Fin management materials / P4AFM-Session15_j08

SESSION 15 – THE ECONOMIC ENVIRONMENT FOR MULTINATIONALS

OVERVIEW

Objective

¾To describe the economic influences on international financial management decisions.

¾To describe the international financial system.

ECONOMIC

ENVIRONMENT

FREE TRADE

AREAS

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1MULTI NATIONAL CORPORATIONS (MNCs)

1.1 Definition

¾A corporation that has operations in at least one country other than its home country. Such companies have offices and/or factories in different countries and usually have a centralised head office where they coordinate global management. Sometimes referred to as a “transnational corporation”

¾Very large multinationals have budgets that exceed those of some small countries.

¾Advocates of multinationals say they create jobs and wealth and improve technology in countries that are in need of such development.

¾On the other hand, critics say multinationals can have undue political influence over governments, can exploit developing nations as well as create job losses in their own home countries.

1.2Competitive advantage

The success of MNC’s may be attributed to various sources of competitive advantage:

¾High investment in R&D

¾Ability to attract and retain top personnel

¾Economies of scale e.g. buying power

¾Flexibility to switch production to lowest cost locations

¾Vertical integration (control of suppliers and distributors)

¾Horizontal integration (buying competitors)

¾Power to negotiate favourable terms with host governments e.g. lower tax rates. grants

¾Brand recognised worldwide

¾Use of international transfer pricing to reduce tax costs

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2INTERNATIONAL TRADE VS. PROTECTIONISM

2.1Potential advantages from trade

(1)Increased competition for domestic producers:

Greater pressure to keep costs and prices down

Dilution of monopoly power in domestic markets

Reduction in price discrimination

(2)Exploitation of the principle of comparative advantage:

Comparative advantage is where a country has a lower cost of producing one particular good or service than another

The country should specialise in the production of that good and then trade with other countries who may have lower production costs for other goods.

(3)Dynamic efficiency gains:

Trade tends to speed up the pace of technological progress and innovation across many different industries

Greater choice for consumers

(4)Economies of scale (lower long run average costs) and higher profits

(5)Trade is seen as a stimulant to short term and long run economic growth:

Exports are an injection of aggregate demand

Boost to exports will have a multiplier effect on GDP

Supply-side improvements from investment and greater factor mobility between countries

2.2Arguments for protectionism

¾The “infant industry” argument:

protecting young domestic firms which do not have access to the same economies of scale as MNC’s”

¾The Balance of Payments argument:

Balance of payments – a summary of economic transactions between a country and other countries over a specific time period.

Desire to control the growth of imports to improve the trade balance

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¾Response to “dumping”:

Dumping is predatory pricing by overseas suppliers

Overseas suppliers “off-load” excess capacity at below cost-price

¾Employment protection:

Fear of structural unemployment in declining sectors

Social costs of unemployment resulting from increased import penetration in particular industries

¾Desire to increase government revenue via import tariffs

¾The “national interest” argument - protecting industries of strategic importance e.g. energy, defence

2.3Arguments against protectionism

¾Welfare losses for consumers (higher prices)

¾Threat to global growth from reduction in trade

¾Threat of retaliation

¾Import controls do not encourage domestic producers to improve efficiency and act as a barrier to entry

¾Bureaucracy of administering import controls

2.4Forms of protectionism

¾“Red tape” – excessive complexity for foreign companies wishing to set up a local subsidiary

¾Refusing licences to foreign companies e.g. banking licence

¾Appropriation of assets of foreign companies

¾Block on remittances to overseas parent

¾Payment of subsidies to domestic producers

¾Tariffs (import duties) – import taxes lead to lower imports, higher prices for consumers and revenue for the government

¾Quotas – quantitative limits on the level of imports allowed

¾Embargoes – a total ban on imported goods

¾Exchange controls – limiting the amount of foreign exchange that can move between countries

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3FREE TRADE AREAS AND CUSTOMS UNIONS

¾established in 1960 by non-EU countries

¾linked up with the EU in 1993 to create European Economic Area (EEA)

¾as members join the EU the EFTA may be left with no role

3.3North American Free Trade Area (NAFTA)

¾Canada, US, Mexico

¾established in 1993 as a free trading block

¾General Agreement on Tariffs and Trade

¾International agreement to progressively remove measures which distort free trade

¾Countries cannot discriminate between trading partners

¾Average tariffs fell from 40% in 1947 to 5%

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¾However this lead to increased use of non-tariff barriers

3.6World Trade Organisation (WTO)

¾The World Trade Organisation (WTO) in 1995 succeeded GATT as the major world forum for international negotiations and agreement in trade.

¾It now includes almost 150 countries, which represent the majority of world trade. In contrast to GATT, which focussed on the trade in goods, the WTO also covers trade in services.

