors.

LICENSING

A licensing agreement is an arrangement whereby a licensor grants the rights to intan- gible property to another entity (the licensee) for a specified period, and in return, the li- censor receives a royalty fee from the licensee.12 Intangible property includes patents, inventions, formulas, processes, designs, copyrights, and trademarks. For example, to enter the Japanese market, Xerox, inventor of the photocopier, established a joint venture with Fuji Photo that is known as Fuji Xerox. Xerox then licensed its xerographic know- how to Fuji Xerox. In return, Fuji Xerox paid Xerox a royalty fee equal to 5 percent of the net sales revenue that Fuji Xerox earned from the sales of photocopiers based on Xerox’s patented know-how. In the Fuji Xerox case, the license was originally granted for 10 years, and it has been renegotiated and extended several times since. The licensing agreement between Xerox and Fuji Xerox also limited Fuji Xerox’s direct sales to the Asian Pacific region (although Fuji Xerox does supply Xerox with photocopiers that are sold in North America under the Xerox label).13

Advantages In the typical international licensing deal, the licensee puts up most of the capital neces- sary to get the overseas operation going. Thus, a primary advantage of licensing is that the firm does not have to bear the development costs and risks associated with opening a foreign market. Licensing is very attractive for firms lacking the capital to develop opera- tions overseas. In addition, licensing can be attractive when a firm is unwilling to commit substantial financial resources to an unfamiliar or politically volatile foreign market. Li- censing is also often used when a firm wishes to participate in a foreign market but is prohibited from doing so by barriers to investment. This was one of the original rea- sons for the formation of the Fuji Xerox joint venture. Xerox wanted to participate in the Japanese market but was prohibited from setting up a wholly owned subsidiary by the Japanese government. So Xerox set up the joint venture with Fuji and then licensed its know-how to the joint venture.

Finally, licensing is frequently used when a firm possesses some intangible property that might have business applications, but it does not want to develop those applications itself. For example, Bell Laboratories at AT&T originally invented the transistor circuit in the 1950s, but AT&T decided it did not want to produce transistors, so it licensed the technology to a number of other companies, such as Texas Instruments. Similarly, Coca- Cola has licensed its famous trademark to clothing manufacturers, which have incorpo- rated the design into clothing. Harley-Davidson licenses its brand to Wolverine World Wide to make footwear that embodies the spirit of the open road, which Harley-Davidson is so known to emphasize in its advertisements and product positioning. 

Disadvantages Licensing has three serious drawbacks. First, it does not give a firm the tight control over manufacturing, marketing, and strategy that is required for realizing experience curve and location economies. Licensing typically involves each licensee setting up its own production operations. This severely limits the firm’s ability to realize experience curve and location economies by producing its product in a centralized location. When these economies are important, licensing may not be the best way to expand overseas.

Second, competing in a global market may require a firm to coordinate strategic moves across countries by using profits earned in one country to support competitive at- tacks in another. By its very nature, licensing limits a firm’s ability to do this. A licensee

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is unlikely to allow a multinational firm to use its profits (beyond those due in the form of royalty payments) to support a different licensee operating in another country.

A third problem with licensing is one that we encountered in Chapter 8 when we re- viewed the economic theory of foreign direct investment (FDI). This is the risk associ- ated with licensing technological know-how to foreign companies. Technological know-how constitutes the basis of many multinational firms’ competitive advantage. Most firms wish to maintain control over how their know-how is used, and a firm can quickly lose control over its technology by licensing it. Many firms have made the mis- take of thinking they could maintain control over their know-how within the framework of a licensing agreement. RCA Corporation, for example, once licensed its color TV tech- nology to Japanese firms including Matsushita and Sony. The Japanese firms quickly assimilated the technology, improved on it, and used it to enter the U.S. market, taking substantial market share away from RCA.

There are ways of reducing this risk. One way is by entering into a cross-licensing agree- ment with a foreign firm. Under a cross-licensing agreement, a firm might license some valuable intangible property to a foreign partner, but in addition to a royalty payment, the firm might also request that the foreign partner license some of its valuable know-how to the firm. Such agreements are believed to reduce the risks associated with licensing techno- logical know-how, since the licensee realizes that if it violates the licensing contract (by using the knowledge obtained to compete directly with the licensor), the licensor can do the same to it. Cross-licensing agreements enable firms to hold each other hostage, which re- duces the probability that they will behave opportunistically toward each other.14 Such cross-licensing agreements are increasingly common in high-technology industries.

Another way of reducing the risk associated with licensing is to follow the Fuji Xerox model and link an agreement to license know-how with the formation of a joint venture in which the licensor and licensee take important equity stakes. Such an approach aligns the interests of licensor and licensee, because both have a stake in ensuring that the ven- ture is successful. Thus, the risk that Fuji Photo might appropriate Xerox’s technological know-how, and then compete directly against Xerox in the global photocopier market, was reduced by the establishment of a joint venture in which both Xerox and Fuji Photo had an important stake.

FRANCHISING

Franchising is similar to licensing, although franchising tends to involve longer-term commitments than licensing. Franchising is basically a specialized form of licensing in which the franchiser not only sells intangible property (normally a trademark) to the fran- chisee but also insists that the franchisee agree to abide by strict rules as to how it does business. The franchiser will also often assist the franchisee to run the business on an ongoing basis. As with licensing, the franchiser typically receives a royalty payment, which amounts to some percentage of the franchisee’s revenues. Whereas licensing is pursued primarily by manufacturing firms, franchising is employed primarily by service firms.15 McDonald’s is a good example of a firm that has grown by using a franchising strategy. McDonald’s strict rules as to how franchisees should operate a restaurant extend to control over the menu, cooking methods, staffing policies, and design and location. McDonald’s also organizes the supply chain for its franchisees and provides management training and financial assistance.16

Advantages The advantages of franchising as an entry mode are very similar to those of licensing. The firm is relieved of many of the costs and risks of opening a foreign market on its own. Instead, the franchisee typically assumes those costs and risks. This creates a good incentive for the franchisee to build a profitable operation as quickly as possible. Thus, using a franchising strategy, a service firm can build a global presence quickly and at a relatively low cost and risk, as McDonald’s has.

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Disadvantages The disadvantages are less pronounced than in the case of licensing. Since franchising is often used by service companies, there is no reason to consider the need for coordination of manufacturing to achieve experience curve and location economies. But franchising may inhibit the firm’s ability to take profits out of one country to support competitive at- tacks in another. A more significant disadvantage of franchising is quality control. The foundation of franchising arrangements is that the firm’s brand name conveys a message to consumers about the quality of the firm’s product. Thus, a business traveler checking in at a Four Seasons hotel in Hong Kong can reasonably expect the same quality of room, food, and service that she would receive in New York. The Four Seasons name is sup- posed to guarantee consistent product quality. This presents a problem in that foreign franchisees may not be as concerned about quality as they are supposed to be, and the result of poor quality can extend beyond lost sales in a particular foreign market to a de- cline in the firm’s worldwide reputation. For example, if the business traveler has a bad experience at the Four Seasons in Hong Kong, she may never go to another Four Seasons hotel and may urge her colleagues to do likewise. The geographic distance of the firm from its foreign franchisees can make poor quality difficult to detect. In addition, the sheer numbers of franchisees—in the case of McDonald’s, tens of thousands—can make quality control difficult. Due to these factors, quality problems may persist.

One way around this disadvantage is to set up a subsidiary in each country in which the firm expands. The subsidiary might be wholly owned by the company or a joint ven- ture with a foreign company. The subsidiary assumes the rights and obligations to estab- lish franchises throughout the particular country or region. McDonald’s, for example, establishes a master franchisee in many countries. Typically, this master franchisee is a joint venture between McDonald’s and a local firm. The proximity and the smaller num- ber of franchises to oversee reduce the quality control challenge. In addition, because the subsidiary (or master franchisee) is at least partly owned by the firm, the firm can place its own managers in the subsidiary to help ensure that it is doing a good job of monitoring the franchises. This organizational arrangement has proven very satisfactory for McDonald’s, KFC, and others.

JOINT VENTURES

A joint venture entails establishing a firm that is jointly owned by two or more other- wise independent firms. Fuji Xerox, for example, was set up as a joint venture between Xerox and Fuji Photo. Establishing a joint venture with a foreign firm has long been a popular mode for entering a new market. The most typical joint venture is a 50–50 ven- ture, in which there are two parties, each of which holding a 50 percent ownership stake and contributing a team of managers to share operating control. This was the case with the Fuji–Xerox joint venture until 2001; it is now a 25–75 venture with Xerox holding 25 percent. The GM SAIC venture in China was a 50–50 venture until 2010, which it became a 51–49 venture, with SAIC holding the 51 percent stake. Some firms, however, have sought joint ventures in which they have a majority share and thus tighter control.17

Advantages Joint ventures have a number of advantages. First, a firm benefits from a local partner’s knowledge of the host country’s competitive conditions, culture, language, political systems, and business. Thus, for many U.S. firms, joint ventures have involved the U.S. company providing technological know-how and products and the local partner provid- ing the marketing expertise and the local knowledge necessary for competing in that country. Second, when the development costs and/or risks of opening a foreign market are high, a firm might gain by sharing these costs and or risks with a local partner. Third, in many countries, political considerations make joint ventures the only feasible entry mode. Research suggests joint ventures with local partners face a low risk of be- ing subject to nationalization or other forms of adverse government interference.18 This

Entry Strategy and Strategic Alliances Chapter 15 443

appears to be because local equity partners, who may have some influence on host- government policy, have a vested interest in speaking out against nationalization or government interference.

Disadvantages Despite these advantages, there are major disadvantages with joint ventures. First, as with licensing, a firm that enters into a joint venture risks giving control of its technology to its partner. Thus, a proposed joint venture in 2002 between Boeing and Mitsubishi Heavy Industries to build a new wide-body jet (the 787) raised fears that Boeing might unwit- tingly give away its commercial airline technology to the Japanese. However, joint-venture agreements can be constructed to minimize this risk. One option is to hold majority ownership in the venture. This allows the dominant partner to exercise greater control over its technology. But it can be difficult to find a foreign partner who is willing to settle for minority ownership. Another option is to “wall off” from a partner technology that is central to the core competence of the firm, while sharing other technology.

A second disadvantage is that a joint venture does not give a firm the tight control over subsidiaries that it might need to realize experience curve or location economies. Nor does it give a firm the tight control over a foreign subsidiary that it might need for engag- ing in coordinated global attacks against its rivals. Consider the entry of Texas Instru- ments (TI) into the Japanese semiconductor market. When TI established semiconductor facilities in Japan, it did so for the dual purpose of checking Japanese manufacturers’ market share and limiting their cash available for invading TI’s global market. In other words, TI was engaging in global strategic coordination. To implement this strategy, TI’s subsidiary in Japan had to be prepared to take instructions from corporate headquarters regarding competitive strategy. The strategy also required the Japanese subsidiary to run at a loss if necessary. Few if any potential joint-venture partners would have been willing to accept such conditions, since it would have necessitated a willingness to accept a negative return on investment. Indeed, many joint ventures establish a degree of autonomy that would make such direct control over strategic decisions all but impossible to establish.19 Thus, to implement this strategy, TI set up a wholly owned subsidiary in Japan.

A third disadvantage with joint ventures is that the shared ownership arrangement can lead to conflicts and battles for control between the investing firms if their goals and objectives change or if they take different views as to what the strategy should be. This was apparently not a problem with the Fuji Xerox joint venture. According to Yotaro Kobayashi, the former chair of Fuji Xerox, a primary reason is that both Xerox and Fuji Photo adopted an arm’s-length relationship with Fuji Xerox, giving the venture’s management considerable freedom to determine its own strategy.20 However, much research indicates that conflicts of interest over strategy and goals often arise in joint ventures. These con- flicts tend to be greater when the venture is between firms of different nationalities, and they often end in the dissolution of the venture.21 Such conflicts tend to be triggered by shifts in the relative bargaining power of venture partners. For example, in the case of ventures between a foreign firm and a local firm, as a foreign partner’s knowledge about local market conditions increases, it depends less on the expertise of a local partner. This increases the bargaining power of the foreign partner and ultimately leads to conflicts over control of the venture’s strategy and goals.22 Some firms have sought to limit such problems by entering into joint ventures in which one partner has a controlling interest.

WHOLLY OWNED SUBSIDIARIES

In a wholly owned subsidiary, the firm owns 100 percent of the stock. Establishing a wholly owned subsidiary in a foreign market can be done two ways. The firm either can set up a new operation in that country, often referred to as a greenfield venture, or it can acquire an established firm in that host nation and use that firm to promote its products.23 For example, ING’s strategy for entering the U.S. insurance market was to acquire estab- lished U.S. enterprises, rather than try to build an operation from the ground floor.

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Advantages There are several clear advantages of wholly owned subsidiaries. First, when a firm’s competitive advantage is based on technological competence, a wholly owned subsidiary will often be the preferred entry mode because it reduces the risk of losing control over that competence. (See Chapter 8 for more details.) Many high-tech firms prefer this entry mode for overseas expansion (e.g., firms in the semiconductor, electronics, and pharma- ceutical industries). Second, a wholly owned subsidiary gives a firm tight control over operations in different countries. This is necessary for engaging in global strategic coor- dination (i.e., using profits from one country to support competitive attacks in another).

