Professional Documents
Culture Documents
Concept Notes
Contents
Concept Notes
2. Concept of Globalization
For consumers, globalization may mean more choices, reduced prices, and an
indistinct national identity for products and services. For instance, a consumer who
buys a General Motors or Ford car may find that the car is made either in Canada or
Mexico or contains several foreign components. In the service sector, similar trends
can be observed. For instance, the mortgage on a resident‟s US property might be
underwritten by Dutch bank ABN Amro; a person‟s retirement benefits might be
managed by Germany-based Deutsche Bank or invested in Switzerland-based Néstle.
Globalization also has an impact on the career choices and progression of people. For
instance, a student upon graduation may work for many of the foreign companies in
the US or work in another country for a US, local, or foreign firm.
In 2000, the share of developing countries in world merchandise trade reached the
highest level in 50 years. The trade growth of the 49 least developed countries (LDCs)
surpassed the global average.
Often, the signs of globalization in wealthy nations end up helping poorer economies.
For instance, when a Singaporean tourist visits Laos, he/she is increasing the export
sales of the country by buying services such as hotel stays and tours. Finally, around
95 percent of the 78 million new births every year take place in developing nations.
This indicates that sooner or later the developing nations will provide the bulk of
consumption and production, profiting more from international trade and investment.
3.2 Globalization and the Monopoly Power of Corporations
A common complaint against globalization is that it deprives nations of their
sovereignty. This may occur because of the growing stature of international
organizations such as the World Trade Organization (WTO) whose officials are not
elected by popular vote, and because to some people, globalization only means
Americanization or westernization and therefore a threat to their values and identity.
The WTO may have assumed the role of conflict resolution that was earlier the
domain of bilateral negotiations, but international trade is very much a government-to-
government domain.
3.3 Globalization and the Environment
Another criticism against globalization is that it comes at the expense of the
environment. Environmentalists often complain that firms relocate their operations
mainly to escape the tough rules of pollution in their home country, an argument titled
„lowest common denominator‟ or „the race to the bottom‟. This argument too is only
partially true. Though some firms focus on lowering costs regardless of their
environmental responsibilities, others adhere strictly to the codes of environmental
protection. For instance, Dow Chemical, have been credited with environmental
cleanup in Eastern Europe and former East Germany. Further, the truth is that for
most organizations, environmental standards are just one the many criteria used in
determining their location and investment decision.
3.4 Striking a social balance with globalization
Globalization has its set of threats and promises and has both winners and losers at the
regional, national, individual, and organizational levels. For instance, it is felt that
trade benefits all participants and globalization is correlated with higher economic
growth. This, however, may not console an employee who loses his/her job as a result
of foreign competition. Globalization is not the only factor that influences wage levels
and job loss. Research indicates that technology puts downward pressure on the wages
of unskilled labor. The challenge of globalization is to maintain a balance between
public interest and the interest of those who could be suffering its consequences in the
short range.
Globalization is linked with other potential negative repercussions. Global capital
flow makes less regulated emerging economies such as Argentina, Thailand, and
Mexico vulnerable to the volatilities of the foreign exchange markets or international
capital.
2
International Business and Globalization
the variations in currency, interest rates, taxation, and inflation among different
nations have an impact on the profitability of an international firm. For a firm that
borrows and invests in a foreign country, higher tax rates, interest rates, and inflation
rates mean high operation costs and low profitability. On the other hand, for a firm
that deposits money in a foreign bank, high rates of interest mean a high return. The
clash of cultures is not rare in international business. For instance, US-based
companies have a very different corporate culture and understanding of how society
works compared to Japanese companies. Therefore when either of these companies
ventures to globalize across the Pacific, they first need to understand and reconcile
differences in cultures.
International firms also have to face different industrial environments compared to
domestic firms. For instance, Coca-Cola receives money in different currencies and
has to convert and protect its values; it has to decide upon effective tax strategies in
environments with different accounting methods; select an effective human resource
for each market, etc. These issues are indicative of challenges which other
international companies as well as their employees, consumers, regulators, and
competitors face while operating globally. Conditions related to market demand and
supply in a foreign country inevitably differ from those of the home country. These
differences and complexities create more opportunities with risks and uncertainties for
international firms than domestic firms. However, if a firm is concerned about
diversification of the product portfolio or financial portfolio, a presence abroad may
help mitigate risks for firms or investors. Risk refers to “unpredictability of
operational and financial outcomes.” Uncertainty refers to “the unpredictability of
environmental or organizational conditions that affect firm performance.” Uncertainty
about organizational or environmental conditions increases the unpredictability of
corporate performance and hence increases risk.
Operationally, international business is more difficult and costly to manage than
economic activities in a single country. If an international firm does not succeed in
leading a complex business effectively, it may not realize the benefits. Local
employees and expatriates may face difficulties in getting along with each other due to
cultural and language differences. The cultural diversity encountered while carrying
out operations in different countries may create problems of coordination,
communication, and motivation. The managerial philosophies and organizational
principles often differ among nations thus increasing the complexity of operation and
management of international business.
5. International Expansion
In general, the motivations for carrying out international business include market
motives, economic motives, and strategic motives. The motives vary from one
business activity to another, producing several motivations for the international firm
with a wide scope of activities in different parts of the world.
5.1 Market Motives
Market motives can be offensive or defensive. An offensive motive seizes market
opportunities in foreign countries through investment or trade. Mary Kall, Amway,
and Avon entered China in the early 1990s in search of opportunities in direct
marketing business in China. Besides being the fastest growing economy with the
largest population in the world, China‟s strong culture of personal connections and
4
International Business and Globalization
pervasiveness of closely knit families and friends helped the country become the
biggest direct selling market.
A defensive motive protects and holds the market power or competitive position of a
firm from threats such as domestic rivalry or changes in government policies. Dell
made investments in Europe, Africa, Asia, and Latin America due to the strong
competition in the US.
5.2 Economic Motives
Firms go in for international expansion to increase their return through lower costs
and higher returns. International trade or investment enables companies to benefit
from differences in costs of capital, natural resources, and labors as well as differences
in the regulatory treatments such as taxation, between international and domestic
countries. Many companies have expanded into Asia in search of cheap labor or
resources. For instance, Fossil, a wrist watch manufacturer, has chosen to locate its
headquarters in east Asia rather than its home country, the US.
5.3 Strategic Motives
Firms participate in international business for strategic reasons. They may aim to
capitalize on their distinctive capabilities or resources already developed at home. By
deploying these capabilities or resources in foreign markets or by increasing their
production through international trade, firms may be able to increase their cash flows.
They may also go international to have a first mover advantage before any competitor
takes that position. This results in strategic benefits for the company such as
technological leadership, competitive position, brand image, and customer loyalty.
Firms could have further advantages from vertical integration involving different
countries. For instance, a firm in the oil exploration and drilling business may
integrate downstream by building or acquiring an oil refinery in a foreign country that
has a market for refined products.
Another strategic motive is for a company to follow its major customers abroad. For
instance, Bridgestone, the Japanese tire maker, landed up in the US market when its
customers, the Japanese car makers, exported their cars to the US with tires supplied
by Bridgestone. Because product adaptation and responsiveness are becoming critical
for business success, proximity to foreign customers is an important driver of foreign
investment.
6. Summary
For consumers, globalization may mean more choices, reduced prices, and an
indistinct national identity for products and services. Globalization has its
winners and losers, and it is often accused of coming at the cost of poorer nations.
A common complaint against globalization is that it deprives nations of their
sovereignty. The globalization challenge is to maintain a balance between public
interest and interest of those who are suffering its consequences in the short range.
International business refers to business activities that involve the transfer of
resources, goods, services, knowledge, skills, or information across national
boundaries.
In general, the motivations for carrying out international business include market
motives, economic motives, and strategic motives.
5
International Business
6
International Business and Globalization
7
International Business
Contd…
economy of the US, and certain flawed trade policies made with North American
Free Trade Agreement (NAFTA) and the World Trade Organization (WTO), which
had resulted in reduced incomes, job losses, and a rise in poverty. Nevertheless,
imposing new trade barriers, would mean nothing but a disaster.
What was thought would be a boon to the US economy, had gradually turned into a
nightmare, and many political leaders were reconsidering their further support to
globalization in the coming years.
Compiled from various sources.
8
International Business and Globalization
Appendix - 1
Country Differences
Introduction
Culture plays an important role in international business. It not only affects employee
interaction but the overall strategy adopted by a business. The different layers of
culture affect the strategy and operations of an MNE in both the home and the host
country.
The political-legal environment is crucial for an MNE at home as well as abroad. The
political environment identifies key constituencies and the legal environment sets the
rules of the game as well as the range in which a legitimate business can be
conducted.
This unit defines culture and its significance in international business. It then explains
correlates of culture. It takes a look at the key classifications of national cultures. The
unit defines corporate culture and explains other layers of culture. It also discusses
key cultural issues. The unit then explains the political environment in which the
MNE operates and the MNE‟s relationship with the governments of the home country
and the host country. The unit finally discusses the legal environment in which the
MNE carries out its operations.
The Oxford Encyclopedia English Dictionary defines culture as “the art and other
manifestations of human intellectual achievement regarded collectively; the customs,
civilization, and achievement of a particular time or people; the way of life of a
particular society or group.”
Anthropologists Herskovits and Harris define culture as “the man-made part of the
environment” and “the learned patterns of thought and behavior characteristic of a
population or society.”
Modern management scholars such as Hofstede define culture as “the collective
programming of the human mind,” whereas Trompenaars and Hampden-Turner define
culture as “the way in which people solve problems and recognize dilemmas.”
The significance of culture to international business cannot be overestimated. For
instance, culture is considered as a key ingredient in the “liability of foreignness”. At
the firm level, the impact of culture ranges from strategy formulation to FDI and
organization design. Culture has an influence on organizational behavior processes
such as perception, leadership, and motivation, as well as human resource
management, and negotiations, decision making, and management style. Marketing,
supply chain management, and accounting and all other functions are virtually
influenced by culture. Culture also plays a crucial role in international alliances and
mergers.
9
International Business
Correlates of Culture
Culture is correlated with other variables that vary cross-nationally. Culture, however,
cuts across linguistic and religious boundaries and the latter cut across national
boundaries. For instance, Belgium, Nigeria, and Switzerland are countries which have
multiple official languages. South Korea and Lebanon have a large Christian minority
while Northern Ireland has both Catholic and Protestant communities.
Language
Religion contains norms and key values that are reflected in the life of an adherent.
Globally, Christianity claims to have the most adherents while Islam is the fastest
growing. De Blij and Murphy term Christianity, Islam, and Buddhism as „global
religions‟ whereas religions dominating a single national culture are termed as cultural
religions.
International business is influenced by religions in many ways. Business firms and
national institutions try to adopt practices that satisfy religious decrees without
undermining modern business practices. For instance, as bank interest is prohibited
under Islamic law, banks in Moslem countries issue shares to depositors and the
borrowers are charged fees and commissions to maintain profitability without any
interest being charged.
10
International Business and Globalization
Power distance
Power distance is “the extent to which hierarchical differences are accepted in society
and articulated.” Power distance should not be confused with power and actual
distribution of wealth in a nation. For instance, Israel is low on power distance though
its income equality is the highest in the developed world. MNEs from cultures
characterized by a high power distance (e.g. Cemex, Mexican cement maker) are less
likely to delegate more authority to their subsidies compared to MNEs from cultures
characterized by a low power distance.
Uncertainty avoidance
Uncertainty avoidance refers to “the extent to which uncertainty and ambiguity are
tolerated.” According to Hofstede, uncertainty avoidance is the most critical dimension
for foreign investment due to its implication for risk taking and investment. For instance,
MNEs with high uncertainty avoidance are likely to take an incremental approach to
internationalization. For instance, Nissan, the Japanese car manufacturer, lagged behind
its US and European counterparts in establishing production facilities in China.
Individualism/collectivism
This framework originated in psychology and has been used to a limited extent in
literature. Schwartz and his associates identify three polar dimensions of culture
which are described here:
Embeddedness versus autonomy
Embeddedness implies emphasis on tradition and social relationships. Autonomy
implies being encouraged to express one‟s own attributes and finding meaning in
one‟s own uniqueness.
11
International Business
Mastery implies mastering the social environment through ambition, success, etc.
Harmony implies living in peace with nature and society.
Trompenaars and Hampden-turner’s Classification
12
International Business and Globalization
Corporate Culture
Corporate culture is “the culture adopted, developed, and disseminated by a
company.” It is crucial for an MNE that adopts a global strategy and adopts corporate
culture to integrate its various units. According to Hofstede, corporate culture is more
superficial than the national culture because the imprints on the national culture reside
in deeply embedded values.
Laurent proposed that corporate culture plays a major role in modifying behavior and
artifacts, and beliefs and values but the underlying assumptions can be found deeply
in national culture.
Other Layers of Culture
Ethnicity
In many countries, significant ethnic communities exist. For instance, in the US,
various Asian and Hispanic communities have been growing rapidly, creating a
subculture within the culture of the US. These variations are recognized by the MNE
as they affect many issues from employee relations to consumption patterns.
Industry
Hofstede et.al. found that age, education, seniority, and hierarchical level have a
strong affect on differences in values. For instance, Ralston et.al. found that the new
generation of Chinese managers were more individualistic than the previous
generation.
Ideology
Stereotypes are the beliefs about others, their attitudes, and behavior. Auto-stereotypes
are how people see themselves as more distinguished than others. Hetero-stereotypes
are how people are seen by others.
13
International Business
Stereotypes are important because they affect how MNE staff at headquarters and
other locations perceive other MNE employees.
Cultural Distance
Cultural distance is “a measure of the extent to which cultures differ from each other.”
It plays a key role in MNE strategies and foreign investment. It also affects alliance
performance and the entry mode.
Convergence and Divergence
The crucial layer of the political environment is constituted by the historical landscape
of political relations and institutions between and within countries. For instance, after
nearly 40 years of the French colonial rule, former western Africa colonies continue to
import their needs from France.
Affinity or animosity between nations reflects how nations are aligned or estranged
based on their history and political reality. Countries with high political affinity and
historical bonds such as the US and the UK tend to have high levels of mutual trade
and investment. In contrast, trade and investment are prohibited among hostile
countries.
Political considerations often have an influence over third countries. For instance, the
US administration warned the Israeli government to cancel the sale of airborne aircraft
warning systems to China, and threatened Israel with cancellation of aid if it entered
into a deal with China.
14
International Business and Globalization
Three models that analyze the MNE-government relationship are sovereignty at bay,
dependency, and no-mercantilism. The sovereignty at bay models consider an MNE as
a threat to the national sovereignty of the host country. The dependency model sees a
cooperative relationship only between the MNE and the government of the home
country.
The nature of the relationship between the MNE and host governments is termed as
coopetition – a combination of cooperation and competition. From the view of the
government, increasing pressure of global integration, decelerated economic growth,
heightened competition for inbound FDI, and stronger needs for upgrading economic
structure encourage coopetition with MNEs. From the viewpoint of an MNE,
increasingly foreign operations are depending on industrial, educational,
technological, and financial structures built by host governments.
The key political goal of an MNE in a host country is to establish a favorable trade
and investment environment. The MNEs aim to face as few regulatory hurdles as
possible and strive to remove limits on foreign ownership and open access to local
markets. Another important goal for an MNE is to obtain legitimacy. Legitimacy is
“the acceptance of the MNE as a natural organ in the local environment.”
The aim of the host governments is to protect their national interests as the security of
the nation is concerned. Local governments are also concerned about protecting their
environment from pollution, unsustainable logging, and the like.
The bargaining power of a nation is high when it offers an attractive environment that
is unmatched by other locations. The bargaining power of an MNE is high when it
offers a differential and technologically advanced product which others cannot
provide. Governments compete with each other and are willing to bargain with an
MNE over provisions for investment incentives. The incentives can be used for
preferential tax treatment, infrastructure development, interest subsidies, and loans
and loan guarantees.
MNE and its Home Government
The home government plays a major role in facilitating the political objectives of an
MNE. For instance, when Saudi Arabia was deciding to buy a new aircraft from
Airbus or Boeing, the then US president, Bill Clinton called the king on behalf of
Boeing. The intervention of the government is only to preserve jobs and protect the
interests of the nation. Political pressure is also applied to close the home market to
foreign competition. For instance, US car manufacturers imposed a limit on Japanese
imports to the US in the late 1970s and 1980s.
15
International Business
Political Risk
A common law system that originated in England was followed by the US and former
British colonies such as New Zealand and Australia. A civil law system that
originated in the Roman Empire was used by Latin America and Continental Europe.
Civil law is considered to be less flexible than the common law system as the former
follows a legal code which is applied universally.
Another legal system is theocratic law, which is a system that relies on religious code.
For instance, countries such as Saudi Arabia and Iran rely on Islamic law as the basis
of their legal system.
Legal Jurisdiction
Legal jurisdiction is “the legal authority under which a legal case can be adjudicated.
It is often difficult to determine legal jurisdiction in international business.” The MNE
is mainly subjected to home country and host country laws and less often to third
country laws.
A firm is subject to international regulatory system and international law at the
international jurisdiction level. A firm is subject to laws and regulations of a regional
entity such as the European Union or trade framework such as the ASEAN, at the
regional-global jurisdiction level. The most importation jurisdiction level for an MNE
is at the national level, whether at the home, host, or a third country.
Of late, the WTO has been proactive in deciding jurisdiction and contradictory laws
matters.
Regional Jurisdiction
Regional bodies are also increasingly taking responsibility for enacting and enforcing
laws. At times, uncertainty prevails as to whether regional jurisdiction supersedes
national jurisdiction.
16
International Business and Globalization
National Jurisdiction
The MNE has to comply with domestic jurisdiction at home and foreign jurisdiction
abroad. For instance, the Foreign Corrupt Practices Act in the US is responsible for
bribery and related activities in foreign operations of MNEs.
Legal Issues
The US anti-trust legislation is the most advanced of legislation and has been
emulated by several countries. In recent years, the European Commission (EU) has
been aggressively enforcing anti-trust legislation. For instance, the EU was
investigating Coca-Cola‟s sales and distribution practices as PepsiCo. alleged that the
former had paid retail outlets not to stock Pepsi‟s products.
Subsidies
EU rules prohibit subsidies from the government that give an edge to a firm from one
country over another. However, the EC is less concerned with infringements
detrimental to non-EU firms.
Marketing and Distribution Laws
National laws determine the practices that are allowed in advertising, distribution, and
promotion. For instance, advertising cigarettes on TV is prohibited in many countries.
Product Liability Laws
Product liability laws are stringent in the EU, the US, and many other developed
countries. The laws are, however, lax or not enforceable in many developing
economies.
Treaties
Patent Laws
Two international treaties that govern patent protection are the Paris Convention for
Protection of Industrial Property and the Patent Cooperation Treaty.
Summary
18
International Business and Globalization
19
International Business
Contd…
The decision of the EU on March 24, 2004, represented a milestone in EU history.
Even though this decision was not the first in the field of information technology
(three years earlier, EU had fined Nintendo heavily for abuse of position in the
market of console videogaming), it was the first such in the field of operating
systems for desktop computers and servers. Apart from imposing a huge fine, the
EC also ordered Microsoft to disclose complete and accurate interface
documentation, which would allow non-Microsoft work group servers to achieve
full interoperability with Windows PCs and servers within 120 days from the time
of sentence, and to offer PC manufacturers a version of its Windows client PC
operating system without the Windows media player within 90 days from the time
of sentence.
Apple Computer Inc and Real Networks (Real), competitors of Microsoft,
welcomed the ruling and Real said that the ruling would allow the company to
increase its market share provided conditions for fair competition in the software
market prevailed. Real went to the extent of claiming that the predatory practices of
Microsoft had resulted in a severe loss of revenue for the company and even filed a
lawsuit of US$ 1 billion against Microsoft for loss of revenue.
Microsoft filed an appeal with the European Court of First Instance (CFI) against
the EC‟s decision on June 7, 2004. On June 25, 2004, it requested the CFI to
suspend the remedies set out by the EC. The CFI issued an order on procedural
matters on July 26, 2004. A two-day hearing regarding Microsoft‟s request for
suspension of the EC‟s orders before the CFI, started on September 30, 2004.
Finally on December 22, 2004, the CFI dismissed the appeal and said that
Microsoft had not shown that it might suffer serious and irreparable damage as a
result of implementing the EC‟s decision.
Compiled from various sources.
20
Concept Note - 2
nations would benefit from free and unregulated trade that would allow individual
countries to specialize in goods that they could best produce due to their natural and
acquired advantages. Smith‟s trade theory came to be known as the theory of absolute
advantage. The theory states that a nation‟s imports should consist of goods made
more efficiently abroad while exports should include goods that are made efficiently
at home. For instance, Caribbean countries should export bananas since they have an
absolute advantage at home and import apples from Washington which has an
absolute advantage in the US.
According to the absolute advantage theory, the market reaches an efficient end by
itself. The intervention of government in the nation‟s economic life and trade relations
among nations is counterproductive. Free trade would benefit a nation as imports
would cost less than the domestic products it would otherwise produce. In absolute
advantage theory, both the countries would gain from global allocation of national
resources unlike the mercantilist doctrine where the nation could gain from trade only
when the trading partner lost.
2.3 Comparative Advantage Theory
The absolute advantage theory could not explain some situations where, for instance,
one country has an edge over another in producing all goods efficiently. In this
situation would it pay for both the countries? This question was answered by a 19 th
century English economist, David Ricardo in his 1817 book On the Principles of
Political Economy and Taxation. According to him, both the countries would benefit
from trade even if one was more efficient in the production of all goods. Thus, this is
“the comparative advantage of a nation in producing a good relative to other nation
that determined international trade flows.”
The concept of opportunity cost can be introduced in the theory of comparative
advantage. If the opportunity cost of producing a piece of goods is lower in the home
country than in the other country, the country has a comparative advantage in
producing the goods.
It is also vital to understand the sources of comparative advantage. The immediate
source of trade is the price difference of the same commodity between different
countries; hence the difference in opportunity costs. The difference in price is
determined by the interaction of supply and demand. Therefore, the price differential
is derived from differences in demand conditions, supply conditions, or both. On the
demand side, differences in demand patterns are caused by differences in tastes and
incomes, and thus differences in prices. When two countries share similar consumer
tastes and income levels, income is unlikely to be a major source of differences in
demand. Similarly, differences in tastes may not result in significant demand
differences and thus for trade between countries belonging to the same socio-cultural
matrix. On the supply side, differences in supply patterns are a result of differences in
the patterns of production costs.
Hence, in today‟s world economy, comparative advantage should be explained by a
reference to comparative production cost differences, which further depends on the
production process of the commodity and on the prices of production factors such as
land, capital, labor, and natural resources. In turn, the factor prices are related to the
factors available in the national economy. The inputs to the production process are
referred to as production factors by economists. The conditions (availability and cost)
of production factors are referred to as the country‟s factor endowment. In today‟s
22
International Trade Theories and Application
global economy, quality levels of production factors become more crucial for
improving the exports of a country or attracting foreign investment. Thus, factor
endowment should also include the quality level of production factors in today‟s
international business environment. However, in the 19 th century, because inter-
country differences in technology were minor, international variations in comparative
advantage were attributed to different national endowment in terms of cost and
availability. This forms the theoretical root for the Heckscher-Ohlin theorem.
2.4 Heckscher-Ohlin Theorem
The Hecksher-Ohlin theorem was propounded by Swedish economists, Eli Heckscher
ad Bertil Ohlin. The theorem explains the link between the comparative advantage of
nations and national factor endowments. The theorem states that “a country has a
comparative advantage in commodities whose production is intensive in its relatively
abundant factor, and will hence export those commodities.” Meanwhile, a country
would import commodities whose production was intensive in the country‟s relatively
scarce factor of production. Therefore the differences in comparative advantage can be
attributed to the differences in the structure of the economy. A country is considered
to be more relatively efficient in activities suiting its economic structure.
There are several assumptions underlying the Heckscher-Ohlin theorem. First, it
assumes that countries differ in the availability of different factors of production.
Second, while each commodity has its own specific production function, the
production function is assumed to be identical anywhere in the world. The production
function shows “the amount of output that can be produced by using a given quantity
of capital and labor.” In other words, the theorem assumes that the same amount of
input will produce the same amount of output in any country. Third, the theorem holds
that the technology is constant in all trading countries and that the same technology is
used in all countries. Finally, it assumes that the conditions of demand for factors of
production are the same in all countries. With identical demand conditions,
differences in the relative supply of production factors will lead to differences in the
relative price of that factor between the two countries.
The Heckscher-Ohlin theorem also implies international equalization of prices of
factors of production under free trade – the so-called Heckscher-Ohlin law of factor
price equalization. It argues that “the exchange of goods between agricultural and
industrial countries would result in an increase in the previously relatively low levels
of land rents and a drop of the high level of industrial wages in the agricultural
country. However, in the industrial country, the opposite change in factor prices
occurs – an increase in industrial wages and a decrease in land rents.” In addition to
similar factors of production across different countries, the theorem assumes other
conditions under which free commodity trade equalizes factor prices: (1) free
competition in every market; (2) absence of costs of transportation; and (3) after the
beginning of free trade, all commodities continue to be produced in both countries.
The implications of the Heckscher-Ohlin theorem are described here:
1. Trade in addition to trade gains should be highest among countries with the
highest economic structure differences.
2. Trade should enable countries to specialize more in the production and export of
goods that are distinct from imports.
23
International Business
3. Trade policy rather than taking the form of trade simulation should take the form
of trade restrictions.
4. Countries should be exporting goods making use of their relatively abundant
factors.
5. Free trade should equalize factor prices not between countries with markedly
different factor endowments but between countries with fairly similar relative
factor endowments.
6. Factor prices should be almost equal between countries with liberal mutual trade.
7. The differences in factor endowments stimulate international investment and
international investment should be negatively correlated to international trade.
2.5 The Leontief Paradox
The central notion of the Heckscher-Ohlin theorem is that a country exports goods
making use of the abundant factor in the country and imports goods making use of the
scarce factor in the country. This proposition was tested in 1953 in the US by Wassily
Leontief, winner of the 1973 Nobel Prize in Economics. Using the trade figures of
1947 and input-output tables covering 200 industries, he found that US imports were
capital-intensive and exports were labor-intensive. Because these results contradicted
the Heckscher-Ohlin theorem predictions, it has come to be known as the Leontief
Paradox. The study by Leontief motivated further empirical research. The empirical
evidence collected since then shows several paradoxical results and contains serious
challenges to the general applicability of factor endowment explanations in other
countries such as Japan, Canada, India, and Germany.
The Leontief paradox stimulated a search for explanations:
Demand bias for capital-intensive goods: The US demand for capital-intensive
goods is extremely strong that it could reverse the US comparative cost advantage
in such goods.
Existence of trade barriers: The labor-intensive imports were reduced by trade
barriers that were imposed to protect and save jobs in America.
Importance of natural resources: Leontief took into consideration only labor and
capital inputs leaving out natural resource inputs. As natural resources and capital
are often used together in production, a country importing capital-intensive goods
may actually be importing natural resource-intensive goods. For instance, the US
imports crude oil, which is capital-intensive.
Prevalence of factor-intensity reversals: A factor-intensity reversal occurs when the
relative prices of capital and labor change over time, which results in changing the
relative mix of capital and labor in the commodity production process from being
labor-intensive to capital-intensive (or vice versa).
2.6 Human Skills and Technology-based Views
Several scholars have challenged the conventional trade theory which assumed that
there was equivalence in technology and human skills among different nations. The
technology-based and human skills view is regarded as a refinement of the
conventional trade theory. To explain the sources of comparative advantage, the
theory has added two new production factors -- human skills and technology gaps.
24
International Trade Theories and Application
The human skills theorists explain the source of comparative advantage in terms of the
comparative abundance of high-level human skills and professional skills. According
to Donald B Keesing, these include (1) scientists and engineers; (2) draftsmen and
technicians; (3) skilled manual workers; (4) managers; and (5) other professionals.
Technology theorists argue that certain countries have a special advantage as new
product innovators. According to them, there is an imitation lag that prevents other
countries from instantly duplicating the new products of the innovating country. These
conditions lead to technology gaps in those products that afford an export monopoly
for the innovating country during the period of imitation lag. Similarly, when a firm
comes up with a different and advanced production technique, it will enjoy cost
advantage and lead the world market for some time.
25
International Business
26
International Trade Theories and Application
Second, the theory suggests that inter-industry trade continues to be determined by the
Heckscher-Ohlin theory. In contrast, intra-industry trade is mainly driven by
increasing returns that result from specialization within the industry. This suggests
that comparative advantage from increasing returns that result from industry
specialization and factor endowment differences can coexist since they vary in the
application of inter-industry versus intra-industry trade.
Finally, the new trade theory comprehends the significance of externality in
international trade and specialization. Externality takes place when the action of one
agent has a direct effect on the environment of another agent. In international trade,
externalities include political relations between two countries; government policies;
history of the importing and exporting country; consumption differences between
different cultures, etc. The theorists of new trade theory contend that these
externalities could be the alternatives to comparative advantage as factors that
influence actual patterns of international trade.
The new trade theory has several implications. First, it helps in explaining the
Leontief paradox by bringing in the concept of economies of scale. According to the
theory, a firm engages in trade as it expects increasing returns from larger economies
of scale. These economies may not essentially associate with factor endowment
differences between exporting and importing countries. Scale economies are likely to
lead countries to specialize and trade with a country which is similar in terms of
consumption preferences and income levels. Second, the new trade theory helps in
explaining the intra-industry trade, which is a two-way trade that is carried out with
goods belonging to the same industry. Trade is carried out with the intent to realize
economies of scale, and may not be correlated with factor endowment differences.
Finally, this theory goes on to explain intra-firm trade, which takes place when import
and export activities are carried out between the subsidiaries of the same multinational
enterprise (MNE). MNEs consider intra-firm trade as a facilitator that globally
integrates upstream and downstream activities.
2.10 Theory Assessment
Though no single theory can explain the entire range of motives of international trade,
they collectively offer invaluable insights into why international trade takes place. The
differences in factor endowments are the most general explanation of the pattern of
old trade. Despite its diminishing power in explaining today‟s international trade, the
comparative advantage theory still has the capability of explaining international trade
in natural resource products. When the factor endowments are extended to include
skilled labors and technologies, the Heckscher-Ohlin theorem can be applied to
current import and export activities between developed and developing nations.
The product life cycle theories and the technological gap (e.g. technology-based views
and human skills) emerge as powerful explanations of trade in new products, i.e.
products made by a skilled workforce using technologies. These technologies and
skills can be used to improve the terms of trade of a country, which is a major concern
of both developed and developing countries. The terms of trade refer to “the relative
price of exports, that is, the unit price of exports divided by the unit price of imports.”
The terms of trade will improve if the country exports more goods associated with
technologies and human skills. In this case, the foreign trade contribution to the
economic growth of the nation will be stronger. Though the product life-cycle model
27
International Business
is not as applicable today as it was at the time it was conceptualized, it still explains
key patterns in the international trade evolution. The import and export structures of a
nation change over time. Similarly, every new product has life stages in the global
marketplace.
The theories which provide insights into the triggers of international trade on trade
between regions with similar levels of income and consumption patterns and
sophisticated manufacturing products are the Leontief Paradox and Linder‟s income-
preference similarity theory. According to these theories, market demands are viewed
as an important parameter for international trade. In reality, international trade today
is driven not only by national differences in factor endowments but also by national
differences in market demand. Intra-regional trade accounts for a high proportion of
the world trade due to similarities in demand structures and income levels, in addition
to efficiencies arising from reduced transaction costs and uncertainty. The limitation
of these theories is that they could not enlighten how trade activities would take place
between nations having similar levels of income with different consumption preferences.
Due to this drawback, the increasing trade between developed countries and industrialized
countries (e.g. Hong Kong, Singapore, South Korea, and Taiwan) or emerging markets
(e.g. India, China, Brazil, Mexico, and Russia). The key driver of this trade phenomenon
seems to be the elevated purchasing power and rising income levels.
Finally, the new trade theory helps in understanding the intra-industry and intra-firm
trade. For explaining international trade, it links national factor endowments with firm
behavior and firm incentives. This link was crucial since firms rather than countries
conduct international trade and investment. The international trade efficiency can be
maximized if economies-of-scale advantages of firms and national factor endowment
differences can be combined and simultaneously realized. The limitation of this theory
is that it overlooks other incentives and focuses only on increasing returns from
economy of scale.
“Tariffs are surcharges that an importer must pay above and beyond taxes levied on
domestic goods and services.” Tariffs are considered to be transparent and ad valorem
i.e. based on the product or service value. In the 19th century, tariffs were widely used
but were reduced over time. This trend was reversed by the Smooth-Hawley Act of
1930 which pushed tariffs to 60 percent level of the import value.
28
International Trade Theories and Application
In the following decades, tariffs in the US and other nations substantially declined.
However, tariffs on some products in the US as, for instance, sugar, remained high.
Over the years, remarkable progress has been made toward tariff reduction or
elimination. Some companies make efforts to circumvent tariffs. For example,
Heartland By-Products, a Michigan-based firm, circumvents the tariff on sugar by
buying sugar molasses from its sister company in Canada which makes it from sugar
bought at world prices. The process is then reversed and the molasses is turned into
sugar syrup which is sold to makers of candy, ice cream, and cereals in the US.
Due to low tariffs, governments try to shift products in the high tariff category while
firms develop strategies to benefit from the lower tariff category.
Optimal Tariff
The optimal tariff theory assumes that by imposing tariffs, governments can capture a
significant portion of the profit margin of manufacturers. In other words, assuming
that the exporter cannot willingly raise prices, domestic customers will not have to
pay a higher price, and the government manages to obtain the proceeds that would
have been otherwise obtained by the exporter. The optimal theory also assumes that
the exporter will not absorb the lower prices and will not shift its efforts to other
markets. The theory does not take into consideration the fact that higher tariffs could
trigger smuggling that would eventually end in reducing government revenues.
Infant Industries
The infant industry for tariffs argues that an industry which is new to a developing
country needs protection through tariff walls or it risks being squeezed by global
players before it begin to grow and develop. This argument was raised vigorously by
the US throughout the 19th century, by Japan after World War II, and by Korea in the
1960s. These countries aimed to encourage domestic industry development while
generating revenues for the state at the expense of foreign manufacturers. Consumer
interests were not taken into consideration as demonstrated by international trade
theories. For instance, when US motor vehicles were kept out of Korea and Japan by
the imposition of high tariffs and other barriers, this resulted in higher local prices.
Quotas
Quotas are “quantitative limitations on the importation of goods typically spelled in terms
of units.” Some quotas allow for an increase that is preset, for instance, an annual increase
of 4 percent, while some quotas allow for a decrease that is preset as contained in the
North America Free Trade Agreement (NAFTA). Quotas can also be established in terms
of market share beyond which cessation of imports or tariffs are triggered.
Quotas hold the quantifiable, definitive protection of domestic producers unlike
tariffs. However, they may lead to unintended consequences. In contrast to tariffs,
quotas do not have the needed potential that could trigger efficiencies arising from the
need to remain competitive with the domestic producers.
Rule of Origin
Tariffs and quotas are administered on the basis of the country of origin, the default
for which is the importing country. The terms for rule of origin differ between types
of tariffs and supports.
29
International Business
Rule of origin is usually an issue of contention, however, because the value added to
the product in the country which is transient could be debatable. For instance, the
French government once returned a shipment of cars of US-based Honda saying that
the cars were Japanese and hence fell under the Japanese car imports quota, which had
already been exceeded.
As a remedy to the problems accruing from rule of origin, the World Trade
Organization (WTO) issued a first ever agreement on rules of origin. It required that
the rules be applied in a consistent way, that they are transparent, that they are based
on positive standards, and that they will not distort, restrict, or disrupt trade.
Export Controls
Most of the countries impose a limit on the number of products that can be exported to
other countries especially those nations that are considered an enemy or where the
security of the exporting nation is at risk. Export controls are “activated against
products with a national security potential, but also to so-called dual-use products
such as computers and trucks that can have both security and civilian uses.”
During emergencies, export controls are used to prevent the export of goods that are
vital to armed forces and the domestic industry, as for example, oil. Export controls
differ from other trade barriers in the sense that they are placed by the exporting country
rather than the importing country. Companies which export goods often pressure their
government to ease export controls by arguing that the importing country will receive
products from competitors where export controls are not strict. Finally, export controls
affect manufacturers in the home country and in the third country. This has relevance
especially in countries such as the US which have substantial surplus in technology
balance of payments. For instance, the US warns Israel to ensure that it does not use
sensitive technologies of the US in its sales to China.
Dumping and Anti-dumping
Dumping is defined by the WTO as “selling a product at an unfairly low price, with
the „fair price‟ defined as the domestic price, the price charged by an exporter in
another market, or a calculation of production costs.” Dumping interferes with the free
flow of trade as it distorts pricing. It also undermines the principle of comparative
advantage as it may cause the exporting country to specialize in any product or service
in which it will not have any advantage over the importing country.
