Accounting in the International Business

Country Differences in Accounting Standards

Accounting is shaped by the environment in which it operates. Just as different countries have different political systems, economic systems, and cultures, they also have different accounting systems. In each country, the accounting system has evolved in response to the demands for accounting information.

Despite attempts to harmonize standards by developing internationally acceptable accounting conventions , a myriad of differences between national accounting systems still remain.

Global Human Resource Management

Introduction

Human resource management refers to the activities an organization carries out to use its human resource effectively. These activities include determining the firm's human resource strategy, staffing, performance evaluation, management development, compensation, and labor relations.

The strategic role of HRM is complex enough in a purely domestic firm, but it is more complex in an international business, where staffing, management development, performance evaluation, and compensation activities are complicated by profound differences between countries in labor markets, culture, legal systems, economic systems, and the like .

Global Marketing and R&D

The Globalization of Markets?

In a now-famous Harvard Business Review article, Theodore Levitt wrote lyrically about the globalization of world markets. Levitt's arguments have become something of a lightning rod in the debate about the extent of globalization. The rise of global media such as MTV , and the ability of such media to help shape a global culture, would seem to lend weight to Levitt's argument. If Levitt is correct, his argument has major implications for the marketing strategies pursued by international business. However, the current consensus  among academics seems to be that Levitt overstates his case. Although Levitt may have a point when it comes to many basic industrial products, such as steel, bulk chemicals, and semiconductor chips, globalization seems to be the exception rather than the rule in many consumer goods markets and industrial markets.

Global Manufacturing and Materials Management

Introduction

In this chapter, we look at the problems that Li & Fung and many other enterprises are facing and at the various solutions. We will be concerned with answering three central questions:

·                 Where in the world should productive activities be located?

·                 How much production should be performed in-house and how much should be out-sourced to foreign suppliers?

·                 What is the best way to coordinate a globally dispersed supply chain?

We will examine each of the three questions posed above in turn.

Entry Strategy and Strategic Alliances

Introduction

This chapter is concerned with three closely related topics: (1) The decision of which foreign markets to enter, when to enter them, and on what scale; (2) the choice of entry mode, and (3) the role of strategic alliances. Any firm contemplating foreign expansion must first struggle with the issue of which foreign markets to enter and the timing and scale of entry. The choice of which markets to enter should be driven by an assessment of relative long-run growth and profit potential.The company was too early.

Strategic alliances are cooperative agreements between actual or potential competitors. The term strategic alliances is often used loosely to embrace a variety of arrangements between actual or potential competitors including cross-shareholding deals, licensing arrangements, formal joint ventures, and informal cooperative arrangements.

The Organization of International Business

Introduction

The objective of this chapter is to identify the organizational structures and internal control mechanisms international businesses use to manage and direct their global operations. We will be concerned not just with formal structures and control mechanisms but also with informal structures and control mechanisms such as corporate culture and companywide networks. To succeed, an international business must have appropriate formal and informal organizational structure and control mechanisms. The strategy of the firm determines what is "appropriate." Firms pursuing a global strategy require different structures and control mechanisms than firms pursuing a multidomestic or a transnational strategy. To succeed, a firm's structure and control systems must match its strategy in discriminating ways.

The Strategy of International Business

Introduction

In this chapter, we look at how firms can increase their profitability by expanding their operations in foreign markets. We discuss the different strategies that firms pursue when competing internationally, consider the pros and cons of these strategies, discuss the various factors that affect a firm's choice of strategy, and look at the tactics firms adopt when competing head to head across various national markets.

The Global Capital Market

Introduction

We begin this chapter by looking at the benefits associated with the globalization of capital markets. This is followed by a more detailed look at the growth of the international capital market and the risks associated with such growth. Next, there is a detailed review of three important segments of the global capital market: the Eurocurrency market, the international bond market, and the international equity market. As usual, we close the chapter by pointing out some of the implications for the practice of international business.

The International Monetary System

Introduction

This chapter will explain how the international monetary system works and point out its implications for international business

Finally, we will discuss the implications of all this material for international business. We will see how the exchange rate policy adopted by a government can have an important impact on the outlook for business operations in a given country. If government exchange rate policies result in a currency devaluation, for example, exporters based in that country may benefit as their products become more price competitive in foreign markets. Alternatively, importers will suffer from an increase in the price of their products. We will also look at how the policies adopted by the IMF can have an impact on the economic outlook for a country and, accordingly, on the costs and benefits of doing business in that country.

The Foreign Exchange Market

Introduction

This has three main objectives. The first is to explain how the foreign exchange market works. The second is to examine the forces that determine exchange rates and to discuss the degree to which it is possible to predict future exchange rate movements. The third objective is to map the implications for international business of exchange rate movements and the foreign exchange market. This is the first of three that deal with the international monetary system and its relationship to international business.

Regional Economic Integration

Introduction

One of the most notable trends in the global economy in recent years has been the accelerated movement toward regional economic integration. By regional economic integration, we mean agreements among countries in a geographic region to reduce, and ultimately remove, tariff and nontariff barriers to the free flow of goods, services, and factors of production between each other. Consistent with the predictions of international trade theory, particularly the theory of comparative advantage (see Chapter 4), the belief has been that agreements designed to promote freer trade within regions will produce gains from trade for all member countries

Levels of Economic Integration

Free Trade Area

In a free trade area, all barriers to the trade of goods and services among member countries are removed. In the theoretically ideal free trade area, no discriminatory tariffs, quotas, subsidies, or administrative impediments are allowed to distort trade between members. Each country, however, is allowed to determine its own trade policies with regard to nonmembers.

 There are also active attempts at regional economic integration in Central America, the Andean Region of South America, Southeast Asia, and parts of Africa.

As the opening case on the European Insurance industry demonstrates, a move toward greater regional economic integration can deliver important benefits to consumers and present firms with new challenges. In the European insurance industry, the creation of a single EU insurance market opened formerly protected national markets to increased competition, resulting in lower prices for insurance products. This benefits consumers, who now have more money to spend on other goods and services. As for insurance companies, the increase in competition and greater price pressure that has followed the creation of a single market have forced them to look for cost savings from economies of scale. They have also sought to increase their presence in different nations. The mergers occurring in the European insurance industry are seen as a way of achieving both these goals.

The rapid spread of regional trade agreements raises the fear among some of a world in which regional trade blocs compete against each other. In this scenario of the future, free trade will exist within each bloc, but each bloc will protect its market from outside competition with high tariffs. The specter of the EU and NAFTA turning into "economic fortresses" that shut out foreign producers with high tariff barriers is particularly worrisome to those who believe in unrestricted free trade. If such a scenario were to materialize, the resulting decline in trade between blocs could more than offset the gains from free trade within blocs.

Levels of Economic Integration

Free Trade Area

In a free trade area, all barriers to the trade of goods and services among member countries are removed. In the theoretically ideal free trade area, no discriminatory tariffs, quotas, subsidies, or administrative impediments are allowed to distort trade between members. Each country, however, is allowed to determine its own trade policies with regard to nonmembers. Thus, for example, the tariffs placed on the products of nonmember countries may vary from member to member. 

Customs Union

The customs union is one step further along the road to full economic and political integration. A customs union eliminates trade barriers between member countries and adopts a common external trade policy. Establishment of a common external trade policy necessitates significant administrative machinery to oversee trade relations with nonmembers. Most countries that enter into a customs union desire even greater economic integration down the road. The EU began as a customs union and has moved beyond this stage.

