Unit I An Overview of International Business

Introduction, Definition of International Business

Definition: International business may be defined simply as business transactions that take
place across national borders. Nearly all business enterprises, large and small, are inspired
to carry on business across the globe. This may include, purchase of raw materials, from
foreign suppliers, assembling products from components made in several countries or
selling products or services to customers in other nations. International Business
Other definitions:
1) IB field is concerned with the issues facing international companies and governments in
dealing with all types of cross border transactions.
2) IB involves all business transactions that involve two or more countries.
3) IB consists of transactions that are devised and carried out across borders to satisfy the
objectives of individuals and organizations. 4) IB consists of those activities private and
public enterprises that involve the movement across national boundaries of goods and
services, resources, knowledge or skills.
Multinational Enterprise: A MNE has a worldwide approach to foreign markets and
production and an integrated global philosophy encompassing both domestic and
international markets.
International Management
It is defined as a process of accomplishing the global objectives of a firm by
(1) Effectively coordinating the procurement, allocation, and utilization of the human,
financial, intellectual, and physical resources of the firm within and across national
boundaries. .
(2) Effectively charting the path toward the desired organizational goals by navigating the
firm through a global environment that is not only dynamic but often very hostile to the
firm’s very survival International Trade: When a firm exports goods or services to
consumers in another country. Foreign Direct Investment: When a firm invests resources in
business

Changing Environment of International Business

International business environment The environment of international business is regarded
as the sum total of all the external forces working upon the firm as it goes about its affairs in
foreign and domestic markets. The environment can be classified in terms of domestic,
foreign, and international spheres of impact.
1. The domestic environment – is familiar to managers and consists of those uncontrollable
external forces that affect the firm in its home market.
2. The foreign environment - can be taken as those factors which operate in those other
countries within which the MNC operates.
3. The international environment - is conceived as the interaction between domestic and
foreign factors and indeed they cover a wide spectrum of forces

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The forces:
 Political environment
 Legal environment
 Cultural environment
 Technological environment
 Economic environment.

The Globalization of the World:

 Globalization of Economy
 Globalization of markets
 Globalization of production
 Decline of barriers to trade (WTO)
 Increased technological capabilities
 60,000 international firms with 500,000 foreign affiliates that generate $11 trillion in sales in
1998 Globalization
 Trade and investment barriers are disappearing.
 Perceived distances are shrinking due to advances in transportation and
telecommunications.  Material culture is beginning to look similar.
 National economies merging into an interdependent global economic system.
Globalization: Pros & Cons
 Pros
1. Increased revenue opportunity through global sales.
2. Reduced costs by
 Cons
1. Different nations = different problems.
2. Similarities between nations may be superficial.
3. Global planning may be easy, but global execution is not.
Definition of Globalization:
The worldwide movement toward economic, financial, trade, and communications
integration. Globalization implies the opening of local and nationalistic perspectives to a
broader outlook of an interconnected and interdependent world with free transfer of capital,
goods, and services across national frontiers. However, it does not include unhindered
movement of labor and, as suggested by some economists, may hurt smaller or fragile
economies if applied indiscriminately. 1.1.6 What is “Globalization”? “The shift toward a
more integrated and interdependent world economy.” Markets Production Globalization of
Markets: “Merging of historically distinct and separate national markets into one huge
global marketplace.”
Facilitated by offering standardized products:
 Citicorp
 Coca-Cola

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 Sony PlayStation
The Largest Global Markets:
 Consumer Goods
 Industrial Goods and Materials
 Commodities such as aluminum, oil and wheat.
 Industrial products such as microprocessors, aircraft.
 Financial assets such as U.S. Treasury bills and
 Eurobonds.
 Industrial Goods and Materials
 Commodities such as aluminum, oil and wheat.
 Industrial products such as microprocessors, aircraft.
 Financial assets such as U.S. Treasury bills and Eur
Globalization of production
 Refers to sourcing of goods and services
 from locations around the world to take
 advantage of o Differences in cost or quality of the factors of
 production
 Labor
 Land
 Capital
Globalization of Production
 “The sourcing of goods and services from locations around the globe to take advantage of
national differences in the cost and quality of factors of production (labor,energy, land and
capital).”
 Companies hope to lower their overall cost structure and/or improve the quality or
functionality of their product offering - increasing their competitiveness.

INTERNATIONALIZATION OF BUSINESS:
Meaning of International Business:
International business is a term used to collectively describe all commercial transactions
(private and governmental, sales, investments, logistics, and transportation) that take place
between two or more nations. Usually private companies undertake such transactions for
profit; organizations undertake them for profit for political reasons.
A multinational enterprise (MNE) is a company that has a worldwide approach to markets
and production or one with operations in more than a country. An MNE is often called
multinational corporation (MNC) or transnational company (TCN). Well known MNCs
include fast food companies such as McDonald's and Yum Brands.
FACTORS CAUSING GLOBALIZATION:
Meaning:
Globalization of the economy means reduction of import duties, removal of Non-Tariff

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Barriers on trade such as Exchange control, import licensing etc., allowing FDI and FPI,
allowing companies to raise capital abroad and grow beyond national boundaries and
encourage exports. Both Foreign Trade and Foreign investment volume have grown rapidly
over the last few years.
The IMF defines globalizations as “the growing economic interdependence of countries
worldwide through increasing volume and variety of cross border transactions in goods and
services and of international capital flows, and also through the more rapid and widespread
diffusion of technology.”
Trends in Globalization
For better understanding, let us have a brief look at the historical background that actually
led to the formation of these powerful institutions. To start with, the post-Second World War
period of international trade came under the influence of a new system called Bretton
Woods System.

The Great Depression of 1929 completely shattered the international monetary system that
led to the formation of monetary blocs and lack of international collaboration. To bring
about an improvement in the monetary conditions, the Allied Forces in the year 1944 met at
Bretton Woods to create a new monetary order.

During the deliberations it was decided that, hence forth, governments would act
responsibly in managing the international fiscal system. The United States of America that
emerged as a dominant power assumed the responsibility of managing, for establishing
post-war economic order that prevents economic nationalism and encourages free trade and
increased interaction among nations.

Thus, this Anglo-American plan approved at Bretton Woods became a first collective
international monetary order that would provide basis for growing international trade and
economic growth along with political harmony. This Bretton Woods conference was the base
for the establishment of two institutions, viz., the International Monetary Fund and
International Bank for Reconstruction and Development (IBRD) or popularly known as
World Bank.

The IMF and IBRD, known as Bretton Wood Brothers were established in 1946. Later in the
year 1947, the General Agreement on Tariffs and Trade (GATT) was formed and in the year
1995, the World Trade Organization was formed which was the culmination of prolonged
negotiations within the framework of GATT.

During the 1950s, two crucial developments concerning the world financial institutions took
place in the global economy. The first one was the growth of regional economic subsystems
and the second, the growth of multi-national corporations or MNCs that function across
national boundaries. Within the capitalistic countries there was a tendency towards

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formation of regional economic groups like the European Union in the early 1990s and
Association of South East Asian Nations.

The growth of MNCs provided scope for increased economic activity and emergence of
transnational corporations as well. As most of these MNCs are US-based they completely
dominated the entire global economy and began to create a complex interdependence. This
also created problems for economies in the field of investment, capital movement and
technology.

With the passage of time there were more and more comments about a new theme called
anti-globalization. This anti-globalization sentiment did not emerge just in developing
countries. Even underdeveloped countries raised their voice against globalization.

The first anti-globalization sentiments were expressed during the 1970s against
multinational companies like ITT in Chile, Nestle all around the world. Citibank in South
Africa, Union Carbide in India, Coca Cola in Guatemala and so on. It was felt that
unrestricted globalization is in many ways responsible for problems like nagging poverty
and uneven development, and creates grave infrastructural mismatches.

The Indian economy has become more dependent on imports, which have put constant
pressure on the value of the rupee, leading to recursive bouts of high inflation. Rather than
expanding, India’s manufacturing strength in new capabilities and in new technologies is
put at global disadvantage.

This is outstanding to the key sectors of modern industry chasing the scientific and
technological advances that occur in other nations while neglect indigenous technology.
Furthermore, analysis of Foreign Direct Investment (FDI) in the last few years indicated that
a considerable amount of investment went not into creation of new companies but in
takeover bids of the existing Indian enterprises.
Opposition to globalization is not related becoming technologically isolated from the rest of
the world. Despite the fact that India liberalized unconditionally to attract high technology
and capital investment, experience has shown that investment of all major MNCs is
miniscule when compared to their investments abroad. Companies like INTEL, AMD,
CISCO, etc., rather than bringing in new technology, are actually taking out technology from
India.

All their investments have been on a division that either develops software on demand, or
provides research assistance to their US counterparts. None of them have set-up any
manufacturing units or signed any technology transfer agreements with any Indian
company.

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All the technology is developed and marketed by the parent company. Further, these
companies provide all perks and privileges to exploit India’s intellectual capital. Moreover,
these MNCs are given tax breaks and also preferential treatment in allocation of land and
uninterrupted power supply.
The need of the hour, therefore, is to question and challenge the mantra of unrestrained
globalization. The strong claims made by the advocates of globalization need to be carefully
scrutinized without any bias. The many failures, economic distortions and pitfalls of
globalization need to be clearly exposed.
Above all, India’s economic policies need to be restructured to give an impetus to the local
development of key technologies that play a crucial role in the modem economy and satisfy
the most pressing needs of the vast majority of the Indian people.
Stages of Globalization:
Ohmae identify five different stages in the development of a firm into a global corporation.
 The first stage is the arm’s length service activity of essentially domestic company which
moves into new markets overseas by linking up with local dealers and distributors.
 In stage two, the company takes over these activities on its own.
 In the next stage, the domestic based company begins to carry out its own manufacturing,
marketing and sales in the key foreign markets.
 In stage four, the company moves to a full insider position in these markets, supported by
a complete business system including R & D and engineering.
 In the fifth stage, the company moves toward a genuinely global mode of operation.
Essential Conditions for Globalization • Business Freedom• Facilities• Government
Support• Resources• Competitiveness• Orientation
Problems in Globalization:
 Global competition and imports keep a lid on prices, so inflation is less likely to derail
economic growth.
 An open economy spurs innovation with fresh ideas from abroad.
 Export jobs often pay more than other jobs.
 Unfettered capital flows give the US access to foreign investment and keep interest rates
low.
 Millions of Americans have lost jobs due to imports or production shifts abroad. Most find
new jobs that pay less
 Millions of others fear losing their jobs, especially at those companies operating under
competitive pressure.
 Workers face pay cut demands from employers, which often threaten to export jobs.
 Service and white collar jobs are increasingly vulnerable to operations moving offshore
 U S employees can lose their comparative advantage when companies build advanced
factories in low-wage countries, making them as productive as those at home.

