International_BusinessSixteenth_EditionChapter_9Global_Foreign

International Business

Sixteenth Edition

Chapter 9

Global Foreign Exchange Markets

1

Learning Objectives (1 of 2)

9-1 Define what foreign exchange is and who the major players are in the foreign-exchange market

9-2 Summarize the major characteristics of the foreign-exchange market

9-3 Compare and contrast spot, forward, options, and futures markets

Learning Objectives for the chapter.

2

Learning Objectives (2 of 2)

9-4 Explain some of the major aspects of the foreign- exchange markets

9-5 Show how companies use foreign exchange to facilitate international trade

Learning Objectives for the chapter.

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Foreign Exchange

Objective 9-1

What is foreign exchange?

Exchange rates

Bank for International Settlements (BIS)

Learning Objective 1: Define what foreign exchange is and who the major players are in the foreign-exchange market.

Foreign exchange is money denominated in the currency of another nation or group of nations. The market in which such transactions take place is the foreign-exchange market. Foreign exchange can be in the form of cash, funds available on credit and debit cards, traveler’s checks, bank deposits, or other short-term claims.

An exchange rate is the price of a currency—specifically, the number of units of one currency that buy one unit of another currency. The number can change daily. The foreign-exchange market is made up of many different players.

The Bank for International Settlements (BIS), a financial organization centered in Basel, Switzerland, owned and controlled by 60 member central banks, divides the market into three major categories: reporting dealers, other financial institutions, and nonfinancial institutions.

Reporting dealers, also known as money center banks, are large financial institutions that actively participate in local and global foreign-exchange and derivative markets smaller local and regional commercial banks, investment banks and securities houses, hedge funds, pension funds, money market funds, currency funds, mutual funds, specialized foreign-exchange trading companies, and so forth.

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How Foreign Exchange is Traded

Objective 9-1

Ways of trading

Electronic means

Two major segments

Over the counter market

Exchange traded market

Learning Objective 2: Summarize the major characteristics of the foreign-exchange market.

Dealers can trade foreign exchange

directly with customers,

through voice brokers,

through electronic,

brokerage systems, or

directly through interbanks.

Recently, more than 50 percent of foreign-exchange trading volume was being executed by electronic means.

.

The foreign-exchange market has two major segments: the over-the-counter market (OTC) and the exchange-traded market. The OTC market is composed of commercial banks as just described, investment banks, and other financial institutions. The exchange-traded market comprises securities exchanges, such as the CME Group, NASDAQ OMX, and Intercontinental Exchange (ICE), where certain types of foreign-exchange instruments, such as futures and options, are traded.

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Global OTC Foreign Exchange Instruments

Objective 9-2

Spot transactions

Outright forward transactions

FX Swap

Currency swap

Options

Futures

Learning Objective 2: Summarize the major characteristics of the foreign-exchange market.

Spot transactions involve the exchange of currency for delivery in two business days the day the transaction was made. For example, a bank would quote an exchange rate for a transaction on Monday, but delivery would take place on Thursday. The rate at which the transaction is settled is the spot rate.

Outright forward transactions involve the exchange of currency on a future date beyond two business days. It is the single purchase or sale of a currency for future delivery. The rate at which the transaction is settled is the forward rate and is a contract rate between the two parties. The forward transaction will be settled at the forward rate no matter what the actual spot rate is at the time of settlement.

In an FX swap, one currency is traded for another on one date and then swapped back later. Most often, the first or short leg of an FX swap is a spot transaction and the second or long leg a forward transaction. Let’s say IBM receives a dividend in British pounds from its subsidiary in the United Kingdom but has no use for British pounds until it has to pay a UK supplier in 30 days. It would rather have dollars now than hold on to the pounds for a month. IBM could enter into an FX swap in which it sells the pounds for dollars to a dealer in the spot market at the spot rate and agrees to buy pounds for dollars from the dealer in 30 days at the forward rate.

Currency swaps deal more with interest-bearing financial instruments (such as a bond) and involve the exchange of principal and interest payments.

Options are the right, but not the obligation, to trade foreign currency in the future.

A futures contract is an agreement between two parties to buy or sell a particular currency at a particular price on a particular future date, as specified in a standardized contract to all participants in a currency futures exchange rather than in the over-the-counter market.

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The U.S. Dollar and Foreign Exchange Markets

Objective 9-2

U.S. Dollar as currency on the foreign exchange market

Insert table 9.1

Learning Objective 2: Summarize the major characteristics of the foreign-exchange market.

The U.S. dollar is the most important currency on the foreign-exchange market; in the latest BIS Survey, it was one side (buy or sell) of 87 percent of all foreign currency transactions worldwide. It’s an investment currency in many capital markets.

Reasons for use of US Dollar:

It’s a reserve currency held by many central banks.

It’s a transaction currency in many international commodity markets.

It’s an invoice currency in many contracts.

It’s an intervention currency employed by monetary authorities in market operations to influence their own exchange rates.

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London as a Trading Center

Objective 9-2

London as an important Trading Center

Geographic Location

Time Zone

Learning Objective 2: Summarize the major characteristics of the foreign-exchange market.

If the U.S. dollar is the most widely traded currency in the world, why is London so important as a trading center? There are two major reasons. First, London, which is close to the major capital markets in Europe, is a strong international financial center where many domestic and foreign financial institutions operate. Thus, its geographic location relative to significant global economic activity is key.

Second, London is positioned in a unique way because of its time zone. As Map 9.1 shows, noon in London is 7:00 a.m. in New York and evening in Asia. The London market opens toward the end of the trading day in Asia and is going strong as the New York foreign-exchange market opens up. Thus, the city straddles both of the other major world markets.

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Geographical Distribution of Foreign Exchange Markets

Objective 9-2

Figure 9.1 Foreign-Exchange Markets: Geographical Distribution, September 2013

Source: Based on Bank for International Settlements, Central Bank Survey Report on Foreign Exchange Turnover in April 2013: Preliminary Global Results (Basel, Switzerland: BIS, September 2013: 14): 1.

