2009

INTERNATIONAL BUSINESS & TRADE

UNIT 4

Dr. Vikas Tripathi

Reader, GLAIBM, MATHURA
19/01/2009
 INTERNATIONAL BUSINESS & TRADE

Introduction
Organizations (either private or government) are involved in commercial transactions.
For private organizations these transactions are generally for the purpose of generating
profit while in case of government organizations societal benefit may be primary motive.
The transaction, which includes activities like investments, production, sales, can be intra
country as well as inter country. Intra country transaction is not a new phenomenon but
due to technological advancement boundaries of nations had shrunk in turn inter country
transactions also increased. It provided organizations a boundary-less market. The

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disappearance of borders had provided, decrease in costs of transportation, new

communication possibilities and increased logistic capacities open possibilities to enter
new markets, but also bring foreign competitors ever closer. Survival in this type of
changing and competitive environment was not easy for organizations so it was necessary
to understand and analyze the inter country transactions. This challenge gave birth to a
new discipline which was named as “International Business”.
International Business is the study of business and management across international
borders. It covers aspects like Globalization, International Trade and Trade Policy,
Foreign Direct Investment, Strategies of international firms, International Marketing,
International Financial Management, International Operations Management and
International human resource management.
Now a days there is a shift in world economy, We are moving from a scenario where
countries were self contained (isolated) to a situation where countries are dependent to
each other. Countries of world are involved in facilitating cross border trade &
investment. It has become essential for business managers, policy makers and researchers
involved in any way in the global environment to understand international business. In
the twenty-first century, goods, services and knowledge flow across country borders
much more easily than in the past. The implications of these flows, and the increased
mobility of human resources, for\ business are profound. On one hand, global
competition has become more intense, while, on the other, opportunities for cooperation
across borders have never been greater. Long-term survival of businesses, and indeed,
entire economies, depends on how well these forces are understood and leveraged.

“International Business involves commercial activities that cross national frontiers. It

concerns the international movements of goods, capital , services, employees and
technology, importing and exporting, cross border transactions in intellectual
property(patents, trademarks, know-how, copyright materials) via licensing and
franchising investments in physical and financial assets in foreign countries, contract
manufacturer or assembly of goods abroad for local sale or for export to other nations,
buying and selling in foreign countries, the establishment of foreign warehousing and
distribution systems, and the import to one foreign country of goods from a second
foreign country for subsequent local sale”. (Source Bennett 1996)

History and Overview of International Business

When we go for the history of International Business we find that it is not a new
phenomenon, but rather a continued expansion of an old idea. International business is
having relationship with Mesopotamian, Greek and Phoenician merchants of 4000 years
ago. Phoenicians were famous in antiquity for the skill with which they loaded and
navigated their vessels throughout the world. Phoenicians learned to sale by the help of
stars at night that is why the North Star was known as the Phoenician’s star. The sea-
borne trade of the Mediterranean was controlled by the Phoenicians, and the goods that
they secured from Egypt or Babylon or produced in their own shops they carried into the

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Aegean, throughout the Mediterranean, and through the straits of Gibraltar to Cape Verde
and the Azores islands in the Atlantic.
From the above discussion we can say that international business is not new activity.
With the advancement of technology world became very small and firms started crossing
boundaries of nations for the purpose of business. The existing structure of international
business started after the industrial revolution. The Industrial revolution consisted mainly
of the application of machinery to manufacturing, mining, transportation,
communication, and agriculture, and of the changes in economic organization that
attended these innovations of methods. A series of invention facilitated the development
of the industrial revolution. Fundamental in the new industrial order was the development
of a cheap, portable source of power. James watt invention of the condenser and of a
practical method of converting the reciprocating motion of the piston into rotary motion
made the steam engine a practical prime mover for all kinds of machinery. The steam
engine soon displaced water wheels and windmills, and it made necessary the production
of great quantities of coal and iron. The textile industry developed as a result of a series
of inventions whose net effect was to multiply many times the amount of cloth that could
be made by a given group of workers. The application of machines to farming
revolutionized agriculture. Early inventions in many fields were subsequently dwarfed by
later inventions, which caused some historians to refer to a second Industrial Revolution,
beginning about 1870 and including the development of electrical technology and of
industries dependent on internal combustion engines.
The traditional method of small-scale production in the home with one’s own tools could
not compete with machine production, and the cost of machinery was prohibitive
workers. Hence the factory system arose, resulting in large-scale production in factories
using machines owned by the employer. The factory system stimulated the growth of a
division of labor and of mass production through standardization of process and parts.
Old industries began to produce on a much larger scale than previously, and new
industries developed, offering new goods to satisfy mass wants. Industrial capitalists
were created, and it was they who shaped the course of future industrialization by
reinvesting their grains in new enterprises. The Industrial Revolution also enormously
accelerated the movement toward international economic interdependence that had begun
in the sixteenth and seventeenth centuries. As the population of Europe became more and
more engaged in urban industry, they raised less food on their farms and became heavy
importers of wheat, meat and other food products. In exchange for food, Europe exported
manufactured goods. The entire world became a marketplace.
The Industrial Revolution and International Business
The industrial revolution had an enormous impact on international business. As soon as it
progressed in a country beyond the earliest stages, foreign supplies of raw materials were
typically sought to supplement the domestic supply. The development of foreign sources
of supplies needed capital and trained personnel supplied by the home country, which
exported capital, and the country that imported it. The demand for ships rose as foreign
trade grew with foreign investment. In addition, the need to defend territorial possessions
and trade routes caused an increase in output of the arms. The effect was stimulating to a
number of industries. As a surplus of commodities developed in home country, foreign
colonies became important markets. If colonial people were too benighted to appreciate
that the home country’s goods were necessary as well as useful, they had to be taught

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differently; the export of culture and mores accompanied the export of cotton shirts and
trousers.
At a later stage in the evolution of foreign markets, the export of capital became a
primary consideration. As the most favorable avenues for capital investment at home
were utilized, additional investments could be made only under conditions of diminishing
returns. High returns could be realized in foreign colonies and in less developed areas,
and there the capital went. The most important spheres for investment were in the
extractive industries, transportation, communication and electric power. The development
of such enterprises facilitated the extraction and shipment of raw material and the
distribution of manufacture in the home country. Sometimes, the capital importing
country developed an industrial economy of its own. It received the culture and science
of industrial country; these blended and often clashed with their own. In some cases,
notably Japan, the backward country became an important industrial rival to the
originally more advanced industrial countries. Thus the Industrial Revolution was
exported along with capital.
Business Organizations
The most important forms of business organization until the mid-19 th century were the
partnership and the joint stock companies, the latter being in reality an enlarged
partnership. Both were eventually supplanted by the corporation as the dominant form of
business enterprise. The development of large-scale enterprises necessitated large scale
capital outlays and facilities and techniques for adequate financing. The corporate form
of business offered the advantages of broadly distributed ownership, limited liability, and
the ability to attract many investors through the sale of low- cost common stock. The ease
of raising capital was a particular advantage a corporation had over other forms of
business units. Moreover, with the use of the corporation came the expansion of
investment banks to serve as an intermediary for corporations and investors. Individually
or, if the security issue was large, in a group organized as a syndicate, investment banks
were prepared to underwrite an issue so that a corporation could be certain of having
funds when they were needed. Aided by branches of correspondents all over the world,
they created a broad market in which to raise capital.
Concentration
The development of the corporation contributed to a trend toward industrial concentration
that began in the latter part of the last century, when many industries, in both the United
States and Western Europe, came to be dominated by large firms. As some industries
became more complex, a certain amount of concentration became inevitable. A case in
point is the steel industry, which, to develop, required a large a capital investment,
particularly in plants and equipment. There are many good reasons for conducting thr
manufacture of iron and steel on a large scale basis. One of the most important is the
tremendous outlay necessary to secure blast furnaces and other equipments. Through its
ability to raise capital from the sale of stocks and bonds, the corporations could afford
large-scale operations. This ability was enhanced by the use of the merger, in which one
corporation would increase its market power through the acquisition of the stock or assets
of another corporation. Thus, such firms as US Steel and General Motors are amalgams
of many mergers that have been consummated over an extended period of time
Later phase of the Industrial Revolution

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A second or later phase of the industrial revolution began in the USA and the industrial
countries of Europe around 1880. This second phase is notable for three major changes:
The employment of new sources of energy, such as gas, electricity, and oil; ever-
increasing use made of science, especially for the creation of materials that do not appear
in nature; and new methods of production involving the use of machines to make ever
more complex tools and the manufacturer of interchangeable parts that are joined
together in an assembly line to make the final product. These changes impacted business
in several ways. The expanse of the new machine ensured that only those who had access
to large concentration of capital could enter the field of big business. Though small and
medium-sized business firms were able to survive in certain areas, in many other large
firms came to dominate the market. The huge market that is necessary for the economic
use of new techniques had to be created both at home and abroad.
To utilize the methods of mass production it became essential to have mass consumption.
The possession large home market gave a great competitive advantage to those countries
that were well populated and industrialized, as long as the bulk of the country’s
production could be consumed in this market. However, some countries, notably Britain,
lacked a large home market and thus had to concentrate much of their manufacturing
capacity on producing goods for export. Enormous pressure developed on manufacturers
in most industrial countries to find new market of manufactured goods because capital
investments became so expensive that producers could not afford to allow their machines
to remain idle. But producers could not afford not to install expensive machines, since
they then would not be able to meet the prices of the competitors who had installed them.
The purpose of machine and mass production is to lower unit costs of output and thus
achieved economies of scale. Expansion into foreign markets was a way in which to
increase the production and lower unit cost of output.

Multinational Corporations
Expansion in foreign market gave rise to Multinational Corporations. A multinational
corporation is an organization doing business in more than one country. A multinational
corporation engages in various activities like exporting, importing, manufacturing, in
different countries.
According to International Labor Organization, “The essential nature of the multinational
enterprise lies in the fact that its managerial headquarters are located in one country
(referred for convenience as the home country) while the enterprise carries out operations
in a number of other countries as well (host country). Obviously, what is meant is a
corporation that controls production facilities in more than one country, such facilities
having been acquired through the process of foreign direct investment. Firms that
participate in International Business, however large they may be, solely by exporting or
by hunting technology are not Multinational Enterprise”
Jacques Maisonrouge, president of International Business Machines World Trade
Corporation, defines a Multinational as a company that meets five criteria
1. It operates in many countries at different levels of economic development
2. Its local subsidiaries are managed by nationals.
3. It maintains complete industrial organizations, including R&D, and
manufacturing facilities, in several countries
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4. It has multinational central management.

5. It has multinational stock ownership.
According to James C. Bakes multinational is a company
1. Which has a direct investment base in several countries
2. Which generally derives 20 to 50 percent or more of its profit from foreign
operations.
3. Whose management makes policy decisions based on the alternatives available
any where in the world.
Thus we can say that those organizations which are involved in marketing and
manufacturing of products in more than two countries is known as Multinational
Corporation. Multinational Corporations are huge business organizations. They extend
their domestic business activities to foreign countries through a network of branches or
subsidiaries. Multinational produces products according to the need of the customers of
host country.
Merits and Demerits of Multinational Corporations
Merits and demerits of multinational corporations can be differentiated on the basis of
concept of home country and host country. Generally benefits of MNCs for host countries
are losses for home country and vice-versa.
For Home Country
Following are the main advantages of MNCs for home country
1. Multinational creates opportunities for marketing the products produced in the
home country throughout the world
2. Multinational creates employment opportunities to the home country people both
at home and abroad.
3. Multinational contributes for favorable balance of payments of the home country
in long run.
Following are the main disadvantages of MNCs for home country
1. Multinational transfers the capital from the home country to various host
countries.
2. Multinational may not create employment opportunities to the people of home
country.
3. Multinationals may neglect industrial and economic development of the home
country.
For Host Country
Following are the main advantages of multinationals for the host country
1. Multinationals helps in increasing the investment level and thereby the income
and employment in the host country.
2. Multinationals act as a vehicle for transferring technology from developed
countries to developing countries
3. Multinationals kindle managerial revolution in the host country with the help of
professional managers and highly sophisticated management techniques.
4. Multinationals enable the host countries to increase their exports and decrease
their import requirement.
5. Multinational works to equalize the cost of factors of production around the
world.
6. Multinationals provide an efficient means of integrating national economies.
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7. Enormous resources of multinationals enable them to have very efficient research

and development systems. Thus, they make a commendable contribution to
inventions and innovations.
8. Multinationals also stimulates domestic enterprise because to support their own
operations, the multinational may encourage and assist domestic suppliers.
9. Multinationals help in increasing competition and break domestic monopolies.
Following are the main disadvantages of multinationals for the host country
1. Multinationals may kill domestic industries.
2. Multinationals may follow the ethnocentric approach in staffing and there by
cause unemployment in the host country.
3. Multinational may use the natural resources of the host country indiscriminately
and cause fast depletion of the resources.
4. Multinational may destroy competition an acquire monopoly powers.
5. Multinationals can evade or underline national economic autonomy control
through their power and flexibility.
6. Multinationals tremendous power poses the risk that they may threaten the
sovereignty of the nations in which they do the business.

Nature and Scope of International Business

The basic tasks and functions of international business are almost the same as domestic
business. But there is a greater difficulty in performing the functions effectively and
integrating them to serve organizational objectives. The international business includes
 Import and export of commodities and manufacturer of goods
 Investment of capital in manufacturing, extractive and agricultural sectors,
transportation, and communication.
 Supervision of employees in different countries
 Investment in international services like banking, advertising, tourism, retailing,
and construction.
 Transactions involving copyrights, patents, trademarks, and process technology.
International business has emerged as a separate branch of study, because of growing
scale and complexity of business transaction across national boundaries give rise to new
and unique problems of management and governmental policies.
A three-pronged approach may be adopted for understanding the scope of International
Business. The first prong deals with the transmission of resource of resources from one
country to another in the form of shipment of goods, transfer of funds, and movement of
people. The second prong is concerned with relationship of the multinational enterprise
with the host countries. Third prong involves elements of conflicts arising from the
national sentiments and nationalistic attitude guiding both the parent and the host
countries. Here the MNE has to grapple with the profitability aspects. It also has to
grapple with the question of how best to accommodate the interest of the parent and host
nations.

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Resource transmission is based on the mutual benefits expected from the trade flows
between the trading nations and the investment activities undertaken by the MNEs
abroad. The resource allocation, according to the comparative cost doctrine propounded
by Ricardo, benefits the countries engaging in trade. Trade across borders and
investments in other countries( resource transmission) provide opportunities to the MNEs
to take advantage of their superior technology, innovativeness and economies of scale.
The diverse economic systems prevailing in different countries confront an MNE with the
choices between conformity and innovation. It may pursue the strategy of introducing the
changes in gradual manner, acceptable to the host government, keeping in view the
employment and welfare of the people. Despite the efforts of MNEs to follow a balanced
approach, areas of conflicts do arise because of different national interest the MNEs are
often seen as penetrating into the host country markets for exploiting there economies.
The objectives of foreign investors and socio-economic objectives of the host
governments may come in conflicts. The conflicts relating to equity participation, use of
local inputs, employment, expansion of export etc., may be resolved through negotiations
with the governments of host nations. International business has many dimensions. It is
not merely the border crossing which is sufficient to comprehend numerous problems
faced by the MNEs in the overseas markets. Different countries follow different business
laws, tax systems, and have different political, economic and cultural environments. The
strategies of the MNEs aiming at efficient management and optimum returns are shaped
by the external factors. An MNE, having company specific advantages on which it may
have some control, has to confront and manage the foreign environments which may not
be in its control. The formulation of policies to achieve efficiency in the functional areas,
such as production, finance, marketing and human resource management, has to take into
account all these realities.
Two types of issues are involved in international business management. The first type
involves the study of trade and FDI theories, and the second type is concerned with the
financial matters which are, in turn, affected by the financial factors such as fluctuation in
foreign exchange rates, change in political and economical conditions and inflation. All
these factors have to be taken into account while evaluating the fruitfulness of the foreign
investments.

Comparison of Domestic Business and International Business

Managing International business is more complex than managing domestic business.

Because of variation in political, social, cultural and economical environments across
countries, business firms find it difficult to extend their domestic business strategy to
foreign markets. To be successful in overseas markets, they need to adapt their product
pricing, promotion and distribution strategies and overall business plans to suit the
specific requirements of the target foreign markets. International business can be
distinguished from domestic business on the basis of following factors-
1. Nationality of key participants
Nationality of buyers and sellers differs between domestic and international
businesses. In the case of domestic business, both the buyers and sellers are from

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the same country. This makes easier for both parties to understand each other and
enter into business deals. But this is not the case with international business where
buyers and sellers come from different countries. Because of differences in their
languages, attitudes, values social customs and business goals and practices, it
becomes relatively more difficult for them to interact with one another and
finalise business transactions.
2. Nationality of stakeholders
Domestic and international business also differ in respect of the nationalities of
other stakeholders such as employees, suppliers, shareholders/partners and
general public who interact with the business firms. In the case of domestic
business, all such actors belongs to one country, and therefore relatively speaking
depict more consistency and value system in their value systems and behavior.
But operations in international business are much more complex as the concerned
business firms have to take into account a wider set of values and aspirations of
stake holders belonging to different nations.
3. Mobility of factors of production
The degree of mobility of factors like labour and capital is less generally between
countries than within a country. While these factors can move freely within a
country there exist various restrictions to their movement across nations. Apart
from legal systems, even the variations socio-culture requirements, geographic
influences and economic conditions in a big way in their movement across
countries
4. Heterogeneity of customers across market
Since buyers in international markets hail from different countries, they differ in
their socio-culture background. Differences in their tastes, languages, beliefs and
customs, attitudes and product preferences cause variations in not only their
demand for different products and services but also in variations in their
communication patterns and purchase behaviors. It is precisely because of the
socio-culture differences that while people in China prefer bicycles, the Japaneese
in contrast like to ride bikes. Similarly people in India use right-hand driven cars
while Americans use left hand driven cars. Moreover, people in USA change their
TV, bike and other consumer durables very frequently- within 2 to 3 years of their
purchase, Indians mostly do not go in for such replacements until the products
currently with them have totally worn out. Such variations greatly complicate the
task of designing products and evolving strategies as appropriate for customers in
different countries.
5. Differences in business practices
The differences in business practices are considerably much more among
countries than within a country. Countries differ from one another in terms of
their socio-economic development; economic infrastructure and market support
services; and business customs and practices due to their socio-economic milieu
and historical coincidence. All such differences make it necessary for firms
interested in entering international markets to adapt their production, finance,
human resource and marketing plans as per the conditions prevailing in the
international markets.

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6. Political risks
Political factors such as the type of government, political party system, political
ideology, political risks etc. have a profound impact on business operations since
a business person is familiar with the political environment of his/her country,
he/she can well understand it and predict its impact on business operations. But
this is not the case with international business. political environment differs from
country to country. One needs to make special efforts to understand the differing
political environments and their business implications. Since political
environments keeps on changing, there is a need to monitor changes on an
ongoing basis in the concerned countries and devise strategies to deal with the
diverse political risks.
7. Business regulations
Coupled with its socio-economic environment and political philosophy, each
country has its own set of business laws and regulations. Though these law and
regulations are more or less uniformly applicable within a country, these differ
widely among nations. Tariff and taxation policies, import quota system,
subsidies and other controls adopted by a nation may be not the same as in other
countries and often discriminate against foreign products, services and capital.
8. Currency system
Another important difference between domestic and international business is that
latter involves the use of different currencies. Since the exchange rate, i.e., the
price of one currency expressed in relation to that of other countries currency,
keeps on fluctuating; an international business firm may find difficulty in fixing
prices of its product and hedging against foreign exchange risks.

From the above discussion we can say that domestic business and international business
are having various similarities as well as various differences. In other words we can say
that international business can be considered as an extension of domestic business

S.No. Domestic Business International business

1 Business activities within the Business activities involving operations
geographical boundaries of a across the country’s geographical
country. boundaries.
2 A domestic firm deals only with An international company also has to
the economic, political, social and manage a wide range of international
cultural environment within the environment.
country.
3 Risk involved in domestic International business is prone to greater
business is comparatively less. degree risks.
4 Business is not much affected by International transactions are subject to
exchange rate risks. exchange rate risks.
5 Management functions regarding Management is based on international
finance and accounting, standards of accounting, marketing etc. in
marketing and production are on personal management, it takes into account

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the basis of domestic standards. the use of expatriate.

6 A domestic company may Technological advancement is required to
continue with the old technology compete in the international arena.
if it does not face any threat from
the competitors.
7 Domestic business is subject to International business transactions are
rules, laws and policies, taxation subject to rules, laws and policies and tariffs
system, etc., of a single country. and quotas, etc. of multiple countries.

Modes of Entry in International Business

In last few years, increasing competitive pressure had forced business to consider
entering in international business. A company’s decision to venture into the international
arena is only the first step in a series of decisions. Identification of international market is
one decision; the type of entry is another; the product and its particular form is a third;
the use of intermediaries may be a forth; and the decisions continue as the firm
progresses. Furthermore, continuation of the international business a initially selected or
the use of a different approach for a different market requires another set of decisions.
Some companies have even evolved to fill some global needs of other companies
conducting international business. To be sure, many companies produce and sell a
tangible product to others around the world. But other companies themselves have
changed or have even been created to adapt today’s global environment. The increased
interest in ib. and changing legislation has brought about the creation of firms such as
export trading companies. The rapid growth of service industries has spawned the
international sale to relatively intangible products creating a demand for more expertise
in marketing these services around the world.
Ib. around the world is changing in other ways, too. The advancement of many third-
world nations and a growing concern for their own best welfare has encouraged
legislation prohibiting the existence wholly owned subsidiaries on foreign soil or
requiring joint ventures instead of total direct investment. As a result, companies
currently involved internationally have to revise some of their global approaches.
A company considering entry into the international arena, a more specific set of strategic
alternatives, often varying by targeted country, focuses on different ways to enter a
foreign market. Managers need to consider how potential new markets may best be
served by their companies in light of the risks and critical environmental factors
associated with their entry strategies. The following are the strategies available to firms
for entering into international business.
Exporting
Exporting is relatively low-risk way to begin international expansion or to test out an
overseas market. Little investment is involved, and fast withdrawal is relatively easy.
Small firms seldom go beyond this stage, and large firm use this avenue for many of their
products. Because of their comparative lack of capital resources and marketing clout,
exporting is the primary entry strategy used by small businesses to compete on
international level.
Licensing and Franchising
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An international licensing agreement grants the rights to a firm in the host country to
either produce or sell a product, or both. This agreement involves the transfer of rights to
patents, trademarks or technology for a specified period of time in return for a fee paid by
the licensee. Licensing is relatively low-risk strategy because it requires little investment,
and it can be very useful option in countries where market entry by other means is
constrained by regulations or profit-repatriation restriction.
Similar to licensing, franchising involves relatively little risk. The franchiser licenses its
trademark, products and services, and operating principles to the franchisee for an initial
fee and ongoing royalties.
Turnkey operations
In a so called turnkey operation, a company designs and construct a facility abroad, trains
local personnel, and than turns the key over to local management- for a fee. There may
also be a critical risk exposure if the turnkey contract is with the host government, which
is often the case. This situation exposes the company to risks such as contract revocation
and the rescission of bank guarantees.
Wholly Owned Subsidiaries
In countries where a fully owned subsidiary is permitted, a company can start its own
product or service business from scratch or it may acquire a firm existing in the host
country. This strategy exposes the company to maximum range of risk, to the extent of its
investment in the host country
Joint Ventures
A joint venture involves an agreement by two or more companies to produce a product or
service together. In an JV ownership is shared, typically by Multinational and local
partner, through agreed upon proportions of equity.

Reasons for Growth of International Business

With the recent development of technological innovation and the emergence of the newly
industrialized countries (NIC), we are witnessing a convergence among nations in terms
of tastes and preferences, financial systems, and organization design. The convergence
along with complementary developments is forcing organizations to “borderless” terms.
Their thinking revolves around the following issues
Where the value-adding activities should be performed?
Where are the most cost-effective markets for new capital and labor?
Can products be designed in one market and then be sold in other countries without
adding further costs?
Answer to above questions will give us the reasons for the development of International
Business. The motivation for going international comes from a combination of reasons.
Experts including Beamish and Hodgets and Luthans, predicts that the international trend
will continue for the foreseeable future with three primary caveats
The product development cycle will have to be shorter- firms should be able to grow
continuously by minimizing the development cycle time.
Since customers will have wider choice, they will demand quality goods at an affordable
price and with reliable after-sales service.

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Segments of a particular product will be made and sold in various countries which would
change the way organization functions.
Following may be understood reasons for the growth of international business
1. Increase in Market Share- Normally business firms crosses boundaries of nations
for the enhancement of their market share in global trade.
2. Transportation- To reduce the cost of transportation firms engages in international
business.
3. Competition- Organizations face severe competition from the companies of home
countries.
4. Limitation in Home Market- Due to limited home market companies tries to go
abroad for doing business.
5. Technology- Availability of advance technology in some countries act as a
pulling factor for business organizations for home country.
6. Profit- Basic objective of any business organization is to maximize profit. For
fulfilling these objective firms goes in international market.
7. Increase in Production Capacity- Technological Advancement is supporting
companies to produce more than their previous capacities. So it is necessary for
them to sell their products in other countries also.
8. Political Conditions- Favorable political conditions of other countries pull
business firms to operate there.
9. Availability of Raw Material- The source of highly qualitative raw materials and
bulk raw materials is a major factor for attracting the companies from various
foreign countries.
10. Availability of Human Resources- If the host country is having high quality and
low cost human resource than the business organizations comes to invest there.
11. Liberalization- Most of the countries in the world liberalized their economy and
opened their countries to the rest of globe. These changed policies attracted the
multinationals to extend their operations to these countries.

Stages of Internationalization
When an organization starts to think for entering in International Business, It has to go
through a process of internationalization. This process includes following stages
International Company
Those companies, who decides to go in international market, with the strategy same as
adopted in domestic market. These companies think to grow beyond the boundaries of
nation but with the same product, with the same marketing strategies. In other words we
can say that these companies select any country for business and extend their domestic
practices in that country.
The companies which are in this stage normally have Ethnocentric Approach. According
to this approach the companies believes that, practices and strategies adopted for
domestic business, product and people involved in domestic business are better to those
of other countries. International Company holds marketing mix constant and extend
operations to other countries.
Multinational Company

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International Companies, sooner or later, understands that the ethnocentric approach for
international business is not a long term solution to survive in this competitive age. Then
these companies shift to second stage i.e. Multinational Company which is also known as
Multidomestic Company. Multinational Companies formulates different strategies for
different markets.
In this stage approach shifts from Ethnocentric to Polycentric. In this stage, offices,
branches, subsidiaries, of a multinational work as a domestic company in each country. In
each country multinational operate with a distinct strategy and policy. Thus they operate
like domestic company.
Global Company
It is the third stage of internationalization. The companies which follow global strategy
are known as Global Company. Global Company produces in a single country and
focuses on marketing these products globally.
Transnational Company
The Transnational Companies produces, markets, invests and operates across the world.
It is an integrated global enterprise which links global resources with global markets at
profits. There is no pure transnational company in present scenario.

Approaches to International Business

Following are the approaches to go for International Business
1.8.1 Ethnocentric Approach
When companies formulate their policies and strategies according to local market
(home country) it is known as Ethnocentric Approach. When the companies design and
manufacture the products according to local customers need but, due to excessive
production or due to change in customer preferences or due to competition, they are
pushed to export the remaining product to foreign country by considering it as an
extension of domestic market, it is said that they are following Ethnocentric Approach.
The executives at the head-office of the company make the decisions relating to exports,
and the marketing personnel of the domestic company monitor the export operations with
the help of export department. The company exports the same product designed for
domestic markets to foreign markets under this approach. This approach is suitable for
Those organizations which are planning to go for international business.
1.8.2 Polycentric Approach
In Polycentric Approach the company establishes a foreign subsidiary and decentralizes
all the operations, delegate decision making and policy making authority to its
executives. The executives of the subsidiaries formulate the policies and strategies,
design the products according to the host countries environmental factors which includes
legal structure, economic environment, government policies, consumers taste &
preferences etc.
1.8.3 Regiocentric Approach
The company after operating successfully in a foreign country thinks of exporting to the
neighboring countries of the host country. At this stage, the foreign subsidiaries consider
the regional environment for formulating policies and strategies (for example Indian Sub-
continent). In this approach companies markets more or less the same product designed

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under polycentric approach in other countries of the region but with different marketing
strategies.
1.8.4 Geocentric Approach
When the company considers the whole world as a single country, we say that the
company is following Geocentric Approach. They select employees from the entire globe
and operate with a number of subsidiaries. The head-quarter coordinates all the activities
of subsidiaries. Each subsidiaries functions like an independent and autonomous
company in formulating policies and strategies.

Globalization
A fundamental shift is occurring in the world economy we are moving away from a
world a which national economy were relatively self-contained entity, isolated from each
other by barriers to cross-border trade and investment; by distance, time zones, and
languages; and by national differences in government regulation, culture, and business
systems. And we are moving toward a world in which barriers to cross boarder trade and
investment tumbling; perceived distance is shrinking due to advances in transportation
and telecommunication technology; material culture is starting to look similar the world
over; and national economy are merging into an independent global economic system.
The process by which this is occurring is commonly referred to as globalization.
For businesses, this is in many ways the best of times; globalization has increased the
opportunities for a firm to expand its revenue by selling around the world and reducing
its cost by reducing in nations where key inputs are cheap. This process was supported by
international institutions such as world trade organization and gatherings of leaders from
the world’s most powerful economies. Regulatory and administrative barriers to doing
business in foreign nations have come down, while nations had transformed their
economies, privatizing state-owned enterprises, deregulating markets, increasing
competition, and well coming investment by foreign businesses. This has allowed
businesses both large and small, from both advanced nations and developed nations, to
expand internationally
In some industries, such as commercial jet aircraft, automobiles, petroleum, house hold
products, semiconductor chips and computers, companies having expanding globally for
decades. Retailing has been primarily local in orientation, but in a testament to the scope
and pace of globalization, this too is now changing. Falling barriers to cross border
investment have made this possible. Rapid economic growths in developing nations and
market saturation at home have made globalization a strategic imperative for established
retailers seeking to grow their business.
At the same time, going global is not without problems because of different taste and
preferences of customers of different countries. Economic policies of different countries
also create problems in font of businesses. Globalization can be broken down into
separate aspects:
 Industrial Globalization i.e. transnationalization - rise and expansion of
multinational enterprises.
 Financial Globalization - emergence of worldwide financial markets and better
access to external financing for corporate, national and sub national borrowers.

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 Political Globalization - spread of political sphere of interests to the regions and

countries outside the neighborhood of political (state and non-state) actors.
 Informational Globalization - increase in information flows between
geographically remote locations.
 Cultural Globalization - growth of cross-cultural contacts.

According to Dr. Ismail Shariff, globalization is the worldwide process of

homogenizing prices, products, wages, rates of interest and profits. Globalization relies
on three forces for development: the role of human migration, international trade, and
rapid movements of capital and integration of financial markets.

History of Globalization
Although the term "globalization' was coined in the latter half of the twentieth century,
and the term and its concepts did not permeate popular consciousness until the latter half
of the 1980's; various social scientists have tried to demonstrate continuity between
contemporary trends of globalization and earlier periods. Earlier forms of globalization
existed during the Mongol Empire, when there was greater integration along the Silk
Road. The first steps towards Globalization as we know it nowadays were taken in
Europe in the 16th and 17th centuries, when the Spanish Empire reached to all corners of
the world. The effects on European industries were notable, e.g. the Silver Mining in
Schwarz in Austria was partly abandoned, as silver was available from the Spanish
colonies for lower prices. Globalization became business phenomena in the 17th century
when the first Multinational was founded in The Netherlands. During the Dutch Golden
Age the Dutch East India Company was established as a private owned company.
Because of the high risks involved with the international trade, ownership was divided
with Shares. The Dutch East India Company was the first company in the world to issue
shares, an important driver for globalization.