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Ripple effects of globalization:

1. Globalization and management

2. Globalization and jobs
3. Globalization and wages
4. Globalization and child labor
5. Globalization and women
6. Globalization and developing countries
7. Inequalities
Disadvantages of globalization:
The negative drivers of globalization included culture which is a major hold back of
globalization. An example of how culture can negatively affect globalization can be seen in
the French film industry. The French are very protective of this part of their culture and
provide huge grants to help its development. As well as government barriers market
barriers and cultural barriers still exist.
 A negative aspect to a countries development is war e.g. tourism in Israel fell by 40% due
to the latest violence. Corporate strategy can also be a negative driver of globalization as
corporation may try to locate in one particular area.
 Another negative driver of globalization is “local focus” or “localization” as it is termed in
Richard Douthwaite’s book “Short Circuit”. Douthwaite (1996) believes that globalization
can and should be reversed.
 He also believes that localization is the way to do this. He defines localization as “not
meaning everything being produced locally but it means a better a balance between local,
regional, national and international markets and thus brings less control to multinational
corporations”.
 Another step to reverse globalization would be for governments to club together to curb
the power of multinational by negotiating new trade and treaties that would remove the
subsidies powering globalization and give local production a chance.
 Douthwaite also states that the global economy is itself nothing less than a system of
structural exploitation that creates hidden slaves on the other side of the world and also that
the North should allow the South to produce for it and not just for us (North). So it can be
seen that Douthwaite is very opposed to globalization especially that part of it exploited by
multinational corporations.
 Further arguments put forward against globalization by Mr. Lawton include that it
actually destroys jobs in wealthy advanced countries. This is due to the lower costs of wages
in developing countries. Multinationals will move to areas of lower wage levels at the drop
of a hat e.g. Fruit of the Loom. Also this ability to relocate has meant that wage levels of
unskilled workers in developed countries have actually fallen relatively speaking. This is
down to the fact that one now needs skill and knowledge in developed economies to
survive. Causes the flow of ideas, services, and capital around the world

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 Offers consumers new choices and greater variety
 Allows the mobility of labor, capital and technology
 Provides employment opportunities
 Reallocates resources and shifts activities to a global level

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 Unit II International Trade and Investment Theories

TRADE THEORY

 what nations export and import what goods

 with what other nations
 under which economic, geographic, and political circumstances,
 with what consequences.

This would allow us to predict and prescribe the content, direction, and size of multilateral
trade flows.
MERCANTILISM
1500-1800

 not a full-blown trade theory (see above); rather,

 an economic policy of governmental accumulation of wealth, in the form of gold
bouillon for:
o domestic control
o investment
o international expansion
 reflects the era of nation-building and the shifting of European political power from
feudal lords and the church to national sovereigns; also reflects and supports the
principal source of wealth -- trading

The trade-policy implication of this economic policy was the generation of a national trade
surplus, paid for by accumulation of gold reserves. Before fully developed financial systems,
there was little international credit. Therefore, a current-account surplus was not matched
by net capital outflow (net loans or investment overseas); rather, it was matched by a net
inflow of gold to pay for the excess of goods exported from the country. Some of this gold
found its way to overseas investment by the sovereign.

ABSOLUTE ADVANTAGE
1776: Adam Smith's The Wealth of Nations

Political and economic liberalism found their expression in Smith's argument that the wealth
of nations depends upon the goods and services available to their citizens, rather than the
gold reserves held by the sovereign.

Maximizing this availability depends, first, on putting all resources to use, and then, on the
ability --

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  to obtain goods and services from where they are produced most cheaply (because
of “natural” or “acquired” advantages), and
 to pay for them by production of the goods and services produced most cheaply in
the country,
 with costs measured in terms of direct and "embedded" labor inputs.

This principle fit the development of capitalist economies based on production via wage
labor (rather than trading commodities for profit); reflects the manufacturing dominance of
Britain; reflects manufacturing economies of scale based on:
 development of specialized equipment;
 labor training and specialization;
 long "runs" of one product.

These are sources of acquired advantage.

The consequent trade policy is relatively free trade, so that a country should import goods
that would be produced more expensively internally, where expense is measured according
to the labor theory of value. These imports are to be paid for by the production of goods that
the country can produce with less use of labor per unit. Exports flow from the country that
can produce a product most cheaply.
COMPARATIVE ADVANTAGE

• 1817: David Ricardo's On the Principles of Political Economy and Taxation

• The possibility of system-wide gains from trade persists, even when a given country has
an absolute advantage in the production of no product.

• Specialization and trade should occur according to the relative opportunity costs of
production in each country, measured in terms of the alternative production given up to
produce a tradable good.
International Trade Theory of Absolute cost advantage
Adam Smith, the Scottish economist observed some drawbacks of existing Mercantilism
Theory of International trade and he proposed a new theory i.e. Absolute Cost Advantage
theory of International trade to remove drawbacks and to increase trade between countries.

Drawbacks of Mercantilism theory

Adam Smith observed following drawbacks of Mercantilism and Neo-mercantlism theory.
1. Mercantilism weakens a country.
2. Restriction on Free Trade decreases country’s wealth
Adam Smith’s Theory (1776)
1. This theory is based on principle of division of labour
(division of labor the separation of a work process into a number of tasks, with each task
performed by a separate person or group of persons.)

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2. Free trade among countries can increase a country’s wealth.
3. Free trade enables a country to provide a variety of goods and services to its people by
specializing in the production of some goods and services and importing others.
4. Every country should specialize in producing those products at the cost less than that of
other countries and exchange these products with other products produced cheaply by other
countries.
5. When one country produces one product at less cost and another country produces
another product at less cost, both can exchange required quantity and can enjoy benefit of
absolute cost advantage.
Advantage of Skilled labour and specialization
1. ABSOLUTE COST ADVANTAGE: Reasons for Absolute Cost Advantage
A. SPECIALIZATION: Specialization of labour leads to higher productivity and less labour
cost per unit of output
B. SUITABILITY: Suitability of the skill of the labour of the country in producing certain
products
C. ECONOMIES OF SCALE: Economies of scale helps to reduce the labour cost per unit of
output.
2. NATURAL ADVANTAGE
Climatic conditions
Natural resources
Example: Indian Climate- Production of Rice, Wheat, Sweet Mangoes, Grapes, Tea,
Coconuts, Cashew nuts, Cotton etc.
Sri Lanka: Production of Tea, Rubber
USA: Production of Wheat
3. ACQUIRED ADVANTAGE
Technology
Skill development
Implications (Significance) of Absolute Advantage Theory
1. More quantity of both products
2. Increased standards of living of both countries
3. Increased production efficiency
4. Increase in global efficiency and effectiveness
5. Maximization of Global productivity and other resources productivity
Criticism
No absolute advantages for many countries
Country size varies
Country by country differences in specialization
Deals with labour only and neglects other factors (Variety of resources)
Neglected Transport cost (It plays significant role)
Scale economies (Large scale economies reduces the cost of production and forms a part of

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absolute advantages, this theory neglects it)
Absolute advantage for many products
COMPARATIVE COST THEORY

This theory is developed by a classical economist David Ricardo. According to this theory,
the international trade between two countries is possible only if each of them has absolute or
comparative cost advantage in the production of at least one commodity. This theory is
based upon following assumption

 There are only two countries and two commodities

 There is no governmental intervention in export and import
 Only labor is factor of production. Quantity of labor used gives cost of production
 There is perfect mobility of labor within the country but not between the countries
 There is no cost of transportation between the countries
 The law of constant returns to scale operates in production.
 The units of labor is homogeneous
 The units of each commodity in both countries are homogeneous

According to comparative cost advantage theory of international trade, each country exports
the commodity in which it has cost advantage and imports the commodity in which it has
cost disadvantage. This theory can be explained as following:

CRITICISM
(1) Unrealistic Assumption of Labour Cost:
The most severe criticism of the comparative advantage doctrine is that it is based on the
labour theory of value. In calculating production costs, it takes only labour costs and
neglects non-labour costs involved in the production of commodities. This is highly
unrealistic be- cause it is money costs and not labour costs that are the basis of national and
international transactions of goods.

Further, the labour cost theory is based on the assumption of homogeneous labour. This is
again unrealistic because labour is heterogeneous—of different kinds and grades, some
specific or specialised, and other non-specific or general.

(2) No Similar Tastes:

The assumption of similar tastes is unrealistic because tastes differ with different income
brackets in a country. Moreover, they also change with the growth of an economy and with
the development of its trade relations with other countries.

(3) Static Assumption of Fixed Proportions:

The theory of comparative costs is based on the assumption that labour is used in the same
fixed proportions in the production of all commodities. This is essentially a static analysis

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and hence unrealistic.

(4) Unrealistic Assumption of Constant Costs:

The theory is based on another weak assumption that an increase of output due to
international specialisation is followed by constant costs.
(5) Ignores Transport Costs:
Ricardo ignores transport costs in determining comparative advantage in trade. This is
highly unrealistic because transport costs play an important role in determining the pattern
of world trade. Like economies of scale, it is an independent factor of production. For
instance, high transport costs may nullify the comparative advantage and the gain from
international trade.

(6) Factors not fully Mobile Internally:

The doctrine assumes that factors of production are perfectly mobile internally and wholly
immobile internationally. This is not realistic because even within a country factors do not
move freely from one industry to another or from one region to another.. The greater the
degree of specialisation in an industry, the less is the factor mobility from one industry to
another. Thus factor mobility influences costs and hence the pattern of international trade.

(7) Two-Country Two-Commodity Model is Unrealistic:

The Ricardian model is related to trade between two countries on the basis of two
commodities. This is again unrealistic because, in actuality, international trade is among
countries trading many commodities.

(8) Unrealistic Assumption of Free Trade:

Another serious weakness of the doctrine is that it assumes perfect and free world trade.
But, in reality, world trade is not free. Every country applies restrictions on the free
movement of goods to and from other countries. Thus tariffs and other trade restrictions
affect world imports and exports. Moreover, products are not homogeneous but
differentiated. By neglecting these aspects, the Ricardian theory becomes unrealistic.

(9) Unrealistic Assumption of Full Employment:

Like all classical theories, the theory of comparative advantage is based on the assumption
of full employment. This assumption also makes the theory static.

(10) Self-Interest Hinders its Operation:

The doctrine does not operate if a country having a comparative disadvantage does not wish
to import a commodity from the other country due to strategic, military or development
considerations. Thus often self-interest stands in the operation of the theory of comparative
costs.

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(11) Neglects the Role of Technology:
(12) One-Sided Theory:
In the words of Professor Ohlin, “It is, indeed, nothing more than an abbreviated account of
the conditions of supply.”

(13) Impossibility of Complete Specialisation:

(14) A Clumsy and Dangerous Tool:
(15) Incomplete Theory:
It is an incomplete theory. It simply explains how two countries gain from international
trade. But it fails to show how the gains from trade are distributed between the two
countries.

OPPORTUNITY COST THEORY

Gottfried von Haberler (German: [ˈhaːbɐlɐ]; July 20, 1900 – May 6, 1995) was an Austrian-
American economist. He worked in particular on international trade. One of his major
contributions was reformulating the Ricardian idea of comparative advantage in
a neoclassical framework, replacing the outdated labor theory of value with the
modern opportunity cost concept.

What is Opportunity Cost?

In the context of production, the opportunity cost of producing commodity, say X, is the
quantity of another commodity, say Y, that must be sacrificed to release resources just
sufficient to produce one unit of X.

In his opportunity cost theory of international trade, Haberler discards Ricardo's restrictive
premise of labour theory of value in favour of a more general framework without otherwise
changing Ricardo's basic argument. 'The opportunity 'cost theory of trade postulates that
relative prices of different commodities are determined by the overall cost differentials.
Here, the term 'cost' does not refer to the amount of labour required to produce a
commodity, but to the alternative production that has to be forgone to produce the
commodity in question. In other words, the value of each commodity is taken to be equal to
its opportunity cost.