Due to the adverse impact of dumping on trade, the WTO allows remedies against it
but only if „material injury‟ has been demonstrated to the domestic industry. In theory,
the extra duties that could be added up to 40 percent of the price of the product can be
brought down to realistic levels, permitting the efficient producers to sell their goods.
The problem arises when retaliation is used in the form of anti-dumping duties for the
protection of inefficient domestic producers.
In 1999, 28 nations had initiated 1,200 anti-dumping measures which are now applied
by developing and developed nations.
3.2 Non-Tariff Barriers
“Non-tariff barriers are obstacles to trade, not anchored in laws and official
regulations and therefore are not transparent.” It is difficult to deal with a non-tariff
barrier as the offending party will not admit that there is a barrier and will refuse to
30
International Trade Theories and Application
enter into negotiations for its removal. Some barriers are difficult to detect and
monitor. There are many non-tariff barriers whose combined effect can be substantial.
3.3 Administrative Barriers
Administrative barriers are often used by governments to block the entry of products
even as they argue that the barrier does not exist. An example of an administrative
barrier is labeling. Most countries require product labels to be in local languages,
which is considered to be a reasonable requirement but one that puts an additional
burden on the small exporter who may not find it economically feasible to do.
3.4 Production Subsidies
Subsidies are “payments provided by a government or its agencies to domestic
companies in order to make them more competitive vis-à-vis foreign competitors at
home and/or abroad.”
Subsidies bring in an artificial incentive into the production equation of domestic
manufacturers by funneling resources away from their optimal deployment. However,
subsidies, in contrast to tariffs, do not distort the decisions of consumers because they
do not increase prices beyond the global level. According to the WTO, subsidies can
be prohibited, actionable, and non-actionable. Prohibited subsidies require the
recipient to make use of domestic goods rather than using foreign goods or to meet
export targets. Actionable subsidies are disallowed when damage is demonstrated to
the national interests of the company which is complaining. Non-actionable subsidies
include offering support to disenfranchised regions to enable companies to comply
with stringent employment laws and R&D assistance not exceeding one quarter or one
half of the total R&D cost. Countervailing duties cannot be imposed on non-
actionable subsidies. These duties are set to counter the impact of subsidies.
3.5 Emergency Import Protection
The WTO recognizes remedies against a surge in imports, defined as “a sudden and
dramatic increase in imports or in market share that can cause material damage to the
domestic industry.” Though the remedies cannot be targeted at a particular country,
they can set a quota formula for allocating supply among different exporting
countries. A variation of emergency restrictions could be seen while setting „voluntary
quotas‟. For instance, the quotas imposed by the US government to stem the rising
tide of Japanese auto imports are voluntary as the importing country threatens other
measures if no heed is paid to the quotas.
Although emergency import protection is seen to disrupt free trade flow, it can be
justified in that it can safeguard competition by preventing existing players from
making an exit from the market.
3.6 Foreign Sales Corporation
In February 2000, the WTO gave a ruling in response to a complaint by the European
Union that the US makes use of a „foreign sales corporation‟ which represents subsidy
to exports. It ruled that the US firms had to face sanctions due to this practice by its
corporations or had to remedy the situation. Such sanctions take the form of
retaliatory tariffs on products in the US, producing an additional barrier to trade in the
opposite part of the trade flow.
31
International Business
Foreign sales corporations are “offshore corporations that market the products and/or
services of firms in foreign countries.” Firms benefited as part of the income
generated by foreign sales corporations as it was excluded from taxes in the US. For
instance, Boeing saved US$ 230 million in 1999 through this mechanism of selling
through foreign sales corporations.
3.7 Embargoes and Boycotts
Embargoes and boycotts halt trade by interfering with the free flow of trade. Both
make an attempt to damage a country by withdrawing international trade benefits. An
embargo is “the prohibition on exportation to a designated country.” A boycott is the
“blank prohibition on importation of all or some goods and services from a designated
country.” Boycotts are considered to be non-tariff barriers as firms deny their
existence. They are initiated by national governments. For instance, the US embargo
on Cuba. They are also sometimes initiated by non-government organizations (NGOs)
such as consumer groups and business associations.
Finally, buy local campaigns make efforts to curtail all imports, regardless of the
origin of the country.
3.8 Technical Standards
Technical standards refer to “provisions made by government agencies in various
countries that pertain to a large array of areas, for example, safety, pollution, technical
performance, and the like.” Companies wishing to sell their products in a country need
to show that that their products meet the standards of the country where they plan to
sell their products. A group appointed by the US National Research Council and
headed by Gary Hufbauer, concluded:
“(1) Standards that differ from international norms are employed as a means to protect
domestic producers; (2) restrictive standards are written to match the design features
of domestic products, rather than essential performance criteria; there remains unequal
access to testing and certification systems between domestic producers and exporters
in most nations; (3) there continues to be a failure to accept test results and
certifications performed between domestic producers and exporters in most nations;
(4) there continues to be a failure to accept test results and certifications performed by
competent foreign organizations in multiple markets; and (5) there is significant lack
of transparency in the system for developing technical regulations and assessing
conformity in most countries.”
3.9 Corruption
Corruption is another trade barrier. For instance, the US which has anti-bribing
legislation, may refrain from doing business in countries where bribes are expected.
Some exporters also refrain from selling in markets where intellectual property (IP) is
not respected. Trebilcock and Howse argue that IP protection is of interest to
innovating countries such as the US but not of economies such as Taiwan and Korea
which imitate knowledge developed elsewhere.
Ironically, the efforts to fight corruption may also serve as barriers to trade. For
instance, a pres-shipment inspection is carried out in many countries to prevent tax
evasion, fraud, and capital flight by subjecting incoming imports to continuous
inspection by private companies which are contracted. In many cases, such
inspections delay or block imports for protecting domestic producers that may be
associated with the inspectors.
32
International Trade Theories and Application
4. Summary
Mercantilism emerged in the mid-sixteenth century in England as the first theory
of international trade. The doctrine set immense faith in government‟s ability to
improve the residents‟ well-being using a system of centralized controls.
The theory of absolute advantage states that imports in a nation should consist of
goods made more efficiently abroad while exports should include goods that are
made efficiently at home.
The concept of opportunity cost can be introduced in the theory of comparative
advantage. If the opportunity cost of producing a piece of goods is lower in the
home country than in the other country, the country has a comparative advantage
in producing the goods.
The Hecksher-Ohlin theorem states that “a country has a comparative advantage
in commodities whose production is intensive in its relatively abundant factor,
and will hence export those commodities.
Wassily Leontief found that US imports were capital-intensive and exports were
labor-intensive.
The technology-based and human skills view is regarded as a refinement of the
conventional trade theory. To explain the sources of comparative advantage, the
theory has added two new production factors -- human skills and technology
gaps.
The product life-cycle model was proposed by Raymond Vernon in the mid-
1960s. The imitation-gap approach was further developed by Vernon where he
suggested that changes take place in the input requirements of a new product as
soon as it becomes established in a market and becomes standardized in
production.
Staffan B Linder, a Swedish economist, divided international trade into two
different categories -- primary products and manufactures. Linder stated that the
factor endowment differences explain trade in natural resource-intensive products
but not in manufactures.
The new trade theory was expounded by Dixit and Norman, Lancaster, Krugman,
Helpman, and Ethier. According to these theorists, countries not only specialize
and trade solely to take advantage of their differences; they also trade due to the
increasing returns, which make specialization beneficial per se.
33
International Business
Tariff barriers chiefly include tariffs and quotas as their derivatives, in addition to
export controls and anti-dumping laws.
The optimal tariff theory assumes that by imposing tariffs, governments can
capture a significant portion of the profit margin of manufacturers.
Non-tariff barriers include administrative barriers, production subsidies,
emergency import protection, foreign sales corporations, embargoes and boycotts,
technical standards, and corruption.
34
International Trade Theories and Application
Contd…
With MFN status, China would move to an even more advantageous position.
According to analysts, the challenge before India was to undertake macro-
economic reforms to step up overall growth. Reforms should include reducing the
fiscal deficit and high borrowings. To compete with China for FDI, India needed to
improve its infrastructure.
Compiled from various sources.
35
International Business
Contd…
In June 2001, former president of the Unites States, George W Bush (Bush),
announced his Steel Program. In March 2002, the president imposed tariff measures
to help domestic producers compete with imported steel. These tariff and quota
measures were not applicable to Canada, Mexico, Israel, and Jordan, US‟s free
trade partners. Most developing countries were also excluded from these measures
provided their share of the total imports during 1996-97 was less than 3 percent. In
August 2002, the government decided against imposing anti-dumping duties on
cold-roll steel from five countries (Japan, Australia, India, Sweden, and Thailand).
This decision was based on the finding by the US International Trade Commission
(USITC) that the import of cold-roll steel was not harming the domestic industry.
Further, the government also announced that it would increase the number of steel
products that were exempted from the tariffs imposed in March 2002 to 178.
However, supporters of free trade and industries using steel hailed the decision
saying that steel companies were already benefiting from higher prices because of
the earlier announced tariffs. Bush‟s tariff measures to protect the domestic steel
industry were hailed by supporters of protectionism but were vehemently criticized
by proponents of free trade. Some analysts felt that the US steel industry should be
protected not only because of the pride associated with it but also because of its key
role in the US economy. The importance of steel as a commodity in the US
economy was next only to oil. Steel was a source of political and economic strength
for the country. Some of these analysts added that major steel producing countries
such as Japan and Korea were not dependable trading partners as they had in the
past resorted to unfair trade practices such as dumping and predatory pricing. Thus
it made sense for the US steel industry to be protected. Some analysts also believed
that without protection, the US steel industry would find it difficult to reorganize
and become more competitive. They argued that protection from foreign
competition had allowed the industry in the1980s to cut down 60 percent of its
workforce and to spend US$ 23 billion on modernizing facilities. Because of
protection, the industry was able to regain its leadership position in quality and
productivity, and in 1991 experienced its highest level of exports since 1970.
Another justification was the legacy costs of the industry. In the early 2000s, the
industry was finding it difficult to fund these legacy costs, which included healthcare
and pension benefits to around 600,000 retirees and their dependents. In 2002, the
number of employees in the industry was 142,000, 60 percent down from its peak in
the early 1970s. With this number, the industry was not able to finance the legacy
costs of the large number of retirees. The government could use the funds generated
from higher tariffs to help the industry meet its healthcare and pension costs.
The government‟s protectionist policies had adversely affected market efficiency
and innovation in the industry some experts observed. Imposition of Section 201
tariff measures would increase government intervention in an industry that was
already protected, they felt. Statistics show that 80 percent of imports into the US
were already subject to tariffs under the US anti-dumping laws. These laws allowed
the government to impose tariffs on steel products that were subsidized by the
foreign governments and dumped in the US. But these measures did not seem to be
helping the still-struggling industry.
Contd…
36
International Trade Theories and Application
Contd…
These analysts felt that the industry was struggling on account of homegrown
problems. Before the government started protecting the domestic steel industry in
the late 1960s, the average compensation in the industry was almost equal to the
average compensation in the manufacturing sector. In the early 2000s, the average
compensation was more than 50 percent higher than that in the manufacturing
sector as a whole. This was mainly because the steel industry was highly unionized
and the strong trade unions without any threat of foreign competition could
negotiate high compensation packages. Thus, far from being of benefit,
protectionism was actually responsible for many of the ills of the industry in the
early 2000s.
Compiled from various sources.
37
International Business
Appendix-2
The strategy of a firm can be defined as “the actions that managers take to attain the
goals of the firm.” For most firms, the major goal is to maximize their value for their
owners, the shareholders. The value of a firm can be maximized by pursuing strategies
that increase the profitability of the firm and its rate of profit growth over time.
Profitability is “the rate of return that the firm makes on its invested capital (ROIC).”
ROIC is calculated by dividing the firm‟s net profits by total invested capital. Profit
growth can be measured by the percentage increase in net profits over time. Higher
profitability and profit growth help in maximizing the value of a firm and thus the
returns acquired by the owners and shareholders.
To maximize a firm‟s profitability, managers pursue strategies that lower costs or add
value to the firm‟s products, which enable the firm to increase prices. Managers can
increase the profit growth rate by pursuing strategies to sell more products in existing
markets or by entering new markets.
Value Creation
By creating more value, firms can increase their profitability. The value created by a
firm is measured by the difference between its cost of production and the value
perceived by the consumers in its products. However, the price charged by a firm for a
product or a service is less than the value placed by the consumer. This is because
consumers capture some of that value in the form of consumer surplus. The consumer
is able to do this because the firm competes with other firms for the customer‟s
business, so the firm has to charge a lower price than it could have if it was the only
supplier.
The strategy that focuses on lowering production costs is called low-cost strategy. The
strategy that focuses chiefly on increasing the product attractiveness is called
differentiation strategy. Michael Porter argues that low cost and differentiation are
two strategies that create value and help a firm attain competitive advantage in an
industry. According to Porter, firms that create superior value get superior
profitability. Superior value could be created by driving down the cost structure of the
business and/or differentiating its product so that the consumers value it more and are
ready to pay a premium.
38
International Trade Theories and Application
Strategic Positioning
According to Porter, a firm has to be explicit about its choice of strategic emphasis
with regard to value creation and low cost. A firm should also be clear about
configuring its internal operations for supporting that strategic emphasis.
Porter emphasizes that it is crucial for management to decide where the firm wants to
be positioned with regard to cost and value and accordingly configure its operations
and manage them efficiently.
Operations
The firm‟s operations can be thought of as a value chain consisting of distinct value
creation activities including production, marketing and sales, materials management,
research and development, human resources, information systems, and the firm
infrastructure. The operations or value creation activities can be categorized as
primary activities and support activities. For a firm to implement its strategies
efficiently, it should manage these strategies effectively.
Primary activities
Primary activities deal with the design, creation, delivery, marketing, support, and
after-sales service of a product. The primary activities are divided into four functions
such as research and development, production, marketing and sales, and customer
service.
Research and development (R&D) is concerned with the product design and the
production process. R&D increases the product‟s functionality through superior
design making it attractive for the customers to buy the product. In addition, R&D
also results in a more efficient production process, thereby cutting the costs of
production. Either way, R&D creates value.
Production is concerned with the creation of a product or service. For physical
products, production means manufacturing processes and their output. An example of
physical production could be production of an automobile in an assembly line. For
services such as healthcare or banking, production occurs when the service is
delivered to the customers. The production activity of a firm creates value by carrying
out its activities efficiently so that it results in lower costs of production or a product
of high quality, or both.
The marketing and sales functions create value in several ways. Marketing through
brand positioning and advertising, increases the value the customers perceive to be
contained in the product. If these create a favorable impression in the minds of the
consumers, the firm can charge a premium.
The marketing and sales function also creates value by discovering the needs of the
consumers and communicating them back to the R&D function, which can then
design products that will suit the needs of the consumers.
The role of the service activity is to offer after-sales service and support. By offering
support and solving the problems of consumers, this function creates a perception of
superior value in the consumers‟ minds.
39
International Business
Support activities
The support activities of the value chain provide inputs for the primary activities to
take place. For a firm to attain competitive advantage, the support activities are as
important as the primary activities. The transmission of physical materials through the
value chain, from procurement through production to distribution is controlled by the
logistics function. The efficiency with which these functions are carried out can
significantly lower costs, thereby creating more value.
The human resource (HR) function creates value by ensuring that the firm has the
right mix of people to perform its value creation activities efficiently. The HR also
ensures that the people are adequately trained, motivated, and compensated to carry
out the value creation activities efficiently.
Information systems are electronic systems that track sales, manage inventory, price
and sell products, deal with customer service queries, etc. Information systems
coupled with the communication features of the Internet can help in altering the
efficiency and effectiveness with which the firm manages its value chain activities.
Firm infrastructure is the final support activity. The infrastructure includes the control
systems, organizational structure, and culture of the firm. As the top management
exerts significant influence in shaping these aspects of a firm, it is also viewed as part
of the firm‟s infrastructure. The top management shapes the firm‟s infrastructure
through strong leadership, thereby enhancing the performance of all the value chain
activities.
Global expansion helps firms increase their profitability and profit growth rate. Firms
operating internationally can:
Expand the market for their local products by selling them in international
markets.
Realize location economies by dispersing individual value creation activities to
those locations across the globe where they can be carried out effectively and
efficiently.
Realize greater cost economies by serving the global market from a central
location, thus reducing the value chain costs.
Leverage valuable skills developed in foreign operations to earn greater return by
transferring them to other entities within the global network of operations of the
firm.
Market expansion: Leveraging products and competencies
A firm can increase its growth rate by taking goods or services developed
domestically and selling them internationally. For instance, automobile companies
such as Toyota and Volkswagen grew by developing products at home and later
selling them worldwide. The returns from such a strategy can be significant if the
competitor in nations which a country enters lacks comparable products.
The success of multinational companies that expand in this manner not only depends
on the product or services offered by them in the international markets but also on the
core competencies that underlie the production, development, and marketing of those
40
International Trade Theories and Application
goods or services. Core competencies refer to “skills within the firm that competitors
cannot easily match or imitate.” These skills may be present in any of the value
creation activities of the firm – production, marketing, R&D, human resources,
logistics general management, etc. Such skills are expressed in product offerings that
other firms cannot imitate or find it difficult to imitate. Core competencies form the
basis for the firm‟s competitive advantage. They allow a firm to reduce the value
creation costs and/or create a value so that their products can be premiumly priced.
For instance, Proctor & Gamble has a core competency in developing and marketing
name brand consumer products.
Location Economies
Countries differ in different dimensions such as economic, political, legal, and cultural
and these differences can either lower or raise the costs of doing business in those
countries. According to the theory of international trade, certain countries have a
comparative advantage in the production of certain factors due to factor cost
differences. For instance, Japan excels in the production of automobiles and consumer
electronics and the US excels in the field of biotechnology, pharmaceuticals, software,
and financial services.
For a firm that tries to survive in a competitive global market ( a market where the
trade barriers and transportation costs are negligible), the firm can benefit by basing
its value creation activities at the location where political, cultural, and economic
conditions including relative factor costs are conducive to the performance of that
activity.
Firms pursuing such strategies realize location economies which can be defined as
“the economies that arise from performing a value creation activity in the optimal
location of that activity, wherever in the world that might be.” Locating a value
creation activity in the optimal location can have one of two effects. It can lower value
creation costs and help the firm to achieve a low-cost position and/or enable a firm to
differentiate its products from those of competitors.
Experience Effects
The experience curve refers “to systematic reductions in production costs that have
been observed to occur over the life of a product.” Some studies have observed that
production costs decline by some quantity each time the cumulative output doubles.
This was observed in the aircraft industry where each time the cumulative output of
airframes doubled, the unit costs declined by 80 percent of their previous level.
Learning Effects
Learning effects are savings in cost that come from learning by doing. For instance,
labor learns more efficiently by repeating how to carry out a task, such as assembling
airframes. The productivity of labor is enhanced over time as the laborers learn to
perform the tasks more efficiently. Similarly, in production facilities, management
learns to manage new operations efficiently over time. Thus the increasing efficiency
and management and labor productivity result in a decline in production costs, which
in turn enhances the profitability of the firm.
Learning effects become more significant when technologically complex tasks are
repeated, because there is more to be learned about the task. Thus learning effects are
noteworthy in an assembly process involving 1,000 complex steps than in just 100
41
International Business
simple steps. However, the learning effects are important only during the start-up
period and disappear after two to three years. Any decline in the experience curve
after such a point is attributed to economies of scale.
Economies of Scale
Economies of scale refer to “the reductions in unit costs achieved by producing a large
volume of a product.” Attaining economies of scale helps in lowering unit costs of a
firm and increases its profitability. There are a number of sources for economies of
scale. First, the ability to spread fixed costs over a large volume. Fixed costs are costs
incurred in a setting up a production facility, developing a new product, etc. Second, a
firm may not be able to attain efficient scale of production unless it serves the global
markets.
Finally, as global sales increase the firm‟s size, its bargaining power increases. This
may allow it to barrage down its cost of inputs, helping it boost its profitability.
Leveraging on Subsidiary Skills
Valuable skills are developed by a firm in its home market and are then transferred to
foreign operations. For instance, Wal-Mart developed its retailing skills in the US and
then transferred them to its foreign operations. However, for mature multinationals
that already have a network of subsidiary operations in foreign markets, valuable
skills can be developed in foreign subsidiaries as well.
Leveraging on the skills developed within subsidiaries and applied to the firm‟s other
operations under the firm‟s global network may create value. For instance,
McDonald‟s finds in its foreign franchisees a source of valuable ideas. Due to low
growth in France, McDonald‟s franchisees experimented with the menu as well as the
layout and theme of restaurants. Following the change, the increase in same stores
sales grew from 1 percent to 3.4 percent in 2002. Impressed by the idea, executives at
McDonald‟s adopted similar changes at other McDonald‟s restaurants where same
stores sales growth was sluggish, including in the US.
This phenomenon creates new challenges for managers of multinational enterprises.
First, they should have the humility to recognize that valuable skills that lead to
competencies can arise anywhere within the global network of the firm and not just at
the corporate center. Second, they should establish an incentive system that
encourages local employees to acquire new skills. Third, managers should have a
process to identify when valuable skills have been created in a subsidiary. Finally,
managers have to act as facilitators for transferring the valuable skills within the firm.
42
International Trade Theories and Application
International business often faces cost pressures in competitive global markets. For
responding to cost pressures, a firm has to lower its value creation costs. For instance,
a manufacturer may mass-produce a product at an optimal location in the world and
may outsource certain functions to low-cost suppliers in a bid to reduce costs.
Cost reduction pressures can be intense in industries where commodity-type products
are produced, where differentiation on non-price factors is difficult, and price is the
major competitive weapon. This is the case with products that serve universal needs.
Universal needs exist when tastes and preferences of consumers in different nations
are similar if not identical. Examples are conventional commodity products such as
petroleum, sugar, steel, etc. It is also the case with several industrial and consumer
products such as personal computers, liquid crystal display screens, handheld
calculators, and semiconductor chips.
Cost reduction pressures are also intense in industries where major competitors are
based in low-cost locations, where consumers are powerful and face low switching
costs, and where there is persistent excess capacity. The liberalization of the world
trade and investment environment by facilitating greater international competition has
resulted in an increase in cost pressures.
Local Responsiveness Pressures
Local responsiveness pressures arise from national differences in consumer tastes and
preferences, infrastructure, business practices, distribution channels, and from the
demand of the host-government. To respond to these pressures, a firm has to
differentiate its products and marketing strategy across countries to accommodate
these factors, all of which tend to raise the cost structure of the firm.
Differences in consumer tastes and preferences
Consumer tastes and preferences differ significantly across countries due to deeply
rooted historic or cultural reasons. In such cases, a multinational‟s marketing message
should be customized to appeal to the local consumers. This creates pressures for a
firm to delegate production and marketing functions and responsibilities to the
overseas subsidiaries of a firm. For instance, consumers in North America have a
strong demand for pickup trucks whereas the European consumers consider pickup
trucks as utility vehicles because of which these are purchased mostly by firms as
opposed to individuals.
Some commentators argue that consumer demands for localization are on the decline
worldwide. This has been highlighted by the fact that modern communication and
transport technologies have created conditions for convergence of consumer tastes and
preferences from different nations. This has resulted in the emergence of several
global markets with standardized consumer products. For instance, companies and
products such as Coca-Cola‟s soft drinks, McDonald‟s burgers, Nokia‟s cell phones,
and Sony‟s PlayStations have gained worldwide acceptance.
43
International Business
However, significant differences in consumer tastes and preferences still exist across
nations and cultures. International business managers do not yet have the luxury to
ignore such differences.
Differences in infrastructure and traditional practices
The local responsiveness pressures that arise from differences in infrastructure and
traditional practices create a need for product customization. This requires a firm to
delegate its manufacturing and production functions to its foreign subsidiaries. For
example, in North America, electrical systems are based on 110 volts whereas in
European countries, the standard is 240 volts. Thus, domestic electrical appliances are
required to be customized for this difference in infrastructure. The traditional practices
also differ among nations. For instance, people in Britain drive left-hand cars thus
creating a demand for left-hand cars whereas in France, people drive right-hand drive
cars and hence want right-hand drive cars.
Differences in distribution channels
The marketing strategies of a firm have to be responsive to differences in distribution
channels among countries, which may demand delegation of the marketing functions
to national subsidiaries. For instance, in the pharmaceutical industry, the Japanese and
the British systems are radically different from the US system. Japanese and British
doctors do not respond to a high-pressure sales force. Thus, pharmaceutical companies
have to adopt different marketing practices in Japan and Britain compared with what
they follow in the US.
Host-government demands
Political and economic demands imposed by governments of the host country may
require local responsiveness. For example, pharmaceutical companies are subject to
registration procedures, local clinical testing, and pricing restrictions, all of which
make it essential that the manufacturing and marketing of a drug should meet local
requirements. As governments and government agencies control a significant
proportion of the healthcare budget in most of the countries, they are in a powerful
position to demand a high level of local responsiveness.
In general, threats of protectionism, local content rules, and economic nationalism
dictate that international businesses manufacture locally. For example, Canada-based
manufacturer of railcars, jet boats, and aircraft, Bombardier, has 12 railcar factories in
Europe. Critics argue that the resulting duplication of manufacturing facilities leads to
high costs and helps explain why Bombardier makes lower profit margins on its
railcar operations than on its other line of businesses. In reply, Bombardier managers
argue that in Europe, informal rules with regard to local content favor people using
local workers. For selling railcars in Germany, they claim manufacturing should be
done in Germany. For addressing its cost structure in Europe, Bombardier has
centralized its engineering and purchasing functions but has no plans to centralize
manufacturing.
Choosing a Strategy
When competing internationally, firms typically select from one of the four strategies
– global standardization strategy, localization strategy, transnational strategy, and
international strategy. The appropriateness of each strategy varies given the extent of
cost reduction and local responsiveness pressures.
44
International Trade Theories and Application
When a firm simultaneously faces strong cost pressures and pressures for local
responsiveness, it is advisable for it to pursue a transnational strategy.
According to researchers Christopher Bartlett and Sumantra Ghoshal, in today‟s
global environment, competitive pressures are so intense that to survive, firms need to
do anything to respond to pressures for cost reductions and local responsiveness.
Firms should realize experience effects and location economies for leveraging on
products internationally, for transferring core competencies and skills within the
company, and for paying attention to local responsiveness pressures. Bartlett and
Ghoshal note that in a modern multinational enterprise, core competencies and skills
do not reside just in the home country but can also be developed in any of the firm‟s
operations worldwide. Thus, they maintain that product offerings and skills should not
45
International Business
just flow from home country to foreign subsidiary but also from foreign subsidiary to
home country and foreign subsidiary to foreign subsidiary. In other words,
transnational enterprises should focus on leveraging on the skills of the subsidiary.
In essence, firms pursuing a transnational strategy make attempts to simultaneously
achieve low costs from location economies, learning effects, and economies of scale;
differentiate their product offerings across geographic markets to account for local
differences; and foster a multidirectional flow of skills between different subsidiaries
of the firm. The transnational strategy is not easy to pursue as it places conflicting
demands on the company. Differentiating the product in different geographic markets
to suit local demands may increase costs, which is in contrast to the firm‟s goal of
reducing costs.
International Strategy
Some multinationals find themselves in a fortunate position where they confront low
cost pressures and low pressures for local responsiveness. Such firms pursue an
international strategy where products are produced in the domestic market and are
then sold in international markets with minimal localization. The distinguishing
feature of such firms is that they sell products that serve universal needs but do not
face significant competitors and thus, unlike firms pursuing a global standardization
strategy, are not confronted with pressures to reduce their cost structures. Xerox found
itself in such position in the 1960s after it invented and commercialized a photocopier.
The technology was protected by patents so Xerox had no competition and had a
monopoly. The product served universal needs and was highly valued in many
developed nations. Thus, Xerox sold the same basic product worldwide, charging a
relative high price. Since Xerox did not face any direct competitor, it did not have to
deal with strong pressures to minimize its cost structure.
Firms pursuing an international strategy have followed a similar developmental
pattern as they have expanded into foreign markets. They tend to centralize product
development functions such as R&D at home. However, they may also make attempts
to establish manufacturing and marketing functions in each major geographic region
or country where they conduct their business. The resulting duplication can increase
costs, but this is not a major issue if a firm does not face strong pressures to reduce
costs. Though the firms may undertake some local customization of marketing
strategy and product offering, this may be limited in scope. Eventually, in most of the
firms that pursue an international strategy, the head office retains tight control over
product and marketing strategy.
Summary
The strategy of a firm can be defined as the actions that managers take to attain
the goals of the firm.
The value created by a firm is measured by the difference between its cost of
production and the value perceived by the consumers in its products.
The operations or value creation activities can be categorized as primary activities
and support activities. For a firm to implement its strategies efficiently, it should
manage these strategies effectively.
46
International Trade Theories and Application
Primary activities deal with the design, creation, delivery, marketing, support, and
after-sales service of a product. The primary activities are divided into four
functions -- research and development, production, marketing and sales, and
customer service.
The support activities of the value chain provide inputs for the primary activities
to take place.
Global expansion helps firms increase their profitability and profit growth rate.
Firms operating internationally can expand the market for their local products by
selling them in international markets, by realizing location economies, by
realizing greater cost economies, and by leveraging on valuable skills developed
in foreign operations.
Firms competing in a global marketplace face two types of competitive pressures
– pressures for cost reduction and pressures for local responsiveness. These
pressures have an effect on their ability to realize location economies and
experience effects, for leveraging products and transferring competencies and
skills within the firm.
When competing internationally, firms typically select from one of the four
strategies – global standardization strategy, localization strategy, transnational
strategy, and international strategy.
47
International Business
Contd…
There was also the aspect of training the employees in creativity, giving them
access to expertise and small amounts of seed funding, the freedom to work on
their ideas, and a way to share information. In short, Whirlpool needed to set up a
formal framework to bring about a culture change and supporting infrastructure
like IT to support this change initiative. Another challenging aspect was that
everything had to be built up from scratch.
While the core groups were being trained, Nancy T Snyder (Snyder), vice president
of leadership and strategic competency development at Whirlpool, focused on
getting the rest of the company‟s global workforce involved in the initiative
through the Internet and innovation fairs. Strategos, a US-based management
consultancy firm, helped Whirlpool to put the necessary infrastructure in place and
to use Information Technology (IT) to facilitate the objective. Whirlpool re-
engineered management processes that slowed down innovation and used IT to
improve and accelerate the innovation chain from idea to final product. Instead of
going in for a few big projects, it encouraged many low-cost “stratlets” (also
known as small strategies).
Snyder put a leadership team in place. The team included a global director of KM,
three regional vice presidents of innovation, and regional innovation boards (I-
Boards) to set goals, allocate resources, and review ideas for funding. Executive I-
boards in each region strove to keep the company‟s innovation pipeline full. They
were responsible for building innovation capability, identifying the next generation
of innovation consultants (I-consultants), coordinating innovation-related
programs, and keeping innovation at the top of Whirlpool‟s corporate agenda. I-
consultants were full-time staff that helped divisions adopt and implement
innovation techniques. They also facilitated individuals, groups, or business units
to come up with new ideas and put these ideas into action.
Later, each major business unit also established an I-Board. Twenty-five people
from each region were trained to serve as in-house I-consultants and I-mentors. I-
mentors were people specially trained to facilitate innovation projects and to help
people with their ideas. I-consultants hired their own team of I-mentors.
A knowledge management system called the Innovation E-Space was started which
provided a course in innovation. It started with the “fuzzy front end” of innovation
where random insights were systematically generated and shared to spark ideas. If
an employee had a concept, he/she could go to the knowledge management system
and post the idea on a bulletin board. The home page linked employees to all the
tools and resources they needed, from insight libraries and innovation templates to
I-mentors. According to Snyder, this provided an informal social system enabled
by technology that worked across the hierarchy level.
All the projects that were in the pipeline were listed on the I-Pipe on the website.
The I-Pipe gave a dashboard view of the innovation pipeline adapted from
Strategos. It tracked ideas from concept to scale-up and provided project details
as well as the big picture, enabling management to focus on areas that needed
Contd…
48
International Trade Theories and Application
Contd…
attention. According to Gary Hamel (a visiting professor of Strategic and
International Management at the London Business School, chairman of Strategos,
and director of the Woodside Institute), the I-Pipe helped innovators to create
strategy and top managers to edit it so as to fit the company‟s requirements. He
also acknowledged that using IT to support innovation sessions was challenging.
The Innovation E-Space was cost-effective and did not require a big investment.
On the front end, Whirlpool used a Lotus Notes-based intranet and added new
capabilities using collaboration tools like QuickPlace and Sametime from Lotus.
For the I-Pipe, the company built a platform on its SAP infrastructure using SAP‟s
xApps for project resource management. Organizing tactical training was
complemented by a significant amount of e-learning technology. Some courses
were put online using LearningSpace of IBM Mindspan Solutions. Using such self-
paced courses freed up Whirlpool resources for assignment tp other products and
significantly reduced costs.
Whirlpool also hosted innovation fairs to felicitate inventors and encourage the
flow of ideas. At these fairs, proud employees demonstrated their new designs and
discussed their proposals.
Instead of waiting for employees to come out with ideas, the I-mentors helped
employees reflect on customer needs, industry trends, and their own experience to
come up with insights on formal innovation sessions.
The insight gained from the cross-fertilization of ideas between people from
various disciplines such as marketing and engineering also helped. For the
employees, the thrill of achievement was its own reward, and innovators received
no bonuses or perks for their ideas. According to Tammy Patrick, global director of
knowledge management, the innovators got charged up by the opportunity for
exposure and the fact that someone was listening to their idea.
Though initially Whirlpool got very few ideas out of the process, the rank-and-file
employees were happy that their participation was being sought on important
matters. However, the immediate superiors of the people who were engaged in this
process and senior managers were not happy as they thought that this initiative was
a distraction from their regular work. Moreover, in the absence of concrete goals
and this initiative not being tied to their performance in any way, the middle level
management had little incentive to support the initiative. The hardest part for
Whirlpool was to change the way leaders saw their roles as this required a huge
shift in thinking. According to Snyder, only leaders could change an environment
and allow an innovator the freedom to pursue different things.
Compiled from various sources.
49
International Business
Contd…
MTVI built its base outside the US by not only launching the MTV channel but
also by acquiring local music channels. It followed the practice of tying up with a
local company for the initial launch and acquiring the channel from the company
after some time.
MTVI entered India in the early 1990s in a tie-up with STAR TV but exited the
country in 1994 after differences erupted between the partners in the tie-up. By the
time it re-entered India in 1995, STAR TV had launched Channel [V], a 24-hour
music channel, which was available in many parts of South-Asia. Channel [V]
became very popular, especially in India, because it aired programs in Hindi.
On its re-entry, MTV Asia tied up with India‟s national television service
Doordarshan (DD). Initially, MTV Asia was aired for two hours every day on DD
Metro, one of the channels of DD, before becoming a 24-hour channel. MTV India
was later launched as a separate channel in 1996.
Taking its cue from Channel [V], MTV India began broadcasting Hindi film songs.
Officials at MTV Asia were confident that the channel would become successful in
India.
By the late 1990s, MTV India had launched a variety of programs with India-
specific content. Most of the programs were film based and were targeted at the
youth. The VJs, many of whom were picked through VJ hunts conducted across the
country, became very popular. Some „Indianized‟ programs like MTV Bakra (a
reality prank show), „Fully Faltoo‟ (a spoof show on Hindi films and songs), and
MTV Roadies (based on the US reality show „Road Rules‟) also gained popularity.
MTV India also co-sponsored many music events and began merchandising
products like clothes and perfumes under the MTV banner in 2001.
Though the programming format of MTV India was more or less similar to that of
MTV in America, the content was localized to suit the preferences of Indian
viewers. By 2004, MTV India had become the leading Indian music channel in
terms of advertising revenues, with a 35% market share. MTV Asia also launched
VH1 and Nickelodeon in a localized format in India.
Compiled from various sources.
50
International Trade Theories and Application
Appendix-3
Organizational Architecture
Organizational architecture refers to “the totality of a firm‟s organization, including
formal organizational structure, control systems and incentives, organizational culture,
processes, and people.”
Organizational structure includes three things: first, the formal organization division
into subunits such as product divisions, national operations, and functions. The second
aspect of the organizational structure is the location of decision making roles and
responsibilities within that structure. Its third feature is the establishment and
integration of a mechanism to coordinate different activities of the subunits in the
organization, including cross-functional teams and/or pan-regional committees.
Control systems are metrics that measure the performance of the subunits and make
judgments about how well the managers are running those subunits. For instance,
Unilever measured the performance of its national operating subsidiaries by setting
profitability as the metric. Incentives are devices used for rewarding appropriate
managerial behavior. For instance, a manager of a unit may receive a bonus if the
performance targets are achieved.