Common Market

Like a customs union, the theoretically ideal common market has no barriers to trade between member countries and a common external trade policy. Unlike a customs union, a common market also allows factors of production to move freely between members. Labor and capital are free to move because there are no restrictions on immigration, emigration, or cross-border flows of capital between member countries. The EU is currently a common market, although its goal is full economic union. The EU is the only successful common market ever established, although several regional groupings have aspired to this goal. Establishing a common market demands a significant degree of harmony and cooperation on fiscal, monetary, and employment policies. Achieving this degree of cooperation has proven very difficult.

Economic Union

An economic union entails even closer economic integration and cooperation than a common market. Like the common market, an economic union involves the free flow of products and factors of production between member countries and the adoption of a common external trade policy. Unlike a common market, a full economic union  also requires a common currency, harmonization of members' tax rates, and a common monetary and fiscal policy. Such a high degree of integration demands a coordinating bureaucracy and the sacrifice of significant amounts of national sovereignty to that bureaucracy.

Political Union

The move toward economic union raises the issue of how to make a coordinating bureaucracy accountable to the citizens of member nations. The answer is through political union. The EU is on the road toward political union.

The Case for Regional Integration 

The Economic Case for Integration

The economic case for regional integration is relatively straightforward. We saw in Chapter 4 how economic theories of international trade predict that unrestricted free trade will allow countries to specialize in the production of goods and services that they can produce most efficiently. The result is greater world production than would be possible with trade restrictions. Although international institutions such as GATT and the WTO have been moving the world toward a free trade regime, success has been less than total. In a world of many nations and many political ideologies, it is very difficult to get all countries to agree to a common set of rules.

Against this background, regional economic integration can be seen as an attempt to achieve additional gains from the free flow of trade and investment between countries beyond those attainable under international agreements such as GATT and the WTO. It is easier to establish a free trade and investment regime  among a limited number of adjacent countries than among the world community. Problems of coordination and policy harmonization are largely a function of the number of countries that seek agreement. The greater the number of countries involved, the greater the number of perspectives that must be reconciled, and the harder it will be to reach agreement. Thus, attempts at regional economic integration are motivated by a desire to exploit the gains from free trade and investment.

The Political Case for Integration

The political case for regional economic integration has also loomed large in most attempts to establish free trade areas, customs unions, and the like. By linking neighboring economies and making them increasingly dependent on each other, incentives are created for political cooperation between the neighboring states. In turn, the potential for violent conflict between the states is reduced. In addition, by grouping their economies, the countries can enhance their political weight in the world.

These considerations underlay establishment of the European Community (EC) in 1957 (the EC was the forerunner of the EU). Europe had suffered two devastating wars in the first half of the century, both arising out of the unbridled ambitions of nation-states.

Impediments to Integration

Despite the strong economic and political arguments for integration, it has never been easy to achieve or sustain. There are two main reasons for this. First, although economic integration benefits the majority, it has its costs. While a nation as a whole may benefit significantly from a regional free trade agreement, certain groups may lose. Moving to a free trade regime involves some painful adjustments. A second impediment to integration arises from concerns over national sovereignty.

The Case Against Regional Integration

Although the tide has been running strongly in favor of regional free trade agreements in recent years, some economists have expressed concern that the benefits of regional integration have been oversold, while the costs have often been ignored. They point out that the benefits of regional integration are determined by the extent of trade creation, as opposed to trade diversion. Trade creation occurs when high-cost domestic producers are replaced by low-cost producers within the free trade area. It may also occur when higher-cost external producers are replaced by lower-cost external producers within the free trade area. Trade diversion occurs when lower-cost external suppliers are replaced by higher-cost suppliers within the free trade area. A regional free trade agreement will benefit the world only if the amount of trade it creates exceeds the amount it diverts.

Regional Economic Integration in Europe

Political Structure of the European Union

The European Council

The European Council is composed of the heads of state of the EU's member nations and the president of the European Commission. Each head of state is normally accompanied by a foreign minister to these meetings.

The European Commission

The European Commission is responsible for proposing EU legislation, implementing it, and monitoring compliance with EU laws by member states. Headquartered in Brussels, Belgium, the commission has more than 10,000 employees. It is run by a group of 20 commissioners appointed by each member country for four-year renewable terms. The commission has a monopoly in proposing European Union legislation. The commission starts the legislative ball rolling by making a proposal, which goes to the Council of Ministers and then to the European Parliament. The Council of Ministers cannot legislate without a commission proposal in front of it. The Treaty of Rome gave the commission this power in an attempt to limit national infighting by taking the right to propose legislation away from nationally elected political representatives, giving it to "independent" commissioners.

The commission is also responsible for implementing aspects of EU law, although in practice much of this must be delegated to member states. Another responsibility of the commission is to monitor member states to make sure they are complying with EU laws. In this policing role, the commission will normally ask a state to comply with any EU laws that are being broken. If this persuasion is not sufficient, the commission can refer a case to the Court of Justice.

The Council of Ministers

The interests of member states are represented in the Council of Ministers. It is clearly the ultimate controlling authority within the EU since draft legislation from the commission can become EU law only if the council agrees. The council is composed of one representative from the government of each member state. The membership, however, varies depending on the topic being discussed. When agricultural issues are being discussed, the agriculture ministers from each state attend council meetings; when transportation is being discussed transportation ministers attend, and so on.

The European Parliament

The parliament, which meets in Strasbourg, France, is primarily a consultative rather than legislative body. It debates legislation proposed by the commission and forwarded to it by the council. It can propose amendments to that legislation, which the commission  are not obliged to take up but often will. The power of the parliament recently has been increasing, although not by as much as parliamentarians would like. The European Parliament now has the right to vote on the appointment of commissioners, as well as veto power over some laws. One major debate now being waged in Europe is whether the council or the parliament should ultimately be the most powerful body in the EU.

The Single European Act

The Stimulus for the Single European Act

There were four main reasons for this:

·                 Different technical standards required cars to be customized to national requirements .

·                 Different tax regimes created price differentials across countries that would not be found in a single market.

·                 An agreement to allow automobile companies to sell cars through exclusive dealer networks allowed auto companies and their dealers to adapt their model ranges and prices on a country-by-country basis with little fear that these differences would be undermined by competing retailers.

·                 In violation of Article 3 of the Treaty of Rome, each country had adopted its own trade policy with regard to automobile

The Objectives of the Act

1.              Remove all frontier controls between EC countries, thereby abolishing delays and reducing the resources required for complying with trade bureaucracy.

2.              Apply the principle of "mutual recognition" to product standards. A standard developed in one EC country should be accepted in another, provided it meets basic requirements in such matters as health and safety.

3.              Open public procurement to nonnational suppliers, reducing costs directly by allowing lower-cost suppliers into national economies and indirectly by forcing national suppliers to compete.

4.              Lift barriers to competition in the retail banking and insurance businesses, which should drive down the costs of financial services, including borrowing, throughout the EC.

5.              Remove all restrictions on foreign exchange transactions between member countries by the end of 1992.

6.              Abolish restrictions on cabotage--the right of foreign truckers to pick up and deliver goods within another member state's borders--by the end of 1992. This could reduce the cost of haulage within the EC by 10 to 15 percent.

7.              All those changes should lower the costs of doing business in the EC, but the single-market program was also expected to have more complicated supply-side effects. For example, the expanded market should give EC firms greater opportunities to exploit economies of scale. In addition, the increase in competitive intensity brought about by removing internal barriers to trade and investment should force EC firms to become more efficient.