Learning Objective 2: Summarize the major characteristics of the foreign-exchange market.

This figure shows the Geographical distribution of foreign exchange markets.

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The Spot Market

Objective 9-3

Bid Rate

Direct and Indirect quotes

Base and term currencies

Learning Objective 3: Compare and contrast spot, forward, options, and futures markets.

The spot market is for foreign-exchange transactions that occur within two business days.

Rates are quoted by foreign-exchange dealers. The bid (buy) rate is the price at which the dealer is willing to buy foreign currency; the offer (sell) is the price at which the dealer is willing to sell foreign currency. The difference between the bid and offer rates is the dealer’s profit margin.

Direct and Indirect Quotes Let’s look at an example of how a bid and offer might work. For example, the rate a U.S.-based dealer quoted for the British pound on April 1, 2016, was $1.4228/30. This means the dealer is willing to buy pounds at $1.4228 each and sell them for $1.4230 each (i.e., buying low and selling high). In this example, the dealer quotes the foreign currency as the number of U.S. dollars for one unit of that currency. This method of quoting exchange rates is called the direct quote, which is the number of units of the domestic currency (the U.S. dollar in this case) for one unit of the foreign currency. It is also known as American terms.

The other convention for quoting foreign exchange is known as the indirect quote, or European terms. It is the number of units of the foreign currency for one unit of the domestic currency.

Base and Term Currencies: When dealers quote currencies to their customers, they always quote the base currency (the denominator) first, followed by the terms currency (the numerator).

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The Forward, Options, and Futures Markets

Objective 9-3

Forward Markets

Forward Discount

Forward Premium

Option

Learning Objective 3: Compare and contrast spot, forward, options, and futures markets.

As noted earlier, the spot market is for foreign-exchange transactions that occur within two business days. But in some transactions, a seller extends credit to the buyer for a period longer than that. For example, a Japanese exporter of consumer electronics might sell television sets to a U.S. importer with immediate delivery but payment due in 30 days. The U.S. importer is obligated to pay in yen in 30 days and may enter into a contract with a currency dealer to deliver the yen at a forward rate—the rate quoted today for future delivery. This is a forward market.

Building on what we said earlier, we now can say that the difference between the spot and forward rates is either the forward discount or the forward premium.

An option is the right, but not the obligation, to buy or sell a foreign currency within a certain time period or on a specific date at a specific exchange rate.

A foreign currency futures contract resembles a forward contract insofar as it specifies an exchange rate some time in advance of the actual exchange of currency. However, a future is traded on an exchange, not OTC. Instead of working with a bank or other financial institution, companies work with exchange brokers when purchasing futures contracts.

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Foreign Exchange Markets

Objective 9-4

Largest Markets

CME Group

NASDAQ

NYSE: ICE

Learning Objective 4: Explain some of the major aspects of the foreign-exchange markets.

When a company sells goods or services to a foreign customer and receives foreign currency, it needs to convert it into the domestic currency. When importing, the company needs to convert domestic to foreign currency to pay the foreign supplier. This conversion usually takes place between the company and its bank.

At one time, only the big money center banks could deal directly in foreign exchange. Regional banks had to rely on them to execute trades on behalf of their clients. The emergence of electronic trading has changed that.

Top exchanges for foreign transactions .

CME Group The CME Group was formed on July 9, 2007, as a merger between the Chicago Mercantile Exchange and the Chicago Board of Trade. The CME operates according to so-called open outcry: Traders stand in a pit and call out prices and quantities. The platform is also linked to an electronic trading platform, which is growing rapidly.

NASDAQ Prior to 2008, the Philadelphia Stock Exchange was one of the pioneers in trading currency options. In July 2008, PHLX merged with NASDAQ OMX, and in 2014, the name was changed to NASDAQ. NASDAQ trades options in seven currencies— the Australian dollar, the British pound, the Canadian dollar, the euro, the Swiss franc, the New Zealand dollar, and the Japanese yen.

NYSE:ICE In 2013, Intercontinental Exchange (ICE) purchased NYSE Euronext, forming NYSE:ICE. The combined company is a giant in futures and options. ICE Futures US offers cross-trades in a number of currencies through ICE’s futures contracts on key currency pairs traded in the interbank market through an electronic trading platform.

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The Foreign Exchange Trading Process: A Visual

Objective 9-4

Figure 9.3 The Foreign-Exchange Trading Process

Learning Objective 4: Explain some of the major aspects of the foreign-exchange markets.

This figure visually shows the trading process for foreign exchange.

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How Companies Use Foreign Exchange

Objective 9-5

Draft or Commercial Bill of Exchange

Letter of Credit

Speculation

Arbitrage

Learning Objective 5: Show how companies use foreign exchange to facilitate international trade.

Companies enter the foreign-exchange market to facilitate their regular business transactions and/or to speculate. Their treasury departments are responsible for establishing policies for trading currency and for managing banking relationships to make the trades. From a business standpoint, a company, first of all, trades foreign exchange for exports/imports and the buying or selling of goods and services.

When Boeing sells the new 787 Dreamliner commercial airplane to LAN, the largest airline in South America, it has to be concerned about the currency in which it will be paid and how it will receive payment. In this case, the sale is probably denominated in dollars, so Boeing will not have to worry about the foreign-exchange market (nor, in theory, will its employees). However, LAN will have to worry about the market. Where will it come up with the dollars, and how will it pay Boeing?

An individual or a company that pays a bill in a domestic setting can pay cash, but checks are typically used—often electronically transmitted. The check is also known as a draft or a commercial bill of exchange. A draft is an instrument in which one party (the drawer) directs another party (the drawee) to make a payment. The drawee can be either a company, like the importer, or a bank. In the latter case, the draft would be considered a bank draft.

With a bill of exchange, it is always possible that the importer will not be able to make payment to the exporter at the agreed-upon time. A letter of credit (L/C), however, obligates the buyer’s bank in the importing country to honor a draft presented to it, provided the draft is accompanied by the prescribed documents.

Speculation: Companies sometimes deal in foreign exchange for profit. This is especially true for some banks and all hedge funds. But sometimes corporate treasury departments see their foreign-exchange operations as profit centers and also buy and sell foreign exchange with the objective of earning profits.