Third, a wholly owned subsidiary may be required if a firm is trying to realize loca- tion and experience curve economies (as firms pursuing global and transnational strate- gies try to do). As we saw in Chapter 11, when cost pressures are intense, it may pay a firm to configure its value chain in such a way that the value added at each stage is maxi- mized. Thus, a national subsidiary may specialize in manufacturing only part of the product line or certain components of the end product, exchanging parts and products with other subsidiaries in the firm’s global system. Establishing such a global production system requires a high degree of control over the operations of each affiliate. The various operations must be prepared to accept centrally determined decisions as to how they will produce, how much they will produce, and how their output will be priced for transfer to the next operation. Because licensees or joint-venture partners are unlikely to accept such a subservient role, establishing wholly owned subsidiaries may be necessary. Finally, es- tablishing a wholly owned subsidiary gives the firm a 100 percent share in the profits generated in a foreign market.

Disadvantage Establishing a wholly owned subsidiary is generally the most costly method of serving a foreign market from a capital investment standpoint. Firms doing this must bear the full capital costs and risks of setting up overseas operations. The risks associated with learn- ing to do business in a new culture are less if the firm acquires an established host-coun- try enterprise. However, acquisitions raise additional problems, including those associated with trying to marry divergent corporate cultures. These problems may more than offset any benefits derived by acquiring an established operation. Because the choice between greenfield ventures and acquisitions is such an important one, we discuss it in more detail later in the chapter.

Selecting an Entry Mode

As the preceding discussion demonstrated, all the entry modes have advantages and dis- advantages, as summarized in Table 15.1. Thus, trade-offs are inevitable when selecting an entry mode. For example, when considering entry into an unfamiliar country with a track record for discriminating against foreign-owned enterprises when awarding govern- ment contracts, a firm might favor a joint venture with a local enterprise. Its rationale might be that the local partner will help it establish operations in an unfamiliar environ- ment and will help the company win government contracts. However, if the firm’s core competence is based on proprietary technology, entering a joint venture might risk losing control of that technology to the joint-venture partner, in which case the strategy may seem unattractive. Despite the existence of such trade-offs, it is possible to make some generalizations about the optimal choice of entry mode.24

CORE COMPETENCIES AND ENTRY MODE

We saw in Chapter 13 that firms often expand internationally to earn greater returns from their core competencies, transferring the skills and products derived from their core com- petencies to foreign markets where indigenous competitors lack those skills. The optimal

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LO 15 -3 Identify the factors that influence a firm’s choice of entry mode.

Entry Strategy and Strategic Alliances Chapter 15 445

entry mode for these firms depends to some degree on the nature of their core competen- cies. A distinction can be drawn between firms whose core competency is in technologi- cal know-how and those whose core competency is in management know-how.

Technological Know-How As was observed in Chapter 8, if a firm’s competitive advantage (its core competence) is based on control over proprietary technological know-how, licensing and joint-venture arrangements should be avoided if possible to minimize the risk of losing control over that technology. Thus, if a high-tech firm sets up operations in a foreign country to profit from a core competency in technological know-how, it will probably do so through a wholly owned subsidiary. This rule should not be viewed as hard and fast, however. Sometimes a licensing or joint-venture arrangement can be structured to reduce the risk of licensees or joint-venture partners expropriating technological know-how. Another ex- ception exists when a firm perceives its technological advantage to be only transitory, when it expects rapid imitation of its core technology by competitors. In such cases, the firm might want to license its technology as rapidly as possible to foreign firms to gain global acceptance for its technology before the imitation occurs.25 Such a strategy has some advantages. By licensing its technology to competitors, the firm may deter them from developing their own, possibly superior, technology. Further, by licensing its tech- nology, the firm may establish its technology as the dominant design in the industry. This may ensure a steady stream of royalty payments. However, the attractions of licensing are frequently outweighed by the risks of losing control over technology, and if this is a risk, licensing should be avoided.

Entry Mode Advantages Disadvantages Exporting Ability to realize location and High transport costs experience curve economies Trade barriers Increased speed and flexibility of Problems with local marketing agents engaging target markets

Turnkey contracts Ability to earn returns from process Creation of efficient competitors technology skills in countries where Lack of long-term market presence FDI is restricted

Licensing Low development costs and risks Lack of control over technology Moderate involvement and commitment Inability to realize location and experience curve economies Inability to engage in global strategic coordination

Franchising Low development costs and risks Lack of control over quality Possible circumvention of import Inability to engage in global barriers, and strong sales potential strategic coordination

Joint ventures Access to local partner’s knowledge Lack of control over technology Shared development costs and risks Inability to engage in global Politically acceptable strategic coordination Typically no ownership restrictions Inability to realize location and experience economies

Wholly owned subsidiaries Protection of technology High costs and risks Ability to engage in global strategic Need for more human and nonhuman coordination resources, and interaction and Ability to realize location and integration with local employees experience economies

TA B L E 1 5 . 1

Advantages and Disadvantages of Entry Modes

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Management Know-How The competitive advantage of many service firms is based on management know-how (e.g., McDonald’s, Starbucks). For such firms, the risk of losing control over the manage- ment skills to franchisees or joint-venture partners is not that great. These firms’ valuable asset is their brand name, and brand names are generally well protected by international laws pertaining to trademarks. Given this, many of the issues arising in the case of tech- nological know-how are of less concern here. As a result, many service firms favor a combination of franchising and master subsidiaries to control the franchises within par- ticular countries or regions. The master subsidiaries may be wholly owned or joint ven- tures, but most service firms have found that joint ventures with local partners work best for the master controlling subsidiaries. A joint venture is often politically more accept- able and brings a degree of local knowledge to the subsidiary.

PRESSURES FOR COST REDUCTIONS AND ENTRY MODE

The greater the pressures for cost reductions, the more likely a firm will want to pursue some combination of exporting and wholly owned subsidiaries. By manufacturing in those locations where factor conditions are optimal and then exporting to the rest of the world, a firm may be able to realize substantial location and experience curve economies. The firm might then want to export the finished product to marketing subsidiaries based in various countries. These subsidiaries will typically be wholly owned and have the re- sponsibility for overseeing distribution in their particular countries. Setting up wholly owned marketing subsidiaries is preferable to joint-venture arrangements and to using foreign marketing agents because it gives the firm tight control that might be required for coordinating a globally dispersed value chain. It also gives the firm the ability to use the profits generated in one market to improve its competitive position in another market. In other words, firms pursuing global standardization or transnational strategies tend to pre- fer establishing wholly owned subsidiaries.

Greenfield Venture or Acquisition?

A firm can establish a wholly owned subsidiary in a country by building a subsidiary from the ground up, the so-called greenfield strategy, or by acquiring an enterprise in the target market.26 The volume of cross-border acquisitions has been growing at a rapid rate for two decades. Over most of the past decades, between 40 and 80 percent of all foreign direct investment (FDI) inflows have been in the form of mergers and acquisitions.27

PROS AND CONS OF ACQUISITIONS

Acquisitions have three major points in their favor. First, they are quick to execute. By acquiring an established enterprise, a firm can rapidly build its presence in the target foreign market. When the German automobile company Daimler-Benz decided it needed a bigger presence in the U.S. automobile market, it did not increase that presence by building new factories to serve the United States, a process that would have taken years. Instead, it acquired the third-largest U.S. automobile company, Chrysler, and merged the two operations to form DaimlerChrysler (Daimler spun off Chrysler into a private equity firm in 2007). When the Spanish telecommunications service provider Telefónica wanted to build a service presence in Latin America, it did so through a series of acquisitions, purchasing telecommunications companies in Brazil and Argentina. In these cases, the firms made acquisitions because they knew that was the quickest way to establish a siz- able presence in the target market.

Second, in many cases firms make acquisitions to preempt their competitors. The need for preemption is particularly great in markets that are rapidly globalizing, such as tele- communications, where a combination of deregulation within nations and liberalization of regulations governing cross-border foreign direct investment has made it much easier

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LO 15 - 4 Recognize the pros and cons of acquisitions versus greenfield ventures as an entry strategy.

Entry Strategy and Strategic Alliances Chapter 15 447

for enterprises to enter foreign markets through acquisitions. Such markets may see concentrated waves of acquisitions as firms race each other to attain global scale. In the telecommunications industry, for example, regulatory changes triggered what can be called a feeding frenzy, with firms entering each other’s markets via acquisitions to establish a global presence. These included the $56 billion acquisition of AirTouch Communications in the United States by the British company Vodafone, which was the largest acquisition ever; the $13 billion acquisition of One 2 One in Britain by the German company Deutsche Telekom; and the $6.4 billion acquisition of Excel Communications in the United States by Teleglobe of Canada.28 A similar wave of cross-border acquisitions occurred in the global automobile industry, with Daimler acquiring Chrysler, Ford acquiring Volvo (and then selling Volvo as well), and Renault acquiring Nissan.

Third, managers may believe acquisitions to be less risky than greenfield ventures. When a firm makes an acquisition, it buys a set of assets that are producing a known revenue and profit stream. In contrast, the revenue and profit stream that a greenfield venture might gen- erate is uncertain because it does not yet exist. When a firm makes an acquisition in a foreign market, it not only acquires a set of tangible assets, such as factories, logistics systems, cus- tomer service systems, and so on, but also acquires valuable intangible assets, including a local brand name and managers’ knowledge of the business environment in that nation. Such knowledge can reduce the risk of mistakes caused by ignorance of the national culture.

Despite the arguments for engaging in acquisitions, many acquisitions often produce disappointing results.29 For example, a study by Mercer Management Consulting looked at 150 acquisitions worth more than $500 million each.30 The Mercer study concluded that 50 percent of these acquisitions eroded shareholder value, while another 33 percent created only marginal returns. Only 17 percent were judged to be successful. Similarly, a study by KPMG, an accounting and management consulting company, looked at 700 large acquisitions. The study found that while some 30 percent of these actually created value for the acquiring company, 31 percent destroyed value, and the remainder had little im- pact.31 A similar study by McKinsey & Company estimated that some 70 percent of mergers and acquisitions failed to achieve expected revenue synergies.32 In a seminal study of the postacquisition performance of acquired companies, David Ravenscraft and Mike Scherer concluded that on average the profits and market shares of acquired com- panies declined following acquisition.33 They also noted that a smaller but substantial subset of those companies experienced traumatic difficulties, which ultimately led to their being sold by the acquiring company. Ravenscraft and Scherer’s evidence suggests that many acquisitions destroy rather than create value. While most research has looked at domestic acquisitions, the findings probably also apply to cross-border acquisitions.34

Why Do Acquisitions Fail? Acquisitions fail for several reasons. First, the acquiring firms often overpay for the as- sets of the acquired firm. The price of the target firm can get bid up if more than one firm is interested in its purchase, as is often the case. In addition, the management of the ac- quiring firm is often too optimistic about the value that can be created via an acquisition and is thus willing to pay a significant premium over a target firm’s market capitalization. This is called the “hubris hypothesis” of why acquisitions fail. The hubris hypothesis postulates that top managers typically overestimate their ability to create value from an acquisition, primarily because rising to the top of a corporation has given them an exag- gerated sense of their own capabilities.35 For example, Daimler acquired Chrysler in 1998 for $40 billion, a premium of 40 percent over the market value of Chrysler before the takeover bid. Daimler paid this much because it thought it could use Chrysler to help it grow market share in the United States. At the time, Daimler’s management issued bold announcements about the “synergies” that would be created from combining the opera- tions of the two companies. However, within a year of the acquisition, Daimler’s German management was faced with a crisis at Chrysler, which was suddenly losing money due to weak sales in the United States. In retrospect, Daimler’s management had been far too optimistic about the potential for future demand in the U.S. auto market and about the

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opportunities for creating value from “synergies.” Daimler acquired Chrysler at the end of a multiyear boom in U.S. auto sales and paid a large premium over Chrysler’s market value just before demand slumped (and in 2007, in an admission of failure, Daimler sold its Chrysler unit to a private equity firm).36

Second, many acquisitions fail because there is a clash between the cultures of the ac- quiring and acquired firms. After an acquisition, many acquired companies experience high management turnover, possibly because their employees do not like the acquiring company’s way of doing things.37 This happened at DaimlerChrysler; many senior manag- ers left Chrysler in the first year after the merger. Apparently, Chrysler executives disliked the dominance in decision making by Daimler’s German managers, while the Germans resented that Chrysler’s American managers were paid two to three times as much as their German counterparts. These cultural differences created tensions, which ultimately exhib- ited themselves in high management turnover at Chrysler.38 The loss of management talent and expertise can materially harm the performance of the acquired unit.39 This may be particularly problematic in an international business, where management of the acquired unit may have valuable local knowledge that can be difficult to replace.

Third, many acquisitions fail because attempts to realize gains by integrating the op- erations of the acquired and acquiring entities often run into roadblocks and take much longer than forecast. Differences in management philosophy and company culture can slow the integration of operations. Differences in national culture may exacerbate these problems. Bureaucratic haggling between managers also complicates the process. Again, this reportedly occurred at DaimlerChrysler, where grand plans to integrate the opera- tions of the two companies were bogged down by endless committee meetings and by simple logistical considerations such as the six-hour time difference between Detroit and Germany. By the time an integration plan had been worked out, Chrysler was losing money, and Daimler’s German managers suddenly had a crisis on their hands.

Finally, many acquisitions fail due to inadequate preacquisition screening.40 Many firms decide to acquire other firms without thoroughly analyzing the potential benefits and costs. They often move with undue haste to execute the acquisition, perhaps because they fear another competitor may preempt them. After the acquisition, however, many acquiring firms discover that instead of buying a well-run business, they have purchased a troubled organization. This may be a particular problem in cross-border acquisitions because the acquiring firm may not fully understand the target firm’s national culture and business system.