Liberalization in the 19th century is often called "The First Era of Globalization", a
period characterized by rapid growth in international trade and investment, between the
European imperial powers, their colonies, and, later, the United States. The "First Era of
Globalization" began to break down at the beginning with the first World War, and later
collapsed during the gold standard crisis in the late 1920s and early 1930s. Countries that
engaged in that era of globalization, including the European core, some of the European
periphery and various European American and Oceanic offshoots, prospered. Inequality
between those states fell, as goods, capital and labor flowed freely between nations.

Globalization in the era since World War II has been driven by advances in technology
which have reduced the costs of trade, and trade negotiation rounds, originally under the
auspices of GATT, which led to a series of agreements to remove restrictions on free
trade. The Uruguay round (1984 to 1995) led to a treaty to create the World Trade
Organization (WTO), to mediate trade disputes. Other bi- and trilateral trade agreements,
including sections of Europe's Maastricht Treaty and the North American Free Trade
Agreement (NAFTA) have also been signed in pursuit of the goal of reducing tariffs and
barriers to trade.

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The world increasingly is confronted by problems that can not be solved by individual
nation-states acting alone. Examples include cross-boundary air and water pollution,
over-fishing of the oceans and other degradations of the natural environment, regulation
of outer-space, global warming, international terrorist networks, global trade and finance,
and so on. Solutions to these problems necessitate new forms of cooperation and the
creation of new global institutions. Since the end of WWII, following the advent of the
UN and the Bretton Woods institutions, there has been an explosion in the reach and
power of Transnational corporations and the rapid growth of global civil society.[4]

The Global scenario group, an environmental research and forecasting organization,

views globalization as part of the shift to a Planetary Phase of Civilization, characterized
by global social organizations, economies, and communications. The GSG maintains that
the future character of this global society is uncertain and contested.

Components of globalization
From the above discussion it is clear that globalization refers to the shift toward a more
integrated and interdependent world economy. Globalization has several components
which are as follows-
1. Globalization of market
Globalization of markets refers to the process of integrating and merging of the
distinct world markets into a single markets. This process involves the identification
of some common norm, value, taste, preference and convenience and slowly enable
the culture shift towards the use of a common product or service.
Features of Globalization of Markets
It includes:
 The size of company need not be too large to create a global market. Even
small companies can also create a global market.
 The distinctions of national markets are still prevailing even after the
globalization of markets. These distinctions require the companies to
formulate different strategies for each market.
 Most of the foreign markets are the markets for non-consumer goods like
industrial products, machinery, equipments, raw materials, computers,
software, financial products etc.
 The global business firms compete with each other frequently in different
national markets including their home markets.
Reasons for Globalization of Markets
It includes:
 Large scale industrialization enabled mass production. Consequently,
companies found that the size of domestic market is very small to suffice the
production output and thus opted for foreign markets.
 Companies in order to reduce the risk diversify the portfolio of countries.
 Companies globalize markets in order to increase their profit and achieve
company goals.
 The adverse business environment in the home country pushed the companies
to globalize their market.
 To cater to the demand for their products in the foreign markets.

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 The failure of domestic companies in catering the needs of their customers

pulled the foreign countries to market their products.
2. Globalization of Production
Factor influencing the location of manufacturing facilities vary from country to
country. They may be more favorable in foreign countries rather than in the home
country.
Reasons for Globalization of Production
Companies globalize their production because of following reasons
 Restriction imposed by the countries in importing of goods forces
organizations to start production in those countries.
 If factors of production are available easily in any country organizations
prefer to start production in those countries. Factors of production include
skilled labor, raw material, technology etc.
 Favorable legal structure for starting production in the country.
 To capture a regional market
 To reduce cost of transportation and delivery time..

Thus, we can say that, globalization of production is adopted by organizations to

gain competitive advantage over other producers. This competitive advantage
may be in cost, quality, availability of raw material, supply chain management
etc.

Components of International Business Environment

With the end of industrial revolution and rise of multinational corporations it was clear
that 20th century is going to see a fundamental shift in world business environment. This
shift showed that we are going to face a world where economies of countries are
changing themselves from a position of isolated and self-contained entities to
intermingled and interdependent situation. The pace of this shifting is very fast due to the
technological advancement in transportation and communication technologies. In early of
20th century countries were isolated from each other by distance, time, language; by
cross-border trade and investment; and by national differences in government regulations,
culture and business systems. And now we are moving to a situation where technological
advancement had removed all the barriers related to distance, time, language; and
formation of international organizations had given support in increase of cross-border
trade and investment by facilitating international business.
A manager in an organization which is going for international business is being
challenged to operate in an increasingly complex, interdependent and intermingled
dynamic global environment. Organizations involved in International Business are
restructuring their strategies and management styles according to the requirement of
those regions where they wish to operate. For competing in this complex environment
firms have to make considerable investment not only in monetary terms but also in
human resources, so that they can work efficiently and effectively in a multicultural
environment.

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Following are the main components of international business environment

 Political Environment
 Legal Environment
 Technological Environment
 Economic Environment
 Socio-cultural Environment
 Taxation Environment

Social Environment Cultural Environment

Political Environment
Legal Environment

Economic Technological
Environment Environment

Political Environment
After winning the general election In India in year 1977, when Janta Party came in
power, newly formed government banned the Coca-Cola Company for performing its
business activities in India. It was very huge setback for the company in terms of loss of a
big market and loss of its investment. Near about after a decade when Rao government
came in power they started liberalization of economy and started promoting foreign
investments. It was the time when once again the Coca-Cola Company started its

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business in India. This case of Coca-Cola gives us an idea that how political environment
of a country can affect
When business crosses the boundary of one nation, it becomes international business, has
to operate in different countries. These countries may be having entirely different
ideologies. These ideologies give birth to political system, in which a multinational has to
operate. For a Multinational to succeed has to understood and analyze the political system
of the country in which it had to operate. It is also necessary to see that its organizational
policies will fit to the concerned country’s ideology. A political system integrates the
parts of a society in to a viable and functioning unit.
Political ideologies have the major task to bring, people of different culture and
background, together countries political system decides that how the business will go
domestically and internationally. These ideologies are established by combining different
views of people coming from the society. Generally, as in India, economic and legal
environments of a country are formed or effected by political ideology of the country.
Political ideology can be of two types singular or plural. In singular political ideology the
society is having only one or very few type of point of views on the basis of these point
of views the government makes its policies. Arab countries are having single
conservative political ideology. In America there are only two types of ideologies-
Liberal ideology (adopted by Democratic Party) and Conservative ideology (adopted by
Republican Party). Plural political ideology is the ideology country ithe ideology when
means
Political Systems
A political system is defined as the system of government in a country. There are two
types of basic political system exists all over the world- Democratic and Totalitarianism.
Democratic political system is the system in which the supreme power is vested in the
hand of the public. This system has vital institution like legislature, government and
judicial. Now a days pure form of democracy is not visible due to the complex nature of
societies and geographical boundaries. Most of modern democracy practice
representative democracy. In this type of democracy citizens of a nation elect a
representative for a fix time. These elected representative form a government and take
decisions on behalf of citizens. Indian and American political systems are the example of
Democratic Political system.
Totalitarianism is also known as authoritarianism. Is this type of political system freedom
of individuals do not exists. Power of the authority of country is concentrated in the hand
of one person or to a small group which is not accountable to the public. Societies are
ruled by pressure. In today’s world there are two basic forms of totalitarianism exists.
First one, which is widely spread, is communist totalitarianism. China, Cuba are
example of communist totalitarianism. Second one is theocratic totalitarianism. In this
type political power is controlled by a party group or individual according to the religious
principles. Iran is example of theocratic totalitarianism.
Political Environment and International Business
International Business is the business which is crossing the boundaries of one nation
(home country) and entering in another nation (host country). This host country may be
having totally different political environment. Politics is having a direct relationship with
business; as it is clear from, the pre-election and post- election period, the instability of
stock market. A government, which is formed by political system, influences the business

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decisions, these business decisions may be related to domestic business or international

business. It is the political system of the country which decides about the direction of the
economic policies regarding the international business.
There may be two main criteria for any multinational to decide about entering in any
country for the purpose of business
First criteria may be regarding the stability of government which is ruling the proposed
country where multinational decides to start its operations. This criterion is very
important for those organizations who are deciding about location for investment after
crossing the boundaries of its origin nation. Normally political stability is associated with
economic policies of that country. As in India, I had stated earlier in this topic that,
election may instable the stock market, so it shows the importance for international
business.
Second criteria may the orientation of the ruling government and nationalism. This
criterion is something which shows the beliefs and values of the society in which
multinational has to operate. India and China may be taken as its example. After year
1991when prime-minister Mr. Narsimha Rao declared about the liberalization of
economic policies India became the destination of many multinationals. This change was
showing that change in the orientation of government can change the whole scenario of
business and market. In the same way when China’s communist orientation towards
business decreased, it became destination for FDI of various global corporations. A
sometimes society, due to its patriotism also, opposes the foreign organizations to enter in
the country.

Legal Environment
The legal environment is very important for a multinational because it had to operate in
different national sovereign. Each country is having its own regulatory system. Legal
environment effects not only working styles of multinational but also all the marketing
mix elements. As in India there is a legal restriction on showing advertisements regarding
alcohol and tobacco products while in USA advertising of these products id from this
type of restrictions. We can say that a manager from a multinational has to look all the
legal aspects before forming any strategy for a country of its origin and also of country
where it he wants to expand its operations.
Although the legal regulatory environment for an international manager consists of the
many local laws and the court systems in those countries in which he/she operates.
Following are the main issues which have to be taken care of by the international
manager during the process of international business
1. Intellectual Property Rights- Copyrights, Trademarks, Patents
2. Taxation- To be faced by the organization during international business not only
in domestic business but also in international business.
3. Labor Laws
Certain legal issues are covered by international law. International Law deals with
upholding order. Originally it was recognizing only nations as entities, but today it also
incorporates role played by individuals. International law can be defined as a set of rules
and regulations which the nations consider binding upon themselves. This international
law governs relationships among different sovereign countries. United Nations
Convention on Contracts for the International Sale of Goods (CISG) regarding the rights
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and obligations of buyers and sellers is one of the examples of international law. This
convention became law on January1, 1988 and applies to contracts for the sale of goods
between countries that have adopted the convention.
International law is less coherent in comparison to domestic law since it not only covers
the laws of individual states but also treaties (multilateral, bilateral, multilateral or
universal) or convention (CISG). International law also contains verbal or unwritten
boundaries behavior, which are results of repeated continuous trade among different
countries. An arm of United Nations, located in Hague (Netherlands), with the name
International Court of Justice had laid down following as the sources of
international law
1. International conventions, whether general or particular, establishing rules
expressly recognizing by the contesting states.
2. International custom as evidence of a general practice accepted as law.
3. The general principles of law recognized by civilized nations.
4. Judicial decisions and the teachings of the most highly qualified publicists of the
various nations, as subsidiary means for the determination of rules of law.
Following are also related principle which governs the conduct of international law-
Concept of sovereignty, international jurisdiction, doctrine of comity, act of state
doctrine, the treatments and rights of aliens and appropriate forum for hearing and
settling dispute.
Generally speaking, the manager of the foreign subsidiary or foreign operating division
will comply with the host country’s legal system. Such system, are based on Common
Law, Civil Law, or Religious Law, philosophies. These philosophies are a reflection of
the country’s culture, religion, and traditions. Common Law- in the USA and many other
countries or English origin influence, past court decision act as presidents to the
interpretation of the law and to common system. Civil Law- based on a comprehensive
set of laws organized into a code. Interpretation of these laws is based on reference to
codes and status. Maximum numbers of countries, predominantly in Europe, are ruled by
civil law. Religious Law- based on the religious beliefs. In Islamic countries, such as
Saudi Arabia, the dominant legal system is Islamic Law; based on religious beliefs, it
dominates all aspect of life. Islamic Law is followed in approximately 27 countries

Contract Law
Contract Law is an agreement by the parties concerned to establish a set of rules to
govern a business transaction. Contract Law plays a major role in international business
transactions because of the complexities arising from the difference in the legal systems
of participating countries. Sometimes the host government in many developing and
communist countries is often a third party, during the international business, in those
situations the contract law works effectively. Contracts are preferred by countries
following either common law or civil law, although there means of resolving disputes
may differ. Under civil law, it is assumed that a contract reflects promises that will be
enforce without specifying the details in the contract; under common law, the details of
promises must be written into the contract to be enforced.

Other Regulatory Issues

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Laws and regulations from one country to another vary in number of ways with different
complex mature. Following main issues are discussed regarding regulatory environment
of different countries, which affects international business
Most of the countries from developing world impose protectionist policies to
multinationals to give preference to their country’s own products and industries by
putting tariffs, quotas and trade restrictions.
Sometimes tax environment of a country is formed in such a way that it affects
attractiveness of investing money in that country which in turn affects the relative level of
profitability for a multinational. A multinational before entering in any country for
business in international market should study foreign tax credits, holidays, exemptions,
depreciation allowances, and taxation of corporate profits and additional considerations
provided by the host country. Many countries have signed tax treaties (conventions) that
define terms such as income, source and residency and spell out what constitutes taxable
activities.
The level of government involvement in the economic and regulatory environment varies
a great deal among countries and has a varying impact on management practices. In some
countries regulatory environment is favorable to the investment from the companies
belonging to any other country than others where regulatory environment is in opposition
of foreign investment. It is the astute of the manager of the global firm to survive in this
type of challenging and different regulatory and legal environment.

Technological Environment
Now a day the effect of technology around the world is visible in all aspects of life which
includes business also. Due to the pace of technological changes some developments are
being skipped in many parts of the world. Life cycle of Pager Industry in India can be
best example of the pace of technology. In India mobile kranti ruined pager industry
which was in its early stages of lifecycle. Technological advancement is bringing
increased productivity for employees, companies, and as well as for countries.
Since we are in a technologically advanced society, hence it is clear indication to
corporations that they must incorporate phenomenon of technoglobalism into their
strategic planning and their everyday operations. This technological advancement in
information and communication is accelerating macro environmental factors which in
turn are propelling globalization and the reverse process is also there. Investment-led
globalization is leading to global production networks, which results in global diffusion
of technology to link parts of the value-added chain in different countries. This value
chain may comprise of parts of the same firm, or it may comprise suppliers and
customers, or technology-partnering alliances among two or more firms. This
technological development is facilitating the network firm structure that allows flexibility
and rapid response to local needs. It is also clear that the effect of technology on global
business and trade transactions can not be ignored; internet is also propelling electronic
commerce around the world. It is also true that use of internet in business and trade had
also raised the question of protection of intellectual property.
New technology specific to a firm’s products represents a key competitive advantage to
firms and challenges international business to manage the transfer and diffusion of
proprietary technology, with its attendance risks. Whether it is a product, a process, or a
management technology, Multinational’s major concern is a appropriability of
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technology- that is, ability of the innovating firm to profit from its own technology by
protecting it from competitors.
A multinational enjoys various technological benefits from its international operations.
Advances resulting from cooperative research and development can be transferred among
affiliates around the world, and specialized management knowledge can be integrated and
shared. However, the risk of technology transfer and pirating is considerable and costly.
Although firms faces few restrictions on licensing agreements, royalties and so forth and
have other legal constraints on patent protection.
In most of the countries, governments use their legal system to control the flow of
technology. These restrictions may be in place because of national security. Less
Developed countries use their investment laws to acquire needed (usually) labor intensive
technology so that they can create jobs and also to increase exports. For protecting
intellectual knowledge and technology common methods are- Patents, Copyrights
In today’s scenario it is also important for global managers to study the effect of
transferring of technology on local people, whether local people are ready and willing to
accept technological changes or not. Level of technology transferring is normally
governed by the local (host) government law system. In some instances, host country
may allow to transfer only the latest technology, while in some cases government may
ask only for labor intensive technologies. Choice for a manager may be capital-intensive,
labor-intensive, or intermediate technology, but most important aspect is that it should be
suitable for the local people’s need and expectation.
International e-Business
It is the internet which is bringing now a days business in so fast pace that people are
bound to believe that technology and business are interrelated. Internet based electronic
trading and data exchange is changing the way of doing business. It is breaking the
barrier of time, space, logistics and culture. It has reduced the administrative cost
throughout the value-chain. The e-Business provides following benefits
 By facilitating communication worldwide, it is providing easiness in conducting
business activities.
 A corporate intranet service which merges internal and external information for
enterprises worldwide.
 It provides efficient Supply Chain System.
 Consumers get number of options and price differentials.
 e-Conferencing is possible which in turn saves time and money for corporate
persons as well as of consumers.

Economic Environment
International business is having direct effect of economic environment of various
countries. In general we can say that businesses have a possible range of production and
distribution from laissez-faire capitalism to totalitarian communism. Each country has its
own institutional arrangement for production and distribution of goods and services. In
today’s era no country is residing in the deep end of production and distribution systems.
We can imagine a spectrum which is starting from laissez-faire situation and ends at
totalitarian communism, countries are distributed in this spectrum. When we study this
spectrum we find there are basically three types of economic systems-Capitalistic, Mixed
and communistic.
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Capitalistic Economic System

When economic system of a country relies only on market arrangements it is known as
free enterprise market economy. Free enterprise market economy is the economy in
which economic decisions are freely made by individuals without direct orders from
others. The essential feature of free enterprise economy is the freedom of the individual
to buy goods and services and to own and organize the means of production for private
gains. It also refers to the freedom of choice of occupation selection and investment of
their money. This type of economic system is known as capitalism.
In capitalism an individual has the freedom or right to acquire property, to consume or
control it, to buy or to sell it, to give it as a gift etc. In addition to private ownership of
property, there are other institutional arrangements; profit, which is the paramount motive
in promoting competition to organize production and supply the market, the price system,
and consumer power that, when expressed in the marketplace, affects what and how
much will be produced. This system gives emphasis on the philosophy of individualism
believing in private ownership of production and distribution facilities.
Mixed Economic System
In this type of economic system major factors of production and distribution are owned,
managed and controlled by the state. The basic purpose of this type of system is to
provide the advantages to the general people on equity basis. Mixed economic system
gives birth to public sectors, control over private wealth, regulation of private investment,
agrarian reforms.
In this system government is having some level of reliance on market economy but the
tilt is towards the socialism. Governments fiscal and monetary policy plays an important
role in the operation of mixed economic system.
Communistic Economic System
When key economic questions, such as what to produce, how much to produce, for whom
to produce and allocation of resources necessary to achieve the desired production and
distribution, are decided by government, we say that it is a communistic economic
system. In this system prices of goods are not determined and fixed by individuals. A
communistic economic system has the ability to make economic plans and to see it that
these plans are carried out. This is because the productive wealth of the system,
consisting of land and capital, is owned by society as a whole; and society, as reflected
through the state, is the only business entrepreneur of any importance and controls most
lines of economic activity.
In a market based economy consumer choice influences resource allocation while in case
of communistic system it is controlled by a central planning body which is governed by
government. Basically this system is based on Marxist ideology.
Stages of Market Development
Markets of different countries are at different stages of development. GNP per capita
provides a very useful way of grouping of these countries. Using GNP as a base, we have
divided global markets into four categories
Low–Income Countries
These countries are also known as pre-industrial countries. Low-income countries are
those with incomes of less than 786$ per capita. These countries constitutes near about
37% of world population but less than 3% of world GNP. Countries in African continents
are best example of Low-income countries.

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Low-income countries share following characteristics

 Limited Industrialization,
 High Birthrates,
 Low Literacy Rates,
 Heavy Reliance on Foreign Aid,
 Political Instability and Unrest.
Lower–Middle-Income Countries
These countries are also known as Less Developed Countries (LDCs). Less developed
countries are those countries which are having per capita income more than 786$ but less
than 3,125$. These countries constitute 39% of world population but only 11% of world
GNP.
These countries have following characteristics
 Early stage of industrialization
 Consumer markets in the stage of expansion
 Availability of relatively cheap and highly motivated labor
Less developed countries represent an increasingly competitive threat as they mobilize
their relatively cheap- and often highly motivated- labor to serve target markets in the rest
of world. Less developed countries have a major competitive advantage in mature,
standardized, labor-intensive products.
Upper-Middle–Income Countries
These countries are also known as industrializing countries. These are the countries with
GNP per capita between 3,126$ and 9,655$. These countries account for 7% of world
population and almost 7% of world GNP.
Following are the main characteristics of upper-middle-income-countries
 Industrialized
 Degree of Urbanization is more than LDCs
 Less emphasis on agriculture sector
In upper-middle-income-countries the percentage of population engaged in agriculture
drops sharply as people move to the industrial sector and the degree of urbanization
increase.
Higher-Income Countries
These countries are also known as developed, industrialized, or first world countries.
These are the countries with GNP per capita above 9,655$. These countries account for
only 16% of world population but 82% of world GNP.
Main characteristic of Higher-Income countries is that these are highly industrialized.

Socio-Cultural Environment
For a business organization going for international business, it is important to understand
the terms society and culture. A society refers to a political and social entity which is
defined geographically. A social system is a combination of different groups and
subgroups. Culture is identified in terms of interaction between groups and subgroups
forming a society. It deals with behavioral pattern and values of social groups. These are
patterns and beliefs that have been learned from other members of a social group. Culture
may also assume the form of language differences that identify a group or region. Culture
is an important element in macro environment.
Social Systems
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Before going for international business one should understood different types of social
systems in which it had to operate. Technological advancement had brought countries
together but still there is vast difference among societies, which can not be bridged by
advancement of communication and technology. They involve things like attitudes,
ideologies, and beliefs that form a set of institutional arrangements. But still there is a
cohesive link in each society that is based on an internal set of beliefs and values.
Following are the main components of social systems
Business
A market economy uses the impersonal forces of the market to determine the allocation
of resources. Market forces are reflected in price changes, and prices determine what is to
be produced, how it is to be produced and for whom it is to be produced. Business firms
transform productive resources into consumer goods and services. These business firms
are subsystems in a social system and are subject to its values.
Government
Government is a creation of societies and as such provides the structures and processes
through which public policies and rules are implemented. Government’s role is
conditioned by the general social environment within which the political processes of
policy making operates. Government becomes the reflection of society. In twenty first
century role of government has increased enormously.
Society
Society covers all aspects of economic and social activity. There are many parts of
society, including the legal system that regulates society, the political system, religion,
and culture. Education, demographics, beliefs are also part of society. Some of these parts
operate in group activity by forming an institution.
Culture
Culture may be defined as rules and regulations (oral or written) adopted by a group of
people. Sometimes people confuse it with a geographical area i.e. country or something
which can be touched or heard. Basically culture includes conscious or unconscious
values, ideas, attitude and symbols.
Culture is a combination of different learned responses to day to day situations. These
responses are adopted very easily but it is very difficult to change them. That is why we
say that culture is transmitted or transferred from one generation to another. The
difference between the habits, attitudes, ideas, values creates the difference between
societies and in turn it affects the purchasing behavior of consumer.
An organization going for international business should understand the culture of the
country where it wants to start its operations. Culture may be classified according to its
nature in two ways- materialistic and non materialistic culture. Materialistic culture is
the culture which refers to physical products and things used by a society. In India
jewelry, made up of gold, wearing is considered as a culture. Non materialistic culture
includes believes, attitudes, values etc. It also includes the language, the history, religion
and the social systems.
High and low context cultures
Concept of high and low context culture was developed by Edward T. Hall. According to
this concept high context culture is characterised by low level of legal formalities and
high level of individual’s values and position in the society. Japan is the best example of

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high context culture. While low context culture are characterised by high level of paper
work and legal documentations. America is the best example of low context culture.
Impact of socio culture environment on managerial behavior
Socio csulture environment do not have impact on working of organization but also to the
behavior of managers. Following are the main area where this environment affects
1. Communication
2. Negotiation
3. Decision-Making

McDonald started business in India after liberalization

Effect of Environment on International Business

This topic is to be discussed in the classroom after collecting
certain cases and data from the student.

Cross Cultural Communication

International businesses are facing new challenges to their internal communication

structures due to major reforms brought about through internationalization, downsizing,
mergers, acquisitions and joint ventures. Lack of investment in cross cultural training and
language tuition often leads to deficient internal cohesion. The loss of clients/customers,
poor staff retention, lack of competitive edge, internal conflicts/power struggles, poor
working relations, misunderstandings, stress, poor productivity and lack of co-operation
are all by-products of poor cross cultural communication.

Barriers of Cross Cultural Communication

Cross cultural communications consultants work with international companies to
minimise the above consequences of poor cross cultural awareness. Here we outline a
few barriers for cross cultural communication:
Lack of Communication
It may seem obvious to state that non-communication is probably the biggest contributor
to poor communication. Yet it continues to prove itself as the major problem within most
companies. Lack of communication with staff is not solely due to lack of spoken
dialogue. Rather it relates to access to information.
For example, not giving feedback (negative or positive), informing staff of decisions and
actions that will affect their roles or failure to properly communicate expectations are all
ways in which information can be withheld from staff. This will eventually result in an
alienated staff base that feels divided from management and superiors If managers are too
selective in providing information, this can cause suspicion and jealously among staff and
will eventually result in internal strife instead of cohesion.

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A management which does not and will not communicate and interact physically with
staff demonstrate a lack of interest, trust and respect. In the West it is often the case that
communication lines are vertical. Staff report up to managers and managers up to senior
levels and so on. Ideally lines of communication should run both ways. Those with a
subordinate place in the communication process tend to feel estranged, indifferent and
possibly even belligerent. Lack of communication in all its forms is unhealthy.
Companies and managers must be aware of how, what and to whom they are
communicating.

Language

Communication difficulties through language come in two forms:

USE OF INAPPRORIATE LANGUAGE

Language carries with it subliminal meanings and messages transmitted through
vocabulary, stress and tone. The wrong use of words or emotions hidden behind phrases
can send messages that affect staff self-perception, confidence and attitude. Critical
language causes poor interpersonal relationships and low self-confidence whereas
supportive language and tones has the opposite effect.
FOREIGN LANGUAGE
These days, offices may have native speakers of over 50 languages all under one roof. It
is important that the main language of the office is established, whether it be English,
French or Spanish. Once this is constituted all employees should only converse in the
main language. This avoids exclusion of staff who can not understand other languages. In
addition, a company should ensure that all its employees are fully conversant in the main
language. Language tuition should be seen as a necessity not a luxury.
Culture
International businesses with a highly diverse workforce in terms of nationality and
cultural background face challenges from the differences in language, values, belief
systems, business ethics, business practices, behaviour, etiquette and expectations.
Cross cultural differences can negatively impact a business in a variety of ways, whether
in team cohesion or in staff productivity. As we have seen above, different methods of
communication are just one area in which cross cultural differences are manifested. In
such multicultural companies, objective help may be needed through a cross cultural
consultant who will show teams and individuals how to manage communication and
work together more cohesively and productively.
Company Culture
Company culture pertains to the internal culture of a company in terms of how it is
managed. For example, does the company view its different departments such as sales,
production, administration and HR as closed or open systems? A closed system is one in
which a total lack of synergy exists between a sales and production department due to the
structure and communication lines between the two. A consequence of such
compartmentalization is that managers of departments have a tendency to become
territorial. It is vital that team work, team building and team spirit are encouraged in
order to create open systems.

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Such measures are especially valid in joint ventures and mergers whereby co- operation
between two or more companies requires their total commitment to an open system.
Understandably many companies are primarily focused on the financial and strategic side
of company operations. International businesses are now realising that many of their
business problems have roots in man-management and communication.

Risk Analysis

Since long ago, cross-border business risk has been an issue that has worried those
individuals and organisations who have transactions or assets to receive from foreign
customers (residents in different countries). The possibility of a nonperformance was
always existing there. In the seventies, the world economy was facing a relevant liquidity,
plenty of dollars, most of them derived from the recycling of money earned by nations
that were members of OPEC. Their strong reserves were deposited in the international
banking system. At that time, the financial institutions were not well prepared to deal
with country risk but, looking for business, they quickly enhanced their exposure in
foreign markets, especially in developing ones, which traditionally require capital. In
several cases, the loans seemed to be contracted without regular attention to credit
procedures of both the borrower and the country. Since the eighties, some important
problems involving the payback of those credits have started affecting countries such as
Poland, Mexico and Brazil, whose defaults had caused heavy losses for the international
banks and, consequently, for its investors and shareholders. For instance, at that time,
over US$ 50 billion were invested in Latin America by the US top ten banks and their
provisions against losses had to be raised significantly to reflect and support new
conditions in their statements. So, the financial institutions were forced to adopt
maximum exposure risk policies, new analytical methods and strong credit procedures,
all of those supported by reliable data.
Following the rapid growth in the international debt of less developed countries in the
1970s and the increasing incidence of debt rescheduling in the early 1980s, country risk,
which reflects the ability and willingness of a country to service its financial obligations,
has become a topic of major concern for the international financial community. Political
changes resulting from the fall of communism, and the implementation of market-
oriented economic and financial reforms, have resulted in an enormous amount of
external capital flowing into the emerging markets of Eastern Europe, Latin America,
Asia, and Africa. These events have alerted international investors to the fact that the
globalisation of world trade and open capital markets are risky elements that can cause
financial crises with rapid contagion effects, which threaten the stability of the
international financial sector.

Country Risk Analysis

The globalization of the world economies, and in particular the internationalization of
financial markets in the last decades, have dramatically expanded and diversified
investment possibilities, leading to numerous new opportunities, accompanied by new

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risks. Consequently, there has been growing interest in obtaining reliable estimates of the
risk of investing in different countries. These concerns have led to the development of the
concept of country risk, and even to the regular publication of country risk ratings by
various agencies. The importance of ratings has been magnified by the recommendations
addressed in the Basel Capital Accord (2001), hat pinpoints the role of agencies’ ratings
for the assessment of credit risk.
Country risk ratings impact countries in a number of ways. The primary significance of
ratings is due to their influence on the interest rates at which countries can obtain credit
on the international financial markets: the higher the ratings (i.e., the lower the risk of
default) the lower the interest rate. Second, sovereign ratings also influence credit ratings
of national banks and companies, and affect their attractiveness to foreign investors.
Third, institutional investors are sometimes contractually restricted on the degree of risk
they can assume, implying in particular that they cannot invest in debt rated below a
prescribed level.
Country risk assessment evaluates economic, financial, and political factors, and their
interactions in determining the risk associated with a particular country. Perceptions of
the determinants of country risk are important because they affect both the supply and
cost of international capital flows. Risk rating agencies provide an independent analysis
of country risk and a consistent method of risk assessment. The leading risk rating
agencies are Standard & Poor’s, Moody’s, Euromoney, Institutional Investor, Economist
Intelligence Unit, and the International Country Risk Guide, all of which employ
different methods in determining country risk ratings. These rating agencies combine a
range of qualitative and quantitative information regarding alternative measures of
political, economic and financial risk into associated composite risk ratings.
The above discussion shows that the concept of country risk and creditworthiness have
become important over the years and despite analytical difficulties there has been growth
in interest in recent years among private and official lending institutions in the systematic
evaluation of country risk.
Country risk may be prompted by a number of country-specific factors or events. There
are three major components of country risk, namely economic, financial and political
risk. The country risk literature holds that economic, financial and political risks affect
each other. As Overholt argues, international business scenarios are generally political-
economic as businesses and individuals are interested in the economic consequences of
political decisions.
The lending risk exposure vis-à-vis a sovereign government is known as sovereign risk.
Sovereign risk emerges when a sovereign government repudiates its overseas obligations,
and when a sovereign government prevents its subject corporations and/or individuals
from fulfilling such obligations. In particular, sovereign risk carries the connotation that
the repudiation occurs in situations where the country is in a financial position to meet its
obligations. However, sovereign risk also emerges where countries are experiencing
genuine difficulties in meeting their obligations. In an attempt to extract concessions
from their lenders and to improve rescheduling terms, negotiators sometimes threaten to
repudiate their “borrowings”. Political risk is generally viewed as a non-business risk
introduced strictly by political forces. Banks and other multinational corporations have
identified political risk as a factor that could seriously affect the profitability of their
international ventures. Political risk emerges from events such as wars, internal and

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external conflicts, territorial disputes, revolutions leading to changes of government, and

terrorist attacks around the world. Social factors include civil unrests due to ideological
differences, unequal income distribution, and religious clashes. There may be some
external reasons also, For instance, if the borrowing nation is situated alongside a country
that is at war, the country risk level of the prospective borrower will be higher than if its
neighbour were at peace. Although the borrowing nation may not be directly involved in
the conflict, the chances of a spillover effects may exist. Additionally, the inflow of
refugees from the war would affect the economic conditions in the borrowing nation. In
practical terms, political risk relates to the possibility that the sovereign government may
impose foreign exchange and capital controls, additional taxes, and asset freezes or
expropriations. Delays in the transfer of funds can have serious consequences for
investment returns, import payments and export receipts, all of which may lead to a
removal of the forward cover.
Economic and financial risks are also major components of country risk. They include
factors such as sudden deterioration in the country’s terms of trade, rapid increases in
production costs and/or energy prices, unproductively invested foreign funds, and unwise
lending by foreign banks. Changes in the economic and financial management of the
country are also important factors. These risk factors interfere with the free flow of
capital or arbitrarily alter the expected risk-return features for investment. Foreign direct
investors are also concerned about disruptions to production, damage to installations, and
threats to personnel.