One type of profit-seeking activity is arbitrage, which is the purchase of foreign currency on one market for immediate resale on another market (in a different country) to profit from a price discrepancy. For example, a dealer might sell U.S. dollars for Swiss francs in the United States, then Swiss francs for British pounds in Switzerland, then the British pounds for U.S. dollars back in the United States, with the goal of ending up with more dollars.

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Copyright

International Business

Sixteenth Edition

Chapter 8

Cross-National Cooperation and Agreements

1

Learning Objectives (1 of 2)

8-1 Define the three major types of international economic integration

8-2 Explain what the World Trade Organization is and how it is working to reduce trade barriers on a global basis

8-3 Summarize the major benefits of regional economic integration

Learning Objectives for the chapter.

2

Learning Objectives (2 of 2)

8-4 Compare and contrast different regional trading groups

8-5 Describe the forces that affect the prices of

commodities and their impact on commodity agreements

Learning Objectives for the chapter.

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What is Economic Integration?

Objective 8-1

Economic Integration Definition

Major ways to approach agreements

Global integration

Bilateral integration

Regional integration

Learning Objective 1: Define the three major types of international economic integration

Economic integration is a term used to describe the political and monetary agreements among nations and world regions in which preference is given to member countries. There are three major ways to approach such agreements:

Global integration—Countries from all over the world decide to cooperate through the World Trade Organization (WTO)

Bilateral integration—Two countries decide to cooperate more closely together, usually in the form of tariff reductions

Regional integration—A group of countries located in the same geographic proximity decide to cooperate, as with the European Union

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GATT: Predecessor to WTO

Objective 8-2

GATT

General Agreement on Tariffs and Trade

Trade without Discrimination

Fundamental principle

Learning Objective 2: Explain what the World Trade Organization is and how it is working to reduce trade barriers on a global basis

In 1947, 23 countries formed the General Agreement on Tariffs and Trade (GATT) under the auspices of the United Nations to abolish quotas and reduce tariffs. By the time the WTO replaced GATT in 1995, 125 nations had become members. Many believe that GATT’s contribution to trade liberalization enabled the expansion of world trade in the second half of the twentieth century.

The fundamental principle of GATT was that each member nation must open its markets equally to every other member nation. This principle of “trade without discrimination” was embodied in GATT’s most-favored-nation (MFN) clause—once a country and its trading partners had agreed to reduce a tariff, that tariff cut was automatically extended to every other member country, irrespective of whether the country was a signatory to the agreement.

GATT lead to the creation of the WTO, discussed next

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The WTO

Objective 8-2

WTO

World Trade Organization

Purpose

WTO and “most favored nation clause”

WTO and Dispute Settlement

Learning Objective 2: Explain what the World Trade Organization is and how it is working to reduce trade barriers on a global basis

The WTO adopted the principles and trade agreements reached under the auspices of GATT but expanded its mission to include trade in services, investment, intellectual property, sanitary measures, plant health, agriculture, and textiles, as well as technical barriers to trade.

The World Trade Organization is the major body for

reciprocal trade negotiations,

enforcement of trade agreements.

Most Favored Nation: The WTO continued the MFN clause of GATT, which implies that member countries should trade without discrimination, basically giving foreign products “national treatment.” Although the WTO restricts this privilege to official members, some exceptions are allowed, especially for developing countries or countries that are part of a regional or bilateral trading group.

Dispute Settlement: One function of the WTO that is garnering growing attention is the organization’s dispute settlement mechanism, in which countries may bring charges of unfair trade practices to a WTO panel, and accused countries may appeal. There are time limits on all stages of deliberations, and the WTO’s rulings are binding. If an offending country fails to comply with the panel’s judgment, its trading partners have the right to compensation.

If this penalty is ineffective, then the offending country’s trading partners have the right to

impose countervailing sanctions.

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Benefits of Regional Economic Integration

Objective 8-3

Static Effects

Dynamic Effects

Learning Objective 3: Summarize the major benefits of regional economic integration

Static and Dynamic Effects Regional economic integration reduces or eliminates barriers for member countries, producing both static and dynamic effects. Static Effects are the shifting of resources from inefficient to efficient companies as trade barriers fall. Dynamic effects are the overall growth in the market and the impact on a company caused by expanding production and by its ability to achieve greater economies of scale.

Static Effects:

Trade Creation: Production shifts to more efficient producers for reasons of comparative advantage, allowing consumers access to more goods at lower prices than would have been possible without integration. Companies protected in their domestic markets face real problems when the barriers are eliminated and they attempt to compete with more efficient producers.

Trade Diversion: Trade shifts to countries in the group at the expense of trade with other countries, even though the nonmember companies might be more efficient in the absence of trade barriers.

Dynamic Effects:

Economies of Scale Dynamic effects of integration occur when trade barriers come down and markets grow

Increased Competition Another important effect of an RTA is greater efficiency due to increased competition. Many MNEs in Europe have attempted to grow through mergers and acquisitions to achieve the size necessary to compete in the larger market.

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The Impact of Trade Agreements

Objective 8-3

Figure 8.1 Impact of Free Trade Agreements

Learning Objective 3: Summarize the major benefits of regional economic integration

This figure shows the impact of trade agreements.

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The European Union (EU)

Objective 8-4

The goals of the EU

Why the EU?

Governing bodies of the EU

Learning Objective 4: Compare and contrast different regional trading groups

The European Union: Changed from the European Economic Community to the European Community to the European Union. It is the largest and most successful regional trade group. Characteristics of the EU:

Free trade of goods, services, capital, and people

Common external tariff

Common currency

Because of the economic and human destruction left by World War II, European political leaders realized that greater cooperation among their countries would help speed up recovery. Many organizations were formed, including the European Economic Community (EEC), which eventually emerged as the organization that would bring together the countries of Europe into the most powerful trading bloc in the world.