Haberler's theory of trade base on opportunity cost is re resented by production possibility

curves. A production possibility curve represents the production frontiers (of generally two
goods) that can be reached by using all the available factors of production. In simple words,
the production possibility curve shows the various combinations of two goods that can be
produced given the 'factor endowments of a country-factor endowments include all the
factors of production available to a country. In this sense, Haberler deviates from the

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classical assumption of only one factor and introduces, in his model, all the factors of
production.

Factor endowment theory

In economics a country's factor endowment is commonly understood as the amount

of land, labor, capital, and entrepreneurship that a country possesses and can exploit
for manufacturing. Countries with a large endowment of resourcestend to be more
prosperous than those with a small endowment, all other things being equal. The
development of sound institutions to access and equitably distribute these resources,
however, is necessary in order for a country to obtain the greatest benefit from its factor
endowment.

Nonetheless, the New World economies inherited attractive endowments such conducive
soils, ideal weather conditions, and suitable size and sparse populations that eventually
came under the control of institutionalizing European colonists who had a marginal
economic interest to exploit and benefit from these new discoveries. Colonists were driven
to yield high profits and power by reproducing such economies’ vulnerable legal and
political framework, which ultimately led them towards the paths of economic
developments with various degrees of inequality in human capital, wealth, and political
power.

Complimentary trade theories – stopler – Samuelson theorem

The Stolper–Samuelson theorem is a basic theorem in Heckscher–Ohlin trade theory. It

describes the relationship between relative prices of output and relative factor rewards—
specifically, real wages and real returns to capital.

The theorem states that—under specific economic assumptions (constant returns, perfect
competition, equality of the number of factors to the number of products)—a rise in
the relative price of a good will lead to a rise in the return to that factor which is used most
intensively in the production of the good, and conversely, to a fall in the return to the other
factor.

Considering a two-good economy that produces only wheat and cloth, with labour and land
being the only factors of production, wheat a land-intensive industry and cloth a labour-
intensive one, and assuming that the price of each product equals its marginal cost, the
theorem can be derived.

The price of cloth should be:

(1)

with P(C) standing for the price of cloth, r standing for rent paid to landowners, w for
wage levels and a and b respectively standing for the amount of land and labour used.

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 Similarly, the price of wheat would be:

(2)

with P(W) standing for the price of wheat, r and w for rent and wages, and c and d for the
respective amount of land and labour used.

If, then, cloth experiences a rise in its price, at least one of its factors must also become more
expensive, for equation 1 to hold true, since the relative amounts of labour and land are not
affected by changing prices. It can be assumed that it would be labour—the factor that is
intensively used in the production of cloth—that would rise.

When wages rise, rent must fall, in order for equation 2 to hold true. But a fall in rent also
affects equation 1. For it to still hold true, then, the rise in wages must be more than
proportional to the rise in cloth prices.

A rise in the price of a product, then, will more than proportionally raise the return to the
most intensively used factor, and a fall on the return to the less intensively used factor.

Criticism

The validity of the Heckscher–Ohlin model has been questioned since the classical Leontief
paradox. Indeed, Feenstra (2004) called the Heckscher–Ohlin model "hopelessly inadequate
as an explanation for historical and modern trade patterns".[3] As for the Stolper–Samuelson
theorem itself, Davis and Mishra (2006) recently stated, "It is time to declare Stolper–
Samuelson dead".[4] They argue that the Stolper–Samuelson theorem is "dead" because
following trade liberalization in some developing countries (particularly in Latin America),
wage inequality rose, and, under the assumption that these countries are labor-abundant,
the SS theorem predicts that wage inequality should have fallen. Aside from the declining
trend in wage inequality in Latin America that has followed trade liberalization in the longer
run (see Lopez-Calva and Lustig (2010)), an alternative view would be to recognize that
technically the SS theorem predicts a relationship between output prices and relative wages.

Three Stages of the International Product Life Cycle Theory

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Product life cycle theory divides the marketing of a product into four stages: introduction,
growth, maturity and decline. When product life cycle is based on sales volume,
introduction and growth often become one stage. For internationally available products,
these three remaining stages include the effects of outsourcing and foreign production.
When a product grows rapidly in a home market, it experiences saturation when low-wage
countries imitate it and flood the international markets. Afterward, a product declines as
new, better products or products with new features repeat the cycle.

General Theory

When a product is first introduced in a particular country, it sees rapid growth in sales
volume because market demand is unsatisfied. As more people who want the product buy
it, demand and sales level off. When demand has been satisfied, product sales decline to the
level required for product replacement. In international markets, the product life cycle
accelerates due to the presence of "follower" economies that rarely introduce new
innovations but quickly imitate the successes of others. They introduce low-cost versions of
the new product and precipitate a faster market saturation and decline.

 Growth
 An effectively marketed product meets a need in its target market. The supplier of

By S.Ojha 17
 the product has conducted market surveys and has established estimates for market
size and composition. He introduces the product, and the identified need creates
immediate demand that the supplier is ready to satisfy. Competition is low. Sales
volume grows rapidly. This initial stage of the product life cycle is characterized by
high prices, high profits and wide promotion of the product. International followers
have not had time to develop imitations. The supplier of the product may export it,
even into follower economies.

 Maturity
 In the maturity phase of the product life cycle, demand levels off and sales volume
increases at a slower rate. Imitations appear in foreign markets and export sales
decline. The original supplier may reduce prices to maintain market share and
support sales. Profit margins decrease, but the business remains attractive because
volume is high and costs, such as those related to development and promotion, are
also lower.

 Decline
 In the final phase of the product life cycle, sales volume decreases and many such
products are eventually phased out and discontinued. The follower economies have
developed imitations as good as the original product and are able to export them to
the original supplier's home market, further depressing sales and prices. The original
supplier can no longer produce the product competitively but can generate some
return by cleaning out inventory and selling the remaining products at discontinued-
items prices.

Market imperfection theory (Stephen Hymer, 1976 & Charles P. Kindleberger, 1969
& Richard E. Caves, 1971)

In economics, a market failure is a situation wherein the allocation of production or use

of goods and services by the free market is not efficient. Market failures can be viewed as
scenarios where individuals' pursuit of pure self-interest leads to results that can be
improved upon from the societal point of view. The first known use of the term by
economists was in 1958, but the concept has been traced back to the Victorian
philosopher Henry Sidgwick.

Market imperfection can be defined as anything that interferes with trade. This includes two
dimensions of imperfections.First, imperfections cause a rational market participant to
deviate from holding the market portfolio. Second, imperfections cause a rational market
participant to deviate from his preferred risk level. Market imperfections generate costs
which interfere with trades that rational individuals make (or would make in the absence of
the imperfection).

The idea that multinational corporations (MNEs) owe their existence to market

By S.Ojha 18
imperfections was first put forward by Stephen Hymer, Charles P. Kindleberger and
Caves.The market imperfections they had in mind were, however, structuralimperfections in
markets for final products.

According to Hymer, market imperfections are structural, arising from structural deviations
from perfect competition in the final product market due to exclusive and permanent control
of proprietary technology, privileged access to inputs, scale economies, control of
distribution systems, and product differentiation, but in their absence markets are perfectly
efficient.

By contrast, the insight of transaction costs theories of the MNEs, simultaneously and
independently developed in the 1970s by McManus (1972), Buckley and Casson (1976),
Brown (1976) and Hennart (1977, 1982), is that market imperfections are inherent attributes of
markets, and MNEs are institutions to bypass these imperfections. Markets experience
natural imperfections, i.e. imperfections that are because the implicit neoclassical
assumptions of perfect knowledge and perfect enforcement are not realized.

New Trade Theory

New Trade Theory (NTT) is the economic critique of international free trade from the
perspective of increasing returns to scaleand the network effect. Some economists have
asked whether it might be effective for a nation to shelter infant industries until they had
grown to a sufficient size large enough to compete internationally.

New Trade theorists challenge the assumption of diminishing returns to scale, and some
argue that using protectionist measures to build up a huge industrial base in certain
industries will then allow those sectors to dominate the world market (via a network effect).

INTERNATIONALISATION THEORY

Internalization theory focuses on imperfections in intermediate product markets. [2] Two

main kinds of intermediate product are distinguished: knowledge flows linking research
and development (R&D) to production, and flows of components and raw materials from an
upstream production facility to a downstream one. Most applications of the theory focus on
knowledge flow.Proprietary knowledge is easier to appropriate when intellectual property
rights such as patents and trademarks are weak. Even with strong protections firms protect
their knowledge through secrecy. Instead of licensing their knowledge to independent local
producers, firms exploit it themselves in their own production facilities. In effect, they
internalise the market in knowledge within the firm. The theory claims the internalization
leads to larger, more multinational enterprises, because knowledge is a public
good. Development of a new technology is concentrated within the firm and the knowledge
then transferred to other facilities.
Location theory

Location theory is concerned with the geographic location of economic activity; it has

By S.Ojha 19
become an integral part of economic geography, regional science, and spatial economics.
Location theory addresses the questions of what economic activities are located where and
why. Location theory rests — like microeconomic theory generally — on the assumption
that agents act in their own self-interest. Thus firms choose locations that maximize their
profits and individuals choose locations, that maximize their utility.

Eclectic paradigm (John H. Dunning)

The eclectic paradigm is a theory in economics and is also known as the OLI-Model. It is a
further development of the theory of internalization and published by John H. Dunning in
1993. The theory of internalization itself is based on the transaction cost theory. This theory
says that transactions are made within an institution if the transaction costs on the free
market are higher than the internal costs. This process is called internalization.

For Dunning, not only the structure of organization is important. He added three additional
factors to the theory:

 Ownership advantages (trademark, production technique, entrepreneurial skills, returns

to scale)
 Locational advantages (existence of raw materials, low wages, special taxes or tariffs)[17]
 Internalisation advantages (advantages by producing through a partnership
arrangement such as licensing or a joint venture)
FURTHER THEORIES

Diffusion of innovations (Rogers, 1962)

Diffusion of innovation is a theory of how, why, and at what rate new ideas
and technology spread through cultures. Everett Rogers introduced it in his 1962
book, Diffusion of Innovations, writing that "Diffusion is the process by which an innovation is
communicated through certain channels over time among the members of a social system."

Diamond model (Michael Porter)

The diamond model is an economical model developed byMichael Porter in his book The
Competitive Advantage of Nations, where he published his theory of why particular industries
become competitive in particular locations.

The diamond model consists of six factors:

 Factor conditions
 Demand conditions
 Related and supporting industries
 Firm strategy, structure and rivalry
 Government
 Chance

By S.Ojha 20
The Porter thesis is that these factors interact with each other to create conditions where
innovation and improve

INSTRUMENTS OF TRADE POLICY

TARIFFS

In simplest terms, a tariff is a tax. It adds to the cost of imported goods and is one of several
trade policies that a country can enact.