Reasons for Country Risk

Country risk may arise due to following any one or a combination of three broad risk
conditions:
 Availability of Resource
 Government Policies(Political Scenario)
 External Accounts(Economic and Financial Scenario)

It is important to remember that they are interrelated and often overlap with each other.

Availability of Resource
Any firm going for investment internationally firstly analyse the resource conditions of
country where it wants to invest. These resources may be natural, human and financial
resources.
Natural resources cannot in themselves make a positive contribution to a country’s ability
to earn or save foreign exchange with every country. While many countries do, many do
not.
Human resources refer to the extent to which a country’s population can contribute to
productive economic activity. It takes into consideration such factors as health, literacy,
productivity plans in the public and private sector, availability of technical and
managerial skills and the presence of an entrepreneurial class.
Financial resources refer to a country’s ability to save, which translates into a higher
proportion of investment it can meet with its own resources.

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A country’s resource base must be regarded in terms of historical trends rather than
simply present circumstances and its implications depend on the quality and effectiveness
of government, public and private sectors over a period of time.

Government policy
Another important reason for country risk analysis may be government policies of the
host country because it can and do strongly influence the economic and business climate
of any country. A government’s political philosophy affects economic policy as well as
the degree of regulation or assistance it exerts on internal commerce and external trade.
Aspects to consider include the quality of the economic and financial management
process, long-term development strategy and short-term policy measures. Regarding the
latter, particular attention should be given to fiscal, monetary, wage-price and foreign
exchange rate policies.

External accounts
External financial conditions relate to: balance for payments, external debt, international
reserves, and potential access to external finance. A negative balance of payments means
that the value of imports exceeds the value of exports and must be financed either
through foreign reserves or borrowings. If a country’s external debt level becomes
unmanageable, the foreign creditor’s risk of incurring blocked funds increases
dramatically. Heavily indebted countries can become a poor credit risk overnight if their
balance-of-payment position suddenly becomes negative due to declining world prices of
a major export. Countries generate foreign reserves from export earnings and foreign
borrowing. Reserves should be sufficient to permit payment of normal trade-related
liabilities without undue delay and also to provide some cushion in case of unanticipated
adverse developments. In this regard, it is also important to evaluate a country’s potential
access to external finances -- the country’s drawing ability from the IMF, borrowing
capacity from the World Bank, regional development banks, bilateral official sources and
international commercial banks.

Country Risk Indicators

Appraisal of any country’s overall creditworthiness is both quantitative and qualitative.
The quantitative aspects of the analysis incorporate a number of measures of economic
and financial performance and contingent liabilities. The analysis is also qualitative due
to the importance of political and policy developments. It should also be emphasized, as
mentioned above, that country risk is an integral part of the assessment of country’s
creditworthiness.
The risk indicators, which are used by the different agencies, are designed to evaluate the
economic growth, monetary and fiscal policy, and external flexibility profiling that are
part of assessing a country’s creditworthiness. In the country risk analysis agencies
examine hard economic data such as real GDP and real per capita growth, the budgetary
performance, public sector indebtedness and its cost in terms of revenue, the consumer
price index, external liquidity, and solvency indicators. Based upon these macroeconomic
variables and on qualitative aspects profiling the quality of economic growth, fiscal and
monetary policy, and external conditions, each country is ranked. In analyzing country

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risk and creating a system of rankings, the overall socioeconomic, political, and
regulatory picture for each country is looked.
Following can be some of the indicators for country risk rankings:
Corruption perceptions
An annual Corruption Perceptions Index (CPI) is compiled by Transparency International
which surveys a broad spectrum of national and regional sources to analyze the extent to
which corrupt practices plague public officials in over 160 countries. Corruption can be
defined as the "abuse of public office for private gain". The CPI is, in itself, a composite
index of corruption-related data and, as a result, serves as an ideal measure on which to
base our own composite country risk scores.
Ease of doing business
The ease of doing business rankings serve as insightful analyses of a country's private
sector and suggest paths forward for developing economies and they also indicate the
level of regulation in place that either enhances or constrains the ability to conduct
business. In the context of country risk, the Doing Business rankings identify the extent
to which the private sector is freely functioning.
In 2006, the World Bank released its updated Doing Business rankings, which monitor
the environment for business and entrepreneurship across 155 countries. As with the CPI,
the Doing Business rankings are compiled as a composite overall score that ranks
countries on categories from the steps to start a business to the enforcement of contracts.
Human development
The U.N. Human Development Index (HDI) serves as the benchmark metric for global
poverty. Employing some 30 separate indicators ranging from technology diffusion to
literacy and enrollment, HDI draws from each of the Millennium Development Goals. It
is the most comprehensive poverty level indicator for our country risk statistics and
serves as the linchpin for the overall country risk composite.
Income equality
This indicator highlights the level of poverty within a country with a proven, direct link
to the risk profile and to the breath of the gap between the rich and the poor.

Some agencies categorises these indicators in three important categories: political,

economic, and financial indicators. Political risk indicators include all those factors
which are associated with the political and social system of the country. Economic risk
indicators are the indicators which are associated with the economic health of the
individual residents of the country as well as with the economic health of the overall
economy. Similarly financial risk indicators are associated with the financial structure of
the country.

Classification of Risk

When we analyse the international business scenario, we find that there are various types
of risks involved. But fundamentally we can classify these risks into following three
types:
 Political Risks

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 Economic Risks
 Financial Risks
 Foreign Exchange Risks

Political risks

The world is turning into a global market place and multinational enterprises are as a
consequence exposed to more and more risks of various kinds. One of these risks is
political risk, which implicates the risk of negative effects for a company due to political
actions. Managers of these multinational enterprises rank different countries primarily on
the basis of political scenario of that country. They know that the change of the
government with different ideology affects the returns from the investments made in
those countries. This risk increases in case of less developed countries. But we cannot say
that developed countries do not have the political risks. It has significance in case of
developed countries as the volume of investment is very large in these countries.
Expropriation, currency controls, requirements for additional local production are just a
few examples of political risk.
Robock was one of the first to address the issue of political risk in 1971.Since then,
political risk has been debated in the management. Robock had defined political risk as
“when discontinuities occur in the business environment, when they are difficult to
anticipate, and when they result from political change”. This definition does not clearly
state that social factors such as strikes, riots and boycotts are included in the political risk.
In its most simple definition, political risk refers to the possibility that political decisions,
conditions, or events in a country will affect the business climate in such a way that
investors will lose money or not make as much money as they expected when the
investment was made. Many of the earlier works on political risk defined political risk as
government interference with business operations. Shapiro defined it as any “government
intervention into the workings of the economy that affects, for good or ill, the value of the
firm”. These definitions clearly indicates that the main influencing factor is the type of
political system, but other factors are ethnic/ religious conflicts, foreign government
intervention and economic stress. The definition of Kennedy provides some more
concrete examples of factors included in political risk “Political risk can be defined as
the risk of a strategic, financial, or personnel loss for a firm because of such nonmarket
factors as macroeconomic and social policies (fiscal, monetary, trade, investment,
industrial, income, labour, and developmental), or events related to political instability
(terrorism, riots, coups, civil war, and insurrection).”
As discussed in above paragraphs political risk ranges from expropriation of a company’s
properties to the kidnapping of its business representatives, But most important type of
political risk is expropriation. Expropriation is the act of taking possession of an item of
property from its owner in exchange for little or no compensation and irrespective of the
wishes of the original owner. The term is used to both refer to acts by a government or by
any group of people.

Economic Risk

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Economic risk can be defined as the impact on business environment of any country by
the economic mismanagement. This economic mismanagement will cause a drastic
change in the environment and in turn will adversely affect the profit and other goals of
any multinational. The inflation is the most important problem which arises due to
economic mismanagement.
There are views that economic risk and political risks can not be differentiated. As we
know that economic mismanagement, which is creating economic risk, can create social
unrest which will be a cause for political risk.

Financial Risks
Financial risks depnds upon the specific method of financing the firm or a particular
project in overseas market. The debt-equity ratio affects the capital structure of the firm.
If a firm performs badly and it is not able to pay the interest and premium on the debt
then it increases more risks for the investors by having preference for the equity capital. It
is so because the equity holders are paid after the lenders have been paid their
outstanding amount.
Moreover, a firm anticipating high financial risk would not prefer loan even at low
interest rate whereas the another firm with low risk would like to borrow at high interest
rate. The firm within the same industry may have high or low preference for debt-equity
ratio depending upon the economic conditions of different countries and the efficiency of
financial institutions.
The financial risks may be minimised by entering into floating interest rate and multi
currency contracts. The floating interest rate permits adjustment every six months or so as
agreed upon. It reduces the risks of both the borrowers and lenders. If the interest rate
falls after the loan is finalised, the borrowers suffer but they are protected because of the
possibility of adjustment under floating interest rate agreement. The loans may also be
arranged interms of multi-currency contracts and the fall in value of one or more
currencies may be compensated by the rise in the value of others. In addition, there are
also the hedging provisions in the financial markets to protect the international business
from the financial risks.

Foreign exchange risks

The result of country risks is foreign exchange risks -- the ability and willingness of the
foreign government to make enough foreign exchange available to its citizens, foreign
residents, private and publicly owned companies and government owned agencies to pay
their foreign currency denominated liabilities or debts.
Over the past 50 years, there has been a huge increase in cross-border flow of goods,
services and investments. While fueling global economic growth, this increase has also
made companies highly vulnerable to fluctuations in foreign exchange risks. That
vulnerability has been exacerbated by the dissolution of the Bretton Wood Agreement of
1971 and the resultant floating of currency, which has caused foreign exchange markets
to be plagued by growing instability.

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Like any other commodity, currencies follow laws of supply and demand, which are
subject to political and economic conditions. Exchange rates can fluctuate wildly,
sometimes several times in one day, severely complicating a company’s short-term
financial and long-term strategic decisions.
Foreign exchange risk includes both a country’s sovereign and transfer risks, in addition
to exchange controls.
Sovereign risk refers to the inability of a government to raise sufficient amounts of
foreign exchange to service its foreign currency debt obligations. Credit managers should
not assume that risk is diminished simply because a credit sale is to a foreign government
entity. When a country experiences adverse country risk conditions, the government
entity is likely to be subject to many of the same adverse conditions as private sector
companies.
Government entities often have access to decreasing foreign exchange reserves; however,
that access varies among government and country owned or operated industries.
Transfer or convertibility risk refers to the inability of companies in the private sector to
raise foreign exchange, even though they are in good financial condition. A vast majority
of international trade is carried on in US dollars because many nations use the US dollar
as their base reserve currency.
Many companies invoice their export credit sales in not only US dollars but also other
hard currencies (major trading currencies) and some soft currencies as well. Since the
foreign purchase must convert its local currency into US dollars or another bulling
currency to pay the bill, the transaction incurs a transfer risk.
In other words, the invoiced currency may not be available when the purchaser tries to
pay the bill. When feasible, you can solve the problem by arranging for collection in
advance or by transferring the risk to a third party.
Exchange controls refer to government-imposed controls, the underlying purpose of
which is to stabilize the country’s currency. Credit people must be aware of exchange
controls that affect extension of credit, payment terms and collections within normal
credit policies. For example, exchange controls may prevent a foreign buyer from
remitting US dollars to the seller.
Credit managers should never underestimate the importance of country risk analysis
because political and economic instabilities of countries have and will continue to have a
tremendous impact on the trade of goods and services between nations. Country
conditions that could affect the foreign customer’s ability and willingness to pay
maturing debt obligations in a timely fashion should form the basis for choosing whether
or not to proceed into customer risk analysis.

Strategies for Managing Risks

Successful businesses take calculated risks to achieve objectives. Globalization,
deregulation, Web-based services, complicated financial instruments and contracts,
emerging markets—all contain tremendous potential advantages for companies and carry
the danger of huge mistakes or unexpected developments. Businesses must measure these
risks, try to minimize them and—if possible—use them to their advantage.
Although each business may have its own unique approach to risk management, but may
be taken as step by step process for managing the risks:
 Analysis of company’s strategy.
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 Identification of the risks.

 Analyse and asses the risks.
 Design response strategies.

Analysis of company’s Strategy

Risk management can get success only when it works within the context of a company’s
environment, goals, objectives and strategies. Organizations may differ greatly in their
risk tolerance and management styles. Deposit-taking institutions necessarily place a high
value on solvency and the preservation of capital. Their investors and customers expect a
good return with little risk. Companies that prospect for minerals or develop high-tech
products focus on big rewards in exchange for big risks. Their investors typically
understand this trade-off and the significance of such an organization’s appetite and
capacity for risk. That is why first step in finding out strategy for risk analysis could be to
examine a company’s business environment and risk tolerance.
Once a company understands the risks of an undertaking, the owners or management can
develop a strategy for containing them. This may involve formally structured policies and
procedures or an informal process, depending on the business. As part of the risk
management process, company can ask following questions:
 What are our objectives?
 What are our values?
 Who is accountable?
 Who has the authority?
Questions like these can help establish the context for an organization’s risk management
efforts.

Identification of Risks

Managers need a systematic approach for uncovering and addressing risks that might
affect a company’s success. Now the question rises that what are those risks? What kinds
of risks might a business typically discover? When we analyse the different types of risk
situations, we find that all different types of risks comes under the umbrella of Political,
Financial and Exchange rate risks. Following may be some of the specific types of
research:

Brand Equity Risk- It is the risk which could affect the company’s brand name or
reputation.
Customer Satisfaction Risk- When company’s performance reflects poor consumer
reception towards its products, it is known as customer satisfaction risks.
Product Quality Risk- When company’s products reflect problem relato the quality
parameters.
Catastrophic Risk- It usually covers the political, natural or other disasters.
Regulatory Risk- This risk is fundamentally related to the political changes which are
affecting the businesses.
Cultural Risk- This risk can arise due to change in the culture which can change the

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attitudes of the consumers.

Trade War Risk- It could be the result of price cutting or other competitive practices.

Analyse and Asses the Risk

When the company is familiar to the types of risks it is going to face during its
international business journey, it needs to rank them. After ranking the risks company has
to establish the priorities in order to make decisions. In the analysis and assessing the
risks involved quantitative data play an important role. This quantitative data provides a
platform for the purpose of making any conclusion and finally to provide a platform on
which company can take certain decision.

Design Response Strategies

After the quantification of the risks which the company is to face following responses can
help to overcome those risks:

Avoid- If the threat associated with an opportunity is too high relative to the potential
reward, it may be appropriate to drop the idea. However, some executives—and entire
company cultures—may unwittingly encourage risk aversion, which can result in missed
opportunities.

Transfer- The Company can shift risk to third parties by buying insurance; by using
financial instruments, such as derivatives; by outsourcing some parts of the process; or by
creating partnerships or strategic alliances. Transferring risk can be a smart strategy—but
part of the due diligence is ensuring that the organization accepting the risk can fulfill its
obligations.

Mitigate- To increase the chances of achieving objectives, the company can establish and
monitor critical success factors and key performance indicators. These critical success
factors and key performance indicators can signal whether a strategy is working or
failing.

Accept- Companies may be able to live with some risks. For example, a mining company
facing fluctuating mineral prices may conclude the profit opportunities outweigh the
risks.

Importance of Risk Analysis for International Business

Country risk has become a topic of major concern for the international financial
community over the last two decades. Various risk rating agencies employ different
methods to determine country risk ratings, combining a range of qualitative and

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quantitative information regarding alternative measures of political, economic and

financial risk into associated composite risk ratings.
The surge in FDI around 1980's has increased and complexified the nature, quality and
amount of risk faced by MNCs. The traditional framework of dealing with risk, which
includes the efforts made to define, to assess and to manage risk on corporate level, is
transformed. One of the distinctive features of the modern management of risk is the use
of international institutional arrangements or framework to offset the risk. This intensive
use of institutional arrangements to manage risks coincides with the development of an
international investment law dealing with the stabilization, the transparency and the
promotion of the investment area. This process of institutionalization of investment is
favoured by the generally positive attitude of LDCs towards the FDI. Surely the
development of accepted investment rules on international level can reduce the impact of
risk on FDI. But this development can not remove the fear of risk for multinationals. The
multinationals have to measure the risk before the investments as well as they have to
develop a genuine business plan to face it.
Following actions can be prerequisites for any country which is attracting foreign
investment. These points can reduce the risk involved in international business and also
can increase the country risk rating:
 To support the market forces (market capability of the country).
 To coordinate with the international organizations, engaged in the activities of
promoting international business, to implement international rules and regulations
(international commitments).
 To maintain civil peace and provide the security (security capability).
 Sharing of reliable information civil society and international institutions
(transparency capability).
From these enumerations, one can derive that all measures which directly or indirectly
are not satisfying these conditions should be counted as risk. In considering the risks in
their strategies, MNCs as the symbolic motors of the globalization should be aware of
this theoretical implication.
As could be seen, country risk analysis is not an easy task. It demands a holistic vision,
specialized skills and persistent approach. After dealing with the macroeconomic, socio-
political and financial aspects, the analysis has to clearly show the strengths and
weakness of a country, in order to define a risk level. Managing the risk of a portfolio
demands a systematic follow up concerning to external and internal environment,
governmental policies, outlook provided by rating agencies, and so on.

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CHAPTER3 International Business Theories

3.1 International Trade
3.1.1 Nature and Significance of
International Trade
3.1.2 International Trade and Interregional
Trade
3.2 International Trade Theories
3.2.1 Mercantilism
3.2.2 Adam Smith’s Absolute Cost
Advantage Theory
3.2.3 Ricardo’s Comparative Cost
Advantage Theory
3.2.4 Haberler’s Opportunity Cost Theory
3.2.5 Hecksher-Ohlin Theory
3.2.6 Modern Theories of International
Trade
3.3 Foreign Direct Investment (FDI) Theories
3.3.1 Market Imperfection Approach
3.3.2 International Product Life Cycle
Theory
3.3.3 Transaction Cost Approach

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3.3.4 The Eclectic Paradigm

Summary
In this chapter we are dealing with the problem that why any country indulge in
international business? Answer lies in the understanding of theories of international
business. This chapter is classified in two parts: first part is associated with international
trade, explaining how and why international trade takes and second part is associated
with foreign direct investment, explaining inter country investment in manufacturing and
service activities and management of these activities. Foreign direct investments took
growth mainly due to imperfections in world market and protective trade policies of
different countries.
As we know that before the emergence of multinationals international business and
international trade were considered as same side of coin. But when multinationals
undertook foreign direct investment abroad for the purpose of establishing production
and marketing facilities, it gave an idea to economists that traditional trade theories are
not enough to explain international business phenomenon. And this was the stage when
people understood that international trade is a part of international business.
3.1 International Trade
Nature had distributed factors of production unequally over the surface of earth.
Countries differ in terms of natural resources, climatic conditions, mineral resources,
labor and capital resources. This unequal distribution generates difference in production
capacities of countries. Thus a country is not able to fulfill all the wants of its citizens.
We know that wants of human being are never ending. Hence, for fulfilling the wants of
individuals, countries engaged in international trade.
Theories of international trade provide us very simple explanation of reasons of
international trade. With the passage of time these theories are changing from the concept
of Mercantilism to Modern theories of international trade (Neo-classical theories).

3.1.1 Nature and Significance of International Trade

For understanding the nature of international trade following aspects of international
trade should be taken care of:
 International trade is the trade which is carried out among different countries or it
can be defined as the trade which is crossing boundary of one nation.
Fundamental difference between international trade and domestic trade is
involvement of different environments such as economic environment,
demographic environment, Foreign exchange (different currencies), political
environment, legal environment (Jurisdiction System) etc.
 International trade depends on economic relations among the trading countries.
These economic relations are affected by geopolitics, cultural differences, and
differences in inflation rate of trading countries, exchange rate (foreign currency),
and legal environment.
 International trade has common motive of well being of the population of trading
countries. By the help of international trade, countries are able to, firstly, fulfill
the wants of individuals and, secondly, improve the standard of living of all the
residents of countries.

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 International trade deals with the study of impact of domestic economic policy on
international economic relations. The trading country’s policies regarding the
import substitution and export promotion policies or in other words we can say
that the country is adapting controlled regime of trade or liberalization of
economy.

Following are the main reasons which are showing significance of studying international
trade:
 As we had discussed in earlier chapters that we are living in a world where
countries are economically interdependent. This interdependency is to fulfill the
needs and wants of their people and also for the welfare of the society as a whole.
The degree of economic interdependence may be known as ratio of imports to
national income. It is possible for some developed economies like USA, some
European countries may survive without any dependency on any other economy.
But this independency (i.e. without international trade) will deprive their people
from many goods. That is why world’s strongest economies are also in favor of
international trade.
 Innovations in the field of transportation and communication technologies are
working as catalyst in increasing the mutual interdependence of economies. It is
helping in increasing returns to scale, high-income elasticity of demand for
differentiated products.
 It is dealt as a separate branch of economics because of theoretical and policy
aspects: Theoretical – the development of comparative cost advantage theory and
factor price equalization theory, Policy – different currencies giving rise to
different exchange rate, factor immobility at international level.
 International trade gives rise in foreign investment, which work as a carrier for
technology. This technological advancement generates higher productivity,
greater employment, and overall welfare of society.

3.1.2 International Trade and Interregional Trade

When trade activities are confined to the boundaries of one nation, than it is known as
interregional trade (domestic trade in the different regions of the country), while in
international trade, trade activities crosses boundaries of a nation.
Following points shows similarities between interregional trade and international trade
 In both the cases trade takes place because of the differences in cost and price of
products or resources in different regions of the country or in different countries;
 Whenever there is a gap in demand and supply i.e. supply decreases with respect
to demand, to fulfill that gap trade occurs.
Following points show differences between interregional trade and international trade:
 In international trade, an organization has to face different credit and currency
system, while in case of interregional trade organizations have to work with same
credit and currency system. This difference in credit and currency system makes
international trade very difficult.
 A geographical distance plays an important role in international trade, while in
case of interregional trade it may or may not have any role. Costs associated with

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transport and insurance are substantial and constitute a major factor in export and
import decisions.
 Environmental factors also create an important difference between international
trade and interregional trade.
 The wage and price system may differ in case of international trade which can
lead to comparative cost differences.
 Mobility of factors of production is also an important difference between
international trade and interregional trade.
3.2 International Trade Theories
3.2.1 Mercantilism
The economic doctrine that prevailed preceding the development of classical theories of
international trade was mercantilism. Mercantilism is known as first theory of
international trade which came in existence during mid of 16 th century. England was the
originating country of this theory. At that time gold and silver were the mainstays of
national wealth. This concept was at the core of mercantilism.
The main emphasis in mercantilism was to increase export and decrease import so that
country can maintain trade surplus. For this purpose mercantilist doctrine gave emphasis
on increasing government intervention for balancing the balance of trade. To achieve this,
imports were limited by imposing tariffs and quotas, while exports of goods were
subsidized heavily.
Following are the main features of mercantilism:
 Mercantilism theory is of very nationalistic in nature i.e. it gives prime
importance to the well being of own country and welfare of population of own
country.
 It favored the regulation and planning of economic activities as an efficient and
effective mean for achieving the goals of the nation.
 It generally viewed foreign trade with suspicion. According to mercantilists, the
most important way a country could grow rich is to acquire precious metal
especially gold and silver. They favored exports so long as they brought gold into
the country. Imports were to be discouraged because they deprive the country of
its true source of richness – precious metals. Therefore, trade had to be regulated,
controlled and restricted because no specific virtue being seen in having a large
volume of trade.
Basic flaw in the theory of mercantilism is that it says benefit or gain of one country is
loss of another country. It deals international trade as a zero sum game in which loss of
one player is the gain of second player.
3.2.2 Adam Smith’s Absolute Cost Advantage Theory
This theory was propounded by Adam Smith in his famous book, “The wealth of nations”
in 1776. In the book Smith argued that countries can gain advantage by trade only when
they specialize in production of only one product. He questioned to mercantilists
assumption that a country’s wealth depends on its holding of treasures (Gold and Silver).
Rather, he suggested that real wealth of a nation is to make available goods and services
to country’s citizens. Smith said that different countries produce some goods more
efficiently than other countries.
This theory depends on following assumptions

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 There are only two countries and two goods.

 There is no difference in cost of resources in both the countries.
 There is no transportation cost between two trading countries.
 Within a country movement of resources is free.
For understanding Smith’s doctrine we are taking following example
Let us assume that:
 Labor is the only factor of production
 There are two countries in the world (India and Kenya) and two commodities
(Tea and Cloth)
 1 unit of labor in each of the two countries will produce:
Kenya India
Cloth 60 120
Tea 80 40
Note:
 India has an absolute advantage over Kenya in the production of Cloth
 Kenya has an absolute advantage over India in the production of Tea
It follows that:
 If India produces Cloth and Kenya produces Tea, and an exchange ratio can be
arranged, both countries will benefit from trade
Before Trade:
Kenya: 1 Cloth = 1.33Tea (i.e. 80/60)
India: 1 Cloth = 0.33 Tea (i.e. 40/120)
So if Kenya specializes in Tea and India specializes in Cloth, international trade would be
beneficial for both countries at any exchange rate between 0.33 and 1.33 Tea for 1 unit of
Cloth.
Let’s now assume an exchange rate of 1 Cloth = 1 Tea
After Trade:
Kenya: 1 Cloth = 1 Tea (gets same unit of cloth for less Tea – i.e. gets more Cloth for
same Tea)
India: 1 Cloth = 1 Tea (gets more Tea for same Cloth – i.e. gets same Tea for less Cloth)
Let’s further assume complete specialization and doubling of output in each country:
Before Trade Kenya India Total (World
(Autarky) output)
Cloth 60 120 180
Tea 80 40 120
Total Output 300
After Trade Kenya India
Cloth 0 240 240
Tea 160 0 160
Total Output 400

It is clear from the above table that free trade leads to greater world output
3.2.3 Ricardo’s Comparative Cost Advantage Theory
Now in the above example, if we consider that, India has absolute advantage over the
Kenya in the production of both goods, than there will not be any trade activity between

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India and Kenya. The absolute advantage theory was not having any solution for these
types of questions. David Ricardo introduced the theory of comparative advantage to give
answer to these questions. The theory of comparative advantage states that nations should
produce those goods for which they have the greatest relative advantage. The key word
here is relative (as opposed to absolute).
The Ricardian theory of comparative advantage is based on opportunity cost, i.e.
opportunity cost of one good in terms of the other. Opportunity costs are determined by
labor productivity. So long as labor productivity differs between countries, trade
(exchange of goods and services between countries) could lead to specialization gains
and exchange gains, thereby leading to an increase in overall well-being
Thus there are gains from trade whenever the relative price ratios of two goods differ under
international exchange from what they would be under conditions of no trade (i.e. autarky).
For understanding Ricardian doctrine we are taking following example
Let us assume that:
 Labor is the only factor of production
 There are two countries in the world (India and Kenya) and two commodities
(Tea and Cloth)
 1unit of labor in each of the two countries will produce:
Kenya India
Cloth 60 120
Tea 30 40
Note:
 India has an absolute advantage over Kenya in the production of both Cloth and
Tea but the relative productivity differs.
 India’s productivity in Tea is 120/60 = 2 times that of Kenya in Cloth, but India’s
productivity in Tea is 40/30 = 1.33 times that of Kenya in Cloth. Hence India has
greatest relative advantage (comparative advantage) in Cloth. So India should
specialize in production of Cloth.
 Kenya has comparative disadvantage in both Cloth and Tea, but its disadvantage
is least in Tea, so Kenya should specialize in Tea.
 Because India has greatest comparative advantage in Cloth rather than in Tea, the
price of Cloth relative to Tea (Pc/Pt) in India is lower than the relative price of
Cloth in Kenya. For example:
(a) In India, 1 Cloth = 0.33 Tea (i.e. 40/120)
Or 100 Clothes = 33 Teas
(b) In Kenya, 1 Cloth = 0.50 Tea (i.e. 30/60)
Or 100 Clothes = 50 Teas
It follows that:
 If India can import more than 33 units of Tea for 100 units of Cloth, it will gain
from trade
 If Kenya can import more than 100 units of Cloth for 50 units of Tea, it will also
gain from trade
 Both countries can benefit from free trade at an exchange rate between 33 and 50
units of Tea for 100 units of Cloth.
Let’s assume an international trade exchange rate of 40 units of Tea for 100 units of
Cloth, then:

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 India, which specializes in Cloth, now gets more Tea for the same Cloth
 Kenya, which specializes in Tea, now sacrifices less Tea for the same Cloth
So, even though India has absolute advantage in the production of both Tea and Cloth
over Kenya, its greatest comparative
(Relative) advantage lies in Cloth (as opposed to Tea). Because of productivity
differentials between the two countries in the two goods, free trade leads to specialization
and exchange gains for both countries.
Should both countries completely specialise in the production of each product? It all
depends on whether or not both are of equal size. Size matters! Whilst small countries
can specialise 100% and still yet all the benefits associated with free trade, big countries
need not specialise completely.