Processes are the manner in which work is carried out and how decisions are made in
an organization. Examples of processes are strategy formulation and resource
allocation.
Organizational culture refers to “the norms and value systems that are shared among
the employees of an organization.” Organizations are composed of societies of
individuals who come together to perform tasks collectively. They have their
distinctive cultural and sub-cultural patterns. Finally, „people‟ refers not just to the
51
International Business
employees in an organization but also the strategy for recruiting, compensating, and
retaining those employees and the kind of people they are in terms of values, skills,
and orientation.
The various components of organizational architecture are not independent of each
other. Each component is shaped by another component. To maximize its profitability,
a firm should pay attention to achieving internal consistency between the various
components of its architecture. Some inconsistencies do exist in the design of the
organization architecture. Though perfection cannot be achieved in the design, it can
be minimized through intelligent design.
Consistency between architecture and strategy is required because architecture must
fit strategy. It is relatively easy for senior managers to announce a change in strategy
but is harder to put into action. A change in strategy also requires a change in the
architecture, and changing architecture is much more difficult than changing strategy.
Even with internal consistency and a fit between strategy and architecture, high
performance cannot be guaranteed. The firm has to ensure that the fusion of strategy
and architecture is consistent with the demands of the market in which the firm
competes.
Organizational Structure
Organizational structure can be understood in terms of three dimensions – (1) vertical
differentiation, which refers to the location of decision making responsibilities within
a structure; (2) horizontal differentiation, which refers to the formal organizational
division into subunits; and (3) establishing integrating mechanisms, which are
mechanisms to coordinate the subunits.
Vertical Differentiation
There are four main arguments for centralization. First, it facilitates coordination.
Second, it ensures that decisions are consistent with the organizational objectives.
Third, it gives top-level managers the means to bring about the needed organizational
changes by concentrating power and authority in one individual or a management
team. Fourth, it avoids duplication of activities that occurs when similar activities are
carried on by various subunits within the organization.
Arguments for decentralization
There are five main arguments for decentralization. First, top management becomes
overburdened when the decision making authority is centralized and this can result in
poor decisions being taken. Decentralization gives time to top management to focus
on critical issues by delegating routine tasks to lower-level managers. Second,
motivational research favors decentralization. Third, decentralization allows for
flexibility. Fourth, decentralization results in better decision making. Fifth,
decentralization can increase control.
52
International Trade Theories and Application
It usually makes sense for firms to centralize some decisions and decentralize others,
depending on the strategy of the firm and the type of decision. Decisions related to the
firm‟s overall strategy, financial objectives, major financial expenditure, and legal
issues are typically centralized at the headquarters of the firm. However, operating
decisions such as those related to marketing, production, R&D, and human resource
management may or may not be centralized depending on the strategy of the firm.
Firms pursuing a global standardization strategy should decide how to disperse the
value creation activities around the globe so that the experience curve and location
economies are realized. The head office must make decisions about where to locate
production, R&D, marketing, etc. In addition, the globally dispersed value creation
activities facilitating a global strategy should also be coordinated. All of this creates
pressure to centralize some of the operating decisions.
In contrast, firms pursuing a localization strategy face strong pressures to decentralize
operating decisions to foreign subsidiaries. Firms that pursue an international strategy
maintain centralized control over their core competency and decentralize other
decisions to foreign subsidiaries.
The situation in firms pursuing a transnational strategy is more complex. The
realization of location and experience curve economies requires some degree of
centralized control over global production centers. However, the need for local
responsiveness dictates decentralization of many operating decisions to foreign
subsidiaries. Thus in such firms, some decisions are centralized and some are
decentralized. In addition, global learning based on multidirectional transfer of skills
between subsidiaries and between subsidiaries and the corporate center is a key
feature of a firm pursuing a transnational strategy. The concept of global learning is
predicated on the belief that foreign subsidiaries within a multinational firm have
significant freedom to develop their own competencies and skills. These can then be
leveraged on to benefit other parts of the organization. To avail of this freedom, a
degree of centralization is required. For this reason, firms pursuing a transnational
strategy require a high degree of decentralization.
Horizontal Differentiation
Horizontal differentiation relates to how the firm decides to divide itself into subunits.
The decision is made on the basis of function, type of business, or geographical area.
One of these predominates in many firms but in some firms, more complex solutions
are adopted.
Structure of domestic firms
Most firms begin with no formal structure and are run by an entrepreneur or a small
group of individuals. As they grow, the management demands become too great for an
individual or a small team of individuals to handle. At this point, the organization is
split into functions reflecting the value creation activities of the firm. These functions
are coordinated and controlled by the top management. Decision making in this
function is centralized.
Horizontal differentiation may be needed if the firm significantly diversifies its
product offering, which takes it into different business areas. In such
circumstances, the functional structure becomes too clumsy. Problems of
53
International Business
coordination and control arise when different business areas are managed within
the functional structure framework. It becomes difficult to ide ntify the
profitability of each distinct business area. Supervising value creation activities of
several business areas is also difficult.
To solve the problems of coordination and control, firms move to the product
divisional structure from the functional structure.
The international division
Firms that expand abroad initially often group their international activities into an
international division. This is in case of firms organized on the basis of functions and
on the basis of product divisions. Despite the firm‟s domestic structure, its
international division tends to be organized on geography.
Though the international division is widely used, it can give rise to some problems. Its
dual structure contains the potential for conflict and coordination problems between
domestic and foreign operations. One problem with the international division structure
is that the heads of foreign subsidiaries are not given as much as voice as the heads of
domestic functions or divisions. Rather, the head of the international division is
assumed to have the ability to represent the interests of all countries to headquarters.
This effectively demotes managers of each country to the second tier of the firm‟s
hierarchy, which is inconsistent with a strategy of trying to expand internationally and
build a multinational organization.
The lack of coordination between domestic operations and foreign operations can
inhibit worldwide introduction of new products, the transfer of core competencies
between domestic and foreign operations, and the consolidation of global production
at key locations for realizing experience curve and location economies.
Due to these problems, many firms that expand internationally abandon this structure
and adopt one of the worldwide structures.
Worldwide area structure
54
International Trade Theories and Application
Some firms have made attempts to cope with the conflicting demands of a
transnational strategy by using a matrix structure. In a global matrix structure,
horizontal differentiation proceeds along two dimensions -- product division and
geographic area. The responsibility of operating decisions related to a particular
product should be shared by the product division and various areas of the firm. It is
believed that the dual decision making responsibility enables a firm to achieve its
objectives. In a classic matrix structure, the idea of dual responsibility can be
reinforced by giving product divisions and geographical areas equal status within the
organization. Thus individual managers belong to two hierarchies – a divisional
hierarchy and an area hierarchy and have two bosses – a divisional boss and an area
boss.
In practice, the global matrix structure is clumsy and bureaucratic. It may require so
many meetings that work does not get done. The area and product division may slow
down the decision making process and may produce an inflexible organization that
will be unable to respond to market shifts or to innovate. The dual hierarchy may also
lead to conflicts and power struggles between the area and product divisions. The
most difficult thing in this structure would be ascertaining accountability as one side
may always blame the other. Thus firms pursuing a transnational strategy build
flexible matrix structures based on enterprise-wide management knowledge networks,
and a shared vision and culture.
Integrating Mechanisms
A firm has to identify some means for coordinating the subunits. One way to achieve
coordination is through centralization. However, centralization will not be effective if
the coordination task is complex. Higher-level managers who are responsible for
achieving coordination can get overwhelmed by the volume of work required to
55
International Business
coordinate the activities of several subunits, especially when the subunits are large,
diverse, and/or geographically dispersed. In this case, firms look toward integrating
both formal and informal mechanisms to achieve coordination.
Strategy and coordination in international business
The need for coordination between subunits varies with the firm‟s strategy. The need
for coordination is lowest in firms pursuing a localization strategy, is higher in
international companies, still higher in global companies, and highest of all in
transnational companies. Firms pursuing a localization strategy are chiefly concerned
with local responsiveness and are likely to adopt a worldwide area structure in which
each has considerable autonomy and its own set of value creation functions. As each
area is set up as a stand-alone entity, the need for coordination between areas is
minimized.
Firms pursuing an international strategy have a higher need for coordination and they
try to profit from transferring core competencies and skills between units at home and
abroad. Coordination is essential to support the transfer of skills and product offerings
between units. The need for coordination is also high in firms pursuing a global
standardization strategy. Achieving experience and location economies involves
dispersing value creation activities to different locations around the globe. The
resulting global web of activities needs to be coordinated for ensuring the smooth flow
of inputs into the value chain, the smooth flow of semi-finished goods through the
value chain, and the smooth flow of finished goods to markets worldwide.
The need for coordination is greatest in transnational firms, which simultaneously
pursue experience curve and location economies, local responsiveness, and
multidirectional transfer of skills and core competencies among their all sub-units. A
transnational strategy also requires coordination between foreign subsidiaries and the
globally dispersed value creation activities of the firm to ensure that any marketing
strategy and product offering is customized to local conditions.
Impediments to coordination
Managers of various subunits have different orientations, partially because they have
different tasks. For instance, marketing managers are concerned with issues related to
marketing such as pricing, promotion, distribution, and market share whereas
production managers are concerned with issues related to production such as capacity
utilization, cost control, and quality control. These differences may inhibit
communication between managers.
Differences in the orientation of sub-units also arise from differing goals, which may
often lead to conflict.
Such impediments to coordination are not unusual in any firm, but can get
problematic in the multinational enterprise with abundant subunits at home and
abroad. Differences in the orientation of subunits are often reinforced in
multinationals by differences in time zones and nationality and distances between
managers of the subunits.
Formal integrating mechanisms
The formal mechanisms used for integrating subunits differ in complexity from simple
direct contact and liaison roles, to teams, to a matrix structure. Generally, the greater
the need for coordination, the more complex the formal integrating mechanisms need
to be.
56
International Trade Theories and Application
The simplest integrating mechanism is the direct contact between subunit managers.
In this mechanism, the managers of various subunits contact each other whenever they
have a common concern. However, direct contact may not be effective if the managers
belong to differing orientations.
Liaison roles are a bit more complex. When the volume of contacts between subunits
increases, coordination can be improved by giving a person in each subunit the
responsibility for coordinating with another subunit on a regular basis. Through these
roles, the people involved establish a permanent relationship. This helps in attenuating
the impediments to coordination.
When the need for coordination is greater, firms tend to use temporary or permanent
teams consisting of individuals from the subunits that need to achieve coordination.
These teams typically coordinate product development and introduction but they are
also useful when any aspect of strategy or operations requires coordination of two or
more subunits. Product development and introduction teams include personnel from
R&D, marketing, and production. The resulting coordination aids product
development tailored to the needs of the consumers that can be produced at reasonable
cost.
When the need for integration is very high, firms may institute a matrix structure in
which all roles are viewed as integrating roles. The matrix structure is designed to
facilitate maximum integration among subunits. The most common matrix in
multinational firms is based on worldwide product divisions and geographical areas.
This results in the achievement of a high-level of integration between the product
divisions and the areas, that is, in theory, the firm pays close attention to the pursuit of
location and experience curve economies as well as local responsiveness.
In some multinationals, matrix structures are complex as they structure the firm into
geographical areas, worldwide product divisions, and functions, all of which directly
report to headquarters. Such a matrix structure, in addition to facilitating local
responsiveness and experience curve and location economies, fosters the transfer of
core competencies within the organization.
Matrix structures tend to be bureaucratic, inflexible, and characterized by conflict. For
such a structure to work it needs to be a little flexible and should be supported by
formal integrating mechanisms.
Informal integrating mechanisms
To avoid problems associated with formal integrating mechanisms, firms with a high
need for integration have experimented with an informal integrating mechanism –
knowledge networks that are supported by an organizational culture that values
teamwork and cross-unit cooperation. A knowledge network is “a network for
transmitting information within an organization that is based not on formal
organization structure, but on informal contacts between managers within an
enterprise and on distributed information systems.” The strength of a knowledge
network is that it can be used as a non-bureaucratic channel for flow of knowledge
within a multinational enterprise. Managers at different locations need to be linked
indirectly for a network to exist.
Networks can be established using two techniques – information systems and
management development policies.
57
International Business
For providing the foundation for informal knowledge networks, firms use their
distributed computer and telecommunications information systems. Electronic mail,
video conferencing, and web-based search engines are spread out over the globe to get
to know each other, to publicize and share best practices, and identify contacts that
might help in solving a particular problem. For instance, Wal-Mart used an intranet
system for communicating ideas related to its merchandising strategy between stores
located in different locations.
Some firms develop informal networks by using management development programs.
Managers are regularly rotated through various subunits to build their informal
networks and management education managers bring managers of subunits together at
a single location so that they can get acquainted with each other.
Knowledge networks themselves cannot achieve coordination if the managers of
subunits persist in pursuing sub-goals that are at variance with the goals of the firm.
Thus managers should share a commitment to the same goals for a knowledge
network to function properly. To eliminate this flaw, firms should have a strong
organizational culture that promotes cooperation and teamwork.
Personal controls are controlled by personal contact with subordinates. This is widely
used in small firms where subordinates‟ actions are under direct supervision. IThis
approach also structures the relationships between managers at different levels in the
multinational enterprise. For instance, Jack Welch, former CEO of General Electric,
had one-to-one meetings with the heads of all GE‟s major businesses. He used these
meetings to probe the strategy, structure, and financial performance of their
operations. In doing so, he exercised control over these managers as well as on their
strategies.
Bureaucratic controls
Bureaucratic control is control through rules and procedures that directs the actions of
subunits. The most important bureaucratic controls in subunits are capital spending
rules and budgets. Budgets are “essentially a set of rules for allocating a firm‟s
financial resources.” The budget specifies how much the subunit may spend. Capital
spending rules require the management at the headquarters to approve any capital
expenditure by a subunit that surpasses a certain amount.
58
International Trade Theories and Application
Output controls
Output controls involve setting goals for subunits for achieving and expressing those
goals in terms of relatively objective performance metrics such as productivity,
market share, profitability, growth, and quality. The performance of managers of the
subunits is judged on their ability to achieve these goals. If goals are met or exceeded,
the managers of the subunits are rewarded. If the goals are not met, top management
usually intervenes to find out why and takes appropriate corrective action. Thus
control is achieved by comparing actual performance against targets and taking
corrective action when needed.
Cultural controls
Cultural controls exist when employees buy into the value systems and norms of the
firm. Employees tend to control their own behaviors, which reduces the need for
direct supervision. In a firm with a strong culture, self-control reduces the need for
other control systems.
Incentive Systems
59
International Business
Processes
Processes can be defined as “the manner in which decisions are made and work is
performed within the organization.” Processes are found at different levels of the
organization. There are processes for formulating strategy, allocating resources,
evaluating new product ideas, handing customer inquiries and complaints, improving
product quality, evaluating employee performance, etc. Often, valuable skills or core
competencies of a firm are embedded in its processes. Efficient and effective
processes lower the costs of value creation and add additional value to a product. For
instance, General Electric‟s process of Six Sigma is used for quality improvement.
Many processes cut across functions or divisions, and require cooperation between
individuals in different subunits. For instance, product development processes require
employees from R&D, manufacturing, and marketing to work in a cooperative manner
to ensure that new products are developed with market needs in mind and are
designed in such a way that they are manufactured at a low cost.
Many processes in a multinational enterprise cut across not only organizational
boundaries but also across national boundaries. For instance, designing a new product
may require R&D personnel from California, production people located in Taiwan,
and marketing personnel located in Asia, America, and Europe.
It is important for a multinational enterprise to recognize that valuable new processes
that might lead to a competitive advantage can be developed anywhere within the
firm‟s global network of operations. It is also important to leverage on valuable
processes. This requires both formal and informal integrating mechanisms such as
knowledge networks.
Organizational Culture
Culture refers to “a system of values and norms that are shared among people.”
Values are “abstract ideas about what a group believes to be good, right, and
desirable.” Norms mean “the social rules and guidelines that prescribe the appropriate
behavior in particular situations.” Values and norms are the behavioral patterns in an
organization that new employees are encouraged to follow.
Creating and Maintaining an Organizational Culture
The culture of an organization comes from several sources. First, the founders or
leaders have a profound impact on the organizational culture often imprinting their
own values on the culture. An example is Lincoln Electric, a US-based wielding
equipment manufacturer, where the values of James Lincoln, the company founder,
became the core values.
Another important influence on organizational culture is the broader social culture of
the nation where the organization is founded. For instance, many American firms
reflect the values of the American culture. Thus organizational culture is influenced
by national culture.
60
International Trade Theories and Application
A culture that leads to high performance in the home nation may not be imposed on its
foreign operations. An organization has to establish values in the new enterprise rather
than imposing the values of an established enterprise. Another solution is for the firm
to devote a lot of time and attention to transmitting its organizational culture to its
foreign operations. A third solution is to recognize that it is essential to change some
aspects of the firm so that it fits in better with the culture of the host nation.
The need for a common organizational culture that is the same across a
multinational‟s global network of subsidiaries varies probably with a firm‟s strategy.
Shared values and norms can facilitate coordination and cooperation between
individuals belonging to different subunits. A strong common culture may lead to goal
congruence and can attenuate problems arising from performance ambiguities,
interdependence, and conflict among managers of different subsidiaries.
Localization Strategy
Firms pursuing a transnational strategy focus on local responsiveness and operate with
worldwide area structures where the operating decisions are decentralized to
subsidiaries that are functionally self-contained. The need for coordination between
subunits is low. In such firms there is no need for high integrating mechanisms. The
lack of interdependence implies that the level of performance ambiguity in such firms
is low, as are the cost of controls. Thus headquarters can manage foreign operations
by relying on bureaucratic and output controls and a policy of management by
exception. Incentives can be linked to performance metrics at the level of country
subsidiaries. As the need for coordination and integration is low, the need for common
organizational culture and processes is also quite low.
61
International Business
International Strategy
62
International Trade Theories and Application
Organizational Change
Within most organizations are strong inertia forces. These forces come from many
sources. The distribution of influence and power in an organization is one source of
inertia. The power and influence enjoyed by individual managers is part of their role
in the organizational hierarchy, as defined by the structural position. Most of the
substantive changes in the organization require a change in structure and a change in
power and influence within the organization. As a result of organizational changes,
some individuals see an increase in their power and influence and vice versa.
The existing culture is another source of inertia expressed in norms and value systems.
Value systems reflect beliefs that are deeply held and are hard to change.
Organizational inertia also arises from the preconceptions of senior managers about
the appropriate business model or paradigm to be used. When a given paradigm has
worked well in the past, mangers may have trouble accepting that it may no longer be
appropriate.
Institutional constraints may also be a source of inertia. Individual nation‟s regulations
including local rules and policies pertaining to layoffs may make it difficult for
multinational firms to alter their global value chain.
Implementing Organizational Change
Though all organizations suffer from inertia, the complexity and global spread of
multinationals might make it difficult for them to change their strategy and structure
to match new organizational realities. Yet globalization in many industries has made it
critical that multinationals do that. Declining trade barriers to cross-border trade and
investment have led to changes in the nature of the competitive environment.
Increasing cost pressures have required multinationals to respond by streamlining
their operations to realize the economic benefits associated with experience curve and
location economies and with transfer of skills and competencies within the
organization. At the same time, local responsiveness remains an important source of
differentiation. To survive in this competitive environment, multinationals change
their strategy as well as their architecture. The basic principles for successful
organizational change can be summarized as follows: (1) unfreeze the organization,
(2) move the organization though a new state, and (3) refreeze the organization into
the new state.
63
International Business
Due to forces of inertia, incremental change often means no change. Those whose
power is threatened by change can also resist change easily. Thus the theory of change
maintains that effective change requires “unfreezing” the established culture of an
organization and changing the distribution of influence and power. Shock therapy to
unfreeze the organization might include closure of a plant deemed uneconomic or the
announcement of some striking changes in organizational structure. It is also
important to realize that change does not take place unless senior managers are
committed to it. Senior managers must articulate the need for change so that
employees understand why it is being pursued and the benefits that can be reaped
from successful change.
Moving to the New Site
Refreezing the organization takes a longer time. It may require a new culture to be
established while the old one is being dismantled. Thus refreezing requires that
employees be socialized into the new way of doing things. For achieving this,
companies use management education programs. However, these programs are not
enough; hiring policies should also be changed to reflect the new realities where such
individuals are hired whose own values are consistent with the new culture the firm is
trying to build. Similarly, control and incentive systems should also be consistent with
the new realities of the organization. Else change will not take place.
Summary
Organizational architecture refers to the totality of a firm‟s organization,
including formal organizational structure, control systems and incentives,
organizational culture, processes, and people.
Organizational structure can be understood in terms of three dimensions – (1)
vertical differentiation, which refers to the location of decision making
responsibilities within a structure; (2) horizontal differentiation, which refers to
the formal organizational division into subunits; and (3) establishing integrating
mechanisms, which are mechanisms to coordinate the subunits.
Multinational firms use four different types of control – personal controls,
bureaucratic controls, output controls, and cultural controls. Incentives are
devices used to reward appropriate employee behavior.
Processes are found at different levels of the organization. There are processes for
formulating strategy, allocating resources, evaluating new product ideas, handling
customer inquiries and complaints, improving product quality, evaluating
employee performance, etc.
64
International Trade Theories and Application
The culture of an organization comes from several sources. First, the founders or
leaders have a profound impact on the organizational culture, often imprinting
their own values on the culture. Another important influence on organizational
culture is the broader social culture of the nation where the organization is
founded. A third influence on organizational culture is the history of the
enterprise, which shapes the values of the organization.
Firms pursuing a transnational strategy focus on local responsiveness and operate
with worldwide area structures where the operating decisions are decentralized to
subsidiaries that are functionally self-contained.
Firms pursuing an international strategy attempt to create value by transferring
core competencies from home to foreign subsidiaries. If they are diverse, most
firms operate with a worldwide product division structure.
Firms pursuing a global standardization strategy focus on the realization of
experience curve and location economies. If they are diversified, these firms
operate with a worldwide product division structure.
Firms pursuing a transnational strategy focus on achieving location and
experience curve economies, local responsiveness, and global learning. These
firms may operate with a matrix structure in which both geographic areas and
product divisions have significant influence.
Within most organizations are strong inertia forces. The existing culture is
another source of inertia expressed in norms and value systems. Organizational
inertia also arises from the preconceptions of senior managers about the
appropriate business model or paradigm to be used. Institutional constraints may
also be a source of inertia.
The basic principles for successful organizational change can be summarized as
follows: (1) unfreeze the organization, (2) move the organization though a new
state, and (3) refreeze the organization into the new state.
Contd…
According to Wal-Mart, the international division had helped the company identify
best practices and transfer them between countries.
Compiled from various sources.
66
Concept Note - 3
Another crucial factor is the value an international business can create in a foreign
market. This depends on the suitability of the product offering to that market and the
nature of the local competition. If the international business offers a product that is not
widely available in that market and one that satisfies an unmet need, the value of that
product will be greater than if it offers the same type of product that local competitors
and other foreign entrants are already offering. Greater value translates into an ability
to charge higher prices and to build volume of sales more rapidly.
By taking into consideration such factors, a firm can rank countries in terms of their
attractiveness and profit potential in the long run.
2.2 Timing of Entry
Having identified attractive markets, it is important for a firm to consider the timing of
entry. An entry is said to be early when the firm enters an international market before
other foreign firms and the entry is said to be late when the firm enters after other
foreign firms have established themselves. The advantages associated with entering a
market early are called first-mover advantages. One first-mover advantage is the
ability to preempt rivals and capture demand by establishing a strong brand name.
Another advantage is the ability to build sales volume in the country and ride down
the experience curve ahead of rivals, giving a cost advantage to the early entrant
before the late entrants. The cost advantage may enable the early entrant to cut prices
to below that of the late entrants, thus driving them out of the market. A third
advantage is the ability of early entrants to create switching costs that bind customers
to their products and services. Such switching costs make it difficult for late entrants
to win business.
Some disadvantages are also associated with entering a foreign market before other
international businesses enter. These are referred to as first-mover disadvantages.
These disadvantages may give rise to pioneering costs that an early entrant has to bear
but a late entrant can avoid. Pioneering costs include the costs of business failure if
the firm makes some major mistakes due to its ignorance of the foreign environment.
The late entrant may also benefit from observing and learning from the mistakes made
by early entrants. An early entrant may also face a severe disadvantage relative to the
late entrant, if regulations diminish the value of investments made by the early entrant.
This is a serious risk faced by early entrants in developing nations where the rules
governing business practices are still evolving.
2.3 Scale of Entry and Strategic Commitments
Entering a market on a large scale involves commitment of significant resources. It
also implies rapid entry. However, some firms enter on a small scale as they do not
have the resources essential to enter on a large scale.
The consequences of entering on a significant scale – entering rapidly – are associated
with the value of ensuing strategic commitments. A strategic commitment has a long-
term impact which is difficult to reverse. A major strategic commitment is when a
firm decides to enter a foreign market on a significant scale. Strategic commitments
such as rapid large scale entry into a market can have an important influence on the
nature of competition in the market.
Strategic commitments that are significant are either good or bad. Rather, they tend to
alter the competitive playing field and unleash several changes, some of which will be
desirable and some which will not. A firm has to consider the implications of entering
68
Entry Strategy and Strategic Alliances
a large-scale market and act accordingly. For instance, a firm has to identify how
actual and potential competitors react to the large-scale entry into a market. Also a
large-scale entrant is more likely to be able to capture first mover advantages
associated with scale economies, and demand preemption and switching costs.
The value of the commitments that flow from rapid large-scale entry into a foreign
market must be balanced against the risks that will result and the lack of flexibility
associated with strategic commitments. But strategic inflexibility also has value.
The benefits of a small-scale entry include balance against the value and risks of the
commitments associated with large-scale entry. A small-scale entry allows a firm to
learn about the foreign market while limiting its exposure to that market. It also
reduces the risks associated with large-scale entry. But the lack of commitment
associated with a small-scale entry may make it difficult for the firm to build market
share and capture first-mover advantages.
3. Entry Modes
Once a firm decides to enter a foreign market, it has to consider the mode of entry.
Firms can use various entry modes such as exporting, turnkey project, licensing,
franchising, establishing joint ventures with a host firm, or setting up a wholly-owned
subsidiary in the host country. Each mode of entry has its advantages and
disadvantages.
3.1 Exporting
Many manufacturing firms commence their global expansion as exporters and later
switch to another mode for serving a foreign market.
Advantages
Exporting has two advantages. First, it avoids the substantial costs associated with
establishing manufacturing operations in the host country. Second, it helps firms
achieve location and experience curve economies. The firm can realize substantial
scale economies from its global sales volume by manufacturing the product in a
centralized location and exporting it to other national markets.
Disadvantages
Exporting has its drawbacks as well. First, exporting from the home base of the firm
may not be appropriate if lower-cost manufacturing locations are found abroad.
Second, the high costs associated with transportation make exporting uneconomical,
particularly for bulk products. Thus, firms should manufacture bulk products
regionally as it enables them to realize some economies from large-scale production
and also limits their transportation costs.
Another drawback is that tariff barriers make exporting uneconomical. A fourth
drawback is that when a firm delegates its sales, marketing, and service to another
company as its local agent, often the local agent carries products of competing firms
and so has divided loyalties. In such cases, a firm can carry off its marketing job itself
better than any local agent. This problem can be solved by setting up wholly-owned
subsidiaries in foreign nations to handle local marketing, sales, and service. This
enables the firm to exercise tight control over marketing and sales in the country while
reaping the cost advantages of manufacturing the product in a single location.
69
International Business
Three drawbacks are associated with a turnkey strategy. First, the firm entering a
turnkey deal will have no long-term interest in the foreign market. This can be a
disadvantage if that country proves to be a major market for the output of the process
that has been exported. Second, the foreign enterprise with which a firm enters into a
turnkey project may turn out to be a competitor. Third, if the process technology of a
firm is the source of competitive advantage, then selling this technology through a
turnkey project is like selling competitive advantage to actual or potential competitors.
3.3 Licensing
A licensing agreement is an arrangement wherein a licenser grants the rights to
intangible property to a licensee or another entity for some specific period, and in
return, the licensor receives a royalty fee from the licensee. Intangible property
includes patent, trademarks, copyrights, formulas, inventions, designs, and processes.
Advantages
A primary advantage of licensing is that the firm does not have to incur the
development costs and risks associated with opening a foreign market. Licensing is
attractive to firms lacking capital to develop overseas operations. It is also attractive to
firms unwilling to commit substantial financial resources to an unfamiliar or
politically volatile foreign market. Licensing is often used when a firm wishes to enter
a foreign market but is unable to do so due to barriers to investment. Licensing is
frequently used when a firm has some intangible property that may have some
business applications, but it does not want to develop those applications itself.
Disadvantages
Licensing involves each licensee setting up their own production facilities and
operations. It does not give a firm the tight control over marketing, manufacturing,
and strategy that is required to realize the experience curve and location economies.
When these experiences and economies are important, licensing may not be the best
way for overseas expansion.
70
Entry Strategy and Strategic Alliances
Second, licensing limits a firm from using the profit earned in one country to support
a different licensee in another country.
A third problem with licensing is the risk associated with licensing technological
know-how to foreign companies.
The risks associated with licensing can be reduced by entering into a cross-licensing
agreement with a foreign firm. Under this agreement, a firm might license some
invaluable tangible property to a foreign partner, but the firm can request the foreign
partner to license some of its valuable know-how to it, in addition to a royalty
payment.
Another way of reducing risk is to link an agreement to license know-how with the
formation of a joint venture in which the licensor and the licensee have equal stakes.
3.4 Franchising
Franchising is a specialized form of licensing in which the franchiser sells the
intangible property to the franchisee and also insists that the franchisee agrees to abide
by the strict rules of conducting a business. The franchiser also assists the franchisee
to run the business on an ongoing basis. Franchising receives a royalty payment like
licensing. Franchising is employed by service firms. For instance, McDonald‟s uses a
franchising strategy where the franchisees follow strict rules of operating a restaurant,
and the control is extended to menu, cooking methods, design, location, and staffing
policies.
Advantages
The firm is relieved of the costs and risks of opening in a foreign market on its own.
Instead, the franchisee assumes these risks and costs.
Disadvantages
Franchising inhibits the ability of a firm to take out profits earned in one country to
support competitive strategies in another country. A significant disadvantage of
franchising is quality control. The foundation of a franchising agreement is that the
brand name of a firm conveys a message to consumers about the firm‟s product
quality. This disadvantage can be overcome by setting up a subsidiary in each country
in which the firm expands. The subsidiary can be a joint venture with a foreign
company or can be wholly owned. The subsidiary assumes the rights and obligations
to establish franchises throughout the particular region or country. The proximity and
smaller number of franchisees to oversee reduces the challenges of quality control.
71
International Business
Advantages
Joint ventures have many advantages. First, firms benefit from the local partner‟s
knowledge about the competitive conditions, language, business systems, and political
systems of the host country. Second, they gain by sharing the development costs and
risks associated with entering a foreign market. Third, in many countries, political
considerations make joint ventures the only possible mode of entry.
Disadvantages
There are major disadvantages with joint ventures. First, a firm entering a joint
venture risks giving control of its technology to its partner. However, joint venture
agreements can be constructed to minimize risks. One option is to hold majority stake
in the joint venture so that the dominant partner can exercise greater control. Another
option is to „wall off‟ from a partner technology that is central to the core competence
of the firm.
A second disadvantage is that a joint venture does not give a firm the kind of tight
control over its subsidiaries that it may need to realize location and experience curve
economies. Nor does it give the firm any control over a foreign subsidiary that it
might need to engage in its global strategies to coordinate against its competitors.
A third disadvantage with joint ventures is that the shared ownership arrangement can
lead to conflicts and battles for control between the investing firms if their objectives
and goals change or if they have different views over what the strategy should be.
There are several advantages of having wholly-owned subsidiaries. First, when the
competitive advantage of a firm is based on technological competence, a wholly-
owned subsidiary will often be the preferred mode of entry as it reduces the risk of
losing control over that competence. Second, a wholly-owned subsidiary gives a firm
tight control over operations in different countries. This is essential for engaging in
global strategic coordination.
Third, a wholly-owned subsidiary may be required if a firm wants to realize
experience curve and location economies. When cost pressures are intense, it may pay
a firm to configure its value chain in such a way that the value added at each stage is
maximized.
Disadvantages
72
Entry Strategy and Strategic Alliances
The competitive advantage of many service firms depends on the management know-
how. For such firms, the risk of losing control over the management skills to joint-
venture partner or franchisees is not great. The valuable asset of these firms is the
brand name, which is protected by international laws pertaining to trademarks. Many
issues arising in the case of technological know-how are of less concern here. Thus,
many service firms favor a combination of subsidiaries and franchising to control the
franchisee within particular countries or regions. The subsidiaries can be wholly-
owned or joint ventures. A joint venture is more acceptable politically and brings a
degree of local knowledge to the subsidiary.
73
International Business
Acquisitions fail for a number of reasons. First, the acquiring firm may overpay for
the assets of the acquired firm. The price of the target firm could be bid up if many
firms are interested in purchasing it. In addition, the management of the acquiring firm
is usually optimistic about the value that can be created through an acquisition and is
thus willing to pay a significant premium over market capitalization of the target firm.
This is known as the „hubris hypothesis‟ of why acquisitions fail. According to this
hypothesis, top managers typically overestimate their ability to create value from an
acquisition, chiefly because rising to the top of a corporation has given them an
overstated sense of their own abilities.
Second, many acquisitions fail due to cultural clashes between the acquired and the
acquiring firm. Many companies also experience employee turnovers as the
employees do not fit in with the culture of the acquiring firm. The loss of expertise
and management talent can harm the performance of the acquired unit. This may be a
problem in international business, where the management of the acquired firm has
valuable local knowledge that is difficult to replace.
74
Entry Strategy and Strategic Alliances
These problems can be overcome if the firm is careful about its acquisition strategy.
The foreign enterprise to be acquired should be screened including a detailed auditing
of the financial position, operations, and management culture. This helps ensure that
the firm does not pay too much for the acquired firm, does not uncover any nasty
surprises post acquisition, and acquires a firm whose organizational culture is not
opposite to that of the acquiring company. It is also important for the acquiring firm to
alleviate any concerns the management of the acquired enterprise would have. The
objective should be to reduce unwanted attrition in management after the acquisition.
Finally, after the acquisition, the management should rapidly put an integration plan
into place and should act on the plan.
5.2 Pros and Cons of Greenfield Ventures
The biggest advantage of setting up a Greenfield venture in a foreign country is that it
gives the firm a greater ability to build the kind of subsidiary company that it desires.
For instance, it is easier to build the organizational culture from scratch than it is to
change the organizational culture of the acquired unit. Similarly, it is much easier to
establish a set of operating routines in a new subsidiary than it is to convert the
operating routines of the acquired firm. This is a very crucial advantage for many
international businesses where transferring competencies, products, skills, and know-
how from the firm‟s established operations to the new subsidiary are principal ways
for creating value.
Despite the advantages, there are several disadvantages of a Greenfield venture. They
are slower to establish and are risky. A degree of uncertainty is also associated with
future revenue and profit prospects. A final disadvantage is the possibility of being
preempted by aggressive global competitors who enter through acquisitions and build
a market presence that limits the market potential of the Greenfield venture.
5.3 Greenfield or Acquisition?
It is not easy to make a choice between acquisitions or Greenfield ventures. Both have
their advantages and disadvantages. In general, the choice depends on the
circumstances confronting the firm. If a firm wishes to enter a market where there are
already-established enterprises, and in which global competitors are also interested in
establishing their presence, an acquisition route is a viable option. If a firm wishes to
enter a country where there are no incumbent competitors for acquisition, the
Greenfield venture may be the only mode. Even if incumbents exist, a Greenfield
venture is still preferable if the firm‟s competitive advantage is based on the transfer
of organizationally embedded skills, routines, competencies, and culture.
75
International Business
6. Strategic Alliances
Strategic alliances refer to “cooperative agreements between potential or actual
competitors.” Strategic alliances range from formal joint ventures in which two or
more firms have equity stakes, to short-term contractual agreements in which two
companies agree to cooperate on a particular task.
6.1 Advantages of Strategic Alliances
One of the biggest advantages of a strategic alliance is that it facilitates entry into
foreign markets. For instance, if a firm is considering making a successful entry into
the Chinese market, it needs a local partner who understands business conditions and
has good connections in China.
Second, strategic alliances allow firms to share the fixed costs of developing new
products or processes. For instance, an alliance between Boeing and a number of
Japanese companies to build the commercial jetliner, the 7E7, was motivated by
Boeing‟s desire to share the estimated US$ 8 billion investment required for
developing the aircraft.