Implications

The implications of the Single European Act are potentially enormous. We discuss the implications for business practice in more detail in the Implications for Business section at the end of the chapter. For now it should be noted that, as long as the EU is successful in establishing a single market, the member countries can expect significant gains from the free flow of trade and investment. On the other hand, as a result of the Single European Act, many EU firms are facing increased competitive pressure. Countries such as France and Italy have long used administrative trade barriers and subsidies to protect their home markets from foreign competition. Removal of these barriers has increased competition, and some firms may go out of business.

But the shift toward a single market has not been as rapid as many would like. Six years after the Single European Act became EU law, there have been a number of delays in applying the act to certain industries, often because countries have  appealed to the Council of Ministers for more time.

European Monetary Union (EMU: The Adoption of A Single Currency

Benefits of EMU

As with many of the provisions of the Single European Act, the move to a single currency should significantly lower the costs of doing business in the EU. The gains come from reduced exchange costs and reduced risk. As for reduced risk, a single currency would reduce the risks that arise from currency fluctuations. The values of currencies fluctuate against each other continually. As we will see in Chapter 9, this introduces risks into international transactions.

Costs of EMU

The drawback, for some, of a single currency is that national authorities would lose control over monetary policy. Thus, the EU's monetary policy must be well managed. The Maastricht Treaty called for establishment of an independent European Central Bank (ECB), similar in some respects to the US Federal Reserve, with a clear mandate to manage monetary policy so as to ensure price stability. Like the US Federal Reserve, the ECB, based in Frankfurt, is meant to be independent from political pressure--although critics question this. Among other things, the ECB will set interest rates and determine monetary policy across the euro zone. Critics fear that the ECB will respond to political pressure by pursuing a lax monetary policy, which in turn will raise average inflation rates across the euro zone, hampering economic growth.

Several nations were concerned about the effectiveness of such an arrangement and the implied loss of national sovereignty. Reflecting these concerns, Britain, Denmark, and Sweden won the right from other members to stay out of the monetary union if they chose. According to some critics, European monetary union represents putting the economic cart before the political horse. In their view, a single currency should follow, not precede, political union. They argue that the euro will unleash enormous pressures for tax harmonization and fiscal transfers, both policies that cannot be pursued without the appropriate political structure. Some critics also argue that the EMU will result in the imposition of a single interest rate regime on national economies that are not truly convergent and are experiencing divergent economic growth rates.

Regional Economic Integration in the Americas

The North American Free Trade Agreement

NAFTA's Contents

The contents of NAFTA include the following:

·                 Abolition within 10 years of tariffs on 99 percent of the goods traded between Mexico, Canada, and the United States.

·                 Removal of most barriers on the cross-border flow of services, allowing financial institutions.

·                 Protection of intellectual property rights.

·                 Removal of most restrictions on foreign direct investment between the three member countries.

·                 Application of national environmental standards, provided such standards have a scientific basis. Lowering of standards to lure investment is described as being inappropriate.

·                 Establishment of two commissions with the power to impose fines and remove trade privileges when environmental standards or legislation involving health and safety, minimum wages, or child labor are ignored.

Environmentalists have also voiced concerns about NAFTA. They point to the sludge in the Rio Grande River and the smog in the air over Mexico City and warn that Mexico could degrade clean air and toxic-waste standards across the continent. Already, they claim, the lower Rio Grande is the most polluted river in the United States, increasing in chemical waste and sewage along its course from El Paso, Texas, to the Gulf of Mexico.

There is also continued opposition in Mexico to NAFTA from those who fear a loss of national sovereignty. Mexican critics argue that their country will be dominated by US firms that will not really contribute to Mexico's economic growth, but instead will use Mexico as a low-cost assembly site, while keeping their high-paying, high-skilled jobs north of the border.

Central American Common Market and CARICOM

Then there is the customs union that was to have been created in 1991 between the English-speaking Caribbean countries under the auspices of the Caribbean Community. Referred to as CARICOM, it was originally established in 1973. However, it has repeatedly failed to progress toward economic integration. A formal commitment to economic and monetary union was adopted by CARICOM's member states in 1984, but since then little progress has been made.

Regional Economic Integration Elsewhere

Association of Southeast Asian Nations

ASEAN includes Brunei, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, and Vietnam. Laos, Myanmar, and Vietnam have all joined recently, and their inclusion complicates matters because their economies are a long way behind those of the original members. The basic objectives of ASEAN are to foster freer trade between member countries and to achieve cooperation in their industrial policies. Progress has been very limited, however.

Asia Pacific Economic Cooperation

Asia Pacific Economic Cooperation (APEC) was founded in 1990 at the suggestion of Australia. APEC currently has 18 member states including such economic powerhouses as the United States, Japan, and China. The stated aim of APEC is to increase multilateral cooperation in view of the economic rise of the Pacific nations and the growing interdependence within the region. US support for APEC was also based on the belief that it might prove a viable strategy for heading off any moves to create Asian groupings from which it would be excluded.

Implications For Business

Opportunities

Additional opportunities arise from the inherent lower costs of doing business in a single market--as opposed to 15 national markets in the case of the EU or 3 national markets in the case of NAFTA. Free movement of goods across borders, harmonized product standards, and simplified tax regimes make it possible for firms based in the EU and the NAFTA countries to realize potentially enormous cost economies by centralizing production in those EU and NAFTA locations where the mix of factor costs and skills is optimal. Rather than producing a product in each of the 15 EU countries or the 3 NAFTA countries, a firm may be able to serve the whole EU or North American market from a single location. This location must be chosen carefully, of course, with an eye on local factor costs and skills.

Even after the removal of barriers to trade and investment, enduring differences in culture and competitive practices often limit the ability of companies to realize cost economies by centralizing production in key locations and producing a standardized product for a single multicountry market. Consider the case of Atag Holdings NV, a Dutch maker of kitchen appliances that is profiled in the accompanying Management Focus. Due to enduring differences between nations within the EU's single market, Atag still has to produce various "national brands," which clearly limits the company's ability to attain scale economies.

Threats

Just as the emergence of single markets in the EU and the Americas creates opportunities for business, it also presents a number of threats. For one thing, the business environment within each grouping will become more competitive. The lowering of barriers to trade and investment between countries is likely to lead to  increased price competition throughout the EU, NAFTA, and MERCOSUR. This could transform many EU companies into efficient global competitors. The message for non-EU businesses is that they need to prepare for the emergence of more capable European competitors by reducing their own cost structures.

A final threat to firms outside of trading areas is the threat of being shut out of the single market by the creation of "Trade Fortress." The charge that regional economic integration might lead to a fortress mentality is most often leveled at the EU. As noted earlier in the chapter, although the free trade philosophy underpinning the EU theoretically argues against the creation of any "fortress" in Europe, there are signs that the EU may raise barriers to imports and investment in certain "politically sensitive" areas, such as autos. Non-EU firms might be well advised, therefore, to set up their own EU operations as quickly as possible. This could also occur in the NAFTA countries, but it seems less likely.

The Political Economy of Foreign Direct Investment

Introduction

The government of a source country for FDI also can encourage or restrict FDI by domestic firms. In recent years, the Japanese government has pressured many Japanese firms to undertake FDI. The Japanese government sees FDI as a substitute for exporting and thus as a way of reducing Japan's politically embarrassing balance of payments surplus. In contrast, the US government has, for political reasons, from time to time restricted FDI by domestic firms.

Political Ideology and Foreign Direct Investment

The Radical View

The radical view traces its roots to Marxist political and economic theory. Radical writers argue that the multinational enterprise (MNE) is an instrument of imperialist domination. They see the MNE as a tool for exploiting host countries to the exclusive benefit of their capitalist-imperialist home countries. They argue that MNEs extract profits from the host country and take them to their home country, giving nothing of value to the host country in exchange. Thus, according to the extreme version of this view, no country should ever permit foreign corporations to undertake FDI, since they can never be instruments of economic development, only of economic domination. Where MNEs already exist in a country, they should be immediately nationalized.