For example:

Before Trade Kenya India Total (World

(Autarky) output)
Cloth 60 120 180
Tea 30 40 70
Total Output 250
After Trade Kenya India
Cloth 0 240 240
Tea 60 0 60
Total Output 300
Whilst the world output for Cloth increases from 180 units to 240 units, the world output
of Tea declines from 70 units to 60 units.
So, it pays for the bigger country to devote a bulk of resources (e.g. 70%) to the
production of the good it has greatest comparative advantage and the rest to the
production of the good whose comparative advantage is least.
Before Trade Kenya India Total (World
(Autarky) output)
Cloth 60 120 180
Tea 30 40 70
Total Output 250
After Trade Kenya India
Cloth 0 204 204
Tea 60 12 72
Total Output 276

So, complete specialization of the smaller country combined with a partial specialization
of the bigger country (India) increases world output. Thus trade provides greater
economic output and consumption to the trading partners jointly as they specialize in
production, exporting the goods in which they have a comparative advantage and
importing the goods in which they have a comparative disadvantage.
Summarizing the Ricardian theory:

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 Ricardo was concerned with demonstrating that countries should specialize on the
basis of Comparative Advantage and not Absolute Advantage. This results in
specialization gains.
 Free trade also results in exchange gains.
 A basis for trade exists when commodity price ratios differ between countries.
 Commodity price ratios are an inverse function of productivity ratios. I.e. the
lower the price ratios, the higher the productivity ratios and vice versa.
 All of this is based on the following assumptions:
 Constant Returns to Scale Production Functions,
 Perfect Competition,
 free mobility of factors between sectors within countries but immobility
of factors between countries.
 Zero transport costs
 A cursory look at differences in wage rates across nations and productivity
differences may, to a large extent, explain the growth of exports from developing
countries in Ricardian goods.
 It is not clear whether these exports were responsible for unemployment and
decline in wages of the unskilled in the developed countries.
 Trade policy should not be used to solve social problems (distribution problems).
3.2.4 Haberler’s Opportunity Cost Theory
Opportunity Cost theory was propounded by Prof. Haberler, According to Haberler goods
are not produced by the labor only. Production of goods uses various combinations of
factors of production (land, labor, capital). Each country exports goods which it produces
at lower opportunity cost and imports those with higher opportunity costs.
For understanding opportunity cost theory read following example
Let us consider that India can produce either 100 meters of cloth or 100 jute bags hen its
all factors of production are fully employed in the production of either cloth or jute bag.
If we draw a curve by taking cloth on vertical axis and jute bag on horizontal axis, than,
we can find out different combinations of both the products.

The above graph shows the production possible curve. Now, if, India decides to produce
50 meters of cloth and 50 jute bags i.e. point , than, production possibility curve
suggests that for the production of 1 meter cloth India has to give up the production of 1
jute bag. The opportunity cost, therefore of a particular commodity ‘A’, is the benefit of
opportunity lost if ‘A’ is instead put to its alternative use.
3.2.5 Hecksher-Ohlin Theory
The factor proportions model was originally developed by two Swedish economists, Eli
Heckscher and his student Bertil Ohlin in the 1920s. The H-O model incorporates a
number of realistic characteristics of production that are left out of the simple Ricardian
model. The standard H-O model begins by expanding the number of factors of production
from one to two. The model assumes that labor and capital are the two factors of
production used in the production of goods. Here, capital refers to the physical machines
and equipment that is used in production. Thus, machine tools, conveyers, trucks,
forklifts, computers, office buildings, office supplies, and much more, is considered
capital. The assumption of two productive factors, capital and labor, allows for the
introduction of a realistic feature in production; differing factor proportions both across
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and within industries. When one considers a range of industries in a country it is easy to
convince oneself that the proportion of capital to labor used varies considerably. For
example, production of industrial product generally involves large amounts of expensive
machines and equipment spread over perhaps hundreds of acres of land, but uses
relatively few workers, while in the agriculture industry, in contrast, harvesting requires
hundreds of labors. The amount of machinery used in this process is relatively small.
In the H-O model we define the ratio of the quantity of capital to the quantity of labor
used in a production process as the capital-labor ratio. We imagine, and therefore assume,
that different industries, producing different goods, have different capital-labor ratios. It
is this ratio (or proportion) of one factor to another that gives the model its generic name:
the Factor Proportions Model.
In a model in which each country produces two goods, an assumption must be made as to
which industry has the larger capital-labor ratio. Thus, if the two goods that a country can
produce are steel and clothing, and if steel production uses more capital per unit of labor
than is used in clothing production, then we would say the steel production is capital-
intensive relative to clothing production. Also, if steel production is capital intensive,
then it implies that clothing production must be labor-intensive relative to steel. Another
realistic characteristic of the world is that countries have different quantities, or
endowments, of capital and labor available for use in the production process. Some
countries like the US are well endowed with physical capital relative to their labor force,
while, in contrast many less developed countries like India have very little physical
capital but are well endowed with large labor forces. We use the ratio of the aggregate
endowment of capital to the aggregate endowment of labor to define relative factor
abundance among countries. Thus as an inference of above statement we can say that the
US has a larger ratio of aggregate capital per unit of labor than India's ratio, we would
say that the US is capital-abundant relative to India. By implication, India would have a
larger ratio of aggregate labor per unit of capital and thus India would be labor-
abundant relative to the US. A fundamental distinction between the H-O model and the
Ricardian model is that the Ricardian model assumes that production technologies differ
between countries; the H-O model assumes that production technologies are the same.
The Heckscher-Ohlin theorem states that a country which is capital-abundant will export
the capital-intensive good. Likewise, the country which is labor-abundant will export the
labor-intensive good. Each country exports that good which it produces relatively better
than the other country. In this model a country's advantage in production arises solely
from its relative factor abundance.
The H-O model assumes that the two countries (US and India) have same technologies,
meaning they have the same production functions available to produce steel and clothing.
The model also assumes that the aggregate preferences are the same across countries. The
only difference that exists between the two countries in the model is a difference in
resource endowments. We assume that the US is capital-abundant compared to India.
Similarly, India, by implication, is labor-abundant compared to the US. We also assume
that steel production is capital-intensive and clothing production is labor-intensive.

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The difference in resource

endowments is sufficient to generate different PPFs in the two countries such that
equilibrium price ratios would differ in autarky. To see why, imagine first that the two
countries are identical in every respect. This means they would have the same PPF
(depicted as the brown PPF0 in the figure), the same set of aggregate indifference curves
and the same autarky equilibrium. Given the assumption about aggregate preferences,
that is U = CCCS, the indifference curve(I), will intersect the country’s PPFs at point A,
where the absolute value of the slope of the tangent line (not drawn), (P C/PS), is equal to
the slope of the ray from the origin through point A. The slope is given by CSA/CCA. In
other words, the autarky price ratio in each country will be given by,

Next suppose that labor and capital are shifted between the two countries. Suppose labor
is moved from the US to France while capital is moved from France to the US. This will
have two effects. First, the US will now have more capital and less labor, France will
have more labor and less capital than initially. This implies that C/L> C*/L*, or that the
US is capital-abundant and France is labor-abundant. Secondly, the two countries PPFs
will shift.
The US experiences an increase in C and a decrease in L. Both changes will cause an
increase in output of the good that uses capital intensively (i.e. steel) and a decrease in
output of the other good (clothing). Now if prices remain constant, production would
shift from point A to B in the diagram and the US PPF would shift from the brown PPF0
to the green PPF.
Using the new PPF we can deduce what the US production point and price ratio would be
in autarky given the increase in the capital stock and decline in labor stock. Consumption
could not occur at point B since, 1) the slope of the PPF at B is the same as the slope at A

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and 2) homothetic preferences implies that the indifference curve passing through A must
have a steeper slope since it lies along a steeper ray from the origin.
Thus, to find the autarky production point we simply find the indifference curve which is
tangent to the US PPF. This occurs at point C on the new US PPF along the original
indifference curve, I. (Note: the PPF was conveniently shifted so that the same
indifference curve could be used. Such an outcome is not necessary but does make the
graph less cluttered.) The negative of the slope of the PPF at C is given by the ratio of
quantities CS'/CC' . Since CS'/CC' > CSA/CCA, it follows that the new US price ratio will
exceed the one prevailing before the capital and labor shift, i.e., PC/PS > (PC/PS)0. In other
words, the autarky price of clothing is higher in the US after it experiences the inflow of
capital and outflow of labor.
India experiences an increase in L and a decrease in C. These changes will cause an
increase in output of the labor-intensive good (i.e. clothing) and a decrease in output of
the capital-intensive good (steel). If price were to remain constant, production would shift
from point A to D in the diagram and the Indian PPF would shift from the brown PPF0 to
the red PPF*. Using the new PPF we can deduce the Indian production point and price
ratio in autarky, given the increase in the capital stock and decline in labor stock.
Consumption could not occur at point D since homothetic preferences implies that the
indifference curve passing through D must have a flatter slope since it lies along a flatter
ray from the origin. Thus to find the autarky production point we simply find the
indifference curve which is tangent to the Indian PPF. This occurs at point E on the new
Indian PPF along the original indifference curve (I). (As before, the PPF was
conveniently shifted so that the same indifference curve could be used.) The negative of
the slope of the PPF at C is given by the ratio of quantities CS"/CC", Since CS'/CC" <
CSA/CCA, it follows that the new Indian price ratio will be less than the one prevailing
before the capital and labor shift, i.e., PC*/PS* < (PC/PS)0. This means that the autarky
price of clothing is lower in India after it experiences the inflow of labor and outflow of
capital.
All of the above implies that as one country becomes labor-abundant and the other
capital-abundant, it causes a deviation in their autarky price ratios. The country with
relatively more labor (India) is able to supply relatively more of the labor-intensive good
(clothing) which in turn reduces the price of clothing in autarky relative to the price of
steel. The US with relatively more capital can now produce more of the capital-intensive
good (steel) which lowers its price in autarky relative to clothing. These two effects
together imply that

Any difference in autarky prices between the US and India is sufficient to induce profit-
seeking firms to trade. The higher price of clothing in the US (in terms of steel) will
induce firms in India to export clothing to the US to take advantage of the higher price.
The higher price of steel in India (in terms of clothing) will induce US steel firms to
export steel to India. Thus, the US, abundant in capital relative to India, exports steel, the
capital-intensive good. India, abundant in labor relative to the US, exports clothing, the

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labor-intensive good. This is the Heckscher-Ohlin theorem. Each country exports the
good intensive in the country's abundant factor.
The Leontief Paradox:
Hecksher-Ohlin theory was first put on test by Wassily Leontief through empirical scrutiny.
Leontief found that the US, which was considered as a capital rich country, was exporting
labour-intensive goods and importing capital-intensive goods (contrary to the H-O theory).
It was termed as Leontief Paradox. For resolving the Leontief paradox several explanations
were looked. The key factors identified in support of Leontief paradox were: Protective
trade policy of U.S. government, investment in human capital and import of natural
resources.

3.2.6 Modern Theories of International Trade

3.3 Foreign Direct Investment (FDI) Theories

Foreign direct investment is a term used to denote the acquisition abroad of physical
assets, such as plant and equipment, with operational control ultimately residing with the
parent company in the home country. FDI may be for the purpose of a new enterprise in
an overseas country or expansion of an existing overseas branch or subsidiaries or the
acquisition of an overseas business enterprise or its assets.
Theories of foreign direct investment came in existence with the rise of multinationals. In
late 1950s theorists were dealing with an important question that how and why
multinationals select a particular country and start their business in that country. It was in
1960, when Hymer in his research revealed that the orthodox theories of international
trade and capital movements are unable to explain the involvement of multinationals in
foreign countries. This gave rise to the theories of foreign direct investment. Any theory
of FDI must give answer to following questions
 Why companies decide to invest abroad directly?
 Why companies give preference to direct investment over exporting or licensing?
 How companies compete with local firms in an unknown environment?
 How companies select countries for direct investment?
Theories of FDI can broadly be classified in four categories
 Market Imperfections Approach
 International Product Life Cycle
 Transaction Cost Approach
 Eclectic Paradigm

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3.3.1 Market Imperfection Approach

Hymer(1960) explained the role of market imperfection to FDI. According to him a
multinational invest its money overseas only when the company has certain advantages
not owned by local competitors. These advantages may derive from skills in
management, marketing, production, finance or technology. They may refer to
preferential access to raw materials or other inputs. This view was further elaborated by
Kindleberger(1969), who suggested that market imperfections offer multinationals
compensating advantage of magnitude that exceeds the disadvantage due to their lack of
origins within a host environment, and it is the financial effects of this that underpin FDI.
Market imperfection permits the multinational to exploit its monopolistic advantages in
foreign markets. Thus we can say that FDI is an outcome of imperfect market.
Market imperfection may arise in one or more of several areas- for e.g. product
differentiation, marketing skill, proprietary technology, managerial skills, better access to
capital, economies of scale and government-imposed market distortions etc.
Market imperfection may be created in number of ways
 Internal or external economies of scale often exists, possibly due to privileged
access to raw materials or to final markets, possibly from increase in physical
production.
 Effective differentiation may create substantial imperfection. This differentiation
may be in product, process, marketing and organization skills.
 Government policies have an impact on fiscal and monetary matters on trade
barriers.

Theory of FDI based on market imperfection suggests that foreign investment is undertaken
by those firms who enjoy some monopolistic or oligopolistic advantage. This is because,
under perfect market conditions, foreign firms would be non competitive due to the cost of
operating from a distance, both geographically and culturally. Presumably the firm going for
foreign investment has some unique advantage. Oligopoly theory may also explain the
phenomenon of defensive investment, which may occur in concentrated industries to
prevent competitors from gaining or enlarging advantages that could then be exploied
globally.

3.3.2 International Product Life Cycle Theory

Vernon(1966, 1977) developed a theory of FDI on the basis of product life cycle. It is based
on concept that a product passes through different stages which are predefined. Vernon
(1966) suggested that new products are developed in advanced economies only because
populations of these economies have sufficient income to demand new product. This theory
depends on following assumptions
 Production of products tries to achieve economies of scale.
 Tastes and preferences of customers are different in different countries.
 With the passage of time products undergo changes in their production technique,
marketing skills etc.
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International Product Life Cycle has following three stages

 New Product Stage
 Maturing Product Stage
 Standardized Product Stage
According to international product life cycle (IPLC) theory, the stimulus to innovation in
the development of new products or processes is typically provided by perceived
opportunity or threat in the firm’s major, generally the home, market. This market
provides both the source of stimulus for the innovation and the preferred location for the
product development. The nature of product development also influences the decision to
begin production first in the home market. Thus we can say that production of a product
with new “know-how” is initiated by the parent firm (‘youth stage of the product’) at the
home market, then by its foreign subsidiaries (‘maturity stage’) in other countries, and
finally anywhere in the world where costs are lowest (standardised stage). This also
provides a very good explanation of question that; why a product that begins as nation’s
export often ends up becoming its import?
The IPLC theory has two important tenets
(a) Technology is a critical factor in creating and developing new products.
(b) Market size and structure are important in determining trade patterns.
Note that the IPLC theory is useful in helping to explain how new, technologically
innovative products fit into the world trade picture, but because new innovative products are
sometimes rapidly improved, it is important to remember that different versions of the
product may be at different stages of the life cycle. E.g. one or two versions of the products
may be in the standardized product stage, while other versions are in the maturing stage, and
still others are in the new product phase.

3.3.3 Transaction Cost Theory

The transaction Cost Theory was conceived by Coase (1937) and further elaborated by
McManus (1972). This theory is based on the criticism of neoclassical economics which
arises from the non-realization of the assumptions of perfect competition. It stipulates the
conditions under which a company will or should choose to use the market, e.g. an agent or
importer, or when it will or should integrate the activities into the company by, for e.g.
establishing a production subsidiary abroad.
The theory stipulates that
If:
 Uncertainty about outcomes prevails, e.g. as to the size/stability of demand.
 Transaction i.e. buying/ selling, recur frequently, and
 The transaction require substantial transaction specific investments in, for e.g.
special production equipments
Then:
The economic activity will be internalized, i.e. carried out by the company itself
rather than transacted using the markets.
The reasons for this behavior is that companies and their managers are characterized by
bounded rationality and they may have opportunistic inclinations. To overcome bounded

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rationality and the potential opportunism, companies decide to products in house rather than
buy them from the market. Inhouse, managers are in control and it is possible to practice
incremental decision making, e.g. breaking a large investment decision into smaller ones.
Related to exports, the three conditions are often fulfilled: The outcome of going and being
international is uncertain; In many cases, transactions are repeated, and, often the exporter
must adopt to specific market conditions and thus make market or transaction specific
investments
However, the financial requirements, pursuing the internalization strategy, are often
comprehensive forcing the companies to adopt a strategy using the market, e.g. using agents
or importers, instead of establishing foreign subsidiaries.

3.3.4 Eclectic Paradigm

This eclectic theory for Foreign Direct Investments was developed by John Dunning. It is
also one of the contingency models. It explains the conditions under which a company
internationalizes through FDIs rather than by exporting. Thus, it shares the same basic idea
with the Transaction Cost Theory and it is also known as the theory which explains the
growth and development of growth and development of multinational companies.
According to the Eclectic Theory, for foreign direct investment to take place three
conditions are stipulated and formulated into OLI formula.
OLI Formula
Ownership Advantage
Ownership advantages are proprietary rights e.g. patent, which provide the firm with a
competitive advantage. An ownership advantage is necessary to overcome the basic
advantages a naturalized company has on its own market. Thus, an ownership advantage is
precondition for going international.
Location Advantage
Location specific advantage, i.e. advantage derived from superior factor or demand
endowment in the foreign country. The location specific advantage is precondition for
establishing production abroad whether by way of a license or an investment in a production
subsidiary.
Internalization Advantage
Internalization advantages, i.e. advantages derived from doing it yourself instead of using
the market. In case a market does not exist for, for e.g., the know-how possessed by a
company or the price offered is too low compared to the company’s own estimates of its
potential or, as in case of a license, the company cannot control the use of it, then the
company may decide to establish its own production or sales subsidiary abroad. Thus, an
internalization advantage is the precondition for investing abroad.

The above told three preconditions can be arranged to form a table of conditions under
which various market entry modes will prevail

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CHAPTER4 International Business Risk

4.1 Country Risk Analysis
4.2 Classification of Risk Involved
4.2.1 Political Risk
4.2.2 Economic Risk
4.2.3 Financial Risk

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4.2.4 Foreign Exchange Risk

4.3 Strategies for Managing Risks
4.4 Importance of Risk Analysis for International Business
Summary
Discussion Questions

Since long ago, cross-border business risk has been an issue that has worried those
individuals and organisations who have transactions or assets to receive from foreign
customers (residents in different countries). The possibility of a nonperformance was
always existing there. In the seventies, the world economy was facing a relevant liquidity,
plenty of dollars, most of them derived from the recycling of money earned by nations
that were members of OPEC. Their strong reserves were deposited in the international
banking system. At that time, the financial institutions were not well prepared to deal
with country risk but, looking for business, they quickly enhanced their exposure in
foreign markets, especially in developing ones, which traditionally require capital. In
several cases, the loans seemed to be contracted without regular attention to credit
procedures of both the borrower and the country. Since the eighties, some important
problems involving the payback of those credits have started affecting countries such as
Poland, Mexico and Brazil, whose defaults had caused heavy losses for the international
banks and, consequently, for its investors and shareholders. For instance, at that time,
over US$ 50 billion were invested in Latin America by the US top ten banks and their
provisions against losses had to be raised significantly to reflect and support new
conditions in their statements. So, the financial institutions were forced to adopt
maximum exposure risk policies, new analytical methods and strong credit procedures,
all of those supported by reliable data.
Following the rapid growth in the international debt of less developed countries in the
1970s and the increasing incidence of debt rescheduling in the early 1980s, country risk,
which reflects the ability and willingness of a country to service its financial obligations,
has become a topic of major concern for the international financial community. Political
changes resulting from the fall of communism, and the implementation of market-
oriented economic and financial reforms, have resulted in an enormous amount of
external capital flowing into the emerging markets of Eastern Europe, Latin America,
Asia, and Africa. These events have alerted international investors to the fact that the
globalisation of world trade and open capital markets are risky elements that can cause
financial crises with rapid contagion effects, which threaten the stability of the
international financial sector.

4.1 Country Risk Analysis

The globalization of the world economies, and in particular the internationalization of
financial markets in the last decades, have dramatically expanded and diversified
investment possibilities, leading to numerous new opportunities, accompanied by new
risks. Consequently, there has been growing interest in obtaining reliable estimates of the

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risk of investing in different countries. These concerns have led to the development of the
concept of country risk, and even to the regular publication of country risk ratings by
various agencies. The importance of ratings has been magnified by the recommendations
addressed in the Basel Capital Accord (2001), hat pinpoints the role of agencies’ ratings
for the assessment of credit risk.
Country risk ratings impact countries in a number of ways. The primary significance of
ratings is due to their influence on the interest rates at which countries can obtain credit
on the international financial markets: the higher the ratings (i.e., the lower the risk of
default) the lower the interest rate. Second, sovereign ratings also influence credit ratings
of national banks and companies, and affect their attractiveness to foreign investors.
Third, institutional investors are sometimes contractually restricted on the degree of risk
they can assume, implying in particular that they cannot invest in debt rated below a
prescribed level.
Country risk assessment evaluates economic, financial, and political factors, and their
interactions in determining the risk associated with a particular country. Perceptions of
the determinants of country risk are important because they affect both the supply and
cost of international capital flows. Risk rating agencies provide an independent analysis
of country risk and a consistent method of risk assessment. The leading risk rating
agencies are Standard & Poor’s, Moody’s, Euromoney, Institutional Investor, Economist
Intelligence Unit, and the International Country Risk Guide, all of which employ
different methods in determining country risk ratings. These rating agencies combine a
range of qualitative and quantitative information regarding alternative measures of
political, economic and financial risk into associated composite risk ratings.
The above discussion shows that the concept of country risk and creditworthiness have
become important over the years and despite analytical difficulties there has been growth
in interest in recent years among private and official lending institutions in the systematic
evaluation of country risk.
Country risk may be prompted by a number of country-specific factors or events. There
are three major components of country risk, namely economic, financial and political
risk. The country risk literature holds that economic, financial and political risks affect
each other. As Overholt argues, international business scenarios are generally political-
economic as businesses and individuals are interested in the economic consequences of
political decisions.
The lending risk exposure vis-à-vis a sovereign government is known as sovereign risk.
Sovereign risk emerges when a sovereign government repudiates its overseas obligations,
and when a sovereign government prevents its subject corporations and/or individuals
from fulfilling such obligations. In particular, sovereign risk carries the connotation that
the repudiation occurs in situations where the country is in a financial position to meet its
obligations. However, sovereign risk also emerges where countries are experiencing
genuine difficulties in meeting their obligations. In an attempt to extract concessions
from their lenders and to improve rescheduling terms, negotiators sometimes threaten to
repudiate their “borrowings”. Political risk is generally viewed as a non-business risk
introduced strictly by political forces. Banks and other multinational corporations have
identified political risk as a factor that could seriously affect the profitability of their
international ventures. Political risk emerges from events such as wars, internal and
external conflicts, territorial disputes, revolutions leading to changes of government, and

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terrorist attacks around the world. Social factors include civil unrests due to ideological
differences, unequal income distribution, and religious clashes. There may be some
external reasons also, For instance, if the borrowing nation is situated alongside a country
that is at war, the country risk level of the prospective borrower will be higher than if its
neighbour were at peace. Although the borrowing nation may not be directly involved in
the conflict, the chances of a spillover effects may exist. Additionally, the inflow of
refugees from the war would affect the economic conditions in the borrowing nation. In
practical terms, political risk relates to the possibility that the sovereign government may
impose foreign exchange and capital controls, additional taxes, and asset freezes or
expropriations. Delays in the transfer of funds can have serious consequences for
investment returns, import payments and export receipts, all of which may lead to a
removal of the forward cover.
Economic and financial risks are also major components of country risk. They include
factors such as sudden deterioration in the country’s terms of trade, rapid increases in
production costs and/or energy prices, unproductively invested foreign funds, and unwise
lending by foreign banks. Changes in the economic and financial management of the
country are also important factors. These risk factors interfere with the free flow of
capital or arbitrarily alter the expected risk-return features for investment. Foreign direct
investors are also concerned about disruptions to production, damage to installations, and
threats to personnel.

4.1.1 Reasons for Country Risk

Country risk may arise due to following any one or a combination of three broad risk
conditions:
 Availability of Resource
 Government Policies(Political Scenario)
 External Accounts(Economic and Financial Scenario)

It is important to remember that they are interrelated and often overlap with each other.

Availability of Resource
Any firm going for investment internationally firstly analyse the resource conditions of
country where it wants to invest. These resources may be natural, human and financial
resources.
Natural resources cannot in themselves make a positive contribution to a country’s ability
to earn or save foreign exchange with every country. While many countries do, many do
not.
Human resources refer to the extent to which a country’s population can contribute to
productive economic activity. It takes into consideration such factors as health, literacy,
productivity plans in the public and private sector, availability of technical and
managerial skills and the presence of an entrepreneurial class.
Financial resources refer to a country’s ability to save, which translates into a higher
proportion of investment it can meet with its own resources.

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A country’s resource base must be regarded in terms of historical trends rather than
simply present circumstances and its implications depend on the quality and effectiveness
of government, public and private sectors over a period of time.

Government policy
Another important reason for country risk analysis may be government policies of the
host country because it can and do strongly influence the economic and business climate
of any country. A government’s political philosophy affects economic policy as well as
the degree of regulation or assistance it exerts on internal commerce and external trade.
Aspects to consider include the quality of the economic and financial management
process, long-term development strategy and short-term policy measures. Regarding the
latter, particular attention should be given to fiscal, monetary, wage-price and foreign
exchange rate policies.

External accounts
External financial conditions relate to: balance for payments, external debt, international
reserves, and potential access to external finance. A negative balance of payments means
that the value of imports exceeds the value of exports and must be financed either
through foreign reserves or borrowings. If a country’s external debt level becomes
unmanageable, the foreign creditor’s risk of incurring blocked funds increases
dramatically. Heavily indebted countries can become a poor credit risk overnight if their
balance-of-payment position suddenly becomes negative due to declining world prices of
a major export. Countries generate foreign reserves from export earnings and foreign
borrowing. Reserves should be sufficient to permit payment of normal trade-related
liabilities without undue delay and also to provide some cushion in case of unanticipated
adverse developments. In this regard, it is also important to evaluate a country’s potential
access to external finances -- the country’s drawing ability from the IMF, borrowing
capacity from the World Bank, regional development banks, bilateral official sources and
international commercial banks.

4.1.2 Country Risk Indicators

Appraisal of any country’s overall creditworthiness is both quantitative and qualitative.
The quantitative aspects of the analysis incorporate a number of measures of economic
and financial performance and contingent liabilities. The analysis is also qualitative due
to the importance of political and policy developments. It should also be emphasized, as
mentioned above, that country risk is an integral part of the assessment of country’s
creditworthiness.
The risk indicators, which are used by the different agencies, are designed to evaluate the
economic growth, monetary and fiscal policy, and external flexibility profiling that are
part of assessing a country’s creditworthiness. In the country risk analysis agencies
examine hard economic data such as real GDP and real per capita growth, the budgetary
performance, public sector indebtedness and its cost in terms of revenue, the consumer
price index, external liquidity, and solvency indicators. Based upon these macroeconomic
variables and on qualitative aspects profiling the quality of economic growth, fiscal and
monetary policy, and external conditions, each country is ranked. In analyzing country

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risk and creating a system of rankings, the overall socioeconomic, political, and
regulatory picture for each country is looked.
Following can be some of the indicators for country risk rankings:
Corruption perceptions
An annual Corruption Perceptions Index (CPI) is compiled by Transparency International
which surveys a broad spectrum of national and regional sources to analyze the extent to
which corrupt practices plague public officials in over 160 countries. Corruption can be
defined as the "abuse of public office for private gain". The CPI is, in itself, a composite
index of corruption-related data and, as a result, serves as an ideal measure on which to
base our own composite country risk scores.
Ease of doing business
The ease of doing business rankings serve as insightful analyses of a country's private
sector and suggest paths forward for developing economies and they also indicate the
level of regulation in place that either enhances or constrains the ability to conduct
business. In the context of country risk, the Doing Business rankings identify the extent
to which the private sector is freely functioning.
In 2006, the World Bank released its updated Doing Business rankings, which monitor
the environment for business and entrepreneurship across 155 countries. As with the CPI,
the Doing Business rankings are compiled as a composite overall score that ranks
countries on categories from the steps to start a business to the enforcement of contracts.
Human development
The U.N. Human Development Index (HDI) serves as the benchmark metric for global
poverty. Employing some 30 separate indicators ranging from technology diffusion to
literacy and enrollment, HDI draws from each of the Millennium Development Goals. It
is the most comprehensive poverty level indicator for our country risk statistics and
serves as the linchpin for the overall country risk composite.
Income equality
This indicator highlights the level of poverty within a country with a proven, direct link
to the risk profile and to the breath of the gap between the rich and the poor.

Some agencies categorises these indicators in three important categories: political,

economic, and financial indicators. Political risk indicators include all those factors
which are associated with the political and social system of the country. Economic risk
indicators are the indicators which are associated with the economic health of the
individual residents of the country as well as with the economic health of the overall
economy. Similarly financial risk indicators are associated with the financial structure of
the country.

4.3 Classification of Risk

When we analyse the international business scenario, we find that there are various types
of risks involved. But fundamentally we can classify these risks into following three
types:
 Political Risks

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 Economic Risks
 Financial Risks
 Foreign Exchange Risks

4.3.1 Political risks

The world is turning into a global market place and multinational enterprises are as a
consequence exposed to more and more risks of various kinds. One of these risks is
political risk, which implicates the risk of negative effects for a company due to political
actions. Managers of these multinational enterprises rank different countries primarily on
the basis of political scenario of that country. They know that the change of the
government with different ideology affects the returns from the investments made in
those countries. This risk increases in case of less developed countries. But we cannot say
that developed countries do not have the political risks. It has significance in case of
developed countries as the volume of investment is very large in these countries.
Expropriation, currency controls, requirements for additional local production are just a
few examples of political risk.
Robock was one of the first to address the issue of political risk in 1971.Since then,
political risk has been debated in the management. Robock had defined political risk as
“when discontinuities occur in the business environment, when they are difficult to
anticipate, and when they result from political change”. This definition does not clearly
state that social factors such as strikes, riots and boycotts are included in the political risk.
In its most simple definition, political risk refers to the possibility that political decisions,
conditions, or events in a country will affect the business climate in such a way that
investors will lose money or not make as much money as they expected when the
investment was made. Many of the earlier works on political risk defined political risk as
government interference with business operations. Shapiro defined it as any “government
intervention into the workings of the economy that affects, for good or ill, the value of the
firm”. These definitions clearly indicates that the main influencing factor is the type of
political system, but other factors are ethnic/ religious conflicts, foreign government
intervention and economic stress. The definition of Kennedy provides some more
concrete examples of factors included in political risk “Political risk can be defined as
the risk of a strategic, financial, or personnel loss for a firm because of such nonmarket
factors as macroeconomic and social policies (fiscal, monetary, trade, investment,
industrial, income, labour, and developmental), or events related to political instability
(terrorism, riots, coups, civil war, and insurrection).”
As discussed in above paragraphs political risk ranges from expropriation of a company’s
properties to the kidnapping of its business representatives, But most important type of
political risk is expropriation. Expropriation is the act of taking possession of an item of
property from its owner in exchange for little or no compensation and irrespective of the
wishes of the original owner. The term is used to both refer to acts by a government or by
any group of people.

4.3.2 Economic Risk

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Economic risk can be defined as the impact on business environment of any country by
the economic mismanagement. This economic mismanagement will cause a drastic
change in the environment and in turn will adversely affect the profit and other goals of
any multinational. The inflation is the most important problem which arises due to
economic mismanagement.
There are views that economic risk and political risks can not be differentiated. As we
know that economic mismanagement, which is creating economic risk, can create social
unrest which will be a cause for political risk.

4.3.3 Financial Risks

Financial risks depnds upon the specific method of financing the firm or a particular
project in overseas market. The debt-equity ratio affects the capital structure of the firm.
If a firm performs badly and it is not able to pay the interest and premium on the debt
then it increases more risks for the investors by having preference for the equity capital. It
is so because the equity holders are paid after the lenders have been paid their
outstanding amount.
Moreover, a firm anticipating high financial risk would not prefer loan even at low
interest rate whereas the another firm with low risk would like to borrow at high interest
rate. The firm within the same industry may have high or low preference for debt-equity
ratio depending upon the economic conditions of different countries and the efficiency of
financial institutions.
The financial risks may be minimised by entering into floating interest rate and multi
currency contracts. The floating interest rate permits adjustment every six months or so as
agreed upon. It reduces the risks of both the borrowers and lenders. If the interest rate
falls after the loan is finalised, the borrowers suffer but they are protected because of the
possibility of adjustment under floating interest rate agreement. The loans may also be
arranged interms of multi-currency contracts and the fall in value of one or more
currencies may be compensated by the rise in the value of others. In addition, there are
also the hedging provisions in the financial markets to protect the international business
from the financial risks.