Third, an alliance brings together complementary skills and assets that neither
company could develop easily on its own. For instance, in 2003, Microsoft
Corporation (Microsoft) and Toshiba entered into an alliance for developing
embedded processors. To the alliance, Microsoft brought its software engineering
skills and Toshiba brought its skills in developing microprocessors.
Fourth, it makes sense to form an alliance that helps the firm establish technological
standards for the industry that would benefit the firms. For instance, in 1999, Palm
Computer, the leading Personal Digital Assistant (PDA) maker, entered into an
alliance with Sony under which Sony would license and use Palm‟s operating system
in Sony PDAs. The alliance focused on establishing Palm‟s operating system as the
industry standard for PDAs, as opposed to rival Microsoft‟s Windows operating
system.
6.2 Disadvantages of Strategic Alliances
Some commentators have criticized strategic alliances saying that competitors get
access to a low-cost route to new markets and technology. The critics also point out
that alliances have risks. A firm may give its partner more than it receives in an
alliance.
6.3 Making Alliances Work
The success of strategic alliance depends on three main factors – partner selection,
alliance structure, and managing the alliance.
Partner Selection
The key to managing a strategic alliance is to select the right partner. A good partner
has three characteristics. First, a good partner helps the firm in achieving its strategic
goals, whether it includes sharing of costs and risks associated with product
development, market access, or accessing critical core competencies. The partner
should have the capabilities lacked by the firm. Second, a good partner shares the
vision of the firm for the purpose of alliance. If the two firms entering an alliance do
76
Entry Strategy and Strategic Alliances
not share the same vision, the relationship will not be harmonious and will not
flourish. Third, a good partner does not exploit the firm opportunistically, that is, it
does not expropriate the technological know-how of the firm while giving away little
in return.
To select a partner with these characteristics, a firm needs to conduct comprehensive
research on potential alliance partners. Thus a firm should collect publicly available
information on potential partners, gather data from third parties, and get to know the
potential partner prior to committing itself to an alliance.
Alliance Structure
Having selected a partner, an alliance should be so structured that the risk associated
with a firm giving too much to its partner is reduced to an acceptable level. First,
alliances can be so designed as to make it difficult to transfer technology that should
not be transferred. The design, development, manufacture, and service of a product
created by an alliance can be structured to separate sensitive technologies to prevent
their leakage to the other participant. For instance, in an alliance between General
Electric and Snecma for building commercial aircraft engines, GE reduced the risk of
transferring in excess by walling off certain sections of the production process.
Second, contractual safeguards can be written into an agreement of the alliance to
guard against the risk of opportunism by a partner.
Third, parties in an alliance can agree in advance to swap skills and technologies to
ensure that both have an equitable gain. This goal can be achieved through cross-
licensing agreements.
Fourth, the risk of opportunism can be reduced if the firm extracts in advance a
significant commitment from its partner.
Managing the Alliance
Once a partner has been selected and an alliance structure agreed on, the task facing
the firm is to maximize its benefits from the alliance. In all international business
deals, an important factor is sensitivity to cultural differences. Most of the differences
in management styles are attributed to cultural differences, and managers need to
make allowances for these in dealing with their partner. Beyond this, maximizing the
benefits from an alliance involves building trust between partners and learning from
them.
Successful management of an alliance requires the building of interpersonal
relationships between the managers of the firm -- what is referred to as relational
capital. For instance, Ford and Mazda set up a framework of meetings within which
managers discussed matters pertaining to the alliance and also had the time to get to
know each other better. The belief is that the resulting friendships help in building
trust and facilitating harmonious relations between the alliance partners. Personal
relationships also foster an informal management network between the firms. This
network can be used to solve problems arising in formal contexts.
Academics have argued that a major determinant of how much acquiring knowledge a
company gains from an alliance is its ability to learn from its partner. For example,
Gary Hamel, Yves Doz, and C K Prahalad conducted a five-year study on 15 strategic
alliances between major multinationals and focused on a number of alliances between
77
International Business
Japanese companies and Western partners. In every case in which the Japanese
company emerged stronger than its Western partner, it had made a great effort to
learn.
Firms can maximize the benefits from an alliance by trying to learn from their partner
and then applying the knowledge to their own organization. It has been suggested that
the operating employees should be briefed on the strengths and weaknesses of the
partners and should understand how acquiring particular skills will bolster the
competitive position of the firm.
7. Summary
A firm has to contemplate three basic decisions for foreign expansion – which
markets to enter, when to enter those markets, and on what scale.
Firms can use various entry modes such as exporting, turnkey project, licensing,
franchising, establishing joint ventures with a host firm, or setting up a wholly-
owned subsidiary in the host country.
Firms expand internationally to earn greater returns from their core competencies,
skill transfer, and products derived from their core competencies in foreign
markets where indigenous competitors lack those skills.
A Greenfield strategy is one where a firm can establish a wholly-owned
subsidiary in a country by building a subsidiary from the ground-up.
Strategic alliances refer to cooperative agreements between potential or actual
competitors.
78
Entry Strategy and Strategic Alliances
Contd…
responsibility of acquiring the property and constructing the building. But the
responsibility of furnishing the building lies with the franchisee. Every franchisee
has to attend training programs conducted by McDonald‟s. However, McDonald‟s
allows its franchisees the freedom to manage their business and does not interfere
in their day-to-day operations.
The franchisees receive support from the parent company in areas like operations,
training, advertising, marketing, real estate, construction, and purchasing
equipment. Thus, even after setting up its own business, the franchisee is offered
support by the franchiser. Generally, the training program lasts for nine months,
and is provided to the franchisees free of cost. The training starts with teaching
basic restaurant operations like cooking, serving, cleaning, etc. Once the trainees
have gained knowledge in these, the training is conducted at regional training
centers. Here, the emphasis is on various areas such as business management,
leadership skills, team building, and handling customer enquiries. In the final part
of the training program, the franchisees are given coaching in controlling the stock
and ordering, recruiting of people, and maintaining of accounts. In 1961,
McDonald‟s established the Hamburger University, a world-wide management
training center in Oak Brook, Illinois, USA, to train its employees and franchisees.
It also set up ten international training centers in England, Japan, Germany, and
Australia.
The franchisees benefit from McDonald‟s various activities such as national marketing,
which is carried out to analyze consumer attitudes and perceptions in different
respective countries. The research findings help the franchisees to predict the market for
a particular product, thereby reducing their risk in the business. McDonald‟s gives
utmost importance to quality and has laid down certain standards to be followed by its
franchisees all over the world. To satisfy customers, the company relies on quality
service, cleanliness, and providing value for money. McDonald‟s also believes in
customizing the menu to suit the tastes of the local customers and in constant
improvisation of the menu to meet customers‟ changing needs.
Compiled from various sources.
79
International Business
Contd…
market share due to the aggressive strategies adopted by low cost competitors,
primarily SoftBank Mobile Corp., that sparked a price war in the market. When mobile
number portability (MNP) was introduced in Japan in 2006, DoCoMo was adversely
affected by a drop in the company‟s market share to 49.7 percent. DoCoMo was also
unable to compete with its rivals in terms of new customer acquisition.
Tata Teleservices was incorporated in 1996 as the telecom division of the Tata
Group led by Tata Sons. It provided a CDMA service in India under the brand
„Tata Indicom‟. Its array of telephony services included mobile services, wire-line
services, public booth services, and wireless desktop phones. As of 2009, it catered
to around 37 million customers across 320,000 towns and villages of India.
In November 2008, Tata Teleservices announced that it was entering into a JV with
DoCoMo. Under the JV, DoCoMo bought a 26 percent stake in Tata Teleservices
for US$ 2.7 billion. Subsequently, DoCoMo made an open offer for 20 percent of
the outstanding equity of Tata Telecom Maharashtra Limited (TTML). In addition
to this, DoCoMo acquired 6 percent of additional shares in the company from the
Tata Group.
The JV was headed by a Business and Technology Cooperation Committee.
This committee consisted of senior personnel from both the companies. Their
mission was to identify the key areas where the companies could work together.
The JV gave Tata Teleservices a presence in the GSM market. After it clinched the
deal with DoCoMo, Tata Teleservices received a pan-India license to offer its GSM
services in 19 telecom circles and received allotments for spectrums in 18 telecom
circles from the Department of Telecommunications. The company planned to
invest US$ 2 billion for offering the GSM services across India.
While the JV marked the entry of Tata Teleservices into the GSM market, it
offered DoCoMo an opportunity to tap the Indian telecom market. DoCoMo
planned to introduce several services for the Indian consumers such as i-mode,
location-based services, and mobile payments. Moreover, the company also
planned to launch advanced technologies such as 3G and Long Term Evolution
(LTE) in India. DoCoMo expected the JV to earn profits within three years and was
ready to increase its stake in Tata Teleservices subsequently.
The Tata DoCoMo service was commercially launched on June 24, 2009, after
approval was received from the Securities Exchange Board of India (SEBI) and the
Foreign Investment Proposal Board (FIPB). The company launched an advertising
campaign consisting of print ads, radio, and outdoor advertising. The campaign was
reportedly well received by the public. Within three weeks of its launch, Tata DoCoMo
had completed its South India rollout covering Andhra Pradesh, Kerala, Karnataka,
Tamil Nadu, and Chennai. The company had also launched the service in Orissa and
Maharashtra, and had plans to have a pan-India presence by the end of 2009.
The unique selling proposition highlighted by Tata DoCoMo was the „pay-as-you-
use‟ scheme under which the subscriber would be charged one paisa per second
and only for the duration of use. Based on this concept, the company formed its
Contd…
80
Entry Strategy and Strategic Alliances
Contd…
tagline „Do the new‟. The „pay-as-you-use‟ benefit was extended to most of the
value added services which Tata DoCoMo offered. These services were voice chat,
24-hour music, cricket commentary, etc. In addition to this, the service for missed
calls alerts was complimentary. All subscribers of Tata DoCoMo could also avail
of voice mail functions without paying any monthly rentals, retrieval charges, or
deposits. In September 2009, Tata DoCoMo introduced the „Diet SMS‟ plan under
which it would charge only 1 paisa per character in an SMS.
The company received an overwhelming response from consumers. In just 45 days
of its launch, nearly 600,000 connections were sold. The demand was still
increasing and resulted in a supply crunch which led to black marketing of the
connections at higher prices.
Though the „pay-as-you-use scheme‟ offered by Tata DoCoMo received
encouraging response from the customers, some subscribers were not satisfied with
the service. They complained of inadequate customer service and poor network.
Tata DoCoMo responded to the consumer complaints and defended itself by saying
that the massive response received for its service had led to the problem of
congestion. It assured the complainants that they would be compensated for the
losses incurred.
Many analysts were of the opinion that this venture heldbig promises for both
sides. Industry observers believed that the Indian telecom market offered both
Indian and foreign operators huge scope for growth. As of July 2009, the
teledensity in India stood at 41 percent with an estimated 479 million subscribers,
and the number was poised to reach 770 million by 2013.
However, some analysts were not too optimistic about the JV since the Indian
telecom market was already overcrowded with established players like Bharti
Airtel Ltd., Vodafone Essar Ltd., and Reliance Communications Ltd. Some experts
also felt that the business model adopted by Tata DoCoMo could be easily
emulated by its competitors. Some experts opined that if the competitors followed
the „pay-as-you-use‟ scheme offered by Tata DoCoMo, the telecom sector‟s
revenue would be reduced by 10-15 per cent.
However, Tata DoCoMo remained optimistic about its future in the Indian telecom
sector. The company also contended that after the introduction of MNP it would be
able to wean away a significant number of subscribers from its rivals.
Compiled from various sources.
81
International Business
Appendix -4
The strategy of a firm can be defined as “the actions that managers take to attain the
goals of the firm.” For most firms, the major goal is to maximize their value for their
owners, the shareholders. The value of a firm can be maximized by pursuing strategies
that increase the profitability of the firm and its rate of profit growth over time.
Profitability is “the rate of return that the firm makes on its invested capital (ROIC).”
ROIC is calculated by dividing the firm‟s net profits by total invested capital. Profit
growth can be measured by the percentage increase in net profits over time. Higher
profitability and profit growth help in maximizing the value of a firm and thus the
returns acquired by the owners and shareholders.
To maximize a firm‟s profitability, managers pursue strategies that lower costs or add
value to the firm‟s products, which enable the firm to increase prices. Managers can
increase the profit growth rate by pursuing strategies to sell more products in existing
markets or by entering new markets.
Value Creation
By creating more value, firms can increase their profitability. The value created by a
firm is measured by the difference between its cost of production and the value
perceived by the consumers in its products. However, the price charged by a firm for a
product or a service is less than the value placed by the consumer. This is because
consumers capture some of that value in the form of consumer surplus. The consumer
is able to do this because the firm competes with other firms for the customer‟s
business, so the firm has to charge a lower price than it could have if it was the only
supplier.
The strategy that focuses on lowering production costs is called low-cost strategy. The
strategy that focuses chiefly on increasing the product attractiveness is called
differentiation strategy. Michael Porter argues that low cost and differentiation are
two strategies that create value and help a firm attain competitive advantage in an
industry. According to Porter, firms that create superior value get superior
profitability. Superior value could be created by driving down the cost structure of the
business and/or differentiating its product so that the consumers value it more and are
ready to pay a premium.
82
Entry Strategy and Strategic Alliances
Strategic Positioning
According to Porter, a firm has to be explicit about its choice of strategic emphasis
with regard to value creation and low cost. A firm should also be clear about
configuring its internal operations for supporting that strategic emphasis.
Porter emphasizes that it is crucial for management to decide where the firm wants to
be positioned with regard to cost and value and accordingly configure its operations
and manage them efficiently.
Operations
The firm‟s operations can be thought of as a value chain consisting of distinct value
creation activities including production, marketing and sales, materials management,
research and development, human resources, information systems, and the firm
infrastructure. The operations or value creation activities can be categorized as
primary activities and support activities. For a firm to implement its strategies
efficiently, it should manage these strategies effectively.
Primary activities
Primary activities deal with the design, creation, delivery, marketing, support, and
after-sales service of a product. The primary activities are divided into four functions
such as research and development, production, marketing and sales, and customer
service.
Research and development (R&D) is concerned with the product design and the
production process. R&D increases the product‟s functionality through superior
design making it attractive for the customers to buy the product. In addition, R&D
also results in a more efficient production process, thereby cutting the costs of
production. Either way, R&D creates value.
Production is concerned with the creation of a product or service. For physical
products, production means manufacturing processes and their output. An example of
physical production could be production of an automobile in an assembly line. For
services such as healthcare or banking, production occurs when the service is
delivered to the customers. The production activity of a firm creates value by carrying
out its activities efficiently so that it results in lower costs of production or a product
of high quality, or both.
The marketing and sales functions create value in several ways. Marketing through
brand positioning and advertising, increases the value the customers perceive to be
contained in the product. If these create a favorable impression in the minds of the
consumers, the firm can charge a premium.
The marketing and sales function also creates value by discovering the needs of the
consumers and communicating them back to the R&D function, which can then
design products that will suit the needs of the consumers.
The role of the service activity is to offer after-sales service and support. By offering
support and solving the problems of consumers, this function creates a perception of
superior value in the consumers‟ minds.
83
International Business
Support activities
The support activities of the value chain provide inputs for the primary activities to
take place. For a firm to attain competitive advantage, the support activities are as
important as the primary activities. The transmission of physical materials through the
value chain, from procurement through production to distribution is controlled by the
logistics function. The efficiency with which these functions are carried out can
significantly lower costs, thereby creating more value.
The human resource (HR) function creates value by ensuring that the firm has the
right mix of people to perform its value creation activities efficiently. The HR also
ensures that the people are adequately trained, motivated, and compensated to carry
out the value creation activities efficiently.
Information systems are electronic systems that track sales, manage inventory, price
and sell products, deal with customer service queries, etc. Information systems
coupled with the communication features of the Internet can help in altering the
efficiency and effectiveness with which the firm manages its value chain activities.
Firm infrastructure is the final support activity. The infrastructure includes the control
systems, organizational structure, and culture of the firm. As the top management
exerts significant influence in shaping these aspects of a firm, it is also viewed as part
of the firm‟s infrastructure. The top management shapes the firm‟s infrastructure
through strong leadership, thereby enhancing the performance of all the value chain
activities.
Global expansion helps firms increase their profitability and profit growth rate. Firms
operating internationally can:
Expand the market for their local products by selling them in international
markets.
Realize location economies by dispersing individual value creation activities to
those locations across the globe where they can be carried out effectively and
efficiently.
Realize greater cost economies by serving the global market from a central
location, thus reducing the value chain costs.
Leverage valuable skills developed in foreign operations to earn greater return by
transferring them to other entities within the global network of operations of the
firm.
Market expansion: Leveraging products and competencies
A firm can increase its growth rate by taking goods or services developed
domestically and selling them internationally. For instance, automobile companies
such as Toyota and Volkswagen grew by developing products at home and later
selling them worldwide. The returns from such a strategy can be significant if the
competitor in nations which a country enters lacks comparable products.
The success of multinational companies that expand in this manner not only depends
on the product or services offered by them in the international markets but also on the
core competencies that underlie the production, development, and marketing of those
84
Entry Strategy and Strategic Alliances
goods or services. Core competencies refer to “skills within the firm that competitors
cannot easily match or imitate.” These skills may be present in any of the value
creation activities of the firm – production, marketing, R&D, human resources,
logistics general management, etc. Such skills are expressed in product offerings that
other firms cannot imitate or find it difficult to imitate. Core competencies form the
basis for the firm‟s competitive advantage. They allow a firm to reduce the value
creation costs and/or create a value so that their products can be premiumly priced.
For instance, Proctor & Gamble has a core competency in developing and marketing
name brand consumer products.
Location Economies
Countries differ in different dimensions such as economic, political, legal, and cultural
and these differences can either lower or raise the costs of doing business in those
countries. According to the theory of international trade, certain countries have a
comparative advantage in the production of certain factors due to factor cost
differences. For instance, Japan excels in the production of automobiles and consumer
electronics and the US excels in the field of biotechnology, pharmaceuticals, software,
and financial services.
For a firm that tries to survive in a competitive global market ( a market where the
trade barriers and transportation costs are negligible), the firm can benefit by basing
its value creation activities at the location where political, cultural, and economic
conditions including relative factor costs are conducive to the performance of that
activity.
Firms pursuing such strategies realize location economies which can be defined as
“the economies that arise from performing a value creation activity in the optimal
location of that activity, wherever in the world that might be.” Locating a value
creation activity in the optimal location can have one of two effects. It can lower value
creation costs and help the firm to achieve a low-cost position and/or enable a firm to
differentiate its products from those of competitors.
Experience Effects
The experience curve refers “to systematic reductions in production costs that have
been observed to occur over the life of a product.” Some studies have observed that
production costs decline by some quantity each time the cumulative output doubles.
This was observed in the aircraft industry where each time the cumulative output of
airframes doubled, the unit costs declined by 80 percent of their previous level.
Learning Effects
Learning effects are savings in cost that come from learning by doing. For instance,
labor learns more efficiently by repeating how to carry out a task, such as assembling
airframes. The productivity of labor is enhanced over time as the laborers learn to
perform the tasks more efficiently. Similarly, in production facilities, management
learns to manage new operations efficiently over time. Thus the increasing efficiency
and management and labor productivity result in a decline in production costs, which
in turn enhances the profitability of the firm.
Learning effects become more significant when technologically complex tasks are
repeated, because there is more to be learned about the task. Thus learning effects are
noteworthy in an assembly process involving 1,000 complex steps than in just 100
85
International Business
simple steps. However, the learning effects are important only during the start-up
period and disappear after two to three years. Any decline in the experience curve
after such a point is attributed to economies of scale.
Economies of Scale
Economies of scale refer to “the reductions in unit costs achieved by producing a large
volume of a product.” Attaining economies of scale helps in lowering unit costs of a
firm and increases its profitability. There are a number of sources for economies of
scale. First, the ability to spread fixed costs over a large volume. Fixed costs are costs
incurred in a setting up a production facility, developing a new product, etc. Second, a
firm may not be able to attain efficient scale of production unless it serves the global
markets.
Finally, as global sales increase the firm‟s size, its bargaining power increases. This
may allow it to barrage down its cost of inputs, helping it boost its profitability.
Leveraging on Subsidiary Skills
Valuable skills are developed by a firm in its home market and are then transferred to
foreign operations. For instance, Wal-Mart developed its retailing skills in the US and
then transferred them to its foreign operations. However, for mature multinationals
that already have a network of subsidiary operations in foreign markets, valuable
skills can be developed in foreign subsidiaries as well.
Leveraging on the skills developed within subsidiaries and applied to the firm‟s other
operations under the firm‟s global network may create value. For instance,
McDonald‟s finds in its foreign franchisees a source of valuable ideas. Due to low
growth in France, McDonald‟s franchisees experimented with the menu as well as the
layout and theme of restaurants. Following the change, the increase in same stores
sales grew from 1 percent to 3.4 percent in 2002. Impressed by the idea, executives at
McDonald‟s adopted similar changes at other McDonald‟s restaurants where same
stores sales growth was sluggish, including in the US.
This phenomenon creates new challenges for managers of multinational enterprises.
First, they should have the humility to recognize that valuable skills that lead to
competencies can arise anywhere within the global network of the firm and not just at
the corporate center. Second, they should establish an incentive system that
encourages local employees to acquire new skills. Third, managers should have a
process to identify when valuable skills have been created in a subsidiary. Finally,
managers have to act as facilitators for transferring the valuable skills within the firm.
86
Entry Strategy and Strategic Alliances
International business often faces cost pressures in competitive global markets. For
responding to cost pressures, a firm has to lower its value creation costs. For instance,
a manufacturer may mass-produce a product at an optimal location in the world and
may outsource certain functions to low-cost suppliers in a bid to reduce costs.
Cost reduction pressures can be intense in industries where commodity-type products
are produced, where differentiation on non-price factors is difficult, and price is the
major competitive weapon. This is the case with products that serve universal needs.
Universal needs exist when tastes and preferences of consumers in different nations
are similar if not identical. Examples are conventional commodity products such as
petroleum, sugar, steel, etc. It is also the case with several industrial and consumer
products such as personal computers, liquid crystal display screens, handheld
calculators, and semiconductor chips.
Cost reduction pressures are also intense in industries where major competitors are
based in low-cost locations, where consumers are powerful and face low switching
costs, and where there is persistent excess capacity. The liberalization of the world
trade and investment environment by facilitating greater international competition has
resulted in an increase in cost pressures.
Local responsiveness pressures
Local responsiveness pressures arise from national differences in consumer tastes and
preferences, infrastructure, business practices, distribution channels, and from the
demand of the host-government. To respond to these pressures, a firm has to
differentiate its products and marketing strategy across countries to accommodate
these factors, all of which tend to raise the cost structure of the firm.
Differences in consumer tastes and preferences
Consumer tastes and preferences differ significantly across countries due to deeply
rooted historic or cultural reasons. In such cases, a multinational‟s marketing message
should be customized to appeal to the local consumers. This creates pressures for a
firm to delegate production and marketing functions and responsibilities to the
overseas subsidiaries of a firm. For instance, consumers in North America have a
strong demand for pickup trucks whereas the European consumers consider pickup
trucks as utility vehicles because of which these are purchased mostly by firms as
opposed to individuals.
Some commentators argue that consumer demands for localization are on the decline
worldwide. This has been highlighted by the fact that modern communication and
transport technologies have created conditions for convergence of consumer tastes and
preferences from different nations. This has resulted in the emergence of several
global markets with standardized consumer products. For instance, companies and
products such as Coca-Cola‟s soft drinks, McDonald‟s burgers, Nokia‟s cell phones,
and Sony‟s PlayStations have gained worldwide acceptance.
87
International Business
However, significant differences in consumer tastes and preferences still exist across
nations and cultures. International business managers do not yet have the luxury to
ignore such differences.
Differences in infrastructure and traditional practices
The local responsiveness pressures that arise from differences in infrastructure and
traditional practices create a need for product customization. This requires a firm to
delegate its manufacturing and production functions to its foreign subsidiaries. For
example, in North America, electrical systems are based on 110 volts whereas in
European countries, the standard is 240 volts. Thus, domestic electrical appliances are
required to be customized for this difference in infrastructure. The traditional practices
also differ among nations. For instance, people in Britain drive left-hand cars thus
creating a demand for left-hand cars whereas in France, people drive right-hand drive
cars and hence want right-hand drive cars.
Differences in distribution channels
The marketing strategies of a firm have to be responsive to differences in distribution
channels among countries, which may demand delegation of the marketing functions
to national subsidiaries. For instance, in the pharmaceutical industry, the Japanese and
the British systems are radically different from the US system. Japanese and British
doctors do not respond to a high-pressure sales force. Thus, pharmaceutical companies
have to adopt different marketing practices in Japan and Britain compared with what
they follow in the US.
Host-government demands
Political and economic demands imposed by governments of the host country may
require local responsiveness. For example, pharmaceutical companies are subject to
registration procedures, local clinical testing, and pricing restrictions, all of which
make it essential that the manufacturing and marketing of a drug should meet local
requirements. As governments and government agencies control a significant
proportion of the healthcare budget in most of the countries, they are in a powerful
position to demand a high level of local responsiveness.
In general, threats of protectionism, local content rules, and economic nationalism
dictate that international businesses manufacture locally. For example, Canada-based
manufacturer of railcars, jet boats, and aircraft, Bombardier, has 12 railcar factories in
Europe. Critics argue that the resulting duplication of manufacturing facilities leads to
high costs and helps explain why Bombardier makes lower profit margins on its
railcar operations than on its other line of businesses. In reply, Bombardier managers
argue that in Europe, informal rules with regard to local content favor people using
local workers. For selling railcars in Germany, they claim manufacturing should be
done in Germany. For addressing its cost structure in Europe, Bombardier has
centralized its engineering and purchasing functions but has no plans to centralize
manufacturing.
Choosing a Strategy
When competing internationally, firms typically select from one of the four strategies
– global standardization strategy, localization strategy, transnational strategy, and
international strategy. The appropriateness of each strategy varies given the extent of
cost reduction and local responsiveness pressures.
88
Entry Strategy and Strategic Alliances
When a firm simultaneously faces strong cost pressures and pressures for local
responsiveness, it is advisable for it to pursue a transnational strategy.
According to researchers Christopher Bartlett and Sumantra Ghoshal, in today‟s
global environment, competitive pressures are so intense that to survive, firms need to
do anything to respond to pressures for cost reductions and local responsiveness.
Firms should realize experience effects and location economies for leveraging on
products internationally, for transferring core competencies and skills within the
company, and for paying attention to local responsiveness pressures. Bartlett and
Ghoshal note that in a modern multinational enterprise, core competencies and skills
do not reside just in the home country but can also be developed in any of the firm‟s
operations worldwide. Thus, they maintain that product offerings and skills should not
89
International Business
just flow from home country to foreign subsidiary but also from foreign subsidiary to
home country and foreign subsidiary to foreign subsidiary. In other words,
transnational enterprises should focus on leveraging on the skills of the subsidiary.
In essence, firms pursuing a transnational strategy make attempts to simultaneously
achieve low costs from location economies, learning effects, and economies of scale;
differentiate their product offerings across geographic markets to account for local
differences; and foster a multidirectional flow of skills between different subsidiaries
of the firm. The transnational strategy is not easy to pursue as it places conflicting
demands on the company. Differentiating the product in different geographic markets
to suit local demands may increase costs, which is in contrast to the firm‟s goal of
reducing costs.
International Strategy
Some multinationals find themselves in a fortunate position where they confront low
cost pressures and low pressures for local responsiveness. Such firms pursue an
international strategy where products are produced in the domestic market and are
then sold in international markets with minimal localization. The distinguishing
feature of such firms is that they sell products that serve universal needs but do not
face significant competitors and thus, unlike firms pursuing a global standardization
strategy, are not confronted with pressures to reduce their cost structures. Xerox found
itself in such position in the 1960s after it invented and commercialized a photocopier.
The technology was protected by patents so Xerox had no competition and had a
monopoly. The product served universal needs and was highly valued in many
developed nations. Thus, Xerox sold the same basic product worldwide, charging a
relative high price. Since Xerox did not face any direct competitor, it did not have to
deal with strong pressures to minimize its cost structure.
Firms pursuing an international strategy have followed a similar developmental
pattern as they have expanded into foreign markets. They tend to centralize product
development functions such as R&D at home. However, they may also make attempts
to establish manufacturing and marketing functions in each major geographic region
or country where they conduct their business. The resulting duplication can increase
costs, but this is not a major issue if a firm does not face strong pressures to reduce
costs. Though the firms may undertake some local customization of marketing
strategy and product offering, this may be limited in scope. Eventually, in most of the
firms that pursue an international strategy, the head office retains tight control over
product and marketing strategy.
Summary
The strategy of a firm can be defined as the actions that managers take to attain
the goals of the firm.
The value created by a firm is measured by the difference between its cost of
production and the value perceived by the consumers in its products.
The operations or value creation activities can be categorized as primary activities
and support activities. For a firm to implement its strategies efficiently, it should
manage these strategies effectively.
90
Entry Strategy and Strategic Alliances
Primary activities deal with the design, creation, delivery, marketing, support, and
after-sales service of a product. The primary activities are divided into four
functions -- research and development, production, marketing and sales, and
customer service.
The support activities of the value chain provide inputs for the primary activities
to take place.
Global expansion helps firms increase their profitability and profit growth rate.
Firms operating internationally can expand the market for their local products by
selling them in international markets, by realizing location economies, by
realizing greater cost economies, and by leveraging on valuable skills developed
in foreign operations.
Firms competing in a global marketplace face two types of competitive pressures
– pressures for cost reduction and pressures for local responsiveness. These
pressures have an effect on their ability to realize location economies and
experience effects, for leveraging products and transferring competencies and
skills within the firm.
When competing internationally, firms typically select from one of the four
strategies – global standardization strategy, localization strategy, transnational
strategy, and international strategy.
91
International Business
Contd…
There was also the aspect of training the employees in creativity, giving them
access to expertise and small amounts of seed funding, the freedom to work on
their ideas, and a way to share information. In short, Whirlpool needed to set up a
formal framework to bring about a culture change and supporting infrastructure
like IT to support this change initiative. Another challenging aspect was that
everything had to be built up from scratch.
While the core groups were being trained, Nancy T Snyder (Snyder), vice president
of leadership and strategic competency development at Whirlpool, focused on
getting the rest of the company‟s global workforce involved in the initiative
through the Internet and innovation fairs. Strategos, a US-based management
consultancy firm, helped Whirlpool to put the necessary infrastructure in place and
to use Information Technology (IT) to facilitate the objective. Whirlpool re-
engineered management processes that slowed down innovation and used IT to
improve and accelerate the innovation chain from idea to final product. Instead of
going in for a few big projects, it encouraged many low-cost “stratlets” (also
known as small strategies).
Snyder put a leadership team in place. The team included a global director of KM,
three regional vice presidents of innovation, and regional innovation boards (I-
Boards) to set goals, allocate resources, and review ideas for funding. Executive I-
boards in each region strove to keep the company‟s innovation pipeline full. They
were responsible for building innovation capability, identifying the next generation
of innovation consultants (I-consultants), coordinating innovation-related
programs, and keeping innovation at the top of Whirlpool‟s corporate agenda. I-
consultants were full-time staff that helped divisions adopt and implement
innovation techniques. They also facilitated individuals, groups, or business units
to come up with new ideas and put these ideas into action.
Later, each major business unit also established an I-Board. Twenty-five people
from each region were trained to serve as in-house I-consultants and I-mentors. I-
mentors were people specially trained to facilitate innovation projects and to help
people with their ideas. I-consultants hired their own team of I-mentors.
A knowledge management system called the Innovation E-Space was started which
provided a course in innovation. It started with the “fuzzy front end” of innovation
where random insights were systematically generated and shared to spark ideas. If
an employee had a concept, he/she could go to the knowledge management system
and post the idea on a bulletin board. The home page linked employees to all the
tools and resources they needed, from insight libraries and innovation templates to
I-mentors. According to Snyder, this provided an informal social system enabled
by technology that worked across the hierarchy level.
All the projects that were in the pipeline were listed on the I-Pipe on the website.
The I-Pipe gave a dashboard view of the innovation pipeline adapted from
Strategos. It tracked ideas from concept to scale-up and provided project details as
well as the big picture, enabling management to focus on areas that needed
Contd…
92
Entry Strategy and Strategic Alliances
Contd…
attention. According to Gary Hamel (a visiting professor of Strategic and
International Management at the London Business School, chairman of Strategos,
and director of the Woodside Institute), the I-Pipe helped innovators to create
strategy and top managers to edit it so as to fit the company‟s requirements. He
also acknowledged that using IT to support innovation sessions was challenging.
The Innovation E-Space was cost-effective and did not require a big investment.
On the front end, Whirlpool used a Lotus Notes-based intranet and added new
capabilities using collaboration tools like QuickPlace and Sametime from Lotus.
For the I-Pipe, the company built a platform on its SAP infrastructure using SAP‟s
xApps for project resource management. Organizing tactical training was
complemented by a significant amount of e-learning technology. Some courses
were put online using LearningSpace of IBM Mindspan Solutions. Using such self-
paced courses freed up Whirlpool resources for assignment tp other products and
significantly reduced costs.
Whirlpool also hosted innovation fairs to felicitate inventors and encourage the
flow of ideas. At these fairs, proud employees demonstrated their new designs and
discussed their proposals.
Instead of waiting for employees to come out with ideas, the I-mentors helped
employees reflect on customer needs, industry trends, and their own experience to
come up with insights on formal innovation sessions.
The insight gained from the cross-fertilization of ideas between people from
various disciplines such as marketing and engineering also helped. For the
employees, the thrill of achievement was its own reward, and innovators received
no bonuses or perks for their ideas. According to Tammy Patrick, global director of
knowledge management, the innovators got charged up by the opportunity for
exposure and the fact that someone was listening to their idea.
Though initially Whirlpool got very few ideas out of the process, the rank-and-file
employees were happy that their participation was being sought on important
matters. However, the immediate superiors of the people who were engaged in this
process and senior managers were not happy as they thought that this initiative was
a distraction from their regular work. Moreover, in the absence of concrete goals
and this initiative not being tied to their performance in any way, the middle level
management had little incentive to support the initiative. The hardest part for
Whirlpool was to change the way leaders saw their roles as this required a huge
shift in thinking. According to Snyder, only leaders could change an environment
and allow an innovator the freedom to pursue different things.
Compiled from various sources.
93
International Business
Contd…
MTVI built its base outside the US by not only launching the MTV channel but
also by acquiring local music channels. It followed the practice of tying up with a
local company for the initial launch and acquiring the channel from the company
after some time.
MTVI entered India in the early 1990s in a tie-up with STAR TV but exited the
country in 1994 after differences erupted between the partners in the tie-up. By the
time it re-entered India in 1995, STAR TV had launched Channel [V], a 24-hour
music channel, which was available in many parts of South-Asia. Channel [V]
became very popular, especially in India, because it aired programs in Hindi.
On its re-entry, MTV Asia tied up with India‟s national television service
Doordarshan (DD). Initially, MTV Asia was aired for two hours every day on DD
Metro, one of the channels of DD, before becoming a 24-hour channel. MTV India
was later launched as a separate channel in 1996.
Taking its cue from Channel [V], MTV India began broadcasting Hindi film songs.
Officials at MTV Asia were confident that the channel would become successful in
India.
By the late 1990s, MTV India had launched a variety of programs with India-
specific content. Most of the programs were film based and were targeted at the
youth. The VJs, many of whom were picked through VJ hunts conducted across the
country, became very popular. Some „Indianized‟ programs like MTV Bakra (a
reality prank show), „Fully Faltoo‟ (a spoof show on Hindi films and songs), and
MTV Roadies (based on the US reality show „Road Rules‟) also gained popularity.
MTV India also co-sponsored many music events and began merchandising
products like clothes and perfumes under the MTV banner in 2001.
Though the programming format of MTV India was more or less similar to that of
MTV in America, the content was localized to suit the preferences of Indian
viewers. By 2004, MTV India had become the leading Indian music channel in
terms of advertising revenues, with a 35% market share. MTV Asia also launched
VH1 and Nickelodeon in a localized format in India.
Compiled from various sources.
94
Concept Note - 4
96
International Monetary System
97
International Business
98
International Monetary System
rates within a specific margin around fixed central exchange rates that are agreed
upon. The target-zone arrangement exists for major European currencies that
participate in the EMS. The European Union members have a cooperative agreement
for maintaining their currencies within a set range against other group members. The
EMS is “a peg of each country‟s currency to all the others, as well as joint float of all
member currencies together against non-EMS currencies.” The target-zone
arrangement helps in minimizing the instability in exchange rates and enhances
economic stability in the group.
However, the target-zone arrangement is not without its problems. Due to the
divergence of national policies, the trade structure and the level of economic
development, it gets difficult for every member to maintain the central exchange rate
for a long time period. Moreover, if the currency speculators attack one of the zone
currencies, defense becomes very costly.
