Chapter 1

Chapter 1

Chapter 1 Current Multinational Challenges and the Global Economy The Multinational Enterprise (MNE) I define globalization as producing where it is most cost-effective, selling where it is most profitable, and sourcing capital where it is cheapest, without worrying about national boundaries. Narayana Murthy, President and CEO, Infosys.

A multinational enterprise (MNE) has operating subsidiaries, branches or affiliates located in foreign countries. The financial crisis of 2007-2009 has disrupted international business and identified disturbing risks. 1-2 2013 Pearson Education, Inc. All rights reserved. Financial Globalization and Risk The global financial market place is a combination

of complex risks: The international monetary system is an eclectic mix of floating and managed fixed exchange rates. China is more and more a dominant player. Monetary and fiscal policies are complicated by large government deficits. Large and continuing balance of payments imbalances will shift the exchange rate landscape. The dominant form of business may have shifted from the publicly-traded firm to the privately owned model. Global capital markets are shrinking and changing. Perhaps too much capital sometimes flows to emerging market countries causing another set of problems 1-3

2013 Pearson Education, Inc. All rights reserved. The Global Financial Marketplace Assets, institutions, and linkages comprise one method to map global capital markets (see Exhibit 1.1). The assets are debt securities issued by governments (e.g. U.S. Treasury securities). These form the baseline for other forms of financing. The institutions are the central banks, commercial, and investment banks. Their health keeps the global financial system stable. The linkages are the interbank networks using

currency. Without ready exchange of currencies the market is hard-pressed to operate efficiently. 1-4 2013 Pearson Education, Inc. All rights reserved. Exhibit 1.1 Global Capital Markets 1-5 2013 Pearson Education, Inc. All rights reserved. The Market for Currencies

Most currencies are quoted against the dollar as in so many units per dollar A few are quoted as dollars per unit due to custom e.g., $/ and $/. There are also several symbols that can be used to write the quotations, but this is the authors stated preference. Exhibit 1.2 provides selected currency exchange rate quotes 1-6 2013 Pearson Education, Inc. All rights reserved.

Exhibit 1.2 Selected Global Currency Exchange Rates 1-7 2013 Pearson Education, Inc. All rights reserved. Exhibit 1.2 Selected Global Currency Exchange Rates (cont.) 1-8 2013 Pearson Education, Inc. All rights reserved.

Eurocurrencies and LIBOR Eurocurrencies (a major linkage in the global and capital markets) These are domestic currencies of one country on deposit in a second country The Eurocurrency markets serve two valuable purposes: Eurocurrency deposits are an efficient and convenient money market device for holding excess corporate liquidity The Eurocurrency market is a major source of shortterm bank loans to finance corporate working capital needs (including export and import financing) 1-9

2013 Pearson Education, Inc. All rights reserved. Eurocurrencies and LIBOR Eurocurrency Interest Rates: LIBOR In the Eurocurrency market, the reference rate of interest is the London Interbank Offered Rate (LIBOR) This rate is the most widely accepted rate of interest used in standardized quotations, loan agreements, and financial derivatives transactions 1-10

2013 Pearson Education, Inc. All rights reserved. The Theory of Comparative Advantage The theory of comparative advantage provides a basis for explaining and justifying international trade in a model world assumed to enjoy: free trade; perfect competition; no uncertainty; costless information; and no government interference.

1-11 2013 Pearson Education, Inc. All rights reserved. The Theory of Comparative Advantage The theory contains the following features: Exporters in Country A sell goods or services to unrelated importers in Country B Firms in Country A specialize in making products that can be produced relatively efficiently, given Country As endowment of factors of production, that is, land, labor, capital, and technology Firms in Country B do likewise, given the factors of

production found in Country B In this way the total combined output of A and B is maximized 1-12 2013 Pearson Education, Inc. All rights reserved. The Theory of Comparative Advantage Because the factors of production cannot be moved freely from Country A to Country B, the benefits of specialization are realized through international trade The way the benefits of the extra production are shared

depends on the terms of trade, the ratio at which quantities of the physical goods are traded Each countrys share is determined by supply and demand in perfectly competitive markets in the two countries Neither Country A nor Country B is worse off than before trade, and typically both are better off, albeit perhaps unequally 1-13 2013 Pearson Education, Inc. All rights reserved. The Theory of Comparative Advantage