4.3.4 Foreign exchange risks

The result of country risks is foreign exchange risks -- the ability and willingness of the
foreign government to make enough foreign exchange available to its citizens, foreign
residents, private and publicly owned companies and government owned agencies to pay
their foreign currency denominated liabilities or debts.
Over the past 50 years, there has been a huge increase in cross-border flow of goods,
services and investments. While fueling global economic growth, this increase has also
made companies highly vulnerable to fluctuations in foreign exchange risks. That
vulnerability has been exacerbated by the dissolution of the Bretton Wood Agreement of
1971 and the resultant floating of currency, which has caused foreign exchange markets
to be plagued by growing instability.

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Like any other commodity, currencies follow laws of supply and demand, which are
subject to political and economic conditions. Exchange rates can fluctuate wildly,
sometimes several times in one day, severely complicating a company’s short-term
financial and long-term strategic decisions.
Foreign exchange risk includes both a country’s sovereign and transfer risks, in addition
to exchange controls.
Sovereign risk refers to the inability of a government to raise sufficient amounts of
foreign exchange to service its foreign currency debt obligations. Credit managers should
not assume that risk is diminished simply because a credit sale is to a foreign government
entity. When a country experiences adverse country risk conditions, the government
entity is likely to be subject to many of the same adverse conditions as private sector
companies.
Government entities often have access to decreasing foreign exchange reserves; however,
that access varies among government and country owned or operated industries.
Transfer or convertibility risk refers to the inability of companies in the private sector to
raise foreign exchange, even though they are in good financial condition. A vast majority
of international trade is carried on in US dollars because many nations use the US dollar
as their base reserve currency.
Many companies invoice their export credit sales in not only US dollars but also other
hard currencies (major trading currencies) and some soft currencies as well. Since the
foreign purchase must convert its local currency into US dollars or another bulling
currency to pay the bill, the transaction incurs a transfer risk.
In other words, the invoiced currency may not be available when the purchaser tries to
pay the bill. When feasible, you can solve the problem by arranging for collection in
advance or by transferring the risk to a third party.
Exchange controls refer to government-imposed controls, the underlying purpose of
which is to stabilize the country’s currency. Credit people must be aware of exchange
controls that affect extension of credit, payment terms and collections within normal
credit policies. For example, exchange controls may prevent a foreign buyer from
remitting US dollars to the seller.
Credit managers should never underestimate the importance of country risk analysis
because political and economic instabilities of countries have and will continue to have a
tremendous impact on the trade of goods and services between nations. Country
conditions that could affect the foreign customer’s ability and willingness to pay
maturing debt obligations in a timely fashion should form the basis for choosing whether
or not to proceed into customer risk analysis.

4.4 Strategies for Managing Risks

Successful businesses take calculated risks to achieve objectives. Globalization,
deregulation, Web-based services, complicated financial instruments and contracts,
emerging markets—all contain tremendous potential advantages for companies and carry
the danger of huge mistakes or unexpected developments. Businesses must measure these
risks, try to minimize them and—if possible—use them to their advantage.
Although each business may have its own unique approach to risk management, but may
be taken as step by step process for managing the risks:
 Analysis of company’s strategy.
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 Identification of the risks.

 Analyse and asses the risks.
 Design response strategies.

Analysis of company’s Strategy

Risk management can get success only when it works within the context of a company’s
environment, goals, objectives and strategies. Organizations may differ greatly in their
risk tolerance and management styles. Deposit-taking institutions necessarily place a high
value on solvency and the preservation of capital. Their investors and customers expect a
good return with little risk. Companies that prospect for minerals or develop high-tech
products focus on big rewards in exchange for big risks. Their investors typically
understand this trade-off and the significance of such an organization’s appetite and
capacity for risk. That is why first step in finding out strategy for risk analysis could be to
examine a company’s business environment and risk tolerance.
Once a company understands the risks of an undertaking, the owners or management can
develop a strategy for containing them. This may involve formally structured policies and
procedures or an informal process, depending on the business. As part of the risk
management process, company can ask following questions:
 What are our objectives?
 What are our values?
 Who is accountable?
 Who has the authority?
Questions like these can help establish the context for an organization’s risk management
efforts.

Identification of Risks

Managers need a systematic approach for uncovering and addressing risks that might
affect a company’s success. Now the question rises that what are those risks? What kinds
of risks might a business typically discover? When we analyse the different types of risk
situations, we find that all different types of risks comes under the umbrella of Political,
Financial and Exchange rate risks. Following may be some of the specific types of
research:

Brand Equity Risk- It is the risk which could affect the company’s brand name or
reputation.
Customer Satisfaction Risk- When company’s performance reflects poor consumer
reception towards its products, it is known as customer satisfaction risks.
Product Quality Risk- When company’s products reflect problem relato the quality
parameters.
Catastrophic Risk- It usually covers the political, natural or other disasters.
Regulatory Risk- This risk is fundamentally related to the political changes which are
affecting the businesses.
Cultural Risk- This risk can arise due to change in the culture which can change the

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attitudes of the consumers.

Trade War Risk- It could be the result of price cutting or other competitive practices.

Analyse and Asses the Risk

When the company is familiar to the types of risks it is going to face during its
international business journey, it needs to rank them. After ranking the risks company has
to establish the priorities in order to make decisions. In the analysis and assessing the
risks involved quantitative data play an important role. This quantitative data provides a
platform for the purpose of making any conclusion and finally to provide a platform on
which company can take certain decision.

Design Response Strategies

After the quantification of the risks which the company is to face following responses can
help to overcome those risks:

Avoid- If the threat associated with an opportunity is too high relative to the potential
reward, it may be appropriate to drop the idea. However, some executives—and entire
company cultures—may unwittingly encourage risk aversion, which can result in missed
opportunities.

Transfer- The Company can shift risk to third parties by buying insurance; by using
financial instruments, such as derivatives; by outsourcing some parts of the process; or by
creating partnerships or strategic alliances. Transferring risk can be a smart strategy—but
part of the due diligence is ensuring that the organization accepting the risk can fulfill its
obligations.

Mitigate- To increase the chances of achieving objectives, the company can establish and
monitor critical success factors and key performance indicators. These critical success
factors and key performance indicators can signal whether a strategy is working or
failing.

Accept- Companies may be able to live with some risks. For example, a mining company
facing fluctuating mineral prices may conclude the profit opportunities outweigh the
risks.

4.5 Importance of Risk Analysis for International Business

Country risk has become a topic of major concern for the international financial
community over the last two decades. Various risk rating agencies employ different
methods to determine country risk ratings, combining a range of qualitative and

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quantitative information regarding alternative measures of political, economic and

financial risk into associated composite risk ratings.
The surge in FDI around 1980's has increased and complexified the nature, quality and
amount of risk faced by MNCs. The traditional framework of dealing with risk, which
includes the efforts made to define, to assess and to manage risk on corporate level, is
transformed. One of the distinctive features of the modern management of risk is the use
of international institutional arrangements or framework to offset the risk. This intensive
use of institutional arrangements to manage risks coincides with the development of an
international investment law dealing with the stabilization, the transparency and the
promotion of the investment area. This process of institutionalization of investment is
favoured by the generally positive attitude of LDCs towards the FDI. Surely the
development of accepted investment rules on international level can reduce the impact of
risk on FDI. But this development can not remove the fear of risk for multinationals. The
multinationals have to measure the risk before the investments as well as they have to
develop a genuine business plan to face it.
Following actions can be prerequisites for any country which is attracting foreign
investment. These points can reduce the risk involved in international business and also
can increase the country risk rating:
 To support the market forces (market capability of the country).
 To coordinate with the international organizations, engaged in the activities of
promoting international business, to implement international rules and regulations
(international commitments).
 To maintain civil peace and provide the security (security capability).
 Sharing of reliable information civil society and international institutions
(transparency capability).
From these enumerations, one can derive that all measures which directly or indirectly
are not satisfying these conditions should be counted as risk. In considering the risks in
their strategies, MNCs as the symbolic motors of the globalization should be aware of
this theoretical implication.
As could be seen, country risk analysis is not an easy task. It demands a holistic vision,
specialized skills and persistent approach. After dealing with the macroeconomic, socio-
political and financial aspects, the analysis has to clearly show the strengths and
weakness of a country, in order to define a risk level. Managing the risk of a portfolio
demands a systematic follow up concerning to external and internal environment,
governmental policies, outlook provided by rating agencies, and so on.

CHAPTER5 Ethics and International Business

5.1 Business Ethics
5.1.1 Approaches to Business Ethics

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5.1.2 Changes in Ethical Aspects Around the

World
5.1.3 International Business Ethics
5.2 Principles of International business ethics
5.3 Ethical problems and concerns around the world
5.4 Social Responsibility of International Business
5.4.1 Analytical Model to Resolve Social Conflict
5.4.2 The Nature of Social Responsibility
5.5 Corporate Social Responsibility
5.6 Corporate Social Responsibility in Indian Context
Summary
Discussion Questions
Case Study

The organizations involved in international business, by their nature, are guests in foreign
countries. Since they are guest, they are expected to abide by the norms and values of the
host countries. Most of the organizations involved in international business try to be a
good corporate citizens of the country in which they are operating. However, at times,
demands of the various host and home countries conflict. Consequently they often
encounter “no-win situations”. Sometimes it also happens that wrong doing of few
organizations shed doubts on the proper conduct of international business.
In the days of industrial revolution it was believed that "all is fair in love, war and
businesses". People became unscrupulous when it came to business ethics. All they
thought about was profit and making money. They had no qualms about treating their
workers badly or taking over companies by deceit. Business was as a business man did.
All that was noticed was the turnover or the revenue that the business generated.
However, as the business world evolved and intellectual rights came into play, some new
terms were coined by organisations. These terms, "business ethics and social
responsibility”, were defined as the method of incorporation of moral values such as
honesty, trust, integrity, respect into a company’s strategies, decision making and
practices. The earlier trend followed in the companies was to define a certain set of rigid
do’s and don’ts for the employees. These days’ companies are seeking to incorporate
such moral values into their agendas that help employees to think and make decision on
their own. These values also help in building up the brand image of the company amongst
its employees, shareholders and customers.
Thus the issue of the ethics and social responsibilities of international business,
although serious, has no easy solution.
Why we are talking about business ethics or social responsibility for business
organisations? Answer to this question is very simple as in any business activity
organization as well as society both are involved. Both have their importance because
business (domestic or international) activities are basically a mode for providing
necessary goods and services to the society. In other words we can say that business and
society both are in an implied agreement or contract. In this contract business
organizations can use resources of the society and will provide goods and services to the

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consumers and will also enhance the general interest of consumers as well as their
employees. Society may also expect that business organizations will follow the social and
legal system of the country. Thus we can say that there is a “social contract” between
society and business. Since it is a contract, hence there must be some rules, codes which
can decide the minimal duties of business professionals and business organisations.
However, the subject of business ethics and social responsibility also deals with the
internal workings of the company. It defines the role played by the company in managing
internal relationships between the employees and the management and its shareholders.
By following business ethics and social responsibility the organizations can help
themselves in different ways like: The organizations will be able to avoid lawsuits, fines
and criminal charges; the organizations can build and strengthen their brand image; can
increase their sales and customer base; the employees of such companies are found to be
more loyal and committed which in turn helps prevent employee attrition and the added
cost of recruiting and training new employees.

5.1 Business Ethics

World number one companies like Enron have crumbled to dust in few months on the
issue of business ethics. What is business ethics and why is it so important for the
survival of any company? Business ethics is an unwritten code which has been a part of
the business dealings world over for ages. Then the question rises why we are so much
interested in business ethics now days? The answer lies in the concept of today’s business
i.e. “Customer is King”. The customers are very much choosy about what they buy or the
brands they want to associate themselves. Now days customers take home not only
physical product but also the good experience attached with the brand image of the
manufacturing organization. They want to trust the people and the organizations which
are dealing businesses with business ethics. The following are the core beliefs which
govern the subject of business ethics:
 Organisation’s values, vision and mission clearly indicates the business ethics
policies which are going to be followed.
 Veracity is a core of business ethics. Commitments are honored and respect is
given to all.
 Justice is implied by the business ethics.
 Ethics in business is truth personification.
 Business ethics are an offshoot of personal moral values.
 In business ethics employees and customers are treated same.
 Trickle down approach is followed by business ethics.

Successful business organizations like G.E., Wipro, and TCS have survived the turmoil
of time primarily because of their deeply ingrained value systems and ethics. These
values and ethics are not new. They are as old as time. They are taught to all children in
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schools from the very beginning. All these values are the anchors of a business. An
ethical business does not just believe in making profit, it also believes in fostering a long
term relationship between its customer, employees and itself. Trust, loyalty, commitment
etc are the fundamental qualities on which a business survives. A business without these
ethics is sure to go down in the initial years of its conception.
Business ethics focuses primarily on individual behavior of professionals (managers).
Thus we can say that ethics in international business depends on moral judgment about
the right or wrong actions taken by managerial cadres of the organizations. International
business ethics refers to the business conduct or morals of multinationals in their
relationship with individuals and entities. Such behavior is basically guided by the
religious, cultural and value system i.e. why ethics for multinationals do not have any
world wide rule book
5.1.1 Approaches to Business Ethics
Regarding business ethics there are various schools of thoughts but generally there are
two basic approaches. These approaches can help managers to examine there personal
ethics, as well as help them to find the ways to work with those who are having different
ethical perspective.

Teleological Perspective
This perspective of business ethics says that rightness or wrongness of any judgment or
action can be made by the consequence of that judgment or action. Result of any action,
either good or bad, determines that the decision taken or action performed was right or
wrong. Most popular and widely accepted teleological perspective is “Utilitarianism”
which can be described as the greatest goods for the greatest number.
This system has criticism that individual actions that can be justified from a teleological
perspective may in the aggregate produce less good for human well-being.
Deontological Perspective
When we talk about deontological perspective we say that good or bad consequence can
be one criterion for judging the right or wrong, but another important criteria is the
intention of the implementer. If the implementer’s intentions are consistent with the
principle of morality, then motives of actions should be considered in addition to the
consequences. The best known deontological system is developed by Immanuel Kant.
The basic imperative of his system was “Act according to the maxim that you would will
to be a universal rule”.
Most of the deontological systems fail to explain why a principle or right should be given
moral standing. Often a teleological system is used to defend a deontological system.

5.1.2 Changes in Ethical Aspects Around the World

It is a question of discussion that why ethics changes with the change in geographical
area? Answer of this question will tell us importance of ethics for international business.
To find the answer we have to find the relation of ethics with other aspects like awareness
about human rights, regulations, levels of corruption etc. In following points we study
these different aspects one by one.

Ethics and Human Rights

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Definition of ethical aspects related to human rights changes with the change in the
country of operation. Firms, which are coming from the democratic countries and
operating in totalitarian countries, normally face ethical dilemma that how to deal with
human rights. In totalitarian countries government violates human rights very frequently.
As we can take example of communist countries like China human rights violation is
very common phenomenon, while in countries like U.S. human rights violation is
consider as a crime.
There are two sides of this issue. On one side some people argue that investing in
totalitarian countries provides comfort to dictators and can help prop up repressive
regimes that abuse basic human rights. In contrast to this argument, some argue that
western investment, by raising the level of economic development of a totalitarian
country, can help change it from within. They note that economic well being and political
freedom often go hand in hand.
Ethics and Regulations
It is the second important ethical issue that an international firm should adhere to the
same standards of product safety, work safety, and environmental protection that are
required in its home country. This point is mainly concern with the western organizations
where laws related to above stated issues are very tight.
Ethics and Corruption
Should multinationals pay bribery to corrupt officials of host country to gain market
access in that country? In most of the part of world bribery is considered as morally
repugnant way of doing business.
Ethics and Religion
As we know that religion is a system of shared beliefs and rituals that are concerned with
the realm of sacred. Ethics is understood as set of moral principles that are used to guide
and shape behaviour. Most of the world’s ethical systems are the product of religions.
Hence we can say that to understand ethical system of any country, managers of
multinational have to understood. Relationship between religion and ethics is very subtle
and complex. There are thousands of religions in the world which can result thousands of
ethical aspects of business.

5.1.3 International Business Ethics

The world has shrunk to a global village today. The internet has made the world a very
small place. It is now possible to sit at home and confer with many international clients.
E-mails, phones, chats have all enhanced communication the world over. Employees in
one country may be interacting with employees of a country they have never even visited.
Due to this there may be times, where cultural differences can create a misunderstanding.
At certain instances, certain statements, which are viewed as acceptable in one culture,
may be taken as an offence in the others. Hence it becomes essential to follow certain
unspoken rules of international business ethics to keep the relationships harmonious and
professional.
These rules require that a research be done on the people on the other side of the globe to
know their general customs and dos and don’ts of their culture.
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 Fostering associations: It is important to know your clients and their customs. It

is also important to build affinity with your clients and know their tastes and
habits. In business building trust is of paramount importance and can lead to
successful and profitable relationships.
 Dressing sense: Understanding the dressing etiquette of the people you are
dealing with is important. People of certain cultures like to dress conservatively
and others may be more informal. Hence it is important to dress appropriately
while dealing with international clients.
 Respect the chain of command: Certain cultures have certain rules about
decision making, especially when traveling in a group. It is important to know the
customs and the protocols of decision making to avoid embarrassment.
 Handshake custom: Different people have different styles when it comes to a
handshake. While the American handshake is a firm grip with two quick pumps
and eye contact and a smile, the Japanese believe in a brief handshake. In many
cultures, a kiss and a hug are also customary. Thus it is important to research and
know the handshake customs when it comes to dealing with international cultures.
 Address tradition: It is important to know how to address a person in the culture
you are dealing with. In certain cultures, it may be considered a rude gesture to
call people by their first name. The safest thing to do in such scenarios is to use
the title and the last name till the person himself gives you the permission to use
their first name.
 Time adherence: Different cultures see time differently. While the Americans
are time conscious and punctual, in many other cultures it may not be so. In
certain cultures, it may be customary for a person of a senior cadre to arrive last.
It is important to stick to guidelines but also respect the custom of the other
person.
 Personal space customs: Different cultures have different perspectives when it
comes to their space issues. Americans do not like anyone infringing their
personal space, while in some cultures it is considered customary to stand close
and talk. Understanding the culture may help prevent awkward situations in this
regard.
Understanding international customs can play a great role in cementing bonds across the
globe. If you want to increase your global presence, remember this rule: When in Rome
do as the Romans do!

5.2 Principles of International Business Ethics

(Adopted from the International Business Ethics Institute)
More and more companies conduct international transactions as a part of their daily
operations. International situations are particularly prone to ‘gray areas’ because norms
and practices that guide ethical behaviors vary across cultures. The ethical decision about
what to do in some international business situations is not always clear. Sometimes, a
decision about ethics is not ‘black or white,’ but is in the ‘gray area’. In this chapter, a
description of a dilemma that requires discussion about international business ethics is
presented.
Most experts in international business ethics agree that an international code of ethical
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practice, and not a code based on each individual culture’s unique norms and practices, is
essential to global economic survival in the 21st century.
Experts have created a list of principles to guide international. These principles are
summarized here:
 Integration – Business ethics must permeate all aspects of organizational culture
and be reflected in key management systems. Companies start by integrating
ethics into goal setting and hiring practices. When promoting workers to higher
levels within the company, ethical principles guide incentive programs.
 Implementation – Ethical conduct is not just an idea, but requires the
implementation of a plan of change in specific areas of work in the company.
Some examples are efforts to modify personnel appraisal processes, promotion of
improved environmental practices, and referrals to specialists, when needed.
 Internationalization – Increased internationalization is necessary to all
successful business in the 21st century. Internationalization is achieved through
the formation of international partnerships, trading blocs, and implementation of
GATT and other free trade agreements. Clarification of an organization’s own
definition of integrity that transcends national borders is necessary. A resulting
program is not culturally defined and requires little or no modification when
applied in global contexts.
How Ethical Decisions Are Made
Ethical decisions are made by business leaders based on these considerations:
 How can employees feel fulfilled professionally?
 How can customers be satisfied?
 How can profit be assured for stake holders or share holders
 How can the society be served?
Many pressures affect business leaders. Ethical considerations are sometimes difficult for
business leaders when they must choose among different priorities. Making decisions
based on the needs of employees, customers, stakeholders and the community requires a
good leader. What do good leaders do in order to achieve ethical standards?
Laws
First, there are laws that guide business leaders. Breaking laws can lead to arrest and
imprisonment.
Individual Ethics
Laws are not always enough to assure ethical behaviors. Heads of the organizations can
set examples for employees by there ethical decision making.

5.3 Ethical Problems and Concerns Around the world

As we have discussed ethics is basically a system of moral principles- rightness or

wrongness of business doing. And since ethics depends upon religion, culture and value
system of the country hence it varies from country to country. As in US, the approach is
to treat everyone the same by making moral judgments based on general rules. Managers
in Japan and Europe tend to make such decisions on shared values, social ties, and their
perception of their obligations.
Corruption perception index www.gwdg.de

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The biggest ethical problem for multinationals in their attempt to define a corporate wide
ethical posture is the great variation of ethical standards around the world. Many
practices that are considered unethical or even illegal in some countries are accepted
ways of doing business in others. Another problem in front of multinational managers is
that of payments which can be termed as questionable payment i.e. when payment for the
completion of any specific task is judged on the moral grounds either in host countries or
home countries. These payments can be termed as bribery.
Bribery payer index From internet
Ethics is now a days gaining attention of the whole world due to following several
reasons
 Ethics is a result of basic personality trait of human being which states that man
desires to be ethical, not only in his private life but also in his business affairs.
That is why ethics is a consequence of basic human needs.
 An organization indulge in ethical business gets more credibility among
customers and is appreciated by society.
 Internally also organizations get credibility among shareholders and employees.
 Use of ethics helps in better decision making.

Ethics is the study of morality and standards of conduct. In recent years a growing
number of multinational corporations have formulated codes of ethics to guide their
behaviour and ensure that their operations conform to these standards worldwide. Ethics
plays an important role in the study of international management because ethical behavior
in one country sometimes is viewed as unethical behaviour in other countries. Ethical
norms and guidelines change from one country to another that is why multinationals have
to rely on their local teams to execute under host country’s rules. Mnay multinationals
have decided to confront concerns about ethical behaviour by developing worldwide
practices that represent the company’s posture. Following are some of those policies
 Development of worldwide code of ethics.
 Ethical issues are considered during strategy development.
 In case of unsolvable ethical problems, withdrawal from the problem market.
 Development of practice of printing ethical statements.
Code of conduct of any company from internet

5.4 Social Responsibility of International Business

Social responsibilities involve not only the corporate philosophy, value, and culture but
also the manager’s beliefs, values and ethical standards. Those who argue that “business
of business is business” ignore that business because it does not exist in vacuum. It is part
and parcel of society, and business decision makers are social creatures.
To whom business is responsible customers, employees, stockholders, community,
government, suppliers, distributors or the society as a whole? Answer can be to all. Since
the responsibility is towards to many facets so it is very important for any multinational
first to plan and then implementation.

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Social responsibilities of managers from multinationals receive attention of masses or in

other words we can say that society as a whole. Whenever a corporate scandal occurs it
becomes headline of news paper. Schmidt had rightly said “News of a faulty product,
pollution of environment, bribery or some other gross misuse corporate power causes
people to ask what kind of people are running our companies, anyway?”
In contrast to domestic companies, multinationals are working in very much unknown
and very less defined situations in which the rules are far more diffuse, contradictory, and
a times fast changing. Under these circumstances, the consequences of social conflicts
can be far more severe. Concept of social responsibility includes the expectation that
multinationals themselves with the social and economic effects of their decisions. The
issue is how far that multinational should go and what level of planning and control that
multinational should take. In domestic businesses, firm is responsible only towards one
own country while in case of multinationals firm is responsible towards the home country
host country, employees of home and host country and as well as towards the society of
rest of the world also.
As we know that a multinational has to respond towards following fronts – Home
country, Host Country, Employees of home and host country and the society of rest of
world. Each stakeholder should be satisfied by the policies of multinationals.

5.4.1 Analytical Model to Resolve Social Conflict

An analytical model given by Thomas N. Gladwin and Ingo Walter states that any
multinational can follow five strategies to resolve social conflict
Competitive Strategy: When multinational’s stakes and power are relatively high,
interest interdependence and relations are relatively negative (domination as objective)
Avoidance Strategy: When multinational’s stakes and power are relatively low, interest
interdependence and relations are relatively hostile (negligence as objective)
Collaborative Strategy: When the multinational’s stakes and power are relatively high,
interests interdependence and the relations with the opposition are relatively positive
(integration as objective)
Accommodative Strategy: When the multinational’s stakes and power are relatively
low, interest interdependence and relations are relatively positive (appeasement as
objective)
Compromise Strategy: When multinational’s stakes are moderate and power advantage
or disadvantage is slight, interest interdependence and relations are a mixture of positive
and negative elements (sharing as objective)

Figure on Page 60 of International Management of Nrgandhi

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5.4.2 The Nature of Social Responsibility

There are four dimensions of social responsibility: economic, legal, ethical, and voluntary
(including philanthropic) Earning profits is the economic foundation, and complying with
the law is the next step. A business whose sole objective is to maximize profits is not
likely to consider its social responsibility, although its activities will probably be legal.
(We looked at ethical aspects in the first half of this chapter.) Finally, voluntary
responsibilities are additional activities that may not be required but which promote
human welfare or goodwill. Legal and economic concerns have long been acknowledged
in business, but voluntary and ethical issues are more recent concerns.
A business that is concerned about society as well as earning profits is likely to invest
voluntarily in socially responsible activities. For example, some companies, such as
IOCL, BHEL, HUL, and ITC support numerous social initiatives. Such businesses win
the trust and respect of their employees, customers, and society by implementing socially
responsible programs and, in the long run, increase profits. Although the concept of
social responsibility is receiving more and more attention, it is still not universally
accepted.
Following are the some of the arguments for and against social responsibility

For:
 Business helped to create many of the social problems that exist today, so it
should play a significant role in solving them, especially in the areas of pollution
reduction and cleanup.
 Businesses should be more responsible because they have the financial and
technical resources to help solve social problems.
 As members of society, businesses should do their fair share to help others.
 Socially responsible decision making by businesses can prevent increased
government regulation.
 Social responsibility is necessary to ensure economic survival: If businesses want
educated and healthy employees, customers with money to spend, and suppliers
with quality goods and services in years to come, they must take steps to help
solve the social and environmental problems that exist today.

Against:
 It sidetracks managers from the primary goal of business—earning profits. Every
dollar donated to social causes or otherwise spent on society’s problems is a
dollar less for owners and investors.
 Participation in social programs gives businesses greater power, perhaps at the
expense of particular segments of society.
 Some people question whether business has the expertise needed to assess and
make decisions about social problems.
 Many people believe that social problems are the responsibility of government
agencies and officials, who can be held accountable by voters.

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5.5 Corporate Social Responsibility

By the late 1990s, many multi-national corporations (MNCs) were redefining their role in
society and their responsibility to human rights and the environment. This phenomenon,
termed corporate social responsibility (CSR), has since received considerable attention
from supporters and critics alike. Supporters claim that CSR provides corporations with
an opportunity to do well while doing good. Critics counter that CSR, as a voluntary
initiative, is little more than a public relations strategy to increase market share and boost
corporate profits.

As the corporate social responsibility movement grew, many companies pledged to

improve their social and environmental performance based on the principles of CSR.
Some companies made a business case for CSR, arguing that it can enhance profitability
by reducing the risk of negative publicity, consumer boycotts, and shareholder activism.
Other companies made an ethical case for CSR, arguing that corporations have a moral
obligation to people and the planet which supersede the singular pursuit of profit.

A single globally accepted definition of CSR does not exist as the concept is still
evolving. The language used in relation to CSR is often used interchangeably with other
related topics such as corporate sustainability, corporate social investment, triple bottom
line, socially responsible investment and corporate governance. However, various
individuals and organisations have developed formal definitions of CSR, including
 The commitment of business to contribute to sustainable economic development,
working with employees, their families, the local community and society at large
to improve their quality of life.(World Business Council on Sustainable
Development).
 Operating a business in a manner that meets or exceeds the ethical, legal,
commercial and public expectations that society has of business. (Business for
Social Responsibility).
 A set of management practices that ensure the company minimises the negative
impacts of its operations on society while maximising its positive impacts.
(Canadian Centre for Philanthropy).
 The integration of business operations and values whereby the interests of all
stakeholders including customers, employees, investors, and the environment are
reflected in the company’s policies and actions (The Corporate Social
Responsibility Newswire Service).
 Concept whereby companies integrate social and environmental concerns in their
business operations and in their interaction with their stakeholders on a voluntary
basis (The European Commission).
Corporate social responsibility should be viewed as a process and not as a destination. It
emerged in response to public disillusionment with the traditional role of business and
continues to be driven by a combination of forces involving consumers, shareholders, and
citizens. Over the last fewive years, efforts have been made to strengthen the CSR
movement through rigorous processes of standardizing, reporting, and auditing social and
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environmental performance. Yet, progress is limited by the reality that CSR remains a
purely voluntary, self-regulated movement.

5.6 CSR in Indian Context

CSR is not new in India rather it has been traditionally practiced by Indian businesses
since long time back as doing some charity and thereby contributing to the society by
way of undertaking some community development activities - though ad hoc. However
this very corporate philanthropy was not seen as an integral part of business as 7% of
Indian companies by 1997 only demonstrated they had written policy on CSR. Corporate
involvement in development tends to be ad hoc and CEO driven. Indian businesses
perceive employees, their families, customers and shareholders as significant
beneficiaries of their social responsibilities. Companies that work with communities do
not necessarily distinguish between the privileged and underprivileged amongst them.
Therefore the overall approach still seems to be driven by philanthropy rather than
integrating it with core business activities.

What is characteristic of evolving CSR models is that they have been developed and used
in the developed world. This does not imply that they are not relevant to the developing
world - indeed they are. The issue is only that of prioritization. It is useful to remember
the Indian context. India is a country where an estimated 350 million people live in
absolute poverty. They are poor not only because of a shortage of material resources but
mainly because of social- economic and political structures that have systematically
denied them the right to access and control the resources they need for a life of dignity.
Thus it is obvious that if economic growth must significantly reduce poverty and
inequity, it must address these structural issues- which means placing particular emphasis
on those who are socially and/or economically disadvantaged.

Social Commitments of Some Indian Companies

Following are some Indian organizations which are performing very well in the field of
corporate social responsibility:
 BHEL has contributed to the development of the quality of life in rural areas,
health care and family welfare, adult-education, etc.
 Colgate Palmolive did pioneering work in the promotion of sports, dental health,
and small industry development.
 Escort has worked for farm mechanisation, agricultural development, health care
etc.
 SAIL contributes to the sectors of agriculture, industry, education, health care,
dairy, poultry, fisheries and drinking water supply.
 ITC is socially active in the areas of agriculture, culture, sports and music.
 Brooke Bond has been interested in animal welfare, providing veterinary service,
and improvements in animal breeding.

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 TISCO has been a pioneer in discharging social responsibility and has made
several contributions in areas such as community development, social welfare,
tribal area development, agriculture and related activities, rural industrialisation,
etc.
 Asian Paints funded a large scale community development project to enable
farmers to use local resources effectively.