The EU encompasses many governing bodies, among which are the European Commission, European Council, European Parliament, European Court of Justice, and European Central Bank

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Other Aspects of the EU

Objective 8-4

Antitrust Investigations

Monetary Union

Schengen Area

Expansion

Bilateral Agreements

Transatlantic Trade and Investment Partnership

Learning Objective 4: Compare and contrast different regional trading groups

Antitrust Investigations The EU has been very aggressive in enforcing antitrust laws in a variety of areas, including high-tech companies like Microsoft and Google on charges that they were harming competitors because of their dominant market positions, Apple and Amazon on suspicion that they were receiving unfair tax advantages from Ireland and Luxembourg respectively, and Facebook on allegations that it was violating privacy policies.

Monetary Union: The Euro In 1992, the members of the EU signed the Treaty of Maastricht in part to establish a monetary union. The decision to move to a common currency, the euro, in Europe has eliminated currency as a trade barrier for its adopters. As of 2016, 19 of 28 EU members had adopted the euro

The Schengen Area In order to facilitate the free flow of people from country to country within the EU, the Schengen Agreement was signed in 1990 with gradual implementation allowing citizens to cross internal borders without having to go through border checks

Expansion One of the EU’s major challenges is expansion. Official candidates for future membership currently include Turkey, Montenegro, Serbia, and the former Yugoslav Republic of Macedonia. Turkey is an interesting candidate since it straddles Europe and Asia

Bilateral Agreements In addition to reducing trade barriers for member countries, the EU has signed numerous bilateral free trade agreements with other countries outside the region.

The Transatlantic Trade and Investment Partnership (T-TIP) One of the more intriguing potential agreements involves the United States and the EU. Even though tariffs between the two superpowers are already low (the United States and the EU have the world’s largest trading relationship and account for nearly half of the world’s economic output), the new agreement would eliminate the remaining tariffs, boost trade between the regions, and aid in harmonizing product standards between them.

10

The European Union Countries

Objective 8-4

Map 8.1 European Trade and Economic Integration

Learning Objective 4: Compare and contrast different regional trading groups

This map shows the participating countries in the EU.

11

NAFTA

Objective 8-4

What is NAFTA?

North American Free Trade Agreement

Reasons and Goals for NAFTA

Learning Objective 4: Compare and contrast different regional trading groups

The North American Free Trade Agreement

includes Canada, the United States, and Mexico;

went into effect on January 1, 1994;

involves free trade in goods, services, and investment;

is a large trading bloc but includes countries of different sizes and wealth.

NAFTA rationale:

U.S.–Canadian trade is the largest bilateral trade in the world.

The United States is Mexico’s and Canada’s largest trading partner.

NAFTA calls for the elimination of tariff and nontariff barriers, the harmonization of trade rules, the liberalization of restrictions on services and foreign investment, the enforcement of intellectual property rights, and a dispute settlement process.

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Other Aspects of NAFTA

Objective 8-4

Rules of Origin

Impact of NAFTA

Learning Objective 4: Compare and contrast different regional trading groups

Rules of Origin and Regional Content An important component of NAFTA is the concept of rules of origin and regional content. Because it is a free trade agreement and not a customs union, each country sets its own tariffs to the rest of the world. Rules of origin” ensure that only goods that have been the subject of substantial economic activity within the free trade area are eligible for the more liberal tariff conditions created by NAFTA. This is a major contrast with the EU, which is a customs union rather than just an FTA. Regional Value Content Requirement One aspect of rules of origin in NAFTA refers to the Regional Value Content requirement. According to regional content rules, at least 50 percent of the net cost of components, raw materials, and labor of most products must come from the NAFTA region to qualify for the FTA.

The Impact of NAFTA There are pros and cons to any trade agreement, and NAFTA is no exception. It is obvious that trade and investment have increased significantly since the agreement was signed in 1994. U.S. goods and services trade with NAFTA totaled $1.6 trillion in 2009 (according to the latest data available). U.S. goods trade with the two partners totaled $918 billion in 2010, with the United States recording a trade deficit in goods. Immigration A major challenge to NAFTA is immigration. As trade in agriculture increased with the advent of NAFTA, more than a million farm jobs disappeared in Mexico due to U.S. competition.

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Economic Integration in Caribbean and Central America

Objective 8-4

Map 8.2 Economic Integration in Central America and the Caribbean

Learning Objective 4: Compare and contrast different regional trading groups

This map shows the variety of economic integration in the Caribbean and Central America.

14

CARICOM

Objective 8-4

Map 8.2 Economic Integration in Central America and the Caribbean

Learning Objective 4: Compare and contrast different regional trading groups

The Caribbean Community (CARICOM) is working hard to establish an EU-style form of collaboration, complete with full movement of goods and services, the right of establishment, a common external tariff, free movement of capital and labor, a common trade policy, and so on.

Countries in Latin America and the Caribbean rely heavily on countries outside the region for trade, so this agreement is important.

15

Economic Integration in Latin America

Objective 8-4

Map 8.3 Latin American Economic Integration

Learning Objective 4: Compare and contrast different regional trading groups

This map shows the variety of economic integration in Latin America.

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Economic Integration: MERCOSUR, Pacific Alliance and CAN

Objective 8-4

What is Mercosur?

What is the Pacific Alliance?

What is CAN?

Learning Objective 4: Compare and contrast different regional trading groups

Mercosur The major trade group in South America is Mercosur, which was established in 1991 by Brazil, Argentina, Paraguay, and Uruguay. Its major goal is to become a customs union with free trade within the bloc and a common external tariff. Mercosur is classified as a customs union by the WTO for trade in goods and as an economic integration agreement for trade in services.

Pacific Alliance Mercosur has problems. It included Venezuela as a full member, and temporarily suspended Paraguay. Brazil and Argentina have serious problems with protectionism. Frustration over these and other issues in both CAN and Mercosur has lead to the creation in 2012 of the Pacific Alliance, comprising Mexico, Colombia, Peru, and Chile. These countries refer to themselves as more hospitable to trade and investment due to their adherence to democracy and the rule of law rather than the more populist and protectionist philosophies of other countries in CAN and Mercosur.