Tariffs are often created to protect infant industries and developing economies, but are also
used by more advanced economies with developed industries. Here are five of the top
reasons tariffs are used:

1. Protecting Domestic Employment

The levying of tariffs is often highly politicized. The possibility of increased competition
from imported goods can threaten domestic industries. These domestic companies may
fire workers or shift production abroad to cut costs, which means
higher unemployment and a less happy electorate. The unemployment argument often
shifts to domestic industries complaining about cheap foreign labor, and how poor
working conditions and lack of regulation allow foreign companies to produce goods
more cheaply. In economics, however, countries will continue to produce goods until
they no longer have a comparative advantage (not to be confused with an absolute
advantage).

2. Protecting Consumers

By S.Ojha 21
 A government may levy a tariff on products that it feels could endanger its population.
For example, South Korea may place a tariff on imported beef from the United States if it
thinks that the goods could be tainted with disease.

3. Infant Industries

The use of tariffs to protect infant industries can be seen by the Import Substitution
Industrialization (ISI) strategy employed by many developing nations. The government of a
developing economy will levy tariffs on imported goods in industries in which it wants to
foster growth. This increases the prices of imported goods and creates a domestic market for
domestically produced goods, while protecting those industries from being forced out by
more competitive pricing. It decreases unemployment and allows developing countries to
shift from agricultural products to finished goods.

Criticisms of this sort of protectionist strategy revolve around the cost of subsidizing the
development of infant industries. If an industry develops without competition, it could
wind up producing lower quality goods, and the subsidies required to keep the state-backed
industry afloat could sap economic growth.

4. National Security

Barriers are also employed by developed countries to protect certain industries that are
deemed strategically important, such as those supporting national security. Defense
industries are often viewed as vital to state interests, and often enjoy significant levels of
protection. For example, while both Western Europe and the United States are
industrialized, both are very protective of defense-oriented companies.

5. Retaliation

Countries may also set tariffs as a retaliation technique if they think that a trading
partner has not played by the rules. For example, if France believes that the United States
has allowed its wine producers to call its domestically produced sparkling wines
"Champagne" (a name specific to the Champagne region of France) for too long, it may
levy a tariff on imported meat from the United States. If the U.S. agrees to crack down on
the improper labeling, France is likely to stop its retaliation. Retaliation can also be
employed if a trading partner goes against the government's foreign policy objectives.

Types of Tariffs and Trade Barriers

There are several types of tariffs and barriers that a government can employ:

 Specific tariffs

By S.Ojha 22
  Ad valorem tariffs
 Licenses
 Import quotas
 Voluntary export restraints
 Local content requirements

Specific Tariffs

A fixed fee levied on one unit of an imported good is referred to as a specific tariff. This
tariff can vary according to the type of good imported. For example, a country could levy a
$15 tariff on each pair of shoes imported, but levy a $300 tariff on each computer imported.

Ad Valorem Tariffs

The phrase ad valorem is Latin for "according to value", and this type of tariff is levied on a
good based on a percentage of that good's value. An example of an ad valorem tariff would
be a 15% tariff levied by Japan on U.S. automobiles. The 15% is a price increase on the value
of the automobile, so a $10,000 vehicle now costs $11,500 to Japanese consumers. This price
increase protects domestic producers from being undercut, but also keeps prices artificially
high for Japanese car shoppers.

Non-tariff barriers to trade include:

Licenses
A license is granted to a business by the government, and allows the business to import a
certain type of good into the country. For example, there could be a restriction on imported
cheese, and licenses would be granted to certain companies allowing them to act
as importers. This creates a restriction on competition, and increases prices faced by
consumers.

Import Quotas

An import quota is a restriction placed on the amount of a particular good that can be
imported. This sort of barrier is often associated with the issuance of licenses. For example, a
country may place a quota on the volume of imported citrus fruit that is allowed.

Voluntary Export Restraints (VER)

This type of trade barrier is "voluntary" in that it is created by the exporting country rather
than the importing one. A voluntary export restraint is usually levied at the behest of the
importing country, and could be accompanied by a reciprocal VER. For example, Brazil
could place a VER on the exportation of sugar to Canada, based on a request by Canada.

By S.Ojha 23
Canada could then place a VER on the exportation of coal to Brazil. This increases the price
of both coal and sugar, but protects the domestic industries.

Local Content Requirement

Instead of placing a quota on the number of goods that can be imported, the government can
require that a certain percentage of a good be made domestically. The restriction can be a
percentage of the good itself, or a percentage of the value of the good. For example, a
restriction on the import of computers might say that 25% of the pieces used to make the
computer are made domestically, or can say that 15% of the value of the good must come
from domestically produced components.

In the final section we'll examine who benefits from tariffs and how they affect the price of
goods.

Who Benefits from all this?

The benefits of tariffs are uneven. Because a tariff is a tax, the government will see
increased revenue as imports enter the domestic market. Domestic industries also benefit
from a reduction in competition, since import prices are artificially inflated. Unfortunately
for consumers - both individual consumers and businesses - higher import prices mean
higher prices for goods. If the price of steel is inflated due to tariffs, individual consumers
pay more for products using steel, and businesses pay more for steel that they use to make
goods. In short, tariffs and trade barriers tend to be pro-producer and anti-consumer.

By S.Ojha 24
 Unit III Foreign Exchange Determination Systems
Basic Concepts Relating to Foreign Exchange
An Indian resident, who is dealing, day in and day out in various commodities and to buy
and sell them, uses legal currency of India i.e., Indian Rupee. But to buy and sell
commodities and services, if he has a currency, which is other than his country’s currency,
what will happen? Say for example, an Indian resident receives US Dollar 1,000 from his
relative, for using in India, he cannot straightaway use the Dollar, but has to convert in
Indian Rupees and use it to buy commodities/services.

Hence can we define Foreign Exchange in the following manner?

1) The currencies of other countries in the form of Currency Notes, Travellers’ Cheques,
Drafts, Telegraphic Transfers, Mail Transfers etc.

2) The mechanism by which our legal tender is converted into another currency and vice
versa.

Why Conversion is necessary?

Conversion of Currencies with each other has become a necessity. Because no country in this
Universe can claim that they manufacture all the goods and services, that their people
require to consume. Even the mighty USA is no exception. They import Coffee from Brazil,
India etc. for their consumption. Similarly India imports Capital goods, Technology etc.
from Western Countries.

All are aware that there is no Universal Currency through which such settlements across the
national barriers and borders could be made and settlements take place in the
sellers’/buyers’/any mutually accepted currency. Hence the invention of conversion
mechanism.

Why Exchange Control?

India is having the following Inflows and Outflows:
INFLOWS OUTFLOWS

1) Inward Remittances Outward Remittances

2) Remittances to to all bank accounts Payments relating imports

3) Foreign Aids/Loans /Borrowings Export related payments like commission,

by Corporates etc. legal fees, etc.

4) Export Receivables Tour/Travel related expenses

5) Tourists’ income Loan repayments / servicing of loans

By S.Ojha 25
Normally in India, there is a shortfall of inflows than outflows. Our import payments are
very crucial for the country’s economy and equally important are our payments towards
repayment of loans and its servicing. When demand outplays supply, it is only prudent that
we manage our foreign exchange reserves judiciously.

Hence Reserve Bank of India, under the provisions of Foreign Exchange Regulation Act
1973, controls the inflow and outflow of foreign exchange. Through the Exchange Control
Manual (1993 Edition) and subsequent AD (MA) Circulars, it enforces the proper
management of country’s foreign exchange.

TRADE CONTROL:
It is equally important for any country to effectively monitor the movement of goods. While
the movement of foreign exchange is being controlled through Exchange Control Manual
(1993) and subsequent AD (MA) circulars, goods movement in and out of the country is
being monitored under the provisions of Foreign Trade (Development and Regulations) Act,
1992. The controlling authority in this case is Director General of Foreign Trade, New Delhi
and their various offices in other places headed by Joint Director of Foreign Trade. D.G.F.T.
and J.D.F.T. are guided by the EXIM POLICY (1997-2002), which is being provided by the
Ministry of Commerce, Government of India. Customs are the authorities who are ensuring
the movement of goods according to the above-said provisions, besides collection of
revenues by way of duty on goods imported or exported.

HOW THE FOREIGN EXCHANGE IS HANDLED?

Reserve Bank of India under the provisions of FERA 1973, has delegated the authority of
handling Foreign Exchange to State Bank of India (and its subsidiaries), Public Sector Banks,
Private Sector Banks and Foreign Banks. They have delegated the authority of handling
Foreign Exchange and they are explained through various Chapters of Exchange Control
Manual, a book released by Reserve bank of India, the latest one being 1993 edition. Under
ECM, designated Authorised Dealers (of Foreign Exchange) will be dealing in various
Foreign Exchange transactions, to comply with all terms and conditions. Again Banks that
are authorised to handle Foreign Exchange, designate certain branches to handle the Foreign
Exchange transactions, depending the necessity and potentiality of branch’s location and
they are called Authorised dealing branches.

Besides the above, Reserve Bank of India also authorises reputed Hotels and other private
establishments to handle Foreign Exchange in a limited way (say they can issue / encash
Foreign Currency Travellers’ Cheques / Foreign Currency Notes) to cater to the foreign
tourists’ requirements. They are called Authorised Money Changers (AMC). They are
classified as FULL-FLEDGED / RESTRICTED MONEYCHANGERS.

By S.Ojha 26
TYPES OF FOREIGN EXCHANGE TRANSACTIONS:
Authorised Dealers can handle two types of transactions viz. Purchase and Sale of Foreign
Exchange. When customers tender export bills denominated in Foreign Currency, ADs shall
purchase the Foreign Currency Bill. Likewise, when customers request for a remittance in
Foreign Currency towards payment of Import bills, then ADs have to sell Foreign Currency
to him. From this, we understand that both selling and purchasing transactions are from the
bank’s angle.

SETTLEMENT OF FOREIGN EXCHANGE TRANSACTIONS:

Settlements of Foreign Exchange Transactions are made through the following accounts: -

1) NOSTRO Account: Our Account with you;

ex: The account maintained by an Authorised Dealer with a foreign bank is called
"NOSTRO" Account or "Our Account with You". When an instrument like a cheque or an
export bill is purchased the same is sent to the overseas bank (correspondent) for realisation,
the amount is collected and credited to Authorised Dealer’s account with them.

Similarly, when a draft is issued on a banks foreign correspondent it will be paid at the
overseas centre by debiting the NOSTRO Account of the issuing bank.

2) VOSTRO Account: Your Account with us

Ex.: Foreign banks (Correspondents) also maintain accounts with any bank in India in
Indian Rupees for the purpose of settling their rupee transactions and these accounts are
called "VOSTRO" Accounts meaning "Your Account with us".

3) LORO Account: Their account with them

Ex.: Just like State bank Of India maintaining an account with foreign correspondent say
BTC, New York, Canara Bank may also maintain a Nostro Account with them. When SBI
advises BTC New York for transfer of funds to Canara Bank Account with them, Canara
Bank Account is titled as Loro Account "i.e. their account with you".

When our bank deals in an export credit bill on collection basis/on realisation of export bills
negotiated /purchased/discounted, the foreign currency funds is to be credited to our
account. For this purpose, we maintain Foreign Currency accounts with our various
correspondents abroad. The account is called NOSTRO account. Once the proceeds are
credited in our NOSTRO account, we receive the statement, based on which, the concerned

By S.Ojha 27
branch, who have handled the transaction, will be informed.

Likewise, when we would like to make remittances, on behalf of our customers towards
import payments, miscellaneous remittances etc., we give instructions to our
correspondents, to debit our NOSTRO account and effect payment.