The Free Market View

The free market view traces its roots to classical economics and the international trade theories of Adam Smith and David Ricardo.. The free market view argues that international production should be distributed among countries according to the theory of comparative advantage. Countries should specialize in the production of those goods and services that they can produce most efficiently. Within this framework, the MNE is an instrument for dispersing the production of goods and services to the most efficient locations around the globeFor reasons explored earlier in this book, in recent years, the free market view has been ascendant worldwide, spurring a global move toward the removal of restrictions on inward and outward foreign direct investment.

Pragmatic Nationalism

In practice, many countries have adopted neither a radical policy nor a free market policy toward FDI, but instead a policy that can best be described as pragmatic nationalism. The pragmatic nationalist view is that FDI has both benefits and costs. FDI can benefit a host country by bringing capital, skills, technology, and jobs, but those benefits often come at a cost. When products are produced by a foreign company rather than a domestic company, the profits from that investment go abroad. Many countries are also concerned that a foreign-owned manufacturing plant may import many components from its home country, which has negative implications for the host country's balance-of-payments position.

The Benefits of FDI to Host Countries

Resource-Transfer Effects

Capital

Given this tension, the mode for transferring technology--licensing or FDI--can be a major negotiating point between an MNE and a host government. Whether the MNE gets its way depends on the relative bargaining powers of the MNE and the host government.

Management

Foreign management skills acquired through FDI may also produce important benefits for the host country. Beneficial spin-off effects arise when local personnel who are trained to occupy managerial, financial, and technical posts in the subsidiary of a foreign MNE leave the firm and help to establish indigenous firms.

The benefits may be considerably reduced if most management and highly skilled jobs in the subsidiaries are reserved for home-country nationals.

Employment Effects

The beneficial employment effect claimed for FDI is that it brings jobs to a host country that would otherwise not be created there. Cynics note that not all the "new jobs" created by FDI represent net additions in employment. In the case of FDI by Japanese auto companies in the United States, some argue that the jobs created by this investment have been more than offset by the jobs lost in US-owned auto companies, which have lost market share to their Japanese competitors.

Balance-of-Payments Effects

Balance-of-Payments Accounts

A country's balance-of-payments accounts keep track of both its payments to and its receipts from other countries. Any transaction resulting in a payment to other countries is entered in the balance-of-payments accounts as a debit and given a negative ( - ) sign. Any transaction resulting in a receipt from other countries is entered as a credit and given a positive (+) sign.

Balance-of-payments accounts are divided into two main sections: the current account and the capital account. The first category, merchandise trade, refers to the export or import of goods. The second category is the export or import of services. The third category, investment income, refers to income from foreign investments and payments that have to be made to foreigners investing in a country.

A current account deficit occurs when a country imports more goods, services, and income than it exports. A current account surplus occurs when a country exports more goods, services, and income than it imports. The capital account records transactions that involve the purchase or sale of assets. Thus, when a Japanese firm purchases stock in a US company, the transaction enters the US balance of payments as a credit on the capital account. This is because capital is flowing into the country. When capital flows out of the United States, it enters the capital account as a debit.

Thus, any international transaction automatically gives rise to two offsetting entries in the balance of payments. Because of this, the current account balance and the capital account balance should always add up to zero.

Governments normally are concerned when their country is running a deficit on the current account of their balance of payments. When a country runs a current account deficit, the money that flows to other countries is then used by those countries to purchase assets in the deficit country.

FDI and the Balance of Payments

Given the concern about current account deficits, the balance-of-payments effects of FDI can be an important consideration for a host government. There are three potential balance-of-payments consequences of FDI. First, when an MNE establishes a foreign subsidiary, the capital account of the host country benefits from the initial capital inflow. However, this is a one-time-only effect. Set against this must be the outflow of earnings to the foreign parent company, which will be recorded as a debit on the current account of the host country.

Second, if the FDI is a substitute for imports of goods or services, it can improve the current account of the host country's balance of payments. A third potential benefit to the host country's balance-of-payments position arises when the MNE uses a foreign subsidiary to export goods and services to other countries.

Effect on Competition and Economic Growth

Economic theory tells us that the efficient functioning of markets depends on an adequate level of competition between producers. By increasing consumer choice, foreign direct investment can help to increase the level of competition in national markets, thereby driving down prices and increasing the economic welfare of consumers. As we saw in the Management Focus, foreign direct investment has helped increase competition in the South Korean retail sector. The increase in choices, and the resulting fall in prices, clearly benefits South Korean consumers.

The Costs of FDI to Host Countries 

Adverse Effects on Competition

Although we have just outlined in the previous section how foreign direct investment can boost competition, host governments sometimes worry that the subsidiaries of foreign MNEs may have greater economic power than indigenous competitors. If it is part of a larger international organization, the foreign MNE may be able to draw on funds generated elsewhere to subsidize its costs in the host market, which could drive indigenous companies out of business and allow the firm to monopolize the market.

In practice, the above arguments are often used by inefficient indigenous competitors when lobbying their government to restrict direct investment by foreign MNEs. Although a host government may state publicly in such cases that its restrictions on inward FDI are designed to protect indigenous competitors from the market power of foreign MNEs, they may have been enacted to protect inefficient but politically powerful indigenous competitors from foreign competition.

Adverse Effects on the Balance of Payments

The possible adverse effects of FDI on a host country's balance-of-payments position have been hinted at earlier. There are two main areas of concern with regard to the balance of payments. First, as mentioned earlier, set against the initial capital inflow that comes with FDI must be the subsequent outflow of earnings from the foreign subsidiary to its parent company. Such outflows show up as a debit on the capital account. Some governments have responded to such outflows by restricting the amount of earnings that can be repatriated to a foreign subsidiary's home country.

A second concern arises when a foreign subsidiary imports a substantial number of its inputs from abroad, which results in a debit on the current account of the host country's balance of payments.

National Sovereignty and Autonomy

Many host governments worry that FDI is accompanied by some loss of economic independence. The concern is that key decisions that can affect the host country's economy will be made by a foreign parent that has no real commitment to the host country, and over which the host country's government has no real control.

The Benefits and Costs of FDI to Home Countries

Benefits of FDI to the Home Country

The benefits of FDI to the home country arise from three sources. First, and perhaps most important, the capital account of the home country's balance of payments benefits from the inward flow of foreign earnings.

Second, benefits to the home country from outward FDI arise from employment effects. As with the balance of payments, positive employment effects arise when the foreign subsidiary creates demand for home-country exports of capital equipment, intermediate goods, complementary products, and the like.

Third, benefits arise when the home-country MNE learns valuable skills from its exposure to foreign markets that can subsequently be transferred back to the home country. This amounts to a reverse resource-transfer effect. Through its exposure to a foreign market, an MNE can learn about superior management techniques and superior product and process technologies. These resources can then be transferred back to the home country, contributing to the home country's economic growth rate.

 Costs of FDI to the Home Country

Against these benefits must be set the apparent costs of FDI for the home country. The most important concerns center around the balance-of-payments and employment effects of outward FDI. The home country's balance of payments may suffer in three ways. First, the capital account of the balance of payments suffers from the initial capital outflow required to finance the FDI. This effect, however, is usually more than offset by the subsequent inflow of foreign earnings. Second, the current account of the balance of payments suffers if the purpose of the foreign investment is to serve the home market from a low-cost production location. Third, the current account of the balance of payments suffers if the FDI is a substitute for direct exports.