Andean Community (CAN) Although the Andean Community (CAN) is not as significant economically as Mercosur, it is the second most important official regional group in South America

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Asia’s Economic Integration Agreements

Objective 8-4

ASEAN Free Trade Area

Asia Pacific Economic Cooperation (APEC)

Trans-Pacific Partnership (TPP)

Learning Objective 4: Compare and contrast different regional trading groups

ASEAN Free Trade Area: On January 1, 1993, ASEAN officially formed the ASEAN Free Trade Area (AFTA) with the goal of cutting tariffs on all intra-zonal trade to a maximum of 5 percent by January 1, 2008. The weaker ASEAN countries would be allowed to phase in their tariff reductions over a longer period. By 2005, most products traded among the AFTA countries were subject to duties from 0 to 5 percent, so AFTA has been successful in its objectives.

Asia Pacific Economic Cooperation (APEC): Formed in November 1989 to promote multilateral economic cooperation in trade and investment in the Pacific Rim,27 Asia Pacific Economic Cooperation (APEC) is composed of 21 countries that border both Asia and the Americas. All but three members of AFTA are members of APEC, plus Canada, the United States, Mexico, Peru, and Chile in the Americas; Australia and New Zealand; and China, Japan, Korea, Russia, and Chinese Taipei. It is a large and powerful organization that is focused on a wide range of activities related to trade and investment, security, energy, sustainability, anticorruption, and transparency, among other things.

Trans-Pacific Partnership (TPP): The TPP was initiated by the United States to spur economic growth and create jobs, and it involves Australia, Brunei, Canada, Chile, Japan, Malaysia, Mexico, New Zealand, Peru, Singapore, the United States, and Vietnam. The formation of the initiative was announced in 2011, the agreement was concluded in October 2015 and signed by the trade ministers in February 2016. However, the TPP will not actually come into effect until it is approved by the government of each member, which is a difficult political task, especially during a contentious election year in the United States.

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ASEAN Free Trade Area

Objective 8-4

Map 8.4 The Association of Southeast Asian Nations

Learning Objective 4: Compare and contrast different regional trading groups

This map shows the ASEAN Free Trade Area.

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Africa Regional Integration

Objective 8-4

Map 8.5 Regional Integration in Africa

Learning Objective 4: Compare and contrast different regional trading groups

This map shows the regional integration of Africa.

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The United Nations

Objective 8-4

What is it?

UN Purpose

UN Family of Organizations

Learning Objective 4: Compare and contrast different regional trading groups

The United Nations The first form of cooperation worth exploring is the United Nations, which was established in 1945 in response to the devastation of World War II to promote international peace and security and to help solve global problems in such diverse areas as economic development, antiterrorism, and humanitarian actions. If the UN performs its responsibilities, it should improve the environment in which MNEs operate around the world, reducing risk and providing greater opportunities

The UN family of organizations is too large to list, but it includes the WTO, the International Monetary Fund, and the World Bank (the latter two discussed in subsequent chapters). These organizations are all part of the Economic and Social Council, one of six principal organs of the UN System, which also includes the General Assembly, the Security Council, and the International Court of Justice. The UN has 193 member states represented in the General Assembly, including 15 that compose the Security Council.

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Commodity Agreements

Objective 8-5

What are commodities?

Purpose of Commodities Agreements

OPEC

Organization of the Petroleum Exporting Countries

Learning Objective 5: Describe the forces that affect the prices of commodities and their impact on commodity agreements.

Commodities refer to raw materials or primary products that enter into trade, such as metals or agricultural products. Primary commodity exports—such as crude petroleum, natural gas, copper, iron ore, tobacco, coffee, cocoa, tea, and sugar—are still important to developing countries.

Many commodity agreements now exist for the purpose of

discussing issues,

disseminating information, and

improving product safety.

The Organization of the Petroleum Exporting Countries (OPEC) is an example of a producer cartel that relies on quotas to influence prices. It is a group of 13 oil-producing countries that have significant control over supply and band together to control output and price. Its members include Algeria, Angola, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. Several.

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Copyright

International Business

Sixteenth Edition

Chapter 7

Governmental Influence on Trade

1

Learning Objectives (1 of 2)

7-1 Recognize the conflicting outcomes of trade protectionism

7-2 Assess governments’ economic rationales and outcome uncertainties with international trade intervention

7-3 Assess governments’ noneconomic rationales and outcome uncertainties with international trade intervention

Learning Objectives for the chapter.

2

Learning Objectives (2 of 2)

7-4 Describe the major instruments of trade control

7-5 Classify how companies deal with governmental trade influences

Learning Objectives for the chapter.

3

What is Protectionism?

Objective 7-1

What is protectionism?

Why do governments intervene in trade?

Stakeholders and protectionism

Learning Objective 1: Recognize the conflicting outcomes of trade protectionism.

Governmental actions to influence international trade are known as protectionism.

Despite free-trade benefits, governments intervene in trade to attain economic, social, or political objectives

Proposals on trade regulations often spark fierce debate among people who believe they will be affected—the so-called stakeholders. Of course, those most directly affected are most apt to speak out, such as workers, owners, suppliers, and local politicians whose livelihoods depend on the actions taken.

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Institutional Factors Affecting the Flow of Trade

Objective 7-1

Figure 7.1 Institutional Factors Affecting the Flow of Goods and Service

Learning Objective 1: Recognize the conflicting outcomes of trade protectionism.

This figure illustrates the variety of factors that can affect trade restrictions and trade enhancements.

5

Economic Rationales for Trade Restrictions

Objective 7-2

To fight unemployment

To protect infant industries

To develop an industrial base

Economic relationships with other countries

Learning Objective 2: Assess governments’ economic rationales and outcome uncertainties with international trade intervention.

Import restrictions to create domestic employment

may lead to retaliation by other countries,

affect large and small economies differently,

reduce import handling jobs,

may decrease jobs in another industry, or

may decrease export jobs because of lower incomes abroad.

The infant-industry argument says that production becomes more competitive over time because of

increased economies of scale, and

greater worker efficiency.