¾The WTO’s overriding objectives are to promote freer trade and to reduce or eliminate protectionist barriers. Its activities involve:

Extending trade concessions equally to all members of the WTO.

Encouraging lower tariffs and fairer trade around the world, including antidumping measures.

Introducing rules that make trade more predictable.

Stimulating competition through cutting subsidies.

3.7Financial contagion

¾Financial contagion refers to the spread of economic and financial problems from one country to another.

¾As barriers to trade, investment and capital flows are reduced or eliminated the resultant more “global” economy is more susceptible to contagion.

¾As can be seen from the problems of the Thai baht in 1997, the problems of even a relatively small economy can easily have severe economic impacts on neighbouring countries and even upon larger countries such as Brazil and Russia.

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4EXCHANGE RATE SYSTEMS

4.1Floating exchange rates

¾A floating exchange rate if is where the value of the currency is allowed to move freely with supply and demand.

¾The main sources of demand are:

Exports of goods

Exports of services

Inflows of foreign investment

Speculative demand

Official buying of by the Central Bank

¾The main sources of supply are:

Imports of goods

Imports of services

Outflows of foreign investment

Speculative selling

Official selling by the Central Bank

¾Managed float - rates allowed to float but Government intervenes if fluctuations are likely to be very large.

4.2Fixed Peg

¾A fixed exchange rate regime where the rate is kept fixed against that of another currency.

¾No fluctuations are permitted; the Central Bank intervenes to maintain the currency.

¾Occasional revaluation or devaluation may be required when economic fundamentals demand it.

4.3Crawling Peg

¾An exchange rate system in which a currency is allowed to fluctuate within a band of rates. The target rate is also adjusted frequently due to factors such as inflation. This gradual shift of the currency’s value is done as an alternative to a

sudden and significant devaluation.

¾For example, in the 1990s, Mexico had fixed its peso with the US dollar. However, due to the significant inflation in Mexico, as compared to the US, it was evident that the peso would need to be severely devalued. Because a rapid devaluation would create instability, Mexico put into place a crawling peg exchange rate adjustment system, and the peso was slowly devalued toward a more appropriate exchange rate.

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5.2International banking

¾Cross-border lending

¾Cross-currency lending

¾Large expansion due to:

deregulation offering new profit opportunities

lower transaction costs arising from technological advances

diversification to reduce risk

¾Syndication -a group of bankers where each agrees a portion of the funding

¾Multi-option facilities - allows companies to choose how to raise funds from a variety of funding instruments on the Euromarkets e.g. note issuance facilities, revolving underwriting facilities

5.3The Bank for International Settlement (BIS)

¾Based in Basle and responsible for monitoring the international banking system

¾Effectively a supervisory body for central banks and aims to improve the capital adequacy of commercial banks

6GLOBAL DEBT

6.1International debt problem

¾Origin of problem is the huge balance of payments problems of developing countries in the 1970s due to:

oil price rises

recessions in developed countries reducing exports by developing nations.

growth of non-tariff barriers

¾Deficits financed not by deflation but by borrowing. Eurocurrency markets channelled surpluses of oil-exporting countries to developing countries which thus accumulated huge international debts.

¾Burden of debt repayment grew during the 1980s, e.g. servicing its debt in 1980 absorbed 63.1% of Brazil’s export earnings.

6.2Efforts to decrease the problem

Measures include:

¾Capping of interest rates by banks

¾Accepting payment of debt in local currencies

¾Debit for equity swaps allowing multinationals to acquire shares in local companies

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¾Restructuring of economies

¾Restructuring of loans allowing countries longer to repay

¾Removal of tariff barriers and quotas by the developed world

¾1985 Baker plan:

Increased commercial lending to developing countries

Economic reform by indebted countries

However, neither banks nor debtor countries co-operated

¾1989 Brady package:

Some debt cancellation by international banks

Economic reform by indebted countries

6.3The Blair-Brown deal

¾Agreement was reached at the 2005 G8 summit to write off the entire US$40 billion debt owed by 18 Highly Indebted Poor Countries to the World Bank, the International Monetary Fund and the African Development Fund. The annual saving in debt payments amounts to just over US$1 billion.

¾The G8 ministers stated that twenty more countries, with an additional US$15 billion in debt, would be eligible for debt relief if they met targets on fighting corruption and to privatize industries, liberalize their economies, eliminate subsidies, and reduce budgetary expenditures.

¾Many criticised the Blair-Brown plan as inadequate and argued that the continuation of structural reform policies outweighs the benefits of debt cancellation, while also pointing out that only a small proportion of the developing world’s debt will be affected by the proposal.

¾Structural reforms have been criticized in the past for devastating poor countries. For example, in Zambia, structural reforms of the 1980s and early 1990s included massive cuts to health and education budgets, the introduction of user fees for many basic health services and for primary education, and the cutting of crucial programs such as child immunization initiatives.

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