Reducing the Risks of Failure These problems can all be overcome if the firm is careful about its acquisition strategy.41 Screening of the foreign enterprise to be acquired, including a detailed auditing of opera- tions, financial position, and management culture, can help to make sure the firm (1) does not pay too much for the acquired unit, (2) does not uncover any nasty surprises after the acquisition, and (3) acquires a firm whose organization culture is not antagonistic to that of the acquiring enterprise. It is also important for the acquirer to allay any concerns that management in the acquired enterprise might have. The objective should be to reduce unwanted management attrition after the acquisition. Finally, managers must move rap- idly after an acquisition to put an integration plan in place and to act on that plan. Some people in both the acquiring and acquired units will try to slow or stop any integration efforts, particularly when losses of employment or management power are involved, and managers should have a plan for dealing with such impediments before they arise.

PROS AND CONS OF GREENFIELD VENTURES

The big advantage of establishing a greenfield venture in a foreign country is that it gives the firm a much greater ability to build the kind of subsidiary company that it wants. For example, it is much easier to build an organization culture from scratch than it is to change the culture of an acquired unit. Similarly, it is much easier to establish a set of

Entry Strategy and Strategic Alliances Chapter 15 449

operating routines in a new subsidiary than it is to convert the operating routines of an acquired unit. This is a very important advantage for many international businesses, where transferring products, competencies, skills, and know-how from the established operations of the firm to the new subsidiary are principal ways of creating value. For ex- ample, when Lincoln Electric, the U.S. manufacturer of arc welding equipment, first ven- tured overseas in the mid-1980s, it did so by acquisitions, purchasing arc welding equipment companies in Europe. However, Lincoln’s competitive advantage in the United States was based on a strong organizational culture and a unique set of incentives that encouraged its employees to do everything possible to increase productivity. Lincoln found through bitter experience that it was almost impossible to transfer its organizational culture and incentives to acquired firms, which had their own distinct organizational cultures and incentives. As a result, the firm switched its entry strategy in the mid-1990s and began to enter foreign countries by establishing greenfield ventures, building operations from the ground up. While this strategy takes more time to execute, Lincoln has found that it yields greater long-run returns than the acquisition strategy.

Set against this significant advantage are the disadvantages of establishing a green- field venture. Greenfield ventures are slower to establish. They are also risky. As with any new venture, a degree of uncertainty is associated with future revenue and profit prospects. However, if the firm has already been successful in other foreign markets and understands what it takes to do business in other countries, these risks may not be that great. For example, having already gained great knowledge about operating internation- ally, the risk to McDonald’s of entering yet another country is probably not that great. Also, greenfield ventures are less risky than acquisitions in the sense that there is less potential for unpleasant surprises. A final disadvantage is the possibility of being pre- empted by more aggressive global competitors who enter via acquisitions and build a big market presence that limits the market potential for the greenfield venture.

WHICH CHOICE?

The choice between acquisitions and greenfield ventures is not an easy one. Both modes have their advantages and disadvantages. In general, the choice will depend on the cir- cumstances confronting the firm. If the firm is seeking to enter a market where there are already well-established incumbent enterprises, and where global competitors are also interested in establishing a presence, it may pay the firm to enter via an acquisition. In such circumstances, a greenfield venture may be too slow to establish a sizable presence. However, if the firm is going to make an acquisition, its management should be cognizant of the risks associated with acquisitions that were discussed earlier and consider these when determining which firms to purchase. It may be better to enter by the slower route of a greenfield venture than to make a bad acquisition.

If the firm is considering entering a country where there are no incumbent competitors to be acquired, then a greenfield venture may be the only mode. Even when incumbents exist, if the competitive advantage of the firm is based on the transfer of organizationally embedded competencies, skills, routines, and culture, it may still be preferable to enter via a greenfield venture. Things such as skills and organizational culture, which are based on significant knowledge that is difficult to articulate and codify, are much easier to embed in a new venture than they are in an acquired entity, where the firm may have to overcome the established routines and culture of the acquired firm. Thus, as our earlier examples suggest, firms such as McDonald’s and Lincoln Electric prefer to enter foreign markets by establishing greenfield ventures.

Strategic Alliances

Strategic alliances refer to cooperative agreements between potential or actual competi- tors. In this section, we are concerned specifically with strategic alliances between firms from different countries. Strategic alliances run the range from formal joint ventures, in

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LO 15 -5 Evaluate the pros and cons of entering into strategic alliances.

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which two or more firms have equity stakes (e.g., Fuji Xerox), to short-term contractual agreements, in which two companies agree to cooperate on a particular task (such as de- veloping a new product). Collaboration between competitors is fashionable; recent decades have seen an explosion in the number of strategic alliances.

THE ADVANTAGES OF STRATEGIC ALLIANCES

Firms ally themselves with actual or potential competitors for various strategic pur- poses.42 First, strategic alliances may facilitate entry into a foreign market. For example, many firms believe that if they are to successfully enter the Chinese market, they need a local partner who understands business conditions and who has good connections (or guanxi—see Chapter 4). Thus, Warner Brothers entered into a joint venture with two Chinese partners to produce and distribute films in China. As a foreign film company, Warner found that if it wanted to produce films on its own for the Chinese market, it had to go through a complex approval process for every film, and it had to farm out distribu- tion to a local company, which made doing business in China very difficult. Due to the participation of Chinese firms, however, the joint-venture films will go through a stream- lined approval process, and the venture will be able to distribute any films it produces. Also, the joint venture will be able to produce films for Chinese TV, something that for- eign firms are not allowed to do.43

Second, strategic alliances also allow firms to share the fixed costs (and associated risks) of developing new products or processes. An alliance between Boeing and a number of Japanese companies to build Boeing’s latest commercial jetliner, the 787, was motivated by Boeing’s desire to share the estimated $8 billion investment required to develop the aircraft.

Third, an alliance is a way to bring together complementary skills and assets that nei- ther company could easily develop on its own.44 In 2003, for example, Microsoft and Toshiba established an alliance aimed at developing embedded microprocessors (essen- tially tiny computers) that can perform a variety of entertainment functions in an automo- bile (e.g., run a backseat DVD player or a wireless Internet connection). The processors run a version of Microsoft’s Windows CE operating system. Microsoft brought its soft- ware engineering skills to the alliance and Toshiba its skills in developing microproces- sors.45 The alliance between Cisco and Fujitsu was also formed to share know-how.

Fourth, it can make sense to form an alliance that will help the firm establish techno- logical standards for the industry that will benefit the firm. For example, in 2011 Nokia, one of the leading makers of smartphones, entered into an alliance with Microsoft under which Nokia agreed to license and use Microsoft’s Windows Mobile operating system in Nokia’s phones. The motivation for the alliance was in part to help establish Windows Mobile as the industry standard for smartphones as opposed to the rival operating sys- tems such as Apple’s iPhone and Google’s Android.

THE DISADVANTAGES OF STRATEGIC ALLIANCES

The advantages of strategic alliances that we have discussed can be very significant. De- spite this, some professionals have criticized strategic alliances on the grounds that they give competitors a low-cost route to new technology and markets.46 For example, 25 years ago some commentators argued that many strategic alliances between U.S. and Japanese firms were part of an implicit Japanese strategy to keep high-paying, high-value-added jobs in Japan while gaining the project engineering and production process skills that underlie the competitive success of many U.S. companies.47 They argued that Japanese success in the machine tool and semiconductor industries was built on U.S. technology acquired through strategic alliances. And they argued that U.S. managers were aiding the Japanese by entering alliances that channel new inventions to Japan and provide a U.S. sales and distribution network for the resulting products. Although such deals may gener- ate short-term profits, so the argument goes, in the long run the result is to “hollow out” U.S. firms, leaving them with no competitive advantage in the global marketplace.

Entry Strategy and Strategic Alliances Chapter 15 451

These critics have a point; alliances have risks. Unless a firm is careful, it can give away more than it receives. But there are so many examples of apparently successful alli- ances between firms—including alliances between U.S. and Japanese firms—that the critics’ position seems extreme. It is difficult to see how the Microsoft–Toshiba alliance, the Boeing–Mitsubishi alliance for the 787, and the Fuji–Xerox alliance fit the critics’ thesis. In these cases, both partners seem to have gained from the alliance. Why do some alliances benefit both firms while others benefit one firm and hurt the other? The next section provides an answer to this question.

MAKING ALLIANCES WORK

The failure rate for international strategic alliances seems to be high. One study of 49 international strategic alliances found that two-thirds run into serious managerial and financial troubles within two years of their formation, and that although many of these problems are solved, 33 percent are ultimately rated as failures by the parties involved.48 The success of an alliance seems to be a function of three main factors: partner selection, alliance structure, and the manner in which the alliance is managed.

Partner Selection One key to making a strategic alliance work is to select the right ally. A good ally, or partner, has three characteristics. First, a good partner helps the firm achieve its strategic goals, whether they are market access, sharing the costs and risks of product develop- ment, or gaining access to critical core competencies. The partner must have capabilities that the firm lacks and that it values. Second, a good partner shares the firm’s vision for the purpose of the alliance. If two firms approach an alliance with radically different agendas, the chances are great that the relationship will not be harmonious, will not flourish, and will end in divorce. Third, a good partner is unlikely to try to opportunisti- cally exploit the alliance for its own ends, that is, to expropriate the firm’s technological know-how while giving away little in return. In this respect, firms with reputations for “fair play” probably make the best allies. For example, companies such as General Elec- tric are involved in so many strategic alliances that it would not pay the company to trample over individual alliance partners.49 This would tarnish GE’s reputation of being a good ally and would make it more difficult for GE to attract alliance partners.

To select a partner with these three characteristics, a firm needs to conduct compre- hensive research on potential alliance candidates. To increase the probability of selecting a good partner, the firm should:

1. Collect as much pertinent, publicly available information on potential allies as possible.

2. Gather data from informed third parties. These include firms that have had alliances with the potential partners, investment bankers that have had dealings with them, and former employees.

3. Get to know the potential partner as well as possible before committing to an alliance. This should include face-to-face meetings between senior managers (and perhaps middle-level managers) to ensure that the chemistry is right.

Alliance Structure A partner having been selected, the alliance should be structured so that the firm’s risks of giving too much away to the partner are reduced to an acceptable level. First, alliances can be designed to make it difficult (if not impossible) to transfer technology not meant to be transferred. The design, development, manufacture, and service of a product manufac- tured by an alliance can be structured so as to wall off sensitive technologies to prevent their leakage to the other participant. In a long-standing alliance between General Elec- tric and Snecma to build commercial aircraft engines for single-aisle commercial jet aircraft, for example, GE reduced the risk of excess transfer by walling off certain sections of the

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production process. The modularization effectively cut off the transfer of what GE regarded as key competitive technology, while permitting Snecma access to final assem- bly. Formed in 1974, the alliance has been remarkably successful, and today it dominates the market for jet engines used on the Boeing 737 and Airbus 320.50 Similarly, in the al- liance between Boeing and the Japanese to build the 767, Boeing walled off research, design, and marketing functions considered central to its competitive position, while al- lowing the Japanese to share in production technology. Boeing also walled off new tech- nologies not required for 767 production.51

Second, contractual safeguards can be written into an alliance agreement to guard against the risk of opportunism by a partner (opportunism includes the theft of technology and/or markets). For example, TRW Automotive has three strategic alliances with large Japanese auto component suppliers to produce seat belts, engine valves, and steering gears for sale to Japanese-owned auto assembly plants in the United States. TRW has clauses in each of its alliance contracts that bar the Japanese firms from competing with TRW to sup- ply U.S.-owned auto companies with component parts. By doing this, TRW protects itself against the possibility that the Japanese companies are entering into the alliances merely to gain access to the North American market to compete with TRW in its home market.

Third, both parties to an alliance can agree in advance to swap skills and technologies that the other covets, thereby ensuring a chance for equitable gain. Cross-licensing agree- ments are one way to achieve this goal. Fourth, the risk of opportunism by an alliance partner can be reduced if the firm extracts a significant credible commitment from its part- ner in advance. The long-term alliance between Xerox and Fuji to build photocopiers for the Asian market perhaps best illustrates this. Rather than enter into an informal agreement or a licensing arrangement (which Fuji Photo initially wanted), Xerox insisted that Fuji invest in a 50–50 joint venture to serve Japan and East Asia. This venture constituted such a signifi- cant investment in people, equipment, and facilities that Fuji Photo was committed from the outset to making the alliance work in order to earn a return on its investment. By agreeing to the joint venture, Fuji essentially made a credible commitment to the alliance. Given this, Xerox felt secure in transferring its photocopier technology to Fuji.52

Managing the Alliance Once a partner has been selected and an appropriate alliance structure has been agreed on, the task facing the firm is to maximize its benefits from the alliance. As in all inter- national business deals, an important factor is sensitivity to cultural differences (see Chapter 4). Many differences in management style are attributable to cultural differences, and managers need to make allowances for these in dealing with their partner. Beyond this, maximizing the benefits from an alliance seems to involve building trust between partners and learning from partners.53

Managing an alliance successfully requires building interpersonal relationships be- tween the firms’ managers, or what is sometimes referred to as relational capital.54 This is one lesson that can be drawn from a successful strategic alliance between Ford and Mazda. Ford and Mazda set up a framework of meetings within which their managers not only discuss matters pertaining to the alliance but also have time to get to know each other better. The belief is that the resulting friendships help build trust and facilitate har- monious relations between the two firms. Personal relationships also foster an informal management network between the firms. This network can then be used to help solve problems arising in more formal contexts (such as in joint committee meetings between personnel from the two firms).