To develop an industrial base: Since the industrial revolution, countries increasing their industrial bases grew their employment and economies more rapidly. This observation led to protectionist arguments to spur local industrialization. These arguments have been based on the following assumptions:

Surplus workers can increase manufacturing output more easily than agricultural output.

Import restrictions lead to foreign investment inflows, which provide jobs in manufacturing.

Prices and sales of agricultural products and raw materials fluctuate widely, which is a detriment to economies that depend heavily on them, especially if the dependence is on just one or a few commodities.

Markets for industrial products grow faster than markets for both agricultural and raw material commodities.

Economic Relationships with other countries: Nations monitor their absolute economic situations and compare their performance to other countries. Among their many practices to improve their relative positions, four stand out: making balance-of-trade adjustments, gaining comparable access to foreign markets, using restrictions as a bargaining tool, and controlling prices.

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Why Government Intervenes in Trade

Objective 7-2

Table 7.1 Why Governments Intervene in Trade

Learning Objective 2: Assess governments’ economic rationales and outcome uncertainties with international trade intervention

This table illustrates the economic and noneconomic reasons governments intervene in trade.

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Noneconomic Rationale for Trade Restrictions

Objective 7-3

Maintain essential industries

Promoting acceptable practices abroad

Maintain or extend spheres of influence

Preserve national culture

Learning Objective 3: Assess governments’ noneconomic rationales and outcome uncertainties with international trade intervention.

Maintaining essential industries (especially defense): not dependent on foreign supplies during hostile political periods.

Promoting acceptable practices abroad: Governments limit exports, even to friendly countries, of strategic goods that might fall into the hands of potential enemies. They also limit exports and imports to compel a foreign country to change some objectionable policy or capability. The rationale is to weaken the foreign country’s economy by decreasing its foreign sales and by limiting its access to needed products, thus coercing it to amend its practices on some issue such as human rights, environmental protection, military activities, and production of harmful products.

Maintaining or extending spheres of influence: Governments use trade to support their spheres of influence—giving aid and credits to, and encouraging imports from, countries that join a political alliance or vote a preferred way within international bodies.

Preserving national culture: To help sustain a collective identity that sets their citizens apart from other nationalities, governments prohibit exports of art and historical items deemed to be part of their national heritage. In addition, they limit imports that may either conflict with or replace their dominant values.

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Instruments of Trade Control: Tariffs

Objective 7-4

Tariff (Duty)

Why are Tariffs levied?

Types of Tariffs

Learning Objective 4: Describe the major instruments of trade control.

Tariff barriers directly affect prices, and nontariff barriers may directly affect either price or quantity. A tariff (also called a duty) is a tax levied on a good shipped internationally. That is, governments charge a tariff on a good when it crosses an official boundary— whether it be that of a nation or a group of nations that have agreed to impose a common tariff on goods crossing the boundary of their bloc.

Tariffs may be levied:

on goods entering, leaving, or passing through a country,

for protection or revenue, or

on a per-unit basis, a value basis, or both.

A tariff assessed on a per-unit basis is a specific duty, on a percentage of the item’s value an ad valorem duty, and on both a compound duty

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Instruments of Trade Control: Non-tariff (1 of 3)

Objective 7-4

Subsidies–Definition

Agriculture Subsidies

Learning Objective 4: Describe the major instruments of trade control.

Subsidies offer direct assistance to companies to boost their competitiveness. Although this definition is straightforward, disagreement on what constitutes a subsidy causes trade frictions. In essence Governmental subsidies may help companies be competitive.

But there is little agreement on what a subsidy is.

Agricultural subsidies are difficult to dismantle. Especially to overcome market imperfections because they are at least controversial

The one area in which everyone agrees that subsidies exist is agriculture especially in developed countries. The official reason is that food supplies are too critical to be left to chance. Although subsidies lead to surplus production, they are argued to be preferable to the risk of food shortages.

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Instruments of Trade Control: Non-tariff (2 of 3)

Objective 7-4

Aids and Loans

Quotas

Embargo

Buy Local Legislation

Standards and Labels

Specific Permission Requirements

Administrative Delays

Learning Objective 4: Describe the major instruments of trade control.

Aid and Loans: When governments require foreign aid and loan recipients to spend the funds in the donor country, a situation known as tied aid or tied loans, some otherwise noncompetitive output can compete abroad. For instance, tied aid helps win large contracts for infrastructure, such as telecommunications, railways, and electric power projects.

A quota limits the quantity of a product that can be imported or exported in a given time frame, typically per year. Import quotas normally raise prices because they (1) limit supplies and (2) provide little incentive to use price competition to increase sales. A specific type of quota that prohibits all trade is an embargo. As with quotas, a country or group of countries may place embargoes on either imports or exports, on particular products regardless of origin or destination, on specific products with certain countries, or on all products with given countries.

Buy local legislation sets rules whereby governments give preference to domestic production in their purchases.

Standards and Labels: Countries can devise classification, labeling, and testing standards to allow the sale of domestic products while obstructing foreign-made ones.

Specific Permission Requirements: Countries may require that importers or exporters secure governmental permission (an import or export license) before transacting trade.

Administrative delays: Closely akin to specific permission requirements are administrative customs delays that may be caused by intention or inefficiency.

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Instruments of Trade Control: Non-tariff (3 of 3)

Objective 7-4

Service Industries

Four factors to consider

Essentiality

Not-for-Profit Services

Standards

Immigration

Learning Objective 4: Describe the major instruments of trade control.

Service is the fastest-growing sector in international trade. In deciding whether to restrict service trade, countries typically consider four factors: essentiality, not-for-profit preference, standards, and immigration.

Essentiality Governments sometimes prohibit private companies, foreign or domestic, from operating in some sectors because they feel the services are essential and provide social stability. In other cases, they set price controls or subsidize government-owned service organizations that create disincentives for foreign private participation. Some essential services

in which foreign firms might be excluded are media, communications, banking, utilities, and domestic transport.

Not-for-Profit Services Mail, education, and hospital health services are often not-for profit sectors in which few foreign firms compete. When a government privatizes these industries, it customarily prefers local ownership and control.