3.4 Managed Float System
Also known as dirty float, the managed float is designed to eliminate excess volatility.
Governments use this to preserve an orderly pattern of changes in exchange rates.
Each central bank sets the exchange rate of a nation against a predetermined goal, but
allows the exchange rate to vary. In other words, the change in exchange rates does
not take place automatically, but is based on the view of the government of an
appropriate rate in the context of the country‟s position in balance of payments,
foreign exchange reserves, and rates that are quoted outside the official market. The
authorities, rather than resisting the underlying forces, sometimes intervene by selling
or buying domestic currency for smoothing the transition from one rate to another. At
other times, the authorities intervene for moderating or counteracting self-correcting
cyclical or seasonal market forces. The rationale for the managed float system is to
reduce uncertainty for improving the economic and financial environments. For
instance, the intervention of the government may reduce the uncertainty of the
exporters caused by disruptive exchange rates. Some of the countries that maintain a
managed float system are Brazil, China, Israel, Egypt, Hungary, Korea, Poland,
Turkey, and Russia.
3.5 Independent Float System
The independent float system is also known as clean float. Under this system, an
exchange rate is allowed to freely adjust to the demand and supply of this currency for
another. As a consequence of this, the economy does not have to undergo the painful
adjustment process set in motion by an increase or decrease in the supply of money.
This category includes the currencies of both developed (e.g. the USA) and
developing nations (e.g. Peru). The central banks of these countries allow market
forces to determine the exchange rates. The central banks may intervene from time to
time to alleviate speculative pressures on their currency. They also intervene
occasionally as one of the anonymous participants in the free market.
3.6 Floating system – Advantages and Disadvantages
The flexible exchange rate system offers a less painful mechanism to adjust trade
imbalances than fixed exchange rates and prevents a country from large persistent
deficits. Flexible exchange rates only lower the foreign exchange value of a currency
unlike the fixed-rate system, which requires recession to reduce real income or prices
when trade deficits arise.
99
International Business
Flexible exchange rates do not require central banks to hold foreign exchange reserves
as there is no need for intervention in the foreign exchange market. They also avoid
the need for strict import and export regulations such as import restrictions, foreign
exchange control, and tariffs.
Finally, floating exchange rates can help in ensuring the independence of trade
policies.
However, the role of flexible rates is limited in balancing trade after a certain time
period. A currency devaluation or depreciation will help the balance of trade if it
reduces the relative prices of goods and services produced locally. However, after a
short time period, the domestic prices of tradable goods will rise following
devaluation or depreciation. This results in an increase in the cost of living, which in
turn puts upward pressure on wages. In addition, flexible rates could increase the
government‟s difficulty in controlling inflation and also create less motivation for the
government to combat it. Finally, free floats may lead to more uncertainty, which may
in turn hamper the stability and growth of economies vulnerable to international
financial and export markets.
100
International Monetary System
In this situation, if there is no change in the exchange rate, the export of goods and
services in a country will become less competitive than comparable products produced
elsewhere. Imports will also become more price-competitive than domestic products
that are highly priced.
The PPP principle offers an economic foundation that determines and adjusts
exchange rates. However, in the real business world, PPP conditions may not always
hold. Thus the exchange rates are always not determined by PPP.
4.2 Interest Rate Parity (IRP)
The PPP principle focuses only on goods and services and excludes the importance of
capital flows while determining exchange rates. This limitation is addressed by the
interest rate parity (IRP) principle which explains how interest rates are linked
between different countries through capital flows. The IRP principle suggests that “the
difference in national interest rates for securities of similar risk and maturity should be
equal to, but opposite in sign of, the forward rate discount or premium for the foreign
currency.” A forward rate is “the rate at which a bank is willing to exchange one
currency for another at some specified future date.” If the exchange takes place
immediately, it is termed spot rate. A forward rate discount measures the percentage
by which the forward rate is more or less than the spot on a specific date. The IRP
implies that the forward premium of exchange rate will match the interest rate
differential between two countries. This relation holds because of efficient arbitrage in
risk-free assets. It applies to international lending as well as international investments.
The rationale underlying IRP is that for financing projects, borrowers compare the
costs in the domestic market with that of the foreign market. For investment projects,
investors compare the return from the domestic market with the return from the
foreign market. When interest parity is established, equilibrium will be achieved.
Like PPP, IRP also faces deviations due to tax factors and transaction costs in
financial markets. The deviations from interest parity between countries are also
caused by political risks because of the need of compensation for the greater risk of
investing in a foreign country.
In general, IRP is applicable to securities that have maturities of one year or less since
forward contracts are not available for a period of more than a year.
Similar to the principle of IRP but involving securities with a maturity of over a year,
the international Fisher effect addresses the relationship between the change in
percentage in the spot exchange rate over time and the differential between interest
rates that are comparable in different national capital markets. The international Fisher
effect states that “the spot exchange rate should change in an equal amount but in
opposite direction to the differences in interest rates between two countries.”
4.3 Implications for MNEs: Foreign Exchange Forecasting
Participants in international financial markets can never be sure what the exchange
rate will be after a month as future exchange rates are uncertain. Hence, a forecast
should be made. Some forecasters believe that for major floating currencies, forward
exchange rates are unbiased predictors of future spot exchange rates and forward
exchange rates are efficient. On the other hand, this hypothesis has been rejected by
empirical studies. Though reference to forward rate is necessary, international
managers should take into account many economic and non-economic factors to
predict foreign exchange rates.
101
International Business
5. Balance of Payments
The exchange rate system is a tool essential for international transactions that involves
multiple currencies. The national goal of international transactions is to accomplish
gains from investment and trade activities, which are recorded in the balance of
payments account. The balance of payments is “an accounting statement that
summarizes all the economic transactions between residents (individuals, companies,
and other organizations) of the home country and other countries.” It reports the
international performance of a country in trading with other nations and the volume of
capital that flows in and out of the country. The balance of payments uses the double-
entry bookkeeping system, which means that every credit or debit in the account is
reflected as a credit or debit somewhere else. In the balance of payments sheet,
inflows of currency are recorded as credit (plus sign) and outflows of currency are
recorded as debit (minus sign).
A standard balance of payments includes current account, capital account, and official
reserves account. Statistical discrepancy is also included in the balance of payments
account for maintaining the balance of total credit and total debit. Statistical discrepancy
reflects omissions and net errors in collecting data on international transactions.
5.1 Current Account
The current account records “flows of goods, services, and unilateral transfers.” It includes
service transactions (also called invisible items) and export and import of merchandise
(trade balance). The service account includes several service income and fees (e.g. royalty,
interests, and dividends). Service income includes transportation charges (i.e. shipping and
air travel), financial charges (i.e. banking and insurance), and tourism income. The
investment income account separates investment income from service income and records
income payments on foreign-owned assets within the country and income receipts on the
country-owned assets abroad. Unilateral transfers include remittances, pensions, and other
transfers for which specific services are not furnished.
102
International Monetary System
6. Summary
The international monetary system refers primarily to the set of policies,
institutions, practices, regulations, and mechanisms that determine foreign
exchange rates.
In the 1870s, the gold standard was accepted as an international monetary system.
Under this system, each country pegged its currency to gold.
During World War I and the early 1920s, currencies were allowed to fluctuate
over wide ranges in terms of another currency and gold. This led to the creation
of arbitrage opportunities for international speculators.
Under the provisions of the Bretton Wood Agreement that was signed in 1944,
the governments of all the member countries took a pledge to maintain a fixed or
pegged exchange rate for their currencies vis-à-vis gold or the dollar.
The Post-Bretton Woods system is characterized by a floating exchange rate system.
Under a fixed-rate system, governments can buy or sell their currencies in the
foreign exchange market whenever there is a deviation in the stated par values.
The crawling peg is an automatic system for revising the exchange rate, establishing
a par value around which the rate can vary up to a given percentage point.
Target-zone arrangement is virtually a joint float system cooperatively arranged
by a group of nations sharing common interests and goals.
Also known as dirty float, the managed float is designed for eliminating excess
volatility. It is employed by governments to preserve an orderly pattern of
changes in exchange rates.
The independent float system is also known as clean float. Under this system, an
exchange rate is allowed to freely adjust to the demand and supply of this
currency for another.
The purchasing power parity (PPP) principle states that in the long run, the
exchange rate between two currencies should reflect differences in purchasing
power, that is, the exchange rate should equalize the price of identical goods and
services in two countries.
103
International Business
The Interest Rate Parity principle suggests that the difference in national interest
rates for securities of similar risk and maturity should be equal to, but opposite in
sign of, the forward rate discount or premium for the foreign currency.
The balance of payments is an accounting statement that summarizes all the
economic transactions between residents (individuals, companies, and other
organizations) of the home country and other countries.
A standard balance of payments includes current account, capital account, and
official reserves account.
104
International Monetary System
Contd…
was not the lone suffer; the undervalued Yuan also became a cause for concern for
countries of the European Union, Germany in particular. On April 16, 2005, US
Treasury Secretary, John Snow, at a meeting of G7 countries said, “They‟ve made
enormous strides in fixing the financial infrastructure.... It's time for the Chinese to
move to flexible currency.” This view was not only supported by the G7 countries,
but also by most of the countries across the globe. The G7 countries gave a call for
flexible currencies in the world, thus indicating to China that it had to alter its
current fixed exchange rate system. In fact, there was growing international
pressure on China to revalue the Yuan in order to correct the global trade
imbalances among various countries.
Considering the pressure from different quarters, China also agreed to reconsider
its decision of continuing with the fixed exchange rate system. But it also made it
clear that before it moved to a flexible currency rate system, it would like to have a
healthy financial system and economic stability in place. It eased controls on
capital outflows, allowing its domestic firms to invest abroad. Some analysts were
of the opinion that China needed some time to reform and strengthen its banking
system. Experts opined that China would have to move to a flexible exchange rate
sooner or later.
Though China had agreed to move to a managed float exchange rate system, it was
still not certain what kind of impact revaluation of the Yuan would have on its
economy. Bowing to international pressure, China had in fact agreed to some
extent to the revaluation of the Yuan. Probably, a closer look at the history of world
currency markets would help China take the appropriate steps to alter the present
exchange rate system. As far as history goes, the currency market, which had been
relatively stable until World War I, became more speculative after it. Till World
War II, the pound was the currency against which all currencies of the world were
pegged. The German government launched a massive counterfeit campaign of the
pound during World War II, and this made people lose confidence in the currency.
The pound shrank during the War, and the US dollar emerged as the most preferred
currency in the world.
Since the Chinese currency Yuan, also called renminbi had been pegged to the US
dollar for more than a decade, the entire world insisted that it should be appraised.
The World Bank also advised China to revalue the renminbi to ensure the stability
of economies in the Asian region. But analysts were of the view that China had to
step carefully in reforming its exchange rate because if things went wrong, it would
inevitably affect financial market stability in all countries with which China had
trade relations. If China decided to revalue its currency, it had the option of
revaluing the Yuan upward or of pegging it to a basket of currencies rather than
against only the dollar. While speculation regarding its exchange rate reform went
on, China continued to consider the various options and had yet to make the final
move.
Compiled from various sources
105
International Business
Appendix - 5
106
International Monetary System
A political union requires participating nations to become one nation in a political and
economic sense. This union involves establishing a common parliament and other
political institutions.
The forms just described reflect economic integration between or among nations in a
region. Global economic integration also takes place through multilateral cooperation
in which nations that participate are bound by rules, responsibilities, or principles
which are stipulated in commonly agreed agreements. Multilateral agreements
promote worldwide economic exchanges. They may be designed for governing
general trade, investment, service, capital flows, financial market stability, or specific
areas of trade.
Economic integration generates economic gains for participating nations. Production
efficiency can be enhanced by increased specialization according to the law of
comparative advantage. The increased market size increases economies of scale which
in turn elevate the level of production. Further, the collective bargaining power of the
member nations increases against non-member nations. This power leads to better
terms of trade, that is, higher price on products exported to non-participating countries
and lower prices on imports from non-participating countries. However, these gains
are not guaranteed nor will each member country benefit equally from integration.
Free mobility of production factors may create pressures on inflation rates,
employment levels, income distribution, or trade balance for nations that are in
different economic stages or have a varying dependence on the goods and services of
other nations.
The three fundamental institutions affecting cooperation among nations at the global
level are the World Trade Organization, the International Monetary Fund, and the
World Bank. While the WTO serves as the institutional foundation of the international
trade system, the IMF and the World Bank serve as institutional foundations of the
international monetary and financial systems.
The World Trade Organization (WTO)
The World Trade Organization came into being on January 1, 1995, as a multilateral
trade organization that aimed at international liberalization of trade. It came as a
successor to the General Agreement on Tariffs and Trade (GATT). GATT was set up
after the first round of tariff negotiations at the Geneva conference held in 1947 on the
proposed International Trade Organization (ITO). GATT was evolved after periodic
rounds of multilateral negotiations on tariff cuts and non-tariff reductions..
Prior to the Kennedy Round, early negotiations primarily dealt with reducing tariffs.
By the end of the Tokyo Round in 1979, the need to confront increasing usage of non-
tariff barriers, especially by developed countries, led to the adoption of a number of
codes that dealt with specific practices. The scope of GATT was broadened in the
Uruguay Round where it reintroduced the idea of a comprehensive international trade
organization for coordinating international economic activities.
107
International Business
The Uruguay Round agreement took effect in 1995 and specified several liberalization
measures that had an effect on the threats and opportunities of international
companies. First, members agreed to slash export subsidies by 36 percent and
domestic agricultural price supports by 20 percent. These subsidy reductions benefited
major exporters in Canada, Australia, Thailand, New Zealand, and the US. Second,
the Uruguay Round set up several principles concerning trade in services. Third, the
Uruguay Round agreement strengthened the protection of intellectual property rights
which includes trademarks, patents, copyrights, brand names, and expertise.
As a successor to GATT, the main objective of the WTO is to establish trade policy
rules that raise living standards and help expand international trade. The WTO pursues
these objectives by administering trade agreements, settling trade disputes, acting as a
forum for trade negotiations, cooperating with international organizations, and
assisting developing countries on trade policy issues through training programs and
technical assistance.
The WTO had 153 members as of July 2008. The Ministerial Conference is the top-
level decision-making body of the WTO, which meets at least once in two years. The
General Council is the highest-level decision-making body of the WTO where
member nations are represented as heads or ambassadors of delegations. The General
Council also meets as the Dispute Settlement Body and the Trade Policy Review
Body. The Goods Council, Trade-Related Aspects of Intellectual Property Council,
and Services Council report to the General Council. In addition, several specialized
working groups or committees deal with individual agreements and other crucial areas
such as the development, membership applications, environment, trade and
investment, regional trade agreements, trade and competition policy, and transparency
in government procurement. Electronic commerce is also studied by many councils
and committees.
Functions
The dominant function of the WTO is reduction of import duties. Other functions
include elimination of discrimination. The main principles designed for eliminating
discrimination are the most-favored-nation treatment and the national treatment. The
most-favored-nation (MFN) treatment means that “any advantage, favor, or privilege
granted to one country must be extended to all other member countries.” For instance,
if Canada reduces its import tariffs on German cars to 20 percent, it should cut its
tariffs on imported cars from all other member nations to 20 percent. The national
treatment means that “once they have cleared customs, foreign goods in a member
country should be treated the same as domestic goods.”
There are some exceptions to the MFN principle. First, the WTO permits members to
establish regional or bilateral custom unions or free trade areas. Second, the WTO
permits members to lower tariffs for developing countries without lowering them for
developed countries. The third exception is the escape clauses allowed by the WTO.
Escape clauses are “special allowances permitted by the WTO to safeguard infant
industries or nourish economic growth for newly admitted developing countries.” The
purpose of the escape clauses is to help the developing country members to safeguard
their economies.
Another WTO function is to combat forms of protection and trade barriers. The WTO
eliminates quantitative restrictions to maintain agricultural products or to balance
foreign exchange reserves by a member government. Quantitative restrictions on
108
International Monetary System
The IMF and the World Bank are together referred to as the Bretton Woods
Institutions, as they were established at Bretton Woods, New Hampshire, in July
1944. The overall objectives of the IMF include expansion of international trade,
reduction of the disequilibrium in balance of payments of member countries, and
promotion of international monetary cooperation. For accomplishing these objectives,
IMF seeks to maintain orderly exchange arrangements, promote exchange stability,
avoid competitive exchange depreciation, and provide confidence to member states.
IMF was established for rendering temporary assistance to member countries trying to
defend their currencies against random, seasonal, or cyclical fluctuations. It also
assists countries having structural trade problems if they take ample steps for
correcting their problems.
The IMF is headed by the Board of Governors consisting of representatives from all
member countries. The IMF requires all members to collaborate with the Fund in
promoting a stable system of exchange rates for facilitating the exchange of goods,
capital, and services, and for providing conditions essential for economic and financial
stability. Members should avoid manipulating exchange rates in order to prevent
effective balance of payments adjustments or as an effort to gain unfair competitive
advantage.
109
International Business
The world community has been increasingly using the IMF as a vital forum for
multilateral surveillance and coordination of monetary and fiscal policies.
IMF has begun to develop greater flexibility for responding purposefully and quickly
to constantly change economic conditions.
The IMF created the Special Drawing Rights (SDR) for carrying out tasks of
monitoring the international monetary system and supplementing foreign exchange
reserves. SDR serves as a unit account for the IMF and other regional and
international organizations, and is also the base against which countries peg the
exchange rate of their currencies. SDRs are not circulated internationally. Individual
countries hold SDRs in the IMF in the form of deposits. Members settle transactions
among themselves by transferring SDRs.
The World Bank Group
The World Bank refers to the International Bank for Reconstruction and Development
(IBRD). It has three affiliates – the International Development Association, the
International Finance Corporation (IFC), and the Multilateral Investment Guarantee
Agency (MIGA). Together with its affiliates, the World Bank is known as the World
Bank Group. The common objective of these institutions is to help raise living
standards in developing countries by channeling financial resources to them from
developed countries.
The World Bank was set up in 1945 and is owned by 160 countries. The subscription
of its member countries provides the capital for the World Bank. Its lending
operations are financed chiefly through its borrowings in the world capital markets. A
significant contribution to the World Bank‟s capital resources also comes from its
flow of repayments on its loans and its retained earnings. The loans offered by the
World Bank are repayable over 15 to 20 years with a grace period of five years. Loans
are geared toward developing countries that are in advanced stages of social and
economic growth. The interest rates on these loans are calculated based on the cost of
borrowing, which makes the interest rate lower than market interest rates.
The World Bank‟s charter lists the basic rules governing its operations. It should lend
only for productive purposes and should stimulate economic growth in the developing
countries which are recipients of the loan. It must pay due regard to prospects of
repayment. Each loan is made to a government or should be guaranteed by the
concerned government. The use of loans cannot be restricted to purchases in any
member country particularly.
The IDA was established in 1960. It concentrates on developing the least developed
nations. The terms of IDA credits, which are usually made to governments, are a grace
period of ten years, 35- or 40-year maturities, and no interest. The IFC was set up in
1956 with the stated aim of assisting the economic development of developing
countries by promoting growth in the private sector of the economies and serving to
mobilize domestic and foreign capital for this purpose. The MIGA was established in
1988. It specializes in encouraging equity investment and other direct investment flows
to the developing countries by mitigating the non-commercial investment barriers.
Since the late 1990s, the cooperation between the WTO, IMF, and the World Bank
has increased significantly. This includes information sharing, participation in
meetings, contacts at the staff level, and the creation of a High Level Working Group
110
International Monetary System
on Coherence that manages the process and prepares an annual joint statement on
Coherence. In 1998, the WTO Secretariat collaborated with the IMF and the World
Bank staff for assisting developing countries to stimulate their foreign trade and their
participation in the multilateral trading system.
Other International Economic Organizations
111
International Business
Second, many developing countries, particularly in Asia and Latin America, have
renewed their interest in regional integration since the beginning of the Uruguay
round. Regional integration can broaden the openness and internationalization of
developing economies while avoiding overdependence on world markets. Moreover,
continued economic reforms suggest that the overall policy environment have become
conducive to the objectives of regional integration.
Third, the level of economic integration varies among different agreements. Most of
the regional integration agreements involve free trade areas, and the number of
customs union agreements is small. It is useful to distinguish between reciprocal
arrangements and non-reciprocal arrangements among free trade agreements. In a
reciprocal agreement, each member agrees to reduce or eliminate trade barriers. In a
non-reciprocal agreement, some developed countries may reduce barriers to trade.
North America: The North American Free Trade Agreement (NAFTA)
On December 17, 1992, the leaders of Canada, Mexico, and the US signed the North
American Free Trade Agreement (NAFTA), creating a tri-national market area.
NAFTA is the first free trade agreement between industrial countries and a developing
nation (Mexico). The agreement enhances the ability of North American producers to
compete globally.
NAFTA came into effect on January 1, 1994, uniting the US with its largest (Canada)
and third largest (Mexico) trading partners. On the basis of the earlier US-Canada
Free Trade Agreement, NAFTA dismantled trade barriers for industrial goods and
included agreements on agriculture, investments, services, and intellectual property
rights.
NAFTA also includes side agreements on import surges, labor adjustments, and
environmental protection. The side agreement on import surges creates an early
warning mechanism for identifying sectors where sudden, explosive trade growth may
significantly harm the domestic industry. The side agreement on labor adjustments
came due to concerns of American workers that US jobs would be exported to Mexico
due to the cheap labor, weak child labor laws, etc. prevailing in the country. The side
agreement on environmental protection ensures the rights of the US to safeguard the
environment.
With the integration of the Mexican, Canadian, and the US markets, many companies
have changed their plans and business strategies for serving the North American
market efficiently.
Europe: The European Union
The post-war efforts for the formation of the European Union have been a long
process, beginning with the formation of the EEC in 1957. On January 1, 1995, the
European Community (EC) was formed. The EC comprised the Netherlands,
Belgium, France, Luxembourg, Ireland, the UK, Denmark, Italy, Germany, Portugal,
Greece, Spain, Finland, Sweden, and Austria. These member states constitute the
economic level of the European economic integration. The outer tier of trade and
economic liberalization around the EC is composed of countries in eastern and central
Europe as well as the Mediterranean countries with which the EC had included
reciprocal trade agreements.
112
International Monetary System
The Treaty of the European Union, signed in February 1992, was enforced in
November 1993. The most basic step in strengthening political and economic ties
among member states of the EC occurred with this treaty. The treaty promotes
economic and trade expansion in a common market besides embracing the formation
of a monetary union, common citizenship, establishment of a common foreign and
security policy, and the development of cooperation on social affairs and justice. The
treaty‟s significance was marked by the adoption of the European Union (EU). The
Maastricht Treaty includes several high-impacting provisions such as:
It creates a common European currency called the European currency unit (ECU).
The ECU is a popular unit for international payment, security investment, bond
issuance, commercial loans, bank deposits, and traveler‟s checks.
Every citizen in an EU member state is eligible to obtain a European passport,
which allows them to move freely from one country to another within the EU.
It includes provisions on cooperation in fields of domestic affairs and justice.
It empowers the EU to play an active role in trans-European transport and
environmental protection.
It increases the European Parliament‟s power to enact legislation.
It removes restrictions on capital movements between member states.
It sets a European Central Bank that is responsible for monetary policy.
Asia Pacific
113
International Business
Latin America
In 1960, the Latin American Free Trade Association (LAFTA) was formed in Latin
America by Argentina, Brazil, Bolivia, Colombia, Chile, Ecuador, Mexico, Peru,
Paraguay, Uruguay, and Venezuela. In the same year, the Central American Common
Market (CACM) was formed by Costa Rica, El Salvador, Guatemala, the Honduras,
and Nicaragua. Both the agreements failed to achieve their objectives due to the
different economic policies and economic conditions of the countries involved.
In 1973, the Caribbean Community and Common Market (CARICOM) was started by
the Caribbean region. The objectives of this treaty is to achieve economies of scale in
the regional production of transportation, services, health, education, and to pool
financial resources for investment in a regional development bank. This treaty also
targets coordination of development planning and economic policies.
In 1980, LAFTA was superseded by the Montevideo Treaty, which set up the Latin
America Integration Association (LAIA) with the stated goal of increasing bilateral
trade among member countries.
In 1991, the Southern Common Market Treaty (MERCO-SUR) was formed by
Argentina, Brazil, Paraguay, and Uruguay, which formed a common market for free
circulation of labor, capital, goods, and services. The member countries also aimed to
coordinate macroeconomic policy and harmonize legislation for strengthening the
integration process. Since January 1, 1995, members of the MERCOSUR have used
common external tariff rates and common tariff structures.
Other members of the LAFTA including Colombia, Peru, Bolivia, Ecuador, and
Venezuela formed the Andean Free Trade Area in 1992 with a common external
tariff. On January 1, 1993, the Central American Common Market (CACM)
established a customs union and reactivated its objectives.
Africa and the Middle East
114
International Monetary System
115
International Business
The MFA has been renewed several times due to the lack of a better solution between
developing and developed countries over the trade involving apparel and textile trade.
For instance, the US and China negotiate yearly over the quota of Chinese exported
garments and textiles. The process is lengthy due to conflicts over issues on which
both the parties do not compromise.
Other multilateral commodity arrangements include The International Sugar
Agreement, The International Tin Agreement, The International Cocoa Agreement,
The Wheat Trade Convention, the International Coffee Agreement, and the
International National Rubber Agreement.
Summary
Economic integration concerns removal of trade barriers or impediments between
at least two participating nations and establishing and coordinating between them.
A free trade area involves country combinations, where the member nations
remove trade barriers among themselves while retaining their freedom related to
policy making vis-à-vis non-member countries.
116
International Monetary System
A customs union is identical to a free trade area except that member nations must
pursue and conduct common external commercial relations like common tariff
policies on imports from non-member nations.
A common market is a particular customs union that permits free trade of
products and services only but with free mobility of production factors across
national member borders.
An economic union is a particular common market that unifies fiscal and
monetary policies.
A political union involves establishing a common parliament and other political
institutions.
The World Trade Organization came into being on January 1, 1995, as a
multilateral trade organization that aimed at international liberalization of trade.
The overall objectives of the International Monetary Fund include expansion of
international trade, reduction of disequilibrium in balance of payments of member
countries, and promotion of international monetary cooperation.
In December 1960, the Organization for Economic Cooperation and Development
(OECD) was established. Its stated mission is to aid in achieving the highest
possible growth in the economies of member countries as well as non-member
states.
UNCTAD is a forum that examines economic problems that plague developing
countries.
NAFTA is the first free trade agreement between industrial countries and a
developing nation (Mexico). The agreement enhances the ability of North
American producers to compete globally.
The Treaty of the European Union, signed in February 1992, promotes economic
and trade expansion in a common market besides embracing the formation of a
monetary union, common citizenship, establishment of a common foreign and
security policy, and the development of cooperation on social affairs and justice.
In November 1994, the Asia-Pacific Economic Cooperation Forum (APEC) was
founded.
The Association of South East Asian Nations aims to promote peace, stability,
and economic growth in the region.
In 1960, the Latin American Free Trade Association (LAFTA) was formed in
Latin America by Argentina, Brazil, Bolivia, Colombia, Chile, Ecuador, Mexico,
Peru, Paraguay, Uruguay, and Venezuela.
The Economic Community of West African States (ECOWAS) eliminated duties
on unprocessed agricultural products and handicrafts.
In 1981, Kuwait, Oman, Bahrain, Qatar, Saudi Arabia, and the UAE established
the Gulf Cooperation Council (GCC) in the Middle East. A free trade area that
covered agricultural and industrial products was set up.
The Organization of Petroleum Exporting Countries (OPEC) is the strongest
collective force that impacts oil prices in the international oil market.
117
International Business
118
International Monetary System
Contd…
With MFN status, China would move to an even more advantageous position.
According to analysts, the challenge before India was to undertake macro-
economic reforms to step up overall growth. Reforms should include reducing the
fiscal deficit and high borrowings. To compete with China for FDI, India needed to
improve its infrastructure.
Compiled from various sources
119
International Business
Contd…
120
Concept Note - 5
representatives of central banks and commercial banks meet and determine a fixed
rate. In those countries, the posted fixed rate acts as a guide for pricing small and
medium-sized transactions between banks and their customers. Major industrial
countries such as Italy, Belgium, France, Japan, and the Benelux and Scandinavian
countries have a daily fixing. The US, the UK, Canada, and Switzerland do not have a
daily fixing.
Foreign exchange trades are done in a 24-hour market. As the market in the Far East
closes, trading in the Middle East financial centers begins. After a couple of hours,
trading in Europe begins. As the London market closes, the New York market opens.
After a few hours, the market in San Francisco opens and trades with the Far East and
the East Coast of the US. The foreign exchange market is dominated by banks with
about 90 percent of foreign-exchange trading comprising interbank trading. Nonbank
participants in foreign-exchange trading include multinational corporations,
commodities dealers, and nonbank financial institutions.
The three major functions performed by the foreign exchange market are described
here:
1. It is part of the international payment system and offers a mechanism for
exchange or transfer of the national currency of a country into the currency of
another country, thus facilitating international business.
2. It assists in supplying credits for the short-term through swap arrangements and
the Eurocurrency market.
3. It offers foreign exchange instruments to hedge against risk.
Foreign exchange trading sharply expanded under the floating exchange rate system
and the number of banks participating in the market significantly increased as they
entered the market for servicing their corporate clients. Increased hedging by
companies of their balance sheets and cash flows was accompanied by the entry of
new corporate participants into the market.
2.3 Foreign Exchange Rate Quotations
A foreign exchange rate quotation is “the expression of willingness to buy or sell at a
set rate.” In foreign exchange businesses, several pairs of quotations are used.
Direct and Indirect
A direct quote is “a home currency price of a foreign currency unit.” (e.g. C$1.489/US
$1 in Canada). An indirect quote is “a foreign currency price of a home currency
unit.” (e.g. US $ 0.67182/C$ 1 in Canada). Under a direct quote, an increase of the
exchange rate (e.g. from C$ 1.489 to C$ 1.589) means appreciation of the foreign
currency (US$) and depreciation of the home currency (C$). In contrast, an increase in
exchange rate (e.g. from US$ 0.67182 to US$ 0.68182 per Canadian dollar) under
indirect quote means depreciation of the foreign currency (US$) and appreciation of
the home currency (C$). Direct quote is used in most of the countries.
Bid and Offer
A bid is “the exchange rate in one currency at which a dealer will buy another
currency.” An offer is “the exchange rate at which a dealer will sell the other
currency.” The difference between the bid and offer prices is called the bid-ask spread
122
Foreign Exchange Markets
and is the dealer‟s compensation or the transaction cost. For instance, a Canadian bank
quotation for the US dollar (US/C$) may be 0.6748 (offer) and 0.6718 (bid). The
transaction cost charged by the Canadian Bank may be 0.0030.
Spot and Forward
Spot rate and forward rate are used for foreign exchange transactions between dealers
in the interbank market. A spot rate is “the exchange rate for a transaction that
requires almost immediate delivery of foreign exchange.” A forward rate is “the
exchange rate for a transaction that requires delivery of foreign exchange at specified
future date.”
Cross Rates
The cross rate is “the exchange rate between two infrequently traded currencies,
calculated through a widely traded third currency.”
2.4 Transaction Forms
Spot Transactions
Spot transactions include spot transactions between banks and bank notes transactions
for individuals. Spot transactions are usually settled on the second working day on
which the transaction concludes. Bank notes transactions include currency changes for
individuals that are exchanged for each other instantaneously over the counter. The
largest financial market in the world is interbank foreign exchange. On the settlement
date, most dollar transactions in the world are settled through the computerized
Clearing House Interbank Payments Systems (CHIPS) in New York, which provides
for calculating new balances owed by any one bank to another and for payment on the
same day in Federal Reserve of New York funds.
When an individual or a company needs foreign exchange to be paid to a foreign
company, it can either use international wire transfers or customer drafts. Under a
wire transfer, the payment instructions are sent through SWIFT or other electronic
means. Under the customer drafts, the bank sells the individual or company a foreign
exchange draft that is payable to the stated holder.
Forward Transactions
A forward transaction occurs “between a bank and a customer calling for delivery at a
fixed future rate, of a specified amount of foreign exchange at the fixed forward
exchange rate.” The exchange rate is set at the time of the agreement, but until
maturity, payment and delivery are not required. International companies may either
buy a foreign currency forward from a bank or sell a foreign currency forward to a
bank. The position where the initial transaction represents an asset or future ownership
claim to foreign currency is termed as long position. The position where the cash
market position represents future obligation or liability to deliver foreign currency is
termed as short position.
Swap Transactions
A swap is “an agreement to buy and sell foreign exchange at prespecified exchange
rates where the buying and selling are separated in time.” A swap transaction involves
simultaneous sale and purchase of a given amount for two different dates of
settlement. The same counter-party carries out both sale and purchase. Swap
transactions are of two types – spot forward swap and forward-forward swap.
123
International Business
In a spot-forward swap, “an investor sells forward the foreign currency maturity value
of the bill, and simultaneously buys the spot foreign exchange to pay for the bill.”
Because a known amount of the home currency of the investor will be received
according to the forward swap component, no uncertainty will exist from exchange
rates. Similarly, those borrowing in foreign currency can buy forward the foreign
currency essential for repaying a foreign currency loan at the same time as they
convert the foreign funds that are borrowed on the spot market.
A forward-forward swap involves two forward transactions. For instance, a dealer
sells Euro 1,000,000 forward for dollars for delivery in three months at US$
0.94/Euro, and simultaneously buys Euro 1,000,000 forward for delivery in six
months at US$ 0.94/Euro.
The two preceding swaps are popular with banks as it is difficult to avoid them when
making a market for future currencies and dates.
2.5 Foreign Exchange Arbitrage
In the foreign exchange market, the information related to price is easily available
through computer networks, which makes it easier for price comparison in other
markets. As such, exchange rates between two particular currencies tend to be equal
worldwide though temporary discrepancies do exist. These discrepancies offer profit
opportunities for buying a currency in one market while simultaneously selling it in
another. This activity is called arbitrage. It continues until the exchange rates in
different locales are so close that it is not worth the costs incurred in additional buying
and selling.
2.6 Black Market and Parallel Market
Due to legal prohibitions or government restrictions on foreign exchange transactions,
illegal markets in foreign exchange exist in many developing countries in response to
private or business demand for foreign exchange. These illegal markets are known as
black markets. The illegal markets exist openly in some countries (e.g. Venezuela and
Brazil) where there is very little government interference. However, in some other
countries, foreign exchange laws are enforced strictly and lawbreakers when caught
receive harsh sentences (e.g. China before 1985).
Often, governments set an official exchange rate that widely deviates from the one
established by the free market. If the government wishes to purchase foreign exchange
at the official rate but private citizens wish to pay the market-determined rate, there
would be a steady supply of foreign exchange to the black market. Thus it can be
inferred that government policy creates a black market. The demand arises due to
legal restrictions on buying foreign exchange, and the supply exists because official
exchanges that are mandated by governments offer less than the free market rate.
Ironically, governments defend the need for restrictions on foreign exchange based on
conserving scarce foreign exchange that flows to the government as traders may
instead wish to sell it to the black market.
The black market when legalized by the government is referred to as parallel market.
It operates as an alternative to the official exchange rate. In countries facing economic
hardship, the parallel markets allow continuation of normal economic activities
through a steady supply of foreign exchange.
124
Foreign Exchange Markets
127
International Business
5. Summary
A foreign exchange transaction is an agreement between a buyer and seller for the
delivery of a certain amount of one currency at a specified rate in exchange for
some other currency.
The foreign exchange market includes individuals, banks, corporations, and
brokers who buy or sell currencies.
128
Foreign Exchange Markets
International money markets are markets where foreign monies are invested or
financed.
International bond markets are markets where corporate bonds or government
bonds are issued, bought, or sold in foreign countries.
International stock or equity markets are markets where company stocks are listed
and traded on foreign stock exchanges.
International loan markets comprise large commercial banks and lending
institutions that offer loans to foreign companies.
The Asian financial crisis depicts how a crisis takes place in international
financial markets and how the crisis relates to international financial markets,
financial institutions, and the governments.
129
International Business
Contd…
Analysts were divided in their opinion on the long-term effects of the rupee‟s
appreciation against the dollar on the Indian economy. Some believed that as
exports as a percent of GDP are low in India, the rupee‟s appreciation against the
dollar, though sure to impact exports, would not significantly affect the economy as
a whole. They were also confident that Indian exports would gradually regain
competitiveness. However, others were not so optimistic and were in favor of the
RBI intervening in the foreign exchange market.
In July-August 2007, the government of India announced measures to counter the
negative impact of the rupee‟s appreciation on India‟s exports. The RBI also started
buying dollars from the market to absorb the oversupply of dollars, indicating that
the rupee-dollar rate had crossed the „comfort zone‟ of the central bank.