Academics have argued that a major determinant of how much knowledge a company gains from an alliance is its ability to learn from its alliance partner.55 For example, in a five-year study of 15 strategic alliances between major multinationals, Gary Hamel, Yves Doz, and C. K. Prahalad focused on a number of alliances between Japanese companies and Western (European or American) partners.56 In every case in which a Japanese company emerged from an alliance stronger than its Western partner, the Japanese company had made a greater effort to learn. Few Western companies studied seemed to want to

Entry Strategy and Strategic Alliances Chapter 15 453

learn from their Japanese partners. They tended to regard the alliance purely as a cost- sharing or risk-sharing device, rather than as an opportunity to learn how a potential competitor does business.

Consider the alliance between General Motors and Toyota constituted in 1985 to build the Chevrolet Nova. This alliance was structured as a formal joint venture, called New United Motor Manufacturing, Inc., and each party had a 50 percent equity stake. The venture owned an auto plant in Fremont, California. According to one Japanese manager, Toyota quickly achieved most of its objectives from the alliance: “We learned about U.S. supply and transportation. And we got the confidence to manage U.S. workers.”57 All that knowledge was then transferred to Georgetown, Kentucky, where Toyota opened its own plant in 1988. Possibly all GM got was a new product, the Chevrolet Nova. Some GM managers complained that the knowledge they gained through the alliance with Toyota has never been put to good use inside GM. They believe they should have been kept to- gether as a team to educate GM’s engineers and workers about the Japanese system. In- stead, they were dispersed to various GM subsidiaries.

To maximize the learning benefits of an alliance, a firm must try to learn from its partner and then apply the knowledge within its own organization. It has been suggested that all operating employees should be well briefed on the partner’s strengths and weak- nesses and should understand how acquiring particular skills will bolster their firm’s competitive position. Hamel and colleagues note that this is already standard practice among Japanese companies. They made this observation:

We accompanied a Japanese development engineer on a tour through a partner’s factory. This engineer dutifully took notes on plant layout, the number of production stages, the rate at which the line was running, and the number of employees. He recorded all this despite the fact that he had no manufacturing responsibility in his own company, and that the alli- ance did not encompass joint manufacturing. Such dedication greatly enhances learning.58

For such learning to be of value, it must be diffused throughout the organization (as was seemingly not the case at GM after the GM–Toyota joint venture). To achieve this, the managers involved in the alliance should educate their colleagues about the skills of the alliance partner.

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C H A P T E R S U M M A R Y

The chapter made the following points: 1. Basic entry decisions include identifying which

markets to enter, when to enter those markets, and on what scale.

2. The most attractive foreign markets tend to be found in politically stable developed and developing nations that have free market systems and where there is not a dramatic

upsurge in either inflation rates or private- sector debt.

3. There are several advantages associated with enter- ing a national market early, before other interna- tional businesses have established themselves. These advantages must be balanced against the pioneering costs that early entrants often have to bear, including the greater risk of business failure.

strategic alliances, p. 432 timing of entry, p. 433 first-mover advantages, p. 433 first-mover disadvantages, p. 434

pioneering costs, p. 434 exporting, p. 437 turnkey project, p. 439 licensing agreement, p. 440

franchising. p. 441 joint venture, p. 442 wholly owned subsidiary, p. 443

Key Terms

4. Large-scale entry into a national market consti- tutes a major strategic commitment that is likely to change the nature of competition in that market and limit the entrant’s future strategic flexibility. Although making major strategic commitments can yield many benefits, there are also risks associated with such a strategy.

5. There are six modes of entering a foreign market: exporting, creating turnkey projects, licensing, franchising, establishing joint ventures, and setting up a wholly owned subsidiary.

6. Exporting has the advantages of facilitating the realization of experience curve economies and of avoiding the costs of setting up manu- facturing operations in another country. Disad- vantages include high transport costs, trade barriers, and problems with local marketing agents.

7. Turnkey projects allow firms to export their process know-how to countries where foreign direct investment (FDI) might be prohibited, thereby enabling the firm to earn a greater return from this asset. The disadvantage is that the firm may inadvertently create efficient global competitors in the process.

8. The main advantage of licensing is that the licensee bears the costs and risks of opening a foreign market. Disadvantages include the risk of losing technological know-how to the licensee and a lack of tight control over licensees.

9. The main advantage of franchising is that the franchisee bears the costs and risks of opening a foreign market. Disadvantages center on problems of quality control of dis- tant franchisees.

10. Joint ventures have the advantages of sharing the costs and risks of opening a foreign market and of gaining local knowledge and political influence. Disadvantages include the risk of losing control over technology and a lack of tight control.

11. The advantages of wholly owned subsidiaries include tight control over technological know- how. The main disadvantage is that the firm must bear all the costs and risks of opening a foreign market.

12. The optimal choice of entry mode depends on the firm’s strategy. When technological know- how constitutes a firm’s core competence, wholly owned subsidiaries are preferred, since they best control technology. When management

know-how constitutes a firm’s core competence, foreign franchises controlled by joint ventures seem to be optimal. When the firm is pursuing a global standardization or transnational strategy, the need for tight control over operations to realize location and experience curve economies suggests wholly owned subsidiaries are the best entry mode.

13. When establishing a wholly owned subsidiary in a country, a firm must decide whether to do so by a greenfield venture strategy or by acquiring an established enterprise in the target market.

14. Acquisitions are quick to execute, may enable a firm to preempt its global competitors, and involve buying a known revenue and profit stream. Acquisitions may fail when the acquir- ing firm overpays for the target, when the cultures of the acquiring and acquired firms clash, when there is a high level of manage- ment attrition after the acquisition, and when there is a failure to integrate the operations of the acquiring and acquired firm.

15. The advantage of a greenfield venture in a foreign country is that it gives the firm a much greater ability to build the kind of subsidiary company that it wants. For example, it is much easier to build an organization culture from scratch than it is to change the culture of an acquired unit.

16. Strategic alliances are cooperative agreements between actual or potential competitors. The advantage of alliances are that they facilitate entry into foreign markets, enable partners to share the fixed costs and risks associated with new products and processes, facilitate the transfer of complementary skills between companies, and help firms establish technical standards.

17. The disadvantage of a strategic alliance is that the firm risks giving away technological know-how and market access to its alliance partner.

18. The disadvantages associated with alliances can be reduced if the firm selects partners care- fully, paying close attention to the firm’s repu- tation and the structure of the alliance to avoid unintended transfers of know-how.

19. Two keys to making alliances work seem to be building trust and informal communications networks between partners and taking proactive steps to learn from alliance partners.

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C r i t i c a l T h i n k i n g a n d D i s c u s s i o n Q u e s t i o n s

1. Review the Management Focus on Tesco. Then answer the following questions: a. Why did Tesco’s initial international expan-

sion strategy focus on developing nations? b. How does Tesco create value in its interna-

tional operations? c. In Asia, Tesco has a history of entering into

joint-venture agreements with local partners. What are the benefits of doing this for Tesco? What are the risks? How are those risks mitigated?

d. In March 2006 Tesco announced it would enter the United States. This represented a departure from its historic strategy of focusing on developing nations. Why do you think Tesco made this decision? How is the U.S. market different from other markets that Tesco has entered?

2. Licensing proprietary technology to foreign competitors is the best way to give up a firm’s competitive advantage. Discuss.

3. Discuss how the need for control over foreign operations varies with firms’ strategies and core

competencies. What are the implications for the choice of entry mode?

4. A small Canadian firm that has developed valuable new medical products using its unique biotechnology know-how is trying to decide how best to serve the European Union market. Its choices are given below. The cost of invest- ment in manufacturing facilities will be a major one for the Canadian firm, but it is not outside its reach. If these are the firm’s only options, which one would you advise it to choose? Why? a. Manufacture the products at home, and let

foreign sales agents handle marketing. b. Manufacture the products at home, and set

up a wholly owned subsidiary in Europe to handle marketing.

c. Enter into an alliance with a large European pharmaceutical firm. The products would be manufactured in Europe by the 50–50 joint venture and marketed by the European firm.

r e s e a r c h t a s k g l o b a l e d g e . m s u . e d u

Use the globalEDGE website (globaledge.msu.edu) to complete the following exercises:

1. Entrepreneur magazine annually publishes a ranking of the top global franchises. Provide a list of the top 25 companies that pursue franchising as their preferred mode of international expansion. Study one of these companies in detail, and describe its business model, its international expansion pattern, desirable qualifications in possible franchisees, and the support and training the company typically provides.

2. The U.S. Commercial Service prepares reports known as the Country Commercial Guide for countries of interest to U.S. investors. Utilize the Country Commercial Guide for Russia to gather information on this country’s energy and mining industry. Considering that your company has plans to enter Russia in the foreseeable future, select the most appropriate entry method. Be sure to support your decision with the informa- tion collected.

Entry Strategy and Strategic Alliances Chapter 15 455

The late 2000s were not kind to General Motors Corpo- ration (GM), but the company is on a much-needed up- swing. The Chinese market, in particular, is becoming

one of the most important foreign markets for GM. GM of course is a U.S.-based multinational corporation head- quartered in Detroit, Michigan. GM was founded in 1908

C L O S I N G C A S E

General Motors Corporation

456 Part 5 The Strategy and Structure of International Business

in Flint, Michigan, and Mary Barra is the company’s CEO. In 2015, GM had revenues of $156 billion and more than 216,000 employees, produced almost 10 mil- lion vehicles, and consisted of four core divisions (Buick, Chevrolet, Cadillac, and GMC). Hurt by a deep recession in the United States and plunging vehicle sales, GM capped off the 2000s decade, where it had progressively lost market share to foreign rivals such as Toyota, by entering Chapter 11 bank- ruptcy. Between 1980, when it dominated the U.S. mar- ket, and 2009, when it entered bankruptcy protection, GM saw its U.S. market share slip from 44 to just 19 percent. The troubled company emerged from bank- ruptcy a few months later a smaller enterprise with fewer brands, and yet going forward some believe that the new GM could be a much more profitable enterprise. One major reason for this optimism was the success of its joint ventures in China. GM entered China in 1997 with a $1.6 billion invest- ment to establish a joint venture with the state-owned Shanghai Automotive Industry Corporation (SAIC) to build Buick sedans. At the time the Chinese market was tiny (fewer than 400,000 cars were sold in 1996), but GM was attracted by the enormous potential in a country of more than 1.4 billion people that was experiencing rapid economic growth. While the company initially rec- ognized that it had much to learn about the Chinese mar- ket, and would probably lose money for a few years in the early years, GM executives believed it was crucial to establish operations and to team up with SAIC (one of the early leaders in China’s emerging automobile indus- try) before its global rivals did. The decision to enter a joint venture was not a hard one. Not only did GM lack knowledge and connections in China, but Chinese gov- ernment regulations made it all but impossible for a for- eign automaker to go it alone in the country. While GM was not alone in investing in China—many of the world’s major automobile companies entered into

some kind of Chinese joint venture during this time period—it was among the largest investors. Only Volkswagen, whose management shared GM’s view, made a similar-size investment. Other companies ad- opted a more cautious approach, investing smaller amounts and setting more limited goals. By 2007, GM had expanded the range of its partnership with SAIC to include vehicles sold under the names of Chevrolet, Cadillac, and Wuling. The two companies had also established the Pan-Asian Technical Automotive cen- ter to design cars and components not just for China but also for other Asian markets. At this point it was already clear that both the Chinese market and the joint venture were exceeding GM’s initial expectations. Not only was the venture profitable, but it was also selling more than 900,000 cars and light trucks in 2007, an 18 percent in- crease over 2006, placing it second only to Volkswagen in the market among foreign nameplates. Equally impres- sive, some 8 million cars and light trucks were sold in China in 2007, making China the second-largest car mar- ket in the world, ahead of Japan and behind the United States. in 2015, GM sold about 3.16 million vehicles in China, up from some 2.4 million vehicles sold in 2010. Much of the venture’s success could be attributed to its strategy of designing vehicles explicitly for the Chinese market. For example, together with SAIC it pro- duced a tiny minivan, the Wuling Sunshine. The van costs $3,700, has a 0.8-liter engine, hits a top speed of 60 mph, and weighs less than 1,000 kilograms—a far cry from the heavy SUVs GM was known for in the United States. For China, the vehicle was perfect, making it the best seller in the light truck sector. It is the future, however, that has people excited. From a market of about 9 million passenger and commercial vehicles sold in China in 2008 to 23.5 million in 2014, the Chinese vehicle market is booming compared with the United States and Europe. China has now become GM’s largest market in vehicles sold. GM also plans to expand its Chinese dealer network to more than 5,000, and it plans to have 17 assembly plants in China by the end of 2015, more than the 12 it has in the United States. Driving this expansion are forecasts from GM that de- mand in China will reach 35 million vehicles a year by 2022, a huge increase from the 23.5 million vehicles sold in 2014. Underlying these forecasts are the still rela- tively low vehicle penetration rates in China. China has about 85 vehicles per 1,000 people compared to around 800 vehicles for every 1,000 people in the United States.

Sources: S. Schifferes, “Cracking China’s Car Market,” BBC News, May 17, 2007; N. Madden, “Led by Buick, Carmaker Learning Fine Points of Regional China Tastes,” Automotive News, September 15, 2008, pp. 186–90; “GM Posts Record Sales in China,” Toronto Star, January 5, 2010, p. B4; “GM’s Sales in China Top US,” Investor’s Business Daily, January 25, 2011, p. A1; K. Naughton, “GM’s China Bet Mimics Toyota’s Bet on U.S. Last Century,” Bloomberg.com, April 29, 2013.