Sometimes our correspondents maintain VOSTRO accounts (Rupee accounts of Non-

resident banks) with our bank and payment or receipts are made through this account. For
exports, they will authorise us to debit their VOSTRO account and for imports, they will
give instructions to credit their account.

Likewise whenever the account of one bank in the books of the same correspondent, where
we are maintaining our NOSTRO account, the other bank’s account with the correspondent
is referred as LORO account. That is the account maintained by Indian Bank with our
correspondent Bankers Trust Co Newyork, will be referred as LORO account of Indian
Bank.

EXCHANGE RATES:
The rate, at which a currency is converted into another currency, is called the rate of
exchange. Such rates are arrived from the base rate, which is decided by market forces and is
quoted on a daily basis. Banks quote various rates for different types of operations like Bill
buying, Bill selling, TT (DD/MT/TT) buying , TT (DD/MT/TT) Selling etc. The rates are
arrived after loading suitable margins, as per F.E.D.A.I. (Foreign Exchange Dealers
Association of India) guidelines.

FOREIGN EXCHANGE MARKET:

Foreign Exchange Market is an Over the Counter Market. It means that there is no fixed
market place. Market players are differently and distantly located. It has no borders and
barriers. All the transactions are put through over telecommunications followed up by
written confirmations. Hence there is the need of high level professionalism for the market
players, which is in place.

Market Players are Authorised Dealers, Recognised Foreign Exchange brokers, Exporters,
Importers, Reserve Bank of India. Sometimes market dealers include foreign banks abroad.

As such, Foreign Exchange Market is a three tier market viz.:

a) Merchant Market : Between Authorised Dealers and the public.

b) Inter Bank Market : Between Authorised Dealers in India including Reserve Bank.
c) INTERNATIONAL MARKET : Comprising all Banks who deal in Foreign Exchange at
select international Foreign Exchange Centres like Singapore, Hong Kong, Tokyo, London,

By S.Ojha 28
New York etc. When an Authorised Dealer is unable to cover a deal in the local market, he
will approach the other Bankers in the International Market for covering his deal.

Foreign Exchange is a scarce commodity, Hence, it is subject to control.

It commands a price due to the forces of supply and demand.

It has an active market (both domestic and international).

Authorised Dealers maintain stocks of Foreign Exchange abroad to meet contingencies in

the form of balances in Nostro Accounts with their Correspondent Banks.

Various types of Exchange Rate Regimes – Floating Rate Regimes

A floating exchange rate or fluctuating exchange rate is a type of exchange-rate regime in
which a currency's value is allowed to fluctuate in response to foreign-exchange market
mechanisms. A currency that uses a floating exchange rate is known as a floating currency.

A floating exchange rate is a regime where the currency price is set by the forex
market based on supply and demand compared with other currencies. This is in contrast to
a fixed exchange rate, in which the government entirely or predominantly determines the
rate. The currencies of most of the world's major economies were allowed to float freely
following the collapse of the Bretton Woods system in 1971.

Floating exchange rate systems mean that while long-term adjustments reflect relative
economic strength and interest rate differentials between countries, short-term moves can
reflect speculation, rumors and disasters, either natural or man-made. Extreme short-term
moves can result in intervention by central banks, even in a floating rate environment.

Why this is needed?

“Foreign exchange” refers to money denominated in the currency of another nation or group
of nations. Any person who exchanges money denominated in his own nation’s currency for
money denominated in another nation’s currency acquires foreign exchange. That holds true
whether the amount of the transaction is equal to a few dollars or to billions of dollars;
whether the person involved is a tourist cashing a traveler’s check in a restaurant abroad or
an investor exchanging hundreds of millions of dollars for the acquisition of a foreign
company; and whether the form of money being acquired is foreign currency notes, foreign
currencydenominated bank deposits, or other shortterm claims denominated in foreign
currency. A foreign exchange transaction is still a shift of funds, or short-term financial
claims, from one country and currency to another. Thus, within the United States, any
money denominated in any currency other than the U.S. dollar is, broadly speaking,
“foreign exchange.” Foreign exchange can be cash, funds available on credit cards and debit

By S.Ojha 29
cards, traveler’s checks, bank deposits, or other short-term claims. It is still “foreign
exchange” if it is a short-term negotiable financial claim denominated in a currency other
than the U.S. dollar. But, in the foreign exchange market described in this book—the
international network of major foreign exchange dealers engaged in high-volume trading
around the world—foreign exchange transactions almost always take the form of an
exchange of bank deposits of different national currency denominations. If one bank agrees
to sell dollars for Deutsche marks to another bank, there will be an exchange between the
two parties of a dollar bank deposit for a DEM bank deposit. In this book, “foreign
exchange” means a bank balance denominated in a foreign (non-U.S. dollar) currency.

Role of Forex
The exchange rate is a price—the number of units of one nation’s currency that must be
surrendered in order to acquire one unit of another nation’s currency. There are scores of
“exchange rates” for the U.S. dollar. In the spot market, there is an exchange rate for every
other national currency traded in that market, as well as for various composite currencies or
constructed monetary units such as the International Monetary Fund’s “SDR,” the European
Monetary Union’s “ECU,” and beginning in 1999, the “euro.” There are also various “trade-
weighted” or “effective” rates designed to show a currency’s movements against an average
of various other currencies (see Box 2-1). Quite apart from the spot rates, there are additional
exchange rates for other delivery dates, in the forward markets. Accordingly, although we
talk about the dollar exchange rate in the market, and it is useful to do so, there is no single,
or unique dollar exchange rate in the market, just as there is no unique dollar interest rate in
the market. A market price is determined by the interaction of buyers and sellers in that
market, and a market exchange rate between two currencies is determined by the interaction
of the official and private participants in the foreign exchange rate market. For a currency
with an exchange rate that is fixed, or set by the monetary authorities, the central bank or
another official body is a key participant in the market, standing ready to buy or sell the
currency as necessary to maintain the authorized pegged rate or range. But in the United
States, where the authorities do not intervene in the foreign exchange market on a
continuous basis to influence the exchange rate, market participation is made up of
individuals, nonfinancial firms, banks, official bodies, and other private institutions from all
over the world that are buying and selling dollars at that particular time. The participants in
the foreign exchange market are thus a heterogeneous group. Some of the buyers and sellers
may be involved in the “goods” market, conducting international transactions for the
purchase or sale of merchandise. Some may be engaged in “direct investment” in plant and
equipment, or in “portfolio investment,” dealing across borders in stocks and bonds and
other financial assets, while others may be in the “money market,” trading short-term debt
instruments internationally. The various investors, hedgers, and speculators may be focused
on any time period, from a few minutes to several years. But, whether official or private, and
whether their motive be investing, hedging, speculating, arbitraging, paying for imports, or

By S.Ojha 30
seeking to influence the rate, they are all part of the aggregate demand for and supply of the
currencies involved, and they all play a role in determining the market exchange rate at that
instant. Given the diverse views, interests, and time frames of the participants, predicting
the future course of exchange rates is a particularly complex and uncertain business. At the
same time, since the exchange rate influences such a vast array of participants and business
decisions, it is a pervasive and singularly important price in an open economy, influencing
consumer prices, investment decisions, interest rates, economic growth, the location of
industry, and much else. The role of the foreign exchange market in the determination of
that price is critically important.
Background

The Bretton Woods Conference took place in July 1944; it takes its name from the resort in
New Hampshire where it took place. A total of 44 countries met, with attendees limited to
the Allies in World War II, which had not yet ended. The Conference established
the International Monetary Fund and the World Bank, and it set out guidelines for a fixed
exchange rate system. The system established a gold price of $35 per ounce, and
participating countries pegged their currency to the dollar. Adjustments of plus or minus 1%
were permitted. The dollar became the reserve currency through which central banks
carried out intervention to adjust or stabilize rates.

The first large crack in the system appeared in 1967, with a run on gold and an attack on the
British pound that led to a 14.3% devaluation. President Richard Nixon took the United
States off the gold standard in 1971. By late 1973, the system had collapsed, and participating
currencies were allowed to float freely.

Central Bank Intervention

In floating exchange rate systems, central banks buy or sell their local currencies to adjust
the exchange rate; this can be aimed at stabilizing a volatile market or achieving a major
change in the rate. Groups of central banks, such as those of the G-7 nations (Canada,
France, Germany, Italy, Japan, the United Kingdom, and the United States), often work
together in coordinated interventions to increase the impact.

An intervention is often short-term and does not always succeed. A prominent example of a
failed intervention took place in 1992, when financier George Soros spearheaded an attack
on the British pound. The currency had entered the European Exchange Rate Mechanism
(ERM) in October 1990; the ERM was designed to limit currency volatility as a lead-in to
the euro, which was still in the planning stages. Soros believed that the pound had entered
at an excessively high rate, and he mounted a concerted attack on the currency. The Bank of
England was forced to devalue the currency and withdraw from the ERM. The failed
intervention cost the U.K. Treasury a reported £3.3 billion.

By S.Ojha 31
Central banks can also intervene indirectly in the currency markets by raising or lowering
interest rates to impact the flow of investors' funds into the country.

Dirty Float
A dirty float is an exchange rate regime in which the country's central bank occasionally
intervenes to change the direction or the pace of change of the country's currency value. In
most instances, the intervention aspect of a dirty float system is meant to act as a buffer
against an external economic shock before its effects become truly disruptive to the domestic
economy. It's also known as a "managed float."!--break--From 1946 until 1971, many of the
world's major industrialized nations participated in a fixed exchange rate system known as
the Bretton Woods Agreement. This ended when President Richard Nixon took the United
States off the gold standard on Aug. 15, 1971; since then, most major industrialized
economies feature floating exchange rates.

Many developing nations seek to protect their domestic industries and trade by using a
managed float in which the central bank intervenes to guide the currency. The frequency of
such intervention varies. For example, the Reserve Bank of India manages the rupee closely
in a very narrow band, while the Monetary Authority of Singapore allows the local dollar to
fluctuate more freely in an undisclosed band.

There are several reasons why a central bank intervenes in a currency market that is usually
allowed to float.
Market Uncertainty
Central banks with a dirty float sometimes intervene to steady the market at times of
widespread economic uncertainty. The central banks of both Turkey and Indonesia
intervened openly numerous times during 2014 and 2015 to combat currency weakness
caused by instability in emerging markets worldwide. Some central banks prefer not to
publicly acknowledge when they intervene in the currency markets; for example, Bank
Negara Malaysia was widely rumored to have intervened to support the ringgit during the
same period, but the central bank has not acknowledged it.
Speculative Attack
Central banks sometimes intervene to support a currency that is under attack by a hedge
fund or other speculator. For example, a central bank may find that a hedge fund is
speculating that its currency might depreciate substantially, thus the hedge fund is building
up speculative short positions. The central bank can purchase a large amount of its own
currency in order to limit the amount of devaluation caused by the hedge fund.

A dirty float system isn't considered to be a true floating exchange rate because,
theoretically, true floating rate systems don't allow for intervention. However, the most
famous show-down between a speculator and a central bank took place in September 1992,

By S.Ojha 32
when George Soros forced the Bank of England to take the pound out of the European
Exchange Rate Mechanism (ERM). The pound theoretically floats freely, but the BoE spent
billions in an unsuccessful attempt to defend the currency.