With regard to employment effects, the most serious concerns arise when FDI is seen as a substitute for domestic production. This was the case with Toyota's investments in Europe. One obvious result of such FDI is reduced home-country employment. If the labor market in the home country is already very tight, with little unemployment.

Government Policy Instruments and FDI

Home-Country Policies

Encouraging Outward FDI

Many investor nations now have government-backed insurance programs to cover major types of foreign investment risk. The types of risks insurable through these programs include the risks of expropriation, war losses, and the inability to transfer profits back home. Such programs are particularly useful in encouraging firms to undertake investments in politically unstable countries. In addition, several advanced countries also have special funds or banks that make government loans to firms wishing to invest in developing countries.

Restricting Outward FDI

Virtually all investor countries, including the United States, have exercised some control over outward FDI from time to time. One common policy has been to limit capital outflows out of concern for the country's balance of payments. In addition, countries have occasionally manipulated tax rules to try to encourage their firms to invest at home. The objective behind such policies is to create jobs at home rather than in other nations.

Finally, countries sometimes prohibit national firms from investing in certain countries for political reasons. Such restrictions can be formal or informal.

Host-Country Policies

Encouraging Inward FDI

It is increasingly common for governments to offer incentives to foreign firms to invest in their countries. Such incentives take many forms, but the most common are tax concessions, low-interest loans, and grants or subsidies. Incentives are motivated by a desire to gain from the resource-transfer and employment effects of FDI. They are also motivated by a desire to capture FDI away from other potential host countries.

Restricting Inward FDI

Host governments use a wide range of controls to restrict FDI in one way or another. The two most common are ownership restraints and performance requirements. Ownership restraints can take several forms. In some countries, foreign companies are excluded from specific fields. The rationale underlying ownership restraints seems to be twofold. First, foreign firms are often excluded from certain sectors on the grounds of national security or competition. Particularly in less developed countries, the feeling seems to be that local firms might not be able to develop unless foreign competition is restricted by a combination of import tariffs and controls on FDI.

Second, ownership restraints seem to be based on a belief that local owners can help to maximize the resource-transfer and employment benefits of FDI for the host country.

International Institutions and the Liberalization of FDI

Until recently there has been no consistent involvement by multinational institutions in the governing of FDI.

However, the WTO has had less success trying to initiate talks aimed at establishing a universal set of rules designed to promote the liberalization of FDI.

Implications for Business

The Nature of Negotiation

The objective of any negotiation is to reach an agreement that benefits both parties. Negotiation is both an art and a science. The science of it requires analyzing the relative bargaining strengths of each party and the different strategic options available to each party and assessing how the other party might respond to various bargaining ploys. The art of negotiation incorporates "interpersonal skills, the ability to convince and be convinced, the ability to employ a basketful of bargaining ploys, and the wisdom to know when and how to use them."

Bargaining Power

The outcome of any negotiated agreement depends on the relative bargaining power of both parties. Each side's bargaining power depends on three factors (see Table 7.3):

·                 The value each side places on what the other has to offer.

·                 he number of comparable alternatives available to each side.

·                 Each party's time horizon.

From the perspective of a firm negotiating the terms of an investment with a host government, the firm's bargaining power is high when the host government places a high value on what the firm has to offer, the number of comparable alternatives open to the firm is great, and the firm has a long time in which to complete the negotiations. The converse also holds. The firm's bargaining power is low when the host government places a low value on what the firm has to offer, few comparable alternatives are open to the firm, and the firm has a short time in which to complete the negotiations.

Foreign Direct Investment

Introduction

This chapter is concerned with the phenomenon of foreign direct investment (FDI). Foreign direct investment occurs when a firm invests directly in facilities to produce and/or market a product in a foreign country.

In the remainder of the chapter, we first look at the growing importance of FDI in the world economy. Next we look at the theories that have been used to explain horizontal foreign direct investment. Horizontal foreign direct investment is FDI in the  same industry as a firm operates in at home. Electrolux's investments in Eastern Europe and Asia are examples of horizontal FDI. Having reviewed horizontal FDI, we consider the theories that help to explain vertical foreign direct investment. Vertical foreign direct investment is FDI in an industry that provides inputs for a firm's domestic operations, or it may be FDI in an industry abroad that sells the outputs of a firm's domestic operations. Finally, we review the implications of these theories for business practice.

Horizontal Foreign Direct Investment

Transportation Costs

When transportation costs are added to production costs, it becomes unprofitable to ship some products over a large distance. This is particularly true of products that have a low value-to-weight ratio and can be produced in almost any location. For such products, relative to either FDI or licensing, the attractiveness of exporting decreases. For products with a high value-to-weight ratio, however, transport costs are normally a very minor component of total landed cost .

Market Imperfections (Internalization Theory)

Market imperfections provide a major explanation of why firms may prefer FDI to either exporting or licensing. Market imperfections are factors that inhibit markets from working perfectly. The market imperfections explanation of FDI is the one favored by most economists.⁸ In the international business literature, the marketing imperfection approach to FDI is typically referred to as internalization theory.

With regard to horizontal FDI, market imperfections arise in two circumstances: when there are impediments to the free flow of products between nations, and when there are impediments to the sale of know-how

Impediments to Exporting

Governments are the main source of impediments to the free flow of products between nations. By placing tariffs on imported goods, governments can increase the cost of exporting relative to FDI and licensing. Similarly, by limiting imports through the imposition of quotas, governments increase the attractiveness of FDI and licensing.

Impediments to the Sale of Know-How.

The competitive advantage that many firms enjoy comes from their technological, marketing, or management know-how. Technological know-how can enable a company to build a better product; for example, Xerox's technological know-how enabled it to build the first photocopier, and Motorola's technological know-how has given it a strong competitive position in the global market for cellular telephone equipment. Alternatively, technological know-how can improve a company's production process vis-á-vis competitors. If we view know-how (expertise) as a competitive asset, it follows that the larger the market in which that asset is applied, the greater the profits that can be earned from the asset.

According to economic theory, there are three reasons the market does not always work well as a mechanism for selling know-how, or why licensing is not as attractive as it initially appears. First, licensing may result in a firm's giving away its know-how to a potential foreign competitor. Second, licensing does not give a firm the tight control over manufacturing, marketing, and strategy in a foreign country that may be required to profitably exploit its advantage in know-how. With licensing, control over production, marketing, and strategy is granted to a licensee in return for a royalty fee. However, for both strategic and operational reasons, a firm may want to retain control over these functions.

Third, a firm's know-how may not be amenable to licensing. This is particularly true of management and marketing know-how. It is one thing to license a foreign firm to  manufacture a particular product, but quite another to license the way a firm does business--how it manages its process and markets its products.

Strategic Behavior

An oligopoly is an industry composed of a limited number of large firms. A critical competitive feature of such industries is interdependence of the major players: What one firm does can have an immediate impact on the major competitors, forcing a response in kind. If one firm in an oligopoly cuts prices, this can take market share away from its competitors, forcing them to respond with similar price cuts to retain their market share.

This kind of imitative behavior can take many forms in an oligopoly. One firm raises prices, the others follow; someone expands capacity, and the rivals imitate lest they be left in a disadvantageous position in the future.