A GM car at a Chinese auto show. Source: Corbis Wire/Corbis

Entry Strategy and Strategic Alliances Chapter 15 457

C a s e D i s c u s s i o n Q u e s t i o n s

1. GM entered the Chinese market at a time when demand was very limited. Why? What was the strategic rationale?

2. Why did GM enter through a joint venture with SAIC? What are the benefits of this approach? What are the potential risks here?

3. Why did GM not simply license its technology to SAIC? Why did it not export cars from the United States?

4. Why has the joint venture been so successful to date?

5. As of 2015 GM appears to be increasing its strategic commitments to China, building more factories and opening more dealers. Why is the company making these bets? Do you think it is doing the right thing? What are the potential risks here?

1. For interesting empirical studies that deal with the issues of timing and resource commitments, see T. Isobe, S. Makino, and D. B. Montgomery, “Resource Commitment, Entry Timing, and Market Performance of Foreign Direct Investments in Emerg- ing Economies,” Academy of Management Journal 43, no. 3 (2000), pp. 468–84; Y. Pan and P. S. K. Chi, “Financial Perfor- mance and Survival of Multinational Corporations in China,” Strategic Management Journal 20, no. 4 (1999), pp. 359–74. A complementary theoretical perspective on this issue can be found in V. Govindarjan and A. K. Gupta, The Quest for Global Dominance (San Francisco: Jossey-Bass, 2001). Also see F. Vermeulen and H. Barkeme, “Pace, Rhythm and Scope: Pro- cess Dependence in Building a Profitable Multinational Corpo- ration,” Strategic Management Journal 23 (2002), pp. 637–54.

2. This can be reconceptualized as the resource base of the en- trant, relative to indigenous competitors. For work that focuses on this issue, see W. C. Bogner, H. Thomas, and J. McGee, “A Longitudinal Study of the Competitive Positions and Entry Paths of European Firms in the U.S. Pharmaceutical Market,” Strategic Management Journal 17 (1996), pp. 85–107; D. Collis, “A Resource-Based Analysis of Global Competition,” Strategic Management Journal 12 (1991), pp. 49–68; S. Tallman, “Strategic Management Models and Resource-Based Strate- gies among MNEs in a Host Market,” Strategic Management Journal 12 (1991), pp. 69–82.

3. For a discussion of first-mover advantages, see M. Lieberman and D. Montgomery, “First-Mover Advantages,” Strategic Man- agement Journal 9 (Summer Special Issue, 1988), pp. 41–58.

4. J. M. Shaver, W. Mitchell, and B. Yeung, “The Effect of Own Firm and Other Firm Experience on Foreign Direct Investment Survival in the United States, 1987–92,” Strategic Management Journal 18 (1997), pp. 811–24.

5. S. Zaheer and E. Mosakowski, “The Dynamics of the Liability of Foreignness: A Global Study of Survival in the Financial Services Industry,” Strategic Management Journal 18 (1997), pp. 439–64.

6. Shaver et al., “The Effect of Own Firm and Other Firm Experience.”

7. P. Ghemawat, Commitment: The Dynamics of Strategy (New York: Free Press, 1991).

8. R. Luecke, Scuttle Your Ships before Advancing (Oxford: Oxford University Press, 1994).

9. Isobe et al., “Resource Commitment, Entry Timing, and Market Performance”; Pan and Chi, “Financial Performance and Sur- vival of Multinational Corporations in China”; Govindarjan and Gupta, The Quest for Global Dominance.

10. Christopher Bartlett and Sumantra Ghoshal, “Going Global: Lessons from Late Movers,” Harvard Business Review, March– April 2000, pp. 132–45.

11. This section draws on numerous studies, including C. W. L. Hill, P. Hwang, and W. C. Kim, “An Eclectic Theory of the Choice of International Entry Mode,” Strategic Management Journal 11 (1990), pp. 117–28; C. W. L. Hill and W. C. Kim, “Searching for a Dynamic Theory of the Multinational Enter- prise: A Transaction Cost Model,” Strategic Management Jour- nal 9 (Special Issue on Strategy Content, 1988), pp. 93–104; E. Anderson and H. Gatignon, “Modes of Foreign Entry: A Transaction Cost Analysis and Propositions,” Journal of Inter- national Business Studies 17 (1986), pp. 1–26; F. R. Root, Entry Strategies for International Markets (Lexington, MA: D. C. Heath, 1980); A. Madhok, “Cost, Value and Foreign Market Entry: The Transaction and the Firm,” Strategic Management Journal 18 (1997), pp. 39–61; K. D. Brouthers and L. B. Brouthers, “Acquisition or Greenfield Start-Up?,” Strategic Management Journal 21, no. 1 (2000), pp. 89–97; X. Martin and R. Salmon, “Knowledge Transfer Capacity and Its Implications for the Theory of the Multinational Enterprise,” Journal of Interna- tional Business Studies, July 2003, p. 356; A. Verbeke, “The Evolutionary View of the MNE and the Future of Internalization Theory,” Journal of International Business Studies, November 2003, pp. 498–515.

Endnotes

458 Part 5 The Strategy and Structure of International Business

12. For a general discussion of licensing, see F. J. Contractor, “The Role of Licensing in International Strategy,” Columbia Journal of World Business, Winter 1982, pp. 73–83.

13. See E. Terazono and C. Lorenz, “An Angry Young Warrior,” Financial Times, September 19, 1994, p. 11; K. McQuade and B. Gomes-Casseres, “Xerox and Fuji-Xerox,” Harvard Business School Case No. 9-391-156.

14. O. E. Williamson, The Economic Institutions of Capitalism (New York: Free Press, 1985).

15. J. H. Dunning and M. McQueen, “The Eclectic Theory of Inter- national Production: A Case Study of the International Hotel Industry,” Managerial and Decision Economics 2 (1981), pp. 197–210.

16. Andrew E. Serwer, “McDonald’s Conquers the World,” For- tune, October 17, 1994, pp. 103–16.

17. For an excellent review of the basic theoretical literature of joint ventures, see B. Kogut, “Joint Ventures: Theoretical and Empirical Perspectives,” Strategic Management Journal 9 (1988), pp. 319–32. More recent studies include T. Chi, “Option to Acquire or Divest a Joint Venture,” Strategic Management Journal 21, no. 6 (2000), pp. 665–88; H. Merchant and D. Schendel, “How Do International Joint Ventures Create Shareholder Value?,” Strategic Management Journal 21, no. 7 (2000), pp. 723–37; H. K. Steensma and M. A. Lyles, “Explaining IJV Survival in a Transitional Economy though Social Exchange and Knowledge Based Perspectives,” Strategic Management Journal 21, no. 8 (2000), pp. 831–51; J. F. Hennart and M. Zeng, “Cross Cultural Differences and Joint Venture Longevity,” Journal of Interna- tional Business Studies, December 2002, pp. 699–717.

18. D. G. Bradley, “Managing against Expropriation,” Harvard Business Review, July–August 1977, pp. 78–90.

19. J. A. Robins, S. Tallman, and K. Fladmoe-Lindquist, “Auton- omy and Dependence of International Cooperative Ventures,” Strategic Management Journal, October 2002, pp. 881–902.

20. Speech given by Tony Kobayashi at the University of Washington Business School, October 1992.

21. A. C. Inkpen and P. W. Beamish, “Knowledge, Bargaining Power, and the Instability of International Joint Ventures,” Academy of Management Review 22 (1997), pp. 177–202; S. H. Park and G. R. Ungson, “The Effect of National Culture, Organizational Complementarity, and Economic Motivation on Joint Venture Dissolution,” Academy of Management Journal 40 (1997), pp. 279–307.

22. Inkpen and Beamish, “Knowledge, Bargaining Power, and the Instability of International Joint Ventures.”

23. See Brouthers and Brouthers, “Acquisition or Greenfield Start- Up?”; J. F. Hennart and Y. R. Park, “Greenfield versus Acquisi- tion: The Strategy of Japanese Investors in the United States,” Management Science, 1993, pp. 1054–70.

24. This section draws on Hill et al., “An Eclectic Theory of the Choice of International Entry Mode.”

25. C. W. L. Hill, “Strategies for Exploiting Technological Innova- tions: When and When Not to License,” Organization Science 3 (1992), pp. 428–41.

26. See Brouthers and Brouthers, “Acquisition or Greenfield Start- Up?”; J. Anand and A. Delios, “Absolute and Relative

Resources as Determinants of International Acquisitions,” Stra- tegic Management Journal, February 2002, pp. 119–34.

27. United Nations, World Investment Report, 2010 (New York and Geneva: United Nations, 2010).

28. Ibid. 29. For evidence on acquisitions and performance, see R. E. Caves,

“Mergers, Takeovers, and Economic Efficiency,” International Journal of Industrial Organization 7 (1989), pp. 151–74; M. C. Jensen and R. S. Ruback, “The Market for Corporate Control: The Scientific Evidence,” Journal of Financial Eco- nomics 11 (1983), pp. 5–50; R. Roll, “Empirical Evidence on Takeover Activity and Shareholder Wealth,” in Knights, Raiders and Targets, ed. J. C. Coffee, L. Lowenstein, and S. Rose (Oxford: Oxford University Press, 1989); A. Schleifer and R. W. Vishny, “Takeovers in the 60s and 80s: Evidence and Implications,” Strategic Management Journal 12 (Winter 1991 Special Issue), pp. 51–60; T. H. Brush, “Predicted Changes in Operational Synergy and Post-acquisition Performance of Acquired Businesses,” Strategic Management Journal 17 (1996), pp. 1–24; A. Seth, K. P. Song, and R. R. Pettit, “Value Creation and Destruction in Cross-Border Acquisitions,” Strategic Manage- ment Journal 23 (October 2002), pp. 921–40.

30. J. Warner, J. Templeman, and R. Horn, “The Case against Mergers,” BusinessWeek, October 30, 1995, pp. 122–34.

31. “Few Takeovers Pay Off for Big Buyers,” Investor’s Business Daily, May 25, 2001, p. 1.

32. S. A. Christofferson, R. S. McNish, and D. L. Sias, “Where Mergers Go Wrong,” The McKinsey Quarterly 2 (2004), pp. 92–110.

33. D. J. Ravenscraft and F. M. Scherer, Mergers, Selloffs, and Eco- nomic Efficiency (Washington, DC: Brookings Institution, 1987).

34. See P. Ghemawat and F. Ghadar, “The Dubious Logic of Global Mega-Mergers,” Harvard Business Review, July–August 2000, pp. 65–72.

35. R. Roll, “The Hubris Hypothesis of Corporate Takeovers,” Journal of Business 59 (1986), pp. 197–216.

36. “Marital Problems,” The Economist, October 14, 2000. 37. See J. P. Walsh, “Top Management Turnover Following Merg-

ers and Acquisitions,” Strategic Management Journal 9 (1988), pp. 173–83.

38. B. Vlasic and B. A. Stertz, Taken for a Ride: How Daimler- Benz Drove Off with Chrysler (New York: HarperCollins, 2000).

39. See A. A. Cannella and D. C. Hambrick, “Executive Departure and Acquisition Performance,” Strategic Management Journal 14 (1993), pp. 137–52.

40. P. Haspeslagh and D. Jemison, Managing Acquisitions (New York: Free Press, 1991).

41. Ibid. 42. See K. Ohmae, “The Global Logic of Strategic Alliances,”

Harvard Business Review, March–April 1989, pp. 143–54; G. Hamel, Y. L. Doz, and C. K. Prahalad, “Collaborate with Your Competitors and Win!” Harvard Business Review, January– February 1989, pp. 133–39; W. Burgers, C. W. L. Hill, and W. C. Kim, “Alliances in the Global Auto Industry,” Strategic Management Journal 14 (1993), pp. 419–32; P. Kale, H. Singh,

Entry Strategy and Strategic Alliances Chapter 15 459

and H. Perlmutter, “Learning and Protection of Proprietary As- sets in Strategic Alliances: Building Relational Capital,” Strate- gic Management Journal 21 (2000), pp. 217–37.

43. L. T. Chang, “China Eases Foreign Film Rules,” The Wall Street Journal, October 15, 2004, p. B2.

44. B. L. Simonin, “Transfer of Marketing Know-How in Interna- tional Strategic Alliances,” Journal of International Business Studies, 1999, pp. 463–91; J. W. Spencer, “Firms’ Knowledge Sharing Strategies in the Global Innovation System,” Strategic Management Journal 24 (2003), pp. 217–33.

45. C. Souza, “Microsoft Teams with MIPS, Toshiba,” EBN, February 10, 2003, p. 4.

46. Kale et al., “Learning and Protection of Proprietary Assets.” 47. R. B. Reich and E. D. Mankin, “Joint Ventures with Japan Give

Away Our Future,” Harvard Business Review, March–April 1986, pp. 78–90.

48. J. Bleeke and D. Ernst, “The Way to Win in Cross-Border Alli- ances,” Harvard Business Review, November–December 1991, pp. 127–35.

49. C. H. Deutsch, “The Venturesome Giant,” The New York Times, October 5, 2007, pp. C1, C8.

50. “Odd Couple: Jet Engines,” The Economist, May 5, 2007, pp. 79–80. 51. W. Roehl and J. F. Truitt, “Stormy Open Marriages Are Better,”

Columbia Journal of World Business, Summer 1987, pp. 87–95. 52. McQuade and Gomes-Casseres, “Xerox and Fuji-Xerox.” 53. See T. Khanna, R. Gulati, and N. Nohria, “The Dynamics of Learn-

ing Alliances: Competition, Cooperation, and Relative Scope,” Stra- tegic Management Journal 19 (1998), pp. 193–210; Kale et al., “Learning and Protection of Proprietary Assets.”