Types of Foreign Exchange rates

Fixed Exchange Rates
There are two ways the price of a currency can be determined against another. A fixed, or
pegged, rate is a rate the government (central bank) sets and maintains as the official
exchange rate. A set price will be determined against a major world currency (usually the
U.S. dollar, but also other major currencies such as the euro, the yen or a basket of
currencies). In order to maintain the local exchange rate, the central bank buys and sells its
own currency on the foreign exchange market in return for the currency to which it is
pegged.
If, for example, it is determined that the value of a single unit of local currency is equal to
US$3, the central bank will have to ensure that it can supply the market with those dollars.
In order to maintain the rate, the central bank must keep a high level of foreign reserves.
This is a reserved amount of foreign currency held by the central bank that it can use to
release (or absorb) extra funds into (or out of) the market. This ensures an
appropriate money supply, appropriate fluctuations in the market (inflation/deflation) and
ultimately, the exchange rate. The central bank can also adjust the official exchange rate
when necessary.

Floating Exchange Rates

Unlike the fixed rate, a floating exchange rate is determined by the private market
through supply and demand. A floating rate is often termed "self-correcting," as any
differences in supply and demand will automatically be corrected in the market. Look at this
simplified model: if demand for a currency is low, its value will decrease, thus making
imported goods more expensive and stimulating demand for local goods and services. This
in turn will generate more jobs, causing an auto-correction in the market. A floating
exchange rate is constantly changing.

In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can
also influence changes in the exchange rate. Sometimes, when a local currency reflects its
true value against its pegged currency, a "black market" (which is more reflective of actual
supply and demand) may develop. A central bank will often then be forced to revalue or
devalue the official rate so that the rate is in line with the unofficial one, thereby halting the
activity of the black market.

In a floating regime, the central bank may also intervene when it is necessary to ensure
stability and to avoid inflation. However, it is less often that the central bank of a floating

By S.Ojha 33
regime will interfere.

Managed Fixed Rate Regime

Managed fixed exchange rate is that exchange rates should be fixed at levels compatible
with fundamentals but should be changed when fundamentals have changed. This contrasts
with the presumption behind the managed float: which is that exchange rates should be
allowed to float - as if exchange rates based on free market forces were automatically
justified by economic fundamentals. Floating exchange rates are to be prevented from
excessive gyrations as if policy makers can tell what is excessive and what is not.
Unfortunately, this latter presumption behind floating exchange rate does not square with
the reality. Often times, exchange rates are driven by market forces away from what is
compatible with economic fundamentals. We have seen the "super dollar" prior to the Plaza
Accord. We have seen how the strong yen ruined the Japanese economy. We have seen the
strong euro kill the Euro economy.

Purchasing Power Parity

The Purchasing Power Parity Theory has been popularized during the inter-war period by
GAUSTAV CASSEL, the Swedish Economist.
According to this theory, rates of exchange between two countries are determined by
relative price level.

The actual rate of exchange must be such that the same amount of purchasing power, when
exchanged at that rate, must buy the same amount of goods and services in both the
countries.

For Example, if by spending Rs. 60/- we can buy an amount of goods in India as we can buy
with £1 in England the rate of exchange between England and India will be Rs. 60/- to £1.
This is easily seen if we reflect on the fact that the price paid in a foreign currency is
ultimately a price for foreign commodities, a price which must stand in a certain relation to
the prices of commodities on the home market. Thus, we arrive at the conclusion that the
rate of exchange between two currencies must stand essentially on the quotient of the
internal purchasing powers of these currencies.

Definition:

“The rate of exchange determined in relation to price-levels is known the Purchasing

Power Parity”

Purchasing Power Parity (PPP) is an economic theory that compares different countries'
currencies through a market "basket of goods" approach. According to this concept, two

By S.Ojha 34
currencies are in equilibrium or at par when a market basket of goods (taking into account
the exchange rate) is priced the same in both countries.

This is how the relative version of PPP is calculated:

Where:

"S" represents exchange rate of currency 1 to currency 2

"P1" represents the cost of good "x" in currency 1
"P2" represents the cost of good "x" in currency 2
To make a comparison of prices across countries that holds any type of meaning, a wide
range of goods and services must be considered. The amount of data that must be collected,
and the complexity of drawing comparisons makes this process difficult. To facilitate this,
the International Comparisons Program (ICP) was established in 1968 by the University of
Pennsylvania and the United Nations. Purchasing power parities generated by the ICP are
based on a worldwide price survey that compares the prices of hundreds of various goods.
This data, in turn, helps international macroeconomists come up with estimates of global
productivity and growth.
Every three years, the World Bank constructs and releases a report that compares various
countries in terms of PPP and U.S. dollars.
Both the International Monetary Fund (IMF) and the Organization for Economic
Cooperation and Development (OECD) use weights based on PPP metrics to make
predictions and recommend economic policy.These actions often impact financial markets in
the short run.Some forex traders also use PPP to find potentially overvalued or undervalued
currencies. Investors who hold stock or bonds of foreign companies may survey PPP figures
to predict the impact of exchange-rate fluctuations on a country's economy.

Mint Parity
Mint Parity Theory of Equilibrium Rate of Exchange!
When the currencies of two countries are on a metallic standard (gold or silver), the rate of
exchange between them is determined on the basis of parity of mint ratios between the
currencies of the two countries. Thus, the theory explaining the determination of exchange
rate between countries which are on the same metallic standard (say, gold coin standard) is
known as the Mint Parity Theory of foreign exchange rate.

By mint parity is meant that the exchange rate is determined on a weight-to-weight basis of
the two currencies, allowance being made for the parity of the metallic content of the two
currencies. Thus, the value of each coin (gold or silver) will depend upon the amount of

By S.Ojha 35
metal (gold or silver) contained in the coin and it will freely circulate between the countries.
Under the system of gold standards, for instance, the rate of foreign exchange is determined
in terms of the gold content of the two given currency units. This is referred to as mint
parity. Thus, if currency A contains 10 grams of gold and В contains 5 grams of gold, then
rate of exchange is: 1A = 2B.
Today, however, the method of determining currency value in terms of gold content or mint
parity is obsolete for the obvious reasons that: (i) none of the modern countries in the world
is on gold or metallic standard, (ii) free buying and selling of gold internationally is not
permitted, by various governments and as such it is not possible to fix par value in terms of
gold content or mint parity, and (iii) most of the countries today are on paper standard or
Fiat currency system.

Interest rates, other Factors Affecting Exchange Rates

The Rates of Exchange fluctuate above and below the mint par. What are the causes which
influence the movements of the rates of exchange? They may be grouped under two main
heads: the demand and supply of foreign currency, and the currency conditions. The
demand and supply of foreign currency arises from three sources.
They are:
(1) Trade conditions,

(2) Stock Exchange influences, and

(3) Banking influences.

1. Trade Conditions:
The demand and supply of foreign currency are dependent primarily on the volume of
exports and imports. When exports are greater than imports, foreigners owe to us a greater
sum than we owe to them. The rate of exchange moves in our favour. On the other-hand
when imports are greater than exports, the demand for foreign currency is greater than the
supply and the rate will fall. Among exports and imports we must include not only goods
but the invisible items, because these also give rise to the demand for and the supply of
foreign currency.

2. Stock Exchange Influences:

Stock exchange influences include the payment of loans, interest and re-payment of loans,
the purchase of sale of foreign securities by home investors or of home securities by foreign
investors. When a country gives loans to another the loans have to be transferred into the
foreign currency. Its demand for foreign currency increases, and the rate of the exchange
moves against it.

In the same way when home investors buy foreign securities or home securities are sold by

By S.Ojha 36
foreigners the rate falls. But when loans are being repaid or when foreigners buy domestic
securities, the demand for home currency or their part rises and the rate of exchange rises.

3. Banking Influences:
Banking influences include the purchase and sale of banker’s drafts, traveller’s letters of
credit, arbitrage Operations etc. when a bank issues a draft or a letter of credit etc. on a
foreign branch, the demand for foreign currency rises and the rate of exchange falls. Bank
Rate is also an important influence on the rates of exchange.

When it is high i.e., in relation to other countries, foreigners will send funds to that country
to earn the high rate of interest. The demand for home currency rises and the rate of
exchange moves up. The opposite will happen when the bank rate is lowered.

The second group of factors which influence the Exchange Rate is:
(a) Currency Conditions:
The conditions of currency in a country also exercise important influence on the rates of
exchange. If there is a rumor that the currency will depreciate due to an over issue of paper
money, the demand for that currency will fall off, since no-body wants to transfer his funds
into a currency whose purchasing power is likely to depreciate the rate of exchange will,
therefore, rise and may jump up to abnormally high figures if there is a “flight from the
foreign currency” i.e., if foreigners not liking to invest their funds to their home currency,
hasten to transfer them to foreign countries where purchasing power is more stable.
Similarly, when the currency of one country is based on silver and another on gold, the rates
of exchange will depend on the gold price of silver.

Besides these there are:

(a) The political conditions,

(b) The growth of speculative sentiment etc. which will affect the rate.

Limits to Fluctuations in Exchange Rates:

When both the countries are on gold standard the actual rates of exchange will fluctuate
around the mint par of exchange within limits fixed by the gold points. The mint par is
determined with reference to the value of the amount of pure gold in the coins of each
country. The rate of exchange is said to be at par when it is the same as the mint par. The
rate of exchange will fluctuate above and below the mint par. The limits to the fluctuations
in the rates of exchange are fixed under gold standard by the gold or specie points.

The actual gold export point is determined by adding the shipping expenses etc. to the mint
par. Similarly, the gold import point is found by subtracting the shipping expenses from the
par. So long as the price of bills is within the gold points, merchants will buy bills in order to

By S.Ojha 37
make payments to foreign countries. But if the price of bills is higher than the gold export
point, they will send gold instead of sending bills.

Similarly, when the rate of exchange touches the import point, gold will be imported. Unlike
the mint par which is stable so long as the gold contents and the fineness of the coins are not
changed, gold points are variable according as the cost of freight, insurance etc. increase or
decrease.

Favourable and Unfavorable Rates:

A country is said to have favourable exchange when the rate of exchange is near the gold
import point; it has unfavorable exchange where the rate is near gold export point. When we
have imported more and exported less we shall have to pay the foreigners for the imports by
sending gold or other funds. The exchange is said to be unfavorable. Conversely, when our
exports are greater than our imports foreigners must pay us by sending gold. The exchange
is then said to be favourable.

Limits under Paper Currency Standard:

When both the countries are on inconvertible paper currency there are no gold points. The
mint par is replaced by the purchasing power, Parity, determined with reference to the
price-levels of the two countries. Unlike the mint par the purchasing power parity is a
moving par, changing in response to every change in the prices. Though there is a part of
exchange, there is however, no limit to the fluctuations in the rates of exchange. The latter
will fluctuate in accordance with every change in the demand and supply of foreign
currency.

Brief History of Indian Rupees Exchange Rate

The history of the Rupee traces back to the Ancient India in circa 6th century BC. Ancient
India was the earliest issuers of coins in the world, along with the Chinese wen and
Lydian staters.