It is possible to extend Knickerbocker's theory to embrace the concept of multipoint competition. Multipoint competition arises when two or more enterprises encounter each other in different regional markets, national markets, or industries. Economic theory suggests that rather like chess players jockeying for advantage, firms will try to match each other's moves in different markets to try to hold each other in check. The idea is to ensure that a rival does not gain a commanding position in one market and then use the profits generated there to subsidize competitive attacks in other markets. Although Knickerbocker's theory and its extensions can help to explain imitative FDI behavior by firms in an oligopolistic industries, it does not explain why the first firm in oligopoly decides to undertake FDI, rather than to export or license. In contrast, the market imperfections explanation addresses this phenomenon. The imitative theory also does not address the issue of whether FDI is more efficient than exporting or licensing for expanding abroad. Again, the market imperfections approach addresses the efficiency issue. For these reasons, many economists favor the market imperfections explanation for FDI, although most would agree that the imitative explanation tells part of the story.

The Product Life Cycle

Vernon's view is that firms undertake FDI at particular stages in the life cycle of a product they have pioneered. They invest in other advanced countries when local demand in those countries grows large enough to support local production. They subsequently shift production to developing countries when product standardization and market saturation give rise to price competition and cost pressures. Investment in developing countries, where labor costs are lower, is seen as the best way to reduce costs.

Alternatively, it may be more profitable for the firm to license a foreign firm to produce its product for sale in that country. The product life-cycle theory ignores these options and, instead, simply argues that once a foreign  market is large enough to support local production, FDI will occur. This limits its explanatory power and its usefulness to business in that it fails to identify when it is profitable to invest abroad.

Location-Specific Advantages

The British economist John Dunning has argued that in addition to the various factors discussed above, location-specific advantages can help explain the nature and direction of FDI. By location-specific advantages, Dunning means the advantages that arise from using resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets. Dunning accepts the internalization argument that market failures make it difficult for a firm to license its own unique assets.

However, Dunning's theory has implications that go beyond basic resources such as minerals and labor. Consider Silicon Valley, which is the world center for the computer and semi-conductor industry. Many of the world's major computer and semiconductor companies, such as Apple Computer, Silicon Graphics, and Intel, are located close to each other in the Silicon Valley region of California. As a result, much of the cutting-edge research and product development in computers and semiconductors occurs here. In so far as this is the case, it makes sense for foreign computer and semiconductor firms to invest in research and (perhaps) production facilities so they too can learn about and utilize valuable new knowledge before those based elsewhere, thereby giving them a competitive advantage in the global marketplace. Evidence suggests that European, Japanese, South Korean, and Taiwanese computer and semiconductor firms are investing in the Silicon Valley region, precisely because they wish to benefit from the externalities that arise there.

Vertical Foreign Direct Investment

Strategic Behavior

According to economic theory, by vertically integrating backward to gain control over the source of raw material, a firm can raise entry barriers and shut new competitors out of an industry. Such strategic behavior involves vertical FDI if the raw material is found abroad.

Another strand of the strategic behavior explanation of vertical FDI sees such investment not as an attempt to build entry barriers, but as an attempt to circumvent the barriers established by firms already doing business in a country. This may explain Volkswagen's decision to establish its own dealer network when it entered the North American auto market.

Market Imperfections

Impediments to the Sale of Know-How

Consider the case of oil refining companies such as British Petroleum and Royal Dutch Shell. Historically, these firms pursued backward vertical FDI to supply their British and Dutch oil refining facilities with crude oil.

Generalizing from this example, the prediction is that backward vertical FDI will occur when a firm has the knowledge and the ability to extract raw materials in another country and there is no efficient producer in that country that can supply raw materials to the firm.

Investment in Specialized Assets

Another strand of the market imperfections argument predicts that vertical FDI will occur when a firm must invest in specialized assets whose value depends on inputs provided by a foreign supplier. In this context, a specialized asset is an asset designed to perform a specific task and whose value is significantly reduced in its next-best use.

Consider the case of an aluminum refinery, which is designed to refine bauxite ore and produce aluminum. Bauxite ores vary in content and chemical composition from deposit to deposit. Each type of ore requires a different type of refinery. Imagine that a US aluminum company must decide whether to invest in an aluminum refinery designed to refine a certain type of ore. Assume further that this ore is available only through an Australian mining firm at a single bauxite mine.

Implications for Business

The implications of the theories of horizontal and vertical FDI for business practice are relatively straightforward. First, the location-specific advantages argument associated with John Dunning does help explain the direction of FDI, both with regard to horizontal and vertical FDI.

Firms for which licensing is not a good option tend to be clustered in three types of industries:

1.              High-technology industries where protecting firm-specific expertise is of paramount importance and licensing is hazardous.

2.              Global oligopolies, where competitive interdependence requires that multinational firms maintain tight control over foreign operations so that they have the ability to launch coordinated attacks against their global competitors (as Kodak has done with Fuji).

3.              Industries where intense cost pressures require that multinational firms maintain tight control over foreign operations (so they can disperse manufacturing to locations around the globe where factor costs are most favorable to minimize costs).

The Political Economy of International Trade

Introduction

In this chapter, we look at the political reality of international trade. While many nations are nominally committed to free trade, in practice nations tend to intervene in international trade. The nature of these political realities are amply illustrated in the case that opens this chapter. In this chapter, we explore the political and economic reasons for intervening in international trade. When governments intervene, they often do so by restricting imports of goods and services into their nation, while adopting policies that promote exports. Normally their motives for intervention are to protect domestic producers and jobs from foreign competition, while increasing the foreign market for domestic products. However, as the opening case illustrates, in recent years "social" issues have tended to intrude in the decision making.

Instruments of Trade Policy

Tariffs

A tariff is a tax levied on imports. The oldest form of trade policy, tariffs fall into two categories. Specific tariffs are levied as a fixed charge for each unit of a good imported. Ad valorem tariffs are levied as a proportion of the value of the imported good.

A tariff raises the cost of imported products relative to domestic products. While the principal objective of most tariffs is to protect domestic producers and employees against foreign competition, they also raise revenue for the government.

The important thing to understand about a tariff is who suffers and who gains. The government gains, because the tariff increases government revenues. Domestic producers gain, because the tariff gives them some protection against foreign competitors by increasing the cost of imported foreign goods. Consumers lose because they must pay more for certain imports. Whether the gains to the government and domestic producers exceed the loss to consumers depends on various factors such as the amount of the tariff, the importance of the imported good to domestic consumers, the number of jobs saved in the protected industry, and so on.

Although detailed consideration of these issues is beyond the scope of this book, two conclusions can be derived from a more advanced analysis. First, tariffs are unambiguously pro-producer and anti-consumer. While they protect producers from foreign competitors, this supply restriction also raises domestic prices. Thus, as noted

A second point worth emphasizing is that tariffs reduce the overall efficiency of the world economy. They reduce efficiency because a protective tariff encourages domestic firms to produce products at home that, in theory, could be produced more efficiently abroad. The consequence is inefficient utilization of resources

Subsidies

A subsidy is a government payment to a domestic producer. Subsidies take many forms including cash grants, low-interest loans, tax breaks, and government equity participation in domestic firms. By lowering costs, subsidies help domestic producers in two ways: they help them compete against low-cost foreign imports and they help them gain export markets.

But subsidies must be paid for. Governments typically pay for subsidies by taxing individuals. Therefore, whether subsidies generate national benefits that exceed their national costs is debatable. In practice, many subsidies are not that successful at increasing the international competitiveness of domestic producers. They tend to protect the inefficient, rather than promoting efficiency.

Import Quotas and Voluntary Export Restraints

An import quota is a direct restriction on the quantity of some good that may be imported into a country. The restriction is normally enforced by issuing import licenses to a group of individuals or firms. A variant on the import quota is the voluntary export restraint (VER). A voluntary export restraint is a quota on trade imposed by the exporting country, typically at the request of the importing country's government.

