Chapter 15: The economic environment for multinationals

Chapter learning Objectives

Upon completion of this chapter you will be able to:

• explain the theory of comparative advantage
• explain the theory of free trade and the development of barriers to trade
• list and explain the major trade agreements and common markets currently in operation
• for a given business, on the basis of contemporary circumstances, advise on the policy and strategic implications of explain the major trade agreements and common markets currently in operation
• list and explain the objectives of the World Trade Organisation
• explain the objectives and function of the main international financial institutions, within the context of a globalised economy:
  • International Monetary Fund.
  • The Bank of International Settlements.
  • The World Bank.
  • The principal Central Banks (The Fed, ECB and Bank of Japan):
• explain the role of the international financial markets with respect to the management of global debt, the financial development of the emerging economies and the maintenance of global financial stability
• explain the implications for financial planning of the level of mobility of capital across borders and national limitations on remittances and transfer pricing
• explain the implications for financial planning of the pattern of economic and other risk exposures in the different national markets
• explain the implications for financial planning of agency issues in the central coordination of overseas operations and the balancing of local financial autonomy with effective central control.

1 Free trade and the development of barriers to trade

Free trade

Practical reasons for overseas trade

• Choice – The diversity of goods available in a domestic economy is increased through the import of goods that could be uneconomic or impossible to produce at home.
• Competition – International trade will increase competition in domestic markets, which is likely to lead to both a reduction in price, together with increasing pressure for new products and innovation.
• Economies of scale – By producing both for the home and international markets companies can produce at a larger scale and therefore take advantage of economies of scale.
• Specialisation – If a country specialises in producing the goods and services at which it is most efficient, it can maximise its economic output.

Illustration 1

Imagine the impact on a country’s consumers if internationaltrade did not take place. No bananas, no tropical fruits at any time ofthe year, vegetables only when they are in season. Less obviously, somecountries would be chronically short of many basic metals and materials.Many countries are also increasingly dependent on energy imports.Overall, world economic output would be far lower as countries would beforced to allocate resources to inefficient methods of production.

The theory of comparative advantage

The main theoretical justification for international trade is the law of comparative advantage.

The law of comparative advantage states that two countries can gainfrom trade when each specialises in the industries in which each hasthe lowest opportunity cost.

Comparative advantage between countries - illustration

Imagine a global economy with two countries and two products. Eachcountry needs both products and at present all needs are met by domesticproduction. Each country has the same resources available to it andthey are split equally between the two products.

Suppose the current situation with regard to production is as follows:

As the situation currently stands, country A has an absolute advantage in production of both X and Y.

Given this what are the benefits of A trading with B?

To answer this question we need to consider the opportunity costs incurred by producing X and Y.

• If country A were to focus on making X only, it would give up 720 units of Y to produce an extra 1,200 units of X, i.e. the opportunity cost of 1 unit of X is 720/1,200 = 0.6 units of Y.
• If country B were to focus on making X only, it would give up 240 units of Y to produce an extra 960 units of X, i.e. the opportunity cost of 1 unit of X is 240/960 = 0.25 units of Y.
• The opportunity cost of producing X is lower for country B than it is for country A. It follows that B has a comparative advantage in production of X and should specialise in this product.

If country B is to make product X, it follows that country A shouldmake product Y. An analysis of opportunity costs supports thisconclusion.

• If country A were to focus on making Y only, it would give up 1,200 units of X to make 720 units of Y, i.e. the opportunity cost of 1 unit of Y is 1,200/720 = 1.67 units of X.
• If country B were to focus on making Y only, it would give up 960 units of X to make 240 units of Y, i.e. the opportunity cost of 1 unit of Y is 960/240 = 4 units of X.
• Since country A has the lowest opportunity cost for production of Y, it should specialise in production of this product.

The impact of this decision by each country to specialise inproduction of the good for which they have the lowest opportunity coston world output is shown below:

Specialisation based on lowest opportunity cost

Trade barriers

There are a number of ways that a country can seek to restrict imports. Trade barriers include:

• Quotas – imposition of a maximum number of units that can be imported e.g. quotas on the number of cars manufactured outside of Europe that can be imported into the EU.
• Tariffs – imposition of an import tax on goods being imported into the country to make them uncompetitive on price.
• Exchange controls – domestic companies wishing to buy foreign goods will have to pay in the currency of the exporter’s country. To do this they will need to buy the currency involved by selling sterling. If the government controls the sale of sterling it can control the level of imports purchased.
• Administrative controls – a domestic government can subject imports to excessive levels of administration, paperwork and red tape to slow down and increase the cost of importing goods into the home economy.
• Embargoes – the prohibition of commerce and trade with a certain country.

Multinational companies have to find ways of overcoming thesebarriers, for example by investing directly and manufacturing within acountry rather than importing into it.

2 Trade agreements and common markets

In many parts of the world, governments have created tradeagreements and common markets to encourage free trade. However, theWorld Trade Organisation (WTO) is opposed to these trading blocs andcustoms unions (e.g. the European Union) because they encourage tradebetween members but often have high trade barriers for non-members.