The word "rūpiye" is derived from a Sanskrit word "rūpaa", which means "wrought silver, a
coin of silver", in origin an adjective meaning "shapely", with a more specific meaning of
"stamped, impressed", whence "coin". It is derived from the noun rūpa "shape, likeness,
image". The word rūpa is being further identified as having sprung from the Dravidian

From 1950 to 1973 Indian Rupee was linked to the British Pound.In 1966 and 1973
devaluation happened.

On 24th September 1975, the connection between Indian rupee and Pound was broken.

In 1975, the Rupee's ties to the Pound Sterling were disengaged. India established a float
exchange regime, with the Rupee's effective rate placed on a controlled, floating basis and

By S.Ojha 38
linked to a "basket of currencies" of India's major trading partners.

In 1993 Liberalized Exchange Rate Management System (LERMS) was replaced by the
unified exchange rate system and hence the system of market determined exchange rate was
adopted.
However, the RBI did not relinquish its right to intervene in the market to enable and
control the Indian currency.

Indian Rupee and its exchange rate historically – Historically, the Indian rupee was a
silver-based currency, while the major economies of the world were following the gold
standard. The value of the rupee was severely impacted when large quantities of silver was
discovered in the US and Europe. After independence, India started following a pegged
exchange rate system. The country was forced to go through several rounds of devaluation
from the 1960s to the early 1990s due to war and balance of payments problems. The rupee
was made convertible on the current account in 1993. The Indian currency is set to be made
fully convertible in phases over the five years ending 2010-2011. In June 2008, the rupee
appreciated to a ten-year high of US$39.29. The stability of the Indian economy attracted
substantial foreign direct investment, while high interest rates in the country led to
companies borrowing funds from abroad.

The global financial crisis exerted pressure on crude oil prices, which gradually plummeted
to below $50 a barrel. Due to this, dollar inflow declined, with oil companies and investors
purchasing more and more dollars. Persistent outflow of foreign funds increased the
pressure on the rupee, causing it to decline. On March 5, 2009, the Indian currency
depreciated to a record low of US$52.06. The US dollar's gains against other major currencies
also weighed on the rupee.

1950 - 4.79 Indian Rupees to 1 American dollar

1955 - 4.79 Indian Rupees to 1 American dollar

1960 - 4.77 Indian Rupees to 1 American dollar

1965 - 4.78 Indian Rupees to 1 American dollar

1970 - 7.56 Indian Rupees to 1 American dollar

1975 - 8.39 Indian Rupees to 1 American dollar

1975 - 8.39 Indian Rupees

By S.Ojha 39
1980 - 7.86 Indian Rupees

1985 - 12.36 Indian Rupees

1990 - 17.50 Indian Rupees

1995 - 32.42 Indian Rupees

2000 - 44.94 Indian Rupees

2000 - 44.94 Indian Rupees

2005 - 44.09 Indian Rupees

2010 - 44 to 50 Indian Rupees

By S.Ojha 40
 UNIT 4 International Institution
UNCTAD:-
UNCTAD, which is governed by its 194 member States, is the United Nations body
responsible for dealing with development issues, particularly international trade – the main
driver of development.
Established in 1964, and is headquartered in Geneva, Switzerland
The organisation grew from the view that existing institutions like GATT (now replaced by
the World Trade Organization, WTO), the International Monetary Fund (IMF), and World
Bank were not properly organized to handle the particular problems of developing
countries.
Principles
The two main tenets were: (1) that prices of primary commodities (staple foodstuffs and
raw materials), which form the main exports of developing countries, have declined relative
to the prices of manufactured exports and that this was an inevitable and continuous
process;
(2) as a result of this tendency most of the gains from international trade accrue to
developed and industrialized countries, while developing countries gain relatively little
from their participation in existing international trade relations.
ACHIEVEMENTS
UNCTAD assists developing countries in promoting the development of their enterprises,
especially small and medium-sized enterprises (SMEs), so that they are able to grow and
compete in the global economy.
UNCTAD is the United Nations focal point for trade and development, and for interrelated
issues in the areas of finance, technology, investment and sustainable development.
Its objective is to assist developing countries, especially the least developed countries, and
countries with economies in transition, to integrate beneficially into the global economy.
It also seeks to help the international community promote a global partnership for
development, increase coherence in global economic policymaking, and assure development
gains for all from trade.
International Monetary Fund (IMF)

The International Monetary Fund (IMF) is an international organization created for the
purpose of standardizing global financial relations and exchange rates

 Monitors the global economy, and its core goal is to economically strengthen its
member countries. Specifically, the IMF was created with the intention of:
 Promoting global monetary and exchange stability.
 Facilitating the expansion and balanced growth of international trade.
 Assisting in the establishment of a multilateral system of payments for current

By S.Ojha 41
 transactions.

ROLE OF IMF
The work of the IMF is of three main types.
 Surveillance involves the monitoring of economic and financial developments, and
the provision of policy advice, aimed especially at crisis-prevention.
 The IMF also lends to countries with balance of payments difficulties, to provide
temporary financing and to support policies aimed at correcting the underlying
problems; loans to low-income countries are also aimed especially at poverty
reduction.
 Third, the IMF provides countries with technical assistance and training in its areas
of expertise. Supporting all three of these activities is IMF work in
economic research and statistics.

WORLD BANK/IBRD
The International Bank for Reconstruction and Development (IBRD) is an international
financial institution that offers loans to middle-income developing countries. The IBRD is
the first of five member institutions that compose the World Bank Group and is
headquartered in Washington, D.C., United States. It was established in 1944 with the
mission of financing the reconstruction of European nations devastated by World War II.
The main objectives of the world bank are -

 The IBRD provides financial services as well as strategic coordination and

information services to its borrowing member countries

 The Bank offers flexible loans with maturities as long as 30 years and custom-
tailored repayment scheduling. The IBRD also offers loans in local currencies

 The Bank provides an array of financial risk management products

including foreign exchange swaps, currency conversions, interest rate
swaps, interest rate caps and floors, and commodity swaps.

 To promote private investment by means of guarantees on participation in

loans and other investment to private members.

 To assist in reconstruction and development of the territories of its members.

 To encourage the development of productive resources in developing

countries by supplying their capital.

By S.Ojha 42
  To promote long term balanced growth of international trade.

WTO
The WTO was born out of the General Agreement on Tariffs and Trade (GATT), which was
established in 1947. A series of trade negotiations, GATT rounds began at the end of World
War II and were aimed at reducing tariffs for the facilitation of global trade on goods. The
rationale for GATT was based on the Most Favored Nation (MFN) clause, which, when
assigned to one country by another, gives the selected country privileged trading rights. As
such, GATT aimed to help all countries obtain MFN-like status so that no single country
would be at a trading advantage over others.
The purpose of the WTO is to ensure that global trade commences smoothly, freely and
predictably. The WTO creates and embodies the legal ground rules for global trade among
member nations and thus offers a system for international commerce. The WTO aims to
create economic peace and stability in the world through a multilateral system based on
consenting member states (currently there are slightly more than 140 members) that have
ratified the rules of the WTO in their individual countries as well. This means that WTO
rules become a part of a country's domestic legal system.

The benefits
 The system helps promote peace
 Disputes are handled constructively
 Rules make life easier for all
 Freer trade cuts the costs of living
 It provides more choice of products and qualities
 Trade raises incomes
 Trade stimulates economic growth
 The basic principles make life more efficient
 Governments are shielded from lobbying
 The system encourages good government

ECONOMIC INTEGRATION

Regional Economic Integration: agreements between groups of countries in a geographic

region to reduce, and ultimately remove, tariff and nontariff barriers to the free flow of
goods, services, and factors of production between each other. By entering into regional
agreements groups of countries aim to reduce trade barriers more rapidly than can be
achieved under the auspices of the WTO .
LEVELS OF ECONOMIC INTEGRATION

Free Trade Area : In a free trade area all barriers to the trade of goods and services

By S.Ojha 43
 among member countries are removed. In the theoretically ideal free trade area, no
discriminatory tariffs, quotas, subsidies, or administrative impediments are allowed to
determine its own trade policies with regard to nonmembers. Ex : EFTA and NAFTA
Customs Union : eliminates trade barriers between member-countries and adopts a
common external trade policy. Ex : Andean Pact

Common Market : The theoretically ideal common market has no barriers to trade
between member-countries and a common external trade policy. Unlike in a customs
union, in a common market factors of production also are allowed to move freely
between member-countries. Thus, labour and capital are free to move, as there are no
restrictions on immigration, emigration, or cross-border flows of capital between
member-countries.

Economic Union : An Economic Union involves the free flow of products and factors of
production between member-countries and the adoption of a common external trade
policy. A full economic union also requires a common currency, harmonization of the
member-countries tax rates and a common monetary and fiscal policy.

THE CASE FOR REGIONAL INTEGRATION - THE ECONOMIC CASE FOR

Unrestricted free trade will allow countries to specialize in the production of goods and
services that they can produce most efficiently Asian, Russian, and Latin American
Crisis: Questioning liberalization of financial markets!!! Opening a country to free trade
stimulates economic growth in the country, which in turn creates dynamic gains from
trade. Flows of FDI can transfer technological, marketing and managerial know-how to
host nations. Stimulates Economic Growth
Incentives are created or political cooperation between neighboring states By grouping
their economies together, the countries can enhance their political weight in the world. B
– POLITICAL CASE FOR INTEGRATION Costs, painful adjustments Concerns over
national sovereignty C – IMPEDIMENTS TO INTEGRATION

THE CASE FOR/AGAINST REGIONAL INTEGRATION A - TRADE CREATION

Occurs when high-cost domestic producers are replaced by low-cost external suppliers
within the free trade area. B - TRADE DIVERSION Occurs when lower-cost external
suppliers are replaced by higher-cost suppliers within the free trade area. A regional free
trade agreement will benefit the wold only if the amount of trade exceeds the amount it
diverts. In theory, GATT and WTO rules should ensure that a free trade agreement does
not result in trade diversion.