As with tariffs and subsidies, both import quotas and VERs benefit domestic producers by limiting import competition. Quotas do not benefit consumers. An import quota or VER always raises the domestic price of an imported good. When imports are limited to a low percentage of the market by a quota or VER, this bids the price up for that limited foreign supply.

Local Content Requirements

A local content requirement calls for some specific fraction of a good to be produced domestically. Local content regulations have been widely used by developing countries as a device for shifting their manufacturing base from the simple assembly of products whose parts are manufactured elsewhere, to the local manufacture of component parts. More recently, the issue of local content has been raised by several developed countries.

For a domestic producer of component parts, local content regulations provide protection in the same way an import quota does: by limiting foreign competition. The aggregate economic effects are also the same; domestic producers benefit, but the restrictions on imports raise the prices of imported components. In turn, higher prices for imported components are passed on to consumers of the final product in the form of higher prices. As with all trade policies, local content regulations tend to benefit producers and not consumers.

Antidumping Policies

In the context of international trade, dumping is variously defined as selling goods in a foreign market at below their costs of production, or as selling goods in a foreign market at below their "fair" market value. There is a difference between these two definitions, since the "fair" market value of a good is normally judged to be greater than the costs of producing that good. Dumping is viewed as a method by which firms unload excess production in foreign markets. Alternatively, some dumping may be the result of predatory behavior, with producers using substantial profits from their home markets to subsidize prices in a foreign market with a view to driving indigenous competitors out of that market. Once this has been achieved, so the argument goes, the predatory firm can raise prices and earn substantial profits.

Antidumping policies are policies designed to punish foreign firms that engage in dumping. The ultimate objective is to protect domestic producers from "unfair" foreign competition. Although antidumping policies vary somewhat from country to country, the majority are similar to the policies used in the United States.

Administrative Policies

In addition to the formal instruments of trade policy, governments of all types sometimes use a range of informal or administrative policies to restrict imports and boost exports. Administrative trade policies are bureaucratic rules designed to make it difficult for imports to enter a country. Some would argue that the Japanese are the masters of this kind of trade barrier.

The Case for Government Intervention

Political Arguments for Intervention .

Protecting Jobs and Industries

Perhaps the most common political argument for government intervention is that it is necessary for protecting jobs and industries from foreign competition. Antidumping policies are frequently justified on such grounds. The voluntary export restraints that offered some protection to the US automobile, machine tool, and steel industries during the 1980s were motivated by such considerations. Similarly, Japan's quotas on rice imports are aimed at protecting jobs in that country's agricultural sector.

In addition to trade controls hurting consumers, evidence also indicates they may sometimes hurt the producers they are intended to protect.

National Security

Countries sometimes argue that it is necessary to protect certain industries because they are important for national security. Defense-related industries often get this kind of attention .Although not as common as it used to be, this argument is still made. Those in favor of protecting the US semiconductor industry from foreign competition, for example, argue that semiconductors are now such important components of defense products that it would be dangerous to rely primarily on foreign producers for them.

Retaliation

Some argue that governments should use the threat to intervene in trade policy as a bargaining tool to help open foreign markets and force trading partners to "play by the rules of the game." Successive US governments have been among those that adopted this get-tough approach. If it works, such a politically motivated rationale for government intervention may liberalize trade and bring with it resulting economic gains. It is a risky strategy, however, because a country that is being pressured might not back down and instead may respond to the punitive tariffs by raising trade barriers of its own.

Protecting Consumers

The ban was motivated by a desire to protect European consumers from the possible health consequences of meat treated with growth hormones. It was motivated by concerns for the safety and health of consumers, as opposed to economic considerations. Many governments have long had regulations to protect consumers from "unsafe" products. Often, the indirect effect of such regulations is to limit or ban the importation of such products. The conflict over the importation of hormone-treated beef into the European Union may prove to be a taste of things to come. In addition to the use of hormones to promote animal growth and meat production, biotechnology has made it possible to genetically alter many crops so that they are resistant to common herbicides, produce proteins that are natural insecticides, have dramatically improved yields, or can withstand inclement weather

Furthering Foreign Policy Objectives

Governments will use trade policy to support their foreign policy objectives. A government may grant preferential trade terms to a country with which it wants to build strong relations. Trade policy has also been used several times as an instrument for pressuring or punishing "rogue states" that do not abide by international law or norms.

Protecting Human Rights

Protecting and promoting human rights in other countries is an important element of foreign policy for many democracies. Governments sometimes use trade policy to try to improve the human rights policies of trading partners.

On the other hand, some argue that limiting trade with countries such as China where human rights abuses are widespread makes matters worse, not better. The best way to change the internal human rights stance of a country is to engage it in international trade, they argue.

Economic Arguments for Intervention

The Infant Industry Argument

The infant industry argument is by far the oldest economic argument for government intervention. According to this argument, many developing countries have a potential comparative advantage in manufacturing, but new manufacturing industries there cannot initially compete with well-established industries in developed countries. To allow manufacturing to get a toehold, the argument is that governments should temporarily support new industries until they have grown strong enough to meet international competition.

Also, the infant industry argument has been recognized as a legitimate reason for protectionism by the WTO. Nevertheless, many economists remain very  critical of this argument. They make two main points. First, protection from foreign competition does no good unless the protection helps make the industry efficient. In case after case, however, protection seems to have done little more than foster the development of inefficient industries that have little hope of ever competing in the world market. Brazil.

A second point is that the infant industry argument relies on an assumption that firms are unable to make efficient long-term investments by borrowing money from the domestic or international capital market. Consequently, governments have been required to subsidize long-term investments.

Strategic Trade Policy

The strategic trade policy argument has been proposed by the new trade theorists. There are two components to the strategic trade policy argument. First, a government can help raise national income if it can somehow ensure that the firm or firms to gain first-mover advantages in such an industry are domestic rather than foreign enterprises. Thus, according to the strategic trade policy argument, a government should use subsidies to support promising firms in emerging industries.

The second component of the strategic trade policy argument is that it might pay government to intervene in an industry if it helps domestic firms overcome the barriers to entry created by foreign firms that have already reaped first-mover advantages. This argument underlies government support of Airbus Industrie, Boeing's major competitor. If these arguments are correct, they clearly suggest a rationale for government intervention in international trade. Specifically, governments should target technologies that may be important in the future and use subsidies to support development work aimed at commercializing those technologies.

The Revised Case for Free Trade

Retaliation and Trade War

Krugman argues that strategic trade policy aimed at establishing domestic firms in a dominant position in a global industry are beggar-thy-neighbor policies that boost national income at the expense of other countries. A country that attempts to use such policies will probably provoke retaliation. In many cases, the resulting trade war between two or more interventionist governments will leave all countries involved worse off than if a hands-off approach had been adopted.

Domestic Politics

Governments do not always act in the national interest when they intervene in the economy. Instead, they are influenced by politically important interest groups. Thus, a further reason for not embracing strategic trade policy, is that such a policy is almost certain to be captured by special interest groups within the economy, who will distort it to their own ends.

Development of the World Trading System

From Smith to the Great Depression

The Corn Laws placed a high tariff on corn imports. The objectives of the Corn Law tariff were to raise government revenues and to protect British corn producers. There had been annual motions in Parliament in favor of free trade since the 1820s when David Ricardo was a member of Parliament. However, agricultural protection was withdrawn only after a protracted debate when the effects of a harvest failure in Britain were compounded by the imminent threat of famine in Ireland. Faced with considerable hardship and suffering, among the populace, Parliament narrowly reversed its long-held position.