Compiled from various sources.
130
Concept Note - 6
To assess market potential within the context of corporate strategy, firms carry out
marketing research. The research aims at finding solutions to questions such as (a)
what are the objectives to be pursued by firms in foreign markets?; (b) what foreign
market segments have to be pursued?; (c) Which are the best product, distribution,
pricing, and promotion strategies; and (d) what must the product-market-company-
mix be to take advantage of the available foreign marketing opportunities?
132
International Business
133
Global Marketing and Supply Chain
134
International Business
have the logistic component, or a long-term logistic provider, which makes the foreign
firm consolidate its supply chain locally. Another solution for SMIEs is sourcing
logistic services from third parties. In such alliances, the shipper leads strategy
formulation while the provider leads day-to-day operations. There exists a sole key
provider with whom the manufacturers establish a close working relationship.
Global Sourcing
World regions vary in size, terrain, and other characteristics that have an impact on
the supply chain. For instance, the land area of NAFTA is over six times that of the
EU. Quality of supplies, skill level, availability of process equipment and
technologies, and the level of transportation and communications differ substantially
among regions. Asia, large parts of the Middle East, Africa, and Latin America suffer
from poor infrastructure. Though Asian infrastructure is relatively weak, Singapore
has superb infrastructure in terms of both shipping and air.
Conditions often vary even among developed nations. For instance, in the US, it takes
three weeks for breakfast cereals to reach the retailers‟ shelves from the time of
manufacturing but it takes eleven weeks in France. This explains why domestic supply
chains continue to dominate the transfer of goods. In addition, increased foreign direct
investment in local production base creates even more reliance on domestic supply
chains. A great number of intermediaries and fragmented supply chains add to the
problem.
138
International Business
4.3 Packaging
Standardization in packaging eases logistics and also promotes brand recognition.
Coca-Cola uses a similar color and logo to enhance its brands. Standardization in
packaging results in savings in design and promotion costs. Packaging size must also
be adapted to the market concerned. Where space is scarce, bulk packaging is less
attractive, for instance, Japanese households.
Some adaptations are essential for logistic reasons. For instance, sturdier packaging is
required to shield the product from outside elements in a harsh environment. Other
adaptations are needed to meet legal requirements. The 1991 German Packaging
Ordinance requires manufacturers to use recyclable and environmentally friendly
packaging material whenever feasible. Various laws govern safety requirements.
In most countries, labels have to be printed in the local language, adding to the time
and cost of distribution. The US requires all food products to carry labels indicating
their nutritional value. Many countries also require clear labeling of the product‟s
country source. In the US, US content should be disclosed on textiles, cars, wool, and
fur products.
Some packaging adaptations are essential for cultural or religious reasons. For
instance, Hogla-Kimberly, a joint venture between an Israeli manufacturer and
Kimberly Clark, sells diaper to the orthodox segment in Israel in a specially designed,
easy-to-prop open packaging that meets the religious requirements for doing no work
on the Sabbath.
Maritime Transportation
Port facilities represent a vital ingredient in the convenience and cost of maritime
transport. According to a report by Conference Board, the most competitive ports
offer low cost, speed processing, and superb intermodal links. Ports are of four types –
(1) the maritime hub – dedicated to transshipment from an ocean vessel to a feeder or
another vessel; (2) the gateway port – an interchange between the maritime hub and
maritime and/or land transport; (3) the logistic-industrial port – interchange between
modes of transport combined with logistic support; and (4) the trade port – logistic
activities together with other value-added international trade services.
Singapore and Hong Kong are the two largest container ports in the world, and
together, they have 44 percent of the container lifts in the world. Non-hub ports can
compete by adopting niche strategies. One port strategy is to specialize in a particular
product line in order to achieve economies of scale.
Ports as key links in the global supply chain face the challenge of accommodating
local distribution. For instance, in needs to integrate domestic and international
shipping in situations where the final destination is closer to a port.
The Inland Port
In central Ohio, „Port Columbus‟ is an inland port. It utilizes 86 million square feet of
warehousing and distribution facilities on the grounds of a former air force base. The
port has arteries to highways, airports, and rail and coastal port access through
agreements with the ports of Los Angeles, New York/New Jersey, and Virginia.
Countries with vast underdeveloped hinterlands show immense interest in the inland
port concept in a bid to improve access to less developed regions.
Trucking
140
International Business
Air transportation was initially confined to high value or perishable items. It is now
increasingly being used when logistics infrastructure is in place and speed of
transportation is vital. A major impediment to globalization of air transport is the
stringent safety standards imposed by developed nations, especially the EU and the
US, vis-à-vis the lax regimes common in most of the developing countries. If the
safety standards are not complied with, the US does not permit the landing of foreign
aircraft.
4.4 Crossing national Borders
A seamless supply chain spanning national borders is difficult to establish. Customs
inspection, processing, and other barriers associated with crossing borders create
unpredictable and costly delays.
The NAFTA agreement offers substantial non-tariff movement of goods across the
US, Canada, and Mexico, on the condition that goods originate from one of these
three countries. For this to take place, substantial documentation is essential to
establish country-of-origin source. Moreover, shortage of border-crossing points, rails,
docks, and bridges undermine traffic expansion.
In the aftermath of the September 11, 2001, terrorist attacks in the US, border delays
worsened considerably in many parts of the world, including major borders such as
that between the US and Canada. Though the delays since then have shortened, they
show that global logistics is vulnerable to the problem of overlapping international
boundaries and the expected contingencies that characterize the global supply chain
and other facets of international business.
5. Summary
Success in international markets depends on many skills such as accurate
assessment of market potential; selection of the right product mix, and making
appropriate adjustments in pricing, packaging, advertising, and distribution.
For assessing market potential, firms seek to identify aggregate demand for a
product or a service and estimate the costs associated with product introduction
and distribution.
141
Global Marketing and Supply Chain
Contd…
the premium dark rum Reserva. Since the new spirit was light gold colored, it was
a completely new category in dark rum and failed to evoke the desired response.
Seeing a potential in the Flavored Alcoholic Beverage (FAB) or Ready-To-Drink
(RTD) segment, BMIL launched the Bacardi Breezer, the largest selling brand in
the RTD segment worldwide.
BMIL launched its „Breezer‟ brand targeting young professionals in the 25-30 age
group. The brand was first available in three flavors – orange, lime, and cranberry.
It was priced between Rs 35 and Rs 40 for a 330 ml bottle. To differentiate the
product from the competition and create excitement in it, BMIL launched variants
of Breezer every year. BMIL used its global ad campaign in India to create brand
awareness and build a brand image. It showcased fun, color, and passion in these
global campaigns. The company stuck to the global format since it was unable to
identify its target customers clearly. In 2002, the company conducted a study,
which revealed that its global ad campaigns could only influence those people who
were willing to test new products. The regulations on advertising of alcoholic
products in various media (electronic, print and outdoor) by the Government of
India added to the woes of the company.
To overcome these problems, BMIL released a new localized advertising campaign
to replace its global TV ad campaign. That was the first time that BMIL was using
a localized ad campaign for its products across any market in the world. The fun,
excitement, and vigor in its advertisements were present but the locales changed
from sandy beaches and fun in the afternoons, to an evening get-together after a
laborious day‟s work. The objective was to make the ads more suitable to the
Indian consumer. This change suited the Indian consumers as the ads focused on
fun after work unlike the global ads. The tag line „Live Life in Color‟ aptly
reflected BMIL‟s philosophy.
To overcome the regulations on advertising alcoholic products, BMIL made use of
below-the-line promotions and event sponsorships to promote Bacardi Breezer. It
also made use of surrogate advertising. „Bacardi Blast‟ was initially launched as a
promotional program through a tie-up with a private music channel. As part of the
promotions, BMIL promoted musical concerts in the metros. The campaign grew
manifold to become a musical extravaganza attracting thousands of consumers,
thereby increasing brand awareness for Bacardi Breezer. „Bacardi Blast‟ parties
became the symbol of youthful energy and began to be considered as one of the
hottest post-work parties. BMIL also released Bacardi CDs containing the latest hit
numbers as part of its brand communications. In addition to the „Bacardi Blast‟
parties, the company also mooted „Bacardi Night Shift‟. Though BMIL aimed at
targeting new customers like women and young people by distributing the brand
through retail chains, it was not successful in this venture as the various state
governments had laws against distribution of liquor through departmental stores.
Through consistent promotions, the brand was able to garner a major share in the
RTD segment, though it was still negligible when compared to the total spirits
market in India.
BMIL also brought about changes in the packaging of its earlier brands, Carta
Blanca and Reserva. The new packaging design was intended to highlight the
brand‟s heritage – established in 1862 in Cuba, and the product quality – the
world‟s smoothest rum.
Compiled from various sources.
143
Global Marketing and Supply Chain
144
Concept Note - 7
2. Strategic IHRM
SIHRM is defined as “human resources, management issues, functions and policies,
and practices that result from the strategic activities of MNEs and that impact the
international concerns and goals of these enterprises.” SIHRM is more complex than
strategic human resource management in a domestic context because it concerns
multiple employee groups and environments and because it needs to be aligned with
the multi-faceted considerations of the MNE. The SIHRM model has three
orientations:
The adaptive system that imitates local human resource management (HRM)
practices.
The exportive system that replicates the HRM system in the home country and
other affiliates.
The integrative system that emphasizes global integration while allowing for
some variations.
An optimal SIHRM has the capacity to balance the different forces in the environment
of the firm, particularly the tension between local responsiveness and global
integration. The overall SIHRM strategy chosen by the parent in conjunction with the
specific conditions of the affiliate (e.g. the cultural distance from the parent)
determines the degree of similarity in SIHRM between the headquarters and the
affiliate. This, in association with the criticality of the group, determines the similarity
of HRM practices for each employee group.
146
Global Human Resource Management
Most MNE employees abroad are „foreign employees‟ or HCNs, for several reasons.
They are easier to employ administratively and legally. They are also knowledgeable
about the local environment. In case of developing and emerging markets, HCNs are
often cheaper to employ than home country nationals, even without adjusting for
expatriate terms.
The availability of qualified candidates is a decisive factor in the selection of HCNs.
Foreign MNEs in Japan finds it difficult to hire qualified Japanese employees. In
some countries, hiring requires a government-controlled labor bureau that may assign
employees to work for the MNE.
The cultural challenges go beyond staffing. A formal career planning system where
individuals are evaluated in terms of abilities, skills, and traits that will be tested,
scored, and computerized may appear to be impersonal in collective cultures.
Individualistic societies use cognitive testing because they emphasize performance,
individual rights, and individual interests, whereas collective cultures emphasize
organizational compatibility and loyalty that cannot be evaluated via cognitive tests.
Finally, the MNE is expected to monitor employment conditions at home as well as at
its subsidiaries. For instance, Wal-Mart was caught in a controversy when it was
reported that it was buying from vendors who used child labor in Bangladesh.
3.3 Country Specific Issues
As in other functional realms, the need for adjustment in corporate practices and
policies is anchored in the variation of employment conditions and labor markets. In
transition economies, older employees who are accustomed to a central planning
system face difficulties adjusting to the higher productivity expected in an MNE.
Despite the overall high employment in such economies, skilled workers are usually
in short supply due to lack of educational infrastructure. For instance, in China, the
biggest problem faced by MNEs is very high employee turnover, which undermines
investment in recruitment and training. To overcome this problem, MNEs in China
customize solutions. Ford Motor Company, for example, offered retention incentives
to its Chinese workers.
control, and as a way to transmit corporate culture and goals. Expatriation creates a
global perspective and is necessary for knowledge and technology transfer.
Some firms do not use expatriates because they block promotion of the local
workforce. The local workforce may also feel deprived by the fact that their wage
levels are lower than that of the expatriates. An expatriate can also rob a company of
the insights, skills, and initiative of local nationals. Another reason for not using
expatriates is their high rates of failure.
4.3 Expatriate Failure
Expatriate failure occurs when the assignee returns prematurely to the home country
or when his/her performance does not meet expectations. Japan and China show the
highest failure rates for US expatriates.
The cost of expatriate failure is substantial, ranging from US$ 55,000 to US$ 150,000
in direct costs. However, the real cost of expatriate failure is considerably higher. It
includes cost of selection, training, preparation, and moving, in addition to the
consequences of poor performance in lower revenues, damage to the firm‟s reputation,
and lost business opportunities. All these may undermine the company‟s future
ventures in the host country.
There are numerous reasons for expatriate failure. They may include a spouse‟s
unhappiness, inability to cope with the responsibilities and stress posed by overseas
work, inability to adjust to an unfamiliar physical and cultural environment,
personality or emotional immaturity, and lack of technical competence. Lack of
motivation to work overseas when a firm attaches low value to an overseas
assignment is also a problem.
4.4 Expatriates Selection
MNEs look for several attributes in an expatriate including cultural empathy, language
skills, adaptability and flexibility, education, maturity, motivation, and leadership.
Adler specifies these competencies: local responsiveness, a global perspective,
transition and adaptation, synergetic learning, cross-cultural interaction, collaboration,
and foreign experiences. The ability to exercise discretion in choosing when to engage
in global integration and when to be locally responsive is another crucial factor.
Successful expatriates need three sets of skills – (1) personal skills, that facilitate
emotional and mental well-being as for instance, reinforcement, stress orientation,
substitution, technical competence, physical mobility, dealing with isolation,
alienation, realistic expectations prior to departure; (2) people skills such as
willingness to communicate, relational abilities, non-verbal communication, respect
for others, and empathy for others; and (3) perception skills, namely the cognitive
process that helps executives understand the foreigners‟ behaviors. Being culturally
adventurous and extroversion are crucial for expatriate success in culturally distant
cultures.
Expatriate Selection Instruments
148
Global Human Resource Management
Training for an overseas assignment has two components – information giving and
experiential learning. Information-giving consists of practical information on living
conditions in the destination country, area studies, which include facts about the
country‟s macro-environment, and cultural awareness information. Experiential
learning combines cognitive and behavioral techniques. The goal is to acquire
intercultural effectiveness skills including relationship building, stress management,
cross-cultural communication, and negotiation techniques.
Effective cross-cultural training requires an integrated approach which includes both
general orientation and specific cultural development. Yoshida and Brislin list five
guidelines for cultural training: (1) identify – become aware of the skills needed to
function in the target culture; (2) understand – know why, where, when, to whom, and
how the behavior is appropriate; (3) use cultural informants for understanding
specifics – observe and consult people from the target culture to ensure that the
behaviors are used in the proper context and are delivered appropriately, (4) practice –
practice helps in gaining proficiency in a new skill; and (5) deal with emotions –
trainees should anticipate new behaviors they use as well as strong emotional
reactions to cultural differences.
Harrison proposed a two-stage cultural orientation. The first stage focuses on trainees‟
attention and prepares them for cross-cultural encounters. This stage involves self-
assessment of factors and cultural awareness. In the second stage, specific cultural
orientation is designed to develop the ability of the trainees to interact effectively
within the specific culture they have been assigned. This stage includes two phases:
knowledge acquisition and skill training.
149
International Business
Tung proposed a contingency framework to determine the nature and level of training
rigor based on the cultural distance between the expatriate‟s native and new culture
and the degree of interaction required in the overseas position. If the cultural distance
is low and the expected interaction between the HCNs and expatriates is low, training
should focus on task-related issues as opposed to cultural issues, and the level of rigor
required is low. If the cultural distance and expected interaction is high, training
should focus on cross-cultural skill development as well as on the new task and on the
new culture, and the level of rigor should be moderate to high.
Another training model is based on the social learning theory, where rigor is defined
as the degree of cognitive involvement by the trainee. The model distinguishes
between participative modeling, which involves observing and participating in the
modeled behavior, and process-symbolic modeling, which involves observation of
modeled behavior.
If the level of interaction and cultural distance is low, training should be less than a
week. If the individual is going overseas for 2 to 12 months, the training should be for
four weeks. If the individual is going into a novel culture and the expected degree of
interaction is high, the level of training rigor should be high and training should be
given for two months. Some field experiences and sensitivity training would be
appropriate.
Compensation
The cost of hiring an expatriate is 3 to 5 times higher than the domestic salary of a
local hire.
Expatriate compensation comprises the following elements:
Salary: Base pay plus incentives determined through competency-based plans or job
evaluation. Incentives in the form of cash or deferred payment may be based on home-
country plans or host-country plans or both.
150
Global Human Resource Management
151
International Business
152
Global Human Resource Management
((i.e. TCNs assigned by the foreign parents to work in the affiliate); (6) Third-country
expatriates of the affiliate (i.e. TCNs recruited by the affiliate); (7) foreign
headquarters executive (i.e. policymakers at foreign parents‟ headquarters who are
board members of the affiliate or play a key role in the functioning of the affiliate at
headquarters); and (8) Host headquarters executives (i.e. policymakers ate the host
parents‟ headquarters, who are board members of the affiliate or play a key role in the
functioning of the affiliate at headquarters).
5.1 HR Problems in Foreign Affiliates
The following HR problems can be expected in WOSs and IJVs:
Staffing friction: As a control measure, parent companies prefer to appoint their own
transferees or expatriates for major positions in the affiliate. If the staffing policy is
not specified contractually, friction could arise. Sometimes, friction develops
regarding the level of staffing. In WOSs as well as IJVs, HCNs are deprived of
opportunities of serving the senior-most positions.
Blocked promotion: In WOs and IJVs, the lack of promotion opportunities frustrates
the local employees if senior positions are reserved for „outsiders‟. The local
employees may be reluctant to join, stay, or contribute their best to the affiliate, when
such outsiders are abundant.
Exile syndrome and reentry difficulties: Feeling exiled in a foreign assignment due to
fear of interruption in the career track in the home country occurs in both WOSs and
IJVs. The exile syndrome can proved to be damaging for the foreign affiliate as
employees may bypass their superiors in the affiliate, report only achievements
leaving behind failures, and take a short-term perspective.
Split loyalty: This problem is unique to IJVs. Employees recruited by the host or the
foreign parent may remain loyal to that parent rather that shifting their loyalty to the
IJV. This results in suspicion and low level of cooperation that prevents the IJV from
attaining its goals.
Compensation gaps: The compensation gap problems (i.e. HCNs receiving much
lower pay than expatriates) occur in both WOSs and IJVs. For example, many US-
based executives of foreign MNEs earn more than their seniors in Asia or Europe.
IJVs face an additional problem of relative deprivation where employees are
compensated based on affiliation with a particular parent or IJV rather than on
universal criteria, such as skills, experience, etc. Every employee has a compensation
policy where differences are significant. Moreover, each employee group has a
different perception about the desired compensation package. The result is a feeling of
deprivation resulting in reduced morale and motivation.
Blocked communication: Effective communication between a parent and an affiliate
and among parents can be hampered by cultural differences and varying
organizational norms and procedures. Such communication blockages can impede
decision making. This problem is serious in IJVs with a 50:50 equity distribution.
Limited delegation: Many parent companies maintain control of their affiliate by
limiting the decision making power and scope of authority delegated by them. This is
true when parents have conflicting goals, when they feel that the staff of the affiliate is
loyal to the other parent, and when they depend on the affiliate for scarce and vital
resources. Under these conditions, the management of the affiliate finds it difficult to
operate effectively, especially in a fast-changing environment.
153
International Business
6. Summary
Strategic international human resource management (SIHRM) is defined as
human resources, management issues, functions and policies and practices that
result from the strategic activities of MNEs and that impact the international
concerns and goals of these enterprises.
Firms seeking to internalize their boards commence by selecting someone who is
similar culturally to existing members but has an international perspective. In the
next phase, firms look for individuals with in-depth business and cultural
experience in a given part of the world.
There are different types of expatriates such as the traditional expatriate;
international cadres; young, inexperienced expatriates; temporaries; expatriate
trainee; and virtual expatriate.
MNEs use expatriates to get the business off the ground, put in the infrastructure,
and, more importantly, have a plan to change the mix of expatriates versus
nationals.
Expatriate failure occurs when the assignee returns prematurely to the home
country or when his/her performance does not meet expectations.
MNEs look for several attributes in an expatriate including cultural empathy,
language skills, adaptability and flexibility, education, maturity, motivation, and
leadership.
Five determinants of cross-cultural adjustment include: previous overseas
experience; pre-departure cross-cultural training; multiple candidate, multiple-
criteria selection; individual skills and perceptual skills; and non-work factors
such as cultural distance and spouse and family adjustment.
MNE compensation programs focus on attracting and retaining qualified
employees, facilitating transfer between the headquarters and the affiliates,
creating consistency and equity in compensation, and maintaining
competitiveness.
There are three approaches to expatriate compensation – home-based, host-based,
and hybrid.
HR problems that can be expected in WOSs and IJVs include staffing friction,
blocked promotion, exile syndrome and reentry difficulties, split loyalty,
compensation gaps, blocked communication, limited delegation, information
screening, and unfamiliarity.
154
Global Human Resource Management
155
International Business
Contd…
country and the destination location). The expats are given information about the
culture of the destination country – particularly differences with the home country,
and social considerations and do‟s and don‟ts. If necessary, the employee and
his/her spouse are given training in the local language. Tessi Romell (Romell),
research and development projects and HR effectiveness leader at AstraZeneca,
said that the company also helps connect new expats with those who had already
served in that location.
Sometimes, follow-up workshops are held in the host country. Once on assignment,
expats stay in touch with their IA manager in addition to the manager they reported
back to in the home country. AstraZeneca sees to it that expats are given the
necessary flexibility for them to achieve a work/life balance.
With AstraZeneca taking various initiatives on this front, there have been few
complaints about work/life balance among the company‟s expat population. Romell
attributes this to the mechanisms the company has put in place to prepare the
employees for life in a different country. Experts too feel that the practices
followed by AstraZeneca, such as preparing the employees for international
assignments, providing them with support and assigning an IA manager are
effective. They laud AstraZeneca‟s practices, which are in contrast to those of
many companies that rush employees to foreign assignments without adequate
support. Chris Buckley, manager of international operations for St. Louis-based
Impact Group Inc., points out that the expats know that the organization is
spending a lot of money on them and might be wary about coming up with any
complaints regarding their new assignment with their boss. In such a scenario,
contact with the IA manager is useful as it can encourage them to open up.
With the economic situation around the globe continuing to be grim in 2009,
experts felt that organizations would be forced to take a relook at the costs
associated with international staffing. Some felt that organizations would send
fewer people on international assignments, or allot them to shorter terms abroad.
They even predicted that the high compensation and benefits generally associated
with foreign assignments could also see cuts. While AstraZeneca also took
measures to cut costs (specifically tax costs), by sending employees on short-term
assignments, Daly (Ashley Daly, senior manager of international assignments at
AstraZeneca noted that this was not always possible. When the expat had a family
and was being posted for a longer term, Daly pointed out that some of the elements
of AstraZeneca‟s expat packages, such as comprehensive destination support and
educational counseling for expatriate children, played a critical role in ensuring the
employee‟s productivity. These supports ensured that the expatriate family was
able to settle down in the host country. Not providing them could result in
employees not being able to focus on their new job, putting the company‟s
investment in risk. So, the company was not looking at this issue in terms of
expenditure alone. The company also did not have any plans to decrease the
number of its staff deployed internationally.
156
Concept Note - 8
2. Globalizing R&D
Globalizing R&D is “a process of locating and operating R&D laboratories in different
countries, under a coordinated and integrated system by the company’s headquarters, in
order to leverage the technical resources of each facility to further the company’s overall
technological capabilities and competitive advantage.” Globalizing R&D differs from
internalizing R&D. The former requires global integration of geographically dispersed
R&D units while internalizing R&D is an early stage of globalizing R&D, which
evolves as the international expansion of a firm grows larger and more complex in scope
and scale. The R&D function serves as the major avenue to build and sustain a
company’s global competitive advantage. MNEs with a well-defined strategy on
globalizing R&D tend to achieve superior sales and profit performance.
R&D intensity has increased at a steady pace in many industries such as
pharmaceuticals, electronics, chemicals, and medical equipment. While American
MNEs lead in innovation in many high-technology industries such as computers,
software, automobiles, healthcare, and advanced materials, MNEs from Europe,
Japan, Canada, and newly industrialized countries such as Israel, Taiwan, and Korea
also demonstrate a high level of R&D and incentive productivity. Of late, the number
of patents developed by MNEs worldwide has surged. The main thrust for global
firms has been to increase the patent output per unit of R&D spending.
Managing global R&D receives greater attention from international business managers
for three reasons: First, technology is recognized as a primary source of competitive
advantage. International R&D augments and expands the overall R&D process of the
firm. Second, the nature of the technological innovation process has changed.
Technological innovations are a result of the integration of technologies from different
disciplines. Countries differ in their competitive advantage and globalizing R&D
enables firms to tap these sources of strength. Third, time is a critical competitive factor
in many industries. R&D activities are decentralized for accelerating the process of
innovation and adaptation. Finally, the growth of network and information exchange
systems facilitates long-distance communication, which lowers the costs of coordination
that are associated with globalization of R&D activities.
International Business
158
Global Research and Development
Finally, globalizing R&D inevitably increases coordination and control costs. MNEs
may face coordination issues such as allocating research tasks among dispersed R&D
centers, developing products that are responsive to market needs in different countries,
and exchanging information among different R&D centers. The decentralized and
distant MNE R&D facilities increase the coordination and control costs. Lack of
coordination and control can lead to costly duplication of effort since different
facilities may not be completely aware of what other facilities are doing. In addition,
the cultural and business differences between home and host countries may intensify
the difficulties in running R&D activities abroad.
Despite these challenges, there is increased globalization of R&D activities as MNEs
have become more internalized. To derive the advantages of global R&D requires
design and structuring in the building phase and well-established systems of
coordination, management, communication, and control in the operational phase.
Managing global R&D activities is complex and difficult while formulating strategies
and policies that concern R&D dispersion and control. The global R&D system of a
firm should be structured to fulfill organizational needs while taking advantage of
external opportunities. Internally, the R&D function has to face the ongoing task of
coordinating and controlling across the firm’s international network of R&D
laboratories. Externally, corporate R&D creates and manages technical cooperation
with research consortia, universities, and even competitors to stay abreast of leading
edge developments. A firm also has to essentially manage critical areas such as
coordination and communication, technology transfer, human resource management,
and collaboration with local firms. Without such management, the economic return of
R&D dispersion cannot be ensured.
159
International Business
products in the European market. When indigenous technology units are designed to
serve a foreign market, they become locally integrated laboratories and involve some
of the basic developmental activities. The particular host-market may be considerably
diverse, fast-growing, large, and may need a nationwide R&D office for coordinating
and integrating host-country R&D activities.
Corporate technology units and global technology units are both globally
interdependent laboratories. These two laboratories provide inputs into a centrally
defined and coordinated R&D program with no essential connection with the
production operations of the host country. The function of these units is to focus on
research and development as opposed to improvement and adaptation. They do not
link to local manufacturing but to corporate and divisional R&D. Examples of
successful corporate technology are Eastman Kodak’s R&D unit in Australia and CPC
International’s R&D affiliates in Japan and Italy. IBM is known for establishing
several global technology units worldwide for developing a product or process that
will have universal applicability in all major local and foreign markets.
Specialized technology units are globally integrated yet individually differentiated
laboratories. These specialized units focus on specific technological areas defined by
headquarters. For instance, DaimlerChrysler has its corporate research center in
Germany. Its R&D center in Bangalore, India, emphasizes the development of
telematics, multimedia, and manufacturing solutions. In Shanghai, the automaker’s
joint R&D center was established to focus on microelectronics and electronic
packaging. These R&D activities are coordinated with microelectronics research in
Germany, and scientists are exchanged between China and Germany regularly.
Regional units focus on respective geographical areas as opposed to specialized units
that focus on specific technological areas.
As international expansion increases, the R&D unit may change over time, the R&D
subsidiary may grow, or the MNE’s strategy may change. The global R&D function
may evolve in stages, along with the extent of internationalization of the MNE. In the
initial stage, a firm may dedicate few technical resources abroad and maintain a highly
ethnocentric management group and domestically oriented management structures. As
its commitment to the foreign market grows, it builds up technical capabilities for
responding to local market conditions, either by modifying the partner’s products or
by generating products for sale in the local market. When the headquarters realizes
that the foreign laboratories have achieved a level of technical competence ahead of
the rest of the firm, it may switch the orientation of its foreign laboratories from the
host-country markets to the world market. The headquarters may assign new product
development projects to the foreign laboratories to take advantage of their specialized
technical skills.
3.2 Selecting R&D Location
Selecting an R&D location is a crucial and complex decision because external
parameters such as resource availability, market conditions, and government policies
differ across countries and even at locations within a country. Once a laboratory is
built, switching costs from one location to another are enormous.
First, location selection depends on the strategic role of an R&D subsidiary that is set
by the parent company. If the subsidiary is designed to serve the home market,
managers should take into consideration the availability of scientific knowledge and
talent from foreign universities. For a subsidiary that targets the world market,
160
Global Research and Development
161
International Business
The disadvantage of this structure is the lack of sensitivity to signals from overseas
markets and insufficient consideration of local market demands. MNEs select this
structure only if they manufacture global, standardized products and do not take into
consideration differentiating between foreign markets.
The polycentric decentralized R&D structure is characterized by a decentralized alliance
of R&D sites with no corporate R&D center for supervision. This structure contains
several indigenous technology units in major foreign markets. Foreign R&D laboratories
are highly autonomous with little incentive for sharing information with central R&D or
other R&D units. Foreign R&D laboratories emphasizes on product development
process in response to local consumer demands and localization requests. In this
structure, efforts to preserve autonomy and national identity may hinder cross-border
coordination, and thus lead to inefficiency on a corporate level and for duplication of
R&D activities. The firm may also lose its focus on a particular technology.
In the specialized laboratory structure, foreign R&D units are assigned global
directives. The aim is to enhance the global efficiency of the product development
process, concentrating on a single location the resources related to development
operations in a particular product category. This structure has specialized technology
units in respective product areas. When a leading market exists in terms of size and
presence of customers, the MNE assigns the global responsibility to develop and
manufacture the product to the laboratories and plants in that country. This approach
helps in achieving economies of scale in R&D and for placing the product
development operations close to the key customers of the company. The global
development laboratories are selected based on their proximity to the manufacturing
plants because there are costs involved in transferring R&D to a manufacturing plant
that is away from the R&D center.
The global center lab structure is used for leveraging on the company’s centralized
technical resources for creating new global products. Though it is also centralized, R&D
under this structure covers a broader market domain than R&D in the ethnocentric
centralized model. In this structure, there can be more than one global technology unit
for generating worldwide innovation. In this model, companies concentrate their
technical resources in the country of origin. To make this structure work, it is crucial to
create an effective market information network that provides an information flow from
the decentralized marketing or production units to the parent company. This helps the
central development laboratories to generate products suitable for the global market
and/or to adapt different product versions to individual markets.
The globally integrated network structure may be filled with a number of foreign
R&D units with different types and roles, such as the corporate technology unit, the
indigenous technology unit, the global technology unit, and the specialized technology
unit. In this model, home R&D is not the center of control for all R&D activities but
rather one among many interdependent R&D units that are interconnected by means
of varied and flexible coordination mechanisms. A central coordinating body
exercises the needed supervision for preventing duplication and integrating the diverse
contributions. Development processes which can be exploited across several markets
involve resources from different facilities whose work is coordinated according to a
common plan. Each unit in the network specializes in a particular component, product,
or technology area, and a set of core capabilities. At times, this unit takes a lead role
as a competence center and is then responsible for the entire value generation process.
162
Global Research and Development
163
International Business
164
Global Research and Development
The R&D staff at the headquarters often performs the role of boundary spanners
between the R&D laboratories that are dispersed. They travel to site location to share
development somewhere else in the global R&D network and for discussing progress
at the particular site. They may also divulge sensitive information across the network
about developments with joint venture partners, customers, or suppliers.
Informal Network
165
International Business
166
Global Research and Development
person to another and it establishes a common work-related and social context that
facilitates more learning and cooperation. Organizational bridges use dedicated
transfer teams for establishing more formal ties between organizational areas. These
groups are formed for building a more formal structure and common context for
effective experience transfer.
6. Summary
Globalizing R&D involves several benefits. First, globalizing R&D may offer a
vehicle for extracting benefits from the technical resources local expertise, and
scientific talent of the target country. Second, globalizing R&D may enhance the
competitive advantage of a firm. Finally, globalizing R&D may enable an MNE
to enjoy the benefits that arise from international division of labor in R&D among
multiple foreign countries or regions.
Globalizing R&D is a complex process that involves several challenges and
difficulties. First, maintaining minimum efficient scale in foreign R&D
operations is not always easy. Second, the leakage of proprietary knowledge
poses a serious threat when R&D is globalized. Finally, globalizing R&D
inevitably increases coordination and control costs.
With regard to the role of foreign R&D units, R&D subsidiaries can be
categorized into corporate technology units specialized or regional technology
units, global technology units, technology transfer units, and indigenous
technology units.
Selecting an R&D location is a crucial and complex decision because external
parameters such as resource availability, market conditions, and government
policies differ across countries and even at locations within a country.
The two crucial factors essential for structuring global R&D operations are (1) the
level of authority an MNE plans to offer to its foreign R&D activities and (2) the
scope of the geographical market to be covered.
The five models in structuring global R&D are ethnocentric centralized,
polycentric decentralized, specialized lab, global central lab, and the globally
integrated network.
The rapid dispersion of R&D laboratories in foreign markets have forced MNEs
to take a global view in managing their research operations through areas such as
human resource management, autonomy specification, global planning, and
communications improvement.
A common alternative for setting up a foreign-based R&D center or laboratory is
to enter into collaborative agreements or technology transfers with foreign
partners. This approach is attractive to firms or projects in need of large
investments which may involve high uncertainties.
167
International Business
Contd…
The R&D activities are incorporated at NESTEC, which offers technical assistance
to all operating units of Nestlé throughout the world. The company has several
researchers who work in many disciplines such as bioscience, food science, plant
science, food safety, food technology, and nutrition.
R&D management sets some research priorities that help in determining Nestlé’s
long-term competencies (category I projects), while Nestlé’s strategic business
units (SBUs) are responsible for prioritizing and monitoring R&D work linked to
new process and product developments (category II projects). The SBUs have close
working relationships with the R&D network as well as operating businesses, and
adopt a multifunctional approach for setting priorities. The R&D coordinators at
the SBUs are responsible for assigning the related research project to the most
competent R&D group within the network and also monitor the progress.
The R&D centers are instructed by NESTEC to take on additional responsibility as
product area managers for improving coordination across various R&D centers
working in the same product area. The product area manager leads the R&D groups
and also helps them in meeting their assigned tasks and deadlines.
168
Concept Note - 9
Consider the case of Britain and the US. Both have well-developed stock and bond
markets in which firms can raise capital by selling stocks and bonds to individual
investors. Most individual investors purchase a very small proportion of the total
outstanding stocks or bonds of a firm. The investors leave the task to professional
managers. But due to their lack of contact with the management of the firms in which
they invest, individual investors may not have the information needed to evaluate how
well the companies are performing. Individual investors generally lack the ability to
get information on management demand because of their small stake in the firms. The
financial accounting system in both Britain and the US evolved to cope with this
problem. In both countries, the financial accounting system is oriented toward offering
individual investors the information they require to make decisions about selling or
purchasing corporate stocks or bonds.
In countries such as Japan, Switzerland, and Germany, a few large banks satisfy most
of the capital needs of business enterprises. In these countries, the role of the banks
has been so important that a bank‟s officers often have seats on the boards of firms to
which it lends capital. In such circumstances, the information needs of the providers
of capital are satisfied in a straightforward manner through direct visits, personal
contacts, and information provided at board meetings. Consequently, though firms do
prepare financial reports, as government regulations in these countries mandate some
public disclosure of the financial position of the firm, the reports historically tend to
contain less information than those of the US or British firms. Because banks are
major capital providers, financial accounting practices are oriented toward protecting
a bank‟s investment. Hence, assets are valued conservatively and liabilities are
overvalued to offer a cushion for the bank in the event of default.
In still other countries, the national government has been a crucial capital provider,
and this has influenced accounting practices. This is the case in Sweden and France,
where the national government has often stepped in to make loans available or
invest in firms whose activities are deemed to be in the national interest. In these
countries, financial accounting practices are oriented toward the needs of
government planners.
170
Accounting in the International Business
171
International Business
2.5 Culture
The culture of a country has a major impact upon the nature of its accounting system.
Researchers have found that the degree to which a culture is characterized by
uncertainty avoidance has an impact on the accounting system. Uncertainty avoidance
refers to “the extent to which cultures socialize their members to accept ambiguous
situations and tolerate uncertainty.” Members belonging to a high uncertainty
avoidance culture give importance to career patterns, job security, retirement benefits,
etc. They also have a strong need for rules and regulations; the manager is expected to
give clear instructions and the initiatives of the subordinates are controlled tightly.