ANNEXURE
International Codes of Conduct for Multinationals
CSR by ITC and HUL

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CHAPTER7 Balance of Payment

Introduction
Constituents of Balance of Payment
Current Account
Capital Account
Official Reserve Account
Disequilibrium in Balance of Payment
Reasons of Adverse Balance of Payments
Remedies for Adverse Balance of Payments
Currency Convertibility
Current Account Convertibility
Capital Account Convertibility
India and Currency Convertibility
Summary
Discussion Questions

7.1Introduction:
Balance of payment of a country is a statistical record of its international transactions.
These international transactions include the value of goods and services, capital loans,
gold, and other items coming into and out of country. It incorporates all the data relating
to the economic flows between the residents of a country and the residents of other
countries of the world. The term residents includes all individuals and business
enterprises, including financial institutions, that are permanently residing within a
country’s borders, as well as government agencies at all levels. Balance of payment may
be prepared on monthly, quarterly, and annual basis. The statistics presented monthly or
quarterly will give a divergent view due to the seasonal changes and require an
explanation about the factors causing the fluctuating trends. Usually balance of payment
statement is taken for one year.
A balance of payments and a corporate balance sheet are similar in that each is a
summary in monetary terms of the result of business activity over a period of time.
Accounting procedure for the two are also similar in that each uses double entry
bookkeeping. In the balance of payment accounts, a debit is any transaction that results in
a money outflow or payments to a foreign country, and credit is any transaction that
results in money inflow or receipts from a foreign country. Double entry bookkeeping
assures in principle that total debits equal total credits or in other words that the balance
of payments always balances in accounting sense(In economic sense, there can be a
surplus or deficit in a country’s balance of payments accounts). It is nothing more than a
totalling of the claims and counterclaims for payment, categorised for convenience that
arise over a period of time between the residents of one country and those of others.
The balance of payments of a country over a period of time can reveal its economic
health relative to the rest of world. It reflects the totality of country’s economic relations
with rest of the world. An imbalance can occur in the balance of payment statement of a
country. In particular, a country’s balance of payment is important to investors,
multinational companies, business managers, consumers, and government officials
because it affects the value of its currency, its policy towards foreign investments and

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also influence important macroeconomic variables like gross national product, interest
rates, price levels, employment scenario and exchange rate.
Balance of Payment Accounting:
Since the balance of payment statement is based on the principle of double entry
bookkeeping, every credit in the account is balanced by debit and vice-versa. The
following section explains the balance of payment accounting principles regarding debits
and credits.
Credit transactions are those that earn foreign exchange and are recorded in the balance
of payments with positive (+) sign. Selling either real or financial assets or services to
non residents is a credit transaction. In example we can say that a product or service
produced in India earns foreign exchange for the country, is recorded as credit
transaction. Borrowing abroad also brings foreign exchange and is recorded as a credit.
Transaction which uses foreign exchange is recorded with negative (-) sign on debit side.
The best example of debit transactions is of import of goods and services from foreign
countries.
The BOP’s accounting principles regarding debits and credits can be summarised as
follows:
Credit Transactions (+) are those that involve the receipt of payment from foreign
countries. Some important credit transactions are-
 Export of goods or services.
 Unilateral transfers (gifts) received from foreigners.
 Capital inflows (Increase in foreign assets of nation or reduction in the nation’s
assets abroad)
Debit Transactions (-) are those that involve the payment of foreign exchange or we can
say that transactions which expend foreign exchange. Some important debit transactions
are-
 Import of goods or services.
 Unilateral transfers (gifts) made to foreigners.
 Capital outflows (Increase in nation’s assets abroad or reduction in the foreign
assets of the nation
7.2 Constituents of Balance of Payment:
Balance of payment statement is classified into three parts:
 Current Account
 Capital Account
 Official Reserve Account
7.2.1 Current Account
The current account is an important component of the balance of payments. It measures
all income producing activity which goes into foreign trade. The current account is
divided into four finer categories: merchandise trade, services, factor income, and
unilateral transfers.
Merchandise trade represents exports and imports of tangible goods such as wheat,
computers, automobiles, electronics items etc. Services include payments and receipts for
legal, consulting, and engineering services, royalties for patents and intellectual property,
tourist expenditure etc. Sometimes these services are also known as invisible trade. The
third category of current account is Factor Income; It is largely consist of payments and
receipt of interest, dividends, and other income on foreign investments that were

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previously made. Unilateral transfers are those which may be in cash or kind and
involve no return commitment. These payments which do not have any return
commitment are also called unrequited payment. It includes foreign aid, reparations,
official and private grants and gifts. The various sub-items falling under the current
account may be understood as follows:
A. CURRENT ACCOUNT Credits Debits Net
I Merchandise
1. Private
2. Government
II Non-monetary Gold Movements
III Invisibles
1 Travel
2 Transportation
3 Insurance
4 Investment income
5 Government not elsewhere classified
6 Miscellaneous
7 Transfer payments
(i) Official
(ii) Private
TOTAL CURRENT ACCOUNT (I + II + III)

7.2.2 Capital Account

The capital account refers to long and short term movements of capital into and out of a
country. Capital account is further subdivided into three categories: direct investment,
portfolio investment, and other investments. Direct investment and portfolio investment
involve financial assets with a maturity of more than a year; other investment consist of
financial paper with a maturity of less than one year.
Direct investment means both ownership and control of assets. It occurs when one from
any country establishes some form of operating facility abroad. If we take example of
India direct investment may be looked at from two standpoints: India’s direct investment
abroad and foreign investment in India. The second category of capital account is
portfolio investment; it represents sales and purchase of foreign financial assets such as
stocks and bonds that do not involve a transfer of control. Portfolio investment comprises
equity securities and debt securities. Equity securities include corporate shares, whereas
debt securities include bonds and notes, money market instruments, and financial
derivatives like options. Third category is other investments which include transactions
in currency, bank deposits and trade credits etc. The details about the capital account of a
country’s BOPs may be understood as below:
B. CAPITAL ACCOUNT Credits Debits Net
I Private.
1 Long term
2 Short term
II Banking
III Official
1 Loans

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2 Amortization
3 Miscellaneous
TOTAL OF CAPITAL ACCOUNT (I + II + III)

7.2.3 Official Reserve Account

The official reserves are assets which are owned by government. The official reserve
account represents only purchase and sales by the central bank of the country e.g. for
India purchasing is look after by Reserve Bank of India. The changes in official reserve
are necessary to account for the deficit or surplus in the balance of payments. If a country
is having deficit in its BOP the central bank will have to either run down its official
reserve assets such as gold, foreign exchange and SDRs (Special Drawing Rights) or
borrow fresh from foreign central bank. However, if a country has a surplus in BOP, then
its central bank will either acquire additional reserve assets from foreigners or retire some
of its foreign debts.
RESERVE ACCOUNT: Credits Debits Net

1 IMF Account
2 SDR Account
3 Reserves and Monetary gold
TOTAL OF (1 + 2 + 3)

Statistical Discrepancy
Internal transactions, in balance of payment statement, are recorded at different times and
place with different methods, as a result these recordings, on which balance of payment is
constructed, are bound to be imperfect. Statistical discrepancy can not be computed
accurately. It represents errors and omissions. Since, however, the balance of payment
must balance to zero when every item is included, one can determine the statistical
discrepancies in the residual manner. This discrepancy is removed by taking an error and
omission account in the BOP.

ANALYSIS AND INTERPRETATION OF THE BALANCE OF PAYMENTS

The BOP of a country may be analyzed in terms of changes taking place in the items
listed under the current account, capital account and the reserve account. The factors
responsible for the changes are also taken into account. The BOP figures on the following
pages help us to analyze India’s balance of payments. The current account of India BOP
turned into deficit in 2004-05 of US $ 5.4 billion while enjoying

surplus continuously during the three preceding years 2001-02, 2002-03 and 2003-04.
The deficit in the year 2004-05 occurred due to the burgeoning excess of merchandise
imports over exports, which was left uncompensated by the net surplus in invisibles. The
deficit on current account in the year 2005-06 is even more than double of the year 2004-
05. However, due to the surplus enjoyed on the capital account, the overall India’s BOP
in the year shows favourable position amounting to US $ 26159 million. The surplus in
the BOP is neutralized by the outflow (─) of foreign reserve for the sake of equilibrating
the BOP in the book-keeping sense.

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There are numerous economic, political and social factors that cause disequilibrium in the
BOP. The economic factors causing a deficit or surplus in the BOP are the large increase
in the expenditure on developmental activities requiring greater imports, business
fluctuations such as recession or depression, inflation in the country resulting into more
imports and depreciation in the currency and adoption of cost effective measures, which
reduces the cost and bring about change in the BOP through changes in trade flows.
Political instability also affects the BOP by giving rise to the capital flight and
discouraging foreign capital inflows. Social factors such as developing tastes for foreign
products carry significant impact on the BOP of a country.

The BOP of a country is the barometer indicating the external performance of the
country, which rather depends on its internal strength. If the trend in the BOP of a
country reflects persistent deficit then the exporter should be careful trading with such
country because the payments for the export proceeds may involve problems. There is
close relationship between the performance of the BOP and foreign exchange market.
The deficit in the current account will produce the pressure on the currency of the deficit
country lowering its value. The surplus in the BOP will have the reverse impact on the
exchange rate of the currency. The deficit in the current account also has implications for
the foreign investment. The likely fall in the value of the currency discourages foreign
capital flows, which have long term bearing on the growth of the country.

INDIA'S BALANCE OF PAYMENTS

(US $ million)
2005-06P 2004-05PR
Item Credit Debit Net Credit Debit Net
1 2 3 4 5 6 7
A.CURRENT ACCOUNT
I. MERCHANDISE 104,780 156,334 -51,554 82,150 118,779 -36,629
II.INVISIBLES (a+b+c) 91,481 50,539 40,942 71,854 40,625 31,229
a) Services 60,610 38,345 22,265 46,031 31,832 14,199
i) Travel 7,789 6,421 1,368 6,495 5,510 985
ii) Transportation 6,277 7,394 -1,117 4,798 4,539 259
iii) Insurance 1,042 985 57 909 722 187
iv) G.n.i.e. 305 480 -175 328 261 67
v) Miscellaneous 45,197 23,065 22,132 33,501 20,800 12,701
of which : Software Services 23,600 1,338 22,262 17,200 674 16,526
b) Transfers 25,220 944 24,276 21,276 432 20,844
i) Official 667 486 181 623 32 591
ii) Private 24,553 458 24,095 20,653 400 20,253
c) Income 5,651 11,250 -5,599 4,547 8,361 -3,814
i) Investment Income 5,477 10,504 -5,027 4,431 7,100 -2,669
ii) Compensation of Employees 174 746 -572 116 1,261 -1,145

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Total Current Account (I+II) 196,261 206,873 -10,612 154,004 159,404 -5,400
B. CAPITAL ACCOUNT
1. Foreign Investment (a+b) 76,635 58,413 18,222 46,508 34,361 12,147
a) Foreign Direct Investment (i+ii) 8,520 2,787 5,733 5,972 2,732 3,240
i. In India 7,752 61 7,691 5,654 65 5,589
Equity 5,820 61 5,759 3,779 65 3,714
Reinvested Earnings 1,676 - 1,676 1,508 - 1,508
Other Capital 256 - 256 367 - 367
ii. Abroad 768 2,726 -1,958 318 2,667 -2,349
Equity 768 1,746 -978 318 1,579 -1,261
Reinvested Earnings - 364 -364 - 700 -700
Other Capital - 616 -616 - 388 -388
b) Portfolio Investment 68,115 55,626 12,489 40,536 31,629 8,907
In India 68,115 55,626 12,489 40,536 31,629 8,907
Abroad - - - - - -
2.Loans (a+b+c) 36,221 31,484 4,737 29,749 18,994 10,755
a) External Assistance 3,415 1,977 1,438 3,809 1,886 1,923
i) By India 20 104 -84 24 128 -104
ii) To India 3,395 1,873 1,522 3,785 1,758 2,027
b) Commercial Borrowings 13,451 11,860 1,591 8,546 3,506 5,040
i) By India - 342 -342 - 23 -23
ii) To India 13,451 11,518 1,933 8,546 3,483 5,063
c) Short Term to India 19,355 17,647 1,708 17,394 13,602 3,792
3. Banking Capital (a+b) 21,658 20,285 1,373 14,507 10,633 3,874
a) Commercial Banks 20,586 20,144 442 14,230 10,251 3,979
i) Assets 772 3,947 -3,175 505 552 -47
ii) Liabilities 19,814 16,197 3,617 13,725 9,699 4,026
of which : Non-Resident Deposits 17,835 15,046 2,789 8,071 9,035 -964
b) Others 1,072 141 931 277 382 -105
4. Rupee Debt Service - 572 -572 0 417 -417
5. Other Capital 4,786 3,853 933 8,063 3,395 4,668
Total Capital Account (1to5) 139,300 114,607 24,693 98,827 67,800 31,027
C. Errors & Omissions 971 - 971 532 - 532
D. Overall Balance 336,532 321,480 15,052 253,363 227,204 26,159
(Total Capital Account, Current Account
and Errors & Omissions (A+B+C))
E. Monetary Movements (i+ii) - 15,052 -15,052 - 26,159 -26,159
i) I.M.F. - - - - - -
ii) Foreign Exchange Reserves
( Increase - / Decrease +) - 15,052 -15,052 - 26,159 -26,159
P : Preliminary.
PR : Partially Revised

Source: Reserve Bank of India Bulletin June 2006

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7.3 Disequilibrium in balance of payment

On account of the double entry of the items both on the credit and debit sides, the BOP is
always in equilibrium in the accounting sense. From such presentations it is difficult to
find out that balance of payment is in equilibrium or in disequilibrium. Thus, when we
speak of disequilibrium in the balance of payments, we refer not to the balance of
payments as a whole, but to the balance in certain categories or section of credits and
debits in the structure of balance of payments.
Symbolically balance of payment can be defined as
BoP= Pr-Pp
Where,
BoP stands for Balance of Payments,
Pr payments received from foreign countries,
Pp payments made to foreign countries.
Clearly when BoP is zero, the balance of payment can be regarded as equilibrium balance
of payments. However, a country’s balance of payment is said to be “favourable” or
“surplus” when the total receipt from rest of world exceed the total payment to the rest of
world. Symbolically, when Pr>Pp BoP is positive, it is called favourable balance of
payment. On the other hand, a country’s balance of payment is said to be “unfavourable”
or “adverse” when the total receipt from rest of world is less than total payment to the
rest of world. Symbolically, when Pr<Pp BoP is negative, it is called unfavourable
balance of payment.
Usually we say that there are short run and long run disequilibrium in balance of
payment. When a country borrows or lends internationally, it will be known as short term
disequilibrium in its balance of payment, as these loans are normally for short period or
even if they are for long duration, they are repayable late on; hence the position will be
automatically corrected. Short run disequilibrium may also emerge if a country’s import
exceeds its exports in a given year. But when such disequilibrium occurs year after year
over a long period, it can affect country’s balance of payment and economy very
seriously. A persistent deficit will tend to deplete its foreign exchange and the country
may not be able raise any more loans from foreigners. This situation is known as situation
of long run disequilibrium. Hence we can say that long term disequilibrium refers to a
deep rooted persistent deficit or surplus in the balance of payments of a country.
Kinds of Disequilibrium
There are three main kind of disequilibrium in balance of payment
 Cyclical Disequilibrium
 Secular Disequilibrium
 Structural Disequilibrium
Cyclical disequilibrium in the balance of payment arises due to the influence of cyclical
fluctuations. It can occur due to following reasons
1. Different paths are followed by trade cycles in different countries.
2. Identical stabilisation programs are not followed by different countries.
3. Income elasticities and price elasticities of demand for import in different
countries are not identical.

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Secular disequilibrium is a long term phenomenon. It is caused by changes in dynamic

forces/factors such as capital formation, population growth, territorial expansion,
technological advancement, innovations etc.
Structural disequilibrium emerges on account of structural changes occurring in some
sectors of the economy at home or abroad which may alter the demand or supply
relations of export or imports or both. A shift in demand can arise due to changes in
tastes, fashions, habits, income, economic progress etc. Structural changes can also be
produced by variations in the rate of international capital movements.
7.3.1Reasons for adverse balance of payment (Causes of Disequilibrium)
As we know that there are two types of international capital flows first is autonomous
capital flows and secondly accommodating capital flow. This classification of
international capital flow will help us to explain the disequilibrium of balance of
payment.
The autonomous capital receipts and payments are the autonomous investment which
may be direct as well as portfolio types. The autonomous investment is planned and its
magnitude is determined by the existing government policies. The current account and
the balance of autonomous capital receipts and payments provide the basic balance and it
will show whether BOP is in equilibrium or in disequilibrium in economic sense. The
deficit in the BOP will cause the inflows of the accommodating type of capital (balance
of foreign accommodation is also known as supplementary foreign capital). These are
unplanned and flow in or out to equilibrate the BOP in bookkeeping sense. The deficit in
BOP may be financed either by the withdrawals from foreign reserve and/or through
short term loans. If a country maintains comfortable foreign reserve, than it can meet the
deficit by the depletion of its foreign reserve only. A government can borrow from
another government by issuing a loan instrument and a corporation may do the same by
floating shares abroad or a bank may issue a loan in a foreign country.
The disequilibrium in the BOP may also be explained in terms of the autonomous
receipts and the autonomous payments. These receipts and payments include in the
transactions as autonomous exports and imports (both visible and invisible), autonomous
unrequited transfers and autonomous capital flows. If the autonomous receipts are equal
to the autonomous payments then the BOP of a country is in the equilibrium. On the
other hand, if the autonomous receipt exceeds the autonomous payments, the BOP will
have surplus and when the autonomous receipts falls short of autonomous payments then
there will be a deficit in the BOP. The accommodating capital flowing in and flowing out
arises merely when there is deficit or surplus in the BOP in economic sense.
Illegal transactions are also one of the reasons which gives rise to adverse balance of
payment situation. When a country imposes restrictions on the free flow of goods and
services, in the form of import and export duties, quotas, outright ban on certain imports
and controls on capital movements (particularly outflows), illegal transaction occurs.
Such restrictions on cross-border transactions give rise to illegal trading. There are two
types of illegal transactions relating to international trade and finance. (i) Illegal
transactions through illegal channels – smuggling; and (ii) illegal transactions through
legal channels (over invoicing of imports and under invoicing of exports- illegal capital
outflow not recorded in the BOP, capital flight). The former totally escape the BOP
account while the latter lead to distortions of the BOP statistics. Foreign tourists selling
foreign currency in black market and migrant workers transferring remittances through

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Hawala transactions also distort balance of payment statement. The illegal transactions
decrease as a country adopts liberal policy regarding cross-border transactions.

From above discussion we can say that disequilibrium in balance of payment may arise
due to various causes and many complex factors interrelated to one another. However,
following are important causes of producing disequilibrium in the balance of payment of
a country:
 Phases and amplitude of cyclical fluctuations differ in different countries which
generally produces cyclical disequilibrium.
 In developing economies huge investment is done on development programs, it
creates a gap between two sides of balance of payment of countries in turn it
creates disequilibrium in balance of payment.
 A vast increase in the domestic production of foodstuffs, raw materials, substitute
goods etc. in advanced countries has decreased their need for import from the
agrarian underdeveloped countries. Thus, export demand has considerably
changed, resulting in structural disequilibrium in these under developed countries.
 Surplus or deficit in balance of payments may arise out of international borrowing
and investment. A country may tend to have an adverse balance when it borrows
heavily from another country, while the leading country will tend to have
favourable balance and a deficit balance when the loan is repaid.
 Due to rapid economic development the resulting income and price effects will
adversely affect the balance of payments position of a developing country.
 A huge population and its high rate of growth in poor countries also have adverse
affect on their balance of payment position.
 Since intensity of reciprocal demand for products of different countries differ,
terms of trade of a country may set differently with different countries under multi
trade transactions which may lead to disequilibrium.

7.3.2 Remedies for adverse Balance of Payment (Methods of Adjusting Balance of

Payment)
Disequilibrium in the balance of payment is undesirable for each country because of its
disastrous affect on the economy of a country. Thus whenever we talk about economic
policy its primary aim is to maintain balance of balance of payment. Imbalance either
surplus or deficit in the balance of payment, if it remains persistently, is harmful for
normal economic operations for a country. Especially a deficit or adverse balance of
payment is more harmful to a country’s economic growth. For obvious reasons, an
adverse balance of payments has to be corrected by encouraging exports and/or
discouraging imports.
There are various measures to correct the adverse balance of payment position of a
country. But we can broadly classify these measures in two ways:
Monetary Measures
Non-monetary Measures
Monetary Measures
Following monetary measures are usually employed for boosting up exports and
checking or curtailing or to reduce imports. This process will correct the position of
adverse balance of payments.

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1.Deflation – Deflation means contraction of the home currency through dear money and
credit policy, and fall in the cost and prices of domestic goods. Naturally, domestic goods
and so the exporting items of the country in the foreign market become relatively cheaper
and demand for them will rise so that exports will increase. Moreover, deflation attempt
to restrict home consumption through reduction of incomes; demand for goods at home
will be reduced and more surpluses may become available for export purposes so that
export may increase.
Deflation is considered as traditional method for correcting disequilibrium in balance of
payments. However, deflation is fruitful when country is on gold standard or fixed
exchange rates because its working assumes that exchange rates are constant during the
process of deflation.
Generally for the interest of internal economic growth of country, and to achieve a high
or full employment level, deflation is not welcomed. It is not welcomed because it
implies unemployment and reduction in money incomes which means reduction in wages
so that service class is most affected.
2. Exchange Depreciation
To depreciate the exchange value of the home currency is also a important monetary
measure for correcting disequilibrium of balance of payment. In this process it is assumed
that the country has adopted flexible exchange rate system. Thus, exchange rate
depreciation is feasible. By exchange depreciation we mean that to decline the rate of
exchange of one country in terms of other country’s currency. This exchange
depreciation will lead to cheapen its domestic goods for the foreigners in turn its export
will be boosted. Thus there will be a check on import and export will be stimulated and
country will achieve a favourable balance of payment.
This method increases the risk and uncertainty involved in international trade which will
hamper the growth of the economy of the country. Exchange depreciation also move
terms of trade unfavourably for the country which is adopting this method for the purpose
of correcting disequilibrium of balance of payment. The exchange depreciation can lead a
country to a hyper-inflation stage.
3. Devaluation
Devaluation can be defined as the lowering of the external value i.e. exchange rate of a
country’s currency by an official edict. This may be either in relation to the currencies of
only a few selected countries. Devaluation and depreciation can be differentiated on the
concept that devaluation is reduction of the external value of a currency as arbitrarily
decided upon by government while depreciation stands for automatic reduction in the
external value of a country’s currency by market forces. Sometimes the act of devaluing a
currency might simply means giving official recognition to what might be termed as
depreciation of currency in the foreign exchange market.
Nowadays a country resorts to devaluation of its currency when it has to correct a chronic
and fundamental disequilibrium (normally it is a case of deficit) in its balance of
payment. When there is a continuous overvaluation of currency of a country than it has
no alternative left but to devalue its currency. Devaluation promotes the export which
corrects disequilibrium of the balance of payment. Success of devaluation depends upon
following conditions:

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a) Fair elastic demand for imports and exports will ease the way or
the successful functioning of devaluation to achieve its desired
goals.
b) Structure of imports and exports also helps in deciding about
the adoption of devaluation policy. If the devaluing country’s
export consists of non-traditional items, and has a large demand
from the rest of world, it can gain by improving terms of trade due
to increase in world’s demand for its product induced by
devaluation. But, if its exports are largely of primary products and
imports are of manufactured goods, raw materials etc., it will have
always unfavourable terms of trade, so it will lose more under
devaluation.
c) International cooperation plays an important role in
implementing devaluation of currency. Devaluation will serve its
purpose only if other countries do not retaliate by resorting to
simultaneous devaluation.
d) Domestic price stability i.e. maintaining internal purchasing
power of devaluing country is very essential to realize fruitful
effects of devaluation. Success of devaluation requires that when
the external value of a currency is deliberately reduced, the internal
value of the currency should not alter, otherwise the whole purpose
will lost.
e) Coordination, devaluation is coordinated with hike in import
duties, lowering of export duties, liberalization of export licences,
fixation of import quotas, export promotion programmes etc.

4. Exchange Control
In this method all the exporters are directed by the authorities (usually central bank) to
surrender their foreign exchange earnings to it and rationing is started for licensed
importers. A quota is also fixed for import of selected items. In result balance of payment
is corrected by controlling imports and acquiring foreign exchange earned by exports.
Exchange control basically deals with the balance of payment disequilibrium by
suppressing the deficit that is only a symptom not problem. Exchange control deals with
deficit only, not its causes. Hence we can say that it may remove disequilibrium of
balance of payment temporarily but can not provide a solution to basic problem.

Non-Monetary Measures
Import duties and quotas are generally used as non monetary measures to correct
disequilibrium in balance of payment. For correction of balance of payment import duties
are imposed as a restrictive measure. This increases the prices of items on which duties
are imposed, and, hence the import decreases. Fixing of import quotas is another and
better method for the correction of disequilibrium of balance of payment.

Other Methods for Correcting Disequilibrium

Following are other methods which are used by countries for the adjustment of balance of
payment:

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1. Automatic adjustment (Gold Standard)

2. The BOP adjustment through policy measures
 Expenditure Reducing Policies (Monetary and Fiscal Policies)
 Expenditure Switching Policies (Devaluation-J-curve effect and Absorption
Approaches)
 Dutch Disease and the BOP adjustment (Avoiding the Unfavourable Outcome of
Prosperity)
 Direct Controls (Tariffs and NTBs)
 International Capital Movements
 Monetary Theory of Balance of Payments Adjustment

These methods depend upon two types of flows; Autonomous Capital Flows and
Accommodating Capital Flow. Autonomous flows are the investment which may be
direct as well as portfolio type. The autonomous investment is planned and its magnitude
is determined y the existing government policies. While accommodating capital flows are
unplanned and flow in or out to equilibrate the balance of payment in book keeping
sense. The accommodating capital inflows provide signal to the monetary authority of the
country for adopting measures to deal with deficit as far as possible. It is important
because the withdrawals on foreign reserve have the depleting tendency and the foreign
borrowings may not be expected forever. They also involve the payments with interest.
Therefore, it is important to adopt remedial measures for correcting deficit in the BOP.
Adjustment in the BOP may be automatic as under gold standard through price-specie
mechanism as well as through policy measures. When the gold standard failed to operate
then different countries to correct the disequilibrium in their BOPs adopted several policy
measures.
1. Automatic Adjustment (Gold Standard)
The automatic adjustment has operated through gold standard. The objective of economic
policy under gold standard 3as to maintain equilibrium in the BOP and the monetary
policy was used by the central banks as the main instruments for achieving the
equilibrium. Currencies of the countries participating in international trade are tied to
gold and the par value is determined by the relative gold content of the currencies. The
exchange rate between the two currencies moves up to the gold export point and he gold
import point, which is equal to the cost of transportation of gold from one country to
another. For instance, if $1=Rs.44.80 under the gold standard and the cost of
transportation between India and USA is 10 paise then the movement in the dollar-Rupee
rate will follow as $1=Rs.44.90 (gold export point) and $1=Rs.44.70 (gold import point)
The deficit in India’s BOP arising due to greater demand for import in comparison with
the foreign demand for exports and giving rise to the demand for foreign exchange would
be adjusted automatically either collectively or separately in the following manner:
(a) Gold will begin flowing out causing decrease in the domestic money supply and the
rise in interest rate. It will increase the cost of borrowing, causing the deflationary
activities, lower income and low demand for import;
(b) Higher interest rates will attract the autonomous type foreign capital with rich
experience and better technology. It raises the productivity, increases the exports and
hereby corrects the imbalances in the BOP; and

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(c) Adoption of tighter monetary policy, which means the rise n bank rate. It decreases
the money supply because of he decline in the credit creating capacity of financial
institutions.

Gold standard operated successfully between the period 1880-1914. It ceased to play an
effective role after the inception of First World War. The war threat and the confiscation
of made the gold flows difficult, raised the gold price and disrupted the par values.
During the 1930’s severe depression the countries one after another abandoned it because
of the adoption of competitive devaluation. The ‘beggar thy neighbour” policy became
the main policy plank in those days. The need was felt to solve the BOP problems by
adopting policy measures.

2. The BOP adjustment through policy measures

The economic policies such as expenditure, expenditure switching, direct controls and
international capital movements are adopted in order to adjust the BOP. The expenditure
reducing policies involve changes in the monetary and fiscal measures for reducing the
deficit and demands restrictive monetary and fiscal policies. The monetary instruments
for reducing deficit requires an increase in the bank rate, selling securities in the open
market, increase in the cash reserve ratio and directives to the commercial banks to issue
loans for selective purposes.
Fiscal measures would necessitate the reduction in public expenditure and increasing the
tax rates. The expenditure reducing policies have been qualified on the ground that the
restrictive monetary policy may dampen the economic growth through the adverse effect
of high interest rate on private investment. The similar impact is of high tax rates on
private investment, which is avoidable by providing incentives to the entrepreneurs in the
form of lower taxes. It is known as supply side economics and became popular as
Regionomics.
Expenditure switching policies works through the changes in he exchange rate of one
currency in terms o another. The deficit country is required to devalue (depreciation) its
currency for promoting the exports and discouraging he imports. The devaluation means
the decrease in the value of the currency in relation with the price of gold where as the
depreciation means the decrease in the value of the currency with respect to other
currencies. Now, the gold does not play its decisive role in the world economy and both
he terms may be used interchangeably.
The devaluation promotes export as the exporters receive more in domestic currency and
they may even earn greater amount by reducing the prices of their products in the
overseas markets (Exporters are to take care because the foreign buyers are very shrewd
and they may plan to share the gains arising from the depreciation. They may soon
encounter the benefits by offering the export the export orders with reduced prices). The
imports become costly by the extent of devaluation. The imports are reduced and imports
competing industries gain fro the better competitive situation in the home market. But the
success of devaluation depends upon the demand elasticities in foreign countries for the
products of deficit facing country. Marshall-Lerner condition for the success of
devaluation requires the sum of the elasticities of demand for country’s exports and its
demand for imports to be more than unity ( Em + Ex > 1 ).

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As a matter of fact, devaluation is not much helpful to the problems of deficit of

underdeveloped countries. Their products face inelastic demand in international markets
and the developed countries have even developed synthetic substitutes, achieved self-
sufficiency in agriculture and pursuing protective trade policies. Even after many years of
the establishment of World Trade Organization (WTO) developed countries continue
providing subsidies to their farmers and imposing many other restrictions such as
countervailing duties (CVD), sanitary and phyto-sanitary
(SPS) measures to make the products from underdeveloped countries incompetitive in
their markets.
The existence of low elasticity implies that devaluation hardly succeeds in
underdeveloped countries and, therefore, the BOP problem demands direct controls like
quota and state trading etc. The export stimulation by way of several fiscal and financial
incentives and the consistent decline in the value of the currency (Hidden devaluation)
does not create export competitiveness. It is the greater competition in the domestic
market, which compels the entrepreneurs to upgrade technology, adopt cost effective
measures and improve the quality of their products in order to become competitive both
in the home and foreign markets. The devaluation by carrying out negative effects on
non-devaluing countries cause retaliation thereby reducing world trade.
Even if the devaluation eventually increases exports and reduces imports it entails
adverse initial impact. It takes place due to the immediate increase in the import price and
slow rise in value of exports because the marketing of additional products takes time. He
volume of imports also does not fall because of the dependence of the underdeveloped
countries on imports of capital goods. Thus, the volume effects dominate and devaluation
does not produce favourable effects in the initial stage. The following figure illustrates
this fact with the help of “J-Curve” phenomenon.