Example of trade agreements and common markets

Bi-lateral trade agreements

e.g. The Closer Economic Relations (CER) agreement between Australia and New Zealand.

Multi-lateral trade agreements

e.g. The North American Free Trade Agreement (NAFTA) between Canada, the United States, and Mexico.

Free trade areas

e.g. The ASEAN Free Trade Area (AFTA) is an agreement by theAssociation of Southeast Asian Nations (Brunei, Indonesia, Malaysia,Philippines, Singapore, Thailand, Vietnam, Laos, Myanmar and Cambodia).

Customs unions

e.g. Mercosur is a customs union between Brazil, Argentina, Uruguay, Paraguay and Venezuela in South America.

Single markets (economic communities)

e.g. The Economic Community of West African States (ECOWAS).

Economic unions

e.g. The largest economic and monetary union at present is theEurozone. The Eurozone consists of the European Union member states thathave adopted the Euro.

The World Trade Organisation (WTO)

In 1995 the World Trade Organisation based in Geneva replaced GATT.

Objectives

• To ensure compliance of member countries with previous GATT agreements.
• To negotiate future trade liberalisation agreements.
• To resolve trading disputes between nations.

For example, there is growing tension between the developed and thedeveloping world. The developing world regards the heavy subsidy of EUand American farmers as a huge barrier to trade for their domesticfarmers. At the same time, the developed world complains about exportsof low cost manufactured goods from the developing world that are notsubject to the same health, safety and environmental regulations thatthey face.

3 Specific strategic issues for multinational organisations – national governance requirements

A multinational company (MNC) is defined as one which generates atleast 25% of its sales from activities in countries other than its own.This rules out returns from portfolio investment and eliminates unit andinvestment trusts.

Different countries have different governance requirements. Thesenational governance requirements will impact on the behaviour ofmultinational organisations.

Test your understanding 1

Explain the difficulties faced by national governments when placing restrictions upon multinational organisations.

4 Specific strategic issues for multinational organisations – the mobility of capital across borders

The mobility of capital

One of the drivers of globalisation has been the increased level of mobility of capital across borders.

Implications of an increased mobility of capital:

• Lower costs of capital.
• Ability of MNCs to switch activities between countries.
• Ability of MNCs to circumnavigate national restrictions.
• Potentially increased exposure to foreign currency risk.

5 Specific strategic issues for multinational organisations – local risk

Local risk for multinationals includes the following:

• Economic risk is the possibility of loss arising to a firm from changes in the economy of a country.
• Political risk is the possibility of loss arising to a firm from actions taken by the government or people of a country.

Political risk

Examples of political risk:

Confiscation political risk

• This is the risk of loss of control over the foreign entity through intervention of the local government or other force.

Illustration 2

• Countries vulnerable to changes of regime – Chile.
• Invasion by powerful neighbours – Lebanon.
• Transition to local ownership – India.
• Confiscation is a very real possibility – Zimbabwe.

Commercial political risk

Illustration 3

The Portuguese revolution of 1974 was followed by several years ofleft-wing military rule in which wages were compulsorily raised andprices controlled at unrealistic falling real levels. Subsidiaries offoreign parents found their margins squeezed and little sympathy fromthe authorities. Those that which happened to be suppliers to thegovernment were hit hardest and also had to face serious attempts by theunions to take control of the management. Many such subsidiaries wereeither abandoned by their shareholders or sold at knockdown prices tolocal interests. It was interference with the commercial processes ofsupply and demand that drove their parents out, not confiscation. Whatdrove their parents out was not confiscation but interference with thecommercial processes of supply and demand.

Financial political risk

This risk takes many forms:

• Restricted access to local borrowings.
• Restrictions on repatriating capital, dividends or other remittances. These can take the form of prohibition or penal taxation.
• Financial penalties on imports from the rest of the group such as heavy interest-free import deposits.

Exchange control risk

One form of exchange control risk is that the group may accumulatesurplus cash in the country where the subsidiary operates, either asprofits or as amounts owed for imports to the subsidiary, which cannotbe remitted out of the country. This can be mitigated by using FOREXhedging.

Illustration 4

A good example is the French regulation under which intra-grouptrade debts of a French subsidiary to its associated companies, if notmade within 12 months of import, become unremittable as ‘capitalinvested in the subsidiary’. Often the French subsidiary delayspayment by more than 12 months because of a shortage of cash created byother French official actions or policies.

6 Specific strategic issues for multinational organisations – control

 Within the hierarchy of firms (in a group) goal incongruence mayarise when divisional managers in overseas operations promote their ownself-interest over those of other divisions and of the organisationgenerally.

In order to motivate local management and to obtain the benefit oftheir local knowledge, decision making powers should be delegated tothem. However, given the wide geographical spread of divisions, it isdifficult for group management to control the behaviour of the localmanagers.

This gives rise to agency costs, and a difficult balance between local autonomy and effective central control.

Agency problems in multinational companies

Agency issues have already been discussed in terms of the relationship between shareholders and managers of a business.