Standards Some services require face-to-face interaction between professionals and clients, and governments limit entry into many of them to ensure practice by qualified personnel. The licensing requirements include such professionals as accountants, actuaries, architects, electricians, engineers, gemologists, hairstylists, lawyers, medical personnel, real estate brokers, and teachers.

Immigration Satisfying the standards of a particular country is no guarantee that a foreigner can then work there. In addition, governmental regulations often require an organization— domestic or foreign—to search extensively for qualified personnel locally before it can even apply for work permits for personnel it would like to bring in from abroad.

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How Companies Deal with Governmental Influences

Objective 7-5

Threats from import competition

Options for companies

Learning Objective 5: Classify how companies deal with governmental trade influences.

When companies are threatened by import competition, they have several options, four of which stand out.

Move operations to another country.

Concentrate on market niches that attract less international competition.

Adopt internal innovations, such as greater efficiency or superior products.

Try to get governmental protection.

Activity Minute:

Of these, which do you think is the best option for companies? Does it depend on the industry?

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Copyright

International Business

Sixteenth Edition

Chapter 6

International Trade and Factor Mobility Theory

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Learning Objectives (1 of 2)

6-1 Understand why policymakers rely on international trade and factor mobility theories to help achieve economic objectives

6-2 Illustrate the historical and current rationale for interventionist and free trade theories

6-3 Describe theories that explain national trade patterns

Learning Objectives for the chapter.

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Learning Objectives (2 of 2)

6-4 Explain why a country’s export capabilities are dynamic

6-5 Summarize the reasons for and major effects of international factor movements

6-6 Assess the relationship between foreign trade and international factor mobility

Learning Objectives for the chapter.

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Factor Mobility and Trade Theory Questions

Objective 6-1

What is Factor Mobility?

Trade theory and focus on IB

Learning Objective 1: Understand why policymakers rely on international trade and factor mobility theories.

Factor mobility is the movement of capital, technology, and people.

Understanding trade theory helps managers to focus on these questions:

What products should we import and export?

How much should we trade?

With whom should we trade?

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Interventionist Theories

Objective 6-2

What is Mercantilism?

Governmental policies

Balance of Trade

What is neomercantilism?

Learning Objective 2: Illustrate the historical and current rationale for interventionist and free trade theories.

Mercantilism holds that a country’s wealth is measured by its holdings of “treasure,” which usually means its gold. This theory, which formed the foundation of economic thought from about 1500 to 1800,2 holds that countries should export more than they import (run a trade surplus) and, if successful, receive gold from countries that run deficits.

Government policies to enact mercantilism: To run a trade surplus, governments restricted imports and subsidized noncompetitive production.

Balance of Trade: Some mercantilist terminology has endured. For example, a favorable balance of trade (also called a trade surplus) still indicates that a country is exporting more than it imports. An unfavorable balance of trade (also known as a trade deficit) indicates the opposite. These terms are misnomers because the word favorable implies “benefit,” and the word unfavorable suggests “impairment.” In fact, running a trade surplus is not necessarily beneficial, nor is running a trade deficit necessarily detrimental.

Neomercantilism is the running of a favorable balance of trade to achieve some social or objective. For example, a country may reduce unemployment by encouraging its companies to produce in excess of the home demand and send the surplus abroad. Or it may attempt to maintain political influence in an area by sending more merchandise there than it receives, such as a government granting merchandise aid or loans to a foreign government.

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Free Trade Theories

Objective 6-2

Why Trade at all?

Absolute Advantage

Natural Advantage

Acquired Advantage

Comparative Advantage

Assumptions made with Comparative Advantage and Absolute Advantage

Learning Objective 2: Illustrate the historical and current rationale for interventionist and free trade theories.

Why do countries need to trade at all? To begin with, no nation has all the natural resources, geographic conditions, and technology necessary to produce everything we consume today.

In 1776, Adam Smith declared that a country’s well-being is its citizens’ access to goods and services rather than the mercantilists’ concept of its ownership of gold. His theory of absolute advantage holds that different countries produce different things more efficiently than others and that consumers should not have to buy domestically produced goods when they can buy them more cheaply from abroad.

A country’s natural advantage in production comes from climatic conditions, access to certain natural resources, or availability of certain labor forces. Most of today’s world trade is in manufactured goods that compete through an acquired advantage, usually in either product or process technology.

Comparative advantage says that global efficiency gains may still result from trade if a country specializes in what it can produce most efficiently—regardless of other countries’ absolute advantage.

Assumptions made about absolute and comparative advantage

Fully employed resources—assumes use of full resources

Economic efficiency--assumes the goal is maximum income

Division of Gains—may forgo trading if to prevent others from gaining an advantage

Transport costs—If it costs more to transport than the savings, the theories don’t work

Insufficient Demand—Even with insufficient demand, there is still an advantage

Statics and Dynamics—Looking at one point in time

Services—The theories deal with products rather than services

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Illustration of Absolute Advantage

Objective 6-2

Figure 6.2 Production Possibilities under Conditions of Absolute Advantage

Learning Objective 2: Illustrate the historical and current rationale for interventionist and free trade theories.

Comparison of wheat and tea production to illustrate absolute advantage.

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Illustration of Comparative Advantage

Objective 6-2

Figure 6.3 Production Possibilities under Conditions of Comparative Advantage

Learning Objective 2: Illustrate the historical and current rationale for interventionist and free trade theories.

Comparison of wheat and tea production to illustrate comparative advantage.

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Map of State and Relative Country Economies

Objective 6-2

Map 6.2 U.S. States’ Economies Compared to National Economies

Learning Objective 2: Illustrate the historical and current rationale for interventionist and free trade theories.

This map shows the comparison between US state economies and similar sized country economies.

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Theories to Explain Trade Patterns

Objective 6-3

How much does a country trade?

Theory of country size

Size of the economy

What types of products should a country trade?

Factor Proportions Theory

With whom do countries trade?

Country-Similarity theory

Learning Objective 3: Describe theories that explain national trade patterns.

How much does a country trade?