REGIONAL ECONOMIC INTEGRATION IN EUROPE

The EU is the product of two political factors:

By S.Ojha 44
 a) Devastation of two wars
b) Desire to hold their own on the world’s political and economic stage TREATY OF
ROME – 1957 IN1973, first enlargement of the EC .Other additions, Greece in 1981, Spain
and Portugal in 1986, and in 1996 by Finland, Austria and Sweden .With a population of
350 million and a GDP greater than that of the United States, these enlargements made
the EU a potential global superpower.
In 1994, following the ratification of the Maastricht treaty Single European Act: The
main problem with the EC was the disharmony of the member-countries technical, legal,
regulatory and tax standards. The rules of the game differed substantially from country
to country, which stalled the creation of a true single internal market. The “White Paper”
was published in 1985, proposing that all impediments to the formation of a single
market be eliminated by 1992. Objectives of the Act: frontier controls, mutual recognition
of standards, public procurement, financial markets, lifting barriers, exchange controls,
freight transport. “ The United States of Europe”
The Treaty of Maastricht Common currency, lower cost of doing business in Europe,
reduce risks that arise from currency fluctuations. National authorities would lose
control over monetary policy Enlargement of the European Union: Eastern European
Countries Europe

REGIONAL ECONOMIC INTEGRATION IN THE AMERICAS

A - The Nafta Agreement Nafta became law January 1, 1994.
Guidelines: Abolition within 10 years of tarifs on 99% of the goods traded among Mexico,
Canada, and the U.S. Remove most of the barriers on the cross-border flow of services
Protect intellectual property rights Removes most restrictions on FDI among the three
members Members are allowed to apply its own environmental standards

FTAA Enlargement of NAFTA or the creation of two major trading blocks in the Americas
SAFTA and NAFTA. CACM, CARICOM ( the Caribbean Community (CARICOM) is an
organization of 15 Caribbean nations and dependencies. CARICOM's main purposes are to
promote economic integration and cooperation among its members, to ensure that the
benefits of integration are equitably shared, and to coordinate foreign policy.) ,
MERCOSUR(sub-regional bloc. Its full members are Argentina,
Bolivia, Brazil, Paraguay, Uruguay and Venezuela. Its associate countries
are Chile, Peru, Colombia and Ecuador. Observer countries are New Zealand and Mexico.
Its purpose is to promote free trade and the fluid movement of goods, people, and
currency. )
 ASIAN AND AFRICAN TRADING BLOCKS ASEAN, APEC AFRICAN
COOPERATION COMMODITY AGREEMENTS BUFFER-STOCK SYSTEM
MULTIFIBER ARRANGEMENT (MFA)
 THE UNITED NATIONS UNCTAD IX - THE ENVIRONMENT THE RIO EARTH

By S.Ojha 45
 SUMMIT

ASEAN
The Association of Southeast Asian Nations is a political and economic organisation of
ten Southeast Asian countries. It was formed on 8 August 1967 by Indonesia, Malaysia,
the Philippines,Singapore, and Thailand. Since then, membership has expanded to
include Brunei, Cambodia, Laos, Myanmar (Burma), andVietnam. Its aims include
accelerating economic growth, social progress, and sociocultural evolution among its
members, protection of regional peace and stability, and opportunities for member countries
to resolve differences peacefully

PURPOSE

the aims and purposes of ASEAN are:

 To accelerate economic growth, social progress, and cultural development in the region.
 To promote regional peace and stability.
 To promote collaboration and mutual assistance on matters of common interest.
 To provide assistance to each other in the form of training and research facilities.
 To collaborate for the better utilisation of agriculture and industry to raise the living
standards of the people.
 To promote Southeast Asian studies.
 To maintain close, beneficial co-operation with existing international organisations with
similar aims and purposes.

SAARC

The South Asian Association for Regional Cooperation (SAARC) is

an economic and geopolitical organisation of eight countries that are primarily located
in South Asia or the Indian subcontinent. The SAARC Secretariat is based
in Kathmandu, Nepal. The combined economy of SAARC is the 3rd largest in the world in
the terms of GDP(PPP) after the United States and China and 5th largest in the terms
of nominal GDP.

The SAARC policies aim to promote welfare economics, collective self-reliance among the
countries of South Asia, and to acceleratesocio-cultural development in the region. The
SAARC has developed external relations by establishing permanent diplomatic relations
with the EU, the UN (as an observer), and other multilateral entities. The official meetings of
the leaders of each nation are held annually whilst the foreign ministers meet twice annually

By S.Ojha 46
By S.Ojha 47
 UNIT -5 Strategic Functions of International HRM
Key Challenges Influencing HR Practices and Processes within an International Context
When entering new markets, organizations are confronted with a wide range of challenges
mostly related to socio-economic, political and technological aspects.

Workforce Diversity

Canada's workforce diversity also produces a wide range of HR-related challenges,

including:

 The Integration and accommodation of an increased number of older workers and

employees with disabilities
 Gender issues
 Aspects related to ethnic and cultural differences amongst employees
The complexity of the current workforce diversity will grow with each foreign market
Canadian organizations decide to enter.
Employment Legislation
A wide range of home and host-country employment legislations represent a key challenge
to HR managers and the development and implementation of employment policies,
processes, and practices in Canadian organizations operating internationally.

The Role of the HR Function

Employment legislation, socio-economic, and technological differences in local markets
demand sophisticated IHRM systems. It is also critical that HR managers responsible for the
development and implementation of such systems are equipped with the necessary staff,
and are integrated in the organizational strategic decision-making process and the
development of organizational goals and objectives.

Flexibility
IHRM systems need to be flexible to quickly adjust their policies and practices to respond to
the changes.

Flexibility is defined as a firm's ability to respond to various demands from a dynamic

competitive environment. Advance IHRM systems can obtain a high level of fit and
flexibility by developing a strategic approach toward the management of international
workforces.

Strategic International HR Planning-

projecting global competence supply, forecasting global competence needs, and developing
a blueprint to establish global competence pools with companies. Strategic International HR

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Management- human resource management issues, functions, policies, and practices that
result from the strategic activities of multinational enterprises and that affect the
international concerns and goals of those enterprises.
Fit – the degree to which the needs, demands, goals, objectives, and/or structure of one
component are consistent with the need, demands, goals, objectives, and/or structure of
another component

Internal Fit-Focus on organization

External Fit- Focus on local environment

1. The Domestic Stage

Domestic strategy – internationalizing by exporting goods abroad as a means of seeking new
markets

2.The Multidomestic Stage

Multidomestic strategy – a strategy that concentrates on the development of foreign markets by
selling to foreign nationals
Adaptive IHRM approach – HRM systems for foreign subsidiaries that will be consistent with the
local economic, political, and legal environment
3.The Multinational Stage

Multinational strategy – standardizing the products and services around the world to gain
efficiency
Exportive IHRM approach – transferring home HRM systems to foreign subsidiaries
without modifying or adapting to the local environment
4. The Global Stage
Global strategy – introducing culturally sensitive products in chosen countries with the
least amount of cost

Integrative IHRM approach

– combining home HR practices with local practices and selecting the most qualified people
for the appropriate positions no matter where these candidates come from

Adaptive IHRM Approach- HRM systems that will be consistent with the local, economic,
political, and legal environment.

Key HR Practices and Processes Within an International Context Recruitment

One of the key strategic decisions in recruitment is the internal recruitment versus external
recruitment. This two-option decision has a three-option parallel in the international domain
and includes:

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Home-Country Nationals (HCNs): Individuals from the subsidiary country who know the
foreign cultural environment well.

Parent-Country Nationals (PCNs): Individuals from headquarters who are highly familiar
with the firm's products and services, as well as its corporate culture.

Third-Country Nationals: (TCNs): Individuals from a third country who have intensive
international experience and know the corporate culture from previous working experience
with corporate branches in a third country.

Strategic IHRM Flexibility

the ability to respond to ratio demands for a dynamic competitive environment. In an
international context, the changes are dramatic and fast paced. though they are different
from country to country. In such a dynamic global competitive environment, IHRM systems
need to be flexible to quickly adjust their polices and practices to respond to change.

Advantages(A) and Disadvantages(D) of Key Recuritment Options:

PCNs: *well versed in company's needs and norms (A)

* potential unfamiliarity with the cultural norms of the host country (D)
* potential blocking of HCNs career progression within the firm

HCNs: *familiarity with the host-country culture (A) * limited familiarity with firms own
operations (D)

TCNs: *greater familiarity with the host country culture than PCN's (A) * some cross-
cultural preparation may still be required (D)
* potentially suffering from a lack of knowledge of the corporate culture (D)
Using the five-factor personality model helps to identify those who will probably adjust well
to overseas assignments. The five factors are:

1. emotional
2. extraversion
3. openness
4.agreeableness
5.conscientiousness

EXPATRIATE PREPARATION AND DEVELOPMENT

 Pre-program assessment and exploration. This includes An assessment of the

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 expatriate’s and family members’ background and prior international experience,
understanding of the host culture, specific goals/concerns, and personal tendencies
should shape a customized expat and family training session.
 Expat and family training program. This stage is designed to increase the assignees’
knowledge about the host country, society, values, business culture, and day-to-day
living. Completing such training should result in significantly reduced risk of
cultural misunderstandings and an enhanced cross-cultural experience.
 Host manager and team cultural briefing. This next stage is focused on the host
country manager and the team with whom the international assignee will be
working, and provides insight into the cultural values and norms of the assignee
 Project alignment meeting. After the expatriate and host organization have received
critical information, it is time for an exchange, either in person or via telephone or
videoconference. A project alignment meeting with the assignee and host manager
should be held to discuss cultural differences that might affect the success of the
assignment, tools and techniques to prevent misunderstandings, and mutual
expectations of the assignee and the manager.
 In-country coaching. As soon as the expatriate arrives in the host country, new and
unknown situations inevitably occur. Therefore, an assignee should receive face-to-
face or telephone coaching. A coach monitors the assignee’s process during the
assignment and captures experiences, case studies, and best practices.
 Knowledge management process. Systematic and ongoing capture (and
dissemination) of relevant documentation and lessons learned from an expatriate
assignment is invaluable to the assignee, future expatriates, and the organization as a
whole. Knowledge management enables the organization to avoid repetitive
occurrences of known issues and over time, best practices and effective case studies
are developed.
Repatriation-
the process of PCNs, TCNs, or even HCNs returning to their home headquarters or
home subsidiaries.

Career Development after Repatriation:

-An international assignment should be seen as only one step in career development
-Managers should make sure that candidate's KSA's developed during assignment are
used:
 They can serve as a mentor or trainer to potential expatriates
 They can serve as a long distance supervisor to other expatriate.
 Another option is to remain a global manager and to move amongst subsidiaries
for the remainder of career

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Staffing Policy – Ethnocentric, Polycentric and Geocentric Approach

Ethnocentric Staffing
Ethnocentric staffing, which involves staffing the most important positions in foreign
subsidiaries with expatriates from the company's home country. Expatriates are often
believed to better represent the interests of the home office and ensure that the foreign
offices are aligned with home headquarters. In fact, many expatriates are selected from the
company's current employees and are simply transferred to a foreign subsidiary.
Ethnocentric staffing presents advantages and disadvantages. The obvious advantage to
ethnocentric staffing is the alignment of interests and perspective of the home office with all
foreign subsidiaries abroad. Communication is also easier because there should be no
language and cultural barriers. The company may also be able to transfer employees with a
clear performance record that will provide some level of predictability.
On the other hand, one can lose local perspective and insights that local employees can
provide that may help overcome unique hurdles in each foreign office. Moreover, hiring
expatriates tends to be expensive compared to hiring locally. Additionally, a high ratio of
expatriates may create local resentment at foreign subsidiaries, which may hurt morale.

Polycentric Staffing
In polycentric staffing, a company will hire host-country nationals for positions in the
company from mail room clerks all the way up to the executive suites. Polycentric staffing is
particularly feasible in developed countries, such as European countries, Canada, Australia
and Japan, where highly educated and trained employees can be easily located.

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Polycentric staffing has advantages and disadvantages. Host-country nationals will be able
to better guide the company on local market conditions, politics, laws and culture at each
foreign location. Use of local employees also sends a message to the country and its
consumers that the company is willing to make a commitment to the country and its people.
Local employees are also cheaper, as there are no relocation expenses and premium
compensation for working abroad.

GEOCENTRIC STAFFING
The geocentric staffing policy seeks the best people, regardless of nationality for key jobs
This approach is consistent with building a strong unifying culture and informal
management network .It makes sense for firms pursuing either a global or transnational
strategy .Immigration policies of national governments may limit the ability of a firm to
pursue this policy .
It enables the firm to make the best use of its human resources builds a cadre of international
executives who feel at home working in a number of different cultures can be limited by
immigration laws is costly to implement

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