In any large business there will also be agency relationshipsbetween the Board of Directors and the managers of individual businessunits. The managers of individual business units may well have goalswhich are not congruent with the main company Board, or the managers ofthe other business units. For example, the manager of a particularbusiness unit will often make decisions which are in the best interestsof that division, without considering how the decision impacts the otherbusiness units or the company as a whole.

In a multinational company, these agency relationships may be moreproblematic, because of the different cultures, languages and time zoneswhich may hamper communication between the parties.

In order to minimise the agency problems which might arise in amultinational company, it is important that the company implementssuitable corporate governance procedures, and attempts to align thegoals of all the managers by using appropriate managerial compensationpackages.

Test your understanding 2

Consider a multinational organisation setting up a newoverseas subsidiary. List the issues arising from decentralising controlto local management.

International Financial Institutions

International Monetary Fund (IMF)

The IMF was founded in 1944 at an international conference atBretton Woods in the USA but did not really begin to fully functionuntil the 1950s. The so called Bretton Woods System that the IMF was tosupervise was to have two main characteristics: stable exchange ratesand a multilateral system of international payments and credit.

IMF objectives and functions:

• Promoting international financial cooperation and establishing a system of stable exchange rates and freely convertible currencies.
• Providing a source of credit for members with balance of payments deficits while corrective policies were adopted.
• Managing the growth of international liquidity.

The Bank for International Settlements

The Bank for International Settlements (BIS) is an intergovernmental organisation (IGO) whose membership consists of central banks and national monetary authorities.

Objectives:

• to foster international monetary and
• to foster financial cooperation and
• to serve as a bank for central banks.

World Bank

The International Bank for Reconstruction and Development (IBRD),also known as the World Bank, was the second institution created at theBretton Woods meeting in 1944. Its membership and decision makingprocesses are similar to those of the IMF. The original purpose of theIBRD was to help finance the reconstruction of economies damaged by thewar. However, it soon shifted the focus of its lending to countries ofthe developing world. The bank now comprises three principal constituentelements:

• The IBRD proper whose function is to lend long-term funds for capital projects in developing economies at a commercial rate of interest. The main source of these funds is borrowing by the IBRD itself.
• The International Development Association (IDA) which was established in 1960 to provide ‘soft’ loans to the poorest of the developing countries. The IDA:
  • (a) is mainly financed by 20 donor countries providing funds every three years; funding therefore depends on the generosity or otherwise of these countries
  • (b) provides loans on concessionary terms, normally interest free loans repayable over 50 years.
• The International Finance Corporation which promotes the private sector in developing countries by lending or by taking equity.

The World Bank is clearly an important source of capital funds forthe developing countries. However, it has been criticised in recentyears over the nature of its lending conditions. For example criticismshave been levelled about conditions that tie farmers into growing cashcrops (e.g. oil seed rape) in countries that have a historicalpropensity for famine (e.g. parts of Eastern Africa).

Principal Central Banks

The Fed

The Federal Reserve System, also known as ‘The Fed,’ is the central bank of the United States.

Functions and objectives:

• In its role as a central bank, the Fed is a bank for other banks and a bank for the federal government.
• It was created to provide the US with a safer, more flexible, and more stable monetary and financial system.
• Over the years, its role in banking and the economy has expanded. The Federal Reserve System is a network of 12 Federal Reserve Banks and a number of branches under the general oversight of the Board of Governors. The Reserve Banks are the operating arms of the central bank.

ECB

The European Central Bank (ECB) is one of the world’s mostimportant central banks, responsible for monetary policy covering the13 member countries of the Eurozone.

The ECB was established on June 1, 1998 and its headquarters are located in Frankfurt, Germany.

Objectives of the ECB:

• The primary objective of the ECB, and the wider ESCB, is ‘to maintain price stability’ within the euro area, i.e. to keep inflation low.
• In addition, and without prejudice to the objective of price stability, the bank has to support the economic policies of the European Union. These are designed to foster a high level of employment and sustainable and non-inflationary economic growth under Article 2 of the Treaty of the European Union (otherwise known as the Maastricht Treaty).

Bank of Japan

The Bank of Japan is headquartered in Nihonbashi, Tokyo.

Objectives and functions.

According to its charter, the missions of the Bank of Japan are:

• issuance and management of banknotes
• implementation of monetary policy
• providing settlement services and ensuring the stability of the financial system
• treasury and government securities-related operations
• international activities
• compilation of data, economic analyses and research activities.

The Bank of England

The Bank of England's Monetary Policy Committee sets interest rates in the UK.

Another of the Bank's main roles is to act as "lender of last resort" to other UK banks.

7 Chapter summary

Test your understanding answers

Test your understanding 1

Individual countries have imposed their own restrictions from time totime by, for example, reserving certain shareholdings for their ownnationals or by limiting the transference of profits or royalties. Buteven governments have to tread carefully lest the subject of theirattentions abandons the market altogether.

Test your understanding 2

Pro centralisation

• Decisions are made at one point and so are easier to coordinate (congruence).
• Senior managers can take a wider view.
• Policies and procedures can be standardised.
• Possibly cheaper.

Pro decentralisation

• Improved motivation.
• Better local knowledge.
• Quicker decision making.
• Greater speed of decision making.

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