54. Kale et al., “Learning and Protection of Proprietary Assets.” 55. Hamel et al., “Collaborate with Your Competitors”; Khanna et

al., “The Dynamics of Learning Alliances”; E. W. K. Tang, “Acquiring Knowledge by Foreign Partners from International Joint Ventures in a Transition Economy: Learning by Doing and Learning Myopia,” Strategic Management Journal 23 (2002), pp. 835–54.

56. Hamel et al., “Collaborate with Your Competitors.” 57. B. Wysocki, “Cross-Border Alliances Become Favorite Way to

Crack New Markets,” The Wall Street Journal, March 4, 1990, p. A1.

58. Hamel et al., “Collaborate with Your Competitors,” p. 138.

Credit: ©Federal Reserve Board.

Exporting, Importing, and Countertrade

part six International Business Functions

16

© Vvvita/Getty Images, RF

L E A R N I N G O B J E C T I V E S Af ter reading this chapter, you will be able to:

LO16 -1 Explain the promises and risks associated with exporting.

LO16 -2 Identify the steps managers can take to improve their firm’s export performance.

LO16 -3 Identify information sources and government programs that exist to help exporters.

LO16 - 4 Recognize the basic steps involved in export financing.

LO16 -5 Describe how countertrade can be used to facilitate exporting.

461

Exporting Desserts

wholesale distributors. Lulu wanted everyone within reach to enjoy her festival of flavors. In going international, Lulu spent some 10 years trying to gain international sales, but continued to run into all kinds of problems and issues. After the trial-and-error decade, she found assistance from the U.S. Export-Import Bank services, and now has deeper confidence in her abilities to export products worldwide. Over the years, Lulu has kept making more and more varieties of her gelatin desserts. A carnival of colors of three-layer gelatins, fruit parfaits, and festive containers of wild new colors and flavors have become identifying marks. This exporting innovation led Bill Hopkins of USA Today to call Maria De Lourdes Sobrino “the queen of ready-to-eat gelatins and a force in the surging number of Hispanic Entrepreneurs.” Hal Lancaster of the Wall Street Journal also recognized her as an innovator and very suc- cessful entrepreneur in “getting out and selling customers your dream.” Today, with its exporting worldwide but especially with exporting to Mexico, and sales across the United States Lulu’s Dessert’s core focus is on five product categories, including the original Mexican gelatin cup, rice pudding Mexican-style cup, the original creamy gelatin cup, parfait treats gelatin cups, and caramel flan cups. The flavors in- clude such exotic descriptors as Fruit Fantasia, Orange Blast, Creamy Vanilla with Cinnamon, and Sugar Free-De-Light.

Sources: D. Barry, “Maria de Lourdes Sobrino, Founder, LuLu’s Dessert,” Exporters: The Wit and Wisdom of Small Businesspeople Who Sell Globally, 2013; J. Hopkins, “Bad Times Spawn Great Start- Ups,” USA Today, December 18, 2001; “Welcome to Lulu’s Dessert,” www.lulusdessert.com, accessed May 25, 2015.

O P E N I N G C A S E The opening line of the “About” section of Lulu’s Dessert’s website—www.lulusdessert.com—is “pull up a chair and join in the festival of flavors with Lulu’s Gelatin Desserts,” Taking basic ingredients and creating a myriad of flavors has led to worldwide exporting success for Lulu’s Dessert Corpora- tion. Started in 1982 in a 700-square-foot storefront in Torrance, California, followed by exporting to Mexico in 1992, the company is a gelatin dessert business with core customer target markets in the United States and Mexico but with exporting to several countries worldwide. Lulu is the nickname of the founder: Maria De Lourdes Sobrino. “Lulu” thought of the idea of ready-to-eat flavored gela- tin desserts when she was looking for the popular dessert in local stores. At the time, she was living in the United States but originally she came from Mexico. The ready-to- eat flavored gelatin desserts were a staple in her native Mexico but the concept was a novelty when she intro- duced it to American grocers. Today, Lulu’s Desserts can be found in a variety of well-known stores (e.g., Albertsons, Safeway, Walmart). Back in the early 1980s, Lulu identified and recognized a need for gelatin desserts, filled it with what has now be- come 45 ready-to-eat products of different sizes and fla- vors, and transformed the food industry by creating the first ready-to-eat gelatin category based largely on her mother’s recipes. The business concept has become quite a “spoon spectacular” since Lulu first began, with a catch line for the company of “more fun for your spoon.” The party started out very small with just Lulu making her mother’s gelatin recipe desserts, with an initial produc- tion of 300 cups of gelatin per day. Ultimately, the party grew so big that Lulu could not handle it by herself and had to negotiate help from established markets and

462 Part 6 International Business Functions

Introduction

The previous chapter reviewed exporting from a strategic perspective. We considered exporting as just one of a range of strategic options for profiting from international ex- pansion. This chapter is more concerned with the nuts and bolts of exporting (and import- ing and countertrade). We specifically look at how to export. As the opening case about Lulu’s Dessert Corp. makes clear, exporting is not just for large enterprises; many small firms such as Lulu’s as well as Two Men and a Truck (the closing case in this chapter) have benefited significantly from the market opportunities of exporting to a variety of worldwide locations.

The volume of export activity in the world economy has increased as exporting has become easier. The gradual decline in trade barriers under the umbrella of GATT and now the WTO (see Chapter 7), along with regional economic agreements such as the European Union and the North American Free Trade Agreement (see Chapter 9), have significantly increased export opportunities. At the same time, modern communication and transportation technologies have alleviated the logistical problems associated with exporting. Over the last two decades firms have increasingly used the Internet, toll-free phone numbers, and international air express services to reduce the costs of exporting. Consequently, it is not unusual to find thriving exporters among small companies.

Nevertheless, exporting remains a challenge for many firms. Smaller enterprises can find the process intimidating. The firm wishing to export must identify foreign market opportunities, avoid a host of unanticipated problems that are often associated with doing business in a foreign market, familiarize itself with the mechanics of export and import financing, learn where it can get financing and export credit insurance, and learn how it should deal with foreign exchange risk. The process can be made more problematic by currencies that are not freely convertible. Arranging payment for exports to countries with weak currencies can be a problem. Countertrade allows payment for exports to be made through goods and services rather than money. This chapter discusses all these issues with the exception of foreign exchange risk, which was covered in Chapter 10.

In Chapter 15, we dealt with the scale of market entry and strategic commitments in going international. Essentially our focus was on involvement and commitment when engaging in the international marketplace. What we find is that the first international level for both involvement and commitment was the exporting (outbound international activity) and importing (inbound international activity) options. The remaining options for involvement and commitment, although they overlapped in some areas, were a bit dif- ferent (Chapter 15 discusses turnkey projects, licensing, franchising, joint ventures, and wholly owned subsidiaries—the latter also a production facility focus in Chapter 17). That places a lot of emphasis on exporting and importing as modes of operations for many companies, and we think that this area deserves a bit more coverage; thus this chap- ter is allocated to digging deeper into the knowledge of operations (“nuts and bolts”) of exporting and importing. This is, after all, the lowest level of involvement and the lowest level of commitment a company can use when going international: selling to foreign mar- kets (exporting) or purchasing raw materials, component parts, or finished goods for op- erations (importing).

The bottom line is that as the global marketplace becomes more viable for many com- panies over time, companies must also adapt to this opportunity by strategically engaging in exporting (see Chapter 15) and operationally go about seeking opportunities globally. This could mean using suppliers from developing nations, importing products from new sources, or exporting products to new markets. Companies that have traditionally operated within national or regional trading groups may feel ill equipped to extend their market horizon. This may be as simple as feeling unable to select and manage a foreign supplier or not knowing how to sell products in a new country. But keep in mind that, by some accounts, 90 percent of the products and services that are needed locally are not pro- duced locally; they are shipped in from somewhere else. As such, market opportunities are globally available everywhere and exporting and importing fill these voids.1

Exporting, Importing, and Countertrade Chapter 16 463

The chapter opens in the next section by considering the promise and pitfalls of ex- porting. The logic for both exporting and importing is very similar. Readiness to export and/or import is a large part of the story, as illustrated in Figure 16.1.2

The Promise and Pitfalls of Exporting

The great promise of exporting is that large revenue and profit opportunities are to be found in foreign markets for most firms in most industries. This was true for Lulu’s Des- sert Corp. in the opening case. The international market is normally so much larger than the firm’s domestic market that exporting is nearly always a way to increase the revenue and profit base of a company. By expanding the size of the market, exporting can enable a firm to achieve economies of scale, thereby lowering its unit costs. Firms that do not export often lose out on significant opportunities for growth and cost reduction.3

LO 16 -1 Explain the promises and risks associated with exporting.

Product Readiness

Product Readiness

Is your product (or service) ready to be exported?

What international customer needs does your product satisfy?

What needs does the product or part satisfy for your value chain?

Do you have top-level commitment, resources, skills, and knowledge?

Do you have top-level commitment, resources, skills, and knowledge?

Is the product (or service) ready to be imported?

Is your company ready to import the product?

Is your company ready to export the product?

Company Readiness

Company Readiness

F I G U R E 1 6 . 1

Product readiness and company readiness to export or import. Source: Adopted from T. Hult, D. Closs, and D. Frayer, Global Supply Chain Management: Leveraging Processes, Measure- ments, and Tools for Strategic Corporate Advantage (New York: McGraw-Hill, 2014).

E X P O R T T U T O R I A L S

Exporting, importing, and countertrade are the focus areas of Chapter 16. The exporting entry mode choice, also discussed in Chapter 15, is the most often used way to conduct cross- border trade for companies. The vast majority of small and medium-sized enterprises, for ex- ample, use exporting as their way to expand to international markets. But that begs the question of whether the company is ready to export and whether the product the company plans to ex- port is ready to be exported. The “Export Tutorials” section of globalEDGE (globaledge.msu.edu/ reference-desk/export-tutorials) includes CORE as a diagnostic tool to assess “company readiness to export.” The “Export Tutorials” section also has a lengthy set of questions and answers to the most common exporting-related questions in the categories of government regulations, financial considerations, sales and marketing, and logistics. For example, one question deals with whether a company needs a license to export. Assume you are based in the United States. How can you identify the relevant commodity jurisdiction for a product?

464 Part 6 International Business Functions

Consider the case of Marlin Steel Wire Products, a Baltimore manufacturer of wire baskets and fabricated metal items with revenues of about $5 million. Among its prod- ucts are baskets to hold dedicated parts for aircraft engines and automobiles. Its engi- neers design custom wire baskets for the assembly lines of companies such as Boeing and Toyota. It has a reputation for producing high-quality products for these niche markets. Like many small businesses, Marlin did not have a history of exporting. However, in the mid-2000s, Marlin dipped its toe in the export market, shipping small numbers of products to Mexico and Canada. Marlin CEO Drew Greenblatt soon real- ized that export sales could be the key to growth. In 2008, when the global financial crisis hit and America slid into a serious recession, Marlin was exporting only 5 per- cent of its orders to foreign markets. Greenblatt’s strategy for dealing with weak de- mand from the United States was to aggressively expand international sales. By 2010, exports accounted for 17 percent of sales, and the company had set a goal of exporting half its output.4

Despite examples such as Lulu’s Dessert, Two Men and a Truck, and Marlin Steel Wire Products, studies have shown that while many large firms tend to be proactive about seeking opportunities for profitable exporting—systematically scanning foreign markets to see where the opportunities lie for leveraging their technology, products, and market- ing skills in foreign countries—many medium-sized and small firms are very reactive.5 Typically, such reactive firms do not even consider exporting until their domestic market is saturated and the emergence of excess productive capacity at home forces them to look for growth opportunities in foreign markets.

Many small and medium-sized firms tend to wait for the world to come to them, rather than going out into the world to seek opportunities. Even when the world does come to them, they may not respond. An example is MMO Music Group, which makes sing-along tapes for karaoke machines. Foreign sales accounted for about 15 percent of MMO’s rev- enues of $8 million, but the firm’s CEO admits this figure would probably have been much higher had he paid attention to building international sales. Unanswered e-mails and phone messages from Asia and Europe often piled up while he was trying to manage the burgeoning domestic side of the business. By the time MMO did turn its attention to foreign markets, competitors had stepped into the breach, and MMO found it tough-going to build export volume.6

MMO’s experience is common, and it suggests a need for firms to become more pro- active about seeking export opportunities. One reason more firms are not proactive is that they are unfamiliar with foreign market opportunities; they simply do not know how big the opportunities actually are or where they might lie. Simple ignorance of the potential opportunities is a huge barrier to exporting.7 Also, many would-be exporters, particularly smaller firms, are often intimidated by the complexities and mechanics of exporting to countries where business practices, language, culture, legal systems, and currency are very different from the home market.8 This combination of unfamiliarity and intimida- tion probably explains why exporters still account for only a tiny percentage of U.S. firms, less than 5 percent of firms with fewer than 500 employees, according to the Small Business Administration.9

To make matters worse, many neophyte exporters run into significant problems when first trying to do business abroad, and this sours them on future exporting ven- tures. Common pitfalls include poor market analysis, a poor understanding of com- petitive conditions in the foreign market, a failure to customize the product offering to the needs of foreign customers, a lack of an effective distribution program, a poorly executed promotional campaign, and problems securing financing.10 Novice exporters tend to underestimate the time and expertise needed to cultivate business in foreign countries.11 Few realize the amount of management resources that have to be dedi- cated to this activity. Many foreign customers require face-to-face negotiations on their home turf. An exporter may have to spend months learning about a country’s trade regulations, business practices, and more before a deal can be closed. The ac- companying Management Focus, which documents the experience of Ambient