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Figure
In figure , devaluation occurs at A’ when the deficit in the BOP amount to AA’. But the
deficit continues to increase up to B’ when it reaches the highest level BB’. It is only
between B’ and C that the balance of trade begins improving and eventually results into
surplus. J-curve effect is more discernible in the LDCs because of the relative rigidities in
their productive structure. There is immediate rise in the price of imports while the
exports do not respond quickly due to the bottlenecks in these economies.
The above is the elasticity approach to devaluation, which provides partial analysis of its
impact on the economy. The approach to the devaluation is the absorption approach,
which deals with its macro effects and thus studies the total economic behaviour. The
absorption approach considers deficit in the current account as the expenditure
(absorption or total demand) to be greater than output. If the situation is like that M>X,
then C+I+M>C+I+X. The certainty of devaluation having positive results on the BOP
would depend upon its effects on reducing the excess absorption over output.

The BOP of a country may also be worsened by the outbreak of “Dutch Disease”. What
happens is that if a country finds some new resources and its one sector expands rapidly
enjoying monopoly in the international market then its currency will appreciate and
adversely affect the exports of traditional sectors. When the boom is over the exports of
other products already suffered, the country is plunged into BOP crisis. It took place in
Netherlands in sixties when the Dutch discovered a large quantity of natural gas and

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thought it as solution for many problems. Soon, they began enjoying surplus and the
Dutch guilder appreciated putting pressure on the manufacture sector and traditional
exports. The exports of radio sets and electrical goods became increasingly difficult and
produced undesirable effects on employment.

The Dutch disease has brought about adverse effects on many economies in recent years.
The North Sea oil discovery in England, the oil industry expansion in Norway, the
sudden oil richness of Saudi Arabia and mineral discoveries in Australia are the examples
of Dutch disease. In early 1970s the recycling of oil funds and the forward moves by the
Swedish banks appreciated the Swiss franc making he exports of manufacturing sector
more difficult and a major setback came specially to the tourist industry. The policy
makers may control the outbreak of Dutch disease by curtailing the production of
newfound product and the appreciation of exchange rate. A suitable strategy has to be
evolved for the balanced development of different sectors of the economy for avoiding h
unfavourable outcome of prosperity.
Direct controls such as quantitative restrictions, which include quota, state trading, import
licenses, rationing and exchange regulations are also available to improve the BOP.
These non-tariff barriers (NTBs) are restrictive and may lead to retaliations by trade
partners and become harmful to the growth of these economies. Tariffs are preferable to
quota as their relative restrictive impact on trade flows is less. The autonomous capital
movement may be encouraged for correcting the disequilibrium. There will be an
improvement in the productive structure of the economy as these capital flows are
accompanied with superior technology and cost effective techniques.
The monetary approach considers the BOP as a monetary phenomenon. At the heart of
the approach is the demand for and supply of money. If the demand for money increases
it will lead a surplus in the Bop by decreasing the demand for goods and services. An
increase in the money supply will cause a deficit. The monetary authority of the country
will have to manage the demand for and supply of money in such a manner as to maintain
equilibrium in the BOP.

7.4 Currency Convertibility

Currency convertibility can be defined as ability to exchange money for gold or other
currencies. Currency is considered to be convertible when the concerned country
formally accepts the obligation of article VII, section 2,3, and 4 of the Articles of
Agreement of the IMF. For the purpose of increase in international business it is
necessary to have easy convertibility of currencies among countries. An international
monetary system is engaged in this process from early 19 th century when gold standard
started.
Convertibility can be external or internal. When all holdings of the currency by non-
residents are freely exchangeable into any foreign currency at exchange rates within
official margins than that currency is said to be externally convertible and if there are no
restrictions on the ability of a country to use their holdings of domestic currency to
acquire any foreign currency and hold it, or transfer it to any non-residents for any
purpose, that country’s currency is said to be internally convertible. When, we have the
sum of external and internal convertibility, it is known as total convertibility.

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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 non-residents to purchase
unlimited amounts of a foreign currency with it. A currency is nonconvertible when
neither residents nor non-residents are allowed to convert it into a foreign currency.
Pros and Cons of Convertibility
Currency convertibility is easy to achieve technically: simply permit everyone, either
resident or non-resident, to buy and sell the home currency for other currencies without
any restriction. But when we discuss the practical aspects of implementation of currency
convertibility then we find that only transaction of currency is not involved but also
various economic and political consequences have to be taken care.
When we go for legal definition of convertibility, it strictly refers to the freedom to
purchase foreign exchange for domestic currency, but it will not be meaningful
economically if licensing is required for the activities which require foreign exchange,
e.g. importing goods or services. Therefore first of all we have to take currency
convertibility not only in legal sense but also in economic sense. That is, convertibility
cannot be considered independently of the accompanying regime for foreign trade.
One factor which goes against the adoption of currency convertibility is that it would lead
to an unsustainable loss of foreign exchange reserves and balance of payment crisis. This
factor presupposes that the government has pegged exchange rate. Now, if exchange rate
is pegged, than an unsustainable outflow of funds must be met by some monetary policy
which in turn will imply the need of smaller government deficit. In turn it will lead to a
decline in output and income in the short run. Another factor which goes against the
currency convertibility is that the practical distinction between current and capital
transactions is difficult or impossible to sustain, and that to prevent outflows of resident
capital requires controls over current transactions as well, with a view to ensuring
domestic savings invested domestically.
Now if we talk about the positive aspects of currency convertibility, we can say that
convertibility would provide a strong stimulus to develop export markets. At the
exchange rate required to make the currency convertible, exports would be extremely
profitable for newly independent enterprises. Autonomous enterprises would have a
strong financial incentive to develop export markets, and that would push them from the
beginning to take into account not only the price but also the quality of products that are
sold in the world market.
The key to a modern, flexible and innovative economy is competitive markets, wherein
information on new patterns of demand or new technological developments is transmitted
to the entire economy through price signals, to which both households and enterprises can
respond by adapting their behavior. Currency convertibility can be helpful in this whole
process.
Another reason for introducing currency convertibility is to encourage alignment of
prices of the country which is adopting currency convertibility with world prices of
traded goods and services, subject to such deviations as the economic authorities wish
explicitly and consciously to make.

From above discussion we can say that adoption of currency convertibility is not an act of
symbolic significance-an act that signifies that the country concerned is taking

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participation in a club. But we can say that adoption of currency convertibility is to be

consider as part of an overall programme of economic transformation and restructuring.
As we know that there is no single blueprint for economic transformation which is
applicable to all economies, in the similar way there is no single blueprint for currency
convertibility also. Implementation of currency convertibility is not an easy task it has
some short-term costs also. That is why it is necessary to assess the benefits in relation to
the costs before implementing it. It can be a point of discussion that to make distinction
between current account convertibility and capital account convertibility.

7.4.1 Current Account Convertibility

Current account is defined as including the value of trade in merchandise, services,
investment, income and unilateral transfers. Current account convertibility, being
essential to the development of multilateral trade, three approaches to current account
convertibility has been adapted by developing countries. These are the pre-
announcement, by-product, and front-loading approaches. Each approach is distinguished
by the importance it attaches to convertibility relative to other economic objectives.
The advantages of adopting current account convertibility seem fairly obvious. On the
demand side, the adoption of convertibility will provide consumers with goods they never
had (either in terms of desired quantity or even more freqiently, in terms of desired
quality)-that is, access to new markets. On the supply side, it is useful to think of
currency convertibility in the context of broader trade liberalization efforts. When a
previously centrally planned economy transforms itself into a market economy, the
opening of the economy to world market forces serves two related functions. First, world
market prices can provide the most reliable guide for production decisions in the
uncharted territory of decentralized decision making. With the guidelines of central
planning removed, it is world market prices that can offer the best guidance to
producers. In addition, openness to world markets can be the most reliable guarantor of
the stimulus of competitive forces, particularly for economies that start from a position in
which most major sectors are highly monopolized, and where the scale of the economy is
too small to accommodate adequate internal competition in many sectors. Openness to
world market prices in fact offers the most appealing means of introducing a competitive
market environment into previously centrally planned economies. But of course there are
risks even with current account convertibility-risks that we hear about time and again.
There will very likely be unemployment in the beginning, especially as unprofitable
enterprises are eliminated. There will be a decline in output, and there may also be a
significant decline in real wages. It may therefore become difficult to maintain the
domestic political support that is so necessary for the success of the economic
transformation. But in reality, there is no alternative, because the starting point is a
distorted economy: restructuring necessarily means that many firms will go out of
business, and their going out of business is in fact desirable. But there is indeed a
problem of how to maintain political support. The best strategy, it seems to me, is to
make sure that the aims and means of the program are transparent from the outset, and
that there are adequate safety nets. In the latter context, however, I am a little nervous
about excessive wage indexation which, as we know from experience, can transform a
microeconomic problem into a macroeconomic disaster.

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7.4.2 Capital Account Convertibility

Capital account includes transactions of financial assets. Its convertibility refers to the
freedom to convert local financial assets into foreign assets in any form and vice versa at
market-determined rates of exchange. Capital controls normally restrict or prohibit cross-
border movement of capital. Thus, controls on capital movements include prohibitions:
need for prior approval; authorization and notification; multiple currency practices;
discriminatory taxes; and reserve requirements or interest penalties imposed by the
authorities that regulate the conclusion or execution of transactions. The coverage of the
regulations would apply to receipts as well as payments and to actions initiated by non-
residents and residents.
Capital account convertibility (CAC) -- or a floating exchange rate -- means the freedom
to convert local financial assets into foreign financial assets and vice versa at market
determined rates of exchange. This means that capital account convertibility allows the
free movement from local currency into foreign currency and back. It refers to the
removal of restraints on international flows on a country's capital account, enabling full
currency convertibility and opening of the financial system.

INDIA and Currency Convertibility

The Indian economy is increasingly being integrated with the global economy and as a
part of the globalization process it should remove the various financial and economic
barriers which prevents it from becoming economic super power. The full Capital
Account Convertibility (CAC) is a major step in this direction, making it on par with
other developed countries.

Currency Convertibility (CC) means that the currency can be freely converted into any
other currency.
Current Account Convertibility
In July, 1991 India announced liberalization of economy in July 1991. Following were
important moves towards current account convertibility
 Partial convertibility of Rupee from March 1, 1992 (40% of earnings convertible
in Rupees at official exchange rate and 60% earnings at market determined
exchange rate).
 Unified market determined exchange rate system in March 1993
 India introduced full convertibility of rupee on current account in August 1994 by
accepting the obligation under Article VIII of IMF. Current account convertibility
relates to the removal of restriction on payments for transactions on current
account.

Capital Account Convertibility

Tarapore committee (1997) defines Capital Account Convertibility (CAC) “ as the

freedom to convert local financial assets into foreign financial assets and vice versa at

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market determined rates of exchange.” In other words, CAC implies complete mobility of
capital across the countries.

Prerequisites

For introducing convertibility and making it effective, certain conditions are to be met
such as
 Realistic exchange rate,
 Low inflation rate,
 Comfortable exchange reserves,
 Fiscal consolidation,
 Labour market reforms

Implications of Ca[pital Account Cconvertibility

Following are important implications of capital account convertibility on country

 It increases the risk of capital flight causing volatility in exchange rates and
financial markets. This risk is very real in practice because most of the
transactions in FEMs are related to financial business.
 It can result in the flooding of the domestic markets with imports, particularly
non-essential ones.
 It increases the misuse of foreign exchange not only for luxury and leisure
industry but also for smuggling of goods, drugs, arms, and for other nefarious
activities.

India and Capital Account Convertibility

After the introduction of economic liberalization in July, 1991 currency convertibility

both on current account as well as on capital account was under active consideration.
Gradual liberalization was introduced on current account and finally in August 1994 full
convertibility of rupee was implemented. For the CAC a committee under the
chairmanship of Tarapore was appointed which submitted its report in 1997 suggesting
certain preconditions for full CAC in India by 1999-2000.
 Reduction in fiscal deficit as percentage of GDP from 4.5 in 1997-98 to 4.0 in
1998-99 and further to 3.5 in 1999-2000;
 Mandated rate of inflation on an average three to five percent for the three-year
period 1997-98 to 1999-2000.
 Fully deregulated interest rate structure by 1997-98.
 Reduction of NPAs as percentage of total advances to 12 per cent by 1997-98, 9
per cent by 1998-99 and five per cent by 199-2000.
 Comfortable foreign exchange reserve.

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None of these conditions were achieved by 1999-2000. However, the sufficient foreign
exchange reserve held by RBI( US$150 billion) in recent years again generated
discussions on full CAC in India.
The Tarapore Committee-2
The Reserve Bank of India appointed a committee to set out the framework for fuller
Capital Account Convertibility on march 20, 2006 called the “Tarapore committee-2”.
Entitled- "Towards fuller convertibility''
The Committee was chaired by former RBI governor S S Tarapore, was set up by the
Reserve Bank of India in consultation with the Government of India to revisit the subject
of fuller capital account convertibility in the context of the progress in economic reforms,
the stability of the external and financial sectors, accelerated growth and global
integration.
Economists Surjit S Bhalla, M G Bhide, R H Patil, A V Rajwade and Ajit Ranade were
the members of the Committee.The committee submitted its report on July 31, 2006 and
was made public in September 2007. The advocates a three-phased approach, the first
phase beginning this year (2006-07), the second during 2007-09 and the last ending 2011.
The Reserve Bank of India has also constituted an internal task force to re-examine the
extant regulations and make recommendations to remove the operational impediments in
the path of liberalisation already in place. The task force will make its recommendations
on an ongoing basis and the processes are expected to be completed by December 4,
2006. The Task Force has been set up following a recommendation of the Committee.
Difference between Capital Account Convertibility and Current Account
Convertibility
Capital account refers to capital transfers and acquisition or disposal of non-produced,
non-financial assets, and is one of the two standard components of a nation's balance of
payments. The other being the current account, which refers to goods and services,
income, and current transfers.
Current account convertibility allows free inflows and outflows of currencies for all
purposes other than for capital purposes such as investments and loans. In other words, it
allows residents to make and receive trade-related payments -- receive dollars (or any
other foreign currency) for export of goods and services and pay dollars for import of
goods and services, make sundry remittances, access foreign currency for travel, studies
abroad, medical treatment and gifts, etc with few restrictions.
Capital account convertibility is considered to be one of the major features of a developed
economy. It helps attract foreign investment. It offers foreign investors a lot of comfort as
they can re-convert local currency into foreign currency anytime they want to and take
their money away. At the same time, capital account convertibility makes it easier for
domestic companies to tap foreign markets. At present, India is following the current
account convertibility. This means one can import and export goods or receive or make
payments for services rendered. However, investments and borrowings are restricted.
Fears about Currency Convertibility

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Economists feel that jumping into capital account convertibility game without
considering the downside of the step could harm the economy. The East Asian economic
crisis is cited as an example by those opposed to capital account convertibility. The East
Asian financial crisis was a financial crisis that started in July 1997 in Thailand and
affected currencies, stock markets, and other asset prices in several Asian countries, like
Indonesia, South Korea, Hong Kong, Malaysia, Laos and the Philippines, many
considered East Asian Tigers. It is also commonly referred to as the East Asian,
currency crisis or locally as the IMF crisis.
Even the World Bank has said that embracing capital account convertibility without
adequate preparation could be catastrophic. But India is now on firm ground given its
strong financial sector reform and fiscal consolidation, and can now slowly but steadily
move towards fuller capital account convertibility.

Safeguards The policymakers seem confident that even after full and free float of the
currency, the economy is resilient enough to withstand the vagaries of international fiscal
and monetary turbulence. With FII inflows playing a significant role, adequate safeguards
to be in place so that the economy are not left vulnerable to flight of capital.
Adopting CAC would require domestic banks to be stronger and bigger to compete with
international banks. They have to build skills to handle multi-currency balance sheet
operations and the dollarisation of domestic assets. They will have to equip themselves
with heightened risk management practices to deal with high volumes of currency flows
at a global level. International experiences with capital account liberalisation suggest a
strong macro-economic backdrop and establishment of prudential norms of supervision
and regulation as essential preconditions for currency convertibility.
With India's growth engine in full throttle, stable inflation, moderating fiscal deficit, low
risk of an external debt crisis, the situation seems just right for an acceleration in the pace
of opening up the boundaries for cross-border flows. Though there are fears that this may
lead to a drop in our GDP, the government agencies are confident enough that the Indian
economy can stand firm in any untoward economic condition. CAC could be the logical
culmination of India's journey towards globalisation.
Implications of CAC for an Indian Resident:-
Indian residents cannot freely move money abroad presently. There are certain allowable
limits beyond which permission from RBI is needed. As far as the common man is
concerned, these limits are already quite liberal.
In any case, the point here is that for the average person, CAC may not have a direct
benefit. However, there could be indirect advantages. CAC would attract more FDI, more
investments and a greater choice of products and services than are available currently.
Therefore, in terms of quality of life and variety of products, both investment and
consumer, CAC is something we all can look forward to.
Implications of CAC for NRIs:
NRI’ s will benefit tremendously if and when CAC becomes a reality. The reason is on
account of current restrictions imposed on movement of their funds. As has been
mentioned in these columns before, no one is born an NRI. An NRI becomes an NRI
when he leaves India for a job or doing business abroad. Now what happens is that in the
process, he may leave his Indian assets behind --- investments and monies that he owned

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when he was an Indian Resident. Though such funds and assets can be moved abroad,
there are some rules and restrictions.
Though an NRI may remit an amount up to $ 1 million per calendar year, out of his NRO
account for all bona-fide purposes, to the satisfaction of the banker, for any such
remittance, an undertaking from the remitter and a certificate from a chartered accountant
is required. For property, there is a lock-in of ten years. In other words, sale proceeds of a
house that has been purchased using rupee funds, cannot be repatriated unless such house
is owned for ten years.
Then there are various documentary evidences that need to be submitted to the banker for
proving that the purpose is bona-fide. For example, if the money is required for medical
purposes, a bill or an estimate from the overseas hospital or the doctor is required. If its
for education purposes, the I-20 or letter from the university along with the estimated fees
would need to be submitted. Even for assets brought out of foreign exchange, which
ordinarily should have full repatriability, some restrictions creep in. For example, take
real estate purchased out of foreign exchange. An NRI can repatriate funds representing
the sale proceeds of only two such properties in his entire lifetime!! CAC will eliminate
these difficulties.
However, the Tarapore Committee has recommended bringing foreign individuals on par
with Non-Resident Indians in terms of convertibility and tax treatment. The committee
has proposed that the government must review tax benefits offered to NRIs for
investments in foreign currency non-resident (banks) and non-resident (external) rupee
account deposit schemes, while suggesting that foreign individuals be allowed to invest
in these deposit schemes but without any tax concessions.
The committee said a movement towards capital account convertibility implied that all
non-residents (corporates and individuals) should get equal treatment. This means that the
tax benefits extended to NRIs under these schemes should be removed. Though there are
views opposite to the above mentioned citing that this may lead to the downfall of Indian

Dr Vikas Tripathi Page 104

dreams of becoming a super power by 2055, there is no doubt that in the next five years
(by 2011) the capital Account will be made fully convertible.
Summary
Capital Account Convertibility is the logical next step in the process of globalisation of
the Indian economy which commenced during 1991. During the initial stages partial
convertibility was implemented on the current account which was in phases made full
convertibility on the Current or Trade account. The experience so far has been
encouraging and the country has been able to build up a comfortable Balance of Payment
(BOP) position of over $130 billion. Given the comfortable monetary position India
could venture into Capital Account Convertibility, taking precautions to ensure that the
currency crisis faced by the south east Asian countries is not repeated.
 CHAPTER6 Foreign Investment
6.1 Foreign Investment
6.2 Foreign Direct Investment
6.2.1 Trends & Direction of FDI in World
Economy
6.2.2 Horizontal & Vertical FDI
6.2.3 Benefits & Costs of FDI
6.3 Foreign Institutional Investment
6.4 Trends & Direction of Foreign Investment in India
Summary
Discussion Questions

One of the key factors influencing economic development of a country is investment. For
achieving high growth rate of economy a country needs large amount of investment.
Most of the developing countries want to have investment more than domestic savings.
This investment can be foreign investment. Due to integration of economies world wide
each country tries to attract foreign investment. Thus now a day it had become an
important way of entering in international business. Although decisions regarding
investment in a particular foreign country are very risky in nature( because of investment
of huge amount) and it may be outcome of combination of strategic, behavioural and
economic considerations, choice of specific project within a particular product-market
posture calls for evaluation of its economic feasibility.
In other words we can define foreign investment as the ownership of foreign property in
exchange for financial return, such as dividends and interests. Foreign investment
requires a very deep analysis because of huge amount of investment.
Why do firms go abroad for investment?
As we have discussed in chapter 1 there are various ways of entering in international
business some of them involve little investment while other involves huge amount of
investment. So the question arise that why companies go for foreign investment although
it involves huge amount of risk? Following reasons may give us some idea that why
firms go for investment abroad
 Trade Barriers- These are the barriers which are imposed by host countries on
multinational doing business internationally. In example we can say that different
forms of excise duties, quotas etc. To overcome these barriers firms decide to
invest abroad.
 Market Imperfections- Hymer(1960) explained the role of market imperfection
to FDI. According to him a multinational invest its money overseas only when the
company has certain advantages not owned by local competitors. These
advantages may derive from skills in management, marketing, production, finance
or technology. They may refer to preferential access to raw materials or other
inputs. Market imperfection permits the multinational to exploit its monopolistic
advantages in foreign markets. Thus we can say that FDI is an outcome of
imperfect market. Market imperfection may arise in one or more of several areas-
for e.g. product differentiation, marketing skill, proprietary technology,
managerial skills, better access to capital, economies of scale and government-
 imposed market distortions etc. Market imperfection may be created in number of
ways
1. Internal or external economies of scale often exists, possibly due to
privileged access to raw materials or to final markets, possibly from
increase in physical production.
2. Effective differentiation may create substantial imperfection. This
differentiation may be in product, process, marketing and organization
skills.
3. Government policies have an impact on fiscal and monetary matters on
trade barriers.

Theory of FDI based on market imperfection suggests that foreign investment is

undertaken by those firms who enjoy some monopolistic or oligopolistic advantage.
This is because, under perfect market conditions, foreign firms would be non
competitive due to the cost of operating from a distance, both geographically and
culturally. Presumably the firm going for foreign investment has some unique
advantage. Oligopoly theory may also explain the phenomenon of defensive
investment, which may occur in concentrated industries to prevent competitors from
gaining or enlarging advantages that could then be exploited globally.

 Product Life Cycle- Raymond Vernon suggested that firms take foreign
investment route at a particular stage of product life cycle. As demand for the new
product develops in foreign countries, the pioneering firm begins to export and
then produce in those countries.
 Shareholder Diversification Services- If investors cannot effectively diversify
their portfolio holdings internationally because of barriers to cross-border capital
flows, firms may be able to provide their shareholders with indirect diversification
services by making direct investments in foreign countries.
 Intangible Assets- Multinationals may undertake foreign investment projects in a
country, despite the fact that local firms may enjoy inherent advantage. This
implies that multinationals should have significant advantages over local firms.
Indeed, multinationals often enjoy comparative advantages due to special
intangible assets they possess. Examples include technological, managerial, R&D
facilities, brand names etc.

Foreign investment may take two forms- Foreign Direct Investment and Foreign Portfolio
Investment. Foreign direct investment is one that gives the investor a controlling interest
in a foreign company. Foreign portfolio investment is a noncontrolling interest in a
company or ownership of a loan to other party. Usually portfolio investment takes one of
two forms: stock in a company or loans to a company or country in the form of bonds,
bills, or notes that the investor purchases.
Foreign Direct Investment
Whenever a firm is engaged in direct production and/or marketing and/or distribution of
goods in other than the country of its origin, we say that it is foreign direct investment.
When Koran steel major decided to invest 50000 crore of rupees in India in 2005, it was
the largest foreign direct investment by any multinational in India. In this way we can
define FDI as an investment by any multinational in a foreign country (other than its
origin) for manufacturing and/or marketing and/or distributing goods.

The fifth edition of the IMF’s Balance of Payments Manual (BPM5) defines FDI as a
category of international investment that reflects the objective of a resident in one
economy (the direct investor) obtaining a lasting interest in an enterprise resident in
another economy (the direct investment enterprise). The lasting interest implies the
existence of a long-term relationship between the direct investor and the direct
investment enterprise, and a significant degree of influence by the investor on the
management of the enterprise. A direct investment relationship is established when the
direct investor has acquired 10 percent or more of the ordinary shares or voting power of
an enterprise abroad.

FDI has become now an important vehicle for globalization. For the purpose of growth
worldwide countries compete to win maximum FDI. The global FDI stock has risen
substantially. According to UNCTAD data the value of world inflows had increased from
US$ 209 billion in 1990s to near about 1.5 trillion in 2005-06 and number of
multinationals from 15 developed countries had increased from 40000 in 1990s to
1,40,000 (approximately) in year 2005-06.

Following are main myths which are said about FDI

 FDI does not necessarily imply control of the enterprise, as only a 10 percent
ownership is required to establish a direct investment relationship.
 FDI does not comprise a “10 percent ownership” (or more) by a group of
“unrelated” investors domiciled in the same foreign country—FDI involves only
one investor or a “related group” of investors.
 FDI is not based on the nationality or citizenship of the direct investor—FDI is
based on residency.
 Borrowings from unrelated parties abroad that are guaranteed by direct investors
are not FDI.
FDI can take two forms
Green-field investments- It involves the establishment of wholly new operation in a
foreign country. In other words we can say that starting of any unit from scratch in
foreign country. The company conduct market survey, selects location, buys or leases
land, creates new facilities, purchases and installs new machineries. EX
Acquisition or Merger- It involves acquiring or merging with an existing firm in a
foreign country. Acquisitions can be a minority (where the foreign firm takes a 19
percent to 40 percent stake in voting rights), majority (where 50 percent to 99 percent), or
full outright stake (where 100 percent). Like coke did with Parle in India. Coke took the
acquisition route to get market share in India. In case of merger foreign company and
domestic company comes into an agreement and starts business.
Any organization adopts route of foreign direct investment for fulfilling following three
major operational objectives- To expand the sales of company, To acquire the resources,
To minimize the risk.
Foreign investment involves both the initial transaction between the two entities and all
subsequent transactions between them and among foreign affiliates, both incorporated
and unincorporated, FDI may be undertaken by individuals as well as business entities.
Flows of FDI comprise capital provided either directly or through other related
enterprises by a foreign direct investor to an FDI enterprise, or capital received from an
FDI enterprise by a foreign direct investor. FDI has following three components
Equity Capital- It is the foreign direct investor’s purchase of shares of an enterprise in a
country other than its origin.
Reinvested Earning- It is the investor’s share of earnings not distributed as dividends by
affiliates, or earnings not remitted to the investor.
Intra-company Loans- It is also known as intra-company debt transactions. It is short
term or long term borrowing or lending of funds between direct investor (parent
enterprise) and affiliate enterprise.
Impact of Foreign Direct Investment
As we know that attracting FDI has become a key strategy for countries for development.
FDI have following impacts
 economic growth;

 trade;

 employment and skill levels;

 technology diffusion and knowledge transfer; and

 linkages and spillover to domestic firms.

6.2.1 Trends & Directions of FDI in World Economy

Global FDI flows have expanded rapidly over the last two decades. As a result of
technological progress in transport, communications, and data processing coupled with
policy reforms has fueled the growth of crossborder production networks, in which
multinational companies break down their production of final goods into stages and
organize their production to achieve the lowest cost of production. The remarkable
progress in information and telecommunication (IT) technologies has boosted the value
added of services sector in the world economy and enhanced globalization process by
enabling companies better-manage and control geographically dispersed businesses.
Last two decades also marked considerable progress in terms of liberalization of FDI and
trade policies in developing countries. As in many developing countries impediments
including restrictions on forms of investment and the degree of foreign ownership has
gradually eased, FDI flows in developing countries not only experienced a surge but also
several changes emerged in terms of mode of investment, recipient industries and the
investor base. The role of M&A as a form of FDI increased in many developing
countries, as developing countries went through a wave of large privatization and M&A
deals in tandem with the surge in global M&A flows. And spurred by this wave of large
privatization and M&A deals, the sectoral distribution of FDI in many developing
countries has shifted towards services. In the process, firms in developing economies
have amassed sufficient capital, knowledge and know-how to invest abroad on their own
and claim the status of emerging multinationals.
While FDI flows in developing countries were undergoing these changes, the expectation
of resilience of FDI flows were tested in the face of economic turbulence in several
countries. In most of these cases, FDI was proved to be more resilient at least in some of
these countries relative to other international capital flows such as portfolio equity and
debt flows due to the assumed long-term expectations of its investors. This said
highlighted by these episodes that although FDI investors do not disinvest immediately,
they do adjust their exposure to the countries affected by crises by repatriating their
earnings—instead of reinvesting, and calling back their inter-company loans. And in
some cases, these adjustments can be considerable leading significant fall in FDI flows.
The importance of M&A activity as a form of FDI increased in the 1990s. Global M&A
rose more than fivefold between 1995 and 2000 (after increasing by only 24 percent in
the first half of the 1990s) to a peak of $1.1 trillion in 2000, before dropping by some 45
percent in 2001 with the decline in stock markets and the global economic slowdown.
Reflecting the recent favorable economic conditions, global cross-border M&As reached
to yet another peak of $1.3 billion in 2006. The M&A activity is driven in part by rapid
increases in the stock prices of some major corporations and in part by expectations
(during the boom) that continuing productivity increases would fuel continued rises in
stock prices (GDF 2006). The bulk of the cross-border M&A transactions continue to be
in service sectors (more than half in finance, transport, storage, and communications
alone). Extensive privatization of state-owned assets during the late 1990s also attracted
FDI in the form of M&A in a number of developing countries particularly in Latin
America and Eastern Europe

FIGURE FROM PAGE4 (CHART ) from DILEK%20aykut pdf file in Trends in fdi
folder

In Asian developing countries, the role of M&A as a form of FDI has been less
significant compared to developed and other developing countries indicated by the
relatively lower ratios of cross-border M&A sales to FDI flows (figure 2). One factor is
limited privatization related FDI in many Asian developing countries which accounted
only 17 percent of $140 billion foreign exchange raised through privatization deals in
developing countries during 1990 to 1999 (World Bank 2000).1 This said the importance
of M&A activity has increased since the late 1990s. Following the Asian crisis, the
acquisition of distressed banking and corporate assets surged in several Asian economies
particularly in Thailand and Malaysia, because of which the value of cross-border M&A
activity in Asia more than doubled in 1998 relative to 1996. During the last few years,
cross-border M&A and privatization deals have picked up again and Asian countries have
increased their participation among developing countries. The value of M&A sales
almost doubled both in newly industrialized economies (NIEs)―Hong Kong, China,
Republic of Korea, Taiwan Province of China and Singapore―and other developing
countries reaching $ 23.2 and 21.7 billion, respectively. The region’s share in total M&A
deals to developing countries also increased to 30 percent in 2005 compared to an
average 20 percent in previous years. The front-runners in the recent increase in value of
M&A transaction were Indonesia, India, Malaysia and China all of which received FDI
flow in form of M&A particularly in telecom and banking sector.

Starting in the late 1980s and early 1990s, there has been a shift of global FDI flows into
the services sector as most countries, both developed and developing, have opened up
their services sectors to foreign investment, and FDI flows into these sectors surged
(GDF 2004; Unctad 2005). Spurred by the surge in privatization and M&A deals, FDI
flows in services rose to overtake FDI in manufacturing. By 2004, services accounted for
more than half of the FDI stock in developing countries (figure 2).