Lower uncertainty avoidance cultures are characterized by an increased readiness to
take risks and less emotional resistance to change. Research indicates that countries
with low uncertainty avoidance cultures tend to have strong independent auditing
professions that audit the accounts of the firms to ensure that they comply with
generally accepted accounting regulations.
172
Accounting in the International Business
firm based in that country. An investor based in Britain buying stock of General
Motors through the New York stock exchange is an example of transnational
investment.
The rapid expansion of transnational financing and transnational investment is
accompanied by a corresponding growth in transnational financial reporting. For
instance, a Danish firm raising capital in London should issue Danish financial
reports, in addition to the financial reports that serve the needs of its British investors.
However, a lack of comparability between accounting standards in different nations
can cause confusion. For instance, the German firm that issues two sets of financial
reports, one prepared under German standards and the other under US standards, may
find that the two reports show a significant difference in its financial position, and its
investors may have difficulty in identifying the true worth of the firm.
In addition to the problems related to lack of comparability faced by the investors, the
firm has to explain to its investors why its financial position looks so different in the
two accountings. Also, an international business may find it difficult to evaluate the
financial positions of key foreign suppliers, customers, and competitors.
3.2 International Standards
Many companies raise money from capital providers across national borders. The
providers demand consistency in the way in which financial reports are reported to
that they can make informed decisions. Also, adoption of common accounting
standards facilitate the development of global capital markets, since more investors
will be willing to make investments across borders, and the end result will be to lower
the cost of capital and stimulate economic growth. Thus, accounting standards were
standardized across national borders in the best interests of the participants in the
world economy.
Formed in March 2001, the International Accounting Standards Board (IASB) has
emerged as a proponent of standardization. The IASB replaced the International
Accounting Standards Committee (IASC), which was established in 1973. The IASB
is responsible for formulating new international financial reporting standards. By
2005, the IASC and the IASB had issued 41 international accounting standards. For a
new standard to be issued, 75 percent of the members of the IASB must agree. It can
be difficult to get three-quarters agreement as members come from different cultures
and legal systems. The IASB offers two acceptable alternatives to get around this
problem.
Another hindrance to the development of international accounting standards is that
compliance is voluntary; the IASB has no power to enforce the standards. Despite
this, the support for IASB and recognition of its standards has been growing.
The impact of IASB standards has been least noticeable in the US as most of the
IASB standards are consistent with opinions already articulated by the US Financial
Accounting Standards Board (FASB). The FASB writes the generally accepted
accounting principles (GAAP) by which the financial statements of US firms should
be prepared. By contrast, the IASB standards have had a significant impact on many
other countries as they have eliminated a commonly used alternative.
EU also has substantial influence on the harmonization of accounting standards. The
EU mandates its accounting principles in its member countries.
173
International Business
174
Accounting in the International Business
In the current rate method, the exchange rate as on the balance sheet date is used for
translating the foreign subsidiary‟s financial statements into the MNE‟s home
currency. Though this seems logical, it is incompatible with the historic cost principle,
which is a generally accepted principle in accounting followed in many countries. For
instance, a US firm invests US$ 100,000 in a subsidiary in Malaysia. Assume the
exchange rate at that time is 1 US$ = 5 Malaysian ringgit. The subsidiary converts the
US$ 100,000 into ringgit to make it 500,000 ringgit and buys land with this money.
Subsequently, if the dollar rate depreciates against the ringgit, so that by the year end
1US$ = 4 ringgit and if this exchange rate is used for converting the value of the land
in dollars for preparing consolidated accounts, the land will be valued at US$ 125,000.
The land value appears to have increased by US$ 25,000, though in reality the
increase will be a function of the change in exchange rate. Therefore, the consolidated
accounts present a misleading picture.
The Temporal Method
The temporal method avoids the problem encountered in the current rate method. The
temporal method translates the value of the assets in a foreign currency into the
currency of the home country using the exchange rate that exists when the assets are
purchased. Though the temporal method ensures that the dollar value of the land does
not fluctuate due to changes in exchange rates, it has its own problems. As the various
assets of the subsidiary will in all probability be acquired at different points of time
and because exchange rates rarely remain stable for a long time, different exchange
rates would need to be used for translating the foreign assets into the MNE‟s home
currency.
4.3 Current US Practice
US-based multinationals should follow the requirements of Statement 52, “Foreign
Currency Translation” issued in 1981 by the Financial Accounting Standards Board.
Under Statement 52, a foreign subsidiary is classified either as an autonomous, self-
sustaining subsidiary or as being integral to the activities of the parent firm.
According to Statement 52, the local currency of the foreign subsidiary, which is self-
sustaining, should be its functional currency. For such subsidiaries, the balance sheet
is translated into the home currency using the exchange rate at the end of the financial
year of the firm, whereas the income statement is translated using the average
exchange rate for the firm‟s financial year. On the other hand, for an integral
subsidiary, the functional currency would be in US dollars. The financial statements
of integral subsidiaries are translated at various historic rates using the temporal
method, and the swinging debit or credit increases or decreases consolidated earnings
for the period.
175
International Business
The head office monitors the performance of the subunit against the agreed goals.
In case any subunit fails to achieve its goals, the head office intervenes to learn
the reason for the shortfall and also takes corrective action when appropriate.
In this process, the accounting function plays a critical role. Most of the subunit goals
are expressed in financial terms and are embodied in the budget of the subunit for the
coming year. The main instrument for financial control is the budget. The budget is
usually prepared by the subunit but has to be approved by the management at the
headquarters.
During the budget approval process, the managements at the headquarters as well as
the subunit debate the goals that need to be incorporated into the budget. A function of
the headquarters‟ management is to ensure that the budget of the subunit contains
challenging but realistic goals. After the budget has been approved, accounting
information systems collect the data throughout the year in order to evaluate the
subunit‟s performance against the goals set in the budget.
In international business, most of the subunits of the firm are foreign subsidiaries.
Thus the performance goals for the coming year are set by negotiation between the
corporate management and the managers of foreign subsidiaries. The most important
criterion for evaluating a foreign subsidiary‟s performance is comparing the actual
profits with the budgeted profits. This is closely followed by a comparison of actual
sales to budgeted sales and its return on investment. The same criteria can be used for
evaluating the performance of the subsidiary managers.
5.1 Exchange Rate Changes and Control Systems
Most international businesses require all budgets and performance data within the firm
to be expressed in the corporate currency, which is normally the home currency. For
instance, the Malaysian subsidiary of a multinational firm in the US would submit its
budget in US dollars as opposed to the Malaysian ringgit and performance data would
be reported to the headquarters in US dollars. This facilitates comparisons between
subsidiaries in different countries and makes things easier for the management at the
headquarters. However, it also allows changes in exchange rates to introduce
substantial distortions. For instance, the profit goals of the Malaysian subsidiary may
not be attained not due to any problems in its own performance but due to a decline in
the value of the ringgit against the dollar. The opposite can also occur, making the
performance of the foreign subsidiary look better than it actually is.
The Lessard-Lorange Model
A research study by Donald Lessard and Peter Lorange suggest that several methods
are available to international businesses for dealing with this problem. Lessard and
Lorange point out three exchange rates for translating foreign currencies into the
corporate currency in setting budgets and in performance tracking:
The initial rate, which is the spot exchange rate when the budget is adopted.
The projected rate, which is the spot exchange rate forecast for the end of the
budget period (i.e. forward rate).
The ending rate, which is the spot exchange rate when the budget is compared
with performance.
176
Accounting in the International Business
Lessard and Lorange recommend that firms use the projected spot exchange rate for
translating both the budget and the performance figures into the corporate currency.
The projected rate will be the forward exchange rate as determined by the foreign
exchange market or some company-generated forecast of future spot rates, referred to
as the internal forward rate. The internal forward rate might vary from the forward
rate quoted by the foreign exchange market if the firm wishes to bias its business
against or in favor of the particular foreign currency.
5.2 Transfer Pricing and Control Systems
The global strategy and the transnational strategy give rise to a globally dispersed web
of productive activities. Firms that pursue these strategies disperse each value creation
activity to its optimal location in the world. Thus a product can be designed in one
country, some of its components can be manufactured in a second country, other
components can be manufactured in a third country and assembled in a fourth country,
and then sold across the globe.
The intra-firm transaction volumes will be very high in such companies. The firms
ship component parts and finished goods between subsidiaries in different countries
on a continuous basis. “The price at which such goods and services are transferred is
referred to as the transfer price.”
The choice of transfer price may have a critical effect on the performance of two
subsidiaries that exchange goods or services. When budgets are set and performance
of the subsidiary is reviewed, corporate headquarters need to keep in mind the
distorting effect of transfer prices.
International businesses manipulate their transfer prices often to minimize import
duties, minimize their worldwide tax liability, and avoid government restrictions on
capital flows.
5.3 Separating Subsidiary and Manager Performance
In many international businesses, the same quantitative criteria are used for evaluating
the performance of both the foreign subsidiary and its managers. However, many
accountants argue that while it is legitimate to compare subsidiaries against each other
based on return on investment (ROI) or other indicators of profitability, it may not be
suitable to use these to compare and evaluate the managers belonging to different
subsidiaries. Foreign subsidiaries operate in an environment that has different
political, social, and economic conditions that have an influence on the costs of doing
business in a country and the profitability of the subsidiary. Thus, it is suggested that
evaluation of a subsidiary should be separated from the evaluation of its managers.
The evaluation of the managers should take into consideration how benign or hostile
the country‟s environment is for that business. Also, managers should be evaluated in
terms of local currency after making allowances for items over which they do not
have any control (e.g. tax rates, interest rates, transfer prices, inflation rates, and
exchange rates).
6. Summary
Accounting is shaped by the environment in which it operates. Countries have
different accounting systems just as they have different economic systems,
political systems, and cultures.
177
International Business
178
Accounting in the International Business
Contd…
nine-month suspended prison sentences and a fine of €220,000 each. The European
executive board member of Ahold, Jan Andreae (Andreae) received a four-month
suspended sentence and a fine of €120,000.
Of the total accounting fraud that led to the reduction in Ahold‟s pre tax earnings to
the tune of US$ 966 million, Ahold‟s wholly-owned subsidiary US Foodservice
(USF) accounted for about US$ 856 million. USF was the second largest
foodservice distributor in the US. In February 2003, after Ahold announced that the
earnings of USF for the financial year 2000 and 2001 had been overstated, its shares
fell by more than 65 percent to a 15-year low of €3.43 on February 24, 2003. The
market capitalization of Ahold plunged to €3.3 billion in February 2003 from €30
billion in the end of 2001. The media was quick to term Ahold „Europe‟s Enron,‟
while analysts downgraded the company‟s stock.
Immediately after the accounting irregularities in USF were reported by Deloitte, on
February 12, 2003, the company authorized an investigation by law firm White &
Case LLP and by forensic accounting advisors from Protiviti Inc. In March 2003,
Morvillo, Abramovitz, Grand, Iason and Silberberg PC (Morvillo) and
PricewaterhouseCoopers (PWC) conducted additional investigations of the accounts
of USF. SEC also conducted a probe on the accounting irregularities at Ahold.
PWC concluded that Ahold did not have a good internal control system in place. As
Ahold expanded globally, it had not given adequate priority to setting up strict
financial and accounting controls. The company had several divisional operations
without proper control or monitoring mechanisms in place. The company did not
document the policies and procedures for review and supervision. There were
several IT systems (more than 27 IT platforms) in the company, many of which
were not documented. Adequate communication between the division and corporate
staff was lacking and the quality of accounting staff was not uniform. PWC
reported that the system followed in booking a promotional allowance at USF was
highly opaque. The senior management at USF was blamed for failing to put in
proper internal controls and systems to track promotional allowance. USF had a
weak internal control mechanism.
USF was blamed for not revealing the existence of written contracts with suppliers
and for informing Deloitte that no written contracts existed, though such contracts
did exist. In its forensic audit, PWC found around 151 written agreements between
USF and its suppliers. The audit report also highlighted corrupt practices that some
of the employees of USF had indulged in. The company‟s determination of the
promotional allowance rate, which could not be verified, was cited as the main
reason for the false increases in reported earnings.
In the interim report of Morvillo submitted on April 25, 2003, it was alleged that
Miller (Jim Miller, President & CEO, USF) and Resnick (Michael Resnick, CFO,
USF), did not have adequate control over the operations of USF and that they had
paid no attention at all to the way promotional allowances were accounted. They
were blamed for not implementing proper control mechanisms and accounting
systems in the company.
Contd…
179
International Business
Contd…
180
Concept Note - 10
2. Investment Decisions
When a firm is considering investing in activities in any country, it should take into
account many political, economic, cultural, and strategic variables before arriving at a
decision. A significant role of the financial managers in international business is to
make attempts to quantify the various benefits, costs, and risks that may flow from an
investment in a given location. This can be done by making use of capital budgeting
techniques.
2.1 Capital Budgeting
As mentioned, the benefits, costs, and risks of an investment can be quantified using
capital budgeting techniques. This helps managers to compare different alternatives of
investment within and across countries in order to make informed choices about
where the firm should invest its scarce financial resources. The theoretical framework
used in capital budgeting for a foreign project is the same as that used in a domestic
project. That is, the firm has to estimate the cash flows with the project over time. In
most cases, the cash flows will be negative first because the firm invests heavily in
production facilities. However, after some time, they will become positive as revenues
grow and investment costs decline. After estimating the cash flows, they have to be
discounted using an appropriate discount rate to know the net present value. The
commonly used discount rate is either the cost of capital of the firm or some other
required rate of return. If the net present value of the discounted cash flows is greater
than zero, the firm should go ahead with the project.
Capital budgeting is a complex process. There are several factors complicating the
process for international businesses. Some of them are:
A distinction has to be made between cash flows to the parent company and cash
flows to the project.
International Business
Economic and political risks, including risks associated with foreign exchange,
can significantly change the foreign investment value.
The connection between the source of financing and cash flows to the parent
company needs to be recognized.
2.2 Parent and Project Cash Flows
A theoretical argument exists for analyzing any foreign project from the parent
company’s perspective because cash flows to the project are essentially not the same
as cash flows to the parent company. The project may not have the ability to remit all
the cash flows to the parent company for several reasons. For instance, the repatriation
of cash flows may be blocked by the government of the host country; the cash flows
may be taxed at an unfavorable rate, or the host government may require a certain
percentage of the cash flows from the project to be reinvested in the host country.
Though these restrictions do not affect the project’s net present value, they do affect
the net present value of the project to the parent company as they limit the cash flows
that can be remitted to it from the project.
When a parent firm evaluates a foreign investment opportunity, it should be interested
in the cash flows it will receive as opposed to the cash flows generated by the project
because those are the basis for dividends to stockholders, repayment of worldwide
corporate debt, investment somewhere else in the world, etc. Stockholders do not
perceive blocked earnings as contributing to the value of the firm, and creditors do not
count those earnings when calculating the ability of the parent to service its debt.
The issue of blocked earnings is not very serious. The greater acceptance of free
market economics has reduced the number of countries in which governments may
prohibit the foreign multinational’s affiliates from remitting cash flows to their parent
companies.
2.3 Adjusting for Political and Economic Risk
When analyzing a foreign investment opportunity, firms should consider the political
and economic risks stemming from the foreign location.
Political Risk
Political risk is defined as “the likelihood that political forces will cause drastic
changes in a country’s business environment that hurt the profit and other goals of a
business enterprise.” Political risk is greater in countries that experience social unrest
or disorder and in countries where the fundamental nature of the society makes the
probability of social unrest high. When political risk is high, there is a high probability
that change will take place in the political environment of a country that will endanger
the foreign firms there.
Political and social unrest may sometimes result in economic collapse, which can
render the assets of a firm worthless. In less extreme cases, political changes may
result in increased tax rates, the imposition of price controls, the imposition of
exchange controls that limit or block the ability of a subsidiary to remit earnings to its
parent company, and the interference of government in existing contracts.
Many firms pay considerable attention to political risk analysis and to quantifying
political risk. The problem with forecasting political risk is that the firms try to predict
a future and in most cases the guesses are wrong.
182
Financial Management in International Business
Economic Risk
Economic risk can be defined as “the likelihood that economic mismanagement will
cause drastic changes in a country’s business environment that hurt the profit and other
goals of a business enterprise.” The biggest problem arising from economic
mismanagement is inflation. Price inflation leads to a drop in the value of the currency
of a country on the foreign exchange market. This can be a major problem for foreign
firms with assets in that country because the value of the cash flows the firm receives
from those assets will fall as the currency of the country depreciates on the foreign
exchange market. This decreases the attractiveness of foreign investment in that country.
There have been many attempts to quantify the economic risk of a country and long-
term movements in their exchange rates. There have been several empirical studies
done of the relationship between the inflation rates of countries and the exchange rates
of their currencies. The studies showed a long-run relationship between the country’s
relative rates of inflation and exchange rate changes. However, the relationship is not
reliable in the short run and totally unreliable in the long run. So, as with political
risks, the attempts to quantify economic risk were tempered with healthy skepticism.
2.4 Risk and Capital Budgeting
When analyzing a foreign investment opportunity, the additional risk stemming from
its location can be handled in at least two ways. The first method is to treat all kinds of
risks as one problem by increasing the discount rate that is applicable to foreign
projects in countries where political and economic risk are perceived to be high. The
higher the discount rate, the higher the projected net cash flows should be for any
investment to have a positive net present value.
The second method is adjusting discount rates to reflect the riskiness of a location. For
instance, several studies of large US multinationals have found that many of them add a
premium percentage for risk to the discount rate they use in the evaluation of potential
foreign investment projects. For any investment decisions, the political and economic
risk being evaluated is not of immediate possibilities, but rather at some distance in the
future. Thus, it can be argued that rather than using a high discount rate to evaluate such
risky projects, it is better to revise future cash flows from the project downward to
reflect the possibility of adverse political or economic changes sometime in the future.
3. Financing Decisions
An international business should take into consideration some factors when
considering its options for financing. The first factor is how the foreign investment
will be financed. If the firm requires external financing, it should decide whether to
borrow from the host country’s sources or tap the global capital market for funds. The
second factor is how to configure the financial structure of the foreign affiliate.
3.1 Financing Decisions and the Global Capital Market
A capital market brings together those who want to make investments and those who
want to borrow money. Corporations with surplus cash, non-bank financial
institutions, and individuals make investments in the capital market. Individuals,
companies, and governments borrow money from the capital market. The global
capital market benefits borrowers by increasing the supply of funds available for
borrowing, which lowers the cost of capital for the firm.
183
International Business
Capital market loans offered to corporations are either equity loans or debt loans. An
equity loan is made when a corporation sells its stock to investors. The money the
corporation receives in return for its stock can be used for purchasing plants and
equipment, paying wages, funding R&D projects, etc. A share of stock gives the
holder a claim to the profit stream of the firm. Corporations honor the claim by paying
dividends to the stockholders. The dividend amount is not fixed in advance; rather, it
is determined by the management based on the profits made by the corporation.
Investors purchase stock for the dividends that they will yield and in anticipation of
gains in the stock price, which in theory reflects future dividend yields. Thus,
investors purchase equity in firms that do not currently issue dividends to stockholders
because they anticipate that the firm will do so at some point. Stock prices increase
when a corporation is projected to have higher earnings in the future, which increases
the probability that it will increase dividend payments in future.
A debt loan requires the corporation to repay a predetermined portion of the loan
amount at regular intervals regardless of how much profit the corporation is making.
Management has no discretion as to the amount it will pay its investors. Debt loans
include cash loans from banks and funds raised from the sale of corporate bonds to
investors. When a corporate bond is purchased by an investor, he/she purchases the
right to receive a specified fixed income stream from a corporation for a specific
number of years, i.e., until the bond matures.
3.2 Lowering Capital Costs
In a domestic capital market, the pool investors are limited to the country residents.
This places an upper limit on the funds supply available to borrowers i.e. the liquidity
of the market is limited. A global capital market, which has a larger pool of investors,
offers a larger supply of funds for borrowers to draw on.
Perhaps the most crucial drawback of the limited liquidity of a domestic capital
market is that the cost of capital tends to be higher than it is in an international market.
The cost of capital is “the price of borrowing money, which is the rate of return that
borrowers must pay investors.” This is the rate of interest on debt loans and the
dividend yield and expected capital gains on equity loans. The limited pool of
investors in a domestic market implies that borrowers should pay more in order to
persuade investors to lend them their money. The larger pool of investors in an
international market implies that borrowers will be able to pay less.
The greater pool of resources in the global capital market leads to greater liquidity.
Thus the global capital market lowers the cost of capital for borrowers.
3.3 Growth of the Global Capital Market
The global capital market is growing rapidly, increasing the opportunities for firms to
lower their capital costs by accessing the market.
The international capital market boomed in the 1980s due to advances in information
technology and governments deregulations through the world, especially the western
markets and the Far East. The financial services industry is information-intensive,
drawing on large volumes of information about markets, risks, interest rates, exchange
rates, credit worthiness, etc. This information is used by the financial services industry
to make decisions on what to invest where, how much the borrowers should be
charged, how much interest should be paid to the depositors, and the value and
riskiness of several financial assets including stocks, corporate bonds, currencies, and
government securities.
184
Financial Management in International Business
The financial services industry is the most tightly regulated of all industries.
Governments worldwide have kept financial services firms of other countries from
entering the capital markets. In some cases, they have also restricted the overseas
expansion of their domestic financial services firms. In many countries, the domestic
financial services industry is segmented by law. For instance, in the US, commercial
banks were prohibited from performing the functions of investment banks and vice
versa. Historically, many countries have limited foreign investors’ ability to purchase
significant equity positions in domestic companies.
Many of these restrictions have been done away with since the early 1980s with a
series of changes that allowed foreign banks to enter the US capital market and
domestic banks to expand to expand their operations overseas.
3.4 Source of Financing
When a firm seeks external financing for a project, it will want to borrow funds from
the lowest-cost capital source available. Firms are increasingly moving toward the
global capital market to finance their investments. The cost of capital in the global
capital market is lower by virtue of its size and liquidity, than in domestic capital
markets, especially those that are small and relatively illiquid. For instance, a US firm
making an investment in Denmark may finance the investment by borrowing through
the London-based Eurobond market as opposed to the Danish capital market.
Despite the trends toward deregulation of financial services, in some cases, the
restrictions of the host country’s government may rule out this option. The
governments of some countries prefer foreign multinationals to finance projects in
their country by local sales of equity or local debt financing. In countries where there
is limited liquidity, this increases the cost of capital used for financing a project. Thus,
in capital budgeting decisions, the discount rate needs to be adjusted to reflect this.
However, some governments court foreign investment by providing foreign firms with
low-interest loans, thus lowering the capital cost. Accordingly, in capital budgeting
decisions, the discount rate should be revised downward in such cases.
In addition to the impact of host government policies on financing decisions and the
cost of capital, the firm may consider local debt financing for investments in countries
where the local currency is expected to depreciate on the foreign exchange market.
When a country’s currency depreciates, the amount of local currency needed to meet
interest payments and retire principal on local debt obligations is not affected.
However, if the foreign debt obligations have to be served, the amount of local
currency needed for doing this will increase as the currency depreciates, and this
effectively raises the cost of capital. Thus, though the initial capital costs may be
greater with local borrowing, it might be better to borrow locally in case the local
currency is expected to depreciate on the foreign exchange market.
3.5 Financial Structure
Different countries have a different financial structure for firms. Financial structure
refers to “the mix of debt and equity used to finance a business.” For instance,
Japanese firms rely more on debt financing than most US firms.
A possible explanation for why the financial structures of firms vary across countries
is that different tax regimes determine the relative attractiveness of equity and debt in
a country. However, empirical research shows that country differences in financial
structure are not related systematically to country differences in tax structure. Another
possibility is that the country differences may reflect cultural norms.
185
International Business
International businesses should decide whether they should conform to local capital
structure norms. A significant advantage of conforming to debt norms of the host-
country is that management can more easily evaluate its return on equity relative to local
competitors in the same industry. Conforming to host-country debt norms can also
enhance the image of foreign affiliates that operate with too little debt and thus appear
sensitive to local monetary policy. The best recommendation is that an international
business needs to adopt a financial structure for each foreign affiliate that minimizes its
cost of capital irrespective of whether that structure is consistent with local practice.
186
Financial Management in International Business
subsidiaries. Firms can use transfer prices and fronting loans to minimize their global
tax liability. In addition, the form in which income is remitted from a foreign
subsidiary to the parent company can be structured in order to minimize the global tax
liability of the firm.
Some firms use tax havens such as Bermuda and the Bahamas to minimize their tax
liability. A tax haven is a country with exceptionally low or even no income tax.
International businesses avoid or defer income taxes by setting up a wholly-owned
non-operating subsidiary in the tax haven. The tax haven subsidiary owns the common
stock of the operating foreign subsidiaries, which allows for transferring funds from
foreign subsidiaries to the parent company by funneling them through the tax haven
subsidiary. The tax levied on foreign source income by the home government of the
firm can be deferred under the deferral principle until the tax haven subsidiary pays
the dividend to the parent. This dividend payment can be indefinitely postponed if the
foreign subsidiaries continue to grow and require new internal financing from the tax
haven affiliate.
187
International Business
Royalties and fees have some tax advantages over dividends, particularly when the
corporate tax rate is higher in the host country than in the home country. Royalties and
fees are tax-deductible locally, so arranging for payments in royalties and fees reduces
the tax liability of the foreign subsidiary. If a foreign subsidiary provides the parent
company dividend payments as compensation, local income taxes need to be paid
before the dividend distribution, and withholding taxes should be paid on the dividend
itself. Though the parent company can offer a tax credit for the local withholding and
income taxes it has paid, a portion of the benefit would be lost is the combined tax
rate of the subsidiary is higher than that of the parent.
6.3 Transfer Prices
In any international business, a large number of goods and services are transferred
between the parent company and foreign subsidiaries and between subsidiaries. This
usually happens in firms pursuing global and transnational strategies because these
firms are likely to have dispersed their value creation activities to various locations
around the globe. “The price at which goods and services are transferred between
entities within the firm is referred to as the transfer price.”
Transfer prices can be used for positioning funds within an international business. For
instance, funds can be moved out of a country by setting high transfer prices for goods
and services that are supplied to a subsidiary in that country and by setting low
transfer prices for the goods and services sourced from that subsidiary. This
movement of funds takes place between the subsidiaries of the firm or between the
parent company and a subsidiary.
Benefits of Manipulating Transfer Prices
The benefits derived from manipulating transfer prices include the following:
1. The firm can reduce its tax liabilities by making use of transfer prices for shifting
earnings from a high-tax country to a low-tax country.
2. Firms use transfer prices for moving funds out of a country where significant
devaluation in currency is expected, thereby reducing its exposure to foreign
exchange risk.
3. Firms use transfer prices for moving funds from a subsidiary to the parent
company when financial transfers in the form of dividends are blocked or
restricted by the polices of the host government.
4. Firms can use transfer prices for reducing the import duties it has to pay when an
ad valorem tariff is in force – tariff that is assessed as a percentage of value. In
such cases, low transfer prices on goods and services being imported into the
country are required. Since this lowers the value of the goods or services, it
lowers the tariff.
Problems of Transfer Pricing
Significant problems are associated with transfer pricing policies. When transfer
prices are used for reducing the tax liabilities or import duties of a firm, governments
feel that they are being cheated of their legitimate income. When transfer prices are
manipulated for circumventing government restrictions on capital flows, governments
perceive this as breaking the spirit of the law, if not the law itself. Many governments
188
Financial Management in International Business
189
International Business
should hold its cash balances or whether cash balances should be held at a centralized
depository. Firms generally prefer to hold cash balances at a centralized depository for
three reasons. First, by centrally pooling the cash reserves, the firm can deposit larger
amounts. Usually cash balances are deposited in liquid accounts such as overnight
money market accounts. As interest rates on such deposits increase with the size of the
deposit, the firm should be able to earn a higher interest rate than it would if each
subsidiary managed its own cash balances.
Second, if the centralized depository is located in a major financial center such as
London, Tokyo, or New York, it should have access to information about good short-
term investment opportunities that are lacking in a typical foreign subsidiary. The
financial experts at the centralized depository must have the ability to develop
investment skills and know-how that are lacking in managers in a typical foreign
subsidiary. Hence, the firm would make better investment decisions if it pools its cash
reserves at a centralized depository.
Third, pooling cash reserves helps a firm in reducing the total size of the cash pool it
should hold in highly liquid accounts, which enables the firm to invest cash reserves
in large amounts in longer-term, less liquid financial instruments that earn a high rate
of interest.
The ability of a firm to set up a centralized depository that can serve short-term cash
needs may be limited by restrictions imposed by governments on flow of capital
across borders. The advantages of this system are also limited by transaction costs of
moving money into and out of different currencies. Despite this, many firms hold
precautionary cash reserves at the centralized depository, having each subsidiary hold
its own day-to-day-needs cash balance. The trends likely to increase the use of
centralized depositories are globalization of the world capital market and the general
removal of barriers for free cash flow across borders.
7.2 Multilateral Netting
Multilateral netting allows a multinational firm to reduce its cost of transaction that
arises when many transactions take place between its subsidiaries. These transaction
costs are the commissions paid to foreign exchange dealers for foreign exchange
transactions and the fees charged by banks for transferring cash between locations.
The volume of such transactions is high in firms that have a globally dispersed web of
independent value creation activities. Multilateral netting reduces the costs of
transaction by reducing the number of transactions.
Multilateral netting is an extension of bilateral netting. Under bilateral netting, if a
French subsidiary owes US$ 6 million to a Mexican subsidiary, for instance, and the
Mexican subsidiary owes US$ 4 million to the French subsidiary, a bilateral
settlement will be made with a single payment of US$ 2 million from the French
subsidiary to the Mexican subsidiary cancelling the remaining debt.
Under multilateral netting, the transactions take place between multiple subsidiaries
within an international business. Consider a firm establishing multilateral netting
among four Asian subsidiaries based in China, Taiwan, South Korea, and Japan.
These subsidiaries trade with each other and at the end of the month a large
transaction volume needs to be settled. If US$ 43,000 is required to flow among the
subsidiaries, the amount can be reduced by multilateral netting. The firm can
determine the payments to be made among its subsidiaries for settling these
190
Financial Management in International Business
obligations. Multilateral netting reduces the transactions to just three; the Korean
subsidiary pays US3 million to the subsidiary in Taiwan; and the Chinese subsidiary
pays US$ 1 million to the Japanese subsidiary and US$ 1 million to the Taiwanese
subsidiary. The total funds are reduced to just US$ 5 million from US$ 43 million,
and the transaction costs are reduced to US$ 50,000, a savings of US$ 380,000 is
achieved through multilateral netting.
8. Summary
A decision to make investments in activities in any country should consider many
political, economic, cultural, and strategic variables.
An international business should take into consideration some factors when
considering its options for financing. The first factor is how the foreign
investment will be financed. The second factor is how to configure the financial
structure of the foreign affiliate.
Money management decisions make attempts to manage the global working
capital in the most efficient manner, especially the firm’s cash resources.. This
involves minimizing cash balances and reducing transaction costs.
Different countries have different tax regimes. Many nations follow the
worldwide principle that they have the right to tax income earned outside their
boundaries by entities based in their country.
International businesses use many techniques to transfer liquid funds across
borders. These include dividend remittances, royalty payments and fees, transfer
prices, and fronting loans.
Firms make use of two money management techniques for managing their global
cash resources efficiently – centralized depositories and multilateral netting.
191
International Business
Contd…
while the value of technology and expertise contributed by Black Sea was
significantly less than US$ 40 million. The new owners also found that the licenses
were owned by Tyumen and therefore Black Sea had no right to the resulting oil
production. The issue was taken to court by Tyumen who subsequently won.
Consequently, Black Sea had to back out from the deal. According to Black Sea, by
legal maneuvering, Tyumen had expropriated Black Sea’s investment in the Tura
JV. The Tyumen management, however, maintained that the company had behaved
in a legal manner.
192
Concept Note - 11
3. E-Readiness
McConnell International has developed a classification of e-readiness factors that
includes connectivity, e-leadership, information security, human capital, and e-
business climate.
International Business
3.1 Connectivity
Connectivity is the existence and affordability of a transportation and communication
network. The US is less competitive when it comes to telephone systems. In China,
Israel, Japan, and Germany, all phones are connected to digital exchanges as against
about 90 percent in the US.
The cost of Internet access is prohibitive in countries such as most of those in Latin
America. In the UK, the low cost of a dial-up connection has much to do with the
remarkable increase in Internet usage.
Another facet of connectivity is distribution. The wide variety of overnight and
ground delivery services in the US are either unavailable or very expensive in many
parts of the world. In developing countries such as China, conventional ground
distribution is also problematic outside a few urban areas. Products are delivered by
bicycles or by pedicarts. The cash is collected upon the product being delivered.
194
Global Internet and E-Commerce
195
International Business
SMIEs have taken advantage of the new opportunities. Latinexus is a Latin American
electronic marketplace that aims to offer an even playing field for SMIEs by providing
them with the same cost benefits and broad audiences available to blue chip firms.
Some SMIEs piggyback on intermediaries such as L L Bean and Amazon in order to
reach international customers.
However, where physical goods are concerned, barriers in the form of logistic
challenges in dealing with dispersed and multiple customers remain significant for the
smaller firm. Size and volume matter even more in an e-commerce operation. The
handling of a large and diverse number of customers might lie beyond the ability of
many SMIEs that lack managerial and strategic capabilities.
4.3 Prospects for Intermediaries
Initially, it was believed that the Internet would make intermediaries superfluous,
however the impact diverged. The number of intermediaries has been reduced for
digitalized products as well as services such as retail, brokerage, and auctions.
However; intermediaries have remained rooted in other areas. A new breed of value-
adding intermediaries have emerged which are no longer involved in the physical
distribution of goods, but are very much present in the coalition, collection,
interpretation, and dissemination of vast amounts of information.
4.4 Other Impacts
The impact of e-commerce extends to other realms as well. For instance, it has made it
difficult to determine the origin of a product or a service, with concomitant
implications for tariffs, taxation, and customers. This is because the manufacturer, the
server, and the physical distributor may be located in different countries. E-commerce
should speed up the mobility of people as a production factor. Jobs in customer
service and back-office may shift to lower-cost countries, particularly where language
is not an obstacle (e.g. from the US to Ireland, India, and Canada).
196
Global Internet and E-Commerce
Logistics is a key area where many firms have failed to make the adjustments
necessary in terms of global e-commerce or in terms of customizing the system for
dealing with the requirements of a particular country.
5.3 Taxation Issues
The Supreme Court in the US ruled that states do not require an out-of-state firm to
collect sales tax on goods coming into the state unless the (?) firm has a “nexus” or
physical presence within the state. Some states suggested that local Internet service
providers should be considered as electronic retailers and be subject to local taxation.
In the international arena, the implications of e-commerce taxation are more ominous.
While cross-border catalog sales have existed for many years, they have not generated
ay substantial interest among governments. All this has changed with the advent of e-
commerce. In the EU, value-added taxes range from 15 to 25 percent, which means
(?) a major portion of government revenues are at risk. A website is not considered as
a fixed business place that could trigger taxation. It could be subject to taxation if it is
in conjunction with a server location and other operations in the country. E-commerce
197
International Business
makes it easy for MNEs to shift their domicile to low-tax locations and to offshore tax
havens as it makes it difficult for other countries to claim the physical presence of the
firm in their territory. In such an environment, problems such as transfer pricing
become acute.
Other taxation issues also arise because of the Internet. For instance, the distinction
between income and royalty taxation is difficult to determine when a customer
downloads software from a vendor. Individual income tax might be avoided in
countries which have a territorial tax base, whereas countries with a global taxation
base, such as the US, might find it difficult to enforce their tax legislation.
The e-commerce tax represents a significant challenge for the MNE as well as the
SMIE. The MNEs can employ various tax strategies to meet this challenge. Additional
strategic opportunities such as placing servers in areas of low-tax jurisdiction are
provided by global e-commerce. It also creates some additional risks. For instance,
most of the tax treaties do not refer to e-commerce activities, and they may be open to
challenge.
6. Summary
The Internet is “the worldwide network of computer networks known as the
World Wide Web (WWW). Electronic commerce (E-commerce) is “the conduct
of transactions to buy, sell, distribute, or deliver goods and services over the
Internet.”
McConnell International has developed a classification of e-readiness factors that
includes connectivity, e-leadership, information security, human capital, and e-
business climate.
For the larger multinational enterprise (MNE), the Internet and e-commerce
create an opportunity that allows for quicker global products dissemination but
they also facilitate rapid imitation on the part of competitors.
The reduction in barriers should open the doors for small and medium
international enterprises (SMIEs), especially those from developed countries that
have been kept off from international trade and investment.
MNEs should set up their local premises in foreign countries in order to have a
local presence.