TEST PREP Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

465 Part 3 Part Title

M A NAG E M E N T F O C U S

Ambient Technologies and the Panama Canal Ambient Technologies, Inc. (ATI) has a core business in the areas of geology, geophysics, and drilling services. Carlos Lemos, CEO, started the business in 1993 after hav- ing previously worked for a very large consulting company for 22 years. Instead of continuing with the larger com- pany, Lemos decided to use his Brazilian heritage and “live the American dream” by starting his own entrepreneurial venture. He says, “we support other companies that are looking to find information that’s below the ground, whether it’s groundwater related, whether it’s construction related, whether it’s engineering related, whether it is any- thing related with infrastructure issues, mining.” The highest-profile project that Ambient Technolo- gies is working on right now is the Panama Canal ex- pansion. This expansion project involves the construction of two new sets of locks: one on the Pacific side and one on the Atlantic side of the existing Panama Canal which opened in 1914. Each lock will have three water chambers and each chamber will have three wa- ter reutilization basins. The Panama Canal project also includes the widening and deepening of existing navi- gational channels in Gatun Lake and the deepening of the Culebra Cut. Additionally, in order to open a new 3.8-mile- (6.1-kilometer-) long access channel to connect the Pacific locks and the Culebra Cut, four dry excava- tion projects are executed. Ambient Technologies is performing all of the drilling underneath where the new set of locks is going to be, as the third set of locks is being built next to the existing locks. These locks will accommodate the much larger ships in service today as well as the increased traffic flow through the Panama Canal. Lemos says that “it’s a

huge, huge, huge operation because it also involves a lot of retention basins because they’re circulating the water instead of just simply discharging it to the ocean.” Ambient Technologies is drilling as part of the Panama Canal project because the project team found some geological faults. Basically, Ambient Technologies is needed to make sure the Panama Canal design is ap- propriate, takes into account any fault concerns, and even suggests relocation of parts of the project such as Gatun Lake. Lemos and Ambient Technologies were honored re- cently at the White House for their activities in exporting from the United States to other countries. Interestingly, Lemos says that even though he is a native of Brazil and speaks the language fluently (Portuguese), he still faced lots of problems and issues when exporting initially to Brazil. He found an easier time exporting to smaller coun- tries, which were more comfortable working with smaller companies like Ambient Technologies. Lemos found these types of smaller countries in Central America. Pan- ama became a target market but also Colombia. This like- mindedness is a common success factor for many small and medium-sized companies that export to new mar- kets: Success is often easiest found where customers and market characteristics are similar to the home environment.

Sources: D. Barry, “Carlos Lemos, CEO, Ambient Technologies,” Ex- porters: The Wit and Wisdom of Small Businesspeople Who Sell Globally, 2013; Canal de Panama, www.pancanal.com, accessed May 26, 2015; Ambient Technologies, www.ambienttech.com, accessed May 26, 2015; M. Cashill, “Ambient Technologies at the Canal,” Tampa Bay Business Journal, July 15, 2011.

Technologies and the Panama Canal, illustrates cultural and language barriers for ex- porters but also the advantages of small exporters in many cases.

Exporters often face voluminous paperwork, complex formalities, and many potential delays and errors. According to a UN report on trade and development, a typical interna- tional trade transaction may involve 30 parties, 60 original documents, and 360 document copies, all of which have to be checked, transmitted, reentered into various information systems, processed, and filed. The United Nations has calculated that the time involved in preparing documentation, along with the costs of common errors in paperwork, often amounts to 10 percent of the final value of goods exported.12

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466 Part 6 International Business Functions

Improving Export Performance

Inexperienced exporters have a number of ways to gain information about foreign market opportunities and avoid common pitfalls that tend to discourage and frustrate novice exporters.13 In this section, we look at information sources for exporters to increase their knowledge of foreign market opportunities, we consider a number of service providers, we review various exporting strategies that can increase the probability of successful exporting, and we illustrate four globalEDGE Diagnostic Tools that can help exporters. We begin, however, with a look at how several nations try to help domestic firms export.

INTERNATIONAL COMPARISONS

One big impediment to exporting is the simple lack of knowledge of the opportunities available. Often, there are many markets for a firm’s product, but because they are in coun- tries separated from the firm’s home base by culture, language, distance, and time, the firm does not know of them. Identifying export opportunities is made even more complex because more than 200 countries with widely differing cultures compose the world of po- tential opportunities. Faced with such complexity and diversity, firms sometimes hesitate to seek export opportunities.

The way to overcome ignorance is to collect information. In Germany—one of the world’s most successful exporting nations—trade associations, government agencies, and commercial banks gather information, helping small firms identify export opportunities. A similar function is provided by the Japanese Ministry of International Trade and Industry (MITI), which is always on the lookout for export opportunities. In addition, many Japanese firms are affiliated in some way with the sogo shosha, Japan’s great trading houses. The sogo shosha have offices all over the world, and they proactively, continuously seek export opportunities for their affiliated companies large and small.14

German and Japanese firms can draw on the large reservoirs of experience, skills, in- formation, and other resources of their respective export-oriented institutions. Unlike their German and Japanese competitors, many U.S. firms are relatively blind when they seek export opportunities; they are information-disadvantaged. In part, this reflects his- torical differences. Both Germany and Japan have long made their living as trading na- tions, whereas until recently the United States has been a relatively self-contained continental economy in which international trade played a minor role. This is changing; both imports and exports now play a greater role in the U.S. economy than they did 20 years ago. However, the United States has not yet evolved an institutional structure for promot- ing exports similar to that of either Germany or Japan.

INFORMATION SOURCES

Despite institutional disadvantages, U.S. firms can increase their awareness of export op- portunities. The most comprehensive source of information is the U.S. Department of Commerce and its district offices all over the country (U.S. Export Assistance Centers, USEAC). Within that department are two organizations dedicated to providing businesses with intelligence and assistance for attacking foreign markets: U.S. and Foreign Commer- cial Service  and International Trade Administration (ITA). ITA regularly publishes A Guide to Exporting (most recently edited by Doug Barry, 2015). This is the “Official Government Resource to Small and Medium-Sized Companies” in their exporting quest.

The U.S. and Foreign Commercial Service and International Trade Administration are governmental agencies that provide the potential exporter with a “best prospects” list, which gives the names and addresses of potential distributors in foreign markets along with busi- nesses they are in, the products they handle, and their contact person. In addition, the Depart- ment of Commerce has assembled a “comparison shopping service” for countries that are major markets for U.S. exports. For a small fee, a firm can receive a customized market research survey on a product of its choice. This survey provides information on marketability, the competition, comparative prices, distribution channels, and names of potential sales repre- sentatives. Each study is conducted on-site by an officer of the Department of Commerce.

LO 16 -2 Identify the steps managers can take to improve their firm’s export performance.

467 Part 3 Part Title

M A NAG E M E N T F O C U S

Exporting with a Little Government Help Exporting can seem like a daunting prospect, but the real- ity is that in the United States, as in many other countries, many small enterprises have built profitable export busi- nesses. For example, Landmark Systems of Virginia had virtually no domestic sales before it entered the European market. Landmark had developed a software program for IBM mainframe computers and located an independent distributor in Europe to represent its product. In the first year, 80 percent of sales were attributed to exporting. In the second year, sales jumped from $100,000 to $1.4 million— with 70 percent attributable to exports. Landmark is not alone; governmental data suggest that in the United States, more than 97 percent of the 240,000 firms that ex- port are small or medium-sized businesses that employ fewer than 500 people. Their share of total U.S. exports has grown steadily and is around 30 percent today. To help jump-start the exporting process, many small companies have drawn on the expertise of governmental agencies, financial institutions, and export management companies. Consider the case of Novi Inc., a California- based business. Company president Michael Stoff tells how he utilized the services of the U.S. Small Business Adminis- tration (SBA) Office of International Trade to start exporting: “When I began my business venture, Novi Inc., I knew that my Tune-Tote (a stereo system for bicycles) had the potential to be successful in international markets. Although I had no prior experience in this area, I began researching and collecting information on international markets. I was willing to learn, and by targeting key sources for informa- tion and guidance, I was able to penetrate international markets in a short period of time. One vital source I used from the beginning was the SBA. Through SBA I was di- rected to a program that dealt specifically with business

development—the Service Corps of Retired Executives (SCORE). I was assigned an adviser who had run his own import/export business for 30 years. The services of SCORE are provided on a continual basis and are free.” “As I began to pursue exporting, my first step was a thorough marketing evaluation. I targeted trade shows with a good presence of international buyers. I also went to DOC [Department of Commerce] for counseling and in- formation about the rules and regulations of exporting. I advertised my product in Commercial News USA, distrib- uted through United States embassies to buyers world- wide. I utilized DOC’s World Traders Data Reports to get background information on potential foreign buyers. As a result, I received 60–70 inquiries about Tune-Tote from around the world. Once I completed my research and evaluation of potential buyers, I decided which ones would be most suitable to market my product internationally. Then I decided to grant exclusive distributorship. In order to effectively communicate with my international custom- ers, I invested in a fax. I chose a U.S. bank to handle inter- national transactions. The bank also provided guidance on methods of payment and how best to receive and transmit money. This is essential know-how for anyone wanting to be successful in foreign markets.” In just one year of exporting, export sales at Novi topped $1 million and increased 40 percent in the second year of operations. Today, Novi Inc. is a large distributor of wireless intercom systems that exports to more than 10 countries.

Sources: U.S. Department of Commerce, “A Profile of U.S. Exporting Companies, 2000–2001,” February 2003, report available at www. census.gov/foreign-trade/aip/index.html#profile; The 2007 National Exporting Strategy (Washington, DC: U.S. International Trade Commis- sion, 2007).

The Department of Commerce also organizes trade events that help potential export- ers make foreign contacts and explore export opportunities. The department organizes exhibitions at international trade fairs, which are held regularly in major cities worldwide. The department also has a matchmaker program, in which department representatives accompany groups of U.S. businesspeople abroad to meet with qualified agents, distribu- tors, and customers. Affiliated with the U.S. Department of Commerce and its USEAC offices is a set of District Export Councils (connected also via the National District Export Council). DECs are composed of some 1,500 volunteers appointed by the U.S. Secretary of Commerce to help U.S. business be more competitive internationally.

Another governmental organization, the Small Business Administration (SBA), can help potential exporters (see the accompanying Management Focus for examples of the SBA’s work). The SBA employs 76 district international trade officers and 10 regional

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international trade officers throughout the United States as well as a 10-person international trade staff in Washington, DC. Among the SBA’s no-fee services are SBDC, SCORE, and ELAN. The Small Business Development Centers (SBDCs) around the country provide a full range of export assistance to business, particularly small companies new to exporting. Through its Service Corps of Retired Executives (SCORE) program, the SBA oversees some 11,500 volunteers with international trade experience to provide one-on-one counsel- ing to active and new-to-export businesses. The SBA also coordinates the Export Legal Assistance Network (ELAN), a nationwide group of international trade attorneys who pro- vide free initial consultations to small businesses on export-related matters.

Via the U.S. Department of Education, the United States has also established a set of 17 Centers for International Business Education and Research (CIBERs) which assist with exporting needs. The CIBERs were created by the U.S. Congress under the Omnibus Trade and Competitiveness Act of 1988 to increase and promote the nation’s capacity for international understanding and competitiveness. Administered by the U.S. Department of Education, the CIBER network links the human resource and technological needs of the U.S. business community with the international education, language training, and research capacities of universities across the country. The 17 CIBERs, including the Uni- versity of Washington and Michigan State University (www2.ed.gov/programs/iegpscibe), serve as regional and national resources to businesspeople, students, and teachers at all levels. Many countries around the world are trying to replicate the CIBER initiative in the United States (e.g., the European Union).

Additionally, nearly every U.S. state, country regions, and many large cities maintain active trade commissions whose purpose is to promote exports. Most of these provide business counseling, information gathering, technical assistance, and financing. Unfortu- nately, many have fallen victim to budget cuts or to turf battles for political and financial support with other export agencies.

A number of private organizations are also beginning to provide more assistance to would-be exporters. Commercial banks and major accounting firms are more willing to assist small firms in starting export operations than they were a decade ago. In addition, large multinationals that have been successful in the global arena are typically willing to discuss opportunities overseas with the owners or managers of small firms.15

SERVICE PROVIDERS

Most companies that engage in international trade enlist the help of export–import service providers, but there are many choices. Let’s look at the main ones: freight forwarders, ex- port management companies, export trading companies, export packaging companies, customs brokers, confirming houses, export agents and merchants, piggyback marketing, and economic processing zones.

Freight forwarders are mainly in business to orchestrate transportation for companies that are shipping internationally. Their primary task is to combine smaller shipments into a single large shipment to minimize the shipping cost. Freight forwarders also provide other services that are beneficial to the exporting firm, such as documentation, payment, and carrier selection.

An export management company (EMC) offers services to companies that have not previously exported products. EMCs offer a full menu of services to handle all aspects of ex- porting, similar to having an internal exporting department within your own firm. For exam- ple, EMCs deal with export documents and operate as the firm’s agent and distributor; this may include selling the products directly or operating a sales unit to process sales orders.

Export trading companies export products for companies that contract with them. They identify and work with companies in foreign countries that will market and sell the products. They provide comprehensive exporting services, including export documentation, logistics, and transportation.

Export packaging companies, or export packers for short, provide services to companies that are unfamiliar with exporting. For example, some countries require packages to meet certain specifications, and the export packaging firm’s knowledge of these requirements is invaluable to new exporters in particular. The export packer can also advise companies on

Exporting, Importing, and Countertrade Chapter 16 469

appropriate design and materials for the packaging of their items. Export packers can as- sist companies in minimizing packaging to maximize the number of items to be shipped.