The Uruguay Round and the World Trade Organization

Against the background of rising pressures for protectionism, in 1986 the members of the GATT embarked upon their eighth round of negotiations to reduce tariffs, the Uruguay Round (so named because they occurred in Uruguay). This was the most difficult round of negotiations yet, primarily because it was also the most ambitious. Until then, GATT rules had applied only to trade in manufactured goods and commodities. In the Uruguay Round, member countries sought to extend GATT rules to cover trade in services. They also sought to write rules governing the protection of intellectual property, to reduce agricultural subsidies, and to strengthen the GATT's monitoring and enforcement mechanisms.

Services and Intellectual Property

In the long run, the extension of GATT rules to cover services and intellectual property may be particularly significant. Extending GATT rules to this important trading arena could significantly increase both the total share of world trade accounted for by services and the overall volume of world trade. Having GATT rules cover intellectual property will make it much easier for high-technology companies to do business in developing nations where intellectual property rules have historically been poorly enforced High-technology companies will now have a mechanism to force countries to prohibit the piracy of intellectual property.

The World Trade Organization

The clarification and strengthening of GATT rules and the creation of the World Trade Organization also hold out the promise of more effective policing and enforcement of GATT rules in the future. This should have a beneficial effect on overall  economic growth and development by promoting trade. The WTO will act as an umbrella organization that which will encompass the GATT along with two new sister bodies, one on services and the other on intellectual property. The WTO will take over responsibility for arbitrating trade disputes and monitoring the trade policies of member countries. While the WTO will operate as GATT now does--on the basis of consensus--in the area of dispute settlement, member countries will no longer be able to block adoption of arbitration reports. Arbitration panel reports on trade disputes between member countries will be automatically adopted by the WTO unless there is a consensus to reject them.

Implications of the Uruguay Round

The world is better off with a GATT deal than without it. Without the deal, the world might have slipped into increasingly dangerous trade wars, which might have triggered a recession. With a GATT deal concluded, the current world trading system looks secure, and there is a good possibility that the world economy will now grow faster than would otherwise have been the case. Estimates as to the overall impact of the GATT agreement, however, are not that dramatic.

WTO: Early Experience

WTO as a Global Policeman

Countries' use of the WTO represents an important vote of confidence in the organization's dispute resolution.

The backing of the leading trading powers has been crucial to the early success of the WTO. Initially, some feared that the United States might undermine the system by continuing to rely on unilateral measures when it suited or by refusing to accept WTO verdicts.

Encouraged perhaps by the tougher system, developing countries are also starting to use the settlement procedures more than they did under the GATT. So far the United States has proved willing to accept WTO rulings that go against it. The United States agreed to implement a WTO judgment that called for the country to remove discriminatory antipollution regulations that were applied to gasoline imports. In a dispute with India over textile imports, the United States rescinded quotas before a WTO panel could start work.

WTO Telecommunications Agreement

As explained above, the Uruguay Round of GATT negotiations extended global trading rules to cover services. The WTO was given the role of brokering future agreements to open global trade in services. The WTO was also encouraged to extend its reach to encompass regulations governing foreign direct investment--something the GATT had never done. Two of the first industries targeted for reform were the global telecommunications and financial services industries. Given its importance in the global economy, the telecommunications services industry was a very important target for reform. The WTO's goal was to get countries to open their telecommunications markets to competition, allowing foreign operators to purchase ownership stakes in domestic telecommunications providers and establishing a set of common rules for fair competition in the telecommunications sector. Three benefits were cited.

First, advocates argued that inward investment and increased competition would stimulate the modernization of telephone networks around the world and lead to higher-quality service. Second, supporters maintained that the increased competition would benefit customers through lower prices.

WTO Financial Services Agreement

Fresh from its success in brokering a telecommunications agreement, in April 1997 the WTO embarked on negotiations to liberalize the global financial services industry. The financial services industry includes banking, securities businesses, insurance, asset management services, and the like.

Participants in the negotiations wanted to see more competition in the sector both to allow firms greater opportunities abroad and to encourage greater efficiency. Developing countries need the capital and financial infrastructure for their development. But governments also have to ensure that the system is sound and stable  because of the economic shocks that can be caused by exchange rates, interest rates, or other market conditions fluctuating excessively. They also have to avoid economic crisis caused by bank failures. Therefore, government intervention in the interest of prudential safeguards is an important condition underpinning financial market liberalization.

The Future: Unresolved Issues

The 1994 GATT deal still leaves a lot to be done on the international trade front. Substantial trade barriers still remain in areas such as financial services and broadcast entertainment, although these seem likely to be reduced eventually. More significantly perhaps, WTO has yet to deal with the areas of environmentalism, worker rights, foreign direct investment, and dumping.

High on the list of the WTO's future concerns will be the interaction of environmental and trade policies and how best to promote sustainable development and ecological well-being without resorting to protectionism. The WTO will have to deal with environmentalists' claims that expanded international trade encourages companies to locate factories in areas of the world where they are freer to pollute and degrade the environment.

Paralleling environmental concerns are concerns that free trade encourages firms to shift their production to countries with low labor rates where worker rights are routinely violated.

Implications for Business

Trade Barriers and Firm Strategy

Trade barriers constrain a firm's ability to disperse its productive activities in such a manner. First, and most obviously, tariff barriers raise the costs of exporting products to a country. This may put the firm at a competitive disadvantage vis-à-vis indigenous competitors in that country. In response, the firm may then find it economical to locate production facilities in that country so it can compete on an even footing with indigenous competitors. Second, voluntary export restraints may limit a firm's ability to serve a country from locations outside of that country. The firm's response might be to set up production facilities in that country--even though it may result in higher production costs.

Third, to conform with local content regulations, a firm may have to locate more production activities in a given market than it would otherwise. From the firm's perspective, the consequence might be to raise costs above the level that could be achieved if each production activity was dispersed to the optimal location for that activity. And fourth, even when trade barriers do not exist, the firm may still want to locate some production activities in a given country to reduce the threat of trade barriers being imposed in the future.

All the above effects are likely to raise the firm's costs above the level that could be achieved in a world without trade barriers. The higher costs that result need not translate into a significant competitive disadvantage, however, if the countries imposing trade barriers do so to the imported products of all foreign firms, irrespective of their national origin.

Policy Implications

Government policies with regard to international trade also can have a direct impact on business.

In general, however, the arguments contained in this chapter suggest that a policy of government intervention has three drawbacks. Intervention can be self-defeating, since it tends to protect the inefficient rather than help firms become efficient global competitors. Intervention is dangerous because it may invite retaliation and trigger a trade war. Finally, intervention is unlikely to be well-executed, given the opportunity for such a policy to be captured by special interest groups. Most economists would probably argue that the best interests of international business are served by a free trade stance, but not a laissez-faire stance. It is probably in the best long-run interests of the business community to encourage the government to aggressively promote greater free trade by, for example, strengthening the WTO. Business probably has much more to gain from government efforts to open protected markets to imports and foreign direct investment than from government efforts to support certain domestic industries in a manner consistent with the recommendations of strategic trade policy.

This conclusion is reinforced by a phenomenon that we touched on in Chapter 1, the increasing integration of the world economy and internationalization of production that has occurred over the past two decades. We live in a world where many firms of all national origins increasingly depend for their competitive advantage on globally dispersed production systems. Such systems are the result of free trade. Free trade has brought great advantages to firms that have exploited it and to consumers who benefit from the resulting lower prices.