Although international trade might have approached the comparative advantage model during the nineteenth century, it certainly does not today, for the following reasons: Countries do not appear to specialize only in those products that could be most efficiently produced by that countrys particular factors of production (as a result of government interference and ulterior motivations) At least two factors of production capital and technology now flow directly and easily between countries 1-14 2013 Pearson Education, Inc. All rights reserved.

The Theory of Comparative Advantage Modern factors of production are more numerous than in this simple model Although the terms of trade are ultimately determined by supply and demand, the process by which the terms are set is different from that visualized in traditional trade theory Comparative advantage shifts over time, as less developed countries become developed and realize their latent opportunities The classical model of comparative advantage did not really address certain other issues, such as the effect of

uncertainty and information costs, the role of differentiated products in imperfectly competitive markets, and economies of scale 1-15 2013 Pearson Education, Inc. All rights reserved. The Theory of Comparative Advantage Comparative advantage is however still a relevant theory to explain why particular countries are most suitable for exports of goods and services that support the global supply chain of both MNEs and domestic firms.

The comparative advantage of the 21st century, however, is one based more on services, and their cross-border facilitation by telecommunications and the Internet. The source of a nations comparative advantage is still created from the mixture of its own labor skills, access to capital, and technology. 1-16 2013 Pearson Education, Inc. All rights reserved. The Theory of Comparative Advantage Many locations for supply chain outsourcing

exist today (see Exhibit 1.3). It takes a relative advantage in costs, not just an absolute advantage, to create comparative advantage. Clearly, the extent of global outsourcing is reaching out to every corner of the globe. 1-17 2013 Pearson Education, Inc. All rights reserved. Exhibit 1.3 Global Outsourcing of Comparative Advantage

1-18 2013 Pearson Education, Inc. All rights reserved. What is Different About International Financial Management? Exhibit 1.4 summarizes the differences. Culture and history differ among countries Corporate governance Greater levels of foreign exchange and political risks Financial theory and applications are modified in the global versus domestic marketplace Specialized and complicated financial

instruments become tools of the trade 1-19 2013 Pearson Education, Inc. All rights reserved. Exhibit 1.4 What Is Different About International Financial Management? 1-20 2013 Pearson Education, Inc. All rights reserved. Market Imperfections: A Rationale for

the Existence of the Multinational Firm MNEs strive to take advantage of imperfections in national markets for products, factors of production, and financial assets. Imperfections in the market for products translate into market opportunities for MNEs. Large international firms are better able to exploit such competitive factors as economies of scale, managerial and technological expertise, product differentiation, and financial strength than their local competitors. 1-21

2013 Pearson Education, Inc. All rights reserved. Market Imperfections: A Rationale for the Existence of the Multinational Firm Strategic motives drive the decision to invest abroad and become a MNE and can be summarized under the following categories: Market seekers

Raw material seekers Production efficiency seekers Knowledge seekers Political safety seekers These categories are not mutually exclusive. 1-22 2013 Pearson Education, Inc. All rights reserved. The Globalization Process Stage I: early domestic phase growing into the international trade phase (Exhibit 1.5)

Stage II: A successful firm will continue to grow from simple international trade to the multinational phase characterized by production and investment both at home and abroad (Exhibit 1.6) Growth may be limited by the twin agency problems of corporate insiders and the rulers of sovereign states (Exhibit 1.7) 1-23 2013 Pearson Education, Inc. All rights reserved. Exhibit 1.5 Trident Corp: Initiation of the

Globalization Process 1-24 2013 Pearson Education, Inc. All rights reserved. Exhibit 1.6 Tridents Foreign Direct Investment Sequence 1-25 2013 Pearson Education, Inc. All rights reserved. Exhibit 1.7 Potential Limits of

Financial Globalization 1-26 2013 Pearson Education, Inc. All rights reserved.

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