The theory of country size holds that countries with larger land masses usually depend less on trade than smaller ones. They are apt to have more varied climates and an assortment of natural resources that make them more self-sufficient.

Size of the economy: While land area helps explain the relative dependence on trade, countries’ economic size helps explain absolute differences in the amount of trade. The world’s largest five economies in 2014 were also the top five exporting countries.

What types of products should a country trade?

Factor proportions theory: According to the factor proportions theory, countries have their best trade advantage when depending on their relatively abundant production factors.

With whom do countries trade?

The country-similarity theory says that companies create new products in response to market conditions in their home market. They then turn to markets they see as most similar to what they are accustomed, especially those markets where consumers have comparable levels of per capita income.

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PLC Theory

Objective 6-4

What is the Product Lifecycle Theory (PLC)?

Introduction

Growth

Maturity

Decline

Learning Objective 4: Explain why a country’s export capabilities are dynamic.

The international product life cycle (PLC) theory of trade states that the production location of certain manufactured products shifts as they go through their life cycle. The cycle consists of four stages: introduction, growth, maturity, and decline

The introduction stage is marked by

• innovation in response to observed need,

• exporting by the innovative country, and

• evolving product characteristics.

Growth is characterized by

• increases in exports by the innovating country,

• more competition,

• increased capital intensity, and

• some foreign production.

Maturity is characterized by

• a decline in exports from the innovating country,

• more product standardization,

• more capital intensity,

• increased competitiveness of price, and

• production start-ups in emerging economies.

Decline is characterized by

• a concentration of production in developing countries,

• an innovating country becoming a net importer.

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Limitations of PLC Theory

Objective 6-4

Exceptions to PLC Theory

Learning Objective 4: Explain why a country’s export capabilities are dynamic.

Some types of products abound for which production locations usually do not shift. Such exceptions include the following:

Products with high transport costs (non-tradable goods) that may have to be produced close to the market, thus never becoming significant exports.

Products that, because of very rapid innovation, have extremely short life cycles, making it impossible to reduce costs by moving production from one country to another. Some fashion items fit this category.

Luxury products for which cost is of little concern to the consumer. In fact, production in a developing country may cause consumers to perceive the product as less luxurious.

Products for which a company can use a differentiation strategy, perhaps through advertising, to maintain consumer demand without competing on the basis of price.

Products that require specialized technical personnel to locate near production so as to continually move the products into their next generation of models. This seems to explain the long-term U.S. dominance of medical equipment production and German dominance in rotary printing presses.

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Diamond of National Competitive Advantage Theory

Objective 6-4

Figure 6.4 The Diamond of National Competitive Advantage

Source: Based on Michael E. Porter, “The Competitive Advantage of Nations,” Harvard Business Review, 68:2 (March–April 1990).

Learning Objective 4: Explain why a country’s export capabilities are dynamic.

According to the diamond of national competitive advantage theory, companies’ development and maintenance of internationally competitive products depends on favorable

demand conditions,

factor conditions,

related and supporting industries, and

firm strategy, structure, and rivalry.

Limitations of this theory:

Observations of foreign or foreign-plus-domestic demand conditions have spurred much of the recent Asian export growth. In fact, such Japanese companies as Uniden and Fujitech target their sales almost entirely to foreign markets.

Companies and countries do not depend entirely on domestic factor conditions. For example, capital and managers are now internationally mobile, and companies may depend on foreign locations for portions of their production.

If related and supporting industries are not available locally, materials and components are now more easily brought in from abroad because of transportation advancements and relaxed import restrictions. In fact, many MNEs now assemble products with parts supplied from a variety of countries.

Companies react not only to domestic rivals but also to foreign-based rivals at home and abroad. Thus the prior domestic absence of any of the four conditions from the diamond may not inhibit companies.

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The Theory and Effects of Factor Mobility

Objective 6-5

What is the Factor Mobility Theory?

Learning Objective 5: Summarize the reasons for and major effects of international factor movements.

The factor mobility theory, which focuses on why production factors move, the effects of that movement on transforming factor endowments, and the impact of international factor mobility (especially people) on world trade.

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Why Production Factors Move

Objective 6-5

Capital

People

Effects of factor movements

Brain drain

Learning Objective 5: Summarize the reasons for and major effects of international factor movements.

Capital, especially short-term capital, is the most internationally mobile production factor. Companies and private individuals primarily transfer capital because of differences in expected return (accounting for risk) that is caused by their outlooks of economic and political conditions.

People are less mobile than capital. Some, of course, travel to other countries as tourists, students, and retirees; however, this does not affect factor endowments because these travelers do not work in the destination countries. Unlike funds that can be cheaply transferred by wire, people usually must incur high transportation costs to work abroad.

A controversial issue is the effect of outward migration on countries. On the one hand, countries lose potentially productive resources when educated people leave—a situation known as a brain drain. On the other hand, many of these people are now sending remittances back. For example, remittances account for 29 percent of Nepal’s GDP. There is also evidence that the outward movement and remittances of people leads to an increase in start-up companies and capital in their home countries. countries receiving productive human resources also incur costs by providing social services and acculturating people to a new language and society.

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The Relationship Between Trade and Factor Mobility

Objective 6-6

Substitution

Complementarity

Learning Objective 6: Assess the relationship between foreign trade and international factor mobility.

Substitution: When the factor proportions vary widely among countries, pressures exist for the most abundant factors to move to countries with greater scarcity, where they can command a better return. If permitted, many in the labor pool where workers are unemployed or poorly paid, go to countries that have full employment and higher wages. They receive higher wages not only because of the greater scarcity, but also because more capital-rich countries have invested in machinery and infrastructure that make the imported laborers more productive than in their home countries.

Complementarity:

Factor mobility through foreign investment often stimulates trade because of

the need for components,

the parent company’s ability to sell complementary products, and

the need for equipment for subsidiaries.

Immigration enhances trade by creating ethnic enclaves of networks that link immigrants with their native countries. The enclaves serve as niche markets for imports from their native countries (e.g., early U.S. soy sauce imports sold mainly to Asian-Americans).

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Copyright

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