198
Global Internet and E-Commerce
Contd…
B2B Market
In 1999, Alibaba was launched when the Chinese Internet industry was in its
infancy. In order to gain a strong foothold in the B2B market, Ma announced that it
would not charge any transaction fees initially. Considering the growth potential of
the budding e-commerce market, other players like Global Sources and MeetChina
were launched in 1999. These players were expected to intensify competition in the
emerging B2B market. Global Sources had an advantage over Alibaba because of
its search technology and detailed information about the products listed on its site.
There was also the threat of many new players entering this space. Despite several
attempts made by Alibaba‟s competitors to carve out a place for themselves in the
rapidly growing B2B market, they failed to make a mark, largely because of
Alibaba‟s dominance in that market. On the other hand, Alibaba continued to enjoy
phenomenal growth.
C2C and B2C Market
Alibaba‟s increasing popularity and the burgeoning Chinese e-commerce market
attracted several foreign competitors to China. In 2002, US-based eBay Inc. (eBay)
entered China by acquiring a 33 percent equity stake in the Shanghai-based e-
commerce website EachNet.com (EachNet). eBay launched its Chinese site based
on its business model in the US. By 2002, it had emerged as one of the leading
online auction sites in China with 3.5 million registered users. By 2003, eBay had
cornered a 79 percent market share in the Chinese online auction market.
eBay‟s success in China and the good prospects offered by the budding e-
commerce market spurred Ma on to team up with Masayoshi Son (Son), founder
and CEO of SoftBank Corporation, to start a rival website to compete with eBay.
Ma raised funds of up to US$ 56 million from Softbank. Ma‟s decision to team up
with Son was due to Son‟s experience in defeating eBay in Japan by collaborating
with Yahoo! Japan. Subsequently, eBay had to move out of Japan in 2002. Ma, in
association with his experienced employees, drafted a plan to launch a consumer
auction website in his apartment in Hangzhou. Finally, they came up with the idea
of launching Taobao, which means „digging for treasure‟.
In May 2003, Ma launched Taobao as a wholly-owned subsidiary of Alibaba. Taobao
aimed to create an online trading platform for both B2C and C2C models. Taobao
differentiated itself from rival eBay by allowing free listings on its website. eBay
charged for listings on its website so as to ensure quality. According to Ma, a loyal
customer base had to be built before Taobao could start charging for its services.
Analysts were uncertain about Taobao‟s success since the C2C market was still in its
infancy in China. On the other hand, Ma was confident and cited the fact that EachNet
had only five million users among the 82 million-odd Internet users in China.
To gain a strong foothold in the Chinese e-commerce market and combat
competition from Taobao, eBay bought the remaining equity stake in EachNet for
US$ 150 million in July 2003. The website was called eBay EachNet. Yibo Shao,
one of the founders of EachNet who remained with eBay, believed that there could
only be one big consumer auction site in China and predicted that eBay would win
Contd…
199
International Business
Contd…
the race against Taobao. Soon after, Ma announced his plans to invest another US$
12 million in Taobao. He said it would be unwise to wait until the market matured
and hinted at using the money on building infrastructure, recruitment, and an online
credit system for the customers.
Analysts said growth in the Chinese e-commerce market was hampered by the
absence of the trust factor between buyers and sellers while trading online. Buyers
refused to send money to sellers before they had received the goods while sellers
were unwilling to ship the goods until they had received payment. To counter this
problem, Alibaba launched an online payment platform called „AliPay‟ based on
the lines of eBay‟s payment system, Paypal, in 2004. AliPay was an escrow-based
payment solution which allowed customers to safely and quickly send and receive
money online. Once a deal had been finalized, the buyer paid the money through
AliPay. The money was held in an AliPay account and was sent to the seller only
after the buyer intimated AliPay about the receipt of the product. Alibaba partnered
with a number of Chinese banks such as China Merchants Bank, Agricultural Bank
of China, etc. to provide AliPay services.
Alibaba devised an aggressive promotional strategy for Taobao which would
enable it to compete with eBay EachNet. Taobao advertised itself online by placing
ads on websites and through billboards in major city centers. All these promotional
strategies were ignored by eBay EachNet. By the fourth quarter of 2004, Taobao‟s
market share had jumped to 41 percent while eBay EachNet‟s had declined to 53
percent. While eBay EachNet had about 10 million users, Taobao quickly gained
four million users in 2004. Further, Taobao‟s easy-to-use features on the website
attracted a number of users and resulted in users shifting to Taobao. Taobao
provided additional features like e-mail and chat facilities to users on its site. It also
allowed the buyers to call the sellers before buying a product while eBay EachNet
concealed the seller‟s identity until the end of the auction and allowed
communication only through offline messages that could be left on the site.
Another reason cited for users shifting to Taobao was the difficulty they faced
while using the new eBay website that was created after it fully acquired EachNet.
The number of product listings decreased from 780,000 to 250,000 after the
website was changed. Further, the lack of a secure online payment system like
AliPay hindered eBay EachNet‟s growth.
In 2005, eBay EachNet‟s market share slipped further to 29.1 percent compared to
Taobao‟s 67.3 percent. Taobao was ahead of eBay EachNet on various counts.
In October 2005, Ma announced a new strategy to phase out eBay EachNet from
China – the services at Taobao would be offered free of charge for three
consecutive years.
In May 2006, Ma announced his plans to launch B2C services on Taobao. By then,
Taobao had already begun to outshine eBay EachNet by gaining more than 20
million users. According to Ma, the B2C services were launched with the aim of
removing the middleman concept by directly connecting large sellers with
consumers. For this, Taobao had already tied up with companies such as Motorola,
the Haier Group, Nokia Corporation, Adidas Group, etc., and was aggressively
planning to expand its product offerings. Analysts opined that a large number of
Alibaba‟s 10 million members would join Taobao.
Contd…
200
Global Internet and E-Commerce
Contd…
Sensing the need for the support of a local company to control its declining market
share, eBay EachNet entered into a joint venture (JV) with TOM Online Inc. (TOM
Online) to form TOM eBay in December 2006. Subsequently, the company also
stopped charging its sellers listing fees and decided that free was a business model.
Despite all these efforts, TOM eBay continued to lose market share.
Industry observers opined that Alibaba and Taobao have been much more
successful in China than their competitors because they were able to cater
specifically to the China market.
201
International Business
Contd…
202
Global Internet and E-Commerce
Contd…
On July 1, 2009, Facebook announced that it would test a new way of adjusting the
privacy settings of its users. With the new settings, members of Facebook could
select with whom they wanted to share all the information they had posted on their
Facebook profile. Members could select any person even if they were not members
of Facebook. Members could also change the privacy settings for specific content
they posted on their Facebook profile, so that the content could be seen only by
some selected people.
The company also made it clear that all the new privacy settings would appear on
the same page so as to avoid confusion. It insisted that there would not be any
overlapping in the options and the options would be standardized so that they
would remain the same each time a user went through the page. Industry experts
opined that with the proposed change in privacy settings, Facebook had addressed
the privacy concerns of many users.
203
International Business
Appendix - 6
204
Global Internet and E-Commerce
205
International Business
206
Global Internet and E-Commerce
207
International Business
outlining the desired performance levels. On the other hand, cultural controls are less
formal and result from shared beliefs and expectations among organizational
members.
Bureaucratic/Formalized Control
The elements of a bureaucratic/formalized control system are (1) an international
budget and planning system; (2) the functional reporting system; and (3) policy
manuals used for directing functional performance.
Budgets refer to “shorter term guidelines regarding investment, cash, and personnel
policies.” Plans refer to “formalized plans with more than a one-year horizon.” The
budget and planning process is the major control instrument in headquarters-
subsidiary relationships. Through the system and execution vary, the aim is to achieve
a good fit with the objectives and characteristics of the firm and its environment.
The period of the budget is typically one year as it is tied to the multinational‟s
accounting system. The budget system is used for several purposes: (1) allocating
funds among subsidiaries; (2) planning and coordinating global production capacity
and supplies; (3) evaluating performance of the subsidiary; and (4) communication
and information exchange among product organizations, subsidiaries, and corporate
headquarters. Long-range plans vary from two years to ten years, and are more
judgmental and qualitative in nature. Shorter periods such as two years are usually the
norm, considering the added uncertainty associated with diverse foreign
environments.
Another control instrument used by headquarters is functional reports. They vary in
number, frequency, and complexity. The structure and elements of the report are
highly standardized in order to allow for consolidation at the level of headquarters.
Since the frequency of reports required from subsidiaries is likely to increase as a
result of globalization, it is necessary that subsidiaries adhere to the basic principle for
conducting efficiently through the time consuming exercise. Two approaches facilitate
this process: participation and feedback. These approaches also enhance
communication between headquarters and the subsidiaries.
Cultural Control
Many multinationals emphasize corporate values and culture, and evaluations are
done on how the individual or an entity fits in with the norms. Cultural controls
require an extensive socialization process in which informal, personal interaction is
central. Substantial resources are spent on training the individual to share the
corporate culture.
The key instruments of cultural controls are careful selection and training of corporate
personnel and the institution of self-control.
MNEs exercise cultural controls in selecting home-country nationals and to some
extent, third-country nationals. Expatriates are used in subsidiaries for control
purposes as well as to effect change processes. Firms control the management efforts
through compensation and promotion policies, as well as through policies concerning
replacement.
208
Global Internet and E-Commerce
Exercising Controls
In most organizations, different functional areas are subject to different guidelines as
they face different constraints. For instance, the marketing function incorporates more
behavioral dimensions than finance or manufacturing. Thus, many MNEs employ
control systems that are responsive to the needs of the function. It is hypothesized that
manufacturing subsidiaries are controlled more than the sales subsidiaries as
production readily lends itself to centralized direction, and engineers and technicians
adhere more firmly to standards and regulations than salespeople.
In the international environment, new dimensions such as inflation, differing rates of
taxation, and exchange rate fluctuations may distort the performance evaluation of any
individual or organizational unit. For an MNE, measuring whether a business unit in a
particular country is earning a superior return of investment relative to risk may be
irrelevant to the contribution an investment may make worldwide or to the firm‟s
long-term results. In the short term, the return may be negative. Therefore, the control
mechanisms may inappropriately indicate reward or punishment. To design a control
system that is acceptable worldwide, great care should be taken to use only relevant
data. Therefore, major concerns include the data collection process and the analysis
and utilization of the data. Evaluators need management information systems that
provide for comparability and equity in administering controls.
In designing a control system, management needs to consider the costs of establishing
and maintaining the system versus the benefits that would be gained. Control systems
require investments in management structure and systems design. If controls are
misguided or consume too much time, they can slow down or undermine the process
of strategy implementation and thus the overall capacity of the firm. The result could
be lost opportunities or increased threats.
The impact of the environment should also be taken into account. First, the control
systems should measure only those dimensions over which the organization has actual
control. Second, control systems should be in harmony with local regulations and
customs. Thus MNEs are faced with many challenges in exercising appropriate and
adequate controls in their organizations.
Summary
If the subsidiaries have a high degree of autonomy, the system is called
decentralization. In such systems, controls are simple and loose, and each
subsidiary operates as a profit center. On the other hand, if subsidiaries have tight
controls and strategic decision making is concentrated at headquarters, the system
is called centralization.
The locus of decision making in a multinational enterprise (MNE) can be
determined by several factors such as its degree of involvement in international
operations, the product marketed by the firm, the size and importance of the
firm‟s market, and the human resource capability of the firm.
Firms adopting the networked global organization have incorporated three
dimensions into their organizations: (1) developing and communicating a clear
corporate vision; (2) the effective management of human resource tools for
broadening individual perspectives and developing identification with corporate
goals; and (3) integrating individual thinking and activities into the broad
corporate agenda.
209
International Business
The global business entity can achieve success only if it moves intellectual capital
within the organization.
The role that a particular country organization can play depends on that market‟s
overall strategic importance as well as organizational competence. From these
criteria, four roles emerge – strategic leader, contributor, implementer, and black
hole.
Controls are the means used by organizations to verify and correct actions that
differ from the established plans.
Bureaucratic controls comprise an explicit and limited set of regulations and rules
outlining the desired performance levels. On the other hand, cultural controls are
less formal and result from shared beliefs and expectations among organizational
members.
210
Global Internet and E-Commerce
Contd…
highly focused company with insurance and investment products as its core
business area. AXA‟s strategy was to be a leader in financial protection. In light of
the rapid globalization, Henri de Castries, (Castries), Chairman, Management
Board and CEO of AXA, realized that there had to be more coordination between
the subsidiaries and headquarters if the company was to be run efficiently. In order
to achieve synergies, AXA centralized some of the functions, while decentralizing
some. It made efforts to leverage on the strengths of each of its global subsidiaries.
In 1997, AXA established a dual corporate governance structure with a
management board and supervisory board managing its activities. The management
board looked after the company‟s day-to-day activities, while the supervisory board
was responsible for the efficient operation of the company. To achieve the
objective of becoming a global company, there were several management issues
that AXA had to sort out first. These included cultural and communication issues,
legal compliance, capital allocation, and integrating people and processes. AXA
operated in many countries across the world and had to take into account several
kinds of statutory, regulatory, and legal systems and accounting and tax systems as
these differed from country to country.
AXA decided to reduce the complexity of its global operations by maintaining a
balance between centralization and decentralization. It centralized its operations to
the extent it felt was necessary. Claude Brunet (Brunet), Member of the AXA
Management Board, described this as „everything decentralized but strategy‟. AXA
had strong governance practices at both the central and local levels. Since 1997, it
had been governed by a supervisory and a management board. This system
demarcated the power of the management from that of the supervisors.
At the headquarters, the functions that remained strongly centralized included
AXA‟s corporate strategy, brand management, some key processes like approval
for new products, and standard Key Performance Indicators (KPIs).
The capital allocation was centralized in order to minimize cost of capital and
ensure financial strength. The risk management function also remained centralized.
AXA had a centralized risk management department, which developed and
deployed several risk measurement and monitoring methods. Each operating unit
also had risk management teams to support the central risk management team.
AXA also centralized functions like procurement and technology services.
AXA ensured that the principles of good corporate governance were implemented
across the group. All the subsidiaries were governed by a board, which included non-
executive directors. An audit committee with independent members also oversaw the
functioning of the subsidiaries. All the subsidiaries were made aware of the group‟s
strategy, operational objectives, reporting lines, and accountability for organizational
objectives. Formal guidelines for business and operations were in place along with a
written code of ethics, anti-fraud, and anti-laundering policies.
All the subsidiaries of AXA prepared three-year forecasts. AXA aimed at
exercising control over the forecasts developed by the subsidiaries by subjecting
the forecasts to critical review. After the review, any adjustments that were
Contd…
211
International Business
Contd…
required were made. A consolidated forecast was prepared that was used as the
group‟s budget. Based on these, the objectives and annual targets of each of the
operating units were arrived at.
The subsidiaries of AXA presented details of their strategic position, performance
review, quantitative targets like revenue, expenses, profitability, etc., about each of
their business segments. Also forming part of the presentation was sensitivity
analysis considering macro-economic conditions and specific plans for HR, IT, and
other aspects. Through this procedure, group management could exert control over
the strategies, plans, and resources of the principal subsidiaries and set targets that
were in tandem with the ambitions of the group.
All employees at the subsidiaries were informed about the corporate strategy, the
target of the group, and their own individual unit. The managers were asked to
inform employees about the details of what was expected of them and the resources
that they had at their disposal to carry out the task. The managers were required to
encourage teamwork and empower employees.
The subsidiaries had their own local strategies. This was necessary because local
laws, practices, and distribution models guided insurance companies. They also had
their own product strategies, market development, distribution, and risk
management practices.
In the Asia Pacific markets like Malaysia, Singapore, Hong Kong, Thailand, and
Indonesia, functions like sales and marketing, underwriting, and regulatory issues
were managed locally. AXA‟s subsidiaries had their own strategic plans, which
were in accordance with the strategic plans of the group.
All the subsidiaries were free to have their own distribution practices. They could
distribute through traditional methods like distribution partners or through
Bancassurance. AXA Japan had different distribution methods for corporate
customers and for new markets. The distributors were placed under four categories
– AXA Advisors, who sold medical and term insurance, AXA Partners, who sold
group policies, AXA Corporates and Agents, who sold term products, and AXA
New Markets, which looked after the savings products.
AXA reaped several benefits by striking a balance between centralization and
decentralization of its operations. The company had firm control over some of the
most important activities and was able to steer the subsidiaries toward the growth
path. At the same time, the subsidiaries were free to carry out their day-to-day
operations. Due to geographical diversification, the group‟s volatility of earnings
went down. AXA was able to replicate the best practices in one country in other
countries and thus obtain a competitive advantage over local players.
212
Concept Note - 12
2.4 Corruption
Corruption has been a problem which is prevalent in almost every society. There have
been and always will be corrupt government officials. By making payments to such
officials, international businesses have gained economic advantages. For instance, in
the 1970s, Carl Kotchian, Lockheed president, made a payment of US$ 12.5 million to
Japanese agents and government officials in order to secure a larger order for
Lockheed‟s TriStar Jet from Nippon Air. When this was discovered, the US officials
charged Lockheed with tax violations and falsification of records.
The Lockheed case gave an impetus for the passage of the Foreign Corrupt Practices
Act (FCPA) in the US in 1977. The act outlawed the paying of bribes to foreign
government officials for gaining business. Some US businesses argued that the act
would put US firms at a competitive disadvantage. Subsequently, the act was
amended to allow for “facilitating payments”. Facilitating payments, also known as
grease payments or speed money, are not payments for securing contracts nor do they
help in gaining preferential treatment; rather, they are payments to ensure receiving
the standard treatment that a business should receive from a foreign government but
may not due the obstruction by a foreign official.
214
Ethics in International Business
In 1997, the trade and finance ministers from the member states of the Organization
for Economic Cooperation and Development (OECD) followed the US lead and
adopted the Convention on Combating Bribery of Foreign Public Officials in
International Business Transactions. In 1999, the convention came into force and
obliged member states to make the bribery of foreign public officials a criminal
offense. The convention excluded the facilitating payments made to government
officials.
While the facilitating payments are excluded from both the FCPA and the OECD
convention on bribery, the ethical implications of making such payments are unclear.
In many countries, payoffs in the form of speed money to government officials are a
part of life. Such investments bring substantial benefits to the local populace in terms
of jobs and income. Some economists argue that corruption in the form of smuggling,
black-marketeering, and side payments to government officials to “speed up” approval
for business investments may enhance welfare. Such arguments persuaded the US
Congress to exempt facilitating payments from the FCPA. In contrast, other
economists have argued that corruption reduces the return on business investments
and leads to slow economic growth.
2.5 Moral Obligations
Multinationals have power that comes from their control over resources and their
ability to move production from one location to another. That power may be
constrained by laws and regulations and by the market discipline and the competitive
process. Nevertheless it is substantial. Moral philosophers argue that with power
comes the social responsibility for multinationals to give something back to the
society that enabled them to grow and prosper. Social responsibility refers to “the idea
that businesspeople should consider the social consequences of economic actions
when making business decisions and that there should be a presumption in favor of
decisions that have both good economic and social consequences.” Advocates of this
approach argue that businesses, particularly large successful ones, should realize that
they have to fulfill their noblesse oblige and give something back to the society that
has made them successful. Noblesse oblige is a French term that refers to “honorable
and benevolent behavior considered the responsibility of people of high (noble) birth.”
Some multinationals, however, abuse their power for private gain.
Some multinationals have acknowledged that they have a moral obligation to use their
power to enhance social welfare in the communities where they carry out their
business. For instance, BP, one of the world‟s largest oil companies has made “social
investments” a part of its company policy in countries where it does business. In
Algeria, BP has invested in a major project to develop gas fields near the desert town
of Salah. The company noticed that there was lack of clean water in Salah and
subsequently built two desalination plants to offer drinking water to the local
community and distributed containers to residents.
3. Ethical Dilemmas
The ethical obligations of an MNE toward employment conditions, human rights,
corruption, environmental pollution, and the use of power are not always clear cut.
There may be no agreement about accepted ethical principles. From an international
business perspective, some argue that what is ethical depends on one‟s cultural
215
International Business
216
Ethics in International Business
217
International Business
this problem, an American manager in Columbia routinely pays the local drug lord in
order to guarantee that his plant will not be bombed and that none of his employees
are abducted. The manager argues that such payments are ethically defensible, not
because everyone else is doing so but because not doing so may cause greater harm.
The objection to this approach is two-fold. First, to say that the action is justified
ethically if everyone is doing it is insufficient. The firm has a clear choice. It need not
abide by the local practices and it can decide not to make any investments in a country
where it finds the practices repulsive. Second, the MNE should recognize that it does
have the ability to change the practices prevalent in a country. It can make use of its
power for a positive moral purpose.
Another solution to the drug lord problem is to refuse to invest in a country where the
rule of law is so weak that drug lords demand protection money. The drug lord
problem constitutes one of those ethical dilemmas where there is no obvious right
solution, and managers need a moral compass to help them find an acceptable solution
to the dilemma.
5.2 Utilitarian and Kantian Ethics
The Utilitarian and Kantian approaches were developed in the 18 th and 19th centuries.
The utilitarian approach to business ethics dates back to philosophers such as David
Hume, Jeremy Bentham, and John Stuart Mill. Utilitarian approaches to ethics hold
“that the moral worth of actions or practices is determined by their consequences.” An
action is considered to be desirable if is leads to the best possible balance of good
consequences over bad consequences. Utilitarianism is committed to maximizing
good and minimizing harm. As a business ethics philosophy, it focuses attention on
the need to carefully weigh all the social benefits and costs of a business action and
pursue only those actions where the benefits outweigh the costs. From the utilitarian
perspective, the best decisions are those that produce the greatest good for the most
number of people.
Many businesses have adopted tools such as risk assessment and cost-benefit analysis
that are firmly rooted in a utilitarian philosophy.
The approach has some drawbacks. One problem is measuring the costs, benefits, and
risks of an action before deciding to pursue it. Second, the philosophy omits the
consideration of justice. The action that does good for many people may result in the
unjustified treatment of a minority. Such an action is unethical because it is unjust.
Kantian ethics are based on the philosophy of Immanuel Kant. Kantian ethics hold
that “people should be treated as ends and never purely as means to the ends of
others.” People are not instruments; they have dignity and need to be respected.
Employing people in sweat shops, making them work for long hours for low pay and
poor working conditions is a violation of ethics, according to Kantian philosophy, as it
treats people like cogs in a machine and not as moral beings who have dignity.
Though contemporary moral philosophers tend to view Kant‟s ethical philosophy as
incomplete – for instance, his system does not have any place for moral emotions or
sentiments such as caring or sympathy – the notion that people should be respected
and treated in a dignified manner still resonates in the modern world.
5.3 Rights Theories
Rights theories developed in the 20th century recognize that human beings have basic
rights and privileges that transcend national cultures and boundaries. Rights set up a
minimum level of morally acceptable behavior. Moral theorists argue that basic
218
Ethics in International Business
human rights form the basis for the moral compass that should be navigated by
managers when they make decisions that have an ethical component. More precisely,
the managers should not pursue actions that violate the basic human rights.
The notion that basic rights that transcend national cultures and boundaries were the
underlying motivation for the United Nations Declaration of Human Rights, which
have been ratified by all countries worldwide and lay down basic principles to be
adhered to irrespective of the culture in which one is doing business.
Within the framework of the rights theory, certain people or institutions are obliged to
offer benefits or services that secure the rights of others. Such obligations fall upon
more than one class of moral agent. (A moral agent is “any person or institution that is
capable of moral action such as government or corporation.”).
5.4 Justice Theories
Justice theories focus on attaining a just distribution of economic goods and services.
Just distribution is one that is considered to be fair and equitable. A justice theory
attributed to philosopher John Rawls argues that all economic goods and services
should be equally distributed except when an unequal distribution will work to
everyone‟s advantage.
According to Rawls, valid justice principles are the ones which are agreed upon by all
people if they can impartially and freely consider the situation. Impartiality is
guaranteed by a conceptual device called the veil of ignorance. Under the veil of
ignorance, everyone is presumed to be ignorant of all of his/her particular
characteristics, for instance, race, nationality, sex, intelligence, family backgrounds,
and special talents. Rawls then asks under the veil of ignorance what system would
people design? Under these conditions, people unanimously agree upon two
fundamental principles of justice.
The first principle is that every person should be allowed the maximum amount of
basic liberty compatible with a similar liberty for others. This refers to political
liberty, liberty of conscience and freedom of thought, freedom of speech and
assembly, the freedom and right to hold personal property, and freedom from arbitrary
arrest and seizure.
The second principle is that once equal basic liberty is assured, inequality in basic
social goods – such as income and wealth distribution, and opportunities should be
allowed only if such inequalities benefit everyone. Rawls formulates what he calls the
difference principle, which states that inequalities are justified if they benefit the
position of the person with least advantage.
In the context of international business ethics, Rawl‟s theory generates an interesting
perspective. Managers can ask themselves whether the policies that they have adopted
in foreign operations can be considered just under the veil of ignorance. For instance,
is it just to pay foreign workers less than what workers are paid in the firm‟s home
country? Rawls‟ theory would suggest that it is just as long as the inequality benefits
the least-advantaged members of the global society. Alternatively, it is difficult
imagining that mangers operating under a veil of ignorance will design a system
where foreign employees would be paid subsistence wages for working long hours in
sweatshop conditions and where they are exposed to toxic and hazardous materials.
Such working conditions are unjust in Rawl‟s framework and hence, it is unethical to
219
International Business
adopt them. While operating under a veil of ignorance, most people would probably
design a system that imparts some level of protection from environmental degradation
to vital global commons, such as the tropical forests, oceans, and atmosphere. Thus,
Rawl‟s veil of ignorance is a conceptual tool contributing to the moral compass that
can be used by managers for navigating through complex ethical dilemmas.
220
Ethics in International Business
Others have recommended a five-step process in order to think through the ethical
problems. In Step 1, businesspeople should identify a decision which would affect a
stakeholder and in what ways it would affect the stakeholder. Stakeholders in a firm
are individuals or groups having a claim, interest, or stake in the company. Internal
stakeholders are individuals or groups working for or owning the business. They
include employees, stockholders, and board of directors. External stakeholders are
other individuals or groups having a claim on the firm. The group comprises
customers, lenders, suppliers, unions, local communities, governments, and the
general public.
Each stakeholder group supplies important resources to the organization and, in
exchange, expects its interest to be satisfied.
Stakeholder analysis involves the analysis of a certain amount of moral imagination.
This means standing in the stakeholder‟s shoes and asking how a proposed decision
may impact that stakeholder.
Step 2 involves judging the ethics of the proposed strategic decision using the
information gained in Step 1. Managers should determine whether a proposed
decision would violate the fundamental rights of any stakeholder. For instance, the
customers should have the right to know about the potentially dangerous features of a
product. Mangers should also ask themselves whether they would allow the proposed
strategic decision if they were designing a system under Rawl‟s veil of ignorance. For
instance, if the decision is whether to outsource work to a subcontractor who offers
low pay and poor working conditions, managers might ask themselves whether such
an action could be allowed under a veil of ignorance, where they themselves might
ultimately be the ones working for the subcontractor.
At this stage, the judgment should be guided by various moral principles that should
not be violated. The principles might be the ones articulated in the code of ethics or
other documents of the company. In addition, certain moral principles that are adopted
by members of the society such as prohibiting stealing should not be violated. The
judgment at this stage will also be guided by the decision rule that is selected for
assessing the proposed strategic decision. Though maximizing profits is the decision
rule stressed by businesses, it should be noted that no moral principles are violated.
Step 3 requires managers to establish moral intent. This means that businesses should
place moral concerns ahead of other concerns in cases where either the key moral
principles or the fundamental rights of stakeholders have been violated. At this stage,
input from top management will be valuable.
Step 4 requires the firm to engage in ethical behavior.
Step 5 requires the business to audit its own decisions, reviewing them to ensure they
were consistent with the ethical principles stated in the company‟s code of ethics. This
final step is critical and is often overlooked. Without auditing past decisions,
businesspeople will not know if their decision process is working and if changes need
to be made to ensure greater compliance with the code of ethics.
6.4 Ethics officers
Businesses have ethics officers to ensure that their business behaves in an ethical
manner. These individuals are entrusted with the responsibility of ensuring that all
employees are trained to be ethically aware, that the company‟s code of ethics is
221
International Business
adhered to, and that ethical considerations enter the business decision-making process.
Ethics officers may also audit decisions to ensure that they are consistent with the
code of ethics. In many businesses, ethics officers act as an internal ombudsperson with
the responsibility of handling confidential inquiries from employees, investigating
complaints, reporting findings, and making recommendations for change.
6.5 Moral Courage
It is crucial to recognize that employees in an international business may be in
significant need of moral courage. Moral courage helps a manger to walk away from a
decision that seems to be profitable but unethical. It gives an employee the strength to
say no to a superior who instructs him/her to pursue an action that is unethical. Moral
courage gives employees the integrity to go to the media and publicly display the
unethical behavior in a company.
Companies can encourage the moral courage of employees by committing themselves
to not retaliating against employees who exercise moral courage, say no to superiors,
or complain about their unethical actions.
7. Summary
The most common ethical issues in an international business setting are
employment practices, human rights, environmental pollution, corruption, and
moral obligations.
Managers need to confront real ethical dilemmas though real-world decisions are
complex and difficult to frame. Doing the right thing or even knowing what the
right thing may be is often not very easy.
Managers behave in an unethical manner for several reasons. First, business
ethics is not dissociated from personal ethics, which are the generally accepted
principles of right and wrong that govern the conduct of individuals. Second,
many studies of unethical behavior in a business setting conclude that
businesspeople sometimes do not realize that they are behaving unethically,
chiefly because they fail to ask whether the decision or action is ethical. Third,
the climate in some business settings does not encourage people to think through
the ethical consequences of business decisions.
The different approaches to business ethics are straw men, utilitarian and kantian
ethics, rights theories, and justice theories.
International business and managers can focus on several things to ensure that
ethical issues are considered in business decisions. They are hiring and
promotion, organization culture and leadership, decision-making processes, ethics
officers, and moral courage.
222
Ethics in International Business
Contd…
American soldiers while the usage of Napalm by the US troops had led to horrific
deaths of thousands of Vietnamese people. Another major criticism faced by the
company was that its subsidiary Union Carbide Corporation (UCC), which it
acquired in 2001, was responsible for the worst industrial disaster in the world in
Bhopal, India. Tragedy struck on December 3, 1984, after water entered the Methyl
Isocyanate (MIC) storage tank No. 610 at the plant. MIC is one of the deadliest
gases produced in the chemical industry and is known to react violently when it
comes into contact with water or metal dust. What followed was a catastrophe that
killed nearly 10,000 people within 72 hours of the gas leak and left hundreds of
thousands of people with eye irritation, acute breathlessness, and vomiting.
Moreover, the plant site was surrounded by hazardous chemicals that contaminated
the soil and water, posing a major threat to people residing in the vicinity. Several
studies also found that the groundwater near the plant area contained toxic heavy
metals and organic chemicals which made it unsafe for drinking. The victims held
Dow responsible for cleaning up the site since it had acquired UCC.
In the months, years, and decades that followed the disaster, thousands of survivors
and their next generations suffered from ill health and multiple symptoms while
their livelihood and future were severely affected. By the end of 2009, it was
estimated that 25,000 had died and around 600,000 people were affected due to
gas-related disorders.
Though the plant was shut down soon after the incident, the toxic remains at the
factory left it in a state to create even more havoc with each passing day. Toxic
chemicals lay in the vicinity and children who played near the site and livestock
grazing on the ground were fully exposed to it. In addition to the surroundings, the
walls of the UCIL plant and the roof remained covered with toxic materials which
far exceeded safety standards. Moreover, sacks of chemicals and pesticides lay
scattered in a state of decomposition around the abandoned factory. Some sources
estimated that nearly 25,000 tons of contaminated material were present at the
plant. Despite this, the people residing in the surroundings of the plant could not
abandon the site and move to safer places as the compensation due to them was
delayed for many years. This was because UCC, the parent company of UCIL,
evaded responsibility for the disaster and engaged in lengthy litigation.
Subsequently, some victims did get a paltry amount as compensation but many did
not get even this.
Experts around the world believed that UCIL‟s lack of information about
toxicology and disaster mitigation measures had led to an increased number of
casualties since the disaster. The catastrophic event had also contaminated the soil
and made the land infertile, as was clear from the fact that there was no grass
growing on the land. Several rounds of laboratory analysis carried out by
governmental and non-governmental organizations (NGOs) found that the
contamination levels of the soil and water near the plant were far in excess of
permissible limits. It was reported that after a heavy rainfall, heavy metals and
solvents had seeped into the groundwater resources, contaminating them. The
residents used this water for drinking, cooking, and washing and this had led to
physical disabilities and stunted growth in children.
Contd…
223
International Business
Contd…
The survivors made several attempts to get access to potable water but these proved
futile. On December 3, 2009, the 25th anniversary of the tragedy, just as they had
in all the previous years, hundreds of citizens of Bhopal marched with torches
demanding that the government take steps to clean up the site. As the people
marched toward the UCIL plant, they chanted slogans like „Down with the
government‟ and „Down with Union Carbide‟.
Even as the victims continued to suffer, business ethicists and people around the
world were disgusted to see that the company responsible for the disaster refused to
be held accountable. People also wondered how the regulators had failed to bring
the perpetrators to book even after 25 long years. The Indian government too drew
a lot of flak from critics who felt that it was siding with the multinational
corporation.
Despite protests from activists and survivors, UCC consistently refused to accept
any liability for the clean-up of the site, saying the plant had been sold to The Dow
Chemical Company (Dow) in 2001. It also pointed out it had paid a „heavy‟ one-
time compensation of US$ 470 million. Dow too contended that the matter had
been resolved and added that the company had insulated itself from UCC‟s Bhopal
liabilities by virtue of how it had structured the acquisition.
As the after-effects of the world‟s worst industrial disaster threatened to affect the
next generations in Bhopal, business ethicists and social activists intensified their
efforts to make Dow realize that it was also the company‟s responsibility to clean
up the mess and provide at least some relief to the victims. But industry observers
wondered whether Dow would ever look beyond the concerns of its shareholders
and address this issue.
224
Ethics in International Business
Contd…
the incident occurred as the blowout preventer of the oil well failed to activate and
did not shut off oil flow as it was supposed to do during emergencies. It thereby
allowed methane gas to enter, which triggered the deadly explosion in the rig, they
said. Documents showed that the blowout preventer had design flaws, leaks in its
hydraulic system, and a deceased battery in its control pod. While some experts
pinpointed the failure of the blowout preventer as the cause of the explosion, others
said that the drilling mud which had been removed from the well before a cement
seal had been put in place violated best drilling practices and was responsible for
the disaster.
Lawmakers criticized BP for its efforts to seal the well by injecting rubber debris
down the top, including old golf balls and bits of tires. It was reported that in early
March 2010, the Deepwater Horizon rig had experienced trouble as the pressure of
the underground petroleum had temporarily overwhelmed the mud, triggering
alarms on the rig. Experts said that despite knowing that there were some problems
on the rig, BP did not have any back-up systems in place to avert any kind of
disaster except the blowout preventer. Though the Coast Guard named both BP and
Transocean as the parties responsible for the incident, two other companies,
Halliburton and Cameron International, which made the blowout preventer, were
also questioned.
Experts opined that it was a massive struggle for BP to slow down the leak despite
the company having taken all possible measures. More than 1,000 volunteers were
involved in driving off the oil from the ocean surface, dissipating it with chemicals
or simply burning it at sea. As an alternative, BP built three large containment
chambers which were placed over the leaks on the ocean floor, so that the oil could
be diverted to the surface and, from there, pumped into tankers. In addition to the
chambers, the company also begun to drill two relief wells at an angle into the
ocean floor, so that cement could be forced into the boreholes and would thereby
stop the flow of oil. The work on the relief wells started in May 2010. It was
estimated that it would take at least three months from then for the wells to be
completed.
BP also used chemicals and dispersants to break the surface oil slicks into
microscopic droplets that could sink into the sea. However, scientists warned that
such dispersants might have an adverse impact on the environment as they
contained toxins. BP applied more than 400,000 gallons of a dispersant sold under
the trade name Corexit to disperse the oil on the ocean floor. But experts were
worried as Corexit contained 2-butoxyethanol, a compound which at high doses
was associated with headaches, vomiting, and reproductive problems.
BP also used another method called a “junk shot” to plug the undersea leak. This
involved pumping materials such as torn tires and golf balls into the well at high
pressure. On May 26, 2010, BP started an operation called “top kill” to stop the
flow of oil from the well. Here, heavy drilling fluids were injected through the
blowout preventer into the well. But all these efforts proved futile as the oil leak
could not be stopped. By the first week of May 2010, the oil slick had reached the
Mississippi delta and the government declared a state of emergency after BP
admitted that it could no longer stop the oil spill on its own.
Contd…
225
International Business
Contd…
226