Trends in Services FDI

The shift has happened in almost all regions and income groups except Africa (figure 2).
Boosted by mega privatization deals, services FDI surged in Latin American and Eastern
European countries particularly into infrastructure (especially transportation, storage and
communication), financial intermediation and insurance sectors. During the climax of
privatization and mega M&A deals era for developing countries in the 1999-2002 period
in Latin America, only in Brazil and Mexico, the total FDI in services sector was $67 and
$36 billion, respectively. During the same time Eastern European countries led by Czech
Republic, Hungary and Poland received almost $40 billion in infrastructure and financial
sector. In recent years, the region was again the frontrunner as the recipient of
privatization and M&A deals but this time newcomers such as Romania, Bulgaria and
Turkey were also major recipients. Africa, on the other hand, continues to receive higher
portion of its FDI in resource-related FDI despite the increase in services sector FDI in
Northern African countries such as Egypt and Tunisia (World Bank 2004).
Figure 3. Sectoral composition of FDI stock in Asia in 2004
Percentage
Source: Same as figure 3.
For Asian developing countries, the role of services sector in terms of FDI sectoral
composition has been significant on aggregate yet its importance varies among countries
(figure 3). While FDI in the sector has been dominant in most NIEs particularly in Hong
Kong and Singapore, FDI in manufacturing is still the leading sector in countries such as
China, Taiwan, China, Malaysia, Thailand and Vietnam. As Singapore and Hong Kong,
China have positioned themselves as financial and trade centers in Asia, services sector
FDI reached to $174 billion and $100 billion in services sector accounting for 64 percent
and 96 percent of their FDI stocks, respectively. In Singapore, financial services—foreign
investment holding companies— attracted $98 billion of FDI flows, 36 percent of FDI
stock in the country (Foreign Equity Investment in Singapore Report, 2004). In Hong
Kong, China, FDI in investment holding, real estate and various business
services account for two-third of the FDI stock valued at $300 billion in 2005, and the
rest was in commerce and financial services. Similarly, FDI in services accounts for more
than half of FDI stock in India but most of it is concentrated in infrastructure industries.
Highly publicized investment in business services— outsourcing—has been increasing in
recent years but only accounts for about 10 percent of inward FDI stock (McKinsey
2005). [Check the India data again] In Pakistan, increased FDI in infrastructure and
financial sectors through large M&A deals led the shift towards services. On the other
hand, manufacturing continues to be the dominant sector in other Asian developing
countries―China, Malaysia, Taiwan and Thailand, even if services FDI has increased
over the years. In China, manufacturing sector that received an aggregate of $240 billion
FDI between 1997 and 2004 accounts 66 percent of the FDI flows. Among services FDI,
real estate sector is the main sector, which received more than 10 percent of all FDI
received during 1997–2004. Some portion of this FDI is due to accounting standards that
some of the real estate expenses of foreign individuals and companies in China are
counted as FDI (Tse 2001; Zhang 1999). The rest is increasing real estate purchases by
non-residents (Unctad 2006). FDI into financial sector in China is on raise. Since China
joined the World Trade Organization in 2001, foreign banks have been positioning
themselves in China’s market, for the recent ease in restrictions on local-currency
transactions. Foreign banks can enter the market in one of two ways: they may either
invest in a domestic bank and hold a minority share (less than 25 percent) or open up
fully owned branches. To gain immediate access to a large branch network, many foreign
banks are increasing their holdings in domestic banks and have invested an estimated $17
billion since 2001. Similar to China, FDI in services is still limited in Malaysia
accounting for only 10 percent of the FDI flows during 1999 to 2004. The shares of
primary and manufacturing sectors were 33 and 57 percent, respectively. The approval
data between 1996 and 2000 also confirms the dominance of manufacturing sector.
During this period, electrical and electronics industry received 41 percent of the
approvals, where the petroleum and petroleum products accounted for 18 percent of
them. Similar to Malaysia, Taiwanese electronics industry received $16 billion, which
was more than half of the country’s FDI flows during the 1951-2002 period. With $ 8
billion FDI stock, banking and insurance sectors were listed the second largest sector in
Taiwan. Interestingly, FDI sectoral composition is almost divided equally between
manufacturing (mostly electronic appliances) and services with manufacturing leading
with a slight difference in Thailand. Most of the services FDI flows were in financial
services where majority foreign ownership of banks, finance firms, brokerage firms and
insurance agencies became possible for the first time in 1997.

Table 1 Average share of services in FDI flows and in GDP (percent)

Services share in: FDI GDP
Asia
NIEs 69 65
China 31 41
India 55 52
Other Asian Countries 43 45
Europe and Central Asia 65 60
Latin America and the Caribbean 65 59
África 29 52
Memo ítem
High-Income OECD 69 72

Trends in Outward FDI flows

Globalization of operations and complex business strategies made it harder than ever to
define and monitorinternational operations of a multinational company. All such
limitations are further magnified in the case of FDI outflows from the South. OFDI
statistics for non-OECD countries tend to be patchy and relatively unreliable. Some of
these countries that have invested abroad (such as Malaysia and Mexico) just started
reporting FDI outflows in recent years. Moreover, for several countries estimates of FDI
outflows are considerably smaller than the actual level of flows. Official statistics do not
usually include financing and reinvested components of OFDI as well as the capital that
is raised abroad (Aykut and Ratha 2004). Also, they in general only reflect the large
investments while excluding small and medium size transactions. In addition, countries
with capital controls, exchange controls or high taxes on investment income provide a
substantial incentive for underreporting by investors. Several country case studies based
on company level
data highlight the under-reporting (Aykut and Ratha 2004). For example, Wong and Chan
(2003) document the substantial under reporting of FDI flows from China: the reported
numbers reflect only investments with official approval (which is required for initial
investments only), and China’s State Administration and Foreign Exchange estimates that
unauthorized capital outflows from China between 1997 and 1999 totaled 53 billion.
Further care is required with Chinese bilateral data with Hong Kong. As FDI enjoys
favorable treatment compared to domestic investment, resulting in an incentive to
investors to channel funds out of, and subsequently into, an economy in the form of FDI.
Because the funds originate in the host economy itself, "round-tripping" inflates actual
FDI inflows. Official estimates of this type of FDI are not available, but others have
suggested that such flows may account for up to 25 percent of the total inflows Aykut and
Ratha 2004; Xiao 2004). The Chinese government has started to address this issue. In
November 2005, for example, SAFE promulgated a regulation concerning foreign
exchange management related to "roundtripping" investments (Unctad 2007). In addition,
as Athukorala (2006) shows, another, perhaps even more important, problem with
Chinese FDI data has to do with “over-reporting” of inward FDI, a phenomenon that
seems to affect flows from other developing Asia countries more than OECD source
countries.
FIGURE PAGE 16

Nevertheless, reported FDI outflows from developing countries rose significantly during
the 1990s reaching $143 billion in 2000 from $12 billion in 1990. After a fall following
the Asian crisis, FDI outflows from developing countries recovered to $117 billion in
2005. As of 2005, the value of outward FDI stock held by developing countries was $1.4
billion, accounting 13 percent of world total (Figure 6). The positive trend has continued
in recent years and FDI by EMNCs reached yet another peak in 2006 as they have started
to acquire major MNCs from developed countries through mega M&A transactions.

Conclusion (TBC)
As a result of technological progress and policy reforms both in developed and
developing countries, FDI flows have evolved in terms of its mode, the sectors it goes to
and in terms of who is investing over the years. Today, developed and many developing
countries alike, services sector has become the major sector attracting investment from
foreign MNCs. And these MNCs are only from developed countries but also from
developing countries. Developing country MNCs are not necessarily inferior to their
developed country competitors in terms of technology; managerial skills and access to
capital, however. On the contrary in some of them are major global players in their fields.
Many Asian economies have not only experienced these changes rather have been the
leading forces behind them. FDI flows in developing Asia region has shifted towards
services sectors and services FDI is in the region is expected to rise in coming years as
impediments to such flows that are prevalent in many Asian economies are continued to
be eased. The sectoral shift in FDI may have implications in terms of its sustainability
and its resilience in face of economic turbulences. The non-tradability nature of most
services sectors products and their high dependence on countries macroeconomic
conditions and institutional framework make it more sensitive to sudden macro-economic
shocks especially when they are coupled with
deterioration in institutional and regulatory framework. The number of EMNCs from
developing Asia has grown rapidly and continues to grow. Most of them are active
investors in the region with increasing favorable global positions. Hence, South-South
FDI flows have been significant in the region. Its role has been very important not only
for Asian countries with smaller and less developed markets, but also larger economies
such as China. While the diversification of the pool of countries’ sources of FDI may
temper fluctuation, positively contributing to the economic development of host
countries, increased South-South integration could also lead to increased vulnerability of
the region developing countries to an economic crisis

6.2.2 Horizontal & Vertical FDI

Horizontal FDI
Horizontal FDI can be defined as the investment by the firm in the same industry abroad
as a firm operates in at home. We have to understand why firms go for horizontal FDI i.e.
why they go abroad? Why they took trouble of acquiring or establishing operations
abroad? If other factors are equal FDI is always costly than other alternatives like
exporting or licensing. But in practicality number of factors can alter the relative
attractiveness of exporting, licensing and FDI. Following are those factors which affects
the company’s decisions
Stage of product in product life cycle- Theory of IPLC (Raymon Vernon) suggests that if
a product is in maturity stage in home country company tries to move to another country
where this product can be launched in introduction or growth phase of life cycle.
Market Imperfections- Market imperfection arises in two circumstances in case of
horizontal FDI: when there is impediment to the sale of know-how and when there is
impediment to the free flow of products between nations (tariffs, quota restrictions are
imposed by host government).
Cost involved in Transportation- Sometimes for companies cost of transportation
becomes major part of cost of product in home country and it becomes impossible to sale
the product or it is sold in unprofitable situation.
Growth Strategy- Companies sometimes give more emphasis to horizontal FDI as a step
to support their growth strategy. This growth strategy may be a result of strategic rivalry
between firms in the global market place.
Vertical FDI
Vertical FDI can be of two types
Backward Vertical FDI- This is the FDI into an industry abroad that provides inputs for a
firm’s domestic production process. Main objective of this type of investment is to
provide inputs into a firm’s downstream operations. Generally, most backward vertical
FDI has been in extraction industries e.g. oil extraction, mining industries.
Forward Vertical FDI- In this type of FDI an industry abroad sells the outputs of a firm’s
domestic production process. In example we can say that when a company dealing in
automobile manufacturing enters in a market acquires a large number of dealers rather
than distribute it through independent dealers.
Once again question arises that why companies go for vertical FDI? Answer of this
question can be obtained by following factors analysis
Strategic Behaviour- According to economic theory, by vertical FDI, a firm can own
source of raw material so that it can raise entry barriers & shut the doors for new
competitors.
Market Imperfection- On the basis of market imperfection we can explain that why firms
go for vertical FDI? There are two explanations: impediments to the sale of know-how
through market mechanism and investments in specialized assets expose the investing
firm to hazards that can be reduces only through vertical FDI.
6.2.3 Benefits & Costs of FDI
We can study benefits and costs of foreign direct investment in two aspects- benefits and
costs for host country, benefits and costs for home country.
For Host Country
In first part we will discuss the effect of FDI on the host country (the country which
receives FDI).
BENEFITS
In this section we will try to find out those areas where the host country gets benefit or
where the host country has to pay some cost for attracting FDI. After analyzing the
different factors, we find that mainly there are five fundamental areas where any host
country either gets some benefit or pays some costs- Employment generation,
maintaining the equilibrium of balance of payment, technological advancement, and
increase in competition.

Employment Generation
First most claimed benefit for FDI is that it brings jobs for the host country. It is
supposed that if FDI would have not been there, jobs were not created. Analysis
shows effect of FDI on employment is direct as well as indirect. Direct effects can
be defined as those effects which are visible directly like when a multinational
gives job offer to the resident of host country. While indirect effect arise when
jobs are created in local market due to the spending of money by the employees of
multinationals. This indirect effect is more intense and deep for a country like
India. These indirect effects on employment generation are equally important
because these are often as large as employment generated by direct effect.
The people against the FDI says that these generated jobs are not more than those
jobs which are reduced due to the loss of market share of the enterprises of the
host country. We can understood this by the example that if Toyota plans for
Greenfield investment in any country i.e. Toyota plans to build the plant for
manufacturing the automobile and plans to market automobile in the country, than
market share of any local automobile manufacturer will decrease and in turn there
will be reduction in jobs of local manufacturer and thus there will not be any net
gain in employment generation for the host country. Now if the multinational
adopt another method of FDI, i.e. by acquisition of any established enterprise,
than also the immediate effect of acquisition will be to reduce the jobs.
Equilibrium of Balance of Payment
Impact of FDI on balance of payment is an important concern for any country
because it is a statement showing the economic strength of the country. For
understanding the impact of FDI on balance of payment first of all we should
understood the structure of balance of payment. As we know that BOP have two
main accounts- Current Account and Capital Account. When we discuss about
current account, it is mainly consists of export and import of goods and services,
and capital account, it is mainly consists of investments, either direct or portfolio.
This clearly implies that FDI is having direct impact on capital account of balance
of payment and indirect impact on current account of balance of payment.
From the above discussion and analysis we find that there are three effects of FDI
on BOP. First, when any multinational establishes its subsidiary in the host
country, the capital account of the host country’s BOP benefits from the initial
capital inflow. This capital inflow will make only one time effect. Against to this,
profit earned by subsidiary is recorded as debit on the current account of the host
country’s BOP. This shows the outflow of capital form the host country. Second,
FDI can be a supplement for imports of goods and services; in turn it can improve
the current account of the host country’s BOP. Third, when multinational uses its
foreign subsidiary as a source for exporting goods and services to other countries.
Technological Advancement
FDI has a direct impact on the advancement of technological status of the host
country’s residents. Technology gives support to the research and development
activities. It has direct positive contribution on the economy of the host country.
This economic growth gives rise to the salary and wages of the people employed
and also there is increase in job opportunities. This is visible in the form of
increase in standard of living of the people of host country.
Many multinationals, are so large in size and have very strong financial strength,
have access to those financial resources which are not available to the host
country’s firms. This financial strength may be internal or due to their reputation
in international market they can borrow from fund market.
Competition
A theory of economy describes the functioning of the market. This theory says
that market depends on the level of competition between manufacturers. When
multinationals go for FDI for establishing the new enterprise, it increases the
number of players in market and thus there is increase in choices for consumers.
In turn, this can increase the level of competition in the national market, thereby
 price of products decreases and increase in the economic welfare of the
consumers. Increased competition tends to stimulate capital investments by firms
in plants, equipments and R&D to gain an edge over their competitors. This can
have a long term growth of increase in productivity, innovations, and ultimately
growth in economy. The impact of FDI on competition in local market is more
visible in services industry particularly in telecommunications, retailing, and
many financial services.
COSTS
This section discusses the negative aspects of FDI for the host country. After anlaysing it
is found that inviting FDI creates some adverse effect on the host county- Adverse impact
on competition, adverse impact on balance of payment, national security.
Adverse Impact on Competition
 CHAPTER8 Role of World Bodies in International Business
8.1 International Monetary Fund(IMF)
8.1.1 Formation of IMF
8.1.2 Objectives and Functions Of IMF
8.1.3 India and IMF
8.2 World Bank
8.2.1 Formation of World Bank
8.2.2 Objectives and Functions Of World Bank
8.2.3 India and World Bank
8.3 Regional Economic Integration
8.3.1 Concept of Regional Economic Integration
8.3.2 Different Regional Economic Groups in World
Economy
8.3.3 Merits and Demerits of Regional Economic
Integration
8.4 World Trade Organisation(WTO)
8.4.1 GATT, Uruguay Round-Formation Of WTO
8.4.2 Objectives and Functions of WTO
8.4.3 India and WTO

Summary

The IMF is the world's central organization for international monetary cooperation. It is an
organization in which almost all countries in the world work together to promote the
common good.
The IMF's primary purpose is to ensure the stability of the international monetary system
—the system of exchange rates and international payments that enables countries (and
their citizens) to buy goods and services from each other. This is essential for sustainable
economic growth and rising living standards.
To maintain stability and prevent crises in the international monetary system, the IMF
reviews national, regional, and global economic and financial developments. It provides
advice to its 184 member countries, encouraging them to adopt policies that foster
economic stability, reduce their vulnerability to economic and financial crises, and raise
living standards, and serves as a forum where they can discuss the national, regional,
and global consequences of their policies.
The IMF also makes financing temporarily available to member countries to help them
address balance of payments problems—that is, when they find themselves short of
foreign exchange because their payments to other countries exceed their foreign
exchange earnings.
And it provides technical assistance and training to help countries build the expertise
and institutions they need for economic stability and growth

The IMF is an international organization of 185 member countries. It was established to

promote international monetary cooperation, exchange stability, and orderly exchange
arrangements; to foster economic growth and high levels of employment; and to provide
temporary financial assistance to countries to help ease balance of payments
adjustment. (See Purposes of the IMF in the Articles of Agreement.)
Since the IMF was established its purposes have remained unchanged but its operations
—which involve surveillance, financial assistance, and technical assistance—have
developed to meet the changing needs of its member countries in an evolving world
economy.

Growth in IMF Membership, 1945 - 2005

(number of countries)
CHAPTER9 Introduction
9.1 Strategy in International Business
9.2 Approaches in formulating and implementing strategy
9.3 International strategic management process
9.4 Pressures for Cost Reductions & Local Responsiveness
9.5 Role of Strategic Management in International Business
Summary
Discussion Questions

Survival in this globally challenging environment of world business is not an easy job it
takes lots of time, resources, and cost of the firm. Any firm can survive only by
differentiating itself from competitors or we can say that by widening the gap. To create
the difference is a very critical function. Strategy is the only basic means by which any
firm can differentiate it from the competitor. A firm’s strategy can be defined as the
actions that managers take to attain the goals of firm.
Strategic management is the process of determining the firm’s basic mission and long
term objectives, and then implementing a plan of action for pursuing this mission and
attaining these objectives. As companies go international, this strategic process takes on
added dimensions. One of the primary reasons that why a multinational need strategic
management, is to keep track of their increasingly diversified operations in a
continuously changing international environment. This need is obvious when we consider
the amount of FDI in recent years in international business. Statistics had revealed that
FDI has grown three times faster than trade and four times faster than world gross
domestic product. These developments are resulting in a need to coordinate and integrate
diverse operations with a unified and agreed on focus.
Strategic management should answer two basic questions “Where are we going?” and
“How are we going to get there?” Some strategies are consistent across markets while
others must be adapted to regional situations, but in either case, a firm’s global strategy
should support decision making in all major operations.
International strategic management has to deal with the competition in industries that
extend across national boundaries, among firms with different national home bases, and
with firms that operate across national boundaries and may tap into strategic resources in
more than one location. As a result, in addition to the “standard” strategic frameworks for
assessing the desirability of an industry or business and the firm’s capabilities that give it
a competitive advantage in particular businesses, international strategic thinking requires
frameworks for the following levels of analysis:

 The geographical scope of the relevant industry.

  The attractiveness of various locations as markets, sources of factor inputs or
strategic competencies, and the overall competitive advantage afforded by various
locations.
 The sustainability of internationalization as a competitive strategy for a particular
firm.
 The degree of global integration and local focus of activities or processes.

By analyzing above facts we can say that formulation and implementation of

international strategy is very complex in nature. Sometimes complexity of international
business environment makes necessary to join hands for two competitors for entering in a
specific market or for survival in the market.
The process by which a firm’s manager evaluate the future prospects of the firm and
decide on appropriate strategies to achieve long term objective is called strategic
planning. It is often the responsibility of top-level executives at home country (HQs) and
senior managers of subsidiaries at host countries. Almost all the successful multinationals
engage in long-range strategic planning, and those with a global orientation position
themselves to take full advantage of worldwide trends and opportunities. Multinationals
accept that strategic planning is essential to contend with the increasing global
competition and to coordinate their far-flung operations.
Nature of International Strategic Management
Strategic management is concerned with the process of formulating, implementing, and
evaluating strategies to achieve a firm’s objectives. Conceptually strategic management
process in any multinational is similar to that in any local organisation. Complication
arises when organisations have to work in differents environments of different countries.
Thus before deciding about the different strategic options organisations have to analyse
and understand different environmental factors. To identify and evaluate external trends
in any multinational requires huge amount of time and effort. Geographic distances,
culture, business practices makes communication difficult between home office and
international operation.
A multinational needs to keep track of its increasingly diversified operations in
continuously changing environment of international business. As we can go through the
statistics of FDI that has takent place in recent years. FDI has outgrown trade across the
globe and this development necessitates the need to coordinate and integrate diverse
operations with the united goal.
Any multinational is able to increase its profitability in ways often not available to a
domestic firm. Following are the main factors where a multinational have an edge over
domestic firm.
Core Competencies: It can be understood as those skills within the firm which any
competitor cannot easily imitate. This skill can be in any functional area like in
marketing, finance, R&D, Production etc. We can take example of Wal-Mart as it
had core competency in information system and logistics through this core
competency it is world leader in field of reatiling.
Acquiring and/or Developing Brands: A multinational can achieve success by
acquiring different brands and thus increasing its sales or by developing its brand
worldwide.
Realising Location Economies:
Approaches to Formulating and Implementing Strategy
Following are four common approaches for the formulation and implementation of
international strategy:
Economic Imperative
Political Imperative
Quality Imperative
Administrative Coordination
Economic Imperative
Multinational which focuses on the economic imperative employ a world wide strategy
based on cost leadership, differentiation, and segmentation. Many of these companies
typically sell products for which a large portion of value is added in the upstream
activities of the industry’s value chain. By the time the product is ready to be sold, much
of its value has already been created through research and development, manufacturing,
and distribution. Some of the industries in this group include automobiles, chemicals,
heavy electrical systems, and steel. Because the product is generally homogeneous and
requires no alteration to fit the needs of specific country, management uses a worldwide
strategy that is consistent on a country to country basis.
The approach is also used when the product is regarded as a generic good and therefore
does not have to be sold based on name brand or support service. European computer
market is the best example of this approach. Initially the market was captured by
multinationals like IBM, Apple etc, but after sometimes clone manufacture began to gain
market share. This was because consumers started to understand that in a computer all the
vendors provide the same product with same performance level only brand name
changes.
Another important economic imperative which has gained prominence in recent years is
global sourcing. Concept of global sourcing is now a days proving very important in
formulating international strategy. A good example is provided by the way in which
manufacturers are reaching into the supply chain and shortening the buying cycle.
Political Imperative
Multinationals those are very much country responsive uses this political imperative
approach. In it their approach is designed to protect local market niches. The products
sold by multinationals often have a large portion of their value added in the downstream
activities of the value chain. Industries such as insurance and consumer packaged goods
are examples of this approach. Typically, these industries use a country centered strategy.
Quality Imperative
A quality imperative takes two interdependent paths: First, a change in attitudes and a
rising of expectation for service quality; and second, the implementation of management
practices that are designed to make quality improvement an ongoing process. This
process is commonly known as total quality management (TQM). This approach takes a
wide number of forms, including cross- training personnel to do the jobs of all members
in their work group, process re-engineering designed to help identify and eliminate
redundant tasks and wasteful efforts, and reward systems designed to reinforce quality
performance.
TQM covers all the aspects of strategy formulation to implementation. It can be
summarized as follows:
  Quality is operationalised by meeting or exceeding customer expectations.
 The quality strategy is formulated at the top management level and is diffused
throughout the organization.
 TQM techniques range from traditional inspection and statistical quality control to
cutting edge human resource management techniques, such as self managing
teams and empowerment.
Multinationals, now a days, make quality as an integral part of their overall strategy,
because they have learned that this is one of the important way to increase market base
and customer satisfaction. Automobile industries now a days is the best example for this
approach. After loosing the market share of four wheelers to Japanese firms, the US firms
have increased their overall quality in recent years so that they can minimize the gap
between them and Japanese firms.
Administrative Imperative
In this approach multinationals makes strategic decisions based on the merits of the
individual situation rather than using a predetermined economic and political strategy.
Wal-Mart can be considered as best suited example for adapting this approach. This retail
giant expanded into Latin America in recent years by following this approach.

Many large multinationals work to combine the economic, political, quality and
administrative approaches to strategic planning. For example IBM uses economic
imperative in developed countries where it has strong market power, the political and
quallity imperative when the market requires a calculative response like in European
countries, and administrative approach when rapid, flexible decision making is needed to
close sales.

Stages in Strategic Planning Process

Stage 1: Analysis of external and internal environment through SWOT analysis, i.e.
looking at each activity of the business and pinpointing key strengths, weaknesses,
opportunities and threats. The goal of external environmental analysis is to identify
opportunities and threats that will need to be addressed. The purpose of an internal
environmental analysis is to evaluate the company’s financial and personnel strengths
and weaknesses
Stage 2: Statement of corporate mission and establishment of corporate objectives. The
following questions must be answered to determine the firm’s basic mission:
o What is the firm’s business?
o What is the reason for its existence?
Stage 3: Specification of overall corporate strategy & establishment of operational plans
in line with overall strategy.
Stage 4: Periodic reviews of strategy in terms of objectives versus performance – the use
of gap analysis, and subsequent revision of objectives. This is the process of Evaluation
and control of operations. Progress is periodically evaluated and changes are made in
the plan to accommodate changing circumstances and new information.

STEP 1 STEP 2 STEP 3 STEP 4 STEP 5

Identification of the Analysis of the Formulation of objectives Implementation of Evaluation and control of
firm’s basic mission external and and overall plan the plan operations
 internal environment

Strategic Planning Process

Pressures for Cost Reductions & Local Responsiveness

The organisations which have to compete in global market have to face two types of
competitive pressures: Firstly they have to face pressures for cost reductions and
secondly pressure to be locally responsiveness. These competitive pressures place
conflicting demands on the organisation. First pressure for cost reduction requires low
unit cost. To achieve this goal firm has to move at the most favourable low cost location,
wherever in the world that might be. It may also necessitate that a firm offer a
standardised product to the global market. This help the organisation to spread its fixed
cost of developing a product over a large volume of products. This distribution of fixed
cost lowers the average unit costs of the product. When organisation offers standardised
product it is possible to attain other scale of economies and ride the experience curve as
quickly as possible. Contrast to the first pressure second pressure says to be locally
responsive. It requires that organisation should differentiate its product offering and
marketing strategy from country to country in an attempt to accommodate the diverse
demands that arise due to the difference of tastes and preferences of customers, business
practices, competition etc of different countries.

Pressure for Cost Reductions

If we take example of automobile sector, in this sector there are some products which are
used irrespective of their brand like tires, batteries, keys etc. Now if we consider
batteries, it is facing intense cost reduction pressures. Batteries are commodity where
meaningful differentiation is difficult and price is the main competitive advantage. In
1990s there was a decline in global automobiles sales this in turn affected sales of
batteries also. The was worldwide pricewar with almost all the battery manufacturing
firms. In response to the resulting cost pressure most firms are now trying to rationalise
their operations in a manner that is consistent with the attainment of low cost position.
Above example clarifies that in this globally competitive market international business
often faces pressures for cost reduction. To overcome the pressure of cost reduction
requires afirm to try to lower the costs of value creation by mass producing a
standardised product at the optimal location in the world, wherever that might be, to
realize location and experience curve economies. This pressure is more intense in
industries producing commodity type products where meaningful differentiation on non
price factors is difficult and price is the main competitive factor. This can be trend for
those products which fulfils the universal needs. This can be the case of bulk chemical,
petroleum, steel etc.
Pressure for cost reduction is also intense for those industries where major competitors
are based in low cost locations, where there is persistent excess capacity, and where
consumers are more powerful and face low switching costs. Many economists have also
argued that the liberalisation of the world trade and investment environment in recent
decades, by facilitating greater international competition, has generally increased cost
pressures.

Pressure for Local Responsiveness

Local responsiveness pressure arises due to the following factors
Consumer Taste and Preference: When there is very significant difference among
consumers taste and preferences, pressure increases for local responsiveness. This
differnce may be due to the historic or cultural reasons. In these cases marketing
strategies and product should be customised. This typically creates pressure to
delegate production and marketing functions to national subsidaries.
As we can take the example of McDonald, the world’s largest fast food chain,
when started its business operations in India it had to change the ingredients of its
products due to the tastes and preference of the Indian customers.

Distribution Channels: A firms strategy should be responsive to the differnces in

distribution channel among different countries. This may necessitate the
delegation of functional independence to the national subsidiaries.
In India distribution channels for retail industry is toally different from the
distribution channels of the western countries. Similarly in pharmaceutical
industry Japneese distribution system is radically different from that of U.S.
system. This differnce necessitate the change in the functional practices of firms
in Japan as compare to U.S.

Differences in Infrastructue and Traditional practices: One of the impaortant

reason of arising of pressure of local responsiveness is the differences in
infrastructural and traditional practices among countries. Thus in this case product
is to be customised according to the infrastructure and traditional practices of
different nations.
We can take example of India, here people drive on left side of the road hence
creating the demand of four wheelers having right hand drive, whereas in
 France,USA people drive on right side of the road hence creating the demand of
left hand drive four wheelers.

Host Country’s Requirement: Sometimes economic and political environment of

the host country may necessitate a degree of local responsiveness. As we had
discussed in chapter 2 that how economic and political environment affects the
international business scenario and forces business organisations to respond
locally.

Global vs.Regional Strategies

A fundamental strategic question arises when we have to answer the question that when
to follow the global strategy and when to follow regional or local strategy. This is
commonly known as global integration vs national reaponsiveness conflict. Global
integration can be defined as the production and distribution of products and services of a
homogeneous type and quality to the whole world. National responsiveness can be
defined as to understand the different consumer tastes in segmented regional marlets and
respond to different national standards and regulations imposed by autonomous
governments and agencies. National responsiveness also relates to the need to adapt tools
and techniquesfor managing the local workforce. Sometimes one stratgy which had
worked wery efficiently in one country is not successful in other countries.

The issue of Global Integration and National Responsiveness can be analysed by a two
dimensional matrix. On vertical axis Global Integration amd on horizontal axis National
Responsiveness is shown.

GLOBAL INTEGRATION VS NATIONAL RESPONSIVENESS MATRIX

FIGURE FROM PAGE 243 INTERNATIONAL MANAGEMENT BY HODGETTS

AND LUTHANS

Thus when we move up on the vertical axis it means that there is greater degree of
economic integration. Global Integration generates economies of scale and also
capitalises on further lowering unit costs as a firm moves into worldwide markets selling
its products or services. These economies are captured through centralising specific
activities in the value added chain. They also occur by reaping the benefits of increased
coordination and control of geographically dispersed activities.
In the similar way when we move away from the origin on horizontal axis need for
national responsiveness increases.This suggests that multinationals must address local
tastes and prefersnces and government regulations. The result may be geographic
dispersion of activities or a decentralisation of coordination and control for individual
multinational.
On the basis of above matrix we can have four quadrants. Each quadrant shows different
strategy (Quadrant 1- International Strategy, Quadrant 2- Multidomestic Strategy,
Quadrant 3- Global Strategy, Quadrant 4- Transnational Strategy).
International Strategy

CHAPTER10 Strategies for International Business

10.1 Entry Decisions for International Business
10.1.1 Selection of Foreign Market
10.1.2 Timing of Entry
10.1.3 Scale of Entry
10.2 Mode of entry in Foreign Market
10.2.1 Exporting
10.2.2 Turnkey Projects
10.2.3 Licensing
10.2.4 Franchising
10.2.5 Joint Venture
10.2.6 Wholly Owned Subsidiary by Green-
Field Venture or Acquisition
10.3 Strategic Alliancess
10.3.1 Selection & Structure of Strategic
Alliance
10.3.2 Advantages of Strategic Alliances
10.3.3 Disadvantages of Strategic Alliances
10.4 Competitive Strategies for International Business
10.4.1 International Strategy
10.4.2 Multidomestic Strategy
10.4.3 Global Strategy
10.4.4 Transnational Strategy
10.4.5 Porter’s Strategy
Summary
Discussion Questions