Customs brokers can help companies avoid the pitfalls involved in customs regula- tions. The customs requirements of many countries can be difficult for new or infrequent exporters to understand, and the knowledge and experience of the customs broker can be very important. For example, many countries have certain laws and documentation regu- lations concerning imported items that are not always obvious to the exporter. Customs brokers can offer a firm a complete package of services that are essential when a firm is exporting to a large number of countries.

Confirming houses, sometimes called buying agents, represent foreign companies that want to buy your products. Typically, they try to get the products they want at the lowest prices and are paid a commission by their foreign clients. A good place to find these po- tential exporting linkages is via government embassies.

Export agents, merchants, and remarketers buy products directly from the manufac- turer and package and label the products in accordance with their own wishes and speci- fications. They then sell the products internationally through their own contacts under their own names and assume all risks. The effort it takes for you to market the product internationally is very small, but you also lose any control over the marketing, promotion, and positioning of your product.

Piggyback marketing is an arrangement whereby one firm distributes another firm’s products. For example, a firm may have a contract to provide an assortment of products to an overseas client, but it does not have all the products requested. In such cases, another firm can piggyback its products to fill the contract’s requirements. Successful piggyback- ing usually requires complementary products and the same target market of customers.

There are now more than 600 export processing zones (EPZs) in the world, and they exist in more than 100 countries. The EPZs include foreign trade zones (FTZs), special economic zones, bonded warehouses, free ports, and customs zones. Many companies use EPZs to receive shipments of products that are then reshipped in smaller lots to cus- tomers throughout the surrounding areas. Founded in 1978 by the United Nations, the World Economic Processing Zones Association (wepza.org) is a private nonprofit organi- zation dedicated to the improvement of the efficiency of all EPZs.

EXPORT STRATEGY

In addition to using export service providers, a firm can reduce the risks associated with ex- porting if it is careful about its choice of export strategy.16 A few guidelines can help firms improve their odds of success. For example, one of the most successful exporting firms in the world, 3M (originally, Minnesota Mining & Manufacturing Company), has built its export success on three main principles—enter on a small scale to reduce risks, add additional prod- uct lines once the exporting operations start to become successful, and hire locals to promote the firm’s products (3M’s export strategy is profiled in the accompanying Management Focus). Another successful exporter, Red Spot Paint & Varnish Company, emphasizes the importance of cultivating personal relationships when trying to build an export business.

The probability of exporting successfully can be increased dramatically by taking a handful of simple strategic steps. First, particularly for the novice exporter, it helps to hire an EMC or at least an experienced export consultant to identify opportunities and navi- gate the paperwork and regulations so often involved in exporting. Second, it often makes sense to initially focus on one market or a handful of markets. Learn what is required to succeed in those markets before moving to other markets. The firm that enters many markets at once runs the risk of spreading its limited management resources too thin. The result of such a shotgun approach to exporting may be a failure to become established in any one market. Third, as with 3M, it often makes sense to enter a foreign market on a small scale to reduce the costs of any subsequent failure. Most important, entering on a small scale provides the time and opportunity to learn about the foreign country before making significant capital commitments to that market. Fourth, the exporter needs to recognize the time and managerial commitment involved in building export sales and should hire additional personnel to oversee this activity. Fifth, in many countries, it is

M A NAG E M E N T F O C U S

3M, which makes more than 55,000 products including tape, sandpaper, medical products, and the ever-present Post-it notes, is one of the world’s great multinational op- erations. Today, more than 60 percent of the firm’s reve- nues are generated outside the United States. Although the bulk of these revenues came from foreign-based operations, 3M remains a major exporter with more than $30 billion in sales, operations in 65 countries, and sales in more than 200 countries. The company often uses its exports to establish an initial presence in a foreign market, only building foreign production facilities once sales vol- ume rises to a level that justifies local production. The export strategy is built around simple principles. One is known as “FIDO,” which stands for first in (to a new market) defeats others. The essence of FIDO is to gain an advantage over other exporters by getting into a market first and learning about that country and how to sell there before others do. A second principle is “make a little, sell a little,” which is the idea of entering on a small scale with a very modest investment and pushing one basic product, such as reflective sheeting for traffic signs in Russia or scouring pads in Hungary. Once 3M believes it has learned enough about the market to reduce the risk of failure to reasonable levels, it adds additional products. A third principle at 3M is to hire local employees to sell the firm’s products. The company normally sets up a local sales subsidiary to handle its export activities in a country. It then staffs this subsidiary with local hires because it believes

Export Strategy at 3M they are likely to have a much better idea than American expatriates of how to sell in their own country. Because of the implementation of this principle, fewer than 200 of 3M’s 40,000-plus foreign employees are U.S. expatriates. Another common practice at 3M is to formulate global strategic plans for the export and eventual overseas pro- duction of its products. Within the context of these plans, 3M gives local managers considerable autonomy to find the best way to sell the product within their country. Thus, when 3M first exported its Post-it notes, it planned to “sam- ple the daylights” out of the product, but it also told local managers to find the best way of doing this. Local manag- ers hired office cleaning crews to pass out samples in Great Britain and Germany; in Italy, office products distribu- tors were used to pass out free samples; while in Malaysia, local managers employed young women to go from office to office handing out samples of the product. In typical 3M fashion, when the volume of Post-it notes was sufficient to justify it, exports from the United States were replaced by local production. Thus, after several years, 3M found it worthwhile to set up production facilities in France to pro- duce Post-it notes for the European market.

Sources: “3M Science of Applied Life,” www.3m.com, accessed May 26, 2015; R. L. Rose, “Success Abroad,” The Wall Street Journal, March 29, 1991, p. A1; T. Eiben, “US Exporters Keep On Rolling,” For- tune, June 14, 1994, pp. 128–31; 3M Company, A Century on Innova- tion, 3M, 2002; 2005, 2015 10K form archived at 3M’s website, www.3m.com.

important to devote a lot of attention to building strong and enduring relationships with local distributors and/or customers. Sixth, as 3M often does, it is important to hire local personnel to help the firm establish itself in a foreign market. Local people are likely to have a much greater sense of how to do business in a given country than a manager from an exporting firm who has previously never set foot in that country. Seventh, several stud- ies have suggested the firm needs to be proactive about seeking export opportunities.17 Armchair exporting does not work! The world will not normally beat a pathway to your door. Finally, it is important for the exporter to retain the option of local production. Once exports reach a sufficient volume to justify cost-efficient local production, the exporting firm should consider establishing production facilities in the foreign market. Such local- ization helps foster good relations with the foreign country and can lead to greater market acceptance. Exporting is often not an end in itself, but merely a step on the road toward establishment of foreign production (again, 3M provides an example of this philosophy).

GLOBALEDGE DIAGNOSTIC TOOLS

In Chapter 1, we introduced globalEDGE website (globaledge.msu.edu), a product of the International Business Center in the Eli Broad College of Business at Michigan State

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University. globalEDGE has been the top-ranked website in the world for international business resources on Google since 2004. Businesspeople, public policy makers, academics, and college students have been using globalEDGE in some form since 1994, when it first started as “International Business Resources on the World Wide Web.” The site is free, including the “Diagnostic Tools” section. In that section of the site, there are four diagnos- tic tools that focus on helping companies export. Each tool has been developed through sophisticated research and numerous Delphi studies with business executives. The tools are CORE, PARTNER, DISTRIBUTOR, and FREIGHT.

CORE (Company Readiness to Export) assists firms in self-assessment of their export- ing proficiency, evaluates both the firm’s and the intended product’s readiness to be taken internationally, and systematically identifies the firm’s strengths and weaknesses within the context of exporting (see Figure 16.2). The CORE tool also serves as a tutorial in ex- porting, and it has been the most successful and most widely used of the tools created by the International Business Center.

PARTNER (International Partner Selection) assists in the analysis and evaluation of potential international partners. It covers a wide variety of types of partnerships: joint ventures, licensees, franchisees, contract manufacturers, and R&D partnerships. It is based on a multidimensional set of criteria that includes trust and relationship factors as well as operational criteria and contains individually identified strengths and weaknesses of each partner. DISTRIBUTOR (Foreign Distributor Selection) helps exporting firms evaluate and compare foreign distributor or agent candidates, given the type of product being sold and the market characteristics, and indicates areas that may require ongoing training and management throughout the life of the relationship. FREIGHT (Freight Forwarder Selection) assists companies in selecting the most appropriate international freight forwarder for their type and volume of business based on six sets of criteria; it evaluates each candidate, highlights the candidates’ strengths and weaknesses, and com- pares the various candidates.

Export and Import Financing

Mechanisms for financing exports and imports have evolved over the centuries in response to a problem that can be particularly acute in international trade: the lack of trust that exists when one must put faith in a stranger. In this section, we examine the financial

LO 16 - 4 Recognize the basic steps involved in export financing.

F I G U R E 1 6 . 2

Company readiness to export.

TEST PREP Use SmartBook to help retain what you have learned. Access your Instructor’s Connect course to check out SmartBook or go to learnsmartadvantage.com for help.

Product Readiness

Company Readiness+ =

Company’s Overall

Readiness to Export

Competitive capabilities in

domestic market

Motivation for going international

Commitment of owners and top management

Experience and training

Skills, knowledge, and resources

472 Part 6 International Business Functions

devices that have evolved to cope with this problem in the context of international trade: the letter of credit, the draft (or bill of exchange), and the bill of lading. Then we trace the 14 steps of a typical export–import transaction.18

LACK OF TRUST

Firms engaged in international trade have to trust someone they may have never seen, who lives in a different country, who speaks a different language, who abides by (or does not abide by) a different legal system, and who could be very difficult to track down if he or she defaults on an obligation. Consider a U.S. firm exporting to a distributor in France. The U.S. businessperson might be concerned that if he ships the products to France be- fore he receives payment from the French businessperson, she might take delivery of the products and not pay him. Conversely, the French importer might worry that if she pays for the products before they are shipped, the U.S. firm might keep the money and never ship the products or might ship defective products. Neither party to the exchange com- pletely trusts the other. This lack of trust is exacerbated by the distance between the two parties—in space, language, and culture—and by the problems of using an underdevel- oped international legal system to enforce contractual obligations.

Due to the (quite reasonable) lack of trust between the two parties, each has his or her own preferences as to how the transaction should be configured. To make sure he is paid, the manager of the U.S. firm would prefer the French distributor to pay for the products before he ships them (see Figure 16.3). Alternatively, to ensure she receives the products, the French distributor would prefer not to pay for them until they arrive (see Figure 16.4). Thus, each party has a different set of preferences. Unless there is some way of establishing trust between the parties, the transaction might never occur.

The problem is solved by using a third party trusted by both—normally a reputable bank— to act as an intermediary. What happens can be summarized as follows (see Figure 16.5). First, the French importer obtains the bank’s promise to pay on her behalf, knowing the U.S. exporter will trust the bank. This promise is known as a letter of credit. Having seen the letter of credit, the U.S. exporter now ships the products to France. Title to the prod- ucts is given to the bank in the form of a document called a bill of lading. In return, the

F I G U R E 1 6 . 3

Preference of the U.S. exporter.

French Importer American Exporter

2 Exporter Ships the Goods after Being Paid

1 Importer Pays for the Goods

F I G U R E 1 6 . 4

Preference of the French importer.

French Importer American Exporter

2 Importer Pays after the Goods Are Received

1 Exporter Ships the Goods

Exporting, Importing, and Countertrade Chapter 16 473

U.S. exporter tells the bank to pay for the products, which the bank does. The document for requesting this payment is referred to as a draft. The bank, having paid for the prod- ucts, now passes the title on to the French importer, whom the bank trusts. At that time or later, depending on their agreement, the importer reimburses the bank. In the remainder of this section, we examine how this system works in more detail.

LETTER OF CREDIT

A letter of credit, abbreviated as L/C, stands at the center of international commercial transactions. Issued by a bank at the request of an importer, the letter of credit states that the bank will pay a specified sum of money to a beneficiary, normally the exporter, on presentation of particular, specified documents.

Consider again the example of the U.S. exporter and the French importer. The French importer applies to her local bank, say, the Bank of Paris, for the issuance of a letter of credit. The Bank of Paris then undertakes a credit check of the importer. If the Bank of Paris is satisfied with her creditworthiness, it will issue a letter of credit. However, the Bank of Paris might require a cash deposit or some other form of collateral from her first. In addition, the Bank of Paris will charge the importer a fee for this service. Typically this amounts to between 0.5 and 2 percent of the value of the letter of credit, depending on the importer’s creditworthiness and the size of the transaction. (As a rule, the larger the transaction, the lower the percentage.)

Assume the Bank of Paris is satisfied with the French importer’s creditworthiness and agrees to issue a letter of credit. The letter states that the Bank of Paris will pay the U.S. exporter for the merchandise as long as it is shipped in accordance with specified instruc- tions and conditions. At this point, the letter of credit becomes a financial contract be- tween the Bank of Paris and the U.S. exporter. The Bank of Paris then sends the letter of credit to the U.S. exporter’s bank, say, the Bank of New York. The Bank of New York tells the exporter that it has received a letter of credit and that he can ship the merchandise. After the exporter has shipped the merchandise, he draws a draft against the Bank of Paris in accordance with the terms of the letter of credit, attaches the required documents, and presents the draft to his own bank, the Bank of New York, for payment. The Bank of New York then forwards the letter of credit and associated documents to the Bank of Paris. If all the terms and conditions contained in the letter of credit have been complied with, the Bank of Paris will honor the draft and will send payment to the Bank of New York. When the Bank of New York receives the funds, it will pay the